Engineering Costs

and Cost Estimating

Costs:
Fixed and Variable Cost Indices
 Direct and Indirect
 Marginal and Average Estimating Benefits
 Sunk and Opportunity
 Recurring and Non-Recurring Cash Flow Diagrams
 Incremental
Cash and Book
 Life-Cycle

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 Engineering Costs and Cost Estimating

Fixed Costs:
are constant and unchanging regardless of the level of the activity
over a feasible range of operations for the capacity or capability
available.
Variable costs:
operating costs that vary in total with the quantity of output or other
measures of activity level.
Direct Costs:
cost that can be reasonably measured and allocated to a specific
output or work activity.

Indirect/Overhead Cost:
cost that it is difficult to attribute or allocate to a specific output or
work activity.

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 Engineering Costs and Cost Estimating

Key Question: Where do the numbers come from that we

use in engineering economic analysis?

• Cost estimating is necessary in an economic analysis

• When working in industry, you may need to consult

with professional accountants to obtain such
information

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 Engineering Costs and Cost Estimating
Example 2-1. Albert’s Charter Bus Venture
Albert plans to charter a bus to take people to see a wrestling
match show in Jacksonville. His wealthy uncle will reimburse
him for his personal time, so his time cost can be ignored.

Item Cost Item Cost

Bus Rental $80 Ticket $12.50
Gas Expense $75 Refreshments $ 7.50
Other Fuel Costs $20
Bus Driver $50

Total Costs $225.00 Total Costs $20.00

• Which of the above are fixed and which are variable costs?
• How do we compute Albert’s total cost if he takes n people to
Jacksonville?

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 Albert’s Charter Bus Venture (example)

• Answer: Total Cost = $225 + $20 n. 

Graph of Total Cost Equation:  

Total cost

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 Albert’s Charter Bus Venture (example)
marginal cost (marginal tax)

-The cost to take one more person Marginal and Average Costs

average cost $300.00

- Average cost: the cost per person
$250.00
Avg. Cost = TC/n
$200.00
Avg. Cost = ($225+$20n)/n
Average
$150.00 Marginal
– For n = 30, TC = $885

Cost
Trip Ticket
Avg. Cost = $885/30 = $29.50 $100.00

$50.00
Total cost cannot be calculated
from an average cost value $0.00
1 3 5 7 9 11 13 15 17 19 21 23
Number of People
For n =35, TC  35*($29.50) = $ 1,032.50

Suppose Albert’s ticket cost drops to $10 per person if he brings 20 or more people. What is the total cost equation? What is
the total cost if number of people exceeds capacity of 1 bus (bus capacity= 40)? What is the marginal cost in this case?

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 Albert’s Charter Bus Venture (example)
Question: Do we have enough information yet to decide how much money
Albert will make on his venture? What else must we know?
– Albert needs to know his total revenue

– Albert knows that similar ventures in the past have charged $35 per person, so that
is what he decides to charge

– Total Revenue = 35n (for n people)

Albert's Charter Bus Venture

Total profit = $1,000.00

Total Revenue – Total Cost:
$800.00
35n – (225 + 20n) = 15n – 225
$600.00

Question: $400.00 Cost

Total Cost
Revenue
How many people does $200.00 Profit
Albert need to break even?
$0.00
(not lose money on his venture) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23
($200.00)
Solve 15 n – 225 = 0 => n=15
($400.00)
more than 15, he makes money Number of People
 
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 Albert’s Charter Bus Venture (example)
Where is the Loss Region?
Where is the Profit Region? 
Where is the Breakeven point?
Can you make this chart in Excel?

Albert's Charter Bus Venture

$1,000.00

$800.00

$600.00

$400.00 Cost
Total Cost

Revenue
$200.00 Profit

$0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23
($200.00)

($400.00)
Number of People

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 Sunk Costs
A sunk cost is money already spent due to a past decision.
– As engineering economists we deal with present and future
opportunities
– We must be careful not to be influenced by the past
– Disregard sunk costs in engineering economic analysis

Example:
Suppose that three years ago your parents bought you a laptop PC for $2000.
– How likely is it that you can sell it today for what it cost?
– Suppose you can sell the laptop today for $400. Does the $2000
purchase cost have any effect on the selling price today?

The $2000 is a sunk cost. It has no influence on the present opportunity to

sell the laptop for $400. ( stock costs now $20 you bought for $80)

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 Opportunity Cost
• An opportunity cost is the benefit that is foregone by
engaging a business resource in a chosen activity instead
of engaging that same resource in the foregone activity.

• Example: Suppose your wealthy uncle gives you $75,000

when you graduate from high school. It is enough to put
you through college
(5 years at $15,000 per year). It is also enough for you to
open a business making web pages for small companies
instead of going to college. You estimate you would make
$20,000 per year with this business.

– If you decide to go to college you give up the opportunity to make

$20,000 per year
– Your opportunity cost is $20,000
– Your total cost per year is $35,000
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 Sunk and Opportunity Cost
Example 2-3. A distributor has a case of electric pumps.
The pumps are unused, but are three years old. They are
becoming obsolete. Some pricing information is available
as follows.

Item Amount Type of Costs

Price for case 3 years ago $7,000 Sunk cost

Storage costs to date $1,000 Sunk cost

List price today for a case of Can be used to help
new and up to date pumps $12,000 determine what the lot is
worth today.
Amount buyer offered for case
2 years ago $5,000 A foregone opportunity

Case can currently be sold for $3,000 Actual market value today
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 Recurring and Non-Recurring Costs
• Recurring costs are those expenses that are known, anticipated,
and occur at regular intervals. These costs can be modeled as cash
flows.

