CHAPTER 3

COST-ESTIMATION TECHNIQUES
INTRODUCTION
 Estimating future cash flows for feasible alternatives is a
critical step in engineering economy analysis
 Estimating costs, revenues, useful lives, residual values,
and other pertinent data can be the most difficult,
expensive, and time-consuming part of the study.
INTRODUCTION
• Results of cost estimating are used for a variety of
purposes:
• Setting selling prices for quoting, bidding, or evaluating
contracts.
• Determining if a proposed product can be made and
distributed at a profit.
• Evaluating how much capital can be justified for changes
and improvements.
• Setting benchmarks for productivity improvement programs.
INTRODUCTION
 Two fundamental approaches to cost estimating:
 Top-down uses historical data from similar projects. It is best
used when alternatives are still being developed and refined
 Bottom-up is more detailed and works best when the detail
concerning the desired output (product or service) has been
defined and clarified
AN INTEGRATED APPROACH
• The integrated cost estimation approach has three major
components:
– Work breakdown structure (WBS): explicitly define the work
elements of a project and their interrelationship, at successive
levels of detail.
– Cost and revenue structure (classification): delineation
(depiction) of the cost and revenue categories and elements -
is made for estimates of cash flow at each level of the WBS
– Estimating techniques (models): mathematical models for
estimating the future costs and revenue
WORK BREAKDOWN STRUCTURE
 The WBS:
 A basic tool in project management
 A framework for defining all project work elements and their
relationships, collecting and organizing information,
developing relevant cost and revenue data, and management
activities
 Each level of a WBS divides the work elements into
increasing detail
WORK BREAKDOWN STRUCTURE
WORK BREAKDOWN STRUCTURE
WORK BREAKDOWN STRUCTURE
• Other characteristics of a WBS:
– Both functional and physical work elements are included
• Functional work elements: logistics support, marketing, engineering, system
integration…
• Physical work elements: parts that make up a structure, product, piece of
equipment….
– The content and resource requirements for a work element are the
sum of the activities and resources of related sub-elements below it
– A project WBS usually includes recurring and nonrecurring work
elements
COST AND REVENUE STRUCTURE
• Used to identify and categorize the costs and revenues that
need to be included in the analysis
• The life-cycle concept and WBS are important aids in
developing the cost and revenue structure for a project
• The cost and revenue structure is a good means of preventing
errors in developing cash flows when overlooking some
important categories of cost and revenue
ESTIMATING TECHNIQUES (MODELS)
• Cost and revenue estimates can be classified according to
detail, accuracy, and their intended use:
– Order-of-magnitude estimates (±30%): used in the planning and
initial evaluation stage of a project
– Semidetailed, or budget, estimates (±15%): used in the preliminary
or conceptual design stage of a project
– Definitive (detailed) estimates (±5%): used in the detailed
engineering/construction stage of a project
ESTIMATING TECHNIQUES (MODELS)
 The level of detail and accuracy of estimates depends on:
 time and effort available as justified by the importance of the
study
 difficulty of estimating the items in question
 methods or techniques employed
 qualifications of the estimator(s)
 sensitivity of study results to particular factor estimates
ESTIMATING TECHNIQUES (MODELS)
• A variety of sources exist for cost and revenue estimation:
– Accounting records: good for historical data, but limited for
engineering economic analysis
– Other sources inside the firm: e.g., sales, engineering, production,
purchasing
– Sources outside the firm: U.S. government data, industry surveys,
trade journals, and personal contacts
– Research and development: e.g., pilot plant, test marketing program,
surveys
SELECTED ESTIMATING TECHNIQUES
 These models are applicable or order-of-magnitude estimates
and for many semidetailed or budget estimates:
 Indexes
 Unit technique
 Factor technique
INDEXES TECHNIQUE
 An index is a dimensionless number that indicates how a cost
or a price has changed with time with respect to a base year
 Indexes provide a means for developing present and future
cost and price estimates from historical data

k = reference year for which cost or price is known.

n = year for which cost or price is to be estimated (n>k).
Cn = estimated cost or price of item in year n.
Ck = cost or price of item in reference year k.
INDEXES TECHNIQUE
 Example: company ABC wants to install a new boiler in
2010.
 In2000, the company installed a similar boiler for $525,000
when the index had a value of 468.
 The index value in 2010 was 542.
 What is the cost of the new boiler?

