Cost Engineering Tools and Techniques

COST ENGINEERING
TOOLS & TECHNIQUES
IGNACIO MANZANERA
2011
Foreword
A project manager is ultimately the person at the top of the team, the person who has
made it happened at least once, but there is no more security at the top than anywhere
else. Success sets traps for executives who are cost-naive and keep their projects from
achieving their full potential. The farther a project manager moves from the cost roots of
the business, the harder it is to keep up with what's happening in that business.
Most executives work, live, lunch and play golf or tennis with the same people. That
means that all of their person-to-person contact is with people who live, work, and think
alike.
Once you start believing your own press releases, you are in trouble.
This gradual isolation from reality is a trap you must fight from the beginning of your
projects. You must work to keep lines of communication open, and you must make
certain that communication comes up to you from the bottom and from cost-crunching
employees.
There are many true methods to achieve this. You can use cost advisory committees,
market analysts, employee surveys, and suggestion boxes. One of your musts should be
maintaining full contact with cost-conscious people. Another is to make sure you are
getting your cost engineering information from a wide variety of sources.
Francis Bacon once said: "He that gives good advice builds with one hand. He that gives
good counsel and example builds with both. But he that gives good admonition and bad
example builds with one hand and pulls down with the other." Ignoring cost engineering
as a project management essential is a recipe for failure and financial ruin on projects
regardless of the fact good substantial efforts might have been input.
Cost engineering and its many tools and techniques give project managers the
opportunity and the basis to take decisions where and when they are needed. Most skills
on this field are pretty straight forward and easy to digest, they will also provide needed
advice before unsuspected project realities endangers your project and your organization.
Cost engineering form premises leading to useful conclusions and make project
managers look innovative, able to take the information and resources at hand and give
their teams a competitive edge.
2
TABLE OF CONTENTS
1 of 4
Subject Page
Chapter I
Cost Mathematics 7
Time Value of Money 8
Discrete Compound Interest 8
Uniform Series 12
Continuous Interest 14
Problems 16
References 18
Chapter II
Profitability and Investment Appraisal 19

Payback Method with Interest 20
Return on Original Investment 21
Discounted Cash Flow Methods 22
Discounted Cash Flow Rate of Return 24
Benefit – Cost Analysis 26
Cost of Capital 27
Life Cycle Cost 28
Chapter III
Break-even Analysis 29
Break-even Analysis Assumptions 31
Dumping 31
Non-Linear Break-even Analysis 32
Marginal Costs 32
Lagrange Equation 34
3
TABLE OF CONTENTS
2 of 4
Subject Page
Chapter IV
Decision Making Tools 36

Expected Value 37
The Random Demand Problem 38
Marginal Probability Analysis 40
Maximim Rule 42
Minimax Regret Rule 43
Expected Opportunity Loss Value 45
Simulation 46
Montecarlo Technique 46
Simulation Problem 50
Chapter V
Forecasting 54
Linear Regression 54
Exponential Function 56
Logarithmic Function 58
Learning Curve 60
Learning Curve for Group Data 66
Chapter VI
Linear Programming 69
The Simplex Method 73
The Simplex Method for Minimizing 77
The Transportation Problem 88
The Assignment Problem 95
Maximizing with the Assignment Method 97
4
TABLE OF CONTENTS
3 of 4
Subject Page
Chapter VII
Constructability 98
Essential Elements of Constructability 99
Constructability Culture 100
Constructability Concepts 100
Design Phase 101
Development Phase 106
Sequence work for optimum efficiency 110
Chapter VIII
Cost Estimating 112

Cost Indexes 114
Cost Factors 116
Equipment Cost by Scaling 118
Turnover Ratios 119
Lang Factors Method 120
Parametric Cost Estimating 121
Range Estimating 126
Chapter IX
Planning and Scheduling 132

Planning Tools 134
Critical Path Method 135
Preliminary Steps for Processing a Network 138
Network Analysis of Engineering Projects 142
Network Construction 149
Lag Factors 150
CPM Implementation Recommendations 151
Scheduling Expressions 154
5
TABLE OF CONTENTS
4 of 4
Subject Page
Chapter X
Cost Engineering Complements 158

Value Analysis 158
Engineering Value Analysis 159
Accounting 160
Cost Accounting 162
Cost Classification 162
Costing 164
Joint Cost Allocation Methods 165
Overhead Allocation 169
Activity Based Costing 173
References 175
Chapter XI
Contracting Basics 176

Parties to a Contract 177
Contract Responsibility 177
Contract Strategy 178
Successful Contracting Attributes 179
Contracting Clauses 182
Pre-contracting Activities 183
Forms of Contract 187
Reimbursable Cost Contracts 187
Target Contracts 189
Measured Contracts 190
Lump Sum / Fixed Price Contracts 191
Appendix A – Interest tables 193
6
Chapter I
Cost Mathematics
This chapter introduces mathematical tools, based on the concept of the time value of
money, which can be used to determine (compare) the cost efficiency among several
financing alternatives.
A systematic approach to such efficiency problems will be established using the tools of
cost mathematics.
Cost Diagrams
A cost diagram represents the amount and timing of receipts and expenditures.
If $100 is spent now and $200 will be received 3 months from now the cost diagram
depicting the operation may be drawn as follows:
Income is always represented on top of the line and expenditures below the line.
The unlabeled vertical lines indicate units of time, in this case months. Other time periods
may be used.
7
Time Value Of Money
The value of money changes with time at the on-going interest rate. If the current interest
rate is 10% per year, $100 will be worth $110 a year form now. Conversely, if $110 will
be received one year from now, its value today would be $100.
Discrete Compound Interest
If a present value P earns an interest ‘i’ per year, its value at the end of the first year F1 is
given by the following equation:
F1 = P + P i (1-1)
or, F1 = P (1+i) (1-2)
where i = decimal interest rate or nominal rate of return
F1 then becomes the starting value for the second year, and its value at the end of the
second year F2 will be given by:
F2 = F1 + i F1
or, F2 = F1 (1+i)
or, F2= P (1+i) (1+i) = P (1+i)2 (1-3)
If the same procedure is continued for n years, the value of Fn at the end of year ‘n’ will
be given by:
Fn = P (1+i)n (1-4)
P is said to be compounding at (1+i) interest factor.
The compounding is considered to be discrete because it is applied yearly. The

compounding factor (1+i) is called (F/P,i,n) and reads as follows:
(F/P,i,n) = Factor for transforming a present value P to a future value F at the i rate of
return for n years . (Tabulated in Appendix A)
Expression (1-4) may now be written as follows:
F = P (F/P, i,n) (1-5)
8
If compounding occurs p times per year equation (1-4) changes to:
F = P (1+i/p)np (1-6)
Manipulating equation (1-6), it becomes:
F = P [ (1+i/p)p]n (1-7)
The expression inside the brackets is the value of 1 at the end of 1 year. Therefore,
(1+i/p)p - 1 = Effective rate of return
The following example illustrates the difference between nominal and effective rates of
return.
Example 1.-Find the difference between the value of $100 one year from now at 10%
compounded yearly and the same amount at 10% compounded monthly.
Utilizing equation (1-4):
10% yearly: F1 = 100 (1+0.10)1
F1 = $110
Utilizing equation (1-7):
10% monthly: F1 = 100 [ ( 1+ 0.10/12)12 ]1
F1 = $110.47
When the timing of discrete compounding involves a fraction of a year, the following
relationship may be utilized:
F = P ( 1+ Q i) (1-8)
where Q = fraction of the year
Example 2.- Find the value of $1,000 compounded annually at 12% for 3 months.
By equation (1-8) and given that Q= 3/12:
F = 1,000 [ 1 +(3/12) 0.12 ]
F = 1,030
9
The relationship given by equation (1-4) may be manipulated to find the present value P
when the future value F is the known variable as follows:
P = F / (1+i)n (1-9)
and P = F (P/F,i,n) (1-10)
Where factor (P/F,i,n) = the factor that transforms the future value F to a present value P
at the ‘i’ interest rate for n number of periods.
Factors (F/P,i,n) and (P/F,i,n) for different interest rates and different durations are
tabulated in Appendix A, at the end of this book.
Example 3.- If money is worth 10 percent per year, find the present value of a $1,000
payment 5 years from now.
P = 1,000 (P/F, 10%,5)
from the tables (P/F, 10%,5) = 0.62092
Therefore, P = 1,000 x 0.62092
P = $ 620.92
Example 4.- If money is worth 8 percent per year, find the value of the following
expenditures and incomes 5 years from now.
Expenditures Income
First Year $ 1,000 $ 3,000
Second Year 800 2,500
Third Year 900 2,800
10
The above cost diagram can be reduced to:
Then, F = 2,000 (F/P, 8%,4) + 1,700 (F/P, 8%,3) + 1,900 (F/P, 8%,2)
F = 2,000(1.3605) + 1,700(1.2597) + 1,900(1.1664)
F = $ 7,078.65
Discount Factor for Discrete Compounding
11
Uniform Series
Uniform series is a uniform amount of money expended or received at regular intervals

for a given number of years.
The following cost diagram illustrates the concept of uniform series, where A is the
uniform amount.
As a receipt:
As an expense:
The present value of the above diagrams is given by the following equation:
P = A {(1+i)n - 1} / [i(1+i)n ] (1-10)
or,
P = A (P/A,i,n) (1-10a)
where, (P/A,i,n) reads: factor to convert a uniform series to present value at the ‘i’ rate
of return for n years.
There is another factor (F/A,i,n) to convert a uniform series to a future value or,
F = A (F/A,i,n) (1-11)
12
Example 5.-A person wants to receive an uniform amount of money for the next 5 years
by investing $ 5,000 now. If money is worth 8 percent per year, find the uniform amount
he or she will receive.
P = A (P/A,8%,5)
A = 5,000/(P/A,8%,5)
A = 5,000 / 3.9927
A = $ 1,252.28
Example 6.- An investor has been receiving $1,500 a year for the past 5 years. If money
is worth 10 percent per year, what is the value of the payments as today?
F = 1,500 + A (S/A,10%,4)
S/A,10%,4 = (P/A,10%,4)*(F/P,10%,4) = (3.1699)(1.4641) = 4.641
S = 1,500 + 1,500 x 4.641 = 1,500 + 6,961.57 = $ 8,461.57
13
Continuous Interest
Equation (1-6) earlier in this chapter gives the mathematical expression to calculate
compounding interest when it is done at time intervals of less than a year, or:
F = P [1+(i/p)]np (1-6)
Setting p to an infinite value (or continuous compounding), the expression, (1+i/p)p

becomes equal to e where e is equal = 2.71828 and equation (1-6) above becomes,
F = P eIn (1-13)
-In
and P =Fe (1-14)
I = yearly continuous compounding interest
Equation (1-13) above transforms a present value to a future value when compounding
is done continuously at the I rate of interest for n years.
Equation (1-14) above transforms a future value to a present value when compounding is
done continuously at the I rate of interest for n years.
Appendix A-1 gives the values of eIn for different interest and durations.
Following the nomenclature utilized earlier in this chapter,
(F/P,I,n) = eIn (1-15)

and, (P/F,I,n) = e-In (1-16)
14
Capital Recovery Factors
Capital investments are costs incurred at the beginning of the project. These costs are
frequently financed with borrowed funds. This borrowed money and accrued interest are
repaid with income received later in the project from the sale of products, or from taxes.
The constant annual payment to repay the financed amount is determined by multiplying
the borrowed amount by the capital recovery cost CRF (i, n) which is calculated by:
CRF (i, n) = i / [ 1- (1 + i)-n] (1-17)
Where I is the interest rate expressed as a decimal and n is the number of interest periods.
The table shown in appendix A lists capital recovery factors per unit of currency as a
function of interest rate and length of financing term.
Example 8.- Find the monthly payments of a $50,000 mortgage over 10 years at 10%
percent continuous compounding interest per year.
Utilizing equation (1-17) above,
CRF = 0.10 / [1 – ( 1 + 0.10)–10]
CRF (10%,10) = 0.16275
Annual payment = 50,000 (0.16275) = $ 8,137.5/year
Monthly payment = 8,137.5 / 12 = $ 678.13
15
Problems
1-1
If money is worth 8 percent per year and the following receipts and payments are due as
shown in the following cost diagram,
3,000 2,000
|______|______|______|______|
1,500 800
Find the following:
a) The present value of total receipts and payments together

b) The Uniform end of the year amount that will represent all receipts and
payments
1-2
What is the present worth of a series of equal end of the year payments of $2,500 for 5
years if money is worth 10 percent per year?
1-3
A person owes $10,000 and is making end of the year payments of $1,500.
If money is worth 8 percent per year, how long will he (she) take to discharge the debt?
1-4
A company is interested in changing its manual operation on which cost is running at

$200,000/year.
The alternative is automation for which running cost would be $50,000/year and would
last 5 years.
If money is worth 8 percent per year, how much can the company spend in automation,
without paying more than the current manual operation?
16
1-5
A company will invest $45,000 now in repairing some of its equipment to avoid more
costly repairs four years from now.
If the repair cost, four years from now, is forecasted to be $150,000, what rate of return is
earned by repairing now?
1-6
How long will it take for money to double if compounded annually at 8%?
1-7
An automobile can be purchased as follows,
- $2,000 down payment
- $255 a month for 48 months
If money is worth 12% percent per year compounded monthly what is the automobile's
cash cost?
1-8
A manufacturing company has two options for buying new equipment as follows:
Option A.- Pay $ 450,000 cash now
Option B.- Pay $ 250,000 cash now, $ 100,000 a year from

now and 200,000 three years from now.
What option is better and by how much, if money is worth 8% per year?
17
REFERENCES
Weston J. F. and E.F. Brigham,: "MANAGERIAL FINANCE" Dryden Press,

1979
Jelen F.C.and J.H.Black,:"COST AND OPTIMIZATION ENGINEERING" McGraw-

Hill, 1982
Lucey T.,: "QUANTITATIVE TECHNIQUES" D.P. Publications 1983
Peters M.S. and K.D.Timmerhaus,:"PLANT DESIGN AND ECONOMIC FOR

CHEMICAL ENGINEERS" McGraw-Hill, 1976
Ernest J.W. and C.L. Ernest.: "BASIC BUSINESS MATHEMATICS", Glencoe

Publishing Co., Inc. 1972
Emory C.W. : "BUSINESS RESEARCH METHODS" , R.D. Irwin Inc.
Pfaffenberger R.C. and D.A. Walker,: " MATHEMATICAL PROGRAMMING FOR

ECONOMICS AND BUSINESS", The Iowa U. Press, 1976
Hackney J.W.,: "MANAGEMENT OF CAPITAL PROJECTS", John Wiley & Son,

1965
Buffa E.S. : "MODERN PRODUCTION MANAGEMENT", John Wiley & Son 1965
Specthrie S.W. : "INDUSTRIAL ACCOUNTING" , Prentice-Hall, Inc., 1959
18
Chapter II
Profitability and Investment Appraisal

Because future events cannot be predicted with total accuracy, uncertainty is an inherent
component of the investment decision-making process.
Events beyond control of the decision-maker, such as new laws and regulations, changing
market standards and competitive pressures affect the accuracy of projection and
estimates.
Investment decisions are influenced by a variety of factors including attitude toward and
perception of risk, possible investment alternatives and the amount of information
available.
Profitability Techniques
Payback without interest
This method calculates the time required for the cash inflows to equal the original cash
outlays. The time value of money is not taken into consideration.
Time is usually expressed in years. The following example illustrates the method.
Three projects are being appraised for profitability by the payback method. The cash flow
of the projects is as follows:
Find the projects ranking. (Most to least profitable)
Therefore, the ranking is B – C – A
19
Payback Method with Interest
The difference between this method and the previous one is the investment charge on the
remaining fixed investment introduced by this procedure.
Utilizing the same example:
Therefore, the projects ranking is B – C – A.
20
Return on Original Investment
This method analyzes the ratio of average annual cash flow to the original investment,
including items as expressed by the following mathematical equation:
Average Annual Cash Flow (during earning life) * 100

ROI =
Original Investment + Non-Depreciable Amounts
The result is expressed as a percentage.

For our example:
Therefore the ranking is B – C – A.
21
While this method provides an indication of the total cash flow return in an investment, it
does not consider the timing of payments or the time value of money.
Discounted Cash Flow Methods
These methods are more sophisticated analyzes because they take into consideration the
time value of money. However, they do not recognize the uncertainty of inflation and
assume the existence of a perfect capital market as well as unlimited access to fund at the
on-going rate of interest.
When combined with other decision-making tools, discounted cash flow analyzes can
provide a useful and important guide for profitability appraisal.
Net Present Value
This profitability appraisal method is based upon the calculation of the present value of
all expected cash inflows and outflows at a given rate of return which is considered
acceptable by the investor.
The project is considered to be acceptable if the net present value is positive at the given
rate.
The following page shows the application of this method to the problem we are
following.
22
Therefore all projects are acceptable at the rate of 10%.
23
Discounted Cash Flow Rate of Return (DCFRR)
This profitability appraisal procedure is also known as the Investor Method or the
Internal Rate of Return.
It calculates the discount rate at which the net present value equals zero. A project is
acceptable if the opportunity cost of capital is less than the discounted cash flow.
A trial and error approach can be used to arrive at the rate of return that equates the sum
of the total outflows present values to the sum of the total inflows present values.
Also by first drawing a graph of net present values against discount rates, the number of
trials can be reduced. The following workout illustrates the procedure.
Following our example of projects:
Project A net present value at 10% = 489.69, at 14% = -522
Project B net present value at 20% = -$138.96, at 16% = $438.62
24
Project C net present value at 20% = $636.51, at 25% = -$243.2
Therefore, the ranking according to the DCFRR criterion is: C – B – A.
25
As it has been noticed through all the profitability methods, the ranking for the same
group of investments varies according to the criterion being applied. Therefore, it is
recommended to consider more than one criterion when performing profitability
appraisals and to understand the significance of the results on each method.
Benefit – Cost Analysis
Benefit/cost analysis can result in highly subjective evaluations due to the fact that it
takes intangibles benefits into consideration.
As a decision-maker tool, benefit/cost analysis is primarily used by public non-profit

organizations where the intangible benefits are a matter of public interest.
This method utilizes 3 additional analysis features:
1. Project cost/savings analysis.
2. Project benefits/disbenefits profiles
3. Merit measurement as a yardstick for comparisons.
The following example illustrates the procedure:
A city major is interested in gaining approval for the construction of a new bridge. His
project has the following economic characteristics:
Initial investment $ 5,000,000

Annual maintenance 120,000
Annual public benefits 3,100,000
Annual public Disadvantages 300,000
Annual cost of capital recovery 500,000
The bridge is expected to last 15 years and the current rate of interest is 4% per year.
Let us find the present value for benefits and cost as follows:
Benefits:
(3,100,000 – 300,000) (15%,4) = $ 31,130,400
Costs:
5,000,000 + (120,000 + 500,000)(P/A,15,4%) = $ 11,893,160
Benefits / Costs = 2.617
26
Cost of Capital
While an arbitrary discount rate has been used of the examples in this discussion, in
practice the company must calculate its own discount rate.
A company’s generated discount rate is usually known as the cost of capital.
Calculation of the cost of capital by a company requires careful study, analysis and
intuition. Knowledge about the cost of capital and how it is influenced by financial
leverage, is useful in profitability analysis.
Weighted Average Cost of Capital
The weighted average cost of capital is the average cost of each source of finance
weighted according to its proportion on the total pool of capital available.
The following example illustrates its calculation:
1. A company has the following sources of capital and their corresponding cost.
2. 10 million $2 ordinary shares currently at $3 each one. Cost of capital = 20%
3. 4 million $2 preference shares at $1.5 each one. Cost of capital = 15%
4. 2 million debenture stock quoted at $0.80 each one. Cost of capital = 10%
(Debentures are long-term debt instruments that are not secured by mortgages)
27
LIFE CYCLE COST
Life cycle cost is an analytical procedure for profitability studies whereby the alternatives
are fully evaluated for their cost through their life span. All the following factors are
considered in the analysis:
• Original cost;
• Transportation Costs;
• Installation Costs;
• Maintenance Costs;
• Required Spare Parts Inventory;
• Overhauls and their frequency;
• Supervision Costs;
• Reliability;
• Safety Requirements;
• Versatility;
• Ecological Impact;
• By-laws;
• Risk and Uncertainty; and
• Salvage Value.
Life cycle profitability procedures are costly and demanding, but extremely rewarding.
Profitability Conclusions
The following guidelines should be taken into consideration while performing

profitability analysis:
• Studies should be conducted on a long-term basis;

