ECIV 5245 Engineering Economy

Engineering Costs and Cost Estimating

Lectures 3 and 4

Dr. Khaled Hamad

Chapter 2: Engineering Costs and Cost Estimating

Costs: Fixed and Variable Direct and Indirect Marginal and Average Sunk and Opportunity Recurring and Non-Recurring Incremental Cash and Book Life-Cycle

Cost Indices Per-Unit Model Estimating Benefits Cash Flow Diagrams

ECIV 5245 Engineering Economy

Dr. Khaled Hamad

Engineering Costs and Cost Estimating

Cost estimating is necessary in an economic analysis Key Question: Where do the numbers we use in an engineering economic analysis come from ? When working in industry, you may need to consult with professional accountants to obtain such information

ECIV 5245 Engineering Economy

Dr. Khaled Hamad

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.

ECIV 5245 Engineering Economy

Dr. Khaled Hamad

Engineering Costs and Cost Estimating

Example 2-1. DK Charter Bus Venture
DK plans to charter a bus to take people to see some event show in the City. He categorized his costs at shown below:

Item Bus Rental Gas Expense Other Fuel Costs Bus Driver Total Costs

Cost $80 $75 $20 $50 $225.00

Item Ticket Refreshments

Cost $12.50 $7.50

Total Costs

$20.00

Which of the above are fixed and which are variable costs? How do we compute DKs total cost if he takes n people to City?

ECIV 5245 Engineering Economy

Dr. Khaled Hamad

Charter Bus Venture Example

Question: How do we compute DKs total cost if he takes n people to the City? Answer: Total Cost = $225 + $20 n. Graph of Total Cost Equation:
Total cost
Variable $225 Fixed

n
6 ECIV 5245 Engineering Economy Dr. Khaled Hamad

Charter Bus Venture Example

Marginal cost -The cost to take one more person Average cost - Average cost: the cost per person Avg. Cost = TC/n Avg. Cost = ($225+$20n)/n For n = 30, TC = $885 Avg. Cost = $885/30 = $29.50 Total cost cannot be calculated from an average cost value
$300 Average $250 $200 Cost $150 $100 $50 $0 1 6 11 16 Number of People 21 Marginal

For n =35, TC 35*($29.50) = $ 1,032.50

Suppose DKs 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?

ECIV 5245 Engineering Economy

Dr. Khaled Hamad

Charter Bus Venture Example

Question: Do we have enough information yet to decide how much money DK will
make on his venture? What else must we know?
DK needs to know his total revenue DK 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)

$1,000 Total profit = Total Revenue Total Cost: $800

35n (225 + 20n) = 15n 225

Question:
How many people does DK need to break even?
(not lose money on his venture)

Total Cost

$600 $400 $200 $0

Cost Revenue Profit

Solve 15 n 225 = 0 => n=15 more than 15, he makes money

($200) ($400)

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15

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ECIV 5245 Engineering Economy

Dr. Khaled Hamad

Number of People

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?
$1,000 $800 Total Cost $600 $400 $200 $0 ($200)
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Cost Revenue Profit

10

15

20

($400) Number of People

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.

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ECIV 5245 Engineering Economy

Dr. Khaled Hamad

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
ECIV 5245 Engineering Economy Dr. Khaled Hamad

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Sunk and Opportunity Cost

Example 22-3. 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 Price for case 3 years ago Storage costs to date List price today for a case of new and up to date pumps Amount buyer offered for case 2 years ago Case can currently be sold for
12 ECIV 5245 Engineering Economy

Amount $7,000 $1,000 $12,000

Type of Costs Sunk cost Sunk cost Can be used to help determine what the lot is worth today. A foregone opportunity Actual market value today

$5,000 $3,000
Dr. Khaled Hamad

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
13 ECIV 5245 Engineering Economy Dr. Khaled Hamad

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 22-4. Philip can choose between model A or model B. The following information is available.
Cost Items
Purchase price Installation cost Annual maintenance cost Annual utility expense Disposal cost after useful life

Model A
$10,000 $3,500 $2,500 $1,200 $700

Model B
$17,500 $5,000 $750 $2,000 $500

Incremental Cost of B
$7,500 $1,500 $-1,750/yr $800/yr $-200

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

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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 Edmonds 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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ECIV 5245 Engineering Economy

Dr. Khaled Hamad

Life-Cycle Costs
Life-cycle costs are the summation of all costs, both recurring and Lifenonrecurring, 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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ECIV 5245 Engineering Economy

Dr. Khaled Hamad

LifeLife -Cycle Costs

L.C. costs committed L.C. costs spent
95% 85% 70% 75% 100%100%

40% 25% 15% 1% 2% 4%

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ECIV 5245 Engineering Economy

Dr. Khaled Hamad

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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ECIV 5245 Engineering Economy

Dr. Khaled Hamad

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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ECIV 5245 Engineering Economy

Dr. Khaled Hamad

Cost Indices
Example 22-7. Miriam needs to estimate material cost for a new plant. For a similar facility built 3 yrs ago, annual labor cost was $2,455,000. CPI was at 544 3 yrs ago but it is 715 today.
Index value today Annual cost today = Annual cost 3 yrs ago Index value 3 yrs ago

715 $2,455,000 = $3,227,000 544

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ECIV 5245 Engineering Economy

Dr. Khaled Hamad

Per-Unit Cost
Uses per unit factor to develop estimate Very simple yet useful technique for rough estimates Commonly used in construction industry Examples:
Service cost per costumer Safety per employee Gasoline cost per mile Maintenance cost per window Mileage cost per vehicle Utility cost per square foot of floor space

Example: Contractor gave you a quote to build you a house for $250 per square meter. Whats your cost to build a 200 sq. meterhouse?
Ans. Cost = 250 x 200 = $50,000

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ECIV 5245 Engineering Economy

Dr. Khaled Hamad

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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ECIV 5245 Engineering Economy

Dr. Khaled Hamad

Cash Flow Diagrams

Cash flow diagrams (CFD) summarize the costs and benefits of projects A CFD illustrates the size, sign, and timing of individual cash flows Periods may be months, quarters, years, etc.
COMMENTS: The end of one period is the beginning of the next one Arrows point up for revenues or benefits, down for costs One persons payment (cash outflow w. neg. sign) is another persons receipt (cash inflow w. pos. sign) It is essential to use only one perspective in any CFD 23

Example: Time Period 0 (today) 1 2 3 4 5

Size of Cash Flow Receive $100 (positive CF) Pay $100 (negative CF) Positive CF of $100 Negative CF of $150 Negative CF of $150 Positive CF of $50

Tomorrow

100

100 50

1 100

Today

ECIV 5245 Engineering Economy

Dr. Khaled Hamad

150

150