ENGINEERING ECONOMY

ENGINEERING COST & COST ESTIMATING

| Syllabus 2

1. Foundations of Engineering Economy

Stage 1 2. How time & Interest affect money
The Fundamentals 3. Combining Factors
4. Nominal & Effective interest rate

5. Present Worth Analysis

Stage 2 6. Annual Worth Analysis
Basic Analysis Tools 7. ROR Single & Multiple Alternative
8. Benefit/Cost analysis

9. Replacement & Retention Decisions

Stage 3 10. Independent Projects
Making Better Decisions
11. Breakeven Analysis

12. Effects of inflation

13. Deprecation Methods
Stage 4 14. After-Tax Economic Analysis
Rounding out the Study 15. Cost Estimation
16. Sensitivity Analysis & DM under Risk
| Introduction 3

“ Cost is the value sacrificed

goods or services that
expected to bring current
future economic benefits to
for
are
or
the

”
firm
| Classifications 4

1 2 3 4 5
Cost Elements Cost Traceability Cost Behavior Decision Making Financial Report

| Material Cost | Fixed Cost | Opportunity Cost

| Direct cost | Product Cost
| Labor Cost | Variable Cost | Sunk Cost
| Indirect cost | Period Cost
| Expenses | Mixed Cost | Incremental Cost
Cost Elements
| Cost Elements 6

Direct Material
Material Material is called as tangible items used in
Indirect production ,The cost of commodities and
materials used by the organization.

Direct Direct Material

Elements Labour E.g. wood used for furniture, cotton for clothes,
Indirect etc.

Indirect Material
Direct
E.g. oils and lubricants, cleaning supplies etc.
Expenses
Indirect
| Cost Elements 7

Direct Labour
Material
Material The cost of
Material is remuneration
called as tangible
paid to items
the employees
used in
Indirect of the organization.
production ,The cost of commodities and
materials used by the organization.
Direct Labour
Direct Direct Material
E.g. wages of operator, workers, skilled labour,
Elements Labour weavers
E.g. wood
etc.used for furniture, cotton for clothes,
Indirect etc.
Indirect Labour
Indirect
E.g. wagesMaterial
of storekeeper, salaries of salesman,
Direct
salary
E.g. oils and
of lubricants,
works manager,
cleaning supplies
Accountant,
etc.
Expenses
maintenance workers, janitors and security
Indirect
guards. etc.
| Cost Elements 8

Direct Expenses
Labour
Material This is the
The cost cost of services
of remuneration provided
paid to to the
the employees
Indirect organization
of the organization.

Direct Expenses
Direct Labour
Direct Expenses which are directly relatedskilled
to costlabour,
of the
E.g. wages of operator, workers,
Elements Labour product such as hire of special machinery,
weavers etc.
Indirect equipment for particular job, cost of defective
Indirect
work etc.
Labour
Direct E.g. wages of storekeeper, salaries of salesman,
Indirect Expenses
salary of works manager, Accountant,
Expenses
E.g. Rent,
maintenance insurance, Telephone
workers, janitors and expenses,
security
Indirect Lightening,
guards. etc. advertising expenses etc.
Cost Traceability
| Cost Traceability 10

Direct Cost

Direct costs are costs that can be easily and

conveniently traced to a unit of product, service or
job.

Examples
Direct material, direct labour and expenses are
included in direct expenses.
| Cost Traceability 11

Indirect Cost

Indirect costs are overhead items or costs incurred

for the benefit of more than one activity.

Examples
Rent, wages, taxes, and janitorial services, etc.
Cost Behavior
| Cost Behavior 13

Fixed Cost
Fixed Cost Fixed cost is the cost, which will remain same whether there is increase or
decrease in size of production (level of activity), This certain limit where fixed
costs remain constant regardless of the level of activity is called relevant
range, Fixed cost per unit goes down as activity level goes up. E.g. Rent,
Variable Cost
insurance etc.