• Non-recurring costs are one-of-a-kind and occur at irregular

intervals. They are difficult to plan for or anticipate.

• Example. You decide to landscape a lot of ground and then care for
it. Which are recurring and which are non-recurring costs you incur? 

– Remove existing trees, vegetation

– Have land graded with bulldozer
– Have yard planted with grass
– Plant shrubs, trees
– Mow grass
– Fertilize grass, shrubs
– Water grass, shrubs 
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 Incremental Cost
• Incremental Cost is the additional cost that results from:
– Increasing the output of a system by one (or more) units
– Selecting one alternative over another

Example 2-4. Philip can choose between model A or model B. The

following information is available.

Cost Items Model A Model B Incremental

Cost of B
Purchase price $10,000 $17,500 $7,500
Installation cost $3,500 $5,000 $1,500
Annual maintenance cost $2,500 $750 $-1,750/yr

Annual utility expense $1,200 $2,000 $800/yr

Disposal cost after useful life $700 $500 $-200

•Can we conclude that model B is more expensive than model A? 13

 Cash Costs vs. Book Costs
Cash costs
require the cash transaction of dollars from “one pocket to
another”.
Book costs
are cost effects from past decisions that are recorded in the
books (accounting books) of a firm
– Do not represent cash flows

– Not included in engineering economic analysis

– One exception is for asset depreciation (used for tax

purposes).

Example: You might use Edmond’s Used Car Guide to conclude the
book value of your car is $6,000. The book value can be thought
of as the book cost. If you actually sell the car to a friend for
$5,500, then the cash cost to your friend is $5,500.
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 Life-Cycle Costs
Life-cycle costs are the summation of all costs, both recurring
and nonrecurring, related to a product, structure, system, or
service during its life span

Products go through a life cycle, just like people

 
– Assessment & Justification Phase
– Conceptual or Preliminary Design Phase
– Detailed Design Phase
– Production or Construction Phase
– Operational Use Phase
– Decline and Retirement Phase  

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 Life-Cycle Costs
Life Cycle Cost Chart
% Total L.C. Cost

120.00%
100.00% L.C. costs
80.00% committed
60.00%
40.00% L.C. costs
20.00% spent
0.00%

Project Phase

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 Life-Cycle Costs
Comments:
• The later design changes are made in the life-cycle, the higher the costs.
• Decisions made early in the life-cycle tend to “lock in” costs incurred later
in the life cycle:

Nearly 70 to 90% of all costs are set during the design phases, while only
10 to 30% of the cumulative life-cycle costs have been spent.

• Question. When is the best time to consider all life-cycle effects, and
make design changes?

• Bottom Line. Engineers should consider all life-cycle costs when

designing products and the systems that produce them.

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 Cost Indices
• The U.S. federal government publishes cost index data through the Department of
Commerce Bureau of Statistics.

• The Statistical Abstract of the United States publishes cost indexes for labor,
construction, and materials.

• The best-known example is the consumer price index (CPI), a measure of inflation.

– The measure is scaled, so it is only the relative values of any two measures that are
meaningful.

– For example, in 1920, the measure was about 20; in 1997 it was about 160. The
conclusion is that one would have to spend 160/20, or 8 times as much in 1997 as in
1920 for the same consumables. 

• Cost indices work in the same way as price indices.

• Cost indices are dimensionless.

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Cost Indices

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 Estimating Benefits
For the most part, we can use exactly the same approach
to estimate benefits as to estimate costs:
– Fixed and variable benefits
– Recurring and non-recurring benefits
– Incremental benefits
– Life-cycle benefits
– Rough, semi-detailed, and detailed benefit estimates
– Difficulties in estimation
– Segmentation and index models

Major differences between benefit and cost estimation:

– Costs are more likely to be underestimated
– Benefits are most likely to be overestimated
– Benefits tend to occur further in the future than costs

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 Example
Two summer Camps have the following data for a 12-week session:

Camp A Camp B
Charge per camper $120 per week Charge per camper $100 per week
Fixed costs $48,000 per session Fixed costs $60,600 per session
Variable cost per camper $80 per week Variable cost per camper $50 per week
Capacity 200 campers Capacity 150 campers

a. Develop the mathematical relationships for total cost and total revenue for
camp A
b. What is the total number of campers that will allow camp B to break even?

c. What is the profit or loss for the 12-week session if camp A operates at 80%
capacity?

d. Determine the breakeven number of campers for the two camps to have
equal total costs for a 12-week session.

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 Cash Flow Diagrams
• Cash flow diagrams (CFD) Example:
summarize the costs and benefits
Time Period Size of Cash Flow
of projects
0 (today) Receive $100 (positive CF)
1 Pay $100 (negative CF)
• A CFD illustrates the size, sign,
2 Positive CF of $100
and timing of individual cash flows 3 Negative CF of $150
4 Negative CF of $150
• Periods may be months, quarters,
5 Positive CF of $50
years, etc.

Tomorrow
COMMENTS:
• The end of one period is the 100 100
beginning of the next one
50

• Arrows point up for revenues or

benefits, down for costs 0 1 2 3 4 5
• One person’s payment (cash outflow
w. neg. sign) is another person’s
receipt (cash inflow w. pos. sign) 100
Today
It is essential to use only one 150 150 22
perspective in any CFD