• Cash flow forecasting is essential for getting significant and meaningful results;
• Allowance must be given for changes of technology, investment climate,
productivity and manpower;
• A company’s attitude toward risk must be included; and
• More than one method of analysis should be used in order to arrive to a
meaningful conclusion.
28
Chapter III
Break-Even Analysis
Break-even analysis is a procedure for studying the relationship between fixed cost,
variable costs and profits in a business operation. It establishes the break-even point at
which the income from an operation equals the cost incurred by the operation.
This is a useful first step when developing data conductive to make financial decisions.
The nature of the break-even analysis is depicted by the chart shown below, which is
called the basic break-even chart or the economic production chart.
There is a linear relationship amongst the elements shown in the above graphic, which
can be expressed mathematically as follows:
Ct = NV + Cf
Where,
Ct = Total costs, N = Number of units produced, V = Variable cost per unit of

production, Cf = Fixed costs.
If S is the selling price per unit, the profit for the operation may be obtained by:
Profit = Z = NS – Ct
Or, Z = NS – (NV + Cf)
29
The break-even point or point of no profit, no loss will be then be given by:
0 = NS – (NV + Cf)
or N= Cf / (S –V)
For example to find the break-even point of an operations that has fixed costs of
$100,000 per year, variable costs of $5 per unit and a selling price of $12 we proceed as
follows:
N = 100,000/(12-5) =14,285.71 units
When production rises above 100 percent capacity the variable cost per unit changes
reflecting the need for increased manpower and materials. Depending on the level of
efficiency and other factors, the variable cost may increase or decrease. Fixed costs may
also change if increased capacity requires construction of new equipment.
Thus, break-even equation becomes:
Z = (N+N’)*S – (NV+N’V’+Cf)
where, N’=units of production over 100% capacity, V’=variable cost per unit of N’
If a factory produces 10,000 gadgets per year at full capacity, fixed costs are
$10,000/year, variable cost is $5/gadget and selling price is $8/gadget and we would like
to know the break-even point and the profit after taxes at 48% for an operation at 120%
capacity if the variable cost above full capacity is $6/gadget.
N = 10,000/(8-5) = 3,334 units
The profit after tax at 120 % capacity can be calculated out of:
Profit = 8 * (10,000 + 2,000) – [5*10,000+6*2,000+10,000] = $24,000 before taxes.
Profit after tax = 24,000 * (1-0.48) = $12,480
30
Break-even Analysis Assumptions
Break-even analysis assumes the following business situation:
• Variable cost is constant;

• There are no financial charges;
• All units are sold at the same price; and
• Fixed costs are independent of production.
Dumping
When production is higher than sales, the manufacturer may decide to sell the excess at a
lower price in order to maintain production at a maximum level.
When it occurs,
Profit (Z) = NS + N’S’ –[(N + N’)*V + Cf]
Where, N=Number of units selling at normal price, N’=Number of unit selling at lower
price, S’= Lower selling price.
If a factory produces 5,000 pairs of tennis shoes per year and has fixed costs of 10,000
dollars, a variable cost of $7/pair and a selling price of $12 we can find the profit taken
when only 80% of production sells at the official price and the rest is sold at $10 per pair
to be able to keep the plant running at 100 percent capacity.
Z = 4,000*12 + 1,000*10 – (5,000*7 +10,000) = $13,000
Break-even Based on Dollar Sales
Calculating break-even points on the basis of dollar sales may sometimes be

advantageous, especially for companies that sell many products at different prices. Only
three values are necessary to calculate the break-even point based on dollar sales.
Profit Z = dollar sales – (variable cost + fixed costs) = 0
Break-even Analysis and Operation Leverage
The degree of operating leverage is the ratio of the percentage change in operating
income to the percentage change in units sold.
Degree of operating leverage (DOL) = COI / CUS
Where COI=% change in operating income and CUS=% change in units sold.
31
Break-even analysis provides an overview of the operating leverage showing how
sensitive operation’s profit is to the volume of sales.
Mon-linear Break-even Analysis
It is a straight forward process to introduce non-linear relationships into the break-even

analysis. Costs such as direct labor, maintenance and utilities may be included as follows:
Z = NS – (NV + NR + Cf)
Where NR = non-linear variable costs
Solving the above-mentioned requires special mathematic techniques.
Marginal Costs
Marginal costs, also called marginal expressions, indicate the additional cost that results
from producing one more unit at a given production level.
It is useful to analyze marginal cost when allocating production among competing

production facilities.
The figure next page shows the incremental cost curves representing different production
facilities manufacturing the same product. Incremental cost ($/unit) are drawn against
units of production. This graphical representation is utilized to solve particular
operational constraints as will be evident in the following example.
Three facilities producing the same product (represented in the figure next page) have the
following annual total cost functions:
Product facility A:
Ct1 = 0.05N1 (1.1) + 900
Product facility B:
Ct2 = 0.03N2 (1.2) + 1,500
Product facility C:
Ct3 = 0.003N3 (1.5) + 600
32
Where, N1 = Facility A annual Production
N2 = Facility B annual Production
N3 = Facility C annual Production
What production should be allocated to each facility in order to minimize costs, if the
total production must be 665 units.
The total annual cost for the three facilities is given by:
CT = CT1 + CT2 + CT3

In this case:
CT = 0.05N1 (1.1) + 0.03N2 (1.2) + 0.003N3 (1.5) + 3.000
The problem is to minimize the equation above subject to:
N1 + N2 + N3 = 665 or N1 + N2 + N3 – 665 = 0
33
This may be solved utilizing a quite simple mathematical technique called the Lagrange
Equation, as follows:
Create the so-called Lagrange Equation (LE) by adding the right side of the first above-
mentioned equation to the left hand side of the second above-mentioned equation
multiplied by the Lagrange multiplier called L:
LE = 0.05N1 (1.1) + 0.03N2 (1.2) + 0.003N3 (1.5) + 3.000 + L(N1 + N2 + N3 – 665)
Now find the partial derivatives of the LE with respect of each one of the variables:
dLE/dN1 = 0.05N1 (0.1) + L
dLE/dN2 = 0.03N2 (0.2) + L
dLE/dN3 = 0.004N1 (0.5) + L
dLE/dL = N1 + N2 + N3 – 665
Set up all the partial derivatives equal to zero for a minimum value of the original
function.
0 = 0.05N1 (0.1) + L
0 = 0.03N2 (0.2) + L
0 = 0.004N1 (0.5) + L
0 = N1 + N2 + N3 – 665
From the above equations we can say that:
0.05N1 (0.1) = 0.03N2 (0.2) = 0.004N1 (0.5)
When comparing the above equalities to the above partial derivatives, it can be said that a
minimum production cost will be achieved when the incremental or marginal costs are
the same for all machines.
The system of equations shown above can be solved graphically or analytically. The
second choice is an arduous one and the only alternative is to resort to the Newton
method whereas the graphical solution is quite simple as will be noticed from the
following explanation.
Following the graphic of this example, the optimum operation is obtained by drawing a
horizontal line which intersects the incremental cost curves at equal incremental costs and
reading the values of the abscissas at intersections.
34
The horizontal line is adjusted up or down in position until the sum of the abscissa values
correspond to the required production.
For this problem the solution line give the following allocations:
N1 = 110 units
N2 = 55 units
N3 = 500 units
35
Chapter IV
Decision Making Tools

Probability laws and concepts are the basis to solve most decision-requiring cost
engineering situations.
Probability can be defined in many ways, but probably the simplex of them all is that
establishing probability as the quantification of uncertainty.
Probability of an event ranges from impossibility or zero probability to total certainty or

probability 1 so, the probability of an event P happening can be mathematically expressed
as:
0 <= P <= 1
Probability of an event happening is said to be objective if it is based on past data, but

past data is not always available and the subjective probabilities based on personal
judgment and/or experience can be adopted.
The best way to deal with uncertainty is to measure it. This sounds ominous, but it is not.
We can learn to measure personal judgment and experience statements and to use them to
our benefit.
Subject Matter Experts (SME) usually come up with statements like:
• Highly Unlikely;
• Unlikely;
• Likely; and
• Highly likely.
Since Probability of an event happening is always between 0 and 1, we can translate the
above statements to the following measuring system:
Understanding probabilities and combining them with other techniques such as the
Paretto rule, fishbone diagrams, control charts, histograms, statistical samplings, scatter
diagrams and montecarlo techniques can provide the cost engineer with excellent
decision-making tools.
36
Expected Value
The expected value of an event is the probability of that event occurring multiplied by the
value of the event.
The following examples will illustrate the concept:
Calculate the expected value for a project with the following possible outcomes:
$10,000 with 0.20 probability

Expected value = 10,000 * 02 + 20,000 * 0.45 + 30,000 * 0.35 = $ 21,500
Calculate the expected net value for a $10,000 investment with the following cash flow
probabilities. Money is worth 10% per year.
37
First, calculate the expected value cash flow for each period:
First Year:
EV1 = 1,000 * 0.3 + 2,000 * 0.45 + 4,000 * 0.25 = 2,200
Second Year:
EV2 = 2,000 * 0.3 + 4,000 * 0.45 + 6,000 * 0.25 = 3,900
Third Year:
EV3 = 3,000 * 0.3 + 6,000 * 0.45 + 8,000 * 0.25 = 5,600
Knowing the expected value for each period, the following cost diagram has to be solved:
NPV = -10,000 + 2,200 (P/F,10%,1) + 3,900 (P/F,10%,2) + 5,600 (P/F,10%,3) = -573.2
The Random Demand Problem
A typical use for expected value concepts is depicted by the following random demand
example.
A supermarket buys loaves of bread at $0.50 each every day and sells them at $0.80.
Loaves of bread which are not sold the same day have to be written off.
Daily demand is uncertain and the owner wants to know what would be the best daily
order knowing the following data from the previous year:
NUMBER OF DAYS SALES

140 42
110 43
80 41
30 40
To solve this problem, let us find the objective probabilities of the given data:
38
Calculate the conditional profit that can be made at any particular stock-demand
situation.
Conditional profit is the one that could be made at any particular combination stock-
demand. For instance if 12 loaves were bought and demand was 9, the conditional profit
is:
Conditional Profit (CP) = 9 * $0.8 – 12 * $0.5 = 1.20
CP = (Loaves demand) * selling price - (loaves bought) * buying price
Now, calculate the expected profit (EP) out of the probabilities calculated before and the
conditional profit calculated before:
39
The maximum total expected profit occurs when the stock is 42, therefore 42 loaves is the
optimum stock.
Marginal Probability Analysis
Another procedure to handle random demand is the marginal probability analysis (MPA).
Let us introduce two new concepts:
Marginal Profit (MP) is the profit from selling one more unit when the decision to stock
one more unit has been made.
Marginal Lost (ML) is the lost from not selling one more unit when the decision to stock
one more unit has been made.
The decision of stocking more units under uncertain demand is made as long as the
following expression is true:
Probability of making and additional sale > Probability of not making an additional sale
Also if P is the probability of making an additional sale then 1-P is the probability of not
making one additional sale and the statement above can be written:
P (MP) > (1-P) (ML)
At the break-even point (no profit, no loss) the expression becomes:
P (MP) = (1-P) (ML)

And, P= ML / (MP + ML)
40
The following example illustrates the use of marginal probability analysis:
A supermarket buys loaves of bread at $0.50 each every day and sells them at $0.80.
Loaves of bread which are not sold the same day have to be written off.
Daily demand is uncertain and the owner wants to know what would be the best daily
order knowing the following data from the previous year:
NUMBER OF DAYS SALES

140 42
110 43
80 41
30 40
By the equation developed for marginal probability analysis,
P = 050 / (0.3 + 0.50) = 0.625
The highest probability above the break-even probability of 0.625 will be the optimum
solution or 42 loaves in this case.
41
Maximim Rule
The maximim rule as decision-making tools is a procedure whereby the selection of an

alternative is reached by choosing the best of the worst.
The following example illustrates the rule:
Three projects showing the net present values at different interest rates are shown below:
(all figures in dollars)
The probabilities of money costing 10, 12 and 14 percent are 0.55, 0.25 and 0.20
respectively.
Select the best project by utilizing expected value and the maximim rule.
Expected Value:
Project 1 EV = (0.55) * 4,500 + (0.25) * 2,000 + (0.20) * -1,500 = $ 2,675

Project 2 EV = (0.55) * -2,800 + (0.25) * 3,200 + (0.20) * 6,300 = $ 520
Project 3 EV = (0.55) * 7,400 + (0.25) * 100 + (0.20) * -4,150 = $ 3,265
Select project No.3
Maximim Rule:
Three worst outcomes from the table above are investigated and the best of them is
selected:
Project No.1: - $ 1,500 @ 14%
Project No.2: -$2,800 @ 10%
Project No.3: -$4,150 @ 14%
Select project No. 1
42
The Maximax Rule
The maximax rule as a decision-making tool selects the best of the best alternatives as
illustrated in the following example:
respectively.
Select the best project by utilizing the maximax rule.
Project No.1: $ 4,500 @ 10%

Project No.2: $6,300 @ 14%
Project No.3: $7,400 @ 10%
The Minimax Regret Rule

The minimax regret rule provides yet another decision-making tool by calculating the
regret or opportunity loss from making one decision given a that certain contingency
occurs and selecting the alternative that provides minimum regret.
The following example illustrates the rule:
43
respectively.
Select the best project by utilizing the minimax regret rule.
Set the best results under each rate of return to zero:
Calculate the opportunity loss for not being at the best position if that position occurs, as
follows:
For Project No.1, if the rate of return happened to be 10%, Project No. 3 will make $
7,400, but if Project No.1 had been chosen, the making is only $4,500 or an opportunity
loss of:
7,400 – 4,500 = $ 2,900
Following the same reasoning for all the projects:
44
The maximum regrets are:
Project No.1: $ 7,800 @ 14%

Project No.2: $10,200 @ 10%
Project No.3: $10,450 @ 14%
Expected Opportunity Loss Value

Expected opportunity loss value is the opportunity loss of an event, multiplied by the
probability of that event occurring.
Minimizing the expected opportunity loss is the equivalent of maximizing the expected
value.
respectively.
Select the best project by utilizing expected opportunity loss value.
45
Expected Opportunity Loss Value:
Project 1 EOLV = (0.55) * 2,900 + (0.25) *1, 200 + (0.20) * 7,800 = $ 3,455
Project 2 EOLV = (0.55) * 10,200 + (0.25) * 0 + (0.20) * 0 = $ 5,610
Project 3 EOLV = (0.55) * 0 + (0.25) * 3,100 + (0.20) * 10,450 = $ 2,865
Select project No.3
Simulation
Business situations may become overwhelming when analytical procedures are utilized
for their study.
Corporate planning, production planning, maintenance planning, inventory control and

profitability analysis are only a few of those analysis that may get extremely painful to
cope with when tools other than the conventional ones are not available.
Simulation is a procedure devised to analyze complicated business situations. It

reproduces business situation by means of a model representative of the real case and
playable by a computer.
The computer outcome will then be utilized to select the most propitious decision.
The model is the most important part of the simulation technique and care must be taken
that it is representative of the actual case, objective, capable of showing variables
relationships at different stages, simple to understand, updated as frequently as possible,
tested for reliability and for inputs to be completely unbiased.
Montecarlo Technique
The montecarlo technique is a simulation procedure using a model and random numbers
to arrive at an expected value for the variable being investigated.
The cost in millions of dollars for a project is broken down in two components A and B
added together. The cost and the corresponding probabilities are as follows:
46
Utilizing the montecarlo technique, find the expected cost of the project.
Organize the data and allocate numbers from 1 to 00 (100 numbers) to different outcomes
according to their given probabilities.
Following a random selection of number as those given by the table below, organize the
results as shown.
47
48
Therefore the project cost is converging towards $ 3,645,000 so we can call it the
expected value.
49
SIMULATION PROBLEM
Three machines are needed to produce a gadget. Breakdown of any machine will stop
production of the gadget.
Probabilities of breakdown duration are:
1 day duration = 0.4

2 days duration = 0.35
3 days duration = 0.25
A flow chart model of the system is presented next page.
The problem can them be solved by using the random number table previously shown or
by developing computer code to be run in many available applications.
50
51
COMPUTER CODE TO SOLV E THE SIMULATION PROBLEM
10 P=0: E=0: F=0: G=0: R=0: S=0: T=0: A=0: B=0: C=0
20 D=0: K=0: L=0: M=0
30 O=0
40 PRINT “ENTER THE NUMBER OF DAYS TO BE SIMULATED”
50 INPUT N
60 FOR I=1 TO N
70 GOSUB 6000
80 IF Z=97 THEN 2000 ELSE 90
90 GOSUB 6000
100 IF Z =97 THEN 3000 ELSE 110
110 GOSUB 6000
120 IF Z =97 THEN 4000 ELSE 130
130 P=P+1
140 GOTO 5000
2000 GOSUB 6000
2005 R=R+1
2010 IF Z<=40 THEN 2020 ELSE 2100
2020 D=D+1 : E=E+1
2030 GOTO 5000
2100 IF Z<=75 THEN 2120 ELSE 2200
2120 D=D+2 : P=P-1: F=F+1
2130 GOTO 5000
2200 D=D+3: P=P-2: G=G+1
2210 GOTO 5000
3000 GOSUB 6000
3005 S = S+1
3010 IF Z<=40 THEN 3020 ELSE 3100
3020 D=D+1: A= A+1
3030 GOTO 5000
3100 IF Z <=70 THEN 3120 ELSE 3200
3120 D=D+2: P=P-1: B=B+1
3130 GOTO 5000
3200 D=D+3:P=P-2:C=C+1
3210 GOTO 5000
4000 GOSUB 6000
4005 T=T+1
4010 IF Z<=35 THEN 4020 ELSE 4100
4020 D=D+1: K=K+1
4030 GOTO 5000
4100 IF Z<=75 THEN 4120 ELSE 4200
4120 D=D+2: P=P-1:L=L+1
4130 GOTO 5000
4200 D=D+3: P=P-2: M=M+1
4210 GOTO 5000
5000 NEXT I
5100 PRINT”PRODUCTION DAYS AFTER “;N; “SIMULATIONS =”;P
5200 PRINT”DOWNTIME DAYS AFTER “;N;”SIMULATIONS =”;D
5220 PRINT”MACHINE A ONE DAY DURATION DOWNTIMES = “;E
52
5230 PRINT”MACHINE A TWO DAYS DURATION DOWNTIMES =”;F
5240 PRINT”MACHINE A THREE DAYS DURATION DOWNTIMES =”;G
5250 PRINT”MACHINE A DOWNTIMES = “;R
5260 PRINT”MACHINE B DOWNTIMES = “;S
5270 PRINT”MACHINE C DOWNTIMES = “;T
5271 PRINT”MACHINE B ONE DAY DURATION DOWNTIMES = “;A
5272 PRINT”MACHINE B TWO DAYS DURATION DOWNTIMES =”;B
5273 PRINT”MACHINE B THREE DAYS DURATION DOWNTIMES =”;C
5274 PRINT”MACHINE C ONE DAY DURATION DOWNTIMES = “;K
5275 PRINT”MACHINE C TWO DAYS DURATION DOWNTIMES =”;L
5276 PRINT”MACHINE C THREE DAYS DURATION DOWNTIMES =”;M
5300 END
6000 RANDOMIZE TIMER
6010 Z=CINT(RND*100)
6200 RETURN
53
Chapter V
Forecasting
Forecasting is a management endeavor to foretell how business is going to be next term.
It is performed by qualitative and quantitative techniques.
Qualitative techniques are forecasting procedures which utilize judgment and experience
to produce estimates of future events.
The Delphi Method, Market Research and Historical Analogy are examples of qualitative
forecasting techniques.
Quantitative techniques are forecasting procedures which use past data to establish a
pattern that will determine the nature of future estimates. These techniques assume that
the past is an indication of what is going to happen in the future.
Several statistical techniques are specifically designed for forecasting, the most common
of them being regression analysis.
Regression Analysis
Regression analysis is a statistical technique that provides a mathematical model that

better represents a series of observations.
Linear Regression
If the observations at hand are suggesting a linear relationship of the form:
Y = A + BX
Where A and B are constants, A is the ordinate value where the straight line representing
the above-shown equation intersects the Y axis, B is the slope of the straight line
representing the same equation or the ratio Y/X.
Linear regression provides the means of calculating the values of A and B characteristic
of the particular observations by resolving the following simultaneous equations:
Y = A*n + B * X
XY = A* X + B* X2
54
Where n is equal to number of pairs of observations and,
X = sum of periods
Y = sum of observations
Solving the above-shown equations for A and B:
A = Y/n – B* X/n (1)

2 2
B = (n XY - X * Y) / (n* X – ( X) ) (2)
Once the equation of the line has been established, forecasting can take place based upon
calculation for different values of the variable to be predicted.
Forecast the sales for year 10 based on the following seven years past observations:
YEAR 1 2 3 4 5 6 7
SALES 11 12 16 21 19 30 26
Organizing:
Using equations (1) and (2),
135 = 7A + 28B
624 = 28A + 140B
55
Solving these equations for A and B:
A = 7.28 and B = 3
And the regression line equation will be: Y = 7.28 + 3X
Sales for year 10 or X = 10, Y = 7.28 + 3*10 = 37.28
Exponential Function
Exponential function regression analysis is required when the past data available suggest
a none linear function or a relationship of the equation:
Y = A Bx
Where,
A = constant representing observation value at time zero

B = Constant indicative of exponential growing or exponential decaying
Y = Variable to be predicted
X = Time periods
If B>1, the exponential equation will be a growing one.

