Engineering Economy

Chapter 3: Cost Estimation

Techniques

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 The objective of Chapter 3 is
to present various methods for
estimating important factors in
an engineering economy
study.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
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.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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.
• Evaluating how much capital can be
justified for changes and improvements.
• Setting benchmarks for productivity
improvement programs.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
The two fundamental approaches are
“top-down” and “bottom-up.”
• Top-down uses historical data from similar
projects. It is best used 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.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 The integrated cost estimation
approach has three major
components.

• Work breakdown structure (WBS)

• Cost and revenue structure
(classification)
• Estimating techniques (models)
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
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.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
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.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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%)

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
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.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 These models can be used in
many types of estimates.

• Indexes
• Unit technique
• Factor technique

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
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).
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
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)

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Most learning curves assume a constant
percentage reduction occurs as the
number of units produced is doubled.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
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.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
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
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 “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.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 “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

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
The objective of value engineering (VE) is to
provide required product fundtions at a
minimum cost. Below are some sample VE
questions than should be asked.
• Are all the functions • Are all the machined parts
provided required by the necessary?
customer? • Would product redesign
• Can less expensive eliminate quality
material be used? problems?
• Can the number of • Is the current level of
different materials used be packaging necessary?
reduced? • Can a part designed for
• Can fewer parts be used? another product be used?
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.