Section 1 : Cost Chapter 1 : Cost Elements Section 1 : Cost Chapter 1 : Cost Elements

Sec 1 Chapter 1
Cost Elements
Cost

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Section 1 : Cost Chapter 1 : Cost Elements Section 1 : Cost Chapter 1 : Cost Elements

Cost Structuring Cost Accounting

Sort the cost elements into direct costs, indirect costs, fixed costs, and variable costs. • The historical reporting of disbursements and costs and expenditures on a project.
Cost element structure “CES” will help to understand how they influence activity cost • Basic Steps: (1)Recording, (2)Classifying, and (3)Summarizing.
and to get a better understanding of how they can be controlled. • Classification can be done using the code of accounts, ABC, or WBS
• Code of Accounts: Used to classify all recorded cost elements and also known as “
Cost Structuring
chart of accounts”. It’s configured to support the recording of cost data in the
Costs expended solely to complete the asset. general ledger.
Direct Costs
Ex: concrete, labors, non reusable forms, and permit fees.
Costs support the work but associated with others, hence allocated
Indirect Costs with some percent. Ex: Head office costs and gasoline.

Must be provided independent of the volume of work, either

Fixed Costs
direct or indirect. Ex: Permit fees and head office costs.
Must be provided dependent of the volume of work, either direct
Variable Costs
or indirect. Ex: Labors and gasoline.

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Section 1 : Cost Chapter 1 : Cost Elements Section 1 : Cost Chapter 2 : Pricing

Cost Management

1. Estimating: Predicts the quantity and cost of resources needed to

accomplish an activity or create an asset.
2. Cost Trending: Howexpenditures are trending relative to physical Chapter 2
accomplishments.
3. Cost Forecasting: Predictions of the cost at completion for cost elements
in progress
4. Life-Cycle Costing (LCC): Once the asset is created, it enters the
P r i c i ng
operations and maintenance (O&M). The CES for this phase will be
around maintenance and disposal

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Section 1 : Cost Chapter 2 : Pricing Section 1 : Cost Chapter 2 : Pricing

Price Business and Economic Ratios

Price is the cost at which something is bought or Sold. In real world price and 1. Simple ROI “Return on Investment” :
cost can be used interchangeably. ROI = (Gains – Investment Costs)/Investment Cost
Ex: gains = 11’000, Cost= 9’500
Pricing Strategies
ROI = (11,000 – 9,500)/9,500 = 15.8 %
• Type I is to win the project and execute it profitably. Bid price is determined
according to the actual project cost. 2. Complex ROI:
ROI = Average yearly profit / (Original investment + Working Capital)
• Type II refers to a new industry that a company is trying to get a foothold into.
3. RAI “ Return on Average Investment“ :
In this “must-win” situation, price is determined by the market forces. RAI = Average yearly profit / (average outstanding investmentl)
4. ROS “Return on Sales” :
ROS = Net Profit after taxes / Sales
5. ROA “Return on Assets” :
ROA = Earnings before interest and taxes / Net operating Assets
6. Gross Profit Margin Ratio
GPMR = Gross Profit / Total Sales

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Section 1 : Cost Chapter 2 : Pricing Section 1 : Cost Chapter 3 : Materials

Break Even Analysis

Definition: Level of sales At the point where total costs equal total revenue
Terms:
• Selling Price (SP): The price of each unit.
• Variable Costs (VC): Costs that vary in proportion to sales levels.
•
•
Contribution Margin (CM): Sales revenues less variable costs (SP – VC).
Fixed Costs (FC): Costs remain constant.
Chapter 3
• Units (X): Number of items sold or produced.

Equation: SP(X) = VC(X) + FC i.e X = FC / (SP-VC) = FC / CM

Materials
Example: Each unit selling price is $4, unit cost is $2, and the fixed costs for the
period are $600. What is the break-even point in units and in sales revenue?
4(X) = 2(X) + 600 à X = 300 units
Or: X = 600 / (4-2) = 300 units
Break-even sales revenu = $4 x 300 = $1’200

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Section 1 : Cost Chapter 3 : Materials Section 1 : Cost Chapter 3 : Materials

Types of Materials
Materials Competition
Materials compete on cost, availability, service life, weight, corrosion/wear resistance, 1. Raw Materials:
Materials utilized in a production or fabrication process The most basic.
machinability, weldability, and other ease-of-fabrication criteria.
Ex: Raw materials such as coal, limestone, and iron ore.

Materials Handling Principles

• Movement over the shortest distance. 2. Bulk Materials:
Materials readily available with minimal lead times for order and delivery.
• Terminal time should be in the shortest time (containers / pallets).
EX: Sheet steel, steel bars, steel pipe, and structural steel members.
• Eliminate manual handling when mechanized is feasible.
• Avoid partial transport loads since full loads are more economical.
3. Fabricated Materials:
• Materials should be identifiable and retrievable.
Bulk materials transformed into custom-fit items for a particular product or project.
Ex: Steel pipe transformed by fabrication into custom dimensions for particular use.
use
Materials Handling Decisions
1. Material to be handled: Clay in loaders, structural steel by crane, liquids in pipelines.
2. Production system type: Job shop or batch process and continuous process . 4. Engineered/Designed Materials:
Materials require substantial work in order to attain their final form.
3. Facility type: Low ceiling height, rectangular area, open area.
EX: Pumps, motors, boilers, chillers, fans, compressors, transformers, and
4. Materials handling system costs: Initial Cost, lifecycle costs, disposal costs.
motor control centers.

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Section 1 : Cost Chapter 3 : Materials Section 1 : Cost Chapter 3 : Materials

Materials Purchase and Management Materials Purchase and Management

• Economic Order Quantity EOQ:
• Materials Quality: EOQ = (2 x D x P) / S
Poor quality materials can result in product defects leading to increased costs. Where: EOQ is the optimal order quantity (not function of item cost) , D is annual
Higher-quality materials in excess of requirements will lead to excessive costs. demand, S is storage costs, and P is purchase order costs which is setup cost
(ordering, shipping, handling) not the cost of goods. It’s a fixed cost and not per unit.
• Materials Traceability & Vendor Surveillance: Ex: If your company has a requirement for 20’000 units per year, where the unit cost
Vendor surveillance may require periodic inspection at the vendors’ location. is $130, order cost for a purchase order is $200, and storage cost is $8
Materials traceability is accomplished by means of mill. EOQ = 2 x 20’000 x 200 / 8 = 1000 units
• Reorder point RP:
• Materials Quantity: RP = (O x R) + I
Materials storage is a further burden that can exceed the value of the materials. Where: RP is reorder point, O is order time, R is production rate, and I is minimum
inventory level or safety stock.
Insufficient inventories may create dangers of “stock-outs” interrupting process.
Ex: Assume that you need 40 units per day, the lead time for an order is 5 days, and
To balance these demands, determine economic order quantity (EOQ) number. the safety stock level is 100 units.
RP = (5 x 40) + 100 = 300 units.

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Section 1 : Cost Chapter 3 : Materials Section 1 : Cost Chapter 4 : Labor

Plant Material Management

• Definition: Materials that are not incorporated into product or project. Instead assist
in production operations. Ex: Oils, greases, solvents, and spare parts.

• Specialized Plant Materials: Such as replacement parts may be available only from the
original equipment manufacturer (OEM) and require significant lead time. Try to
Chapter 4
maintain an inventory & networking with others willing to lend in case of emergency.

• MSDS & Hazard Communication: MSDS must be readily available and accessible to
those dealing with hazardous materials as required by (OSHA).
Labor
• Waste Materials: (1)Original materials cost, (2)Handling costs, (3)Disposal costs.

• Surplus materials: This is usually due to (1)Excessive order, (2)Change in material

requirements, (3)Incorrect quantity information.

