Chapter 2

Cost Estimations
Objectives
• The student will be able to:
– Define various concepts
– Provide examples that show the
importance of such concepts
– Define engineering cost estimating
– Explain the types of estimations
Index
• Introduction 3. Estimating models
1. Engineering Costs – Per unit model
– Fixed, variable, marginal, and – Segmenting model
average costs – Cost indexes
– Sunk costs – Power sizing models
– Opportunity costs – Improvement and the
– Recurring and non recurring learning curve
costs 4. Estimating benefits
– Incremental cost 5. Cash Flow diagrams
– Cash costs vs Book costs – Cash flow categories
– Life cycle costs – Drawing a cash flow diagram
2. Cost estimation
– Types of estimate
– Difficulties in Estimation
• One of a kind
• Time and effort available
• Estimator expertise
1. Engineering Costs
• All the alternatives considered can be
measured through the cost involved in them.
– We can be facing long term investments
– We can be facing current services
– We can be measuring components to include
• To deal with them we usually create
mathematical indicators that provide answers
to specific questions.
Fixed, variable, marginal, and
average costs
• If we want to characterize the relation between the decision to produce
and the involved cost we provide these indicators:
– Fixed Cost:
• Is the part of the cost that has to be supported independently of the level of
production.
• Is the cost associated with the decisions to be ready to produce, but not to the
quantity produced.
– Variable Cost
• Is the part of the Cost that increases with the amount produced
• It is the cost associated with the decision of how much to produce.
• If we want to measure cost associated with individual units we can use
two different possibilities
– Marginal Cost :
• Is the result of collecting the individual increase in cost associated with each
single unit we produce.
• Reflects the cost of each decision to produce individual units.
– Average cost:
• Is the result of collecting total costs and comparing with total production.
• Can be calculated both from fixed and variable costs
Break Even point
• With this model we can determine
B<0 B>0 whether or not a firm might obtain
benefits depending on
– The level of production,
I = PX – The cost structure
– The prices
• Incomes Increase linearly with
production I = PX
C=Co+cX • Cost is obtained through CF + CV
– CF = Co
– CV= c X
• If Actual production level is x1 we can
derive:
– Incomes: PX1
– Cost: Co+ cx1
Co x1 x – Profits:Px1- Co-CX1
x*  – Security margin: x.-x*
 P  c • An increase in market from X1 to X2
induces an increase in benefits (P-C) (x2-
x1).
 p  c  x 2  x1
e
 p  c  x1  Co
 x 2  x1
x1
More ways to categorize costs
• Direct: can be measured and allocated to a
specific work activity
• Indirect: difficult to attribute or allocate to a
specific output or work activity (also
overhead or burden)
• Standard cost: cost per unit of output,
established in advance of production or
service delivery
We need to use common cost
terminology.
• Cash cost: a cost that involves a payment of
cash.
• Book cost: a cost that does not involve a
cash transaction but is reflected in the
accounting system.
• Sunk cost: a cost that has occurred in the
past and has no relevance to estimates of
future costs and revenues related to an
alternative course of action.
More common cost terminology
• Opportunity cost: the monetary advantage
foregone due to limited resources. The cost
of the best rejected opportunity.
• Life-cycle cost: the summation of all costs
related to a product, structure, system, or
service during its life span.
Sunk Costs
• If cost has to inform us about the
consequences of any decision we run it is
necessary to avoid including the cost
associated with past irreversible decisions.
• Sunk Costs are those that have been
generated in previous phases
– Cannot be avoided.
– Should not condition future decisions.
• They are typically observed when people over
invest in their assets and then tries to sell
them overprized.
Opportunity Cost
• When a decision-maker assigns resources to a certain use, and
cannot be shared or fractionate, they are not available anymore.
• As far as resources are scarce and time is irreversible the
consequences of the assignment can be measured through the
forgone opportunities.
– If the alternative assignation for the resource is idle the resource
should have no cost.
– If the alternative assignation would provide an extra profit of 1.000
the real cost (what we loose) is that forgone benefit.
– If markets work perfectly, for market prize to be the opportunity
cost, it is necessary that nobody can obtain an extra profit through
the use of the resource.
• Opportunity cost may easily not be included in financial
documents and calculations, been one of the main differences
between finance and economic analysis
Recurring and non recurring
costs
• When observed through time arts can show
two different behaviors
– Recurring costs can be easily predicted
• Their occurrence is regular
• Their amount can be predictable through estimation
based on previous occurrence
– Non recurring costs are not So easily treated.
• We have to estimate their occurrence.
• We have to estimate their told amount.
• Very often there are directly derived from our decisions.
Incremental Cost
• We include cost through this concept
when we deal with incremental
alternatives
– We question the actual dimension of the
solution (whether we install a certain
capacity or a greater one) not the solution
itself
– There are interferences between the cost
of the different alternatives considered.
Incremental Cost
Items Alt. A Alt. B B vs A
• What is the cost of Prize 10.000 17.500 +7.500
alternative A? Inst. 3.500 5.000 +1.500
Annual 2.500 750 -1.750
• What is the cost of Manten.
alternative B? Annual 1.200 2.000 +800
• What is the cost of general
Disposal 700 500 -200
changing from A to
Initial 13.500 22.500 + 9.000
B? cost
Yearly 3.700 2.750 -950
Cost
End cost 700 500 -200
Cash Costs vs Book Costs
• If we need to measure the total cost involved in a
process we shall include all the resources that have
been employed.
• This total cost can be observed in two different
situations :
– Cash Flow: A certain part of this cost can be observed
through the monetary interchange associated with
payments.
– Book costs: part of the cost computed is the result of
previous decisions and payments and are transferred to the
present situations through accounting books.
• They describe the best image of real cost involved
• They don’t describe the real flow of payments and
 Life-cycle costs
• Modern Economic analysis has defined a different framework to analyze the
resources employed in a project.
• If we broaden the temporal and technical view of the process of production,
we can see it as a process adding value
– Starting with the designing
– Continuing with production
– Ending with the retirement and disposal
• At each step
– There are activities that add value to the project that can be measured through
the involved cost.
– There are decreasing degrees of freedom to change the situation and optimizing
the process
• Under this framework cost provides a different image of the consequences
of activities.
• This analysis is a typical matter for accounting rather than financial
analysis.
Life cycle cost C

