Engineering Economy

Chapter 3: Cost Estimation

Techniques
 The objective of Chapter 3 is
to present various methods for
estimating the future cash
flows (mainly costs) which are
required in an engineering
economic analysis.
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.
• Provide information in setting selling prices
for quoting, bidding, or evaluating contracts.
• Determine if a proposed product can be
made and distributed at a profit.
• Evaluating how much capital can be justified
for changes and improvements.
• Setting benchmarks for productivity
improvement programs.
 The two fundamental approaches are
“top-down” and “bottom-up.”
• Top-down uses historical data from similar
engineering projects. It is best used early when
alternatives are still being developed and refined.
• Bottom-up is more detailed and works best when
the detail concerning the desired output (product
or service) has been defined and clarified.
Figure 3-1 Bottom-Up Approach to Determining the Cost of a College Education
An integrated cost estimation approach

Three components:
•Work breakdown structure (WBS)
•Cost and revenue structure (classification)
•Estimating techniques (models)
An integrated cost estimation approach

Integrated approach for developing cash flows for alternatives

Work Breakdown Structure (WBS)
• A basic tool in project management and a vital aid
in an engineering economy study
• Serves as 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.
A WBS has other characteristics.
• Both functional (e.g. planning) and physical (e.g.
foundation) 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 (e.g.
maintenance) and nonrecurring (e.g. initial
construction) work elements.
Figure 3-4 WBS (Three Levels) for Commercial Building Project in Example 3-2
 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.
Some categories of cost and revenues that are often
needed in an engineering economy study:
•Capital investment
•Labor costs
•Material costs
•Maintenance costs
•Property taxes and insurance
•Overhead costs
•Disposal costs
•Revenues based on sales
•Quality (and scrap) costs
•Market （ or salvage) values
Estimating Techniques (Models)
• 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.
1. Order-of-magnitude estimates (±30%-50%)
2. Semidetailed, or budget, estimates (±15%)
3. 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.
 Four major sources of
information.
1. Accounting records: good for historical data, but
limited for engineering economic analysis.
2. Other sources inside the firm: e.g., sales,
engineering, production, purchasing.
3. Sources outside the firm: Published information,
personal contacts.
4. Research and development: e.g., pilot plant, test
marketing program, surveys.
The internet can also be a source of cost-estimating data!
How estimates are accomplished
1. A conference of various people who may have
good information or bases for the estimation, e.g.
Delphi method
2. Comparison with similar situations or designs
about which there is more information
(estimating by analogy)
3. Using quantitative techniques
Selected Estimating Techniques
(Models)

• Index technique

• Unit technique

• Factor technique
 1. Index technique

 Costs/prices vary with time for different

reasons, e.g. technological progress, inflation,
availability of labor and materials
 An index is a dimensionless number that
indicates how a cost or a price has change over
time with respect to a base year
 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 also be constructed for
multiple items

A general weighted index is given by

 Pause and solve
In 2010 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 2000. The index in 2010 was 212.
Acme is now (2020) 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?
 2. Unit technique

 The unit technique involves using a “per unit

factor” that can be estimated effectively
 Some examples:
‑ Capital cost of plant per kW of capacity
‑ Operating cost per mile
‑ Revenue per customer served
‑ Construction cost per square foot
 The techniques is useful in preliminary estimates,
but using average costs can be very misleading.
 3. Factor technique
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
 It is the use of historical cost data and statistical
techniques (e.g., linear regression) to predict future
costs.
 Often 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).
 Various statistical and other mathematical
techniques are used to develop the cost estimating
relationships (CERs)
Two commonly used techniques: Power-sizing
techniques, Learning curve
 1. Power-sizing technique
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)

 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?
 2. Learning curve
• A learning curve is a mathematical model that explains the
phenomenon of increased worker efficiency and improved
organizational performance with repetitive production of a
good and service.
• It is also called an experience curve or manufacturing
progress function.
• It was first observed in the aircraft and aerospace industries
with respect to labor hours per unit, but applies in many
different situations.
• The basic idea 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.
An example:
Assume that 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.
Question:
Can you use
spreadsheet to
solve it?
Example 3-7
 Developing a Cost Estimation
Relationship (CER)

 A CER is a mathematical model that describe the

cost of an engineering project as a function of one
or more design variables.
 There are four basic steps in developing a CER.
• Problem definition
• Data collection and normalization
• CER equation development
• Model validation and documentation
Several typical equation forms