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Section 1 : Cost Chapter 4 : Labor Section 1 : Cost Chapter 4 : Labor

Labor Classifications Developing Labor Rates

• Direct Labor: Involved in the work activities that directly produce the product
• Indirect Labor: Needed for activities that do not become part of the final installation,
product, or goods produced, but that are required to complete the project.
• Overhead Labor: Labor portion of costs inherent in the performing of a task that is not
a part of the work, and therefore must be allocated as a business expense
independent of the volume of production.
• Time Units: Year = 12 months, Week = 5 days, Day = 8 Hours, Year = 52 Weeks
• Base Wages: Amount that will go directly to the employee (usually per hour).
• Fringe Benefits: Paid time off PTO (Sick time, vacation, holidays) + Medical/Life Insurance.
• Example:
Base wage = $60’000/year = 60’000 /(52x5x8) = $28.8 / hour
PTO: Considering yearly (5 days sick, 10 vacation, 10 holidays)
Sick time = 28.8 x 5 x 8 = $1’154 / year
Vacation = 28.8 x 10 x 8 = $2’308 / year
Holidays = 28.8 x 10 x 8 = $2’308 / year
PTO = $5’770 / year
Working hours / Year = (52x5x8) – (5x8 + 10x8 + 10x8) = 1880 hrs
PTO = $5’770 / 1880 = $3.07 / hr

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Section 1 : Cost Chapter 4 : Labor Section 1 : Cost Chapter 4 : Labor

Developing Labor Rates Developing Labor Rates

Medical Insurance / Government Benefits
• Fully Loaded Rate (Billing Rate):
Considering the following:
• Medical insurance= 400/month = 400 x 12 / 1880 = $2.55/hr It’s the base salary + adders + overhead + profit. On time & material basis, owner
• Retirement contribution (> 401K) = 300/month = 300 x 12 / 1880 = $1.91/hr pays for worker job only and doesn’t pay for sick leaves, vacations, holidays.
• Government mandated benefits (US Only) are
Ø 6.2% retirement = 6.2% x 28.85 = $1.79/hr • Indirect Labor:

Ø 1.35% retirement medical = 1.35% x 28.85 = $0.39/hr 1. Direct estimate of the indirect staff required.
Ø 1 % state unemployment = 1% x 28.85 = $ 0.29/hr 2. Using historical data (ex: 25% or 30% of direct labor cost).
Total medical insurance = 2.55 + 1.91 + 1.79 + 0.39 + 0.29 = $6.93/hr
• Overtime:
Total Benefits = 3.07 + 6.93 = $10/hr
When calculating Overtime, (PTO, insurance, and some governmental programs) are
Total wage = 28.85 + 10 = $38.85/hr
not added to overtime. Some other governmental retirements such as social security
Benefits adder = 10 / 28.85 = 34.7 %
and Medicare are usually added to overtime.

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Section 1 : Cost Chapter 4 : Labor Section 1 : Cost Chapter 4 : Labor

Weighted average Rates (Crew Composition) Factors Affecting Productivity

• Will union or non-union craft labor be used?
• Is sufficient labor available locally?
• If the area is remote, do workers have to be bused in?
• What will the weather conditions be like (hot, cold, rainy, etc.)?
• Are there any local holidays?
• Are temporary living quarters needed?
• Is overtime necessary to attract workers?
Example: If working 10 hrs/day for two weeks, 10 hours for two Saturdays. • What are the standard work hours and work days?

Normal time: 40 hrs x 2 weeks x $23.83 x 9 workers = $17’158

Overtime : $18.33 x 1.5 = $27.5/hr with benefits adder (say) 7.5% = $29.56/hr
(5 days x 2 hrs + 8 hrs Saturday ) x 2 weeks x $29.56 x 9 workers = $9’577

Double Time: $18.33 x 2 = $36.66/hr with benefits adder (say) 7.5% = $39.41/hr
(2 hrs Saturday ) x 2 weeks x $39.41 x 9 workers = $1’418

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Section 1 : Cost Chapter 5 : Engineering Section 1 : Cost Chapter 5 : Engineering

Product, Project, and Process Development (1/2)

• Pure / Basic Research: Work without a specific particular end product such as
examining the interactions of different chemical compounds.

Chapter 5 • Applied Research: The attempt to develop usable products or add new feature-sets
to existing products. It’s carried out by the organization producing the product.

Engineering • Computer-Aided Design/Engineering CAD/CAE: Utilization of computerized work

stations and software to develop and analyze a product, project, or process design.

• Computer-Aided Manufacturing CAM: CAD/CAE ported directly into CAM software.

Design is directly sent to machines like CNC Computer-numerically controlled.

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Section 1 : Cost Chapter 5 : Engineering Section 1 : Cost Chapter 5 : Engineering

Product, Project, and Process Development (2/2) Product, Project, and Process Design (1/2)

• Prototypes: Developed prior to large-scale production to (1)test designs and also to • Standardization: The attempt to base product designs. The advantages are lower
(2)test customer reaction. Prototype development is expensive, but is less expensive costs, shorter time, and maintenance personnel are more familiar. The disadvantage
than discovered after numerous units are in customer hands. that If there is a flaw, it will be spread over a wide variety of products.

• Patents & Trade Secrets: Organizations wishing to emulate patent’s provisions will
develop different approach different or pay to the patent holder. (In USA 17 Years).
• Product Liability: Those injured by a product can seek compensation for their
damage. The tort law in this area has evolved over decades from a concept of
“buyer beware” to a concept of “seller beware”.
• Process Selection: Relates to production methods, continuous and discrete.
1. Continuous production methods such as petrochemical plants, power plants and
manufacturers with assembly-line methods. It’s less expensive in the long run.
2. Discrete production such as pre-cast concrete plant, or structural steel fabrication
shop. It has a higher labor factor. Favored where labor costs are less expensive.
Some products will envelope both methods sometimes by the same firm.

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Section 1 : Cost Chapter 5 : Engineering Section 1 : Cost Chapter 5 : Engineering

Product, Project, and Process Design (2/2) Engineering Production / Construction (1/2)

• Manufacturability: Slight modifications in a design that promote ease of product • Production Health & Safety: An accident results in the loss of a trained worker and
assembly without affecting the product. Designs should be:
an interruption in the process. Systems must be selected that reduce/eliminate the
1. Forgiving of minor inaccuracies
2. Easy to fabricate, potential of accidents.
3. Based on efficient utilization of labor, materials, and equipment
• Facility Layout: Decisions as to arrangement, including equipment location, labor
• Constructability: The Counterpart of manufacturability applied to constructed location, and services location. Layout decisions should always consider the
projects to pinpoint problems before designs are developed to the point where
potential impact of additional demand therefore considering future expansion.
changes create significant delays and associated costs.

• Make-or-Buy Decision: Which items should be subcontracted out and which should • Assembly And Flow Process Charts: Assist in planning the facility layout. They help
be made in-house. Do organization’s quality and cost on an item can compete with to analyze production operations in terms of operations sequences performed,
outside suppliers. If trade secrets are involved, the decision will typically be to make distances between operations, and operation time requirements.
the item, The goal is to enhance overall quality at a lower cost.

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Section 1 : Cost Chapter 5 : Engineering Section 1 : Cost Chapter 6 : Equipment

Engineering Production / Construction (2/2)

• Quantitative Analysis In Facility Layout.

1. Linear programming is a mathematical technique that is widely used in finding
optimal solutions to problems.
2. Monte Carlo techniques can be used to simulate wait time for a crane in a
Chapter 6
plant and its cost impact. Data can be generated via computer programs with
random number generators. Equipment, Parts, and Tools
• Reengineering: Redesign of process to achieve improvements such as cost, quality,
service, and speed. Ex: Let your supplier monitor your inventory of their supplied
items. Reengineering focuses on the optimization of the total organization, rather
than sub-optimization of individual departments. Moreover, reengineering focuses
on the “whys” of an action or process as opposed to the “hows”.

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Section 1 : Cost Chapter 6 : Equipment Section 1 : Cost Chapter 6 : Equipment

Equipment Value Categories Equipment Value Categories

1. Replacement Cost New 2. Market Value

• Reproduction Cost: The cost new of an identical item. • Fair Market Value-in-Place: Value expected between a willing buyer and a willing
seller, both not under any compulsion and taking into account installation and
• Replacement Cost: The cost new of an item having the same or similar utility.
the contribution of the item to the operating facility.
• Fair Value: Cost new of an item considering similar items cost, and taking into
• Fair Market Value-in-Exchange: Value expected to be exchanged in a third-party
account utility and all standard adjustments and discounts to list price.
transaction between a willing buyer and a willing seller, both not under any
• Sources of Data: compulsion, also referred to as retail value
• Manufacturers price lists • Orderly Liquidation Value: Probable price for all assets from an orderly
• Sales representatives liquidation, given a maximum six months to conduct sale and adequate funds
• Manufacturers or dealers quotations available for the remarketing campaign, also referred to as wholesale value.

