Chapter 2: Engineering Costs and Cost Estimating

Costs: Fixed and Variable Direct and Indirect Marginal and Average Sunk and Opportunity Recurring and NonRecurring Incremental Cash and Book Life-Cycle

Cost Indices Estimating Benefits Cash Flow Diagrams

Engineering Costs and Cost Estimating

Fixed Costs:
are constant and unchanging regardless of the level of the activity over a feasible range of operations for the capacity or capability available.

Variable costs:
operating costs that vary in total with the quantity of output or other measures of activity level.

Direct Costs:
cost that can be reasonably measured and allocated to a specific output or work activity.

Indirect/Overhead Cost:
cost that it is difficult to attribute or allocate to a specific output or work activity.

Engineering Costs and Cost Estimating

Cost estimating is necessary in an economic analysis

Key Question: Where do the numbers we use in an engineering economic analysis come from ?
When working in industry, you may need to consult with professional accountants to obtain such information

Engineering Costs and Cost Estimating

Example 2-1. Alberts Charter Bus Venture
Albert plans to charter a bus to take people to see a wrestling match show in Jacksonville. His wealthy uncle will reimburse him for his personal time, so his time cost can be ignored.
Item Bus Rental Gas Expense Other Fuel Costs Bus Driver Total Costs Cost $80 $75 $20 $50 $225.00 Item Ticket Refreshments Cost $12.50 $7.50

Total Costs

$20.00

Which of the above are fixed and which are variable costs? How do we compute Alberts total cost if he takes n people to Jacksonville?
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Alberts Charter Bus Venture (example)

Question: How do we compute Alberts total cost if he takes n people to Jacksonville? Answer: Total Cost = $225 + $20 n. Graph of Total Cost Equation:
Total cost

$250

n
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Alberts Charter Bus Venture (example)

marginal cost (marginal tax) -The cost to take one more person
average cost - Average cost: the cost per person
Marginal and Average Costs
$300.00 $250.00 $200.00
Cost

Avg. Cost = TC/n

Avg. Cost = ($225+$20n)/n For n = 30, TC = $885 Avg. Cost = $885/30 = $29.50 Total cost cannot be calculated from an average cost value

Average $150.00 $100.00 $50.00 $0.00 1 3 5 7 9 11 13 15 17 19 21 23 Number of People Marginal Trip Ticket

For n =35, TC 35*($29.50) = $ 1,032.50

Suppose Alberts ticket cost drops to $10 per person if he brings 20 or more people. What is the total cost equation? What is the total cost if number of people exceeds capacity of 1 bus (bus capacity= 40)? What is the marginal cost in this case?

Alberts Charter Bus Venture (example)

Question: Do we have enough information yet to decide how much
money Albert will make on his venture? What else must we know?
Albert needs to know his total revenue Albert knows that similar ventures in the past have charged $35 per person, so that is what he decides to charge

Total Revenue = 35n (for n people)

Total profit = Total Revenue Total Cost:

35n (225 + 20n) = 15n 225
Total Cost

Albert's Charter Bus Venture

$1,000.00 $800.00 $600.00

Question:
How many people does Albert need to break even?
(not lose money on his venture)

$400.00 $200.00 $0.00 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 ($200.00)

Cost Revenue Profit

Solve 15 n 225 = 0 => n=15 more than 15, he makes money

($400.00) Number of People

Alberts Charter Bus Venture (example)

Where is the Loss Region? Where is the Profit Region? Where is the Breakeven point? Can you make this chart in Excel?
Albert's Charter Bus Venture
$1,000.00 $800.00 $600.00
Total Cost

$400.00 $200.00 $0.00 0 ($200.00) ($400.00) Number of People 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

Cost Revenue Profit

Sunk Costs
A sunk cost is money already spent due to a past decision. As engineering economists we deal with present and future opportunities We must be careful not to be influenced by the past Disregard sunk costs in engineering economic analysis Example: Suppose that three years ago your parents bought you a laptop PC for $2000. How likely is it that you can sell it today for what it cost? Suppose you can sell the laptop today for $400. Does the $2000 purchase cost have any effect on the selling price today? The $2000 is a sunk cost. It has no influence on the present opportunity to sell the laptop for $400. ( stock costs now $20 you bought for $80)
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Opportunity Cost
An opportunity cost is the benefit that is foregone by engaging a business resource in a chosen activity instead of engaging that same resource in the foregone activity. Example: Suppose your wealthy uncle gives you $75,000 when you graduate from high school. It is enough to put you through college (5 years at $15,000 per year). It is also enough for you to open a business making web pages for small companies instead of going to college. You estimate you would make $20,000 per year with this business.
If you decide to go to college you give up the opportunity to make $20,000 per year Your opportunity cost is $20,000 Your total cost per year is $35,000
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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 Amount $7,000 Type of Costs Sunk cost