 Solution:
C = $525,000(542/468) = $608,013
INDEXES TECHNIQUE
 Indexes can be applied at the lower levels of a WBS
as well as the top level of a WBS
 Indexes can be created for a single item or for
multiple items
 For single item, the index value is the ratio of the cost of the item in the
current year to the cost of the same item in the reference year, multiplied
by the reference year factor (typically 100)
 For multiple items, a composite index is created by averaging the ratios
of selected item costs in a particular year to the cost of the same items in
a reference year.
 Different weights can be given to the items in the index according to
their contribution to total cost.
UNIT TECHNIQUE
 Use a per unit factor that can be estimated effectively
 Capital
cost of plant per kilowatt of capacity
 Revenue per mile
 Revenue per customer served
…

 Useful for preliminary estimating purposes

 Example: Estimating the cost of a particular house:

 Using a per unit factor of $120 per square foot,
 The house is 3,000 square feet,

 estimated cost: $120 x 3,000 = $360,000.

FACTOR TECHNIQUE
 An extension of the unit technique
 Sum the product of several quantities or components and add
these to any components estimated directly:

C = cost being estimated

Cd = cost of the selected component d estimated directly
fm = cost per unit of component m
Um = number of units of component m
FACTOR TECHNIQUE
 Example: building a house consisting of 2,000 square
feet, two porches, and a garage.
 Unit factor:
 $85/square foot
 $10,000/porch

 $8,000/garage

 Estimated total cost:

$852,000 + $10,0002 + $8,0001 = $198,000
PARAMETRIC COST ESTIMATING
 Use historical cost data and statistical techniques to predict
future costs.
 Used in the early stages to get an idea of how much the product
will cost on the basis of a few physical attributes (weight,
volume, power…)
 Statistical techniques are used to develop cost estimating
relationships (CER) that tie the cost or price of an item to one
or more independent variables.
POWER-SIZING TECHNIQUE
 Is sometimes referred to as an exponential model
 Used for developing capital investment estimates for industrial
plants and equipment

(both in $ as of the point in time for which

the estimate is desired)

(both in the same physical units)

LEARNING AND IMPROVEMENT
 A learning curve is a mathematical model that explains the
phenomenon of increased worker efficiency and improved
organizational performance with repetitive production of a
good or service.

 The basic concept of learning curves is that some input

resources decrease, on a per-output-unit basis, as the number
of unit produced increases.
LEARNING AND IMPROVEMENT
 Most learning curves assume a constant percentage reduction
occurs as the number of units produced is doubled
LEARNING AND IMPROVEMENT
Example:
Assume the first unit of production required 3 hours time for
assembly. The learning rate is 75%. Find:
(a) the time to assemble the 8th unit, and

(b) the time needed to assemble the first 6 units.

DEVELOPING A COST ESTIMATING
RELATIONSHIP (CER)
 CER is a mathematical model that describes the cost of
an engineering project as a function of one or more
design variables.
 Four basic steps in developing a CER:
 Problem definition
 Data collection and normalization
 CER equation development
 Model validation and documentation
DEVELOPING A COST ESTIMATING
RELATIONSHIP (CER)
 Problem definition:
 A well-defined problem is much easier to solve
 WBS can be used to describe the elements of a problem
 A review of the completed WBS can also help identify
potential cost driver for developing CER
DEVELOPING A COST ESTIMATING
RELATIONSHIP (CER)
 Data collection and normalization:
 The most critical step
 Garbage in – garbage out
 Sources of data:
 Internal and external sources
 Past similar projects

 Published cost information

 …

 Data must be normalized to account for differences due to inflation,

geographical locations, labor rates…
DEVELOPING A COST ESTIMATING
RELATIONSHIP (CER)
 CER equation development:
 Formulate an equation that accurately captures the
relationship between the selected cost driver(s) and project
cost.
 Plot the data to determine the basic equation form for the
CER
 Determine the values of the coefficients in the CER equation
DEVELOPING A COST ESTIMATING
RELATIONSHIP (CER)
 Model validation and documentation:
 Determine how well the CER can predict cost  validation
 Validation can be accomplished with:
 Standard error: measure the average mount by which the actual cost valued
and the predicted cost values vary
 Correlation coefficient: measure the closeness of the actual data points to the

regression line
 The development and the appropriate use of CER will then be
documented for future used of the CER