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Chapter 2: " Engineering Costs and Cost Estimating!

BSEN 206. Engineering Economy! ! Jeffrey C. Woldstad, Ph.D., P.E.!

University of Nebraska

Fixed and Variable Costs!

-! Fixed Costs: constant, independent of the output or
-! Property taxes, insurance! -! Management and administrative salaries! -! License fees, and interest costs on borrowed capital! -! Rental or lease! -! Direct labor cost! -! Direct materials!
level. ! activity level.!

-! Variable Costs: Proportional to the output or activity

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Problems 1-6!
For each of the following, are they: (A) xed costs or (B) variable costs?" ! 1.Your rent each month? ! 2.Your electricity bill?! 3.Your cable TV bill?! 4. A companies hourly labor cost?! 5. A companies engineering labor cost?! 6. A companies Taxes?!

Fixed and Variable Costs!

-! Total Variable Cost (TVC) = Unit Variable Cost

(VC) * Quantity (Q)!

-! Total Cost (TC) = Fixed Cost (FC) + Total

Variable Cost (TVC)!

TVC = VC * Q!

-! Total Revenue (TR) = Unit Selling Price (SP) *

Quantity (Q)! TR = SP * Q!
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TC = FC + VC * Q!

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Problem 6!
To help pay for college, you have decided to start selling coffee outside of Othmer Hall. Costs associate with this are:!
$10,000 for the coffee stand and $0.50 per cup of coffee in supplies (coffee, cups and electricity)?!

What is the minimum you should consider selling a cup of coffee for?!
(A) $0.50! (B) $0.51! (C) $1.00! (D) $2.00!

Problem 7!
Based on the market value for coffee, you set your price at $1.00 per cup. How many cups of coffee do you need to sell to start making a prot?!
(A) 1! (B) 10,000! (C) 20,000! (D) 50,000!

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Breakeven Point!
-!
Because most operations have both xed and variable costs,

the selling price is set to a level above the variable costs what happens if this is not the case?! revenue is equal to total cost. !

-! Break-even point (BEP): the output level at which total

SP * BEP = FC + VC * BEP! BEP = FC / (SP - VC)!

-! Applications of Break-even Analysis:! -! Determining minimum production quantity! -! Forecast production prot / loss!
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$
Profit

Total Revenue Total Costs

Variable Costs

Loss

Fixed Costs

Break-even Point

Production Quantity

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Problem 8!
A labor-intensive process has a xed cost of $338,000 and a variable cost of $143 per unit. A capitol-intensive (automated) process for the same product has a xed cost of $1,244,000 and a variable cost of $92.50. If the selling price for the product is $197, how many units must be sold to justify the automated process?!
(A) 1! (B) 6259! (C) 11,904! (D) 17,940!

PROBLEM 8!
$4,500,000! $4,000,000! $3,500,000! $3,000,000! $2,500,000! $2,000,000! $1,500,000! $1,000,000! $500,000! $0! 0! 5000! 10000! 15000! Units Produced! 20000!
338,000 + 143x = 197x x = 6259 1,244,000 + 92.5x = 197x x = 11,904

Revenue!
Cost of Laborintensive Process ! Cost of Automated Process !

1,244,000 + 92.5x = 338,000 + 143x x = 17,940

25000!

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-! Marginal Costs: the variable cost for one -! Capacity Planning: Excess capacity! -! Basis for last-minute pricing! -! Average Costs: total cost divided by the -! Basis for normal pricing!
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Marginal and Average Costs!

more unit of output!

total number of units produced.!

Sunk Costs and Opportunity Costs!

-! Sunk Costs: Cost that has occurred in the past -! Purchasing price of current equipment in -! Opportunity Costs: Cost of the foregone
opportunity and is hidden or implied!
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and has no relevance to estimates of future costs and revenues related to an alternative! deciding new equipment (except for capital gain/loss consideration)!

-! Existing equipment in replacement analysis!

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Sunk Costs!

