Cost Estimating, Cost Engineering and Cost Management

15. Cost Estimating, Cost Engineering and Cost Management (Notes)

15.1 Introduction

Chapter Aim: introduce cost estimating, cost engineering, and cost management.
Design objective: create affordable products/processes/facilities (e.g., Henry Ford making cars affordable).
Many emerging industries need cost reduction for adoption/diffusion (e.g., space tourism, fuel cell vehicles).
Diffusion of technology depends on cost reductions, economies of scale, and learning effects.
Cost is crucial for both mature (commodities, price takers, low cost for profit) and new (differentiated products, price protection) technologies.
Cost management, control, and estimating support project and operational stages.
- Operational budgets: forecast income/expenses (Chapter 14).
- Capital cost estimation: evaluates project viability by comparing capital expenditure with forecasted cash flows (Chapter 16).
Reasons for estimation:
- Many engineering products/services vary; cost estimates and quotes must include estimated cost, contingency, and profit.
- Understanding costs aids product/service costing, analysis, and control.

15.2 The Nature of Costs

Variable costs:
- Vary directly with volume/activity level (e.g., tonnes mined, units produced).
- Driven by an activity base (e.g., machine-hours, tonnes).
- Example: explosives, labour, power in a mine.
- Consistent upward relation with volume (Figure 15.1).
Fixed costs:
- Do not vary with volume within a relevant production capacity; may change with time/capacity expansion.
- Examples: supervisor salaries (over a period), depreciation/lease charges.
- Tend to rise with significant capacity expansion (e.g., mining capacity).
- Often increase due to automation/investment.
- Fixed only within a relevant range.
- Escalation (cost increases over time) discussed in Chapter 16.
- Rise with production capacity and time (Figure 15.2).
Semi-variable costs and unit costs:
- Vary with volume but not directly proportionally (e.g., indirect labour, maintenance, telephone costs).
- Split into fixed (e.g., line rental) and variable components (e.g., usage) where possible.
- Variable cost per unit is constant; fixed cost per unit decreases as volume increases.
- Unit cost (UC) = Total cost / Number of units = $UC = rac{TC}{N}$
- Unit variable cost (UVC) or unit marginal cost = change in total cost for an additional unit.
Direct costs:
- Directly attributable to specific work: direct labour, direct materials, direct equipment.
- Direct labour includes wages, benefits, taxes.
- Direct materials are essential for production; BOM lists quantities/costs.
- Easy to identify for single products; harder for multiple products (requires allocating indirect costs).
Indirect costs:
- Not directly tied to a single product/job: supervisor salaries, management, selling/distribution, R&D, indirect materials, maintenance, tax, overhead (e.g., head-office rent).
- Tax is indirect, dependent on status/country.
Cost allocation:
- Total product cost = direct + indirect costs.
- Indirect costs allocated using a basis (e.g., direct labour cost, activity drivers).
- Example 15.1: Furniture factory allocates indirect costs by direct labour hours.
Activity-Based Costing (ABC):
- Improves overhead allocation when labour is small share of costs (advanced manufacturing).
- Uses cost drivers (machine hours, computer time) to allocate overheads to activities.
Cost structures across types of enterprises:
- Trading enterprises: buy finished goods, add value via distribution/marketing; no manufacturing costs.
- Manufacturing/mining enterprises: incur costs for raw materials, labour, machinery, maintenance; passed through supply chain.

15.3 Cost-Volume-Profit (CVP) Analysis

Application of CVP:
- Models production cost/revenue characteristics.
- Addresses questions like:
  - Volume for break-even (total costs = income)?
  - Volume for planned profit?
  - Profit from a given sales volume?
  - Price needed to break even at given capacity?
  - Impact of expansion or cost changes on profits?
Assumptions in CVP models:
- Costs divided into variable and fixed components (often difficult).
- Cost–volume relationships are linear.
- Prices/revenues may change over time; model should incorporate these.
CVP relationships and key formulas:
- Income/Sales: $ext{Income} = R imes N$
- Profit: $ext{Profit} = ext{Income} - ext{Total cost}$
- Contribution: $ext{Contribution} = ext{Income} - ext{Variable cost}$
- Contribution margin: $ext{Contribution margin} = ext{Unit price} - ext{UVC}$
- Total cost: $ext{Total cost} = FC + VC$
- Variable cost: $VC = ext{UVC} imes N$
- Unit total cost: $UTC = rac{TC}{N}$
- Break-even units: $N^* = rac{FC}{R - ext{UVC}}$
Key CVP model notes:
- Determines break-even volume where revenue equals cost for a given price/cost structure.
- Depicted with units (horizontal) vs. revenue/cost (vertical), showing intersection.
Example 15.2: Pete's hot-dogs:
- Given: $FC = R450$ , $UVC = R1.70$ , Unit price $R = R2.50$ .
- 1) Break-even volume: $N^* = rac{450}{2.50 - 1.70} = 563 ext{ units}$ .
- 2) Profit/loss:
  - 440 units: Loss of R98.
  - 940 units: Profit of R302.
- 3) Profit increase for 10% sales rise (940 to 1034 units):
  - Profit at 1034 units = R377.20.
  - Increase = R75.20 (approx. 24.9% increase).
- Degree of Operating Leverage (DOL) at 940 units: $DOL = rac{ ext{Contribution}}{ ext{Profit}} = rac{940 imes 0.80}{302} \approx 2.49$ .
- DOL shows how percentage change in output affects profit; higher DOL implies higher profit when fixed costs spread over larger volume.