If B<1, the exponential equation will be a decaying one.
Taking logarithms both side of the equation:

Log Y = Log A + X Log B
Where Log A and Log B are constants, the exponential equation takes the form of a
straight line and a linear regression procedure can be used to find the values characteristic
of the observations at hand.
Forecast sales for the year 2007 based on the following data:
YEAR 2002 2003 2004 2005 2006

SALES 200 300 450 700 1100
56
Organizing the data:
Using the above-mentioned linear equations:
Log A = (13.3179 / 5) – (10 Log B) / 5

Log B = 5 * 28.4844 – 10 * 13.3179 / (5*30 - 102)
Solving: Log A = 2.2983, A = 196.71, Log B = 0.18487 and B = 1.53
Therefore the regression curve will be:
Y = 196.71 (1.53)X
Now, the sales forecast of year 1987 can be calculated as follows:
2007 period will be number 5 or X = 5
Replacing X in the above-developed equation: Y = 196.71 (1.53)5 = 1,649.23
57
Logarithmic Function
Another non-linear function, the logarithmic function has the following form:
Y = A XB
Where,
Y = Variable to be forecasted
X = Time periods
A and B = Constants
Taking logarithms both sides of the equation will result in:
Log Y = Log A + B Log X
This equation will be a straight line when drawn on Log-log paper.
Following the same procedure utilized for the exponential function before, it is possible
to find the values of A and B for the observations under study and therefore obtain an
equation that enables forecasting based on past data.
Forecast sales for the year 2009 utilizing the following past data:
YEAR 2004 2005 2006 2007 2008

SALES 100 400 650 1050 2200
Change the appearance of the data as follows:

PERIOD 1 2 3 4 5
SALES 100 400 650 1050 2200
Now, make all the calculations needed to apply linear regression based on the equation
discussed above.
58
Utilizing the technique developed earlier in this discussion,
B = [5 * 6.2799 – 2.079 * 11.7784] / [5 * 1.169 – (2.079)2]

B = 4.5392
Log A = 11.7784 / 5 – 4.5392 * 2.079 /5 = 0.4683
A = 2.94
And, Y = 2.94 X 4.53
Now, 2009 will be period 6 or X = 6
So, Y = 2.94 * 6 4.53 = 9,848.6
59
Learning Curve Function
A particular forecasting technique which describes the learning process taking place
when repetitive tasks are performed will be reviewed in this section.
The learning curve function is commonly utilized by industry where the repetitive
production task performance improves with the cumulative output.
The concept is mostly applied to direct labor hours and is defined as the reduction in
effort per unit required for a repetitive production operation.
The learning curve function variables have the same characteristics observed for the
logarithmic function or the following mathematical expression:
EN = K Ns
Where,
EN = Effort required to produce unit N

N = Unit of production number
K = Effort required to produce the first unit, a constant
s = Slope of the equation when it is drawn on Log-Log paper, a constant.
The characteristic values for K and s in a particular operation can be obtained by the
same procedure developed for the logarithmic function above.
60
Learning Curve Function Properties
The first property is that every time production is double, the effort required per unit is a
constant 2s of what it originally was. This effect can be noticed by performing the
following exercise:
Effort for producing unit 1: E1 = K* (1)s

Effort for producing unit 2: E2 = K* (2)s
Dividing these two equations:
E1 = K* (1)s / E2 = K* (2)s
E1 / E2 = (2)s
Similarly,
E4 = K* (4)s
And, E4 / E2 = (2)s
61
This property is used to express the learning curve function. A ninety percent learning
curve function for a process means that every time production is doubled the effort
required will be only 90 percent of the previous one, or:
E4 / E2 = 90 = (2)s
It is usually express as: Ld = 2 s (decimal ratio effort)
Taking logarithms both sides of the equation and clearing s:
s = Log (Ld ) / Log 2
Another form of expressing this learning curve property is introducing the concept of
percentage learning ratio or:
Lp = 100 Ld
Manipulating this:
s = [ Log (Ld ) – 2] / Log 2
s is always negative because the effort for producing new units will always decrease by
the learning process.
A table shown next page gives values for transforming decimal learning ratio to s.
The Second important property of the learning curve is that s is the slope of the line
representing the function when it is drawn in Log-Log paper.
62
63
Cumulative Effort Values
Cumulative effort values can be calculated by the following expression:
Etotal = [ K / (s + 1) ] N(s+1)
A cumulative average effort can be useful at times:
Etotal / N = K * N(s+1) / (s + 1)
The following examples illustrate the utilization of the above-mentioned concepts:

150 man-hours were required for the fourth production unit and 125 for the sixth. How
many man-hours were required for producing the first and second units?
Applying the above-developed equations:
150 = K (4)s
125 = K (6)s
Dividing these two equations:
125 / 150 = (6/4)s = (1.5)s

0.83 = (1.5)s
Taking logarithms at both sides of the equation:
Log 0.83 = s Log 1.5
And,
s = Log 0.83 / Log 1.5 = -0.45953
Now, the effort required for the first unit (K) may be calculated by solving:
K = 150 / (4) (-0.45953) = 283.63
So, 283.63 man-hours were required for the first unit.
Now, the second unit,
E2 = K (2) (-0.45953) = 283.63 * (2) (-0.45953) = 206.29 manhours
64
Another example,
Find the percentage learning ration knowing that every time production is tripled, the
man-hour required to produce a unit are reduced by 15 percent.
The problem statement can be interpreted as follows,
E2N / EN = K (3)s / K(1)s = 3s = 0.85
Taking logarithms,
s log 3 = Log 0.85

s = -0.14792
By applying concept developed earlier,

Log Lp = [s Log (2)] + 2
Log Lp = 1.955
Lp = 90.26 percent
Yet another example,
If 35 man-hours are required for the fifth production unit and 32 for the seventh, answer
the following questions:
How Many man-hours are required for the tenth through the fourteenth units?
What is the man-hour average for production of the fourteen units?
Applying the logic used in the previous example,
35 = K (5)s
32 = K (7)s
Clearing s,
S = Log (0.914) / Log (1.4) = -0.2668

K = 35 / (5) (-0.2668) = 53.77
Then,
E(total 9 units) = {53.77 / [(-0.2668) + 1]} * (9) (-0.2668 +1) = 366.68 man-hours
E(total 14 units) = {53.77 / [(-0.2668) + 1]} * (14) (-0.2668 +1) =509.83

E(total 14 units) - E(total 9 units) = 143.15 man-hours required for the 10 through the 14 units.
65
Now,
E(total) / N = 53.77 (14) -0.26 / (-0.26 + 1) = 36.4 man-hours average for the production of
the 14 units.
Learning Curve Function for Grouped Data
In most cases the effort for production of units is not given on individual unit basis,
instead it is reported as follows:
AVERAGE
QUANTITY IN PRODUCTION
LOT PRODUCTION
LOT EFFORT
EFFORT
1 20 700 Man-hours 35 mhrs / unit
Data presented in this fashion is called grouped data.
With the available information presented as grouped data it is impossible to utilize the
mathematical expressions derived so far in this discussion.
A new approach must be taken to establish the learning curve function for grouped data
and it will better explained with the following example:
Given the following production data:
Find the learning curve function for the operation.
Assign the average effort for the lot to one of the units in the lot.
If the first lot contains less than 10 units, assign the average effort for the lot to the unit
number equal to half the number of units in the lot.
66
If it contains ten or more, assign the average effort for the lot to the unit number equal to
one third the number of units in the lot.
After that, assign the average effort for the lot to the unit number equal to half the number
of unit in the lot.
Therefore,
Now, utilizing the logarithmic function regression procedures discussed before,
67
Since the learning curve function is a logarithmic function of the form:
EN = A N-B
Where,
A = K and B = s
Applying, B = (n XY - X * Y) / (n* X2 – ( X)2)
B = {[5*(9.37501)] – [(6.13750)(7.72153)]} / [5*(8.7409) – (6.1375)2] = -0.08548
Now, using: A = Y/n – B* X/n
Log A = (7.72153 / 5) – (-0.08548) * (6.13750) / 5 = 1.64923
Therefore, the learning curve function is:
EN = 44.58 N(-0.8548)
68
Chapter VI
Linear Programming
Cost and engineering decisions usually are optimization of resource allocations and there
are several techniques to provide the needed solutions.
Linear Programming (LP), the Transportation Problem (TP) and the Assignment Problem
(AP) are the techniques usually utilized by the Cost Engineer.
This chapter will introduce Linear Programming, its formulation and its solution by
graphical and other means.
Definition
LP is a mathematical method utilized to optimize an objective function when its elements

are subject to some constraints.
As an example, one may want to maximize a function defined by 8x +2y, subject to

constraints x<=40 (less or equal) and y<=2,000.
Restrictions
LP can only be used if the problem at hand complies with the following characteristics:
• Relationship between the elements involved in the problem must be linear;
• Formulation in numeric terms is possible; and
• There are one or more restrictions.
The term programming is not related to computer programming, but to the development
of the optimum schedule by means of an iterating method whereby the user moves from
one solution to a better solution each time a repetition is carried out until it is find out that
not better solution can be achieved.
LP users should be able to follow a procedure to properly organize the information given
by the problem and to this objective the following steps are recommended:
1. Formulate the objective function (decide what result is desired and set it up in numeric
terms) For instance: A machine can produce 2 gadgets X and Y. Profits achieved by sales
of the two gadgets are defined by: 20X + 40Y, where 20 is given in dollars as the profit
for each X gadget produced and similarly 40 dollars as the profit for each Y gadget
produced.
69
2. Formulate the constraints. All the circumstances named by the problem statement and
limiting the optimum achievement of the objective function are called constraints and
they have to be expressed mathematically.
For instance: Product X requires 2 machine-hours and product Y requires 4 machine-

hours while the machine availability is only 4,000 hours. This limitation or constraint
may be formulated as follows:
2X + 4Y <= 4,000
There is one additional general limitation to each optimizing problem and it is that the
decision variables cannot be negative. This fact will be expressed as follows: X>=0 and
Y>=0.
Types of Constraints
Constraints may be of two types:
Less than or equal to (<=)

Greater than or equal to (>=)
The first type is usually found in maximizing problems, the second type is mostly found
in minimizing problems.
Graphical Solutions
Graphical Solutions are only feasible when you are dealing with 2 decision variables. The
following example illustrates the technique:
A factory produces two types of computers X and Y. Each computer must pass through
assembly lines 1 and 2 successively. Passing through assembly line 1 computers type X
and Y take 6 and 2 hours respectively.
Going through line 2 they take 2 and 7 hours respectively.
Assembly line 1 is available 60,000 hour a month and assembly line 2 is available 70,000
hours a month.
The net profit from computer sales is $100 per unit X and $200 per unit Y.
Find the optimal production plan that maximizes monthly profits.
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LP model formulation:
Objective Function:
Maximize 100X + 200Y
Subject to constraints:
6X + 2Y <= 60,000 (assembly line 1)

2X + 7Y <= 70,000 (assembly line 2)
X>=0 and Y>=0
Drawing development
Draw the axes of the graph which represent the decision variables and each limitation as
a separate line.
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Locate the point of maximum or minimum profit within the feasible solution area. Solve
the system of constraints equations for any value (ignoring the <) and then move the
solution to maximum profit.
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THE SIMPLEX METHOD
Linear programming problems with more than 2 decision variables cannot be solved by
graphical means. G.B. Dantzig developed a procedure known as the simplex method
based upon the manipulation of variables when all but two are set to zero.
A flowchart describing step by step the simplex method is shown below.
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So let us solve the same problem with the simplex method.
Include the slack variables
Since constraints do not have the linear equation form, they must be transformed by
means of slack variables in the following fashion:
6X + 2Y + A = 60,000
2X + 7Y + B = 70,000
Where, A and B are the slack variables that will compensate for the change of the
original unequal form of the constraints.
Formulate the first tableau
Are there any positive values on the Z row?
For the first tableau there always will be a yes answer. For the subsequent tableaus, if
there are no positive values in the Z row it does mean that the solution quantities column
will be the optimum solution.
Select the highest positive value on the Z row
In this case it is 200 in column Y.
Select the pivot element
This is achieved by dividing all the elements on the solution quantities column by the
corresponding row element on the selected column (Y) and choosing the lowest result.
60,000/2 = 30,000
70,000/7 = 10,000 ( B pivot row and 7 pivot element are chosen)
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The selection of the pivot element is very important since it gives the clue of which
variable enters the solution variables in replacement of the originally entered variable.
In this case variable Y enters the solution variable column and the slack variable B leaves
it.
Calculate the row replacing the pivot row for the second tableau
Divide each element on the pivot row by the pivot element to get the new elements of
that row on the second tableau.
The new row is: Y 2/7 1 0 1/7 10,000
Manipulate the other rows on the tableau utilizing the already calculated Y row.
Set up a new tableau
There is still a positive element in the Z row. More iterations are necessary to reach the
final tableau:
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Since there are no positive values on the Z row, this is the final tableau and no
improvement could be achieved by further iterations.
Final Tableau Interpretation
Checking
Substitution of the decision variables, on the objective function, by the solution quantities
obtained in the final tableau should give the same profit as the one obtained by the final
tableau.
100X + 200Y = 100(7,368,.42) + 200(7,894.73) = 2,315,789
Showing the effect of a change in assembly line 1 availability
Let the assembly line 1 hours availability be increased by 1,000 so the constraint
involved becomes:
6X + 2Y <= 61,000
Extracting the A column and the solution column from the final tableau:
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It is important to observe that column A has been selected because it is the slack variable
introduced by the assembly line 1 availability constraint.
With the 1,000 hours availability increase the solution becomes:
The difference between the original solutions and the above solution indicates the
increase or decrease of profit with the increase of line 1 availability.
2,323,679 – 2,315,789 = 7,890
Which means, each additional 1,000 hours available for line 1, will increase the total
profit by $7,890.
A similar exercise may be performed for all the variables involved in the problem and the
final product will be a sensitivity analysis for the problem at hand thus allowing the user
to estimate ranges and probabilities at will.
The simplex method for minimizing
When utilizing the simplex method for resolving linear programming minimizing
problems, the best procedure is to transform the minimizing problem into a maximizing
one, called the dual, and solve it utilizing the techniques already explained taking care of
making the correct interpretation of the final tableau.
The following example illustrates the procedure.
A company manufactures three products A, B, and C each of which is made out of two
raw materials X1 and X2 with costs at $10 and $20 per kilo respectively.
The company wishes to minimize its raw material production costs subject to the
following limitations:
Production should be at least:

100 units of product A
200 units of product B
50 units of product C
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From each kilo of X1 the company can get 2 units of A, 4 units of B and 3 units of C.
From each kilo of X2 the company can get 3 units of A, 3 units of B and 2 units of C.
Formulate the problem:
Objective function: Minimize 10X1 + 20X2 – Where, X1 and X2 are the number of kilos
of raw material.
Constraints:
2X1 + 3X2 >= 100
4X1 + 3X2 >= 200
3X1 + 2X2 >=50
Formulate the Dual Problem
This is achieved by taking all the constraints inequalities right hand side values and
utilizing them to create a new objective function with newly introduced variables as
follows:
100W + 200Y + 50Z
New constraints are created by utilizing the coefficients of each variable on the original
constraints and the coefficients of the objective function as inequality right hand side
values as follows:
2W + 4Y + 3Z <= 10
3W + 3Y + 2Z <= 20
Proceed to maximize the new objective function subject to the new constraints.
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Following the maximizing simplex procedure:
There are no positive values on the Z row and therefore, the optimum answer has been
reached.
Different from the maximizing procedure, the results are taken from the Z row for values
A and B.
In this case: A = 50(ignore the sign) and B = 0
Since A is the slack variable related to X1 and B the slack value related to X2:
X1 = 50 and X2 = 0
The following pages show basic computer code to solve linear problems automatically.
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THE TRANSPORTATION PROBLEM
The transportation problem is a linear programming technique in which a number of

origins and a number of destinations are given and the objective is to optimize the
transportation cost or contribution obtained by supplying goods from origins to
destinations.
The following example will introduce the technique.
A computer company has the following client requests and transportation costs situation:
The company wants to minimize delivery costs by dispatching computers in the optimum
cost efficient manner.
The graphic below shows an outline of the transportation method.
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The number of available and the number of requested computers is equal so there is no
need for a dummy.
Proceed with the initial allocation of deliveries following the lowest distribution cost.
Check for degeneracy
Degeneracy is a situation whereby this transportation technique is repeated indefinitely

without finding the optimal solution.
Degeneracy occurs if the allocations made are less than the result of the following
calculation:
Matrix rows + Matrix columns -1

In this example: 3 + 3 – 1 = 5
If the allocations are less than expected, a zero allocation has to be made in order to be
able to follow the technique.
Calculate the cost of the original allocation
3*8 + 4*7 + 5*6 + 5*4 + 3*4 = $114
Check the solution to see if it is the optimum possible.
The checking procedure consists of calculating the shadow costs for the cells where no
allocation was made and subtract it from its actual cost. If all the results from this
operation are positive values, the allocation is said to be the optimum otherwise, further
improvement can be achieved.
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Calculations
Assume that the transportation costs for the cells where allocation was mad can be
divided into dispatch and reception costs as follows:
Assume D1 = 0 and calculate the other costs:
Now the shadow cost calculations for the unoccupied cells can be performed:
Then the difference between the actual cost and the shadow cost for the unoccupied cells
can be calculated:
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The negative value for cell 3:X means the total transportation cost of the first allocation
can be reduced by $1 for every unit that can be transferred to that cell.
Allocate as much as possible to the cell with highest negative value in the precedent step.
Proceed as follows:
Insert a plus sign on the selected cell 3:X
Following the row with a plus sigh on it, locate a cell in that row with allocation in its
column.
Insert a minus sign on that cell.
Following the selected cell column on the step before, locate a cell with allocation on its
row and insert a plus sign.
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Do as described on the steps before until you return to the cell with a first plus sign.
Now, select the lowest number out of the cells with a minus sign allocation on the
precedent step.
For this example it will be 3 and it does mean that 3 units must be added to the cells with
a plus sign and subtracted from the cell with a minus sign.
The resulting matrix is:
With a transportation cost of: 7*7 + 5*6 + 4*5 + 3*4 = $111, or $3 less expensive than
the initial allocation.
Then, check that no further improvement can be achieved repeating the procedure from
the check for degeneracy.
Only one table is required for all the calculations, but for the purpose of explaining the
method, several tables will be shown.
Check for degeneracy: Allocations = 4, Matrix rows + Matrix columns -1 = 5
This time the condition for degeneracy exists so a zero allocation has to be made for an
independent cell.
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Organize the table as follows:
The required zero allocation to overcome degeneracy is input on cell 1:X. The next step
is to calculate the dispatch and reception cost for each origin and each destination for the
allocated cells.
The table next page shows how to do it for origin 1 to destination X, Y and Z.
Since dispatch from origin 1 is assumed to be zero , the reception cost for X, Y and Z are
easily calculated.
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The following table shows the calculation of dispatch and reception costs for the rest of
the origins and destinations and the calculation of the shadow costs for the unoccupied
cells with figures in parenthesis, which are directly subtracted from the actual cost and
the results are immediately obvious: the previous allocation is the optimum solution since
no negative values are found.
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THE ASSIGNMENT PROBLEM
The assignment problem is a technique utilized to allocate resources in an optimum

manner when the availability at the sources and the requirements at the various
destinations is only one item.
The following example will show the technique.
A telephone company has four service stations located in different parts of a city and the
city has been divided in four asymmetrical sections.
Distances from service stations to different sections are given by the table below.
All distances in kilometers
The company’s goal is to assign service calls to service stations in such a way as to
minimize the distances covered by service men.
Assignment Problem Procedure
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Reduce each column member by the smallest member figure in that column.
Reduce each row member by the smallest member figure in that row.
Cover all the zeros with the minimum number of lines.
Compare the number of lines with the number of assignments to be made. If the number
of assignments is equal to the number of lines, go to step 6 otherwise, find the smallest
matrix element that is not covered by a line and subtract it from every matrix element and
then add it back to every element covered by a line.
If an element is covered by two lines as 10 and 23 in this example, add it twice.
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Repeat step 3 and 4 until the number of lines covering zeros is equal to the number of
assignments to be made.
Assignment Rules
1. Assign source to destination where a zero is unique to both a column and a row.
2. Assign source to destination where a zero is unique to a column or a row.
3. Ignore assignments already made and repeat the assignment above.
As a result: assign SS2 TO B and SS1 to D
The remaining matrix is:
So assign SS4 to C and SS3 to A.
Maximizing with the assignment method
Instead of minimizing costs of distances, the problem can be formulated as maximizing

contributions.
The procedure only changes on step 1 where the column members must be reduced by
the largest member on each column instead of the smallest one.
Number of Destination Different form Number of Sources
When the number of destinations differs from the number of sources, the matrix will not
be squared and the procedure previously described only works for a square matrix.
To overcome this situation a dummy column or row can be introduced with zero value
for all its members and the normal procedure can be followed.
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Chapter VII
Constructability
The objective of this procedure is to make optimum use of development knowledge

and experience in planning, design, procurement, and field operations to achieve
overall project objectives. A common view of design guidelines involves only:
Determining more efficient methods of development after initiation of the
project;
Allowing development personnel to review engineering documents
periodically during the design phase;
Assigning development personnel to the engineering office during design;
and
A modularization of pre-assembly program.
In fact, each of these represents merely a part of the optimization process. Yet only
through effective and timely integration of development input into planning, design,
and field operations will the potential benefits of optimization be achieved.
The planning/execution phases for a typical major project involve conceptual
engineering, detailed engineering, procurement, development, and start up.
Development optimization analysis should begin during the conceptual stage, at the
same time as operability, reliability and maintainability considerations surface. It can
then continue through the remaining phases. Planners must recognize that the payoff
for optimization analysis is greatest in the earliest phases of a project, growing
progressively less, but never ceasing, until the end of the project. In modern
engineering jargon this process of design optimization is called constructability.
Constructability
Constructability analysis is a form of both Value Engineering (VE) and Value

Analysis (VA) that focuses mainly on the development phase. Constructability
decisions are oriented toward:
Reducing total development time by creating conditions that maximize the
potential for more concurrent (rather than sequential) development, and
minimize rework and wasted time;
Reducing work-hour requirements by creating conditions that promote
better productivity or creating designs that demand less labor;
Reducing cost of development (and tools) by reducing requirements for
such equipment, creating conditions that promote more efficient use of the
equipment, and minimizing the need for high-cost, special purpose
equipment;
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Reducing materials costs through more efficient design, use of less costly
materials, and creation of conditions that minimize waste;
Creating the safest work place possible, since safety and work efficiency go
hand in hand; and
Promoting total quality management (TQM)
Essential Elements of Constructability
Three elements must be present if a constructability program is to realize its full

potential.
First
Constructability must be viewed as a program that requires proactive attention. The
mistaken idea that constructability is a review of designs by someone familiar with
development is totally wrong. By the time designs are ready for review, it may be too
late to change anything, and, if such changes are made, they will be costly.
Instead, individuals with a knowledge of development must jointly participate with
the other interested parties—owner, engineer, operator, and maintainer- to brainstorm
concepts and approaches before they are committed to a drawing. In other words,
constructability is a component of planning that must be included in all phases.
Second
Constructability is a team effort. Only if the interests of all parties are jointly
represented in all decisions will the optimum solution be realized. Reducing
development costs is certainly an important objective, but doing so must not
compromise other needs.
Third
Constructability must have management commitment and support. The time and
resources needed for such a program must be made available if the program is to be a
success.
Constructability Program
While no single approach will fit every program, the consensus is that most
successful constructability programs have the following elements:
Clear communication of senior management’s commitment to the program;
Single-point executive sponsorship of the program;
An established policy and program, as well as tailored implementing phases
for each project;
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A database compiling “lessons learned and examples;
Orientation and training as needed; and
Active appraisal and feedback.
Constructability Culture
Constructability works best when it is an accepted part of the way an organization

operates. If the subject is given enough emphasis and attention over time, it becomes
ingrained within the organization reaching what it can be called a constructability
culture. Every staff person must feel part of the system, since their input is frequently
sought in constructability brainstorming session and their ideas are welcome additions
to the database.
Constructability Concepts
The Management Approach
Recognize that startup and development drive engineering and procurement

scheduling.
Develop a network schedule as early as possible; and
Include engineering and procurement packages in the control schedule.
Use contracting and management approaches that promote development efficiency.

