Engineering Costs

and Cost Estimating

Chapter 2 (in Book)
 Engineering Costs and Cost Estimating
• Cost is the amount of money, time, or effort required to obtain something.
In engineering economics, "cost" refers to the monetary value of all
expenses incurred throughout the life cycle of a project, including initial
purchase price, operation and maintenance costs, and potential future
replacement costs, used to evaluate the economic viability of different
engineering alternatives when making decisions.
Buy Equipment for Rs 450,000, Cost = Rs 450,000
Future benefit = Use of equipment

Hired and IT Expert for a year on monthly salary 150,000 Monthly Cost:
150,000
Yearly Cost: 1800000
 Engineering Costs and Cost Estimating
• In this lecture we will study fundamental cost concepts. These include
fixed and variable costs
marginal and average costs
sunk and opportunity costs,
recurring and nonrecurring costs,
incremental cash costs, book costs, and life-cycle cost
• Evaluating a set of feasible alternatives requires that many costs be analyzed.
Examples include
o costs for initial investment
o new construction
o facility modification
o general labor
 Engineering Costs and Cost Estimating
o Training
o computer hardware and software
o material handling
o fixtures and tooling
o data management
o technical support, as well as general support costs (overhead)
o parts and materials
o inspection and quality
o contractor and subcontractor labor
 Fixed and Variable Cost
 Fixed costs are constant or unchanging regardless of the level of output
or activity. In contrast, variable costs depend on the level of output or
activity
 Example Equipment, Labor
 Which costs are variable and which are fixed depends on the time horizon
 Short time horizon – most costs are fixed
 Long time horizon – many costs become variable
 In determining how changes in production will affect costs, must consider if
fixed or variable costs are affected.
Fixed and Variable Cost
 Fixed and Variable Cost
 Total cost =Total fixed cost + Total variable cost

TC FC  VC
where number of people on the trip
='X. Thus

Total cost = 225 +

20x
 Marginal and Average Cost
 Marginal Cost (MC):The cost of expanding output by one unit, fixed costs
have no impact on marginal cost, so it can be written as:
ΔVC ΔTC
MC  
Δq Δq
Average Total Cost (ATC): Cost per unit of output, also equals average
fixed cost (AFC) plus average variable cost (AVC)
TC
ATC   AFC  AVC
q
TC TFC TVC
ATC   
q q q
 Example
 Total cost = 225 + 20x
 Considering Price 35 $ and no of customers 12
 Total Revenue = 12 x 35 = 420
 Profit= Rev – Cost = 420-465 = - 45

Based on data find breakeven point.

Example
VC (starting from
FC TC AV MC Rev Proft
12 customers)

225 240 465 0 420 -45

38.75
225 260 485 20 455 -30
37.30769
225 280 505 20 490 -15
36.07143
225 300 525 20 525 0
35
225 320 545 20 560 15
34.0625
225 340 565 20 595 30
33.23529
225 360 585 20 630 45
32.5
225 380 605 20 665 60
31.84211
Example
 Sunk and Opportunity Cost
 Sunk costs is money already spent as a result of a past decision. Sunk
costs should be disregarded in our engineering economic analysis because
current decisions cannot change the past. For example, dollars spent last
year to purchase new production machinery is money that is sunk: the
money allocated to purchase the production machinery has already been
Example
spent-there is nothing that can be done now to change that action. As
engineering economists we deal with present and future opportunities.
 An opportunity cost is associated with using a resource in one activity
instead of another. Every time we use a business resource (equipment,
dollars, manpower, etc.) in one activity, we give up the opportunity to use
the same resources at that time in some other activity.
SUNK AND OPPORTUNITY COST
Example 2-3. 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 $7,000 Amount
Sunk cost Type
of Costs
Storage costs to date $1,000 Sunk cost
List price today for a case of Can be used to help
new and up to date pumps $12,000 determine what the lot is
worth today.
Amount a buyer offered for case
2 years ago $5,000 A foregone opportunity

Case can currently be sold for $3,000 Actual market value today
 RECURRING AND NON-RECURRING
COSTS
• Non-Recurring Costs are one-of-a-kind and occur at irregular intervals
and thus, are sometimes difficult to plan for or anticipate from a budgeting
perspective. They are difficult to plan for or anticipate.
• Recurring Costs are those expenses that are known, anticipated, and
occur at regular intervals. These costs can be modeled as cash flows.
• Examples of recurring costs include those for resurfacing a
highway, annual expenses for maintenance and operation are
also recurring expenses. Examples of nonrecurring costs include
the cost of installing a new machine (including any facility
modifications required), the cost of augmenting equipment based
on older technology to restore its usefulness, emergency
maintenance expenses.
 INCREMENTAL COST
• incremental cost" refers to the difference in cost between two mutually exclusive project
alternatives, essentially representing the additional cost incurred by choosing one option
over another. Philip is choosing between model A (a budget model) and model B (with
more features and a higher purchase price). What incremental costs would Philip incur if he
chose model B instead of the less expensive model A?
Cost Items Model A Model B Incremental Cost Model
of B (B-A)
e price $10,000 $17,500 $7,500
lation cost $3,500 $5,000$1,500

