Module 3: Cost Estimation Techniques

Chapter Objectives

At the end of this chapter, you will be able to:

• Discuss the techniques of cost estimation

• Apply cost analysis in design decision

2
Economic Analysis
 Cash Flow Estimation

 Estimating the future cash flows for feasible alternatives is a

critical step in engineering economy studies.
 Estimating costs, revenues, useful lives, residual values, and
other pertinent data can be the most difficult, expensive, and
time-consuming part of the study
 Case Study – iPhone X

Apple’s 64GB iPhone X is priced at $1,000

(RM3,499). Do you know the profit margin
for Apple from selling an iPhone X?

The estimated production cost of the iPhone

X is around $412.75. That's about 59%
cheaper than the $999 retail starting price
for the 64GB model.

How does Apple come up with such an

estimate of various component costs before
pricing their product?

Unsurprisingly, the most expensive part of

the iPhone X is the Samsung-made 5.8-inch
Super Retina display
 Cost Estimation

Results of cost estimating are used for a

variety of purposes.
 Setting selling prices for quoting, bidding, or
evaluating contracts.
 Determining if a proposed product can be made and
distributed at a profit. (Price = Cost + Profit)
 Evaluating how much capital can be justified for
changes and improvements.
 Setting benchmarks for productivity improvement
programs.
The costs incurred to generate particular revenue should
be recognized as expenses in the same period that the
revenue is recognized
 Example 1 – Manufacturing Overhead

General Cost Terms in Manufacturing Setting

 Manufacturing Costs
 Direct Raw Materials
 Direct Labor
 Manufacturing Overhead
 Nonmanufacturing Costs
 Overhead
 Marketing
 Administrative Functions
 Cost Estimation Techniques

The two fundamental approaches are “top-down” and

“bottom-up.”

 Top-down uses historical data from

similar projects. It is best used when
alternatives are still being developed
and refined.
 Bottom-up is more detailed and works
best when the detail concerning the
desired output (product or service) has
been defined and clarified.
 Integrated Cost Estimation

The integrated cost estimation approach has three

major components.
 Work breakdown structure (WBS)
 Cost and revenue structure (classification)
 Estimating techniques (models)
 Integrated Cost Estimation
Cost Estimation Flowchart

Integrated Approach for Developing the Cash Flows for Alternatives

 1-Work Breakdown Structure

Work Breakdown Structure (WBS)

 A basic tool in project
management
 A framework for defining all
project work elements and
their relationships, collecting
and organizing information,
developing relevant cost and
revenue data, and
management activities.
 Each level of a WBS divides
the work elements into
increasing detail.
WBS Template
 Example 2 – Period & Product Costs

 Period costs
 General and administrative
expenses
 Marketing expenses
 Insurance premiums
 Income taxes
 Nonmanufacturing costs
 Product costs
 Direct material costs
 Direct labor costs
 Manufacturing overhead
Example 2 – Period & Product Costs (Ice-cream)

 Breakdown of unit cost items

The annual sales volume (the number of

ice cream cones sold) averages around
185,000 cones, bringing in revenue of
$462,500. The table shows the unit price
of an ice cream cone and the costs that
go into producing the product. If you
were to classify the operating costs into
either product costs or period costs, how
would you do it?
Example 2 – Period & Product Costs (Ice-cream)

 Breakdown of unit cost items  Product costs

 Period costs
 WBS Characteristics

A WBS has other characteristics.

 Both functional and physical work elements

are included.
 The content and resource requirements for
a work element are the sum of the activities
and resources of related sub-elements
below it.
 A project WBS usually includes recurring
and nonrecurring work elements.
 2-Cost and Revenue Structure

 Used to identify and categorize the costs and revenues that need
to be included in the analysis.
 The life-cycle concept and WBS are important aids in developing
the cost and revenue structure for a project.
 Perhaps the most serious source of errors in developing cash
flows is overlooking important categories of costs and revenues.
Typical Costs and Revenues

 Capital Investment (fixed and working)

