LECTURE 04

ENGINEERING ECONOMICS

Demand Estimation
COST-ESTIMATION TECHNIQUES
 Engineering economy studies need estimating the future cash flows
for feasible alternatives of its projects.
 Often, the most difficult, expensive, and time-consuming part of an
engineering economy study is the estimation of
i. Costs
ii. Revenues
iii. residual values
iv. and other data pertaining to the alternatives being analyzed.
 A decision based on the analysis is economically sound only if
these cost and revenue estimates are representative of what
subsequently will occur.
 In an engineering economic analysis, the cost-estimating effort for
that analysis should be an integral part of a comprehensive planning
and design process
Results of cost estimation are used for a variety of purposes,
including the following:
1. Providing information used in setting a selling price for quoting,
bidding, or evaluating contracts
2. Determining whether a proposed product can be made and
distributed at a profit (for simplicity, price = cost + profit)
3. Evaluating how much capital can be justified for process changes or
other improvements
4. Establishing benchmarks for productivity improvement programs
There are two fundamental approaches to cost estimating:
 the “top-down” approach and the “bottom-up” approach.
 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 in inflation or deflation, activity level,

weight, energy consumption, size, and other factors.

 This approach is best used early in the estimating process when alternatives

are still being developed and refined.

 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 best when the detail concerning the desired

output (a product or a service) has been defined and clarified.

 Example
A simple example of cost estimating of the expense of getting a Bachelor of
Science (B.S.) from a university.
Use the two approaches to estimate the cost.
Solution
 A top-down approach would take the published cost of a four-year
degree at the same (or a similar) university and adjust it for inflation
and extraordinary items that an incoming student might encounter,
such as fraternity/sorority membership, scholarships, and tutoring.
 Suppose that attending the university is $15,750 for the current year.
 This figure is anticipated to increase at the rate of 6% per year and
includes fulltime tuition and fees, university housing, and a weekly
meal plan.
 Not included are the costs of books, supplies, and other personal
expenses.
 Suppose “other” expenses are assumed to remain constant = $5,000
per year.
 The total estimated cost for four years can now be computed.
 We simply need to adjust the published cost for inflation each year
and add in the cost of “other” expenses.
 In contrast with the top-down approach, a bottom-up approach to
the same cost estimate would be to first break down anticipated
expenses into the typical categories shown in Figure 3-1 for each
of the four years at the university.
 Tuition and fees can be estimated fairly accurately in each year, as
can books and supplies.
 For example, suppose that the average cost of a college textbook
is $100.
 You can estimate your annual textbook cost by simply multiplying
the average cost per book by the number of courses you plan to
take.
 Assume that you plan on taking five courses each semester during
the first year. Your estimated textbook costs would be
The other two categories, living expenses and transportation, depend on your

lifestyle.

For example, whether you own and operate an automobile and live in a “high-

end” apartment off-campus can dramatically affect the estimated expenses during

your college years.

An Integrated Approach
 An integrated approach to developing the net cash flows for feasible project
alternatives is shown in Figure 3-2.
 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)
• Description 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.
 The integrated approach begins with a description of the project in terms of a WBS
(see Figure 3-2,)
 WBS is used to describe the project and each alternative’s unique characteristics in
terms of design, labor, material requirements, and so on.
 Then these variations in design, resource requirements, and other characteristics are
reflected in the estimated future costs and revenues (net cash flow) for that alternative.
 To estimate future costs and revenues for an alternative, the perspective (viewpoint) of
the cash flow must be established and an estimating baseline and analysis period
defined.
 Normally, cash flows are developed from the owner’s viewpoint.
 The net cash flow for an alternative represents what is estimated to happen to future
revenues and costs fromthe perspective being used.
 Therefore, the estimated changes in revenues and costs associated with an alternative
have to be relative to a baseline that is consistently used for all the alternatives being
compared.
The Work Breakdown Structure (WBS)

 The first basic component in an integrated approach to developing cash flows

 is the work breakdown structure (WBS).

 The WBS is a basic tool in project management and is a vital aid in an

engineering economy study.

 The WBS serves as a framework for defining all project work elements and

their interrelationships, collecting and organizing information, developing

relevant cost and revenue data,and integrating project management

activities.
 Figure 3-3 shows a diagram of a typical four-level WBS.
 It is developed from the top (project level) down in successive levels of
detail.
 The project is divided into its major work elements (Level 2).
 These major elements are then divided to develop Level 3, and so on.
 For example, an automobile (first level of the WBS) can be divided into
second-level components (or work elements) such as the chassis, drive train,
and electrical system.
 Then each second-level component of the WBS can be subdivided further
into third-level elements.
 The drive train, for example, can be subdivided into third-level components
such as the engine, differential, and transmission.
 This process is continued until the desired detail in the definition and
description of the project or system is achieved.
 Different numbering schemes may be used.
 The objectives of numbering are to indicate the interrelationships of the work
elements in the hierarchy.
 The scheme illustrated in Figure 3-3 is an alphanumeric format.
The Cost and Revenue Structure
 The second basic component of the integrated approach for developing cash
flows (Figure 3-2) is the cost and revenue structure.
 This structure is used to identify and categorize the costs and revenues that
need to be included in the analysis.
 Detailed data are developed and organized within this structure for use with
the estimating techniques of Section 3.3 to prepare the cash-flow estimates.
 The life-cycle concept and the WBS are important aids in developing the cost
and revenue structure for a project.
 The life cycle defines a maximum time period and establishes a range of cost
and revenue elements that need to be considered in developing cash flows.
 The WBS focuses the analyst’s effort on the specific functional and physical

work elements of a project and on its related costs and revenues.