15.4 Cost Estimating and Cost Evaluation

Engineers estimate costs for bids, pricing new products, and evaluating opportunities.
Challenges: limited information at tender stage, need for prudence.
Estimating methods vary with information; historic cost data (direct/indirect separately) is valuable.
Capital investment estimates checked against forecasted cash flows.
Cost databases and data collection:
- Quantities/work items list needed for direct costs (materials, labour, machinery).
- Project scope documents aid direct cost estimation.
Indirect cost checklist:
- Covers overhead and general costs: salaries (supervisors, engineering), transport, facilities, support systems, utilities, safety, environmental protection (Table 15.1).
General expenses and overheads:
- Forthcoming in detailed estimates (office, admin, IT, insurance).

15.5 Capital Cost Estimating Methods

Spectrum of methods (rough to detailed); accuracy depends on data and method.
Key ideas:
- Estimating is an art, guided by information quality and method.
- Method selection depends on data availability and project stage.
Order-of-magnitude (conceptual/ball-park) estimates:
- Limited data; uses cost capacity curves, scale-up/down factors, ratio estimates.
- Accuracy: roughly +50% to -30%.
- Uses criteria like output, square metres, or units.
- Techniques: End-product units, Scale-of-operations, Ratio/factor, Physical dimensions.
End-product units method:
- Relates end-product units to construction/manufacturing costs using historic data.
- Example: Eskom 1,800 MW plant at ~R20 billion, 3,600 MW estimated at ~R40 billion (use cautiously, ignores escalation/economies of scale).
Scale-of-operations estimating method:
- Incorporates economy of scale (cube-square principle).
- Equation 15.1: $C2 = C1 imes igg( rac{Q2}{Q1} igg)^Y$ where $Y$ (cost-capacity factor) is usually 0.6 to 0.8 (six-tenths rule).
- Examples 15.3, 15.4, 15.5 illustrate scaling for containers, engines, cooling plants.
Pareto principle in cost estimation:
- 20% of items account for ~80% of value; focus estimation on high-value items.
- Supports using ratio/factor methods for low-value items.
Detailed estimate (Detailed estimate step list):
- For high-value items/high production volumes; uses historical data.
- Steps: list materials (quantities, wastage), design time, operations sequence, labour time, sub-contract work, equipment, special tooling/test equipment.
- Requires technical involvement (purchasing, engineering, manufacturing, accounting).
Inflation and cost indices:
- Historic data needs adjustment for inflation/deflation using industry-specific indices (PPI, CPI).
- Joint estimation across departments improves accuracy.
Cost estimation of long-term projects:
- Less accurate, requires greater contingency.
Example 15.7: Detailed cost estimate record for motor components prototype illustrates format.

15.6 Learning Curves and (Labour) Cost Estimating

Learning-curve phenomenon: time per unit decreases with increased production.
Learning rate concept: time for nth unit reduced according to power law (e.g., 92% learning rate).
General formula (Equation 15.2): $T = T_1 imes n^r$
- $T$ = time for nth unit; $T_1$ = time for 1st unit; $n$ = unit number; $r = rac{ ext{log}( ext{learning rate})}{ ext{log}(2)}$ .
Example: 92% learning rate shows decreasing duration with doubling units (e.g., 1st unit 22h, 2nd 20.2h).
Interpretation and use:
- Learning rate is an educated guess, captures efficiency gains from repetition.
- Applies to individuals, teams, organizations; affects costs/time as output scales up without capacity change.

15.7 Pricing

Influenced by multiple factors, various methods used:
- Mark-up pricing: price = total cost per unit + fixed percentage markup.
- Target-return pricing: price set for desired ROI.
- Perceived value pricing: price driven by consumer perceived value.
- Value pricing: low price for high-quality product.
- Going-rate pricing: price based on similar products.
Cost-to-price progression:
- Direct cost (materials + labour + engineering + expenses) $ext{Rightarrow}$ Factory cost (+ factory expenses) $ext{Rightarrow}$ Production cost (+ admin expenses) $ext{Rightarrow}$ Total cost (+ selling/distribution expenses) $ext{Rightarrow}$ Price (+ mark-up).
Price setting and risk management:
- No estimate is 100% accurate; contingency added to price in bids to manage risk of not achieving desired return.

Key formulas to remember:

Unit cost: $UC = rac{TC}{N}$
Break-even: $N^* = rac{FC}{R - ext{UVC}}$
Income: $ext{Income} = R imes N$
Profit: $ext{Profit} = ext{Income} - ext{Total cost}$
Contribution: $ext{Contribution} = ext{Income} - ext{Variable cost}$
Contribution margin: $ext{CM} = R - ext{UVC}$
Unit total cost: $UTC = rac{TC}{N}$
Total cost: $TC = FC + VC$
Variable cost: $VC = ext{UVC} imes N$
Scale-of-operations (cost scalability): $C2 = C1 imes igg( rac{Q2}{Q1} igg)^Y, ext{ with } 0.6 ext{ \leq } Y ext{ \leq } 0.8$
Learning curve: $T = T_1 imes n^r, ext{ where } r = rac{ ext{log}( ext{learning rate})}{ ext{log}(2)}$

Real-world relevance and takeaways:

Understanding cost types (fixed, variable, semi-variable) aids budgeting, pricing, and financial planning, especially for capital investments and operating budgets.
CVP analysis offers a clear framework for profitability thresholds and volume change impact.
Economies of scale can significantly reduce unit costs at higher volumes, requiring sufficient market demand.
Learning curves capture efficiency gains from repetition, crucial for long-run cost forecasts and project planning.
Pricing decisions balance cost-based calculations with strategic factors (market, competition, customer perception, risk).