1. Engineering Economic Analysis Canadian Edition
Chapter 2:
Engineering Costs and Cost Estimating

2. Chapter 2 … Defines cost concepts and engineering cost estimating.
Explains three types of engineering estimates.
Discusses the effect of the learning curve on cost estimates.
Covers models for estimating costs and benefits.
Presents cash flow diagrams to show costs and benefits.

3. Engineering Costs
Value of the economic resources used in the production of goods and services.
Land, labour, capital, and entrepreneurial skills
Initial investment, wages and salaries, material purchases, utilities
Profits indicate that scarce economic resources are being used properly.
The value of the goods and services produced exceeds the value of the resources used in their production.
Losses reflect a waste of resources.

4. Classification of Costs
Fixed: constant and unchanging
Rent on premises is constant regardless of how much space is utilized.
Variable: depends on activity level
Linear (proportional) or non-linear
Amount of raw material used depends on how many units are made.
Total cost = Fixed cost + Variable cost
Marginal cost: variable cost for the next unit.
Average cost: total cost per unit =

5. Fixed, Variable, and Total Costs
Example 2-1

6. Costs Output Total Cost Total Fixed Cost Total Variable Cost
Average Fixed Cost
Average Variable Cost
Average Cost
Marginal Cost
1.0
3.0
2.0
2.00
1.00
3.00
3.8
1.8
0.90
1.90
0.8
4.4
2.4
0.67
0.80
1.47
0.6
4.0
4.8
2.8
0.50
0.70
1.20
0.4
5.0
5.2
3.2
0.40
0.64
1.04
6.0
5.8
0.33
0.63
0.97
7.0
6.6
4.6
0.29
0.66
0.94
8.0
7.6
5.6
0.25
0.95
9.0
8.8
6.8
0.22
0.76
0.98
1.2
10.0
10.2
8.2
0.20
0.82
1.02
1.4

7. Total, Variable, and Fixed Costs

8. Average and Marginal Costs

9. Profit and Loss Terms Total revenue = Unit price  units sold
Breakeven: total revenue = total costs
Just getting by
Profit region: total revenue > total costs
Putting money in the bank
Loss region: total revenue < total costs
Going into debt

10. Profit and Loss (non-linear cost and revenue)
Total cost
Total revenue
Profit
Output
Profit Zone

11. Breakeven
Example 2-2

12. Past (Sunk) Costs Sunk cost: money spent due to a past decision.
We cannot do anything about these costs.
Example: the amount paid to purchase a car two years ago.

13. Future (Opportunity) Costs
Opportunity cost: a benefit that is foregone by engaging a resource in a chosen activity instead of engaging that same resource in another foregone activity.
We make a choice or decision.
Example: Buying lunch instead of gas.
Which type of cost is a specific value?
Example 2-3

14. Expense Types
Recurring expense: anticipated and occurs at regular intervals.
Purchasing food, paying rent.
Non-recurring expense: one-of-a-kind event that occurs at an irregular interval.
Illness, accident, death.
Sometimes we attempt to plan for large non-recurring costs by buying insurance. Paying the periodic insurance premium turns this expense into a recurring cost.

15. Incremental Costs
Incremental cost: the difference between the costs of two alternatives.
Example 2-4

16. Cash versus Book Costs
Cash costs: movement of money from one owner to another.
Also known as a ‘cash flow’.
Payment this month on an auto loan.
Book costs: cost of a past transaction that is recorded in a book.
Down payment recorded in your cheque book from last year’s automobile purchase.

17. Life-cycle Costs
Life-cycle: all the time from the conception to the death of a product or process.
Life-cycle costs: the sum total of all the costs incurred during the life-cycle.
Life-cycle costing: designing with an understanding of all the costs associated with a product during its life-cycle.