Total Costs
Cost/Unit

Mixed Cost

Number of Units Number of Units

| Cost Behavior 14

Variable Cost
Fixed Cost Variable costs are costs, which change with a change in the level of activity,
For example materials.

Variable cost per unit remains the same over Wide ranges of activity.

Variable Cost

Total Costs
Cost/Unit

Mixed Cost

Number of Units Number of Units

| Cost Behavior 15

Mixed Cost
Fixed Cost Costs that have both a fixed and variable costs.

For example, the cost of operating an automobile includes some fixed costs
that do not change with the number of miles driven, Other costs vary with the

Variable Cost number of miles driven.

𝑦 =𝑎 +𝑏 𝑥

Total Costs
Mixed Cost
𝑎
Number of Units
Decision Making
| Opportunity Costs 17

The cost of forgoing the chance to earn

interest (or profit) on investment funds,
Benefit foregone when alternative is
selected over another.

Example
“
Work Travel

+3000 $ - 5000 $
”
| Sunk Cost 18

A sunk cost is money already spent as a

result of a past decision.
“
Not relevant

”
to future decisions

Sunk costs should be disregarded in our

engineering economic analysis because
current decisions cannot change the past.

Sunk costs are historical or past costs, and

cannot be changed by any decision that will
be made in the future. they may also be
termed unrecoverable costs
 | Examples 19

“
Not relevant

”
to future decisions
the
Dollars
You bought
production
$25,000 two
sunk money
spent last
an year
machinery
years ago.
because allocated
automobile
is The
whether you
to purchase
money
that cost
$25,000
to drive
new
that iscost
purchase
sunk:is
it, parktheit,
production
trade it, ormachinery
sell it, you has
cannot
already
change beenthe
spent-there
$25,000 cost.is nothing that can be done
now to change that action. As engineering
economists we deal with present and future
opportunities.
| Incremental Cost 20

An incremental cost is the difference between

the costs of two alternatives.

Example
Choose between alternative models A and B.
What incremental costs occur with model B?

Incremental Model B Model A Cost Items

7,500 $ 17,500 $ 10,000 $ Purchase Price

1,500 $ 5,000 $ 3,500 $ Installation Costs

(1,750 $) 750 $ 2,500$ Annual Maintenance Costs
800 $ 2,000 $ 1,200 $ Annual Expenses
(200 $) 500 $ 700 $ Disposal Costs
Financial Reporting
| Financial Reporting 22

Direct Materials Cost

Prime Costs
Product costs Direct Labour Cost
Cost

Conversion Costs
Period Cost Overhead Cost
Other Costs
| Recurring & Nonrecurring Costs 24

If costs are repetitive and occur when an

organization produces goods or services on a
continuing basis, they are “recurring.” Otherwise
they are “nonrecurring.”

Examples $ 5,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000

Annual expenses for maintenance and Recurring

operation are also recurring expenses.
$ 35,000
Nonrecurring costs, Examples are purchase Nonrecurring
cost for real estate upon which a plant will be
built, and the construction costs of the plant
itself.
| Cash Vs. Book Costs 25

Cash Cost Book Cost

Cash cost is movement of Book cost or non-cash cost is a

money from one owner to
another, also known as a cash
flow.
Cash cost is a cost that involves
actual cash payment.
payment that does not involve
cash transaction.
Reflected only in the accounting
system
| Life-Cycle Costs 26

Life cycle cost is defined as all costs, both nonrecurring and recurring, that occur over
the life cycle of a product

The Life-cycle cost is the sum of all the costs and revenues over the entire life of the
structure, or system. All amounts are expressed in dollars and they must be time
equivalent, In includes purchase price, installation cost, operating costs, maintenance and
upgrade costs, and remaining (residual or salvage) value at the end of ownership or its
useful life.