Storage costs to date List price today for a case of new and up to date pumps
Amount buyer offered for case 2 years ago Case can currently be sold for

$1,000
$12,000

Sunk cost Can be used to help determine what the lot is worth today. A foregone opportunity
Actual market value today
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$5,000 $3,000

Recurring and Non-Recurring Costs

Recurring costs are those expenses that are known, anticipated, and occur at regular intervals. These costs can be modeled as cash flows.
Non-recurring costs are one-of-a-kind and occur at irregular intervals. They are difficult to plan for or anticipate. Example. You decide to landscape a lot of ground and then care for it. Which are recurring and which are non-recurring costs you incur? Remove existing trees, vegetation Have land graded with bulldozer Have yard planted with grass Plant shrubs, trees Mow grass Fertilize grass, shrubs Water grass, shrubs
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Incremental Cost
Incremental Cost is the additional cost that results from: Increasing the output of a system by one (or more) units Selecting one alternative over another
Example 2-4. Philip can choose between model A or model B. The following information is available. Cost Items
Purchase price Installation cost Annual maintenance cost Annual utility expense Disposal cost after useful life

Model A
$10,000 $3,500 $2,500 $1,200 $700

Model B
$17,500 $5,000 $750 $2,000 $500

Incremental Cost of B
$7,500 $1,500 $-1,750/yr $800/yr $-200
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Can we conclude that model B is more expensive than model A?

Cash Costs vs. Book Costs

Cash costs require the cash transaction of dollars from one pocket to another.
Book costs are cost effects from past decisions that are recorded in the books (accounting books) of a firm Do not represent cash flows Not included in engineering economic analysis One exception is for asset depreciation (used for tax purposes). Example: You might use Edmonds Used Car Guide to conclude the book value of your car is $6,000. The book value can be thought of as the book cost. If you actually sell the car to a friend for $5,500, then the cash cost to your friend is $5,500. 14

Cost Indices
The U.S. federal government publishes cost index data through the Department of Commerce Bureau of Statistics.
The Statistical Abstract of the United States publishes cost indexes for labor, construction, and materials.

The best-known example is the consumer price index (CPI), a measure of inflation.
The measure is scaled, so it is only the relative values of any two measures that are meaningful. For example, in 1920, the measure was about 20; in 1997 it was about 160. The conclusion is that one would have to spend 160/20, or 8 times as much in 1997 as in 1920 for the same consumables. Cost indices work in the same way as price indices. Cost indices are dimensionless.
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Cost Indices

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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

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
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Example
Two summer Camps have the following data for a 12-week session:
Camp A
Charge per camper Fixed costs Variable cost per camper Capacity $120 per week $48,000 per session $80 per week 200 campers

Camp B
Charge per camper Fixed costs Variable cost per camper Capacity $100 per week $60,600 per session $50 per week 150 campers

a. Develop the mathematical relationships for total cost and total revenue for camp A b. What is the total number of campers that will allow camp B to break even? c. What is the profit or loss for the 12-week session if camp A operates at 80% capacity? d. Determine the breakeven number of campers for the two camps to have equal total costs for a 12-week session.
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Cash Flow Diagrams

Cash flow diagrams (CFD) summarize the costs and benefits of projects
Example: Time Period
0 (today) 1 2 3 4 5 Size of Cash Flow Receive $100 (positive CF) Pay $100 (negative CF) Positive CF of $100 Negative CF of $150 Negative CF of $150 Positive CF of $50

A CFD illustrates the size, sign, and timing of individual cash flows
Periods may be months, quarters, years, etc.

Tomorrow

COMMENTS: The end of one period is the beginning of the next one

100

100 50

Arrows point up for revenues or benefits, down for costs

One persons payment (cash outflow w. neg. sign) is another persons receipt (cash inflow w. pos. sign)

1
100

It is essential to use only one perspective in any CFD

Today

150

150

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