 Labor Costs
 Material Cost
 Maintenance Costs
 Property Taxes and Insurance
 Overhead Costs
 Disposal Costs
 Revenues based on sale, etc.
 Quality (and scrap) Costs
 Market (or salvage) values
Example 3 – Costs & Revenues
 3-Estimating Techniques (Models)

REMEMBER! The purpose of estimating is to develop cash-flow

projections—not to produce exact data about the future, which is
virtually impossible. Cost and revenue estimates can be classified
according to detail, accuracy, and their intended use.
 Order-of-magnitude estimates (±30%) – (planning & initial evaluation)
 Semidetailed or budget estimates (±15%) – (preliminary or conceptual)
 Definitive (detailed) estimates (±5%) – (detail engineering/construction)
 Estimation Details

The level of detail and accuracy of estimates depends on

 Time and effort available as

justified by the importance of the
study,
 Difficulty of estimating the items in
question,
 Methods or techniques employed,
 Qualifications of the estimator(s),
and
 Sensitivity of study results to
particular factor estimates.
 Estimation Data

A variety of sources exist for cost and revenue estimation.

 Accounting records: good for
historical data, but limited for
engineering economic analysis.
 Other sources inside the firm: e.g.,
sales, engineering, production,
purchasing.
 Sources outside the firm: U.S.
government data, industry surveys,
trade journals, and personal contacts.
 Research and development: e.g., pilot
plant, test marketing program,
surveys.
 Selecting Estimating Techniques (Models)

These models can be used in many types of estimates.

 Indexes
 Unit technique
 Factor technique
 Cost-Price Index

Indexes, I, provide a means for developing present and

future cost and price estimates from historical data.
Eq. 3-1

k = reference year for which cost or price is known.

n = year for which cost or price is to be estimated (n>k).
Cn = estimated cost or price of item in year n.
Ck = cost or price of item in reference year k.
In = price index in year n
Ik = price index in year k

Indexes can be created for a single item or for multiple items (Eqs. 3-1, 3-2).
 Exercise 1 – Costs (Price Index)

In 2011 Acme Chemical purchased a large pump for $112,000. Acme keys
their cost estimating for these pumps to the industrial pump index, with a
baseline of 100 established in 2001. The index in 2011 was 212. Acme is
now (2019) considering construction of a new addition and must estimate the
cost of the same type and size of pump. If the industrial pump index is
currently 286, what is the estimated cost of the new pump?
𝐼𝑛ҧ
Cost of the new pump (using Eq. 3-1) 𝐶𝑛 = 𝐶𝑘
𝐼𝑘ҧ

𝑘 = 2011; 𝑛 = 2019; ҧ
𝐼2011 = 212; ҧ
𝐼2019 = 286; 𝐶2011 = $112,000; 𝐶2019 =?

𝐼𝑛ҧ
𝐶𝑛 = 𝐶𝑘
𝐼𝑘ҧ
ҧ
𝐼2019 283
𝐶2019 = 𝐶2011 = $112,00 = $151,094
ҧ
𝐼2011 212
 Cost-Unit Technique

The unit technique is one that is widely known and

understood.
A “per unit factor” is used, along with the
appropriate number of units, to find the total
estimate of cost. An often used example is the cost
of a particular house. Using a per unit factor of,
say, $120 per square foot, and applying that to a
house with 3,000 square feet, results in an
estimated cost of $120 x 3,000 = $360,000.

This techniques is useful in preliminary estimates,

but using average costs can be very misleading.
 Cost-Unit Technique

The unit factor used…..