• Past transactions invoices and purchase orders • Forced Liquidation Value: Value of equipment that can be derived from a
• Journals and trade shows literature properly advertised and conducted auction where time is of the essence, also
referred to as “under the hammer” or “blow-out” value.
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Section 1 : Cost Chapter 6 : Equipment Section 1 : Cost Chapter 6 : Equipment

Equipment Value Categories Equipment Value Categories

2. Market Value Market Value Example:

• Salvage Value/Part-Out Value: Value of equipment that a buyer will pay to a
Orderly Liquidation Sale = Purchase price at auction = $5,500
seller, recognizing the component value of parts of the equipment that can be
De-installation, rigging, shipping, and delivery to warehouse = $600
used or resold to end-users, usually for repair or replacement purposes.
Cost of money (90 days to sell, 10% rate ) = 3 x $6,100 x 10% = $154
• Scrap Value: Value of equipment that relates to the equipment’s basic
Overhead (20%) = $5,500 x 20% = $1,100
commodity value. For example, dollars per ton of steel or pound of copper.
Profit (20% of purchase price plus de-installation ) = $6,100 x 20% = $1,220
• Sources of Data:
Min. desired selling price = $5,500 + $600 + $154 + $1,100 + $1,220 = $8,574
• Sales advertisements for used equipment
Retail Asking = Ask advertise for sale = $9,800
• Used equipment dealers
Fair Market Value-in-Exchange = Take (sale to end user) $8,600
• Used equipment quotations in previous transactions
Buyer (end user) pays sales tax (6%) $516, Delivery $600, Installation and
• Market data publications
• Auction “sales catalogs” available from auction companies debugging $1,400
• Past sales results from one’s own firm. Fair Market Value-in-Place = $8,600 + $516 + $600 + $1,400 = $11,116

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Section 1 : Cost Chapter 6 : Equipment Section 1 : Cost Chapter 6 : Equipment

Equipment Value Categories Equipment Value Categories

Cost Adjustments : To normalize data, the following considerations should be addressed Data Filing Systems : Most firms file data using one of four methods
• Different years of manufacture
1. Standard Industrial Classification (SIC) code where data is stored in broad
• Utilization (amount of wear/use)
industry category codes, such as #34-machine tools, #44-marine, etc. This
• Condition
• Different attachments, drive motors, etc. method is quite effective when utilizing an electronic database.

• Location of the sale (market area vs. a remote area)
Condition Terms and Definitions Example:
• Excellent (E): New condition, no defects, and may still be under warranty.
• Good (G): Good appearance, may recently overhauled but no repairs required.
2. List data by equipment class and type, such as crane, trailers, or bulldozer.
3. Lists equipment by industry category, such as construction, mining, or aircraft.
4. Manufacturer’s name, such as Caterpillar construction equipments, Boeing

• Average (A): Operating 100 %, but may need repair or replacement in the future. commercial aircraft, and IBM-computers, etc.
• Fair (F): High utilization, defects are obvious and will require repair soon.
• Poor (P): Not operational, requires repair, or overhaul before it can be used
35 36
Section 1 : Cost Chapter 6 : Equipment
Equipment Residual Values:
Residual Value Curve:
1. Normal Curve: long-lived equipment, usually L-Shape.
2. Disrupted-Market: Usually U-Shape, results from equipment
shortage or regulatory pressures causing suddenly deviation.
3. Regulatory Change Curve: Illustrates sudden impact on market
value that regulation can cause
4. High Obsolescence Curve: Illustrates impact of technological
obsolescence such as computers and high-tech equipment.
5. New Tax Law / High Inflation Curve: Tax laws
and inflation can cause a normal residual curve
to rise in a short time.
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Section 1 : Cost Chapter 6 : Equipment
Variables That Affect Residual Value (2/4)
2. Maintenance: It can affect the useful life of equipment. In calculating a residual
value, estimators must consider how the equipment will be maintained and/or the
maintenance provisions in the lease.
3. Use, Wear, and Tear: Equipment in harsh service versus mild service can be
substantial. Ex: hopper used in grain service lives 40 to 50 years. However, if used in
salt service, their useful lives can be as short as 15 years.
Some types of equipment, such as aircraft, define use in hours of utilization and
cycles (takeoffs and landings); other transportation equipment defines use in miles
per year. Most mechanical equipments tend to wear out at around 10,000 to 20,000
hours. At these milestones, usually some form of rebuild is required.
4. Population: This gives statistical significance to the residual value, because the value
will be based on a large sample.
39
Section 1 : Cost Chapter 6 : Equipment
Variables That Affect Residual Value (4/4)
9. Tax Law: Sometimes tax laws can affect new equipments price, hence affecting used
equipment price.
10. Legislation/Regulation: Regulations may impact values in positive ways, however,
the impact is often negative.
11. Equipment Location: Does the equipment required to be delivered to a prime
market location or will it have to be sold in a remote area?
12. Method of Sale: Price of cash sales will not be like installment sales.
41
Section 1 : Cost Chapter 6 : Equipment
Variables That Affect Residual Value (1/4)
1. Initial Cost: For residual purposes, the estimator should consider hard costs only.
Hard cost includes the cost new + items necessary to make it operate such as
motors, electricals, and controls. Soft costs should not be included such as
foundations, freight, debugging, taxes, and installation.
Example: A transaction valued at $2.1 million. Subsequent investigation found that
basic cost of the machine was $1.5 million, the soft cost was $600’000.
Residual curve indicated 30 percent of the new cost.
Total Cost: $2.1 million x 30% = $630,000
Hard Cost: $1.5 million x 30% = $450,000
Difference = $180,000
This difference could present a future shortfall.
In some instances, such as a lease or financing or life-cycle costing, soft costs should
be considered in determining residual values.
38
Section 1 : Cost Chapter 6 : Equipment
Variables That Affect Residual Value (3/4)
5. Age: Equipment presented as new in January 2003 could have a 2001 or 2002 build
date. Both are new with the same condition but the price is different.
6. Economy: A used truck in a robust economy may be sold for lower price and longer
time in a recession. Cost of money should also be calculated in the overall cost.
7. Changes in Technology: An analysis of technological changes occurring over the past
20 years shows that future advances in technology were generally known at the time
of lease origination. time necessary to “fix” an image from minutes to seconds.
8. Foreign Exchange: Changes in foreign exchange value could affect selling / residual
value, causing them to suddenly drop or increase. Strong foreign currency may rise
the price of foreign equipment, which in turn, may pull residuals up, and vice versa.
40
Section 1 : Cost Chapter 7 : Economic Costs
Chapter 7
Economic Costs
42
Section 1 : Cost Chapter 7 : Economic Costs Section 1 : Cost Chapter 7 : Economic Costs

Types of Costs Changes In Costs (1/2)

1. Opportunity Cost: Foregone benefit by choosing one alternative over another. A
company has 3 investments options with ROI = 1.37, 1.34, 1.32. The opportunity cost
of choosing the 1.34 is 0.33 loss for not exploiting the higher ROI investment.
2. Sunk Costs: Funds already spent by past decisions. Since these expenditures are in
the past, they should not influence current decisions.
3. Book Costs: Original cost less any depreciation. They do not represent cash flow and
thus are not taken into account for economic decisions. If market price is lower than
the original price, price will be carried at the lower of cost or market value.
1. Inflation: A rise in the price level that does not occur by itself but must have a
driving force behind it. There are four effects that can result in inflation:
I. Money supply: Influenced by central bank operations. A loosening of monetary
policy will increase the flow of money, which means increased money is
chasing the same amount of goods. This bids up price resulting in inflation.
II. Exchange rates: They influence price of imported goods. If the import is a basic
industrial commodity, utilized in several products, this will lead to inflation.
III. Demand-pull inflation: When excessive quantities of money are chasing a
limited amount of goods resulting in what is essentially a “seller’s market” as

4. Incremental Costs: When comparing between many alternatives, cost differences sellers receive premium prices
between them are called incremental costs. Ex: If two units have annual costs of IV. Cost-push inflation: It takes place when product producers encounter higher

$1,500, $1,800, then incremental cost difference is $300. costs and then push these costs along to others in the production chain
through higher prices.
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Section 1 : Cost Chapter 7 : Economic Costs Section 1 : Cost Chapter 7 : Economic Costs

Changes In Costs (2/2) Governmental Cost Impacts (1/2)

2. Deflation: A fall in the general price level for goods. The same factors of money
supply, exchange rates, demand-pull, and cost-push factors operate but in the
opposite direction with a resultant decrease in prices.
3. Escalation: A technique to accommodate price increases or decreases during
contract life. A clause is incorporated into the contract so that the purchaser will
compensate the supplier in the event of price changes. Without such clauses,
suppliers would include contingency amounts that might not used. The supplier
would gain from this windfall while the purchaser would be the loser.
4. Currency Variation: A significant cost impact both on those inside the country as
well as those outside the country. Protection can be accomplished through:
1. Currency futures hedging or
2. Valuing contracts against very stable currencies.
1. Taxes: Ex: Income taxes, property taxes, inventory taxes, employment taxes, and
sales taxes. In the case sales taxes, the firm acts as the tax collector for the
government adding the sales tax and collecting it from customers. Some countries
have a value-added tax (VAT) applied to the added value. Therefore, if a firm took
$100 worth of raw materials and produced a product valued at $250, the (VAT)
would be applied to the $150 difference or value added by the firm.
2. Effective & Marginal Tax Rates:
• Effective tax rate (Average tax rate) = (Tax Liability / Total Taxable Income).
• Marginal tax rate is the tax rate on the next dollar of taxable income. For
financial decision-making, marginal tax rate is a key element because the firm is
concerned with the tax impact of additional income.