On engineering-procurement-development projects executed on a fast-track
basis (overlapping phases), use single management of the total effort from
the outset of conceptual engineering;
Use development contract packages of a quality that will allow fixed-price
bidding as a means of reducing or eliminating the problems associated with
changes;
Do not start on a work package until the availability of all required
resources is assured (personnel, materials and support equipment.);
Work with the owner to use any existing facilities or services rather than
creating duplicate ones for the development period;
When packaging designs for specialty subcontracting, consider normal
jurisdictional lines so that packages logically fit the specialty contractors
involved and do not require sub-tier subcontracting;
Plan the release of contracts to take advantage of favorable development
weather;
Provide adequate planning time for contractors and subcontractors in the
bidding-award process;
Keep the control schedule at a summary level;
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Ensure that project milestones are reasonably attainable considering both
development and procurement time;
Do not impose unnecessary hold points for quality checks;
Keep requirements for owner involvement in the project(such as reviews
and approval) to a minimum;
Issue MEP, instrumentation and insulation packages as early as possible,
since these require the most field time to execute; and
Use a contract form that incorporates incentives designed to reduce
development costs. For example, include Value engineering (value analysis)
clauses that provide for sharing in savings engendered by adopting cost
improvement suggestions made by the contractor;
Ensure that project requirements and conditions are understood.
Make certain that field conditions are accurately reflected on design

documents;
Identify all access routes and any limitations on their use;
Be sure that all parties understand their roles and responsibilities with
regard to providing equipment, the use of project areas and facilities,
security and gate control, administrative policies, etc;
Identify disposal areas for excavations, vegetation, non-hazardous waste
and hazardous waste; and
If working in or adjacent to an operating facility, identify all constraints that
the situation presents.
Design Phase
Emphasize standardization and repetition.

Standardization and repetition maximize application of the learning curve to
the work force, allow volume buying of materials, and simplify purchasing
and warehousing.
Standardize structural members, foundations, bolt sizes, and other
components as much as possible;
Dimension concrete components to take advantage of readily available
commercial form sizes; and
Repeat designs throughout the facility. This will reduce design costs while
promoting the learning curve effect during development.
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Take maximum advantage of readily available, off-the-shelf materials and
components.
Maintain access to commercial catalogs of equipment and materials;
Make maximum use of vendor representatives to assist in item selection;
Survey the area to determine which materials are most readily available
locally;
Require procurement specialists to publish bulletin on a regular basis,
identifying materials and items in short supply on the world market and
approximating order-ship-deliver lead times of all equipment and materials
regularly used in the contractor’s work; and
Consider using pre-engineered structures in lieu of specially designed
structures.
Choose configurations that facilitate or simplify handling and erection.
Require design engineers to develop recommended development methods

and include them with the design. This will force them to think
constructability;
When designing steel members and connection, remember that erection is

much easier if a member to be connected to another can be temporarily
positioned on top of the in-place member or on a pre-installed seat on that
member before bolting or welding;
Take advantage of modularization. Vendor-assembled modules are

produced under more favorable conditions than those in the field. This
ensures better quality while reducing field erection time;
Use designs that employ pre-cast concrete components which can be cast in
a controlled environment, delivered to the project when needed without
intermediate handling, and directly installed;
Avoid components that require special care and handling in the field;
Create designs not requiring special care and handling in the field;
Include special foundations in the design o structures for mounting climbing

cranes and elevators if such equipment will be used during development;
Locate heavy and/or bulky items within structures so that as many as

possible can be hoisted from a single location of the lifting equipment;
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Maximize the use of straight runs and perpendicular tie; avoid curves
(particularly complex curves) and angles;
Consider limitations of standard transport and lifting equipment when

designing components. If necessary, design over-size items so they can be
fabricated, transported and erected in parts;
Use designs that minimize the need for temporary structures such as
forming, shoring, bracing, and tie-downs;
For multiple electrical and piping systems, consider using common utility
tunnels, trays, or conduits through which multiple system can be installed
(and easily removed or expanded later if necessary) rather than using direct
embedment or multiple conduits;
For multiple foundations in the same are, establish the same bottom
elevation for all foundation so that excavation can be handled on a mass
basis rather that individually;
Design engineered items so that they can be dressed out on the ground for
installation. In other words, design any components that cross several items
(such as ladders or raceways) so portions of them can be pre-assembled
with the engineered item to create a module;
Design electrical/instrumentation connections with plug-in configurations

rather than a labor-intensive connection;
For complex wiring networks, specify the use of wiring harnesses that are
factory assembled and coded;
In lieu of cast-in-place reinforced walls, consider using the lift-slab

technique;
On multi-storied buildings with reinforced concrete floors, consider casting

the floors one at a time on the lower deck and lifting them into position.
This will eliminate many bracing and scaffolding requirements;
In lieu of specifying concrete block wall using conventional masonry

techniques (mortar between blocks), specify simple stacking of blocks
followed by plastering of both sides with fiber-reinforced mortar. The result
is a better-looking, stronger wall that can be constructed more quickly by
less skilled personnel;
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When designing connections for hydraulic or other systems, create unique
designs for each category of connection to avoid any potential for
connection mix-ups in the field.
When designing or specifying large components (such as vessels or rotating

equipment), include lifting hooks or other handling devices/features in the
design so field erectors will not have to improvise the rigging and handling;
and
Provide designs for special measuring devices, templates, or other erection

aids that may be useful for aligning or achieving tolerances.
Create designs that promote accessibility and provide adequate space for
development personnel, material, and equipment.
Consider interstitial designs for buildings. This means providing space

above all operating floors that is zoned for various operating systems. The
vertical clearance in this space should be enough to allow for easy
movement of workers. This design greatly simplifies development, and
facilitates future maintenance and upgrading;
Locate electrical pull boxes with adequate space around them to simplify
cable pulling;
Size pipe racks to allow easy addition of new lines;
Incorporate access openings in both exterior and interior walls; and
Provide for reasonable working space around all installed components.
Adapt designs and strategies to project location and time.
In an area with a very short development season or limited labor

availability, make maximum use of factory-assembled modules and
components that have been designed for rapid assembly;
Consider local labor and specialty contracting capabilities;
Select designs that best use these capabilities, since they will be less costly
than imported capabilities;
If the local population lacks needed skills, maximize the use of remote, off-
site fabrication;
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In a union environment, consider jurisdictional rules and wage scales when
selecting a design approach;
Avoid designs whose development is particularly weather sensitive; and
Avoid the use of materials expected to be in short supply or subject to

unusual price inflation during the duration of the project.
Use realistic specifications.
Do not require unnecessarily tight tolerances. For example, the imposition

of ASTM or nuclear-quality specifications on ordinary development can be
an overkill;
Do not specify an expensive, hard-to-install material when another is far
more economical. for example, PVC conduit is lighter, more flexible, and
easier to work with than rigid conduit;
Designers must learn to challenge each specification. Is it the best for the
project at hand?
Maximize the use of performance rather than proprietary or descriptive
specifications to five grater feasibility to the field;
Minimize the number of specifications applying to the same type of work,
such as concrete, bolt sizes, etc.
Consider field installation costs in the economic evaluation of material or
equipment choices;
Include in the specification file information on where and why a given
specification is applicable. This will assist engineers in selecting the best
specification for the job at hand;
Maintain and continually update a file of “lessons learned” from previous
projects. Make these the subject of training sessions;
When possible, allow for alternates in case the primary method or item is
not achievable;
Include requirements for packing and shipping critical items that assure
undamaged delivery of them; and
Specify testing methods and procedures that are reasonable for the field.
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Assure quality and completeness of design deliverables (such as drawing and
specifications).
Be willing to hire outside expertise when the in-house staff does not have
the talent or time needed to prepare quality deliverables;
Establish a complete system of reviews and checks to ensure accuracy of

dimensions, compatibility of drawings and specifications, and consistency
of flow diagrams, piping and instrumentation diagrams, etc. and
Use physical or computer models to be sure there are no interference among

systems.
Incorporate safety in designs.
Specify locations where beams and columns should be drilled to

accommodate safety cables; and
Design components to facilitate pre-assembly on the ground and lifting into

final position in modular form.
Development Phase
Plan and develop the site to promote worker efficiency.
Use cardboard cutouts that have been cut to scale to represent temporary
development facilities on an overall map of the site drawn to the same scale;
brainstorm the best layout of the site to support development;
Provide for dust control on roads;
Develop and stabilize all heavily used foot traffic areas around the
development site;
Design the development road network to isolate administrative traffic from

traffic that directly supports development activity;
If space permits, develop a perimeter road around the site. This will help
prevent traffic congestion and interference;
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Design laydown areas as a series of alternating roads and narrow laydown pads
that allow any item in the laydown area to be handled using lifting equipment
on the adjacent road;
Shape all laydown areas for drainage, and construct a supporting drainage
network. Stabilize surfaces where material will be placed and spray them with
weed killer or cover them with plastic sheeting to prevent grass and weed
growth. Make cribbing available for off-ground placement of materials;
Do not allow long-term storage of any materials adjacent to a facility under

development. Leave clear space around its perimeter that is available for
development equipment and pre-positioning of materials needed for current
work activity;
Locate smoke- and dust-producing activities downwind from the center of

development activity;
Locate/relocate portable facilities to minimize travel distances from worker

concentrations;
Regularly clean up and remove development debris and garbage from work
areas;
Schedule work shifts to minimize interference with local traffic patterns and to
avoid excessively hot portions of the day;.
Establish grids for development electrical, gas, water and compressed air
service with distribution points in convenient locations. Design connection
trees that are modular and can be moved from distribution point to distribution
point as needed; and
Have portable lighting sets available to illuminate work areas where natural
illumination is poor.
Perform work when and where it is most efficiently accomplished.
Complicated process equipment is often best assembled in modules at a

factory, requiring only positioning and connecting at the project site. This
takes advantage of the factory environment, which generally has more
skilled workers, better productivity, and better working conditions. Pay
scales also may be more favorable. Module assembly can be accomplished
in parallel with other development work, which permits field development
schedules to be shortened;
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On-site prefabrication yards for forms, steel cages, and piping spools allow
such work to be accomplished under the best conditions and, look for the
yards to be weather-protected to allow work to continue during inclement
weather;
Work on the ground can be accomplished more efficiently and safely than
in the air. For example, insulated components can be at least partially
insulated while on the ground, with only the finish work left;
During development of multi-level structures, pre-position installed

equipment and other materials on the various levels as decks are completed
to avoid later problems of access;
In a congested area where multiple piping and electrical systems are

competing for space, install the heavier, bulky components first, leaving the
lighter, more flexible items for last;
When building development roads, include non-drainage culverts and ducts

where future utility lines are expected to be located so that roads will not be
cut up later to accommodate laying these lines;
Fabricate like components, such as rebar cages, on an assembly line basis;

and
Allow materials to be delivered to the site only during off-shift hours.
Minimize unscheduled and unproductive activity.
Use detailed work package planning and adopt a philosophy of never

starting on a work package until personnel, materials, and equipment
availability is assured. Use separate crews for materials pickup and spotting
at the point of use to keep the supervisor with the crew;
Obtain old trailers to use in picking up and positioning materials to be used

by crews. Materials can be moved directly from the trailers to the point of
placement, thus eliminating multiple handling;
To avoid the inevitable productivity degradation associated with rework due

to changes, use a special crew within each craft to handle rework, thereby
allowing the primary crew to move on to other first-time work;
If special equipment, such as heavy cranes, must be rented to support

certain phases of a project, concentrate the scheduling of work requiring this
equipment into as short a time span as possible;
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Use bar codes or other codes to identify materials in storage. This will speed
up identification time;
For critical layouts, use two separate survey crews, each starting from the
primary benchmark, to lay out development. This will minimize the
potential for layout errors;
When storing materials in a laydown area, store them in order of retrieval.

This will minimize damage and loss associated with handling and re-
handling;
Paint distinguishing marks (such as a North arrow or “Top”) on components

to facilitate their final positioning. This will eliminate lost time due to
misplacement;
Assign laydown areas by discipline;
Place tool boxes, tool rooms, parts lockers, etc. on wheels or skids to permit
their relocation as work moves. Install lifting hooks on them so they can be
handled with cranes;
Use bar coding and computerized inventory control to speed tool issuance.
This is even more effective if employee ID badges have a bar code so that
the employees accessing the tools can be quickly identified; and
Consider using “just-in-time” materials deliveries from suppliers to

eliminate the cost and effort of intermediate storage and handling.
Employ work-saving tools/equipment and modern development techniques.
It is impossible to keep up with the market, since new and better technology is
always introduced. Ask vendors to demonstrate their equipment. They are
usually receptive to providing training as well;
Use automatic welding machines, nail guns, cordless tools, laser levelers,
craftsman stilts, etc.
Use commercially available material items designed to speed the development

process. For example, commercial forms are available for concrete work, and a
complete family of high chairs, clips and other gadgets can speed the
placement and tying of re-steel. Comparable items are available for carpentry,
electrical, and other work;
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Have a representative of the organization attend trade shows to learn what is on
the market. Bring back literature and make it available to those with a need to
know. Consider making a video tape using scenes from a trade fair or pictures
from brochures with appropriate narrative, and distribute this video among the
staff;
Subscribe to trade publications, which contain many advertisements describing

innovative products. Prepare a scrapbook of those with the most potential and
make it available to the staff; and
Cut out articles from trade and other publications that describe innovative
techniques used by competitors. Compile them in a scrapbook that is available
to the staff.
Sequence work for optimum efficiency.
When the facility to be built includes repeated designs, try to schedule work
on repeated elements in series to take advantage of the learning curve;
Pre-position and temporarily lash heavy and/or bulky components within a

structure when access is most favorable;
On large concrete slabs, pour sections in checkerboard fashion to reduce the

need for forms;
Hold stairs and platforms early so they can be used in lieu of scaffolding
and elevators;
Schedule development activity around the weather. For example, some

building may be erected early to provide protected work space for later
development; and
With owner concurrence, construct selected permanent facilities early and

use them for development support.
Employ development practices that emphasize safety.
Erect stair towers early so they may be used for access during development;
Use remotely-activated release devices on rigging equipment so workers

will no have to be hoisted to release them manually from equipment lifted
into place;
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Have safety equipment vendors demonstrate available state-of-art safety
equipment and provide any training needed; and
Install safety lines and other safety devices on structural members before
they are lifted into position.
Employ Value Engineering principles to solve field problems.
Describe the goal in terms of a verb and a noun (Example: move materials);
Identify all options possible;
Evaluate all options, eliminate those not practical, and make a short list of
options with most potential;
Evaluate the remaining options in detail; and
Select the best option.
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Chapter VIII
Cost Estimating
Cost estimating is an essential part of project management. It provides the project

information everyone is striving to know from the beginning of a project to its
completion. Cost estimates are activities people do most of the time to see if they can
afford what they want or if they can continue doing as they are doing.
Indexes, factors, methods, equations, rates, productivity profiles, historical data basis,
performance measurement procedures and the like are developed and maintained with the
sole purpose of producing better cost estimates and improve the probabilities of success.
It would be safe to say that cost estimates are everybody's business since they are the
foundations of all business transactions and profitability measurements and analysis. If
cost estimating is given the rightly and timely consideration businesses usually prosper.
The reverse situation usually brings disaster and bankruptcy.
Cost estimating may bring a great deal of frustration if pursued as an absolute value
representing the sole alternative of being right. Cost estimates rarely are matched by
actual cost data due to the remarkable number of parameters that influence a final
outcome of a cost performance.
Parameters such as inflation, shortages, business speculation, political reforms, weather

conditions, unions unrest to name a few are always present in business transactions
bringing distortion to the original forecasts.
Understanding cost estimating as a tool for guidance and cost control of a business
transaction may bring feelings of personal and professional accomplishment. Knowing in
anticipation the expenditures required for developing a project or task is the goal of every
member of the management team. Cost estimates may be classified as follows:
Order of magnitude estimates
Accuracy -30% to +30%

Basis : Cost capacity curves
Cost capacity ratios
Use : Investment screening
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Preliminary estimates
Accuracy -15% to +30%

Basis : Flow sheets
Layouts
Equipment details
Use : Budget proposal

Expenditure approval
Definitive estimates
Accuracy -5 to +15%
Basis: Defined Engineering data
Use : Processing
Construction
Capital cost estimating accuracy is directly related to information availability.
The following check lists are a guide as to what kind of information is required according
to the expected accuracy for the estimate.
Order of magnitude:
• Capacity;
• Location;
• Utility requirements;
• Service requirements;
• Building requirements;
• Raw materials and storage requirements; and
• Finished products and its storage requirements.
Preliminary:
• Site description, surveys and soil studies;

• Preliminary process flowsheet;
• Equipment Engineering specifications;
• Preliminary structural design;
• Preliminary Architectural design;
• Preliminary construction plan;
• Preliminary utility heat balance/flow sheets;
• P&ID's preliminary;
• Rough insulation specifications;
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• Motor list and sizes preliminary;
• Substations specifications;
• Preliminary lighting specifications; and
• Engineering and drafting manhours.
Definitive estimate
• Full site information;

• Process flow sheet;
• Equipment and vessels specifications and Engineering;
• Arrangements;
• Detail Engineering Building and structures drawings;
• P&ID's Engineered flowsheets and schedules;
• Insulation drawings and specifications;
• Electrical installations drawings and specifications;
• Utility installation drawings and specifications; and
• Manhours calculations for Engineering, drafting, labor, and supervision.
Order of Magnitude Estimating Methods
Cost Indexes
A cost index is a number used to indicate change in magnitude as compared with the
magnitude at some specified time usually taken as 100. Cost indexes are produced by
different procedures and different sources and published by several periodicals.
It is important to have a good knowledge of the procedures and sources utilized by the
index editor before making use of the index. Indexes are utilized when the cost of an
article in the past is known. The following expression shows how to use a cost index.
NCC ={ Cost in the past } [ I(2) / I(1) ]
where, NCC = Needed current cost
I (1) = Index value at past time

I (2) = Index value at present time
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Index Limitations
1. Indexes do not take local conditions into consideration.