1 2 3 4
Conception Development Execution Retirement
ENGINEERING ECONOMY

ENGINEERING COST & COST ESTIMATING

| Aims of cost estimation 28

To make decisions

To determine the most economical process

To establish the selling price of a product, so as to ensure

reasonable profit to the company

To evaluate the alternate designs

To prepare budget

To initiate the cost reduction in existing facilities

| Direct Cost 29

1 What cost components should be estimated?

2 What approach to cost estimation will be applied?

3 How accurate should the estimates be?

4 What estimation techniques will be utilized?

| Cost Estimation Approach 30

Bottom-up Approach Top-down Approach

| Bottom-up Approach Required Price =
31

Desired Profit + C
Total Cost =
Indirect Costs + B

Maintenance & Operations +

Direct Cost
Direct Labour +
Components A
Direct Materials +
Equipment & Capital Recovery +
| Top-Down Approach Competitive Price A
32

Allowed Profit - =
Target Cost =
Indirect Costs + C

Maintenance & Operations +

Direct Cost
Direct Labour +
Components B
Direct Materials +
Equipment & Capital Recovery +
| Accuracy of Estimates 33

General guidelines for accuracy Accuracy Vs. Estimation Time

±30 Feasibility
Conceptual/Feasibility stage
Cost estimates are in range of ±20% of ±25
Order of Magnitude estimate
actual costs ±20

Detailed design stage ±15 Design 60-100% complete

Detailed estimates are in range of ±5% ±10 Detailed Estimate
of actual costs (good enough for Go
±5
no-go Decisions)
Hr 1 Day 1 Week 1 Weeks 3
| Estimation Techniques 34

Estimation Techniques

Cost Estimating
Unit Method Cost Index
Relationships

Cost Capacity
Equation

Factor Method
Unit Method
| Unit Method 36

The unit method is a popular preliminary estimation technique applicable to virtually all
professions. The total estimated cost CT is obtained by multiplying the number of units N
by a per unit cost factor u.

𝐶 𝑇 =𝑢 𝑋 𝑁
Cost estimate Unit Cost factor Number of Units

Unit cost factors must be updated frequently to remain current with changing costs,
areas,and inflation.
| Example 37

An Engineer has been asked to make a preliminary estimate of the total

cost to manufacture 1500 sections of high-pressure gas pipe using an
advanced centrifugal casting method. Since a ±20% estimate is acceptable
at this preliminary stage, a unit method estimate is sufficient. Use the
following resource and unit cost factor estimates to help an Engineer.

 Materials: 3000 tons at $45.90 per ton

 Machinery and tooling: 1500 hours at $120 per hour
 Direct labor in plant:
 Casting and treating: 3000 hours at $55 per hour
 Finishing and shipping: 1200 hours at $45 per hour
 Indirect labor: 400 hours at $75 per hour
| Solution 38

Cost Estimate Unit Cost u Amount N Resource

137,700 45.90 per ton 3000 tons Materials

180,000 120 per hour 1500 Hr Machinery, tooling

165,000 55 per hour 3000 Hr Labor, Casting

54,000 45 per hour 1200 Hr Labor, Finishing

30,000 75 per hour 400 Hr Labor, indirect

566,700 $ Total Cost Estimate

Cost Index
| Cost Index 40

A cost index is a ratio of the cost of something today to its cost sometime in the past.
The index is dimensionless and measures relative cost change over time.

Index Value at time t

𝐼𝑡
𝐶 𝑡 =𝐶 𝑜 𝑋 ( )
𝐼𝑜
Cost estimate at Index Value at time to
present time (t) Cost at previous
time (to)

Because these indexes are sensitive to technological change, the predefined quantity
and quality of elements used to define the index may be hard to retain over time, thus
causing “index creep” Timely updating of the index is very important.
| Example 1 41

Estimate the total cost of labor today in Libyan Dinars for a construction project using
data from a similar project in Europe completed in 2007.