18. Phases of Life-cycle Costs
Needs assessment and justification
Conceptual or preliminary design
Detailed design
Production or construction
Operational use
Decline and retirement

19. Life-cycle Costing
In general, the later a product design change is made, the higher the cost.
Earlier changes are easier and less costly.
Decisions made early in the life-cycle tend to ‘lock-in’ cost that will be incurred.
About 70% to 90% of all costs are set during the design phases.
Only 10% to 30% of cumulative life-cycle costs have been spent.

20. Cost Estimating Engineering economic analysis is future based.
Future consequences (costs and benefits) of current decisions and require estimating.
Estimated costs and benefits are not known with certainty.
The more accurate the estimate, the more reliable the decision.

21. Types of Estimates Rough: gut level
Inaccurate.
30% to +60%.
Semi-detailed: based on historical records
Reasonably sophisticated and accurate.
15% to +20%.
Detailed: based on specifications and cost models
Very accurate.
3% to +5%.
Difficulties arise when the future is uncertain.

22. Types of Estimates … One-of-a-kind or first time projects
There are few such projects in engineering economic analysis.
Example: First NASA mission.
Resource constraints
Time and human resources.
Quality and accuracy of estimates adversely affected.
Estimator expertise
Experience and knowledge  better quality (and more reliable) estimates.

23. Estimating Models Model Explanation Per unit Uses a ‘per unit’ factor
$/sq ft, Benefits/employee
Segmenting
Divide problem into items, estimate each and sum
Cost indexes
Index number based on history
Power sizing
Scaling previous known costs up or down
Triangulation
Looking at costs from several perspectives
Learning curve
Tracking cost improvements
Examples
Click an Excel® icon to open a spreadsheet.

24. Learning Curves
In general, as the output doubles, the unit production time will be reduced by a fixed percentage or learning curve rate.
If the 3rd unit took 200 minutes to produce in a production run with a 90% learning time curve, then the 6th unit will take 200(0.90) = 180 minutes.
Estimating time in repetitive tasks:
TN = TInitial  Nb
where TN = time required for the Nth unit
TInitial = time required for the 1st unit
N = number of completed units
b = learning curve exponent

25. Learning Curve Example 2-10
A company has a learning curve rate of 85% and a production run of 20 units. Unit production time is 5.0 minutes when 16 units have been produced. Total production time is minutes.

26. Cash Flow Diagrams
Arrows: the usual interpretation is positive for cash inflows (revenues) and negative for cash outflows (expenses).
Length of the arrow represents the magnitude ($) of the cash flow.
Time dimension: when the positive and negative cash flows occur
Discount factor

27. Categories of Cash Flows
First cost ≡ construction, purchase, or installation expense.
Operations and maintenance ≡ annual expense.
Salvage value ≡ receipt at project termination.
Revenues ≡ annual receipts due to sale of products.
Overhaul ≡ major capital expenditure occurring during life of asset.

28. Cash Flow Diagrams …
Cash flow diagrams summarize the flow of money over time. They can be represented using a spreadsheet.

29. Cash Flow: Annuity End of Year Cash Flow $10,000 1 $5,000 2 3 4 5 6 7
$10,000 1
$5,000 2 3 4 5 6 7 8 9 10

30. Irregular Cash Flow End of Year Cash Flow $10,000 1 $3,000 2 $2,000 3
$10,000 1
$3,000 2
$2,000 3
$1,000 4
$5,000 5
$6,000 6
$2,000 7 8
$3,000 9
$4,000 10
$8,000

31. Cash Flow: Geometric Series
End of Year
Cash Flow
$10,000 1
$3,000 2
$3,600 3
$4,320 4
$5,184 5
$6,221 6
$7,465 7
$8,958 8
$10,750 9
$12,899 10
$15,479

32. Suggested Problems
2-3, 2-7, 2-10, 2-11, 2-20, 2-21, 2-23, 2-24, 2-26, 2-27, 2-28, 2-31, 2-32, 2-34, 2-35, 2-36, 2-37