2. Indexes do not make provision for technological advance.
3. Indexes are recommended within a 10-year range of known past cost only.
An IT project was built at a cost of S.R. 15 million in 1997. The cost index for this kind
of project at the development time was 350. What would be the project cost in 2003, if
the cost index for this year is 410?
The solution:
Project cost in 2003 = 15,000,000 * 410/350

Project cost in 2003 = S.R. 17,571,429
Known Cost Indexes
Engineering News-Record Construction Index
The Engineering news-record construction Index shows variations of industrial

construction cost due to variations in labor rates and material costs.
This index is based on an index value of 100 for the year 1949 and is developed upon a
composite cost for 2,500 pounds of structural steel, 1,088 feet board measure of lumber, 6
bbl of cement and 200 hours of common labor.
Marshall And Swift Equipment-Cost Indexes
The Marshall and Swift indexes are divided in two categories as follows:
• The all-industrial equipment index; and

• The process-industry equipment index
The former category is an arithmetic average of the individual indexes for 47 different
types of industrial, commercial and housing equipment.
The process-industry equipment index is the weighted average of eight process-industry

equipment, usually as follows:
Chemical 48
Petroleum 22
Paper 10
Rubber 8
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Paint 5
Glass 3
Cement 2
Clay products 2
The above indexes are based on an index value of 100 for the year 1926. The indexes
include cost of machinery, major equipment, installation, fixtures, tools, office furniture
and minor equipment.
Cost Factors
Cost factors obtained by analysis of historical data of over 500 industrial capital projects
are a handy tool for order of magnitude estimates.
After careful investigation the following factors are proposed:
Direct costs
PERCENTAGE
Purchased equipment
Cost 24
Installation 10
Instrument. & controls install 4
Mechanical 8
Electrical installed 4
Building including services 7
Services facilities installed 11
Land 2
70
Indirect costs
PERCENTAJE
Engineering and supervision 10
Construction expense 8
Contractor's fee 6
Contingency 6
Total: 30
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The following example illustrates the utilization of cost factors to produce order of
magnitude estimates.
Make an order of magnitude estimate for a factory, knowing that the cost of purchased
equipment is $500,000.
The solution:
COST ASSIGNED %
Direct costs
Equipment 500,000 24
Installation 208,000 10
Instrument / controls 83,000 4
Mechanical (installed) 166,400 8
Electrical (installed) 83,000 4
Buildings (services incl.) 145,600 7
Services facilities (inst.) 228,800 11
Land 41,600 2
Indirect costs
Engineering /Supervision 208,000 10
Construction expense 166,400 8
Contracting fee 124,800 6
Contingency 124,800 6
TOTALS $ 2,080,400 100
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Equipment Cost by Scaling
When not enough cost data for a piece of equipment is available, the following
mathematical expression, known as the six-tenth factor rule, provides the means of
developing an order of magnitude estimate.
Cx = Cy ( Qx/Qy ) 0.6 (1)
where, Cx = Cost of equipment x

Cy = Cost of equipment y
Qx = Capacity of equipment x
Qy = Capacity of equipment y
Equation 1 is the equation of a straight line when drawn on log-log paper and the
exponent 0.6 is the slope of that line. Equation 1 should not be utilized beyond a tenfold
range of capacity.
The utilization of 0.6 as the exponent for equation 1 is an oversimplification of the

concept. The actual exponent value ranges between 0.2 and 1.0 for different kinds of
equipment. Furthermore, when the cost of the equipment at different capacities is known,
the characteristic exponent for the equipment can be calculated by plotting the available
information on Log-Log paper.
Other illustrations:
A Pentium 5, 20 GB computer server costs $120,000. Estimate the cost of a Pentium 5,

50 GB with similar specifications utilizing cost by scaling and knowing that the
exponent value for this kind of equipment is 0.9.
By equation 1 :
Cx = 120,000 ( 300/200) 0.9
Cx = $ 172,847.60
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Estimate the cost by scaling of a IT facility capable of handling 200,000 services per
hours, knowing the following information:
Capacity (services / hour) Cost ($)
100,000 870,000
120,000 1,830,000
150,000 2,640,000
180,000 3,370,000
Plotting the above information in log-log paper, the slope of the line can be calculated as
follows:
slope = (log 180,000 - log 100,000) / (log 3,370,000 - log 870,000)
slope = 0.43
Utilizing equation 1:
Cost (200,000 services/hour facility) = 3,370,000 (200,000/180,000) 0.43
Cost (200,000 services/hour facility) = $ 3,526,189
Turnover Ratios
Turnover ratios are the means to develop rapid order of magnitude estimates, utilizing the
following mathematical expression:
TOR = Turnover ratio
TOR =GAS /Fixed capital investment (2)
where,
GAS = (Unit selling price)(annual production rate)
Turnover ratios are found to be in the range between 0.2 and 5.0 depending on the type of
business establishment. For chemical industries the turnover ratio is usually in the range
of 1.0 to 1.25.
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Estimate the fixed capital investment required for a chemical plant with an expected
production of 30,000 tons per year of phosphate fertilizers that sell at $300 per ton.
The turnover ratio of this kind of industry is considered to be 1.1.
Utilizing the mathematical expression given by 2 above:
Fixed capital investment = 30,000(300)/1.1 = $8,181,000
Capital Ratios
Capital ratios are the reciprocal of turnover ratios or,
C R = Fixed capital investment / Gross annual sales (3)
As the turnover ratios, these are utilized for order of magnitude estimates.
The Lang Factors Method
H.J. Lang suggests that a quick order of magnitude estimate for a process plan can be
developed multiplying the delivered cost of equipment by the following factors:
• 3.10 For solid process plants;

• 3.63 For solid-fluid process plants; and
• 4.74 For fluid process plants.
As an example, make an order of magnitude estimate for a fluid process plant knowing
that the delivered cost of the equipment is $ 4,000,000.
Utilizing the Lang factor for fluid plants:
Total plant cost = 4,000,000 (4.74) =$18,960,000
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The Hand Factors Method
Similar to the Lang factors method, W.E. Hand suggests that quick order of magnitude
estimate for battery-limits process plants can be developed by multiplying the cost of
different types of delivered equipment by the following factors:
• 4.0 For fractioning columns, pressure vessels, pumps and instruments
• 3.5 For heat exchangers
• 2.5 For compressors
• 2.0 For fired heaters
Parametric Cost Estimating
Parametric cost estimating is a technique for estimating costs from physical and/or
performance characteristics of the subject under research, regardless of the magnitude of
the aggregated systems involved. Parametric estimating may be seen as the cost
estimating of any system, made up of added components, by means of mathematical
models containing parameters and derived from prior case histories.
Apparently, parametric cost estimating was an answer to the cost growth brought about in
the 1980's due to rapidly changing technologies and performance standards.
Parametric cost estimating system building procedure.
This cost estimating procedure follows well known research techniques as follows:
Step Description
1 Problem definition
2 Data collection
3 Data normalization
4 Characteristics interdependence
5 Cost estimating relationships
6 Limitations
1 - Problem definition.
As in any Engineering endeavor, this first process determines the objectives and scope of
the whole exercise.
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2 - Data collection.
This process relates to historical cost information and how it may be collected. Essential
breakdown of cost collection usually refers to the project life cycle and its comprising
phases.
Data collection must be planned according to specific needs and parametric definitions.
3 - Data normalization.
A data normalization process means that all collected data must be adjusted for:
• Time;
• Size;
• Inflation;
• Technological advance;
• Learning process;
• Productivity; and
• Social activity.
All data gathered should be subject to consistent definitions to avoid redundant

information or confusion.
4 - Cost drivers identification.
This process identifies project characteristics that are most directly related to its cost. For
instance: Size, complexity, density, fuel economy, speed etc.
5 - Cost estimating relationship.
Once all cost drivers are identified, a relationship or interdependence may be developed
by means of statistical techniques such as regression analysis or the correlation
coefficient.
6 - Limitations.
As it is well known all these statistical methods to arrive at a mathematical best

representation of the system under study are subject to error since they are based on the
development of the line or curve of best fit and are not an exact representation of the
actual historical data.
• Forecasts must be subjected to professional interpretation;

• Time range for the derived relationship may be the most critical item;
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• Sensitivity analysis should be carried out to test the results against the parameters
influence;
• The most common difficulty in parametric estimating is to develop a comprehensive
and sufficient data bank of historical costs; and
• Records have to be collected from past projects, supplier quotations, price lists, and
other sources.
Once the data has been normalized, a "curve-fit" procedure must be followed to find the
best curve-fit for the data. Straight line, power curves, logarithmic curves, and
exponential curves are tested and reliability measured to find the best curve fit.
Once the curve-fit procedure has taken place, the information is added to the data bank
historical records to be utilized in future parametric estimating. The engineering input to
the parametric estimating system is as essential as the data bank itself. The engineering
goal should be to define and promote:
• The total design concept;

• The individual tasks picture;
• The component requirements;
• A review by the cadre; and
• A review by top management.
There are five parametric estimating methods for utilization of the data bank in
conjunction with the engineering information.
System Parameters (The sleeve of experience).
The average costs of a group of comparable projects, when equated or properly weighted
and then plotted on log-log paper, dollars versus quantity, usually fall within a certain
pattern similar to a sleeve in shape.
Each company has a unique sleeve of experience into which all of their experience data
of completed programs will fall. Learning curve techniques are then applied for the
estimating of inexperienced but similar projects.
Unit of Function Parameters
This method is based on the theory that anything can be estimated if one knows its weight
and has a reliable cost per pound multiplier or any measurable function. This method call
for developing constants from historical data and adjusting them for newness of
components and techniques, inflation and state of the art.
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Parameters for Budgeting Men, Materials, and Money
This method uses planning basic elements to set the estimate in perspective. It spreads the
requirements (manpower, materials, money) in a project over the period of performance
to provide costs for a coordinated plan to complete the project on schedule.
The estimate is based on:
• Establishing the required project activities;

• Finding activities precedence and time boundaries;
• Determining activities constraints; and
• Setting up activities manpower and material constraints.
Parameters by Type of Work and/or Material
Estimating standards (dollars per unit of output) can be developed and applied to each
type of work to arrive at the estimated total cost for any project. Standards may be as
broad or as detailed as convenient.
Parameters for Modular Work Measurement
This method calls for a system procedure that uses historical data to develop monograms
and formulas to be utilized in cost estimating new projects. It utilizes a data bank of
essential production planning and estimating know-how of specialists for each type of
work for developing modular historical data.
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Example:
Develop a parametric cost estimate for a project with the following information.
The parameters are:
Projected
Parameter
Parameter name Quantity
Code
1 Square feet of finished floor area 28,200

2 Linear feet of interior wall 23,700
3 Cross-sectional area of building 5,300
The work packages are:
Historical Unit
Package name Parameter code
cost
Excavation 3 0.40
Foundations 3 0.80
Exterior walls 1 0.95
Historical Unit
Package name Parameter code
cost
Interior walls 2 0.65
Finishes 2 0.70
Roof 3 0.29
Electrical 1 0.35
Mechanical 1 0.40
Plumbing 1 1.50
General conditions 1 0.34
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Solution:
Estimated cost per trade:
Work package Code Unit cost Trade cost
Excavation 3 0.40 (5,300)0.40 = 2,120

Foundations 3 0.80 (5,300)0.80 = 4,240
Exterior walls 1 0.95 (28,200)0.95 = 26,790
Interior walls 2 0.65 (23,700)0.65 = 15,405
Finishes 2 0.70 (23,700)0.70 = 16,590
Roof 3 0.29 (5,300)0.29 = 1,537
Electrical 1 0.35 (28,200)0.35 = 9,870
Mechanical 1 0.40 (28,200)0.40 = 11,280
Plumbing 1 1.50 (28,200)1.50 = 42,300
General cond. 1 0.34 (28,200)0.34 = 9,588
Total cost $ 139,720
Range Estimating
Traditional estimating is an application of simple mathematics. All items of the estimate

are represented by a number and to arrive to the total project estimate we add, subtract,
multiply and divide these numbers assuming they are absolutes. Real life tells us that cost
estimates are affected by ranges of possibilities and not simple numbers frozen in time
just waiting for us to count them.
Real life story is that we live in an uncertain world, a probabilistic one. Range estimating
is a decision tool that tells us the probability of having a cost overrun, how large it may
be, and what should be done now to reduce risk. Range estimating complements
traditional estimating.
The basic assumptions of range estimating are:
• Only few elements of an estimate are critical (Pareto's rule application: the few
significant and the many insignificant);
• Measure uncertainty to manage it.(Montecarlo technique); and
• It is better to approximately right than exactly wrong.
126
Range estimating breaks the problem down into its component parts. Critical elements of
the estimate are identified, the uncertainty of each critical element is assessed and then by
the use of the Montecarlo technique and a good computer the uncertainty at the bottom
line may be measured.
The Range
Range estimating uses a range as the most effective measure of uncertainty.
The range is established by three parameters:
• The probability that the critical element's actual value is equal to or less than its
target;
• The lowest estimate; and
• The highest estimate.
For instance, a critical element having a target of $5 and with the following range:
probability of 75 percent, a lowest estimate of $3 and a highest estimate of $7, means:
• There are 75 percent chances out of 100 that the critical element's value will be equal
to or less than $5;
• If the actual value is less than $5, it may be any value from $3 to $5; and
• If the actual value is greater than $5, it may be any value between $5 and $7.
So the probability parameter measures the under run probabilities, the lowest estimate
measure the degree of potential under run and the highest estimate measure the degree of
potential overrun.
Applying the Montecarlo technique one can come up with overrun, priority and
contingency profiles that will give management a range cost estimate for the project at
hand along with their probability of achieving a cost within that range.
The probability profile portrays the relationship of total cost to the chances of overrun.
The priority profile disclose those cost estimate elements contributing to larger risks and
opportunities thereby presenting management with a chance to concentrate on them.
The contingency profile generated by this procedure is an excellent management tool to

establish the confidence of not having an overrun by adding a contingency sum to the
target estimate.
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Range Estimating Example
A production expansion is to be carried out for the Arango Co. and the conceptual cost
estimate shows the following:
Labor $ 2,000,000
Material 700,000
Equipment 1,300,000
Contractor fee at 7% 280,000
Escalation fee at 5% 214,000
Total project cost estimate: $ 4,494,000
By applying the 0.5 percent rule for conceptual estimates to calculate the bottom line
critical variance:
4,494,000 x 0,005 = 22,470
Then, by reviewing the estimate, cost elements changing the project's bottom line cost
either favorably or unfavorably by $22,470 are identified.
All efforts are then concentrated on those critical cost items.
For instance :
Labor: total estimate $ 2,000,000
total critical 240,000
total noncritical 1,760,000
Contractor's fee and escalation are considered non-critical since the potential variability
of these rates is not great enough to change the bottom line cost of the project by more
than its critical variance.
The next step is to build a model that more closely represents the total cost estimate
calculations as the one shown in the diagram next page.
128
When running the model system in a computer, thousands of estimates scenarios are
created in a matter of seconds giving the user all kind of statistics to analyze.
Montecarlo simulation resulting scenarios provides the range estimator user with a set of
ranges and their corresponding probability, a quite useful proposition having into
consideration all the work input.
129
AACEI Cost Estimates Classification
130
Popper H. "MODERN COST ENGINEERING", McGraw-Hill, 1989
Turban & Meredith, "FUNDAMENTALS OF MANAGEMENT SCIENCE",

Business Publications Inc., 1985
Brosh I., "QUANTITATIVE TECHNIQUES FOR MANAGERIAL DECISION

MAKING", Reston Publishing Co.,Inc., 1995
Cleland D. : "SYSTEMS ANALYSIS AND PROJECT MANAGEMENT",

McGraw-Hill, 1975
AACE International Recommended Practice No. 17R-97
Lock D. : "PROJECT MANAGEMENT", Gower Press, 1996
Black, J.H. :"APPLICATION OF PARAMETRIC ESTIMATING TO COST

ENGINEERING", 1994 AACE TRANSACTIONS.
Adrian, J.J. CONSTRUCTION ESTIMATING", Reston Publishing company,

1992
Gallagher, P.F.,"PARAMETRIC COST ESTIMATING FOR EXECUTIVES AND

ESTIMATORS", Van Nostrand Reinhold company, 1992
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Chapter IX
Planning and Scheduling
The lack of adequate tools, techniques, and system design knowledge has been primarily
responsible for the historical difficulties with project management. Most of the traditional
scheduling techniques are based on the Gantt or barchart, a tool which has been in
common use for over 50 years. Although it is still a valuable tool, its use is limited in the
scheduling of large scale operations.
In particular, the bar chart fails to delineate the complex interactions and precedence
relationships existing among the project activities. In addition, it does not lend itself to
mechanization through the use of a high-speed electronic computer and thus cannot
utilize many of the scientific management techniques that computers make feasible.
The process of detailed planning is simply an application of the thought process that must
be developed before the actual scheduling or event-timing can begin. Planning is
determining what has to be done, when and by who in order to accomplish an objective.
The preliminary process of planning should include answers to the following questions:
Material procurement:
• Are materials needed for the project been researched for local availability?
• Have vendors established there procuring conditions according to the
project conditions?
Time for construction:
• Is the time allowed to complete the project adequate for the location and
the seasons, or will it require increased crew sizes or premium time?
Special construction equipment:
• Will special equipment be required for construction? If so, is it off-road

equipment that will require special haul routes?
• What are the load limits and bridge clearances for roads in the area?
Interdependence of the tasks:
• Are some of the tasks in this project dependent upon the completion
of another contractor or utility owner before they can be started?
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Work and storage areas:
• Have provisions been made for contractor's work and storage areas?
Manpower availability:
• Have studies been made about local availability for different labor trades?
and if so, how will the results impact the man loading of the project?
Temporary utilities:
• Will temporary utilities lines be required during the construction period?
Local by-laws:
• Have local by-laws been researched and understood? If so, what

regulations have to be followed and what permits required?
Once these questions and the additional ones drawn from the natural business process,
have been answered and satisfied the task of planning can begin.
There are three kinds of planning:
Strategic Planning
It is a planning effort considering activities to be implemented looking at a long-term

horizon, usually, it should look at more than five years ahead.
Tactical Planning
It is a planning effort regarding activities to be performed in the medium-term future,
usually, between 1 and 5 years ahead.
Operational Planning
It is a planning effort regarding activities to be performed in the immediate future

usually, between 1 and 12 months ahead.
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Planning Elements
A structured planning procedure should include the following elements:
Objective: goals/target/quota to be accomplished

Program: strategy to be follow
Budget: Resources and expenditures organized logically
Forecast: Projections of what is going to happen
Policy: guidance for decision making
Procedures: detailed methods for carrying out a policy
Standard: Define accepted performance level
Planning Tools
Engineering management science has always helped to provide the needed tools for good
planning practices. Some of the tools are enumerated here:
• Historical Information;
• Engineering capital projects checklists;
• Local time and cost estimating data;
• Project Management Software;
• Estimating methods;
• Work breakdown structures:
• Network scheduling;
• Statistical analysis;
• Optimization techniques;
• Learning curves;
• Responsibility matrix;
• Safety regulations;
• Security regulations;
• Contracting administration;
• Resource allocation techniques;
• Accountability check lists; and
• Computerized simulation techniques.
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Planning Primary Objectives
Planning engineers primary objectives are concerned with getting things done within the
shortest available period of time, minimizing cost and risk, and complying with the
required technical specifications.
To achieve these primary objectives, resources utilization, communications, and project

controls must be optimized and team spirit fostered at all times. Misunderstanding of
corporate goals, lack of discipline, poor financial estimates, plans based on insufficient
data, schedules neglected are only a few of the parameters that can go wrong.
Scheduling Engineering
Scheduling engineering is a management tool providing time and other resources

allocation to a plan, time-cost trade-offs for all activities involved, and expenditures
control.
As may be seen from the above definitions scheduling is the heart of good cost control.
Unfortunately, it is usually neglected by management due to the level of complexity that
is normally achieved and the consequent lack of understanding.
Scheduling is one of the simplest and less sophisticated tools available for cost control,
yet it only requires a good team effort at the beginning of the task and good management
support to have a powerful tool working for all.
When scholars talk about different methods of scheduling they mention:
• Barcharts scheduling;
• Velocity curves(S curves) scheduling; and
• Network scheduling.
True scheduling engineering is only concerned with network analysis practices such as
critical path method (CPM), program evaluation and review technique (PERT) and
similar developments.
Barcharts and velocity curves (S curves), are good tools when used along with network
analysis, but they should not be considered as stand-alone means to control capital
expenditures.
Critical Path Method (CPM)

CPM is a network analysis technique providing management with:
• Estimates of time and resources required to accomplish plans;

• A sequence of events and responsible personnel;
135
• Time-cost trade-offs for all activities involved;
• Resource allocation for all phases of the plan;
• Activity completion and cost compliance control;
• An organized, clear, concise way of documenting plans, programs start
and completion dates and cost performance;
• Easy training and indoctrination of new management personnel; and
• A comprehensive, psychological communication resource to foster team
unity and delineation of responsibilities.
Critical Path Method Development
To properly understand the CPM procedure, the reader should introduce himself to the
scheduling engineering jargon shown in Attachment 1 at the end of this chapter.
Once you have familiarized yourself with the scheduling terms it will be easy for you to
follow the next discussion.
Basic Rules for Drawing Networks
Rule 1. A complete network should have only one point of entry (a start event) and
only one point of exit (a finish event).
Start Finish
Rule 2. Every activity must have a preceding or tail event and a succeeding or head
event. Many activities may share a tail or a head event but not the same tail
and head event.
Rule 3. No activity can start until its tail event has been reached.
Rule 4. An event is not complete until all the activities leading into it are complete.
Rule 5. A series of activities leading back to the same event are not allowed.
(Looping)
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Convention for Drawing Networks
Convention 1. Networks proceed from left to right.
Convention 2. Networks are not drawn to scale. (convenient but not mandatory)
Convention 3. Events or nodes should be progressively numbered.(convenient but not

mandatory)
There are several ways of identifying activities on a network and they are:
• Shortened description of the job;

• Alphabetic or numeric code; and
• Identification by the head and tail events.
There are two widely used methods of diagramming networks:
• Arrow diagram method (ADM); and

• Precedence diagram method (PDM).
ADM represent activities as follows:
Activity name
Resources needed
PDM represent activities as follows:
Activity name Activity name

Resources needed Resources needed
137
Preliminary Steps for Processing a Network
Step 1
Establish what activities are involved in the project at hand and make a list of them
disregarding timing and logic. For example:
Survey, fabricate forms and rebar, excavate, grade, pour concrete, install forms and rebar
Step 2.
Establish the logical relationship among all the activities listed in step 1.
(What has to go first?)
A Survey
B Grade
C Excavate
D Fabricate forms and rebar
E Install Forms and rebar
F Pour concrete
Step 3.
Make a diagram showing activities as arrows and depicting the logic established in
step 2.
Install Pour
Grade Excavate F&R Concrete
3 4 5 6
Survey
1 2
Fabricate
Forms & Rebar
3
138
Step 4.
Estimate the time needed for the completion of each activity and depict them for each
activity on the diagram drawn in step 3.
Install Pour
Grade Excavate F&R Concrete
3 4 5 6
2 5 2 1
Survey
1 2
1
Fabricate
Forms & Rebar
3
4
Earliest Start Time Calculations (FORWARD PASS)
The earliest start of a head event is calculated by adding the earliest start of the tail event
to the duration of the linking activity. Where more than two or more routes arrive at the
same event, the longest route time must be taken as the earliest starting time. (highest
number)
The earliest starting time for the finish event is the project duration and it is the shortest
time in which the project can be completed. The figure next page shows the forward pass
calculations for the example at hand.
Activity names have been changed by initials and node numbers eliminated to avoid
congestion.
139
3 8 10 11
B C E F
2 5 2 1
0 1
A
1
5
D
Latest Start Time Calculations (BACKWARD PASS)
Starting at the last event for which the earliest start time and the latest start time is the
same, work backward through the network deducting each activity duration from the
previously calculated latest start time. When the tails of activities join the same event, the
lowest calculated late start time is taken for the event.
The figure below shows the backward pass calculations.
3 3 8 8 10 10 11 11
B C E F
2 5 2 1
0 0 1 1
A
1
5 8
D
140
Once early start and late start for each event within the network has been established, it is
easy to proceed calculating the early start, early finish, late start, and late finish for each
activity as follows.
For each activity the calculated numbers of its tail event represent its early start, late
start. Similarly, calculated numbers of its head event represents its early finish, late
finish. The following graphic illustrates it:
ES LS EF LF
(tail) (head)
Where,
ES = Early Start LS = Late Start
EF = Early Finish LF = Late Finish
The critical path is established by following the activities where early start and late start
are the same and early finish and late finish are the same. There may be several critical
paths although this situation is not desirable.
Total Activity Float (slack)
Total activity float or slack is equal to the difference between the earliest and latest
allowable start or finish times for the activity in question. The total float calculation
shows the amount of time that an activity has before it becomes critical.
Project team members are always interested in this calculation during planning and
scheduling updates for the duration of the project since they do not want surprises from
critical path deviations or more than one critical path.
There is another kind of float that is called free float and it is defined as the difference
between the earliest start of the activity's successor activity minus the earliest finish time
of the activity in question.
This concept of free float is not widely used today perhaps because it does not provide
immediate management information and is often misunderstood.
141
Network Analysis of Engineering Projects
Schedule analysis should start with careful and detailed planning of each activity and this
mean that every resource needed to accomplish the activity must be clearly consolidated
and supervised.
Let us considered the activity "Install Pumps" shown in the figure below. It is imperative
to know more about resources other than time needed to perform this activity.
INSTALL PUMPS
4 DAYS
For instance, we should know:
• Who is supposed to provide the pump?