Annual maintenance cost $2,500 $-1,750/yr

$750
ual utility expense $1,200 $2,000 $800/yr

Disposal cost after useful life $700 $500 $-200

 CASH COSTS VS BOOK COSTS
• Cash costs A cash cost requires the cash transaction of dollars "out of one
person's pocket" into "the pocket of someone else." When you buy dinner for
your friends or make your monthly automobile payment you are incurring a
cash cost or cash flow.
• Book costs are cost effects from past decisions that are recorded in the books
(accounting books) of a firm Book costs
• do not ordinarily represent cash flows
• and thus, are not included in engineering economic analysis.
• book cost is an accounting entry reflecting the asset's value on the books based on
depreciation schedules.
• The book cost may not necessarily reflect the current market value of an asset.
if a machine was bought for $10,000 and has accumulated $3,000 in depreciation over
time, its "book cost" would be $7,000.
 LIFE CYCLE COSTS
• Life-cycle costs Life-cycle costing refers to the concept of designing
products, goods, and services with a full and explicit recognition of the
associated costs over the various phases of their life cycles. Two key
concepts in life-cycle costing are that the later design changes are made,
the higher the costs, and that decisions made early in the life cycle tend to
"lock in" costs that are incurred later
• Products go through a life cycle, just like people
DESIGN
PHASE
• Assessment & Justification Phase
• Conceptual or Preliminary Design Phase
• Detailed Design Phase
• Production or Construction Phase
• Operational Use Phase
• Decline and Retirement Phase
LIFE CYCLE COSTS
LIFE CYCLE COSTS

Life-cycle costing refers to the concept of designing products,

goods, and services with
a full and explicit recognition of the associated costs over the
various phases of their life
cycles. Two key concepts in life-cycle costing are that the later
design changes are made,
the higher the costs, and that decisions made early in the life
cycle tend to "lock in" costs
that are incurred later
 ESTIMATING MODE
• Per-Unit Model (uses a "per unit" factor, such as cost per square foot, to develop
the estimate desired.)
• Cost per square foot for construction
• Mileage cost per mile for a vehicle
• Cost per line ofcoding

• Segmenting Model (An estimate is decomposed into its individual components,

estimates are made at those lower levels, and then the estimates are aggregated
(added) back together.)

• Cost Indexes
• These are numerical values that reflect historical change in engineering (and
other) costs.
• These are dimensionless, and reflect relative price change in either individual
cost items (labor, material, utilities) or groups of costs (consumer prices,
producer prices).
 ESTIMATING MODE
• Power-Sizing Model
• Used to estimate the costs of industrial plants and equipment.
• The model "scales up“ or "scales down“ known costs, thereby accounting for
economies of scale.
• Consider the cost to build a refinery. Would it cost twice as much to build the same
facility with double the capacity? It is unlikely.
• The power-sizing model uses the exponent (x), called the power-sizing exponent,
to reflect economies of scale in the size or capacity:

• The power-sizing exponent (x) can be 1.0(indicating a linear

cost-versus-size/capacity relationship) or greater than 1.0 (indicating diseconomies
of scale), but it is usually less than 1.0 (indicating economies of scale).
 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
• Triangulation
• 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 thus they are more difficult to estimate
accurately, and more uncertainty is typical
 CASH FLOW DIAGRAMS (CFD)
Example:
Time Period Size of Cash Flow
• Cash flow diagrams (CFD) summarize the 0 (today) Receive $100 (positive CF)
costs and benefits of projects
1 Pay $100
• A CFD illustrates the size, sign, and timing of (negative CF)
individual cash flows 2 Positive CF of
$100
• Periods may be months, quarters, years, etc. 3 Negative CF of
$150
4 TomorrowNegative CF of
COMMENTS: $150
• The end of one period is the beginning of the next 5 100 100 Positive CF of $50
one 50
• Arrows point up for revenues or benefits, down for
costs
0 1 2 3 4 5
• One person’s payment (cash outflow with -ve
sign) is another person’s receipt (cash inflow with
+ve sign)
100
Today
It is essential to use only one perspective in any CFD 150 150