Cost Committed

Cost spent
2. Cost Estimation
• Economic Analysis deals with measuring the
future cost consequences of present
decisions.
– They have to be estimate as far as they are
futures
– They produce a substantial uncertainty that have
to be dealt with.
– The only data we can start on are
• The technical information we obtain from engineers
• The past experience the decisioner can accumulate
• The risk level we are ready to assume
2.1. Types of estimate
• Under the concept of estimated cost we can find different meanings depending on:

– The project phase we are working.

– The level of certainty we are facing
– The time and resources available
1. Rough Estimates:
– They are used for preliminary studies.
– They are based on envelope general data
– They offer an order of magnitude of results (-30%, +60 %)
2. Semidetailed estimates
– They are used for budget calculation in preliminary studies.
– They are based on specific information about the adopted solution
– They are costly and time consuming to elaborate
– They offer middle accuracy results (-15% , +20%)
3. Detailed estimates
– They ore used in actual Contracting
– They are based on detailed technical specifications and commercial offers
– They are the most costly and time consuming activities
– They offer high accuracy (-3%, 5%)
2.2. Difficulties in Estimation
• One of a kind estimates
– Certain projects have to be analyzed and estimate without any
previous experience that can help.
– Usually there are very few occasions where we cannot build an
estimate without analogy.
• Time and Effort Available
– Information is costly and time consuming to obtain
– As far as resources are limited, engineers face a trade off between
accuracy of estimates and resources employed to obtain it.
• Estimator Expertise
– Estimates have to be made and they might be different when
developed by different analysts.
– Unfortunately if we choose to assign all the work to the best
experience technician, although we can easily obtain high quality
results while this agent is active, after his promotion or retirement we
will face an era of low quality estimates.
Bottom Up vs Top Down
Accuracy of Estimates
barato, rápido
Poco preciso

caro, lleva tiempo

Gran precisión
3. Estimating models
• Per unit model
– Costs can be estimated on a standard per unit basis
– Under this standard cost factors can be asymmetrically treated
• We shall obtain a good view of variable cost
• We will be obliged to develop exogenous scale estimates of fixed cost estimates
• Segmenting model
– If process are decomposed in individual units each of them might be more
accessible to estimation
• Cost indexes
– If our estimates are based on historical data we will face the temporal
evolution of monetary units value.
– Cost Index provide an indicator of the relationship between part and
present valve of the employed resources.
– Tipically they are published by public agencies or professional institution.
Unit Cost
• Unit Method
• The unit method is a popular preliminary estimation technique applicable to virtually
all professions.
– The total estimated cost C T is obtained by multiplying the number of units N by a per unit
cost factor u .