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Section 1 : Cost Chapter 7 : Economic Costs Section 1 : Cost Chapter 7 : Economic Costs

Governmental Cost Impacts (2/2) Depreciation Techniques (1/2)

3. Investment Tax Credits : To encourage economic activity, governments may give 1. Straight-Line Depreciation : D = (C - S) / N
firms tax credits ‫ اﻋﻔﺎء ﺿرﯾﺑﻲ‬based on location, equipment type, or certain public goals Where: D = depreciation charge, C = asset original cost, S = salvage value, and
such as equipment that reduces energy consumption. N=asset depreciable life (years).
4. Depreciation and Depletion: Ex: Asset with a $8’000 original cost, 5-years life, and $400 salvage value.
D = ($8’000 – $2’000) / 5 = $6’000 / 5 = $1’200
• Depreciation: Governmental entities allow depreciation to encourage investment
in equipment. Depreciation is a non-cash expense that reduces taxable income. It 2. Double-Declining Balance Depreciation (DDM): D = ( 2 / N ) (BVt-1)
provides an incentive for firms to invest in new plant and equipment based on Where: D = depreciation charge, C = asset original cost, BV = Book value at given
original equipment costs (inflation cannot be taken into account for these year, and N = asset depreciable life (years).
Ex: For the previous example,
purposes). The rationale underlying depreciation is that physical assets lose value
Year Calculation Dep. Amount Allowable Dep. Book Value
over time due to such factors as deterioration, wear, and obsolescence.
1 (2/5) x (8000) $3’200 $3’200 $4’800
• Depletion : Analogous to depreciation but for natural resources. Thus, owners of 2 (2/5) x (4800) $1’920 $1’920 $2’880
a stone quarry or an oil well can take depletion allowances based on the 3 (2/5) x (2880) $1’152 $880 $2’000

percentage of the resource used up in a given time period. Total - $6’272 $6’000 -

47 48
Section 1 : Cost Chapter 7 : Economic Costs Section 1 : Cost Chapter 7 : Economic Costs

Depreciation Techniques (2/2) Economic Analysis Techniques

3. Sum-of-Years Digits Depreciation (SOYD): Dr = (C - S) x [ (N-r+1) / ((N(N + 1) /2 )] Time Value of Money:

Where: Dr = Depreciation charge for the rth year, C = asset original cost, S = salvage In order to compare different alternatives on the same basis, these cash
value, N = remaining asset depreciable life (years), r = rth year. amounts of income and expenditures must be set to equivalent terms.
Ex: For the previous example, Year Calculation Dep. Amount
1 (8000 – 2000) x (5/15) $2’000
2 (8000 – 2000) x (4/15) $1’600
3 (8000 – 2000) x (3/15) $1200
4 (8000 – 2000) x (2/15) $800
5 (8000 – 2000) x (1/15) $400

4. Modified Accelerated Cost Recovery System Depreciation (MACRS):

• Unique to the United States Tax Code.
• Based on original asset cost, asset type, asset recovery period.

5. Units of Production Depreciation:

• Utilized when depreciation is more accurately based on usage instead of time.
49 50

Section 1 : Cost Chapter 7 : Economic Costs Section 1 : Cost Chapter 7 : Economic Costs

Economic Analysis Techniques Economic Analysis Techniques

1. Net Present Worth Method (NPW): 2. Capitalized Cost Method: A = PxI

Ex: Unit A price=$10’000, life=4years, salvage=0, Annual maintenance = $500/year.
Unit B price=$20’000, life=12year, salvage=$5’000, maintenance costs are Year1=0,
Year2=$100 and increase by $100/year. The firm’s cost of capital is 8 percent.
Solution:
• Life is different and the common multiple is 12 years
• NPW(A)= 10’000 + 10’000/1.084 + 10’000/1.088 + 500 x [(1.0812-1)/(0.08x1.0812)]
= 10’000 + 7350.3 + 5402.7 + 3768 = 26’521
Capitalized cost (CC) represents the present sum of money that needs to be set
aside now, at some interest rate, to yield the funds required to provide the
service.
Example:
A bridge is built for $5,000,000 and will have maintenance costs of $100,000
per year. At 6 percent interest, what is the capitalized cost of service?
Solution:

• NPW(B)=20’000+ 100 x [ (1.0812 -0.08x12-1)/(0.0812 x 1.0812)] – 5000/1.0812 Maintenance Capitalized Cost = ($100,000) / 0.06 = $1’666’667
= 20’000 + 3463 - 1985.6 = 21’277.82

Decision: Select unit B that has the least cost.

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Section 1 : Cost Chapter 7 : Economic Costs Section 1 : Cost Chapter 7 : Economic Costs

Economic Analysis Techniques Economic Analysis Techniques

3. Equivalent Uniform Annual Cost or Benefit (EUAC/EUAB): (P-S)(A/P,I,n) + SI 4. Rate of Return Analysis (ROR):
The comparison may be made on the basis of equivalent uniform annual cost Many organizations often set hurdle rates (benchmark rate of return) that a capital
(EUAC), equivalent uniform annual benefit (EUAB) or on the EUAB-EUAC difference. investment decision must achieve to be acceptable. In the case where investment
funds are limited, projects with the highest ROR values can be selected.
Example : Unit A has an initial cost of $20,000 and $3,000 salvage value, while Unit
B has an initial cost of $15,000 and $2,000 salvage value. Unit A has a life of 10 Example : Unit A cost of $20,000 and Unit B of $10,000 and each 1-year life.
years, whereas Unit B has a 5-year life. Cost of capital is 10 percent. Incremental benefit of $15,000 for A compared to B. Organization hurdle rate is 20%.
Solution: Solution:
EUACA = P (A/P,I,n) – S (A/F,I,n) or you can use the formula above NPW (A vs B) = 20’000 – 10’000 = $10’000
= 20’000 x0.1 x 1.110 / (1.110 - 1) - 3’000 x0.1 / (1.110 -1 ) P = F / (1+i)n à (1+i)n = F/P
= 3254.9 – 188.24 = $3066.67 (1+i)1 = 15’000 / 10’000 = 1.5 à 1+i = 1.5
EUACB = 15’000 x0.1 x 1.15 / (1.15 - 1) - 2’000 x0.1 / (1.15 -1 ) i= 0.5 à ROR = 50%
= 3429.37 – 327.59 = $3629.37
Decision: As long as ROR > 20%, investment is OK.
Decision: Select unit A that has the least annuity.
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Section 1 : Cost Chapter 7 : Economic Costs Section 1 : Cost Chapter 8 : ABC Management

Economic Analysis Techniques

5. Benefit-Cost Ratio Analysis Method:

If B/C > 1 then project is viable. If comparing projects, take the highest B/C ratio.

Example : A Benefits= $1’500’000 and Cost= $1’200’000. B Benefits= $2’000’000 and

cost= $1’700’000
Chapter 8
Solution: B/CA = 1.25 B/CB = 1.17
Decision: Take the highest B/C which is for A Ac tivity-Based
6. Payback Period Method:
• Period of time necessary for the benefits to pay back the associated costs.
Cost Management
• Differences in the timing of cash flows are not considered nor are benefits and
costs beyond the payback period.
• Example: Investment of $4,000 with benefits of $800 per year would have a
payback period of 5 years ($4,000/$800 = 5 years).