• How the pump is going to be install?
• What kind of crew is needed to install the pump?
• Where the pump is going to be install?
• How much does the pump cost?
• How heavy the pump is?
• How much equipment if any is needed to install the pump?
• Does the equipment need a certified specialist?
• What tools are needed to install the pump?
• What kind of inspection should be carried out before and after pump
installation?
• How many tests are necessary to commission the pump?
• What kind of working permits are needed to install the pump?
• Do we need additional electrical installations to provide power to the pump?
• How many instrumentation connections are needed?
As it may be noticed, the job is not as easy as just scheduling the activity by determining
the time it will take to accomplish it. It does require a great deal of additional planning
and scheduling if we are to attain the desired objective. The figure next page shows how
resources should be loaded to an activity in the master schedule.
142
INSTALL PUMPS
4 DAYS
1 MECHANIC
1 ELECTRICIAN
2 HELPERS
1 MASON
3 PUMPS
3 BREAKERS
5 MTRS OF CABLE DOUBLE O
1 CRANE
1 SET OF SMALL TOOLS
FIGURE No.2
Therefore, the question know is to decide how much information should be enough input
for the schedule and how it should be handle to avoid confusion while at the same time
certifying that the schedule may go as planned by communicating all requirements to all
interested parties within the project team.
The answer to the first question is an easy one, all information related to the activity must
be made available to the schedule. As for the second question, however, it would be very
confusing to present everyone within the project team with information other than that
concerning their responsibilities. The best solution is to produce additional schedules out
of the master one to communicate with the corresponding trades and trigger action from
them when required.
The Original Schedule Analysis
Once all activities in the original approved schedule have been loaded with resources and
responsibilities as explained before, the original schedule analysis can start.
This task is mostly performed by charting resources against time during the project
duration as shown in the figure next page.
.
These charts will help the planners/schedulers in their job to create resource pools with
enough anticipation to avoid production bottlenecks and low productivity areas.
143
JAN FEB MAR APR M AY JUN JUL AUG SEP
10
MECHANICS
10
ELECTRICIANS
10
HELPERS
144
Cash flow analysis for the project is one of the immediate results of this analysis.
Regardless of the procedure used for time distribution of the activity cost the
planners/schedulers can calculate the amount of cash needed for each project period just
by adding the expenditures of the activities following in that period as shown in
the figure below.
Planning a company's cash flow is an important part of good financial management and
its purpose is to identify cash shortages or surpluses and to deal with them in the most
efficient manner.
Project management must supply the company with all required information about the
projects needs with enough anticipation to allow company's cash flow planning
accordingly.
100,000
50,000
DOLLARS
The concept of cash flow is not an obscure one. Either the company has a certain amount
of cash or it has not. And a lack of cash is critical. A company can sustain losses for a
time without suffering permanent damage, but a company that has no cash flow is
insolvent and in imminent danger of bankruptcy, no matter what profit picture
the future may be showing.
Projects may be significantly affected if cash flow planning is not given the necessary
attention.
From the project management point of view there are three major concerns when dealing
with cash flow planning:
1.- Project cost must be scheduled according with company's cash flow capabilities.
145
The project financial representative must establish his cash flow needs according to the
Projects consolidated budget and schedule. The company's finance department will come
back with the financial constraints ruled by the company's cash flow.
Company's priorities will play an important role in deciding what project must be
developed first.
2.- Approved projects' cash flow variances may affect the company's overall cash flow by
the lack of return in cash not expended or by the cost of meeting unplanned cash
requirements.
3.- Projects’ cash flow analysis is the foundation for capital investment appraisal and
management decision-making.
The standard method of evaluating potential investments is the cash flow analysis, which
provides the timing and the amount of all projected capital and operating expenditures
and related revenue. Annual net cash flow equals revenues minus expenditures calculated
for each year of the economic life of the project.
The reliability of the projects evaluation depends on the accuracy and completeness of
the cash flow analysis, so it is important to include all related costs, including direct
support costs. Economic evaluations of investments involve comparison of some
alternatives including taking no action.
The figure in the page before is a summary of the cash needed for each period of time
during the project duration. If there are several projects needing control by the same
planners/schedulers, they will be able to establish the cash flow needs for the group of
projects by just adding the individual cash flow need for each project. The figure next
page shows and instance of this.
The lack of adequate tools, techniques, and system design knowledge has been primarily
responsible for the historical difficulties with project management. Most of the traditional
scheduling techniques are based on the Gantt or barchart, a tool which has been in
common use for over 50 years. Although it is still a valuable tool, its use is limited in the
scheduling of large scale operations.
In particular, the bar chart fails to delineate the complex interactions and precedence
relationships existing among the project activities. In addition, it does not lend itself to
mechanization through the use of a high-speed electronic computer and thus cannot
utilize many of the scientific management techniques that computers make feasible.
146
JAN FEB MAR APR MAY JUN JUL AUG SEP
100,000
50,000
DOLLARS PROJECT A
100,000
50,000
DOLLARS PROJECT B
200,000
100,000
DOLLARS TOTAL A+B
147
The Network-Based Approach
In recent years, the problems of project management have received concentrated

attention. The work of several independent investigators led to a family of techniques that
represents a major breakthrough in project planning and scheduling techniques. The
complexity of the systems required for military projects has given great impetus to this
development.
The Polaris missile program led to the development of PERT, Program Evaluation and
Review Technique by Lockheed Aircraft Corporation along with the US navy special
projects office and a consulting firm called Booz, Allen and Hamilton. PERT is a
probabilistic approach specifically designed for new projects or projects involving a high
degree of uncertainty.
However, the normal activities of industry also involve work which fits into the project
concept quite naturally. DuPont and Remington Rand Univac interest in optimization of
such projects as routine plant overhaul, maintenance, and construction work led to the
design of CPM, the Critical Path Method in the late 50’s.
CPM is a deterministic approach requiring not only a high level of professional discipline
but a complete commitment of top management to become a useful management tool.
Known by these and hundreds of other acronyms, these techniques share a large number
of common elements. Chief among these is the use of a network flow diagram as a model
of the project's precedence relationships.
The network represents all the activity paths or sequences that must be accomplished
before the project's objective can be achieved. The longest of these sequences is the
"critical path," the identification of which permits management to focus its attention on
the progress-pacing activities of the project.
Much of the early success of PERT/CPM was based on the explicitness of the project
plan, this explicitness being essential to the construction of a network.
Being explicit about what was to take place at some much later time was a new
experience for many.
Improved communications among those concerned with a given project was the result
most frequently cited by the individuals involved in the early attempts at networking the
project plan.
148
Role of Networks in the Engineering Management System
The project management system requires the existence of means for the description and
evaluation of alternative project plans. The network models described here are means of
depicting a particular project plan in such a manner that evaluation is not only possible
but is in fact a logical extension of the model.
A given model of this basic type will describe one alternative. Other models will be
required if other alternatives are to be examined.
The modeling process will be described on the assumption that the project management
consultant is preparing the network based on information he extracts from the project
manager and others selected as sources of information.
It will further be assumed that the project management consultant knows little of the
technical details of the project and the project managers know little of the network
concept being used.
Network Construction
The network concept involves the graphic representation of activities and their
precedence requirements. Activities are elements of the project representing logical
subdivisions of the work to be done. If you considered preparing breakfast as a project,
pouring a cup of coffee could be an activity.
The level of detail used depends upon the degree of control desired.
Precedence requirements indicate which activities must be completed before a given

activity can proceed.
The project network may be formed in several ways. One of these is to start at the
realization of the end product or objective and work backwards in time in a step-by-step
fashion, determining what work must be completed in order to start a given activity.
Another approach is to list randomly all the jobs having a bearing on the project and to
determine their technological relationships as the diagram is developed.
We want to be able to identify each activity by a work item number for use in a computer
analysis of the network. Activities may be numbered in any fashion, as long as a number
is not repeated, without creating any logic or identification problems.
Computer processing of networks depends upon such numbering, but most computer
programs have the capability to take any activity numbering and renumber with
predecessor less than successor for internal usage, reverting to original numbers in the
output.
149
The belated discovery of activities is an inherent property of the network design of a
project plan. The fact that such activities may cause substantial redesign of the network
not only slows down the networking, but also tends to inhibit the project planners in their
search for activities overlooked previously. An important psychological factor in the
planning stage is inertia.
The networking system should be capable of maintaining an up-to-the minute graphical

representation of the project plan as it is being formulated. PDM precedence
diagramming system is quite effective in this respect when compared to the ADM arrow
diagramming approach. Planners sitting around waiting for the networker to incorporate
their latest disclosure into the ADM network tend to lose the enthusiasm with which they
may have started.
LAG Factors
There are situations in which establishment of the proper precedence relationship gives
an erroneous representation of the project. Consider the following portion of a project:
PAINT ROOM INSTALL CARPET
While it is true that carpeting should follow painting, it is not true that all painting must
be completed before carpeting starts. The proper representation could be obtained by
representing the activities as follows:
PAINT ROOM
INSTALL CARPET
Indicating that carpet installation can start 2 days after painting of the room has started.
150
CPM Implementation Recommendations
The project management consultant must acquaint himself with the project objective
before starting the construction of the network model. He may do this in any or all of the
following ways:
1. Reading the specifications

2. Revising drawings
3. Looking at artists' concepts of finished product
4. Discussing the function of the end product
5. Seeing a similar end product in use.
Then, he determines the management objectives, discussing with the project manager the
question of which of the following objectives should govern the project management
system operation to:
1. Meet a deadline for project completion

2. Minimize project length
3. Minimize the sum of direct and indirect costs
4. Minimize the variation in resource requirements
5. Limit the maximum resource requirements of one or more resource types
6. Communicate project information to various levels of individuals concerned
7. Co-ordinate the project with interface groups
The consultant is now ready to undertake the networking of one of the alternative
approaches to the project. Subdividing the project as discussed earlier is the first step
which should be attempted.
After either arriving at subdivisions or determining that no reasonable basis for

subdivision exists, the planner should obtain a summary narrative from the project
manager describing the approach to this portion of the work. This narrative should be in
the order of 5-15 minute discussion of the intended project plan.
The consultant is now ready to start networking. It is possible to proceed by eliciting

responses from the project manager to the question, "What other activity must take
place?", and putting the response on paper as an activity node.
In general, one should put activity descriptions, abbreviated if necessary, in the nodes
rather than code letters or numbers referring to some separate list. The network should be
a document that can be read directly. Reference to a coded list destroys the flow of logic
that one should perceive when examining a network.
151
Precedence can be ignored at this time and the result will be a sprinkling of unconnected
activities over the worksheet. Some activities are obviously near the start of the project
and will likely be placed to the left of the sheet, just as activities likely to have few
successors will be placed toward the right. It is not necessary, however, that any location
rules be followed. Worksheets containing pre-printed or predrawn nodes will speed up
the network building process.
There is reluctance on the part of many individuals to commit to even the most
preliminary network. It must be emphasized that this first network will be re-drawn and
eventually change forms and that the original network will be discarded. Even then,
however, some project managers respond more readily if their tentative descriptions are
placed in a list first, then put into the network format.
The network planner may well invest some time in listing activities purely for the
purpose of getting the modeling process underway. The network planner should never
attempt to indicate predecessors on the list, however. Precedence information is much
more easily obtained by directly incorporating each bit of information into the network as
it drawn.
When the process of discovering activities begins to lag, it is desirable to turn to

precedence identification, rather than try to identify 100% of the activities on the first
pass. Precedence may be determined by asking this question with reference to the
predecessor: "What activities cannot start until this activity is completed?" In the process
of establishing precedence connections, additional activities will be discovered and
redefinition of existing activities will become necessary.
This process should be continued until the project manager is unable to readily find
additional precedence relationships. There will usually be some precedence relationships
that are not found in this first phase, but these remaining ones can best be discovered
during the duration/resource assignment phase.
Network planning differs from bar charting in that no time/resource concerns restrict the
construction of a network. This time-free model tends to encourage the consideration of
more alternatives than does the bar chart. When the planners begin to have difficulty in
thinking of additional activities to place on the network, however, it is then time to
consider activity durations and resource requirements.
As the activities are reviewed for time/resource requirements, additional activities and
precedence relationships will be discovered and some existing ones changed.
At this point it will be helpful to have a draftsman or clerical assistant redraw the
network, attempting to have predecessors to the left of successors and attempting to
minimize the crossing of arrows.
152
It is impossible to avoid having some arrows crossing others, but a sense of flow of the
work is best attained when these are minimized. The revised network is then ready for
use in estimating time and resource requirements of each activity.
For some individuals and groups, the process of obtaining this basic network model will
give new understanding of the nature of the project. In fact, an organization may find it
desirable to go no further on its first attempt at network project management.
Such an approach might involve posting the network where the project manager can refer
to it during meetings and shading in each arrow as the activity is completed.
153
Scheduling Expressions
Activity: Work item represented by an arrow when using arrow diagramming

or by a box when utilizing precedence diagramming.
Actual completion date: The date an activity is actually completed.
Activity duration: Time allocated to complete an activity. OD stands for original

duration and RD stands for remaining duration.
Arrow diagram: A logical plan to accomplish a job where all the activities required
to complete the job are represented by arrows organized and interconnecting in sequential
order of execution.
As of date: The calendar date equivalent of time-now for statusing purposes.
Barchart: Graphic representation of items of work displaying duration of item as a

bar whose length is proportional to the time allocated to perform the item.
Calendar days: Scheduling time units for measuring activity durations which
includes weekends and holidays.
Concurrent Activities: Activities which can be performed at the same time
Constraint: Any factor which exerts a time or sequence effect upon the plan
activities.
Critical Path: The shortest time in which a plan can be performed.
Cut-off date: The assigned date on which accumulation of data for a reporting period
must be completed.
Data base: A collection of records for the project which allows management's
information requirements to be drawn from it.
Direct cost: The portion of total cost which takes into account only material, labor
and equipment assigned to a project or activity.
Dummy arrow: A dotted arrow used as a constraint in a network to display where a

relation exists between tasks but no activity arrow connects them.
Early finish (EF): Computed value for the earliest possible time at which an activity
can be completed.
154
Early start (ES): Computed value for the earliest possible time at which an activity
can begin.
Event: The starting or ending point of the activities.
Float: The difference between the computed time available in which an activity may
be completed and the estimated duration time previously assigned to the task.
Fragnet: Any area of a network that has been expanded into more detail and
definition for analysis.
Forward pass: Procedure to calculate early event times for all activities in a network.
Gantt chart: Synonym of barchart
Hammock activity: Summary of a entire subset of activities utilized to reduce the

number of project elements to track or for analysis of a portion of the plan.
I-node: The number assigned to the beginning event of an activity arrow.
J-node: The number assigned to the ending event of an activity arrow.
Lag factor: A ratio or quantity used in precedence diagramming (PDM) which

numerically indicates when a dependent activity can start relative to the
duration of the predecessor.
Lag time: A time delay required by a sequential connection in a network.
Late finish (LF): Computed value for the latest possible time an activity should be
completed according to CPM calculations.
Late start (LS): Computed value for the latest possible time an activity should begin
according to CPM calculations.
Lead time:
a) Time between the ES and schedule start for an activity.

b) Time period acting as a constraint for the beginning of an activity.
c) Time in overlapping related activities between the start of one and the start of
the second.
Loop: A networking drafting error situation in which activities are so arranged as to

cause a sequence of work to return to the originating point.
155
Leeway: Synonym for float
Logic diagram: The network plan without quantification time data.
Milestone: Planned date to start or to finish a special event.
Merge: To combine or relate two or more networks at any level to form a single
network.
Node: A circle graphically depicting the beginning or the ending event of an activity.
Normal cost: Direct cost estimate for an activity based on the normal time to perform
it.
Normal time: The estimated duration time allocated to an activity according to

established standards.
Operational planning: That aspect of planning that relates to how things will be
accomplished.
Original schedule: The user approved schedule at the time, or immediately following
project award.
Output: Material coming out of the computer which results from processing input
data
Precedence diagramming: A network diagramming technique for showing the

relationships of activities in a project with rectangular boxes symbolizing the activities.
Print out: A document usually produced from a computer that translates data into
usable, readable form.
Proposed schedule: A preliminary schedule used for a study and/or proposal.
Remaining Duration: Time required to finished an activity once it has been started.
Revised schedule: Original adjusted schedule after actual data and /or new change
decisions has been introduced.
Resource leveling: The process of scheduling activities within their available float so
as to control fluctuations of resource requirements.
Status: Activity completion level at a given point in time.
156
Sorting: The selective arranging of data to provide a needed pattern of information.
Strategic planning: That aspect of planning which evaluates what must be done
within a reasonable period of time.(usually 5 years or more)
Target: A copy of the original plan saved to compare it against performance in the
field.
Time compression: A scheduling technique by which project duration is shortened

by resource allocation speculation.
Updating: Revising the monitoring plans and documents to reflect current

performance, needed changes on logic, durations, and physical resource allocations as of
a given date.
Work Breakdown Structure: Breakdown of a project in activities and sub-activities

to allow better planning and control.
Working days: Scheduling time units for measuring activity durations which
excludes weekends and holidays.
REFERENCES
Manzanera I., “PLANNING AND SCHEDULING REFERENCES”, Aramco Saudi

Arabia, 1991
Lasser's, J.K.,"BUSINESS MANAGEMENT HANDBOOK", McGraw Hill Book

Company, 1998
Joseph J. Moder, Cecil R. Phillips, Edward W. Davis, “PROJECT MANAGEMENT

WITH CPM, PERT AND PRECEDENCE DIAGRAMMING”, Van Nostrand Reinhold
Company, 1995
PMI, "PRACTICE STANDARD FOR EARNED VALUE MANAGEMENT", PMI 2005
S.J. Amos, "SKILLS & KNOWLEDGE OF COST ENGINEERING", AACEI, 2004
A.Damodaran, "STRATEGIC RISK TAKING", WHARTON School Publishing 2007
157
Chapter X
Cost Engineering Complements

Developing a good knowledge about cost engineering related techniques such as value
analysis, engineering value analysis, and accounting procedures is the complement
needed by the cost oriented engineer.
This knowledge will foster the communication and interface required to achieve the
ultimate goal of keeping companies within profitable business.
This discussion will introduce the main concepts related to these techniques.
Value
Value may be defined as the rating or scaling of similar products or services, according to
their usefulness, importance, general worth, and degree of excellence.
Four types of value may be identified for a product:
• Exchange value: Rating according to the possibility of producing revenue;

• Use value: Rating according to the characteristics needed to perform the designed
task;
• Cost value: Rating according to the resources needed to generate the product or a
service; and
• Esteem value: Rating associated to the design features that make the product or a
service more attractive to the consumer.
It may be said that good value is the combination of lowest exchange and cost value that
provides the best use and esteem value.
Value Analysis
Value analysis is an implemented procedure utilized to eliminate unnecessary costs.
The key of the procedure is to follow a check list of common business pitfalls. It will
provide ideas for cost reduction and control, by simply asking yourself if your product or
service has an added cost due to one of the items mentioned on the list. It is pure common
sense but it does not come to all of us unless we establish and implement the procedure.
158
Value analysis checklist:
• Over-design;
• Temporarily changed circumstances;
• Temporary business pressures;
• Insufficient information;
• Poor guidance from Management;
• Employees habits and attitudes; and
• Lack of original ideas.
Companies and professionals wanting to keep unnecessary cost to a minimum should run
the checklist at least once a year.
Engineering Value Analysis
Similar to value analysis, engineering value analysis is a procedure to eliminate

unnecessary cost oriented specifically to the elimination of unnecessary project and
production expenses.
It follows six phases :
Phase 1. Feasibility study: To ascertain that the value engineering investment is

reasonable.
Phase 2. Information gathering: To collect all related literature and facts on the subject at
hand.
Phase 3. Creativity time: Ideas generation for the product or service.
Phase 4. Evaluation study: Optimization of the proposal.
Phase 5. Proposal presentation: Communication of the results to management for their

approval.
Phase 6. Implementation: Provision of all necessary means to achieve the required

objectives.
159
Accounting
The purpose of this section is to try to make the reader familiar with the accounting
jargon so he (she) may be able to interface accounting information with the rest of the
tools already presented.
Emphasis must be placed on understanding how accounts are organized for collecting
costs and how costs are allocated to those accounts according to different criteria.
Accounting is a collection, analysis, measurement, recording, and reporting of financial

data about an organization needed to:
• Plan and control costs;

• Take management decisions; and
• Costing of products.
Accounting, using centuries-old double-entry bookkeeping, is still the nearly universal

system for providing financial control of business and its build-in balancing requirements
provides an important check on accuracy.
Accounting often is subdivided into financial accounting and management accounting.