• Capital cost of plant per kilowatt of capacity
• Revenue per mile
• Capital cost per installed telephone
• Revenue per customer served
• Temperature loss per 1,000 feet of steam pipe
• Operating cost per mile
• Construction cost per square foot
 Cost - Factor Technique

The factor technique is an extension of the unit technique

where the products of several quantities are summed and
then added to components estimated directly.
C = cost being estimated
Cd = cost of the selected component d
estimated directly
fm = cost per unit of component m
Um = number of units of component m
 Exercise 2 – Costs (Factor Technique)

The first floor of the building has 15,000 gross square feet of retail space, and
the second floor has the same amount planned for office use. Based on
discussions with the sales staff, the following additional information were
develop:
(a) The retail space should be designed for two different uses—60% for a
restaurant operation (utilization = 79%, yearly rent = $23/sq.ft.) and 40%
for a retail clothing store (utilization = 83%, yearly rent = $18/sq.ft.).
(b) There is a high probability that all the office space on the second floor will
be leased to one client (utilization = 89%, yearly rent = $14/sq.ft.).
(c) An estimated 20 parking spaces can be rented on a long-term basis to two
existing businesses that adjoin the property. Also, one spot along the road
frontage can be leased to a sign company, for erection of a billboard, without
impairing the primary use of the property.

Estimate the annual project revenue.

 Exercise 2 – Costs (Factor Technique)

𝑅𝑒𝑣𝑒𝑛𝑢𝑒, 𝑅 = 𝑊 𝑟1 12 + 𝑉 𝑟2 12 + ෍ 𝑆𝑗 (𝑢𝑗 )(𝑑𝑗 )

𝑗=1
𝑤ℎ𝑒𝑟𝑒 𝑊 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑎𝑟𝑘𝑖𝑛𝑔 𝑠𝑝𝑎𝑐𝑒𝑠 = 20
𝑉 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑏𝑖𝑙𝑙𝑏𝑜𝑎𝑟𝑑𝑠 = 1
𝑟1 = 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ 𝑝𝑒𝑟 𝑝𝑎𝑟𝑘𝑖𝑛𝑔 𝑠𝑝𝑎𝑐𝑒 = $22
𝑟2 = 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ 𝑝𝑒𝑟 𝑏𝑖𝑙𝑙𝑏𝑜𝑎𝑟𝑑 = $65
𝑗 = 𝑖𝑛𝑑𝑒𝑥 𝑜𝑓 𝑡𝑦𝑝𝑒 𝑜𝑓 𝑏𝑢𝑖𝑙𝑑𝑖𝑛𝑔 𝑠𝑝𝑎𝑐𝑒 𝑢𝑠𝑒
𝑆𝑗 = 𝑠𝑝𝑎𝑐𝑒 𝑔𝑟𝑜𝑠𝑠 𝑠𝑞𝑢𝑎𝑟𝑒 𝑓𝑒𝑒𝑡 𝑏𝑒𝑖𝑛𝑔 𝑢𝑠𝑒𝑑 𝑓𝑜𝑟 𝑝𝑢𝑟𝑝𝑜𝑠𝑒 𝑗
𝑢𝑗 = 𝑠𝑝𝑎𝑐𝑒 𝑗 𝑢𝑡𝑖𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑓𝑎𝑐𝑡𝑜𝑟 % 𝑛𝑒𝑡 𝑟𝑒𝑛𝑡𝑎𝑏𝑙𝑒
𝑑𝑗 = 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑟𝑒𝑛𝑡𝑎𝑏𝑙𝑒 𝑠𝑞𝑢𝑎𝑟𝑒 𝑓𝑜𝑜𝑡 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 𝑜𝑓 𝑏𝑢𝑖𝑙𝑑𝑖𝑛𝑔 𝑠𝑝𝑎𝑐𝑒 𝑢𝑠𝑒𝑑 𝑓𝑜𝑟 𝑝𝑢𝑟𝑝𝑜𝑠𝑒 𝑗

𝑅 = 20 $22 12 + 1 $65 12
+[(0.6)(15,000) 0.79 $23 + (0.4)(15,000 0.83 $18 + 15,000 0.89 $14 ]
𝑅 = $6,060 + $440,070 = $446,130
 Parametric Cost-Price Estimating

 Parametric cost estimating is the use of historical cost data and

statistical techniques (e.g., linear regression) to predict future costs.
 Parametric models are used in the early design stages to get an idea of
how much the product (or project) will cost, on the basis of a few
physical attributes (such as weight, volume, and power).
 Case Study 1 – Power Sizing

The power-sizing technique (or exponential model) is frequently

used for developing capital investment estimates for industrial
plants and equipment.

