Chapter 3:

Cost Estimation Techniques

 Cost-Estimation Techniques
Whenever an engineering economic analysis is
performed for a major capital investment, the
cost-estimating effort for that analysis should be
an integral part of a comprehensive planning and
design process requiring the active participation
of not only engineering designers but also
personnel from marketing, manufacturing, finance,
and top management.
Estimating the future cash flows for
feasible alternatives is a critical step in
engineering economy studies. Estimating
costs, revenues, useful lives, residual
values, and other pertinent data can be
the most difficult, expensive, and time-
consuming part of the study.
Results of cost estimating are used for a
variety of purposes.
 Setting selling prices for quoting, bidding, or evaluating
contracts.
 Determining if a proposed product can be made and
distributed at a profit (for simplicity, price=cost +
profit).
 Evaluating how much capital can be justified for
changes and other improvements.
 Setting benchmarks for productivity improvement
programs.
Approaches for Cost Estimating
 The two fundamental approaches are “top-down”
and “bottom-up.”
 The top-down approach basically uses historical data
from similar engineering projects to estimate the costs,
revenues, and other data for the current project by
modifying these data for changes.
 This approach is best used early in the estimating process
when alternatives are still being developed and refined.

KP Gwachha (M.Phil) 5
 “bottom-up approach”

 The bottom-up approach is a more detailed method

of cost estimating. This method breaks down a project
into small, manageable units and estimates their
economic consequences.
 These smaller unit costs are added together with other
types of costs to obtain an overall cost estimate.
 This approach usually works bet when the detail
concerning the desired output (a product or a service)
has been defined and clarified.
KP Gwachha (M.Phil) 7
 An Integrated Approach
This integrated approach includes three basic components:
1. Work breakdown structure (WBS) :This is a technique for
explicitly defining, at successive levels of detail, the work
elements of a project and their interrelationships (sometimes
called a work element structure).
2. Cost and revenue structure(classification) :Delineation of
the cost and revenue categories and elements is made for
estimates of cash flows at each level of the WBS.
3. Estimating techniques (models) :Selected mathematical
models are used to estimate the future costs and revenues
during the analysis period. • These three basic components,
together with integrating procedural steps, provide an organized
approach for developing the cash flows for the alternatives.)
Figure: Integrated Approach for Developing the Cash Flows for
Alternatives
Work Breakdown Structure (WBS)
 A basic tool in project management
 A framework for defining all project work elements
and their relationships, collecting and organizing
information, developing relevant cost and revenue
data, and management activities.
 Each level of a WBS divides the work elements into
increasing detail.
Figure : The WBS Diagram
A WBS has other characteristics.
 Both functional and physical work elements are
included.
 The content and resource requirements for a work
element are the sum of the activities and resources
of related subelements below it.
 A project WBS usually includes recurring and
nonrecurring work elements.
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KP Gwachha (M.Phil) 14
Cost and Revenue Structure
 Used to identify and categorize the costs and
revenues that need to be included in the analysis.
 The life-cycle concept and WBS are important aids
in developing the cost and revenue structure for a
project.
 Perhaps the most serious source of errors in
developing cash flows is overlooking important
categories of costs and revenues.
Estimating Techniques
REMEMBER! The purpose of estimating is to develop
cash-flow projections—not to produce exact data about the
future, which is virtually impossible. Cost and revenue
estimates can be classified according to detail, accuracy, and
their intended use.

 Order-of-magnitude estimates (±30%)

 Semidetailed, or budget, estimates (±15%)
 Definitive (detailed) estimates (±5%)
The level of detail and accuracy of
estimates depends on
 time and effort available as justified by the
importance of the study,
 difficulty of estimating the items in question,
 methods or techniques employed,
 qualifications of the estimator(s), and
 sensitivity of study results to particular factor
estimates.
A variety of sources exist for cost and
revenue estimation.
 Accounting records: good for historical data, but
limited for engineering economic analysis.
 Other sources inside the firm: e.g., sales,
engineering, production, purchasing.
 Sources outside the firm: U.S. government data,
industry surveys, trade journals, and personal
contacts.
 Research and development: e.g., pilot plant, test
marketing program, surveys.
These models can be used in many
types of estimates.
 Indexes
 Unit technique
 Factor technique
 Indexes
 Costs and prices vary with time for a number of reasons,
including (1) technological advances, (2) availability of
labor and materials (3) inflation.
 An index is a dimensionless number that indicates how a
cost or a price has changed with time (typically escalated)
with respect to a base year.
 Indexes provide a convenient means for developing
present and future cost and price estimates from
historical data.