-! Note that people have a particular difculty -! In the current housing crisis, many peoples
ignoring sunk costs in decision making.! houses are not worth what they were 2 years ago and they will not sell the house for what it is worth now.! conviction that their luck must change in the future (Gamblers ruin)!
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-! Losing gamblers often keep gambling with the

Recurring and Incremental Costs!

-! Recurring Costs: Repetitive and occur when a rm -! Ofce space rental!
produces similar goods and services on a continuing basis!

-! Non-recurring Costs: Not repetitive, even though the -! Examples are purchase cost for real estate, and the -! Incremental Costs: Difference in costs between two
alternatives.!
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-! Typically involve developing or establishing a capability

or capacity to operate! construction costs of the plant!

total expenditure may be cumulative over a period of time!

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Cash and Book Costs!

-! Cash Costs: Costs that involve money/cash -! Book Costs: Costs that that do not involve -! Depreciation is charged for the use of assets,
such as plant and equipment! money/cash transaction!

-! Interest payments, taxes, etc.!

transaction!

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Life-Cycle Costs!

-! Life-Cycle Costs: Summation of all costs, both -! Life cycle begins with the identication of the

recurring and nonrecurring, related to a product, structure, system, or service during its life span.! economic needs or wants (the requirements) and ends with the retirement and disposal activities.!

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Cost Estimating!

-! Until a cost is incurred, it can only be estimated

of parameters this includes engineering students.!

-! Engineers need to be good at estimating a variety

as a result most economic analysis is based on estimates.!

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Some Things to Remember about Estimation!

-! Experience often plays a big role in estimating.

-! Because estimation is often subjective, bias can

Be careful when discounting the estimates of people who have more experience than you do.! often effect estimates. Be careful when interpreting estimates from people who have a clear reason for providing biased values. !

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Methods of Estimation!

-! Bound the upper and lower limits of a parameter -! Estimates should almost always be provided as -! Generalize from the a specic measurable event
to a less specic non-measurable event.! an interval statistical condence interval.! and then examine the assumptions of each.!

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Problem 10!
How much will the monthly payments be on a $20,000 car if the loan period if 48 months, and the interest rate is 5% (compounded monthly)!
(A) $416.67 ! (B) $460.59! (C) $500.00!

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Problem 11!
How much money ($) is in the room? !
(A) LESS THAN $10 ! (B) BETWEEN $10 AND $100! (C) MORE THAN $100!

Cost Estimating Approaches!

-! -! -! -! -! -! -! -!
Top-down Approach! Uses historical data from similar engineering projects! Modies original data for changes in ination, activity level, weight, energy consumption, size, etc! Best use is early in estimating process! More detailed cost-estimating method! Attempts to break down project into small, manageable units and estimate costs, etc.! Smaller unit costs added together with other types of costs to obtain overall cost estimate! Works best when detail design is available!
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Bottom-up Approach!

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Cash Flow Diagrams!

-! Summarizes costs & benets occur over time! -! Illustrates the size, sign, and timing of individual cash -! Components! -! A segmented time-based horizontal line, divided -! A vertical arrow representing a cash ow is added -! Arrow pointing down for costs and up for benets!
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ows!

into time units!

at the time it occurs!

Timing of Cash Flow At time zero (now) 1 time period from today 2 time periods from today 3 time periods from today 4 time periods from today 5 time periods from today

Size of Cash Flow Positive $100 Negative $100 Positive $100 Negative $150 Negative $150 Positive $50

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-! First cost: expenses to build or to buy and install! -! Operations and maintenance (O&M): annual -! Salvage value: receipt at project termination for -! Revenues: annual receipts due to sale of products -! Overhaul: major capital expenditure that occurs
during the assets life!
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Categories of Cash Flows!

expense, such as electricity, labor, and minor repairs! sale or transfer of the equipment! or services!

Drawing a Cash Flow Diagram! -! Shows when all cash ows occur! -! The end of period t is the same time as the

-! Rent, lease, and insurance payments are usually -! O&M, salvage, revenues, and overhauls are -! The choice of time 0 is arbitrary!
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beginning of period t+1!

treated as beginning-of-period cash ows! assumed to be end-of-period cash ows!

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