Eq. 3-4

(both in $ as of the point in time for which

the estimate is desired)

(both in the same physical units)

 Exercise 2 – Costs

Acme Logistics provides “less than truck load” (LTL) services throughout the U.S.
They have several hubs where they use cross-docking to move goods from one
trailer to another. Acme built its last hub 10 years ago, and it had 36 dock doors.
The cost index at that time was 140, and the total cost was $6 million. Acme plans
a new hub that will have 48 dock doors. The cost index now is 195, and Acme will
use a capacity factor of 0.82. What is the estimated cost of the new hub?
𝑋
𝐼𝑛ҧ 𝑆𝐴
Cost of the new hub (using Eqs. 3-1 and 3-4) 𝐶𝑛 = 𝐶𝑘
𝐼𝑘ҧ
𝐶𝐴 = 𝐶𝐵
𝑆𝐵
ҧ
𝐼−10 ҧ
= 140; 𝐼𝑛𝑜𝑤 = 195; 𝑆−10 = 36; 𝑆𝑛𝑜𝑤 = 48; 𝐶−10 = $6,000,00; 𝑋 = 0.82;
𝐶𝐴 =? ; 𝐶𝐵 =?
𝐼𝑛ҧ ҧ
𝐼𝑛𝑜𝑤 195
𝐶𝑛 = 𝐶𝑘 𝐶𝐵 = 𝐶−10 = $6,000,000 = $8,357,143
𝐼𝑘ҧ ҧ
𝐼−10 140

𝑋 0.82
𝑆𝐴 48
𝐶𝐴 = 𝐶𝐵 = $8,357,143
𝑆𝐵 36
= $10,580,534
 Case Study 2 – Learning Curves

A learning curve reflects increased efficiency and performance with

repetitive production of a good or service. The concept is that some
input resources decrease, on a per-output-unit basis, as the number
of units produced increases.
Most learning curves assume a constant percentage reduction
occurs as the number of units produced is doubled.
 Exercise 3 – Learning Curve

Assume the first unit of production required 3 hours time for

assembly. The learning rate is 75%. Find
(a) the time to assemble the 8th unit, and
(b) the time needed to assemble the first 6 units.

log 𝑠 log 0.75

𝑍𝑈 = 𝐾(𝑢𝑛 ) 𝐾 = 3; 𝑢 = 8; 𝑛 = =
log 2 log 2

𝑎 𝑍8 = 3 8(log 0.75Τlog 2) = 1.27 ℎ𝑜𝑢𝑟𝑠

𝑥 6
𝑏 𝑇𝑥 = 𝐾 ෍ 𝑢𝑛 𝑇6 = 3 ෍ 𝑢(log 0.75Τlog 2)
𝑢=1 𝑢=1

𝑇6 = 3 3.9346 = 11.8 ℎ𝑜𝑢𝑟𝑠

 Cost Estimating Relationship

A cost estimating relationship (CER) describes the cost

of a project as a function of design variables.

There are four basic steps in developing a CER.

 Problem definition
 Data collection and normalization
 CER equation development
 Model validation and documentation
 Cost Estimating Relationship
(CER)

Type of Relationship Generalized Equation

Linear 𝐶𝑜𝑠𝑡 = 𝑏0 + 𝑏1 𝑥1 + 𝑏2 𝑥2 + ⋯
Power 𝑏 𝑏
𝐶𝑜𝑠𝑡 = 𝑏0 + 𝑏1 𝑥1 11 𝑥2 12 + ⋯
Logarithmic 𝐶𝑜𝑠𝑡 = 𝑏0 + 𝑏1 log 𝑥1 + 𝑏2 log 𝑥2 + ⋯
Exponential 𝐶𝑜𝑠𝑡 = 𝑏0 + 𝑏1 𝑒𝑥𝑝𝑏11𝑥1 + 𝑏2 𝑒𝑥𝑝𝑏22𝑥2 + ⋯