55 56

Section 1 : Cost Chapter 8 : ABC Management Section 1 : Cost Chapter 8 : ABC Management

Overhead Expenses Are Displacing Direct Costs Expressing Activities And Tracing Expenses
• Over the last few decades, overhead expenses General Ledger ABC/M
have been displacing the recurring costs.
Transaction-centric Work-centric
• Organizations have visibility of direct costs, but not have any insights into overhead
or its reasons. ABC/M can help provide for insights. Uses chart of accounts Uses chart of activities

• Most of people believe that overhead expenses are displacing direct costs because What was spent What it was spent for
of technology, equipment, automation, or computers. Calculates the costs of
Records the expenses
activities and unit cost
• The primary cause for the shift is the increasingly offering of variety of products,
using more types of sales channels, and servicing different types of customers. This Organized around cost Describes activities using
centres to accumulate an “action verb- adjective-
creates complexity which results in more overhead expenses to manage it.
transactions into their noun” format, such as
• ABC/M does not fix or simplify complexity, but points out where the complexity is accounts. But this inspect defective
format is deficient for products, open new
and where it comes from.
decision support customer accounts

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Section 1 : Cost Chapter 8 : ABC Management Section 1 : Cost Chapter 8 : ABC Management

Drivers triggers Using Attributes of ABC

• It’s what would make activity cost increase or decrease • One role for calculating costs is to identify which activities are :
• Ex of activity is “Analyze claims”, Ex of Driver is “Number of claims analyzed”. 1. Not required and can be eliminated (Ex: Duplication of effort)
2. Ineffectively accomplished and can be reduced
Cost Re-Assignment Network
3. Required to sustain the organization (not be possible to reduce or eliminate).
ABC re-assigns 100 % of the costs into the final products, service lines, and customers. In
4. Discretionary and can potentially be eliminated (Ex: Annual employees’ picnic).
short, ABC connects customers to the unique resources they consume. ABC cost re-
• Traditional methods do not provide any way to tag/highlight individual costs. ABC/M
assignment network consists of the three modules connected by cost assignment paths.
allow managers to differentiate activities from one another.
1. Resources: The capacity to perform work. Ex: salaries and materials. They are traced
• Example of tags are:
to work activities to convey resource expenses into the activity costs.
q very important / required / postponable.
2. Activity Module: It’s where work is performed. It contains the structure to assign
q High-value-adding / low-value-adding.
activity costs to cost objects
q Exceeds / meets / below customer expectation.
3. Cost objects: At the bottom of the cost assignment network, represent outputs and
• Multiple attributes can be applied.
services where costs accumulate. Ex: Products, service lines, and customers. The
Ex: performance (vertical axis) and importance (horizontal axis).
customers are the final-final cost objects.
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Section 1 : Cost Chapter 8 : ABC Management
Local vs. Enterprise-Wide ABC/M
• A common misconception is that ABC/M system must be enterprise-wide. However
In practice, the majority of ABC/M is applied to subsets of the organization for
process improvement rather than revenue enhancement.
• The local model is used for tactical purposes, often to improve productivity. In
contrast, the enterprise-wide model is often used for strategic purposes because it
helps focus on where to look for problems and opportunities.
• Also, enterprise-wide models are popular for calculating profit margin at all levels.
• Commercial ABC/M software now enables consolidating some, and usually all, of the
local, children ABC/M models into the enterprise-wide, parent ABC/M model.
61
Section 1 : Cost Chapter 8 : ABC Management
Applications Of Local ABC/M
• The objective of local ABC/M models is not to calculate the profit margins; it is to
compute the diverse costs of outputs to better understand how they create the
organization’s cost structure.
• An interesting application is when marketing department is trying multiple tools,
such as newspapers, radio, television, tradeshows, Websites, ...etc.
ABC/M calculation determine the costs versus benefits of all the channel
combinations to rank in order which are the least to best return on spending.
Why ABC/M ?
• In the past, most organizations were reasonably profitable. They could make
mistakes, and their adequate profitability would mask the impact of their wrong or
poor decisions. However, error margin today is slimmer. Businesses cannot make
many mistakes as in the past and remain competitive or effective.
• Mature users try to integrates ABC/M output data with their decision support
systems, such as their cost estimating, predictive planning, budgeting, activity-based
planning (ABP) systems, customer relationship management (CRM), and balanced
scorecard performance measurement systems.
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Section 2 : Cost Estimating Chapter 9 : Estimating Section 2 : Cost Estimating Chapter 9 : Estimating

Sec 2 Chapter 9
Estimating
Cost Estimating

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Section 2 : Cost Estimating Chapter 9 : Estimating Section 2 : Cost Estimating Chapter 9 : Estimating

Introduction Estimate Classifications

• Why Estimating:
1. Determining the economic feasibility of a project,
2. Evaluating between project alternatives
3. Establishing the project budget
4. Providing a basis for project cost and schedule control
• Estimating Steps:
1. Understand scope of the activity to quantify the resources required,
2. Apply costs to the resources
3. Apply pricing adjustments
4. Organize the output in a way that supports decision-making.
• Estimate Accuracy:
• Each subsequent decision-making point (whether project should be
continued) requires cost estimates of increasing accuracy.
• Estimating is an iterative process that is applied in each phase of the
project life cycle as the project scope is defined, modified, and refined.

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Section 2 : Cost Estimating Chapter 9 : Estimating Section 2 : Cost Estimating Chapter 9 : Estimating

Estimating Methodologies A. Conceptual Estimating Methodologies

• Used for class 4 or 5 (sometime for class 3)

A. Conceptual
Project
Low level of Project Definition
Definition Level
Independent
Variable used in Not direct measure of units
estimating algorithm
Significant effort in data
gathering and cost analysis.
Effort
Preparing estimate itself takes
little time sometimes an hour.
B. Deterministic • Referred to as order of magnitude (OOM) in reference to the wide range of
accuracy.
High level of Project • May be used for project screening, feasibility evaluation, initial budget.
Definition
• Common used methods are:
1. End-Product Units Method
Direct measure
Item x unit cost 2. Physical Dimensions Method
3. Capacity Factor Method
Large effort, sometimes 4. Ratio / Factor Method
weeks or even months. 5. Parametric Method

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Section 2 : Cost Estimating Chapter 9 : Estimating Section 2 : Cost Estimating Chapter 9 : Estimating

A. Conceptual Estimating Methodologies A. Conceptual Estimating Methodologies

1. End-Product Units Method:
• Used when enough historical data available from similar projects such as
electric plant and its capacity in kilowatts, a hotel and the number of guest
rooms, or a hospital and the number of patient beds.
• Ex: A 1’000 guest rooms hotel was completed for $67,500,000. Therefore,
the cost of the 1,500 room hotel is $101,250,000 ($67,500/1,000 x 1,500).
• This meets the needs of the feasibility study, however it has ignored several
factors like scale, location, or timing. Cost indices can be used for adjustment.
2. Physical Dimension Method:
• Use length, area, volume, … etc as the driving factor such as building area in
m2 or pipeline length in m.
• Ex: 2900 m2 warehouse was built for $623’500. A new ware house of 3’600
m2. The expected cost will be $623’500 / 2900 x 3600 = $774’000
• We have ignored quality specifications between the two warehouses.
3. Capacity Factor Method:
• It relies on the nonlinear relationship between capacity and cost.
• $B = $A (CapB / CapA)e. Where B is the facility being estimated, “e” is the
exponent or proration factor, typically lies between 0.5 and 0.85
• If e is less than 1, capacity increases by a percentage (say, 20 percent), the
costs to build the larger facility increase by less than 20 percent.
• Capacity factor also referred to as the “scale of operations” method or the
“six tenth’s factor” method due to the common reliance on e = 0.6
• With e = 0.6, doubling the capacity increases costs by approximately 50 %
and tripling the capacity increases costs by approximately 100 %.
• As e tends towards a value of 1, it becomes more economical to build two
facilities of a smaller size than one large facility.

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Section 2 : Cost Estimating Chapter 9 : Estimating Section 2 : Cost Estimating Chapter 9 : Estimating

A. Conceptual Estimating Methodologies A. Conceptual Estimating Methodologies

3. Capacity Factor Method: 4. Ratio Factor Method:
• Example: 100’000 BBL/day hydrogen peroxide unit to be built in Philadelphia • Used when cost can be estimated from a primary component cost, This is
and completed in 2004. We have recently completed a 150,000 BBL/day often referred to as “equipment factor” estimating.
plant in Malaysia with a final cost of $50 million in 2002. Our recent history • Estimate is often a feasibility estimate (Class 3). Then may be used to justify the
shows a capacity factor of 0.75 is appropriate. funding required to produce a budget estimate (Class 3).
• Factors may estimate Total Installed Costs (TIC) or Direct Field Cost (DFC) for
• Solution: $B = $50 x (100/150)0.75 = $36.89 M
the Inside Battery Limits (ISBL) facilities, however sometimes appropriate
• Example: Assume adjustment for scope(-10M) for piling, location(1.25) factors are used to estimate the costs of the complete facilities.
higher cost, timing(1.06) multiplier, and additional cost for pollution(5M).
• Hans Lang (1947):
• Solution:
Total plant $ = total equipment $ x equipment factor.
$50 - $10 piling not required = $40 M Steps
1. Deduct costs N/A in new plant Factors based on process type (Solid Process Plant 3.1 , Solid-Fluid Process
$40 x 1.25 location = $50 M
2. Adjust location and escalation Plant 3.63, Fluid Process Plant 4.74 ). Lang’s factors cover ISBL & OSBL costs.
$50 x 1.06 timing = $53 M
3. Apply capacity factor
$B = $53 x (100/150)0.75 = $39 M Ex: A fluid process plant with estimated equipment cost = $1.5M
4. Add additional costs required
$39 + $5 Pollution Cost = $44 M for the new plant Total plant cost = $1.5M X 4.74 = $7.11M