• Unit cost factors must be updated frequently to remain current with changing costs,
areas, and inflation. Some sample unit cost factors (and values) are
– Total average cost of operating an automobile (52¢ per mile)
– Cost to bury fiber cable in a suburban area ($30,000 per mile)Cost to construct a parking
space in a parking garage ($4500 per space)
• Cost of constructing interstate highway ($6.2 million per mile)
• Cost of house construction per livable area ($225 per square foot)
• Applications of the unit method to estimate costs are easily found. If house
construction costs average $225 per square foot, a preliminary cost estimate for an
1800-square-foot house, is $405,000. Similarly, a 200-mile trip should cost about
$104 for the car only at 52¢ per mile.
• When there are several components to a project or system, the unit cost factors for
each component are multiplied by the amount of resources needed, and the results
are summed to obtain the total cost C T . This is illustrated in Example 15.1.
Cost Indexes
• An index is a ratio or other number based on observation and
used as an indicator or measure. A preliminary cost estimate is
often based on a cost index.
• 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.
• 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.
• One such index that most people are familiar with is the
Consumer Price Index (CPI), which shows the relationship
between present and past costs for many of the things that
“typical” consumers must buy.
3. Estimating models
• Power sizing models
– To make an accurate prediction of the cost we propose to base the
estimation on a different solution (different capacity)
– The proposed model defines a relation between cost and capacity
of the solution we propose a potential expression C(q)=Kqa
– According with this expression cost and capacity follow the law:
c’/c=(q’/q)a
– The model is based on an estimate of the scale factor a that can be
obtain from several technical publications
• Improvement and the learning curve
– Learning Curves show the fact that a repeated process is expected
to show a decreasing Cost though the learning process involved in
repetition
– The evolution of time needs in a repeated process follow this
behavior: TN = To x N b
– Learning Curve is characterized by
• The % of reduction of time obtained when the number of operations is doubled.
• The production level where steady state is reached
Power Sizing
Scale Analysis
• We have to estimate the 
cost of a heat installation C (q ')  q '  C (q ')  2.500  0, 55
    
for a 2.500 ft2 C (q)  q  50.000  1.000 
• Data available is:  2.500 
0, 55
C (q ')  50.000     82.800
– An equivalent installation for  1.000 
a 1.000 ft2 5 years ago had
Prize index
a cost of $50.000
– Sizing exponent is 0.55 C(t') IP(t') C(t') 1487
  
generally accepted in C(t) IP(t) 82.800 1306
technical framework 1487
– Prize index has changed C(t')  82.800   94.300
1306
from 1.306 to 1.487
• Cost increases with capacity
according with a potential
function with an exponent of
0,55
Learning Curve
• A task shows a LCR of • TN = T1 x N b

85% • TN/2 = T1 x (N/2) b

• The steady state is • Tn/Tn/2=(2) b

reached on 5’ at unit
• 0.85 =(2) b
16
• Log (0.85) = b log2
• The tasks requires 2
workers for a unit • b=log(0.85)/log2 =
cost of 20 €/h -0.2345
• 5 = T1 x 16 -0.2345
• T1 =5/16 -0.234=9.6’
Learning Curve Model
n t Acum(t)
1 9.6 9.6
2 8.2 17,8 8.2=0.85x 9.6
3 7.4 24.2
4 6.9 32.1 6.9 = 0.85 x 8.2
…
8 5.9 57.0 5.9 = 0.85 x 6.9
…
16 5 99,8 5 = 0.85x 5.9
...
20 5 119,8 2wx2hx22€/hw 88 €
9.6x20/60x2wx22€/h 140 €
5x20/60x2wx22€/h 73 €
4. Estimating Benefits
• Benefits are an important part of assessment process, as
far as they have to be confronted with costs.
• We can deal with benefits in three different situations.
– Computing expected cash flow from the activities we propose.
– Computing expected cost savings from the activities we avoid.
– Computing both incomes and Costs Savings
• Benefits are treated in a different way than costs
– Risk is caused for overestimating benefits not for
underestimating them
– Information about benefits can be very different
5. Cash Flow Diagrams
• Cash Flow are represented along a
temporal axis with arrows pointing up
and down depending of the Sign.
• The usual categories we can find are:
– First Cost: associated with investment
expenses.
– Operations and maintenance
– Salvage value
– Revenues obtained
– Overhaul during life
• The analysis often Consists in
confronting up-head arrows with
down-head ones
• To do so the problem is reduced to
the calculation of a temporal
equivalent quantity for each group
EXERCISES
• Certain firm is designing a digital camcorder that is projected to have
the following per unit costs:
– Material Costs: 112
– Labor cost 85
– Overhead Cost 213
• Firm includes 30% of Manufacturing cost as expected benefit.
• Total Cost: 410 $ (1+30%)=533
• Unit Benefit = 123
• C(10.000) = 410 x 10.000 =4.1 mill
• Benefit with incidences of a batch 10.000
– 1% prod scrapped : 100 uds
– 3% prod unsold : 0.03(9.900) = 297
– 2% Sales refunded: 0.02 (9.603) =192
– Revenues: (10.000-100 -297-192) 123= 9411*123 =1.157.553
• How much would the firm pay for a change in conditions that would
produce a reduction in material cost to 50%
– 50% x 112 a 10.000= 560.000
 Exercise
• The Budget for a new Project has to be built based
on past experiences according with the table.
• Nevertheless we have a draft estimate done for
one of the components.
• Can you complete the Budget?