Financial accounting focuses on the use of accounting information in the decision-
making processes of individual and groups external to the business, that is, owners,
investors, creditors and the public at large.
Management accounting focuses on the role of accounting information in the decision-

making processes of managers with responsibilities inside the organization.
Whether you eventually become an owner, a manager, an investor or a creditor, or even if

your only interest in a business firm is that of a curious individual, an understanding of
accounting will enhance significantly your effectiveness as a decision-maker.
Long-term success depends in large part on the quality of the resource-allocation

decisions that are made.
Accounting information will aid the decision-making process and measure the results
after the decisions are made and implemented.
160
Cost accounting provides management with cost for products, inventories, operations, or
functions and compares actual to predetermined data.
It also provides a variety of data for many day-to-day decisions as well as essential
information for long-range planning.
Chart of Accounts
Business transactions are identified and classified with a list of named and coded files
which is called the chart of accounts.
Accounts are established according to the kind of business the company is running and
the need to keep records of different expenditures incurred, management analysis,
decision-making, and establishment of periodical financial status.
Accounts have debit and credit transactions and the difference between the total debit and
credit transactions establish the balance for them.
Not all the accounts included in the chart of accounts are shown in the balance sheets.
Those shown in the balance sheets are usually called balance sheet accounts. Similarly,
profit-and-loss accounts are those accounts utilized for preparing a financial statement
called the income statement which reflects the operation results for a specified period of
time.
A typical chart of accounts is shown on pages 171 to 173.
Accounting Benefits
The role of accounting in business is only limited by the imagination of the system user.
Some of the multiple benefits that a good accounting system can bring to an organization
are listed below:
1. Data-preparation required in planning and controlling operations.

2. Data-preparation in connection with day-to-day decisions or special projects that
require a choice among alternative courses of action.
3. Participation in the creation and execution of budgets.
4. Establishment of procedures to improve operations and reduce costs.
5. Cost analysis and development to improve cost determination and review of
variances.
6. Cost recording and reporting by product or department.
161
Cost Accounting
Cost accounting is the processing and evaluation of operating cost data to provide
information for external reporting internal planning, control of ongoing operations, and
special decisions. Cost accounting is a more detailed cost-analysis oriented form of
management accounting.
The requirements to establish a good cost accounting system are:
1- Good knowledge of the company's organizational structure.

2- Understanding of the company's procedures and processes.
3- Knowledge of cost information management is expecting to have.
Cost accounting provides the company with the following functions:
A- Means of costing inventories

B- Efficient measuring for resource utilization
C- Data base for planning the future and controlling the present
D- Cost of sales information
E- Basic data for establishing sales prices
F- Cost data base for decision-making on new issues
Cost Classification
Cost may be classified by countless business needs and particular business reasons. Some
of those classifications are presented below:
A- By Time of Computation
• Historical costs: Those costs that have been incurred and recorded in
company's books; and
• Budgeted costs: Estimates for future costs.
B- By Behavior in Relation to Activity Fluctuation
• Variable costs: Costs which change in direct proportion to change in volume or

activity;
• Fixed costs: Costs which remain unchanged within a relevant range despite wide
fluctuations in volume or activity; and
• Semi-variable costs: Costs which vary but not in direct proportion to volume or
activity.
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C- By Management Function
• Manufacturing costs: Sum of all costs needed to manufacture a product;

• Selling costs: Cost incurred in selling a product or a service;
• Administrative costs: Costs incurred in policy-making activities; and
• Financial costs: Costs related to financial activities.
D-By Product Costs
• Direct materials costs: Cost of materials which are an integral part of the finished
product;
• Direct labor costs: Cost of labor directly involved in manufacturing a product and
• Indirect manufacturing costs: Cost of manufacturing supervision and other
resources that cannot be charged directly to units of production.
E-By Representation Costs
• Unit costs: Total costs divided by total production; and

• Total costs: Summation of all cost involved in the operation.
F-By Timing of Charges against Revenue
• Product costs: Direct costs of finished goods; and

• Period costs: Expenses incurred for the period which belong to different operation
stages.
G-By Utilization of Decision-Making
• Sunk costs: Cost which do not have any bearing in decision-making because they
have been already incurred or they are unavoidable;
• Relevant costs: Cost which can be monitored and controlled;
• Avoidable or incremental costs: Cost that can be avoided or increased for
beneficial purposes;
• Opportunity costs: Cost incurred to make use of circumstantial market situations;
and
• Standard costs: Costs representing a product's planned cost.
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Types of standard costs:
• Basic: Cost remaining constant through the year and is utilized as an index
number;
• Expected: Anticipated standard cost result for the year based on actual conditions;
• Normal: Average figure representing the standard cost result during a period; and
• Theoretical: A standard cost based on maximum possible level of output under
ideal conditions.
Costing
Costing refers to the system utilized to account for all operation costs.
Costing is deciding:
A- The company's inventory valuation procedure

B- The organization's way of allocating cost to different phases of the operation
C- The procedure to handle joint products
D- The procedure to allocate costs to by-products
E- The company's procedure to accumulate unit costs
There are two basic accounting techniques for accumulating unit costs:
• Job order costing: is used when a company is producing many different products
in batches. Costs are assigned to the job order and then averaged over the number
of units produced within the job order; and
• Process costing: is used when a company is processing a single product on a
continuous basis. Costs are assigned to units of work performed during a given
period.
Absorption Costing
Absorption costing is an inventory valuation procedure whereby all manufacturing costs,

including direct materials, direct labor, and variable manufacturing overhead are assigned
to the units produced.
Direct Costing (Variable Costing)
Unlike the absorption costing this procedure assigns only variable manufacturing cost to
the units produced. All other costs including fixed manufacturing, variable selling and
administrative, and fixed selling and administrative, are treated as period costs.
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Absorption costing separates costs on the basis of function:
Manufacturing costs v. selling and administrative costs
Direct costing separates costs on the basis of behavior:
Variable costs v. Fixed costs
Joint Products
Joint products refer to individual products, each of significant sales value, produced
simultaneously as a result of a common process or series of processes.
Joint product costs are those which arise in the course of such common processes
involving common raw materials.
Joint product costs are inherently indivisible having been incurred simultaneously for all
joint products.
Joint Costs Allocation Methods
Market or sales value method
This method assumes that a direct relationship exists between cost and selling price,
namely, that the selling of a product is determined primarily by the production cost.
The procedure used under this method depends on whether or not the market value is
known at the split-off point.
When market value is known at split-off point:
JCA = (A/B)*C
Where, JCA = Joint cost allocation

A = Total market value of each product
B = Total market value of all products
C = Joint cost
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When market value is not known at split-off point a hypothetical market value at split-off
point is calculated.
Quantitative unit method for Joint Cost Allocation
Under this method the quantity of output (expressed in units) is utilized as the basis for
allocating joint costs.
JCA = (M/N) * JC
Where,
JCA = Joint cost allocation for each product
M = Total units of each product
N = Total units of all products
JC = Joint cost
For the same example above:
Product A: (40,000*310,000)/140,000 = 88,571

Product B: (80,000*310,000)/140,000 = 177,143
Product C: (20,000*310,000)/140,000 = 44,286
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Single Average Unit Method
This method assumes that all products from a common process should be charged a
proportionate share of the total joint cost based on the number of units produced.
Cost per unit = Total joint costs / Total number of units produced
Utilizing the same example above :
Cost per unit = 310,000/ 140,000 = $2.2143
Allocation:
Product A = 40,000 * 2.2143 = 88,572
Product B = 80,000 * 2.2143 = 177,144
Product C = 20,000 * 2.2143 = 44,286
Weighted average unit cost method
JCA = {(F )( V)}/ E

where,
JCA = Joint cost allocation
F = Total weighted average units of each product
E = Total weighted average units of all products
V = Joint cost
A weighted factor is given to each product according to special production conditions.
By-products
A by-product is a product of relatively small total value that is produced simultaneously

with a product of greater total value, usually called the main product.
An example is the animal skins at a slaughter house.
By-products can be of two kinds:
A- Those sold in their original form without need of further processing

B- Those which require further processing before they can be sold
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By-products Costing
There are various methods for costing by-products depending on whether allocation of
joint production cost to the by-product is performed or not.
If joint production cost is not allocated to the by-product:
A non-cost Method
The revenue from sales of the by-product is listed on the income statement as:
Other income
Additional sales revenue
A deduction from cost of goods sold of the main product
A deduction from the total manufacturing cost of the main product
Recognition of Net Revenue Method
The revenue from sales of the by-product, less the cost of marketing it is shown in the
income statement as in method 1.
Replacement Cost Method
This method is applied by companies whose by-products are used within the company.
Production cost for the main product is credited for the cost of the by- product (if it had to
be bought) and the department using the by-product is debited accordingly.
If some portion of the joint production cost is allocated to the by-product:
Market Value Method
Manufacturing cost of the main product is credited by an estimate of the by-product's

value at the time of recovery. (prior to the split-off point from the main
product)
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Overhead Allocation
The overhead-cost allocation classification includes all production costs which are not
considered prime costs (direct material and direct labor).
The main overhead costs can be distinguished as follows:
Indirect Materials also known as supplies are materials such as lubricants that do not
become a part of the finished product.
Indirect Labor also known as the wages and salaries of employees who are not directly
connected with the manufacture of a product such as supervisors, maintenance workers,
and internal transportation. Frequently, fringe benefits are included in this classification.
Facilities costs, both short-term costs of the current year and long-term costs which are
depreciated over a number of years. The former include building maintenance, local real
estate taxes, and others; long term costs include buildings and equipment investments.
Service-department costs, for facilities which support production but are not part of
production, e.g., accounting, laboratories, stores, cafeteria, and first-aid stations.
The accumulated overhead costs are allocated in two stages. First, the overhead costs are
allocated to the cost centers (departments).
These, in turn, allocate the overhead to job-order costs and process costs.
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170
171
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Activity Based Costing
Activity based costing is an alternative to the traditional way of accounting. Traditionally,

it is believed that high volume customers are profitable customers, a loyal customer is
also a profitable one, and profits will follow a happy customer.
Studies on customer profitability have unveiled that the above is not necessarily true.
ABC is a costing model that identifies the cost pools, or activity centers, in an
organization and assigns costs to products and services (cost drivers) based on the
number of events or transactions involved in the process of providing a product or
service.
As a result, ABC can support managers to see how to maximize shareholder value and
improve corporate performance.
Historically, cost accounting models related indirect cost on the basis of volume. Typical
benefits of ABC include:
• Identifying the most and least profitable customers, products and channels;
• Determine the true contributors to- and detractors from- financial performance;
• Accurately predict costs, profits and resource requirement associated with
changes in production volumes, organizational structure and resource costs.
• Easily identify the root causes of poor financial performance;
• Track costs and activities and work processes;
• Equip managers with cost intelligence to drive improvements;
• Facilitate better marketing mix;
• Enhance the bargaining power with the customer; and
• Achieve better positioning of products.
With the costing based on activities, the cost of serving a customer can be ascertained
individually. Deducting the product cost and the cost to serve each customer, one can
arrive at customer’s profitability. This method of dealing with customer cost and product
cost separately has lead to identifying the profitability for each customer and to position
product and services accordingly.
ABC implementation can help make employees to understand the various costs involved,
which will in turn enable them to analyze the cost, identify the value added and non value
added activities, implement the improvement and realize the benefits. This a continuous
improvement process in terms of analyzing cost, to reduce or eliminate the non value
added activities and to achieve overall efficiency.
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ABC has helped enterprises in answering the market need of better quality product at
competitive prices. Analyzing the product profitability and customer profitability, the
ABC method has contributed effectively to the top management’s decision making
process. With ABC, enterprises are able to improve their efficiency and reduce the cost
without sacrificing the value for the customer. Many companies also use ABC as a basis
for a balanced scorecard.
This has also enabled enterprises to model the impact of cost reduction and subsequently
confirm the savings achieved. Overall, ABC is a dynamic method for continuous
improvement. With ABC any enterprise will have a built in competitive cost advantage
and can continuously add value to both its stakeholders and customers.
The implementation of ABC is not easy - not an ABC. However, special activity bases
costing software can be helpful.
Furthermore, Kaplan and Anderson have suggested time activity based costing. This is a
new approach to sidestep difficulties associated with large-scale ABC implementation. In
this revised model, managers estimate the resource demands imposed by each
transaction, product, or customer, rather than relying on time-consuming and costly
employee surveys.
The time driven ABC method is simpler since it requires for each group of resources,
estimates of only two parameters: how much it cost per time unit of capacity to supply
resources to the business activities (the total overhead expenditure of a department
divided by the total number of minutes of employee time available) and an estimation of
the unit times of activities – how much time does it take to carry out one unit of each kind
of activity – (as estimated or observed by the manager).
This time driven ABC approach also overcomes a serious technical problem associated
with employee surveys: the fact that, when asked to estimate time spent on activities,
employees invariably report percentages that add up to 100. Managers should take into
account time that is idle or unused.
This method also supports time equations, a feature that enables the ABC model to reflect
the complexity of real-world operations by showing how specific order, customer, and
activity characteristics cause processing times to vary.
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ABC Costing Models
REFERENCES
Morse W.J., "COST ACCOUNTING", Addison-Wesley Publishers Co. 1981

Matz A.and M.F. Usry,"COST ACCOUNTING", Planning and control, South-
WesternPublishing Co. 1980
Horngren C.T.,"COST ACCOUNTING", A managerial emphasis, Prentice-Hall, Inc.
1977
Beams F.A., "ADVANCED ACCOUNTING", Prentice-Hall, Inc. 1985
Arnstein W.E.and F. Gilabert, "DIRECT COSTING", Amacom, 1980
Finney and Miller's, "PRINCIPLES OF ACCOUNTING", Prentice- Hall Inc. 1974
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CHAPTER X
Contracting Basics
It is essential that the administration and management of contracts results in reducing
risks, maximizing cost savings, minimizing claims, and improving economic return.
These results can only be achieved through effectively managing contract risks:
developing tough but fair contract documents, engaging in aggressive negotiating
practices, and employing outstanding communication skills.
The process of reaching a contract requires a specific sequence of steps. In taking these
steps, the Project Manager must make a series of choices between priorities for project
objectives, degrees of risk to be assumed by the contracting parties, control over project
activities, and the cost of achieving selected goals.
This process must first be fully understood by the Project Manager, then be tempered by
experience, and finally be expanded into the ability to reach a contract through the
exercise of negotiating and communicating skills.
A Contract Definition
A contract is a mutual business agreement recognized by law under which one party
undertakes to do work (or provide a service) for another party for a previously agreed
sum of money.
Owner contracting arrangements would cover:
• Contract Conditions;
• Commercial Terms & Pricing Arrangements;
• Scope of Work (Technical); and
• Project Execution Plan.
Need for a Contract
A written contract provides the document by which the risks, obligations, and
relationships of all parties are clearly established, and ensures the performance of these
elements in a disciplined manner. In the Owner situation, the contract is the means by
which the Contractor can be controlled and ensures that the work and end product satisfy
the Owner’s requirements.
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Parties to the Contract
Most projects are executed under a three-party contractual relationship:
• The Owner, who establishes the Form of Contract and the General Conditions;
• The Engineer, who can have the following three roles:
1. Designer - carrying out the detailed engineering work, and purchasing equipment
and material on the Owner’s behalf
2. Arbitrator - acting as the Owner’s agent in administering the contract and

deciding, impartially, on certain rights of the parties under the contract
3. Project Manager – on the owner’s behalf handling design, procurement, and

construction or construction management/services; and
• The Contractor, who executes the work.
The normal contractual relationship among these three parties on a single project is for
the Owner to have one contract with the Engineer for design, procurement, and other
services, and a separate contract with the Contractor for the construction work. No
contractual relationship exists between the Engineer and the Contractor.
This is usually referred to as a “divided or split responsibility” arrangement. In an

alternative arrangement, called “single responsibility”, a General Contractor is awarded
total responsibility for the engineering, procurement, and construction.
The Project Manager must carefully decide on a specific contracting arrangement.
Contract Responsibility
The Project Manager is essentially responsible for the contract strategy, which is
developed as part of the project strategy. However, the proposed division of work,
contracting arrangements, forms of contract, and bidders’ lists should be developed in
conjunction with the company’s Contracts Department.
This combined responsibility of the Project Manager and the Contracts Department in the
contracting process can lead to inefficiencies, delays, and disagreements and can
negatively impact the project cost and schedule when there are organizational conflicts.
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Close coordination and effective communications must exist between all groups to ensure
complete agreement and commitment to the proposed contracting program. This is
particularly important in all submissions to Contract Committees and/or senior
management.
The Project Manager must obtain agreement from the company’s Contracting
Department and Insurance Department before committing to contractual language
regarding liability, indemnity, or insurance.
Contract Strategy
The following would be major considerations when developing a contract strategy for the
project:
• When and how will the work be divided up?
• How will the division of work affect Client/Project Team/Main contractor/

Vendor/Subcontract or interfaces? (This division enables the Project Coordination
Procedures to be properly prepared.)
• What type of contract should be used? Segment the project into discrete work
packages to facilitate management, and subject the work packages to available
resources. Consider the contract philosophy, the type of contract best suited to the
project, contract interfaces, bid evaluation techniques, and bid documentation.
This enables the contract strategy to be produced in liaison with the Contracts
Department.
• What roles are licensors and consultants expected to play? This allows
arrangements to be made for prequalifying suitable contractors, issuing invitations
to bid, evaluating bids, and making award recommendations.
• Are there potential conflicts of interest with other Owner projects in contractors’
offices, in vendors’ workshops, or within fabrication yards? Such conflicts can
have an impact on the bidder’s list.
• What is the availability of skilled labor? What is the industrial relations climate
local to fabrication yards and local to the construction site? Lack of labor can
delete a contractor from the bidder’s list.
• What is the quality and availability of personnel to develop, evaluate, and

administer the required type of contract/contract conditions?
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Generalities about Contracting
Contracting differs from others disciplines in the degree of uncertainty. The contractor
must deal with difficult variables, such as adverse environment, weather, terrain,
interference, personnel qualifications and tempers, different types of jobs, different
specifications and widely fluctuating costs in addition to an unknown future market for
his services. Generally speaking, contractors are men of integrity for those who are not
eventually do not survive.
Profit is the contractor's incentive and no one should expect a contractor to perform at
cost. The point is that a healthy contractor is a solid performer and a good businessman,
knows its costs and what he can or cannot do, and realizes that his reputation is built upon
his past performance.
Success breeds success. A contractor may overbid or underbid any given project, but on
the whole, at year end, he should show up reasonably in the black. This is the motivation
and makes his efforts worthwhile.
While an established contractor tries to provide steady year-round employment for a

fixed group of people he has found reliable, he must deal with multiple factors affecting
his potential. Some of these factors are:
• Level of economical activity in his area of business;

• Specialized personnel available to perform;
• Ever-growing competition;
• Difficult-to-deal-with customers;
• Internal organization problems; and
• Adverse weather conditions.
Successful Contracting Attributes
Successful contractors outside of attributing their good fortune to esoteric business skills,
suggest the following general precepts as particularly important in operating a profitable
contracting firm:
• Well-trained, experienced personnel;