𝑦 = 𝑏0 + 𝑏1 𝑥
𝑛 σ𝑛𝑖=1 𝑥𝑖 𝑦𝑖 − σ𝑛𝑖=1 𝑥𝑖 σ𝑛𝑖=1 𝑦𝑖
𝑏1 = 2
𝑛 σ𝑛𝑖=1 𝑥𝑖2 − σ𝑛𝑖=1 𝑥𝑖

σ𝑛𝑖=1 𝑦𝑖 − 𝑏1 σ𝑛𝑖=1 𝑥𝑖
𝑏0 =
𝑛
Cost Estimating Relationship
(CER)

σ𝑛𝑖=1(𝑦𝑖 − 𝐶𝑜𝑠𝑡𝑖 )2 Standard Error

𝑆𝐸 =
𝑛−2

σ𝑛𝑖=1(𝑥𝑖 − 𝑥)(𝑦
ҧ 𝑖 − 𝑦)
ത
𝑅=
Correlation Coefficient
σ𝑛𝑖=1(𝑥𝑖 − 𝑥)ҧ 2 σ𝑛𝑖=1(𝑦𝑖 − ത 2
𝑦)
 Example 3-8 & 3-9 (CER)
In the early stages of design, it is believed that the cost of a Martian rover
spacecraft is related to its weight. Cost and weight data for six spacecraft
have been collected and normalized and are shown in the next table. A
plot of the data suggests a linear relationship. Use a spreadsheet model to
determine the values of the coefficients for the CER.

Spacecraft Weight (lb) Cost ($ million)

i xi yi
1 400 278
2 530 414
3 750 557
4 900 689
5 1,130 740
6 1,200 851
 Example 3-8 & 3-9 (CER)
40

I xi yi x i2 x iyi Costi (yi-Costi)2 (x-x')(y-y') (x-x') 2 (y-y') 2

1 400 278 160,000 111,200 312.18 1,168.08 129,753 175,003 96,203.36
2 530 414 280,900 219,420 397.94 257.83 50,218 83,136 30,334.03
3 750 557 562,500 417,750 543.08 193.64 2,130 4,669 971.36
4 900 689 810,000 620,100 642.05 2,204.76 8,235 6,669 10,167.36
5 1,130 740 1,276,900 836,200 793.78 2,892.75 47,321 97,136 23,053.36
6 1,200 851 1,440,000 1,021,200 839.97 121.75 100,315 145,669 69,081.36
TOTAL 4,910 3,529 4,530,300 3,225,870 3,529.00 6,838.82 337,972 512,283 229,811

b1 0.6597 𝑛 σ𝑛𝑖=1 𝑥𝑖 𝑦𝑖 − σ𝑛𝑖=1 𝑥 𝑖 σ𝑛𝑖=1 𝑦𝑖 SE 41.34857

𝑏1 = 2 σ𝑛𝑖=1(𝑦𝑖 − 𝐶𝑜𝑠𝑡𝑖 )2
b0 48.283 𝑛 σ𝑛𝑖=1 𝑥 2𝑖 − σ𝑛𝑖=1 𝑥𝑖 𝑆𝐸 =
𝑛−2
R 0.985008
σ𝑛𝑖=1 𝑦𝑖 − 𝑏1 σ𝑛𝑖=1 𝑥 𝑖
𝑏0 = σ𝑛𝑖=1(𝑥 𝑖 − 𝑥ҧ )(𝑦𝑖 − 𝑦ത)
𝑛 𝑅=
x' 818.33 σ𝑛𝑖=1(𝑥𝑖 − 𝑥ҧ) 2 σ𝑛𝑖=1(𝑦𝑖 − 𝑦ത) 2
y' 588.17

y = 48.2829 + 0.6597358 x

𝑦 = 𝑏0 + 𝑏1 𝑥
 Summary
41

 Engineering economic analysis require cash flow

projection to determine worthiness of engineering projects.

 Integrated cash flow analysis must include (1) WBS

definition, (2) cost revenue structure, (3) estimation
techniques.

 estimating techniques form a bridge between the WBS and

detailed cost and revenue data and the estimated cash
flows for the alternatives.