KP Gwachha (M.Phil) 20
Indexes, I, provide a means for developing
present and future cost and price estimates
from historical data.

k = reference year for which cost or price is known.

n = year for which cost or price is to be estimated (n>k).
Cn = estimated cost or price of item in year n.
Ck = cost or price of item in reference year k.
Indexes can be created for a single item or for multiple
items (eqs. 3-1, 3-2).
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Pause and solve
In 2002 Acme Chemical purchased a large pump for
$112,000. Acme keys their cost estimating for these
pumps to the industrial pump index, with a baseline of
100 established in 1992. The index in 2002 was 212.
Acme is now (2010) considering construction of a new
addition and must estimate the cost of the same type
and size of pump. If the industrial pump index is
currently 286, what is the estimated cost of the new
pump?
The unit technique is one that is widely known
and understood.
A “per unit factor” is used, along with the
appropriate number of units, to find the total estimate
of cost. An often used example is the cost of a
particular house. Using a per unit factor of, say,
$120 per square foot, and applying that to a house
with 3,000 square feet, results in an estimated cost of
$120 x 3,000 = $360,000.

This techniques is useful in preliminary estimates,

but using average costs can be very misleading.
The factor technique is an extension of
the unit technique where the products of
several quantities are summed and then
added to components estimated directly.

C = cost being estimated

Cd = cost of the selected component d estimated directly
fm = cost per unit of component m
Um = number of units of component m
Parametric cost estimating is the use of historical
cost data and statistical techniques (e.g., linear
regression) to predict future costs. Parametric
models are used in the early design stages to get
an idea of how much the product (or project) will
cost, on the basis of a few physical attributes
(such as weight, volume, and power).
The power-sizing technique (or exponential model)
is frequently used for developing capital investment
estimates for industrial plants and equipment.

(both in $ as of the point in time

for which the estimate is desired)

(both in the same physical units)

KP Gwachha (M.Phil) 28
Pause and solve
Acme Logistics provides “Less than truck load” (LTL)
services throughout the U.S. They have several hubs
where they use cross-docking to move goods from one
trailer to another. Acme built its last hub 10 years ago,
and it had 36 dock doors. The cost index at that time
was 140, and the total cost was $6 million. Acme plans
a new hub that will have 48 dock doors. The cost
index now is 195, and Acme will use a capacity factor
of 0.82. What is the estimated cost of the new hub?
 A learning curve reflects increased efficiency and
performance with repetitive production of a good
or service. The concept is that some input
resources decrease, on a per-output-unit basis, as
the number of units produced increases.
Most learning curves assume a constant
percentage reduction occurs as the number of
units produced is doubled.
Learning curve example: Assume the first unit of
production required 3 hours time for assembly. The
learning rate is 75%. Find (a) the time to assemble
the 8th unit, and (b) the time needed to assemble
the first 6 units.
A cost estimating relationship (CER) describes
the cost of a project as a function of design
variables.

There are four basic steps in developing a CER.

 Problem definition
 Data collection and normalization
 CER equation development
 Model validation and documentation
Cost Estimation in the Design Process
 To ensure that products can be sold at competitive
prices, cost must be a major factor in the design of the
product.
 Both a bottom-up approach and a top-down approach
can be used to determine product costs and selling
price.
 Used together with the concepts of target costing,
design-to-cost, and value engineering, these techniques
can assist engineers in the design of cost-effective and
competitively prices products.
“Bottom-up” cost estimating is commonly
used to make decisions about what to produce
and how to price products.
Major types of costs to estimate are
 tooling costs,
 manufacturing labor costs,
 material costs,
 supervision,
 factory overhead, and
 general and administrative costs.
Example: Determination of the cost of a throttle assembly
“ Top-down,” or target costing, focuses on “what
should the product cost” instead of “what does the
product cost,” with the aim of designing costs out of
products before they enter the manufacturing
process. Costs are viewed as an input to the design
process.

or
The practice of considering cost performance
(i.e., the target cost) as important as technical
performance during the design process is
termed design to cost.

If the total manufacturing cost is more than

the target cost, then the design must be fed
back into the value engineering process to
challenge the functionality of the design and
attempt to reduce the cost of design.