EQ Size Cost Factor Price New Cost (const. Prize)

Index Size
Varnish 50 gal 3.500 0.8 171/154 75 gal

Power ¾ hp 250 0.22 900/780 1.5 hp

Scrapper
Paint 3 ft2 3.000 76/49 12 ft2 10.690
Booth
total 6.750
 EXERCISES
• A firm is planning to expand his capacity
• Old equipment can be sold on a 15% of his value.
• Initial cost of 6.750 is transformed in 12.024 (+78%)
• 15% of 6.750 1.012 can be recover as revenue
• If prize increase is considered the results increase to
16.401

EQ Size Cost Factor Price New Cost (const. Prize)

Index Size
Varnish 50 gal 3.500 0.8 171/154 75 gal C= 3.500x (75/50) 0.8=4.841 4841x171/154= 5. 375

Power ¾ hp 250 0.22 900/780 1.5 hp C= 250x (1.5/0.75) 0.22=291 291x900/780=336

Scrapper
Paint 3 ft2 3.000 0.6 76/49 12 ft2 C= 3.000x (12/3) 0.6=6.892 6.892x76/49= 10.690
Booth
total 6.750 12.024 16.401
The general price-demand
relationship
The demand for a
product or service is
directly related to its
price according to p=a-
bD where p is price, D is
demand, and a and b are
constants that depend on
the particular product or
service.
Total revenue depends on price
and demand.
Total revenue is the product of the selling price per
unit, p, and the number of units sold, D (eq. 2-4).
Calculus can help determine the
demand that maximizes revenue.

Solving, the optimal demand

is (eq. 2-6)
We can also find the maximum
profit…
CT = CF + CV but by assumption total CV = cv.D
Profit = Revenue- Cost = (aD-bD2)-(CF + CV) =
(aD-bD2)-(CF + cv.D) = aD - bD2 - CF + cv.D , then:

for

Differentiating, we can find the value of D that maximizes

profit (eq. 2-10).
Pause and solve
Acme Manufacturing is a major player in the lawn sprinkler
business. Their high-end sprinkler is used commercially,
and is quite popular with golf course greens keepers. In
producing these sprinklers Acme’s fixed cost (CF) is $55,000
per month with a variable cost (cv) of $15.50 per unit. The
selling price for these high-end sprinklers is described by the
equation p=$87.50 – 0.02(D).

a) What is the optimal volume of sprinklers? Does Acme

make a profit at that volume?
b) What is the range of profitable demand?
And we can find revenue/cost
breakeven.
Breakeven is found when total revenue = total cost.
Solving, we find the demand at which this occurs (eq. 2-
12) by solving the quadratic equation.
Engineers must consider cost in the design
of products, processes and services.

• “Cost-driven design optimization” is critical

in today’s competitive business
environment.
• In our brief examination we examine
discrete and continuous problems that
consider a single primary cost driver.
Two main tasks are involved in cost-
driven design optimization.
1. Determine the optimal value for a certain
alternative’s design variable.
2. Select the best alternative, each with its own
unique value for the design variable.

Cost models are developed around the design

variable, X.
Optimizing a design with respect to
cost is a four-step process.
• Identify the design variable that is the primary cost
driver.
• Express the cost model in terms of the design variable.
• For continuous cost functions, differentiate to find the
optimal value. For discrete functions, calculate cost
over a range of values of the design variable.
• Solve the equation in step 3 for a continuous function.
For discrete, the optimum value has the minimum cost
value found in step 3.
Here is a simplified cost function.

where,
a is a parameter that represents the directly varying cost(s),
b is a parameter that represents the indirectly varying cost(s),
k is a parameter that represents the fixed cost(s), and
X represents the design variable in question.
“Present economy studies” can
ignore the time value of money.
• Alternatives are being compared over one year or
less.
• When revenues and other economic benefits vary
among alternatives, choose the alternative that
maximizes overall profitability of defect-free
output.
• When revenues and other economic benefits are
not present or are constant among alternatives,
choose the alternative that minimizes total cost per
defect-free unit.
Pause and solve !?!
As energy costs continue to rise, power efficiency is increasingly
important. Acme Chemical is evaluating two different electric motors to
drive a mixing motor and needs to perform a present economy study.
The motor will produce 75 hp and will be operated eight hours per day,
365 days for one year (maintenance will be performed on second shift—
assume no down time during operation), after which time the motor will
have no value. Select the most economical motor. Assume Acme’s
electric power costs $0.16 per kWh. 1 hp = 0.746 kW.

Motor A Motor B
Purchase price $3,200 $3,900
Annual maintenance cost $250 $450
Efficiency 75% 85%