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Section 2 : Cost Estimating Chapter 9 : Estimating Section 2 : Cost Estimating Chapter 9 : Estimating

A. Conceptual Estimating Methodologies A. Conceptual Estimating Methodologies

4. Ratio Factor Method:
4. Ratio Factor Method:
• W. E. Hand(1958):
• W. E. Hand(1958):
1. Equipment cost x factor

• Elaboration for Lang’s method proposing factors for type of equipment

2. Sum to calculate DFC
such as vessels or heat exchangers. Hand’s factors for equipment
3. DFL (labor) = 25% x DFC
excluding instrumentation range from 2.0 to 3.5 and if including
4. IFC = 115% x DFL
instrumentation they range from 2.4 to 4.3 . Hand’s factors estimated
DFCs and excluded indirect field costs (IFC), home office costs (HOC), and 5. HOC = 30% x DFC

the costs for outside battery limit (OSBL). 6. Commissioning = 3% x DFC

7. Sum

8. Contingency = 15% x Sum

9. Total

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Section 2 : Cost Estimating Chapter 9 : Estimating Section 2 : Cost Estimating Chapter 9 : Estimating

A. Conceptual Estimating Methodologies A. Conceptual Estimating Methodologies

4. Ratio Factor Method:
• Arthur Miller (1965):
Ø Miller recognized impact of (1)Size, (2)metallurgy, (3)operating pressure).
Ø When size gets larger, amount of corresponding materials (foundation,
support steel, piping, instruments) does not increase at the same rate. Thus,
as equipment size increases, value of the equipment factor decreases.
Ø A similar tendency exists for metallurgy and operating pressure.
Ø Miller suggested that these three variables could be summarized into a single
attribute known as the “average unit cost” of equipment.
Ø Average unit cost = Total cost of equipment/number of equipment items
Ø There’s a statistical correlation between increasing average unit cost of
equipment and decreasing equipment factors that if the average unit cost of
equipment increases, then the equipment factor is scaled smaller.
13
4. Parametric Method
• A correlation between physical or functional characteristics of a plant (or
process system) and its resultant cost [NASA].
• Capacity factor & equipment factor are simple examples of parametric
estimates; however sophisticated parametric models involve several variables .
• Developing a parametric model involves the following steps :
1. Cost model scope determination: End use, physical characteristics.
2. Data collection: Quality of model can be no better than quality of data.
3. Data normalization: Escalation, location, site conditions.
4. Data analysis: Series of linear and non-linear regression analysis will be
run to determine the best algorithm (model).
5. Data application: User interface that accept user inputs then calculate
costs and display results. Spread sheets is an excellent tool.
6. Testing: Test the result validity and accuracy.
7. Documentation: User manual.
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Section 2 : Cost Estimating Chapter 9 : Estimating Section 2 : Cost Estimating Chapter 9 : Estimating

B. Deterministic (Detailed) Estimating Methodologies B. Deterministic (Detailed) Estimating Methodologies

• Strategy: Each component of scope is quantitatively surveyed and priced. • Detailed Estimate Steps:
• Class: Support final budget authorization, contractor bid tenders, cost control 1. Estimate basis and schedule: Review organization procedures and formats,
during project execution, and change orders (Class 3 : Class 1 estimates). identify estimating resources and techniques, prepare estimate schedule.
• Minimum required engineering data: Drawings, diagrams, data sheets, layouts, 2. Direct field cost (DFC) estimate: Review scope, perform takeoff including
plot plans, and specifications. material and labors, then summarize estimates.
• Pricing data should include: 3. Indirect field cost (IFC) estimate: Apply in-direct wages and allowances,
1. Vendor quotations 2. Recent purchase orders 3. Current labor rates apply indirect factors (if applicable).
4. Subcontract quotations 5. Project schedule 6. Construction plan 4. Home office cost (HOC) estimate: Detailed work-hours estimate for
administration / Engineering disciplines then applying wages , factors if any.
• Completely detailed estimate: All costs are detailed including DFC, IFC, HOC,
5. Sales tax/duty estimates
other costs for both ISBL and OSBL facilities.
• Semi-detailed estimate: Costs for the ISBL process facilities are detailed, and the 6. Escalation estimates: Based on project schedule.

costs for the OSBL facilities are factored. 7. Project fee estimate (for contractors): Depending contracting strategy.
• Forced-detailed estimate: Detailed takeoff quantities are generated from 8. Risk analysis/contingency
preliminary drawings (incomplete design ). 9. Review/validate estimate

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Section 2 : Cost Estimating Chapter 9 : Estimating Section 2 : Cost Estimating Chapter 9 : Estimating

B. Deterministic (Detailed) Estimating Methodologies Take-Off:

• Notes for estimating
• Formal vendor quotes are preferred; however sometimes time constraints in
do not permit. In this case, pricing may depend on informal quotes from
vendors like phone discussions, recent purchase orders, capacity factored
estimates from similar equipment, or from parametric pricing models.
• Check equipment list against flow diagrams to ensure all items are identified.
• Ensure that cost of equipment accessories (trays, baffles, ladders) included.
• Freight costs for equipment can be significant. Identified them explicitly.
• Identify required vendor assistance / support costs
• Major spare parts need to be accounted for and included.
• Prepare equipment installation costs.
• Consider costs for calibration, soil settlement, special internal coatings,
hydrotesting and other testing.
• It’s quantifying project material & labor. The term take-off is also used to refer to
BOQ. This involves examination of drawings to count each item then quantities
are summarized then costed resulting in project direct field costs.
• Guidelines for preparing an efficient take-off include the following:
• Use pre-printed forms, abbreviate consistently, measure carefully.
• Convert imperial (feet/inch) to decimal.
• Do not round or convert units until final summary.
• Identify drawing/section numbers on take-off forms for future checking.
• Be alert for notes shown on drawings, changes in drawings scale.
• Care to quantify labor operations that may not have material component.
Costing Vs. Pricing:
• Costing is applying unit costs to quantities, usually in the form of labor hours,
wage rates, material costs, and perhaps subcontract costs.
• Pricing, on the other hand, is adjusting costs to allow for overhead and profit.

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Section 2 : Cost Estimating Chapter 9 : Estimating Section 2 : Cost Estimating Chapter 9 : Estimating

Estimating Allowances Factors Affecting Estimate Accuracy

• Included in an estimate to account for the predictable but un-definable costs like:
1. Design allowances: To account for continuing design that occurs after
placement of a purchase order. From 2 to 5 % of engineered equipment cost.
2. Material take-off allowances: To cover the cost of undefined materials while
estimating. For example, concrete accessories not included in drawings. From
2 to 15 % of discipline costs.
3. Overbuy allowances: For inventory losses due to damage, cutting waste,
misuse of materials, theft, etc. From 2 to 10 % of discipline material costs.
4. Shipping damage: Usually covered by insurance if detected upon arrival at
site. This allowances are to cover losses that are not covered by insurance.
5. Undefined major items: A particular area of scope may not have progressed
in design but its cost must be included in the estimate.
6. Miscellaneous allowances: Like hand/machine excavation, formwork
accessories, steel connections (bolts & gaskets), piping hangers and guides.
19
• Level of project definition (Better definition is superior than detailed estimate).
• State of new technology in the project
• Quality of used cost information
• Estimator experience and skill
• Estimating techniques employed
• Level of effort budgeted to prepare the estimate
• Desired end use of the estimate.
Contingency Reserve
• Definition: Amount added to the estimate to achieve a certain probability
• Contingency Includes: Estimating errors, Incomplete design, Conceptual estimating
for some items, wages variability, labor availability, lower productivity & skills, and
inflation of material and equipments costs.
• Contingency doesn’t Include: Scope changes, disasters & force majeure, strikes,
excessive unexpected inflation, and excessive unexpected currency fluctuations.
20

Section 2 : Cost Estimating Chapter 9 : Estimating Section 2 : Cost Estimating Chapter 9 : Estimating