 Labor index, 2007: 789.6

 Cost in 2007: 3.9 million €
 Labor index, current: 1165.8
 Currently, 1 € 1.65 LD

Solution
5.76 million €

€5.76 million 1.65 9.504 million LD

| Example 2 42

If the Actual construction project cost is 12 millions LD, what should the index value be?

Solution
9.504 million LD 12 million LD (20.8 %)

𝐼𝑡 𝐶𝑡
𝐶 𝑡 =𝐶 𝑜 𝑋( ) 𝐼𝑡 = 𝐼𝑜 𝑋( )
𝐼𝑜 𝐶𝑜

1,472.44
Cost-Estimating Relationships
| Cost-Estimating Relationships 44

CER equations are used in design stages to estimate plant, equipment and
construction costs, CERs are generically different from index relations,
because they estimate based on design variables.

Horse
Speed Size Weight Pressure Efficiency
power

Sample Design Variables

| Cost-Estimating Relationships 45

1 2
Cost-Capacity Factor
Equation Method
| Cost-Capacity Equation 46

Cost is based on capacities at two levels with economy of scale considered

Capacity at C2
Correlating exponent
𝑥
𝑄2
𝐶 2= 𝐶 1 𝑋 ( ) 
𝑄1
Cost at Q2 Capacity at C1
Cost at Q1

x = 1, relationship is linear
x < 1, economies of scale (larger capacity is less costly than linear)
x > 1, diseconomies of scale
| Example 1 47

$ C1 = 7500 ESP Upgrading

$ ? = C2
Q1 = 4000 HP X=0.67
Q2 = 5600 HP

ESP GN4000 ESP GN5600

| Exponents X 48

 X is called capacity factor.

 X has the approximate value of 0.6 to 0.7 for wide variety of equipment and process.
 Model is often referred to as six-tenth model.
 Handbooks provide values of X.

Exponent Equipment Exponent Process

0.67 Submersible pumps 0.45 Chlorine

0.70 Spherical Tank 0.73 Ethanol

0.80 Electric Motors 1.35 Methanol

| Cost-Capacity Combined with CI 49

Multiply the cost-capacity equation by a cost index (It/I0) to adjust

for time differences and obtain estimates of current cost (in
constant-value dollars)

𝑥
𝐼 𝑡 𝑄2
𝐶 2= 𝐶 1 𝑋 ( )( )
𝐼 0 𝑄1
| Example 2 50

A 100 HP air compressor costs $3000 five years ago when the cost index
was 130. Estimate the cost of a 300 HP compressor today when the cost
index is 255. The exponent for a 300 HP air compressor is 0.9.

Solution

( )( )
0. 9
2 55 300
𝐶 300 =3000 𝑋 =15 , 817 $
1 30 100
| Factor Method 51

 Factor method is especially useful in estimating total plant cost in processing

industries
 Both direct and indirect costs can be included

Cost of major
𝐶 𝑇 =h 𝑋 𝐶 𝐸equipment items

Total cost
estimate
overall cost factor
Number of
components including
𝑛 indirect
h =1 + ∑ 𝑓 𝑖
𝑖=1
| Example 52

A new container-handling crane at the Port of Singapore is expected to

have a delivered equipment cost of $875,000.

The cost factor for the installation of tracks, concrete, steel, noise
abatement, supports, etc., is 0.49. The construction factor is 0.53, and the
indirect cost factor is 0.21. Determine the total cost by Using Factor
method?
Solution
h=1+0 . 49+ 0 .53+ 0 . 21=2 . 23
𝐶 𝑇 =2 . 23 𝑋 8 75 , 000=1 , 951 , 250 $
| Indirect Cost Allocation 53

1 2
Traditional Activity-Based
Method Costing
| Traditional Method 54

01 Possible Allocation Bases

Direct labor Hrs., Horse power Hrs., Machine Hrs. Power

Cost Category

Identify Possible
Allocation Bases
Space Occupied, Direct labor Hrs. Building maintenance