• Sound job selection;
• Effective cost-control and reporting procedures;
• Careful analysis and cost/time estimating;
• Good labor and public relations;
• Alertness to improvements; and
• Sound financial policies.
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Well Trained, Experienced Organization
The secret of success in any endeavor has been defined as organization. This is certainly
true in the case of a contractor. His success and reputation depend on the effectiveness of
the organization he directs. The contractor, his management, and his staff must be well
qualified for their positions by reason of education, experience, and demonstrated ability,
with capability in organizing and directing men to accomplish jobs in minimum time with
quality workmanship, not an easy task by any means.
Contractor failures are by and large due to managerial inability, lack of experience, and
incompetence. These, of course, are linked to organizational incapability, which results in
ineffectiveness in other areas as well.
Sound Job Selection
A contractor usually has an opportunity to bid many jobs each year; many more than he
has capacity to perform. From these solicitations he must be astute enough to select only
those he can perform and which offer him a reasonable opportunity for profit. He cannot
afford to be indiscriminate, since bidding is a costly process.
If he were not selective, he might find himself overextended with disastrous results. Of
course, he would prefer a cost-plus or a negotiated contract, which minimizes this risk
and assures a profit.
Effective Cost Control and Reporting Procedures
The importance of this item should be quite obvious. It is necessary to report and record
costs effectively so that the contractor can keep on top of his job. These guide him in the
control of the job, provide the data on which he can base future estimates, and bring to
light opportunities for savings on jobs he performs.
Careful Analysis and Estimating
This is vital to the successful contractor. Knowing and understanding thoroughly all
facets of the job being bid and providing for possible unknowns he must now be able to
estimate accurately his costs for performing the job including a reasonable profit. An
estimator actually plans how the work is to done taking into account all pertinent factors.
This is true on firm or cost-plus contracts.
All plant engineers and other top management people have a need for accurate estimates;
these are the basis for approval or disapproval of proposed projects. A pet peeve of most
plant managers and plant engineers is the inaccuracy of an estimate as compared with the
final cost of the project.
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Good Labor and Public Relations
The contractor is a businessman in a community and he needs to attain and reinforce a

positive favorable image in that community. By this image he becomes known, and his
reputation becomes enhanced. Certainly this is more desirable than the alternative.
Perhaps of greater importance is his ability to deal with the people he has on his jobs. His
success or failure depends on the accomplishment of his jobs at a profit through the
people he employs.
The management skill of his organization is tested almost constantly in coordinating and
motivating various crafts involved in a job. Certainly each supervisor should have a
working knowledge of the limits of craft responsibility, as well as an understanding of the
working class environment, union or otherwise, and should be able to control and guide a
project effectively and wisely to a successful conclusion.
Alertness to Improvements
Every businessman, including contractors, must be aware of developments and methods

improvement, which may make it easier and less costly to perform his tasks. He needs to
be flexible, willing to change and not married to the old way of job performance. Many
new types of material and labor-saving devices are being developed in the present
competitive environment. The contractor must keep abreast of and utilize this advance if
he is to remain alive.
Sound Financial Policies
Most contractors who have failed seem to have met their doom because of ineptness in
financial management. It is important at all times to have sufficient cash reserves and
working capital. Excessive investments in fixed assets may result in insufficient working
capital, burdensome fixed charges and a high break even point. Inventories should be
held to a minimum, since having cash tied up in inventory may result in insufficient cash
available to cover current liabilities.
Working capital should be adequate to avoid becoming overextended financially. Many

different financial ratios, compiled by various associations from balance sheets and
profit-and-loss statements, are available. Some of the more meaningful ratios which may
apply to a contractor's business are:
• Working capital to sales 10-15%

• Cash to current liabilities 25-30%
• Net profit to net sales 5-10%
• Current assets to current liabilities 1.5-2.5 times
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Contracting Clauses
Contracting is basically an agreement between two parties, one called the contracting
party or owner and the other the contracted party or the contractor, to perform a
previously determined scope of work for a previously determined amount of money.
It is the contractor's duty to perform the scope of work for which he (she) was contracted
according with the clauses stipulated in the contract related to:
• Job specifications;
• Level of quality;
• Safety requirements;
• Cost control services;
• Reporting requirements; and
• Labor laws.
Contracting usually follows a cycle as the one depicted in the figure below. This plan
shows all the usual pre-contracting activities, the bidding process and after bidding
contract development. The discussion that follows will speculate on each area with more
detail.
Type of Contract
A pprove Technical Specs Internal Review Bid Package
Approve Bidding Draw ings
PHASE I
Invitations to bid Job ex meeting Bid Closure
PHASE II
Post-Qualif ication Technical Package Commercial Package Aw ard
PHASE III
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Pre-contracting Activities
The owner contracting representatives usually rank the contractors in the area with
special qualification requirements well either in anticipation of starting any specific
contracting activity (pre-qualification) or asked for credentials along with the bid offer
(Post-qualification).
Whatever system is chosen contractor’s qualification is usually carried out taking into
consideration a number of parameters as:
• Financial capabilities;
• Supervisory staff;
• Manpower availability;
• Equipment;
• Previous experience; and
• Workload.
Supervisory staff should be qualified by name and resume. A team of ten is essential:
• General superintendent;
• Superintendent assistant;
• Chief engineer;
• Civil engineer;
• Mechanical Engineer;
• Electrical engineer;
• Accountant;
• Quality assurance supervisor; and
• Security & safety supervisor.
Equipment should be measured by maintenance state and reported success based on

historical data. So when a project comes by the contracting people have clearly
established in anticipation the slate of contractors available to perform the job.
Once the job is ready for contracting, a bid package has to be put together. This bid
package usually contains the following:
• Instruction to bidders on how to handle their proposals;

• Contracting general conditions;
• Contracting special conditions;
• Technical specifications; and
• Drawings and schedules.
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Instruction to Bidders
The instruction to bidders should contain:
• Project description, parties involved and schedules;

• Type of contract to be followed;
• Deadline for proposal submissions;
• Number of copies for offer;
• Sealed proposals and a one-time opening after due date;
• Payment routine;
• Procurement needs;
• General safety requirements;
• Inspection regulations; and
• Bond requirements.
General Conditions
Contract general conditions will depend on specifics about every project in particular but
it usually includes:
• Definition and interpretation;

• Contract documents;
• Responsibilities;
• Duties;
• Performance bonds;
• Site inspection procedures;
• Project cost and schedule controls;
• Safety regulations;
• Security regulations;
• Compliance with company bylaws;
• Patent rights and royalties;
• Cleanliness requirements;
• Hold owner harmless clauses;
• Labor relation matters;
• Quantity assurance and quantity control clauses;
• Project modification and changes procedures;
• Unit rates;
• Owner rights; and
• Contractor default clauses.
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Special Conditions
Special conditions usually refers to those related to the kind of contract at hand which
sometimes makes the job specifically different from run-of-the mill contracts.
They usually include:
• Special work hours;

• Extensive insurance coverage;
• In-depth definitions of responsibilities;
• Extra safety precautions;
• Highly confidential issues; and
• National security involvement.
Technical Specifications
Technical specifications are the heart of the job definition and as a minimum they should
contain the following:
• Written description of what is to be built;

• Interfaces with drawings to show details and with procurement schedules
to establish real needs;
• Work breakdown structure; and
• Organization breakdown structure.
Drawings and Schedules
Drawings and schedules are the complement of the technical specification and they depict
the total scope of the job and material quantities required to be installed.
They are usually marked "For quotation only" (FQO) as opposed to drawings and
schedules later issue marked "Authorized for construction" (AFC).
Once the bid packages are distributed to bidders, a job explanation meeting is prepared to
allow prospective contractors to consult the owner design team representatives. A
physical visit to the construction site will follow and bidders are usually asked to present
certification of attendance to these procedures along with their proposals.
During the period between bid distribution and bid closing a great deal of consultation
activity takes place between bidders and owner representatives to clear:
• Bid errors;
• Bid omissions;
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• Additions; and
• Deletions.
At bid closing time, contractors are requested to deposit commercial and technical
proposals in different envelopes in specially locked boxes belonging to the owner.
Owners usually have an internally developed proposal to be able to compare bids against
it.
The technical proposals go to the owner's technical team where their compliance with bid
technical requirements is established and returned to owner contracting representatives.
The owner's contracting representatives along with the owner's auditors open and analyze
commercial proposals and establish the best offers with matching technical acceptance.
A management executive committee then decides where the award goes based on the
previous analysis by other groups mentioned above. Once the award is communicated to
the successful contractor, a meeting is set up to ultimate details and analyzed the contract
document to be signed.
The contract should establish clearly the owner and contractor representatives and their
respective duties through out the contract. After contract signature, the contract
performance starts by securing approval of the contractors planning and scheduling of the
activities involved and mobilization of contractor's equipment and personnel.
Performance measurement procedures are set up and followed and accountability reports
based on the project breakdown structure and the previously establish code of accounts
are started. During the first construction site meeting, daily, weekly and monthly report
needs are organized and enforced.
Inspection and safety from the owner's office will keep close attention to field
developments and highlights of inappropriate work produced. Close analysis of the data
collected by the above mentioned reports and schedule updates will generate decision-
making activities within the project management team to keep the contract running under
budget and on schedule.
Planning and Scheduling
As mentioned above Planning and scheduling starts at contract signature with the
approval of the contractor's schedule. The contract should have specific provisions to deal
with:
• Lack of progress;
• Project design changes;
• Manpower allocation;
• Original schedule updates and revisions;
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• Reporting needs and frequency;
• Material procurement interface; and
• Tools and equipment allocation.
Contracting Arrangements
Engineering and construction contracts can be drawn in a great variety of forms,

depending on the contract strategy and the financial resources of the Contractor. The
most successful contracts have at least one element in common: thoughtful and thorough
preparation before the contract is let.
Contractual arrangements in construction are becoming increasingly more involved,

which leads to the potential for significant added costs. Project complexity and the
changing and increasingly costly legal and insurance environments, are major reasons for
considering whether better contractual arrangements are possible.
Contracts, of course, must be made early in the life of a project. To do this while
simultaneously providing for the risks of uncertainties and gaining improved performance
and innovation presents major challenges for Owners and Contractors alike.
Forms of Contract
There are three principle types of contracts: reimbursable, measured (unit price), and
lump sum. The following forms of contract are typical of these types:
• Cost Reimbursable (Time & Material);

• Cost Reimbursable with Percentage Fee;
• Cost Reimbursable with Fixed Fee;
• Cost Reimbursable Plus Cost/Schedule Bonus – Penalties;
• Measured Unit Price (Mostly Construction);
• Guaranteed Maximum Price; and
• Lump Sum/Fixed Price.
The objectives of cost, time, quality, risks, and liabilities must be analyzed and
prioritized, since trade-offs will probably be necessary in deciding the type of contract to
be used.
Reimbursable Cost Contracts
These require little design definition, but need to be constructed in a way that allows
expenditures to be properly controlled. The major advantage of a reimbursable cost
contract is time, since a contract can be established during the early stages of a project.
187
This type of contract does present a disadvantage to an Owner, however, since poor
Contractor performance can result in increased costs, and the final costs are the Owner’s
responsibility. Additionally, the final/total investment level is not known until the work is
well advanced.
Reimbursable cost contracts can contain lump sum elements. E.g. the Contractor’s
overhead charges and profit, which is usually preferable to a percentage basis for
calculating these costs. Reimbursements may be applied to salaries, wages insurance and
pension contributions, office rentals, communication cost, etc. Alternatively,
reimbursement can be applied to all-inclusive hourly or daily rates for time spent by
engineers on the basis that all office support costs are built into these rates.
This form of contract is generally known as a fixed fee/reimbursable cost contract and
can be used for both engineering and other office services as well as for construction
work.
Such arrangements give the Owner greater control over the Contractor’s engineering
work, but the effect of reducing the lump sum content of the Contractor’s remuneration is
to reduce its financial incentive to complete the work economically and speedily. It also
reduces the ability to compare/evaluate competitive bids, since the comparison that can
be made between Contractor bids involves only a small percentage of the project cost. It
is possible that the “best” Contractor may not quote the lowest prices.
Requirements
• A competent and trustworthy contractor;

• Close quality supervision and direction by the Owner; and
• Detailed definition of work and payment terms covered by lump sums and
by “all-inclusive” rates.
Advantages
1. Flexibility in dealing with changes (which is very important when the job is not
well defined), particularly if new technology development is proceeding
concurrently with the design.
2. An early start can be made.
3. Useful where site problems such as Internal Review (IR) delays and disruptions
may be encountered.
4. Owner can exercise control on all aspects of the work.
188
Disadvantages
1. Final cost is unknown.

2. Difficulties in evaluating proposals--strict comparison of the amount tendered
may not result in selection of the “best” Contractor or in the lowest cost of the
project.
3. Contractor has little incentive for early completion or cost economy.
4. Contractor can assign its “second division” personnel to the job and may make
excessive use of agency personnel and/or use the job as a training vehicle for new
personnel.
5. Owner carries most of the risks and faces the difficult decisions.
Target Contracts
(Cost and Schedule)
Target contracts are intended to provide a strong financial incentive for the Contractor to
complete the work at minimum cost and time. In the usual arrangement, the Contractor
starts work on a reimbursable cost basis.
When sufficient design is complete, the Contractor produces a definitive estimate and
project schedule for Owner review, mutual negotiation, and agreement. After agreement
is reached, these become targets. At the end of the job, the Contractor’s reimbursable
costs are compared with the target and any savings or overrun is shared between the
Owner and the Contractor on a pre-arranged basis.
Similarly, the Contractor qualifies for additional payment if it completes the work ahead
of the agreed-upon schedule. The main appeal this form of contract has to the Contractor
is that it does not involve competitive bidding for the target cost and schedule provisions.
Requirements
• A competent and trustworthy contractor; and

• Quality supervision by Owner (both technical and financial).
Advantages
1. Flexibility in controlling the work.

2. Almost immediate start on the work, even without a scope definition.
3. Encourages economic and speedy completion (up to a point).
189
Disadvantages
1. Final cost initially unknown.

2. No opportunity for competitive bidding for the “targets”.
3. Difficulty in agreeing on an effective target.
4. Variations are difficult and costly once the target has been established--
Contractors tend to inflate the cost of all variations so as to increase profit
potential with “easy” targets.
5. If the Contractor fails to achieve the targets, it may attempt to prove that this was
due to interference by the Owner, or to factors outside the Contractor’s control;
hence, effective control and reporting is essential.
Measured Contracts
(Unit Price)
These require sufficient design definition or experience in order to estimate the

unit/quantities for the work. Contractors then bid fixed prices for each unit of work. The
advantage is that the time and cost risk is shared: the Owner will be responsible for the
total quantities, and the Contractors will have the risk of the fixed unit price. A quantity
increase greater than 10% can lead to increases in the unit prices.
Requirements
o An adequate breakdown and definition of the measured units of work;

o A good quantity surveying/reporting system;
o Adequate drawings and/or substantial experience for developing the Bill
of Quantities;
o Financial/payment terms that are properly tied to the measured work and
partial completion of the work;
o Owner-supplied drawings and materials must arrive on time; and
o Quantity-sensitivity analysis of unit prices to evaluate total bid price for
potential quantity variations.
Advantages
1. Good design definition is not essential-“typical” drawings can be used for

the bidding process.
2. Very suitable for competitive bidding and relatively easy Contractor
selection, subject to sensitivity evaluation.
3. Bidding is speedy and inexpensive and an early start is possible.
4. Flexibility - depending on the contract conditions, the scope and quantity of
work can be varied.
190
Disadvantages
1. Final cost is not known at the outset since the Bills of Quantities have been
estimated on incomplete engineering.
2. Additional site staff is needed to measure, control, and report on the cost and
status of the work.
Lump Sum/Fixed Price Contracts
In this type of contract, the Contractor is generally free to employ whatever methods and
resources it chooses in order to complete the work. The Contractor carries total
responsibility for proper performance of the work although approval of design, drawings,
and the placement of purchase orders and subcontracts can be monitored by the Owner to
ensure compliance with the specification.
The work to be performed must be closely defined. Since the contractor will not carry out
any work not contained in the specification without requiring additional payment, a fully
developed specification is vitally important. The work has to be performed within a
specified period of time, and status/progress can be monitored by the Owner to ensure
that completion meets the contractual requirements.
The lump sum/fixed price contract presents a low financial risk to the Owner, and the
required investment level can be established at an early date. This type of contract allows
a higher return to the Contractor for superior performance.
A good design definition is essential, although this may be time-consuming. Further, the
bidding time can be twice as long as that for a reimbursable contract bid. For Contractors,
the cost of bids and the high financial risk are factors in determining the lump sum
approach.
Requirements
• Good definition and stable project conditions are essential;

• Effective competition is essential;
• Several months are needed for bidding and appraisal; and
• Minimal scope changes.
Advantages
1. Low financial risk to Owner; maximum financial risk is on the Contractor.

2. Cost (and project viability) is known before commitment is made.
3. Minimum Owner supervision - mostly quality assurance and schedule monitoring.
4. Contractor will usually assign its best personnel to the work.
191
5. Maximum financial motivation of Contractor - maximum incentive for the
contractor to achieve early completion at superior performance levels.
6. Contractor has to solve its own problems - and quickly.
7. Contractor selection (by competitive bidding) is fairly easy, apart from deliberate
low price.
Disadvantages
1. Variations are difficult and costly - the Contractor, having quoted keenly
when bidding, will try to make as much as possible on extras.
2. An early start is not possible because of the time taken for bidding and for
developing a good design basis.
3. The Contractor will tend to choose the cheapest and quickest solutions,
making technical monitoring and strict quality control by the Owner
essential; schedule monitoring is also advisable.
4. The Contractor has a short-term interest in completing the job and may cause
long-term damage to local Internal Review (IR) relationships, e.g. by setting
poor precedents/union agreements.
5. Bidding is expensive for the Contractor, so the bid invitation list will be
short; technical appraisal of bids by the Owner may require considerable
effort.
6. Contractors will usually include allowances for contingencies in the bid price
and they might be high.
7. Bidding time can be twice that required for other types of contracts.
192
APPENDIX A
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201
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203

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Cost Engineering Tools and Techniques

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COST ENGINEERING

TOOLS & TECHNIQUES

Profitability and Investment Appraisal 19

Decision Making Tools 36

Cost Estimating 112

Planning and Scheduling 132

Cost Engineering Complements 158

Contracting Basics 176

Appendix A – Interest tables 193

Discrete Compound Interest

or, F1 = P (1+i) (1-2)

where i = decimal interest rate or nominal rate of return

or, F2= P (1+i) (1+i) = P (1+i)2 (1-3)

P is said to be compounding at (1+i) interest factor.

The compounding is considered to be discrete because it is applied yearly. The

Expression (1-4) may now be written as follows:

F = P (F/P, i,n) (1-5)

Manipulating equation (1-6), it becomes:

(1+i/p)p - 1 = Effective rate of return

Utilizing equation (1-4):

10% yearly: F1 = 100 (1+0.10)1

Utilizing equation (1-7):

10% monthly: F1 = 100 [ ( 1+ 0.10/12)12 ]1

where Q = fraction of the year

By equation (1-8) and given that Q= 3/12:

F = 1,000 [ 1 +(3/12) 0.12 ]

and P = F (P/F,i,n) (1-10)

P = 1,000 (P/F, 10%,5)

from the tables (P/F, 10%,5) = 0.62092

Therefore, P = 1,000 x 0.62092

First Year $ 1,000 $ 3,000

Second Year 800 2,500

Third Year 900 2,800

F = 2,000(1.3605) + 1,700(1.2597) + 1,900(1.1664)

Discount Factor for Discrete Compounding

Uniform series is a uniform amount of money expended or received at regular intervals

P = A {(1+i)n - 1} / [i(1+i)n ] (1-10)

S/A,10%,4 = (P/A,10%,4)*(F/P,10%,4) = (3.1699)(1.4641) = 4.641

S = 1,500 + 1,500 x 4.641 = 1,500 + 6,961.57 = $ 8,461.57

Setting p to an infinite value (or continuous compounding), the expression, (1+i/p)p

I = yearly continuous compounding interest

Following the nomenclature utilized earlier in this chapter,

(F/P,I,n) = eIn (1-15)

CRF (i, n) = i / [ 1- (1 + i)-n] (1-17)

Utilizing equation (1-17) above,

CRF = 0.10 / [1 – ( 1 + 0.10)–10]

CRF (10%,10) = 0.16275

Annual payment = 50,000 (0.16275) = $ 8,137.5/year

Monthly payment = 8,137.5 / 12 = $ 678.13

Find the following:

a) The present value of total receipts and payments together

A company is interested in changing its manual operation on which cost is running at

An automobile can be purchased as follows,

- $2,000 down payment

- $255 a month for 48 months

Option A.- Pay $ 450,000 cash now

Option B.- Pay $ 250,000 cash now, $ 100,000 a year from

Weston J. F. and E.F. Brigham,: "MANAGERIAL FINANCE" Dryden Press,

Jelen F.C.and J.H.Black,:"COST AND OPTIMIZATION ENGINEERING" McGraw-

Lucey T.,: "QUANTITATIVE TECHNIQUES" D.P. Publications 1983

Peters M.S. and K.D.Timmerhaus,:"PLANT DESIGN AND ECONOMIC FOR

Ernest J.W. and C.L. Ernest.: "BASIC BUSINESS MATHEMATICS", Glencoe

Emory C.W. : "BUSINESS RESEARCH METHODS" , R.D. Irwin Inc.

Profit = 8 * (10,000 + 2,000) – [510,000+62,000+10,000] = $24,000 before taxes.

Z = 4,00012 + 1,00010 – (5,000*7 +10,000) = $13,000