 Perhaps the most serious source of errors in developing cash flows is

overlooking important categories of costs and revenues.

 The cost and revenue structure, prepared in tabular or checklist form, is a

good means of preventing such oversights.

 Technical familiarity with the project is essential in ensuring the completeness

of the structure, as are using the life-cycle concept and the WBS in its

preparation.
The following is a brief listing of some categories of costs and revenues that are
typically needed in an engineering economy study:

1. Capital investment (fixed and working)

2. Labor costs

3. Material costs

4. Maintenance costs

5. Property taxes and insurance

6. Overhead costs

7. Disposal costs

8. Revenues based on sales, etc.

9. Quality (and scrap) costs

10. Market (or salvage) values

 
 Estimating Techniques (Models)
 The third basic component of the integrated approach (Figure 3-2) involves
estimating techniques (models).
 These techniques, together with the detailed cost and revenue data, are used to
develop individual cash-flow estimates and the overall net cash flow for each
alternative.
  The purpose of estimating is to develop cash-flow projections—not to
produce exact data about the future, which is virtually impossible.
 Neither a preliminary estimate nor a final estimate is expected to be exact;
rather, it should adequately suit the need at a reasonable cost and is often
presented as a range of numbers.
 Cost and revenue estimates can be classified according to detail, accuracy, and
their intended use as follows:
1. Order-of-magnitude estimates: used in the planning and initial evaluation

stage of a project.

2. Semidetailed, or budget, estimates: used in the preliminary or conceptual

design stage of a project.

3. Definitive (detailed) estimates: used in the detailed engineering/construction

stage of a project.

Order-of-magnitude estimates are used in selecting the feasible alternatives for

the study.
Sources of Estimating Data
The information sources useful in cost and revenue estimating are too numerous
to list completely.
The following four major sources of information are listed roughly in order of
importance:
1. Accounting records. Accounting records are a prime source of information
for economic analyses; however, they are often not suitable for direct,
unadjusted use.
2. Other sources within the firm. The typical firm has a number of people and
records that may be excellent sources of estimating information. Examples
of functions within firms that keep records useful to economic analyses are

engineering, sales, production, quality, purchasing, and personnel.

 3. Sources outside the firm. There are numerous sources outside the firm that
 can provide helpful information. The main problem is in determining those
 that are most beneficial for particular needs. The following is a listing of some
 commonly used outside sources:
 (a) Published information.
 Current Wage Developments, Handbook of Labor Statistics, and the
Chartbook
 on Wages, Prices and Productivity.
 (b) Personal contacts are excellent potential sources. Vendors, salespeople,
 professional acquaintances, customers, banks, government agencies,
 chambers of commerce, and even competitors are often willing to furnish
 needed information on the basis of a serious and tactful request.
4. Research and development (R&D).
 If the information is not published and
 cannot be obtained by consulting someone, the only alternative may be to

 undertake R&D to generate it. Classic examples are developing a pilot plant
 and undertaking a test market program.
 The Internet can also be a source of cost-estimating data, though you should
assure
 yourself that the information is from a reputable source. The following Web
sites
 may be useful to you both professionally and personally.
  
Selected Estimating Techniques (Models)

 The estimating models discussed in this section are applicable for order-of

magnitude estimates and for many semidetailed or budget estimates.

 They are useful in the initial selection of feasible alternatives for further

analysis and in the conceptual or preliminary design phase of a project.

 Sometimes, these models can be used in the detailed design phase of a

project.
 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.
 An estimate of the cost or selling price of an item in year n can be obtained by
multiplying the cost or price of the item at an earlier point in time (year k) by
prices. Use of this technique allows the cost or potential selling price of an item

to be taken from historical data with a specified base year and updated with an

index.

This concept can be applied at the lower levels of a WBS to estimate the cost

of equipment, materials, and labor, as well as at the top level of a WBS to estimate

the total project cost of a new facility, bridge, and so on.

 Unit Technique
The unit technique involves using a per unit factor that can be estimated effectively.
Examples are as follows:
1. Capital cost of plant per kilowatt of capacity
2. Revenue per mile
3. Capital cost per installed telephone
4. Revenue per customer served
5. Temperature loss per 1,000 feet of steam pipe
6. Operating cost per mile
7. Construction cost per square foot
Such factors, when multiplied by the appropriate unit, give a total estimate of cost,
savings, or revenue.
 As a simple example of the unit technique, suppose the Air Force’s B-2 aircraft
 costs $68,000 per hour to own, operate, and maintain.
 A certain mission requires two B-2 aircrafts to fly a total round-trip time of 45
hours.
 Thus, the total cost of this mission is (2 planes) (45 hours per mission per plane)
($68,000 per hour) = $6,120,000 per mission.
 While the unit technique is very useful for preliminary estimating purposes,
 such average values can be misleading. In general, more detailed methods will
 result in greater estimation accuracy.
References