DI labor Hrs., DI labor costs, DI material cost Machine

Number of accesses Software

Number of Inspections Quality Control

02 𝐼𝑛𝑑𝑖𝑟𝑒𝑐𝑡 𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑒=

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙𝑖𝑛𝑑𝑖𝑟𝑒𝑐𝑡 𝑐𝑜𝑠𝑡𝑠
Calculate ICR
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑏𝑎𝑠𝑖𝑠 𝑙𝑒𝑣𝑒𝑙
| ABC Allocation 55

Identify Cost Drivers & expected volume

Maintenance Purchase orders Production

𝑇𝑜𝑡𝑎𝑙 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑐𝑜𝑠𝑡
𝐴 𝐵𝐶 𝑟𝑎𝑡𝑒=
𝑉𝑜𝑙𝑢𝑚𝑒 𝑜𝑓 𝑐𝑜𝑠𝑡 𝐷𝑟𝑖𝑣𝑒𝑟

Legal Utilities Quality

Use ABC rate to allocate IDC to cost centers for each activity

01 02 03 04
Identify each activity Identify Cost Drivers Calculate ABC Cost Allocate IDC
& its total cost & expected volume Rate
| Example 56

 A company produce two products ( x , y ), both of these products has the same
processes and same equipments, the difference between them lies in the size of the
product.

Number of Number of Direct Yearly No. of Direct

shipping purchase working Cost Source
Production Hrs. per unit
times orders hours
40 80 4000 1000 4 Product X

60 160 40,000 10,000 4 Product Y

 Costs related to the production volume = 110,000 $

 Costs related to the purchase orders = 120,000 $
 Costs related to shipment = 210,000 $
 Determine the indirect cost per product by using traditional and ABC method?
| Solution (Traditional) 57

 Costs related to the production volume = 110,000 $

 Costs related to the purchase orders = 120,000 $
 Costs related to shipment = 210,000 $

1) Total Indirect Cost = 110,000 + 120,000 + 210,000 =440,000 $

2) Estimated Activity Level ------------> Direct working Hours

Estimated total indirect costs 440 , 000

Indirect
3) cost rate = = =10 $ / Hr
Estimated basis level 44 , 000

4) No. of Direct Hrs. per unit = 4 hrs. for product X and Y = 4 X 10 = 40 $/Hr
| Solution (Traditional) 58

5) Indirect cost of Product X = 1000 X 40 = 40,000 $

6) Indirect cost of Product Y = 10,000 X 40 = 400,000 $

Indirect Cost Indirect Cost Rate Cost Source

40,000 40 Product X
400,000 40 Product Y
| Solution (ABC) 59

Number of Number of Direct

Yearly No. of Direct
shipping purchase working Cost Source
Production Hrs. per unit
times orders hours

40 80 4000 1000 4 Product X

60 160 40,000 10,000 4 Product Y

100 240 44,000 11,000 Total

Shipment purchase orders production Cost Source

210,000 120,000 110,000 Cost

100 240 11,000 Volume of Cost Drivers

2100 per shipment 500 per order 10 per unit ABC Rate
| Solution (ABC) 60

Shipment purchase orders production Cost Source

210,000 120,000 110,000 Cost

100 240 11,000 Volume of Cost Drivers

2100 per shipment 500 per order 10 per unit ABC Rate

1) Indirect cost of Product X = (10 X 1000) + (80 X 500) + (40 X 2100) = 134,000 $

2) Indirect cost of Product Y = (10X10,000) + (160 X 500) + (60 X 2100) =306,000 $

3) Indirect Cost of Product X per Unit = 134,000 /1000 = 134 $/Unit

4) Indirect Cost of Product Y per Unit = 306,000 /10,000 = 30.6 $/Unit

| Comparison 61

Indirect Cost of Product per Unit

Cost Source
ABC Traditional
134 $ 40 $ Product X
30,6 $ 40 $ Product Y
Thank You 