Risk Analysis Structuring The Estimate

• Risk Analysis Types:
• Project Breakdown System (PBS):
1. Strategic Risk Analysis Models: Evaluate the level of project definition and
• A numbering system used to identify each cost center
project technical complexity in determining the overall risk to project cost.
• It must reflect the project execution and the way costs can be collected.
2. Detailed Risk Analysis Models: Evaluate the accuracy range for individual or
• The matrix of the WBS and RBS forms the project breakdown system (PBS) and
groups of estimate components in determining the overall risk to project cost.
the intersection points are called cost centers.
Both generate probability distributions for the expected final cost outcomes
• Cost code of the labor to pour concrete in the main building: 01-02-C-2-003-1
which are used to determine amount of contingency (difference between
Area Building Function Discipline Resource Project
selected funding value and original point estimate).
01 01 A 01 001
• Example: Original estimate = $23.3. Probability of not exceeding this value is 20 % Onsite Admin Engineering Earthwork Labor Onsite Offsite

• If We need to achieve 50 % probability, 02 02 B 02 002

Offsite Workshop Construction Concrete Material Admin Workshop
we would fund project at $25.4M, Building Building

Contingency added = $2.1M = 9 % Labor

• If we wanted 70 % probability , Concrete

Construction Material
Fund at $26.6M, contingency = $3.3M Project Earth Work
Engineering
• Note: Contingency does not increase accuracy, however, reduce the level of risk

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Section 2 : Cost Estimating Chapter 9 : Estimating Section 2 : Cost Estimating Chapter 9 : Estimating

Cost / Schedule Integrating (1/2) Cost / Schedule Integrating (2/2)

1. One-to-one approach: Breakdown the estimate to the level of schedule activities.
• Schedule provide dates that are essential to calculate escalation, cash flow, … etc.
Problems of this approach:
• Estimate provides labor hours essential to determine durations & resource loading.
• Not feasible.
• Cost reporting system needs to be correlated with schedule progress.
• Activities are subject to more change than cost codes.
• Cost / schedule breakdown not necessarily compatible, however, aligned at a level.
• Tracking bulk material costs by activity is difficult and costly.
• Estimate is very sensitive to schedule. Changes to plan may significantly affect cost:
• Costs are often not incurred at the same time as activities.
1. Unit material costs are schedule dependent for impacts of inflation and
2. Integrating at a sufficient level of detail: Keeping both structures identical to a
seasonal variations.
certain level of WBS then diverge to meet each structure’s control needs.
2. Unit labor hours are schedule dependent for seasonal labor availability,
climate, and schedule impacts due to execution plan changes.
3. Wage rates are also sensitive for impacts of inflation, seasonal variation, and
execution plan changes (affecting overtime and/or shift premiums).
• Some costs are dependent on when they occur in the calendar year. Labor
productivity can be adversely affected by weather.
• Shortening project duration may cause overtime, shift premiums, … etc.

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Section 2 : Cost Estimating Chapter 9 : Estimating Section 2 : Cost Estimating Chapter 10 : Process Production

Estimate Review
• Review Types:
1. Team Review:
• Check the math of estimate
• Check basis of estimate (BOE)
1. Design: scope, assumptions, equipment list, drawing list, and specs.
2. Planning: Milestones, resources, calendar, and overtime/shifts use.
3. Cost: Pricing sources, quotes, purchases, allowances, and escalation.
Chapter 10
4. Risk: How contingency was determined.
• Check following “Estimating Department” guidelines:
Process Product Manufacturing
Methods, techniques, procedures, formats, factors, and allowances.
2. Engineering Department Review:
• Check completeness of engineering deliverables (Drawings, specs, lists)
• Check basis of estimate (BOE): Design, cost and risk.
3. Project Manager Review
4. Management Review
5. Review By Others
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Section 2 : Cost Estimating Chapter 10 : Process Production Section 2 : Cost Estimating Chapter 10 : Process Production

Operating Cost Estimates Production Cost Estimating Form

• Can be performed on (1) a daily, (2) unit of production, or (3) annual basis.

• Annual is preferred because:

1. It considers seasonal variations.
2. It is readily adapted to less-than-full capacity operation.
3. It readily includes the effect of periodic large costs (scheduled maintenance,
vacation shutdowns, catalyst changes, etc).
4. It is directly usable in profitability analysis.
5. It is convertible to the other bases, daily cost and unit-of-production.

• A basic flow-sheet of the process is vital to preparation of an estimate. To properly

prepare an operating or manufacturing cost estimate, a prepared estimating form
should be used to assure that the estimate is performed in a consistent manner
and to avoid omitting major items. The estimating form acts as a checklist and as a
device for cost recording and control.

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Section 2 : Cost Estimating Chapter 10 : Process Production Section 2 : Cost Estimating Chapter 10 : Process Production

Production Cost Estimating Form Cost of Operations At Less Than Full Capacity
• It’s necessary to perform estimates at full plant capacity and at conditions other
than full capacity. Performing an estimate only at full design capacity does not
consider unscheduled downtime, market fluctuations in product demand, time
required to develop markets for a new product, ... etc.

• When you consider cost effects of operation at less than full capacity, you take into
account the fixed, variable, and semi-variable costs:
1. Fixed Costs: Such as depreciation, property taxes, insurance.
2. Variable Costs: Such as raw materials, utilities, chemicals, and catalysts.
3. Semi-Variable Costs: Such as direct labor, supervision, general expense, and
plant overhead.

• Royalties may be variable, semi-variable, fixed, or even a capital expense. If paid in

a lump sum should be capitalized. If paid in equal annually are fixed costs. If paid
as a fee per unit of production or sales are variable costs. If paid at a rate per unit
of production that declines as production increases are semi-variable.
• Packaging may be variable or semi-variable depending on the situation.
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Section 2 : Cost Estimating Chapter 10 : Process Production Section 2 : Cost Estimating Chapter 10 : Process Production

Cost of Operations At Less Than Full Capacity Raw Material Costs

• F : Fixed expense • It can constitute a major portion of operating costs. Hence , a complete list of all
• V : variable expense raw materials must be developed considering the following:
• R : Semi-variable expense
• C : Total operating cost 1. Unit cost rates and units of purchase (tons, m3, item, etc.)
• S : sales income 2. Quantity required per unit of time and/or unit of production
• N : income to achieve 3. Quality of raw materials (concentration, acceptable impurity levels, etc.)
minimum ROI 4. Availability in markets.
• n : Semi-variable fraction
at zero capacity • Raw materials obtained in-house are not purchased, however, don’t neglect their
cost because they represent a cost to the company. In addition, internal company
freight, handling, and transfer costs must be added.
• Variable expense declines to 0 at zero-capacity, fixed expense is constant, and semi-
variable expense at zero-capacity is (20 to 40) % of its value at full capacity. By-Product Credits & Debits
• By-products, including wastes and pollutants, must be considered in the estimate.
• (A) Shutdown point (shut down rather than operating at lower rates)
• These costs may be credits (if salable or usable) or debits (if wastes or unsalable).
• (B) Breakeven point (Income = total operating cost )
• Cost of treating these products (including equipments) must be included in the
• (C) Minimum return Point.
estimate.

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Section 2 : Cost Estimating Chapter 10 : Process Production Section 2 : Cost Estimating Chapter 10 : Process Production

Utility Costs Labor Costs

• It’s necessary to determine the requirements of utility costs such as plant lighting,
sanitary water, etc.
• Electric rates in the past were stable for many years, this is no longer true, and the
estimator must obtain current rates from the utility companies.
• Natural gas prices depend on quantity required.
• For steam costs, it depends on fuel cost, boiler water treatment, operating labor,
maintenance, etc. Black suggested that steam costs is 2 to 3 times the cost of fuel.
• Water costs are highly variable depending upon the water quality and quantity
required. Purification costs, if contamination occurs before disposal, must also be
included, as must cooling costs if the process results in heating of process water.
• Fuel costs vary with the type of fuel used and the source of supply. Also, consider
the type of firing equipment required and to required fuel storage facilities.
• Utility consumption generally is not proportional to production due to economies
of scale and reduced energy losses on larger process units.
• A detailed staffing must be established which indicates: (1) Skill or craft required,
(2) labor rates, (3)supervision required, (4) overhead personnel required.
• Labor costs can be estimated from company records, union wage scales, salary
surveys of various crafts and professions, or other published sources.
• Further, when estimating around-the-clock, 168-hr/wk operations, allowance must
be made for the fact that a week includes 4.2 standard 40-hr weeks.
• An alternate method of calculating labor requirements, if sufficient data are not
available, is to consider a correlation of labor in work hours per ton of product per
processing step. This relationship, which was developed by Wessel :

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Section 2 : Cost Estimating Chapter 10 : Process Production Section 2 : Cost Estimating Chapter 10 : Process Production

Supervision And Maintenance Cost Operating Supplies And overhead Costs

• Supervision costs established in details. If not possible, 15:20 % of direct labor cost. • Operating supplies: They are a relatively minor cost of operations. It Includes
miscellaneous items, such as lubricating oil and wiping cloths. Ranges from a few
• Maintenance labor costs are often estimated as a percentage of depreciable capital
percent to 20 % of payroll depending upon plant complexity, for example, 6 % in a
investment per year. For complex plants and severe corrosive conditions 10 : 12 %
coal preparation plant, 20 % in an oil refinery. Better to use past projects records.
or higher. For simple plants with noncorrosive conditions 3 : 5 %.
• Overhead (burden costs):
• Maintenance costs are semi-variable (35 : 40 % direct labor, 7 : 8 % direct
• Such as workers’ compensation, pensions, insurance, paid vacations and
supervision, 35 : 40 % materials, 18 : 20 % contract maintenance.
holidays, social security, unemployment taxes and benefits, profit-sharing
• As the project evolves toward a final staffing plan, factors can be replaced with programs, and a host of others.
numbers generated from the staffing table. • These costs varies from industry to industry, and company records are the best
measure of their magnitude. However, in the absence of company data, payroll
• When operating at less than 100 % of capacity, Percent of Maintenance cost as %
capacity of cost at full capacity overheads may be roughly estimated at 25 : 40 % of ( direct labor + supervision
maintenance costs increase per unit of production as 100 % 100 % + maintenance labor costs).
shown in table: 75 % 85 %
• Operating company testing and research laboratories is another overhead
50 % 75 %
• Maintenance generally increases with age of equipment. 0 30 %
expense which must be included in the estimate. It’s best estimated based upon
company experience or as a percentage 3 : 20 % of direct labor costs.
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Section 2 : Cost Estimating Chapter 10 : Process Production Section 2 : Cost Estimating Chapter 10 : Process Production

Royalties And Rentals: General Works Expense (Factory Overhead)

• Royalties may be variable, semi-variable, fixed, or capital costs (or a combination of • It represents the factory indirect cost and depends on investment and labor.
these), and the same is true of rental costs. • It does not include general expense (marketing/sales cost, administrative expense).
• Royalty expenses, in the absence of data, are treated as a direct expense and may • Black’s suggested that :
be estimated at 1 : 5 % of the product sales price. Factory overhead = (Investment x investment factor)+ (Labor x labor factor).
In this case, labor is total annual cost of labor, including direct operating labor,
Contingencies:
repair/maintenance, supervision, and labor for (loading, packaging, shipping).
• Cost estimate should include contingency to account for undetermined costs. • Black’s suggested factors as in the table:
• Contingency allowance applies both to direct and indirect costs.
• It ranges from 1 : 5 % depending upon uncertainty in data used. • For preliminary estimates, indirect
• Hackney has suggested the following guidelines: overhead costs may be 40 : 60 % of labor
1. Installations similar to those currently used by the company for which standard costs or 15 : 30 % of direct costs.
costs are available: 1 % • Humphreys suggested 55 % of ( operating
2. Installations common to the industry, for which reliable data are available: 2% labor, supervision, maintenance labor) for
3. New installations that have been completely developed and tested: 3 % the mineral industries.
4. New installations that are in the development stage: 5 %

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Section 2 : Cost Estimating Chapter 10 : Process Production Section 2 : Cost Estimating Chapter 11 : Discrete Production

Depreciation
• Not a true operating cost, but considered to be an operating cost for tax purposes.
• Depreciable portion = Initial investment – (working capital + salvage value). In
theory, working capital, salvage value can be recovered after plant shut down.
• Taxing authorities permit the use of any generally accepted method of depreciation
calculation provided that it is applied in a consistent manner to all investments
• In 1981 in the U.S., accelerated cost recovery system (ACRS) was mandated by law. Chapter 11
• In 1986, ACRS was replaced by modified accelerated cost recovery system (MACRS).
• Most industrial firms utilize accelerated depreciation. This deferring ‫ ﯾؤﺟل‬taxes to Discrete Product Manufacturing
the latest possible date. However, for preliminary estimates, straight-line is used.
• Straight-line depreciation: D = C / Y , where D is annual depreciation, C is
depreciable portion, Y is asset life in years.
• Double-declining balance method: D = 2 (F-CD) / n , where F is initial asset value,
CD is cumulative depreciation charged in prior years, n is asset life in years.
• Sum-Of-Years-Digits Depreciation: D = C x [ 2(n-Y+1) ] / [ n(n+1) ] , where C is
depreciable portion, n is asset life in years.

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Section 2 : Cost Estimating Chapter 11 : Discrete Production Section 2 : Cost Estimating Chapter 11 : Discrete Production

Operations in Discrete Manufacturing Discrete Manufacturing Philosophies (1/2)

• Six major groups of component operations are presented in the following table. • Computer-aided process planning (CAPP):
• Automatically generate process plan to produce the component from drawings.
• It includes operation parameters/sequence & optimize time, costs, and quality.
• Approaches: (1)Variant approach (searches a database for similar parts and
modifies the closest similar), (2)Generative approach (starting from scratch).
• Concurrent Engineering: Approach to the concurrent design of products and their
manufacture. This cause designers to consider all elements of product life cycle.
• Group Technology:
• Identify and exploit sameness of component parts and manufacturing process.
• Approaches: (1)Similar design features, (2) Similar processing operations.
• Just-in-Time: Raw materials are delivered when required, thus, inventory costs are
theoretically zero. It’s related to “pull” system (parts are not produced until ordered).
• Lean Manufacturing: Shorten lead times, reduce costs/waste. (continuous improvement )
1. Reducing waste (scrap), improving yields, new products from waste materials.
2. Improving employee performance, skills, and satisfaction via training / recognition
3. Improve processes, process rates, and capabilities.
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Section 2 : Cost Estimating Chapter 11 : Discrete Production Section 2 : Cost Estimating Chapter 11 : Discrete Production

Discrete Manufacturing Philosophies (2/2)

Basic Cost Relationships
• Material Requirements Planning (MRP):
• It uses bills of material, inventory and open order data, and master production • Prime cost = direct cost of (material, labor, engineering) + direct expense
schedule information to calculate requirements for materials. • Manufacturing cost = prime cost + factory expense
• Supply Chain Management: • Production cost = manufacturing cost + administrative expense
• Complex products require different components from a variety of suppliers. • Total cost = production cost + marketing, selling, and distribution expense
• Supply chain management involves the assurance that the parts will arrive • Selling price = total cost + mark-up (profit and taxes)
from the suppliers when required to avoid production stoppages. • Prime cost is also called direct cost, manufacturing cost is also called factory cost.
• It also requires the involvement of suppliers in the design process to eliminate
inefficient / unnecessary operations and components.
• It involves information on delivery status, financial flow of credit, and payment
schedules as the materials move through the various stages of supply chain.
• The goals are to reduce inventory, time-to-market, costs, and improve quality.
• Total Quality Management:
A leadership philosophy, organizational structure, and working environment
that fosters ‫ ﺗﻌزز‬a personal accountability and responsibility for the quality and
a quest ‫ اﻟﺳﻌﻲ‬for continuous improvement in products, services, and processes.
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Section 2 : Cost Estimating Chapter 11 : Discrete Production Section 2 : Cost Estimating Chapter 11 : Discrete Production

Cost Estimating For Discrete Manufacturing Cost Estimating For Discrete Manufacturing
• Direct and Indirect Costs: • Cost Estimating Example: (1/2)

• Ex: Copying of a report on a copy machine

• Costs: paper cost, toner cost, machine rate costs, operator cost, and staple cost.
• Direct labor cost is operator cost (Wage + benefits).
• Direct material costs is paper and toner.
• Staple Costs are so small, so it’s included as part of the indirect burden costs.
• Machine cost (capital & operating) indirect cost, applied directly to the product.
• Energy consumed, purchasing costs, and installing costs are direct costs, but
considered as indirect costs as the machine is used for not only one report.

• Other indirect costs are those which cannot be directly tied to the product such as
supervision, administrative salaries, maintenance, material handling, and legal, etc.

• In large companies, indirect costs also include items such as basic and applied
research and development, however, it must be recovered on the current products
being produced and so it’s considered indirect burden costs for current products.

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Section 2 : Cost Estimating Chapter 11 : Discrete Production Section 2 : Cost Estimating Chapter 11 : Discrete Production

Cost Estimating For Discrete Manufacturing Break-Even Analysis

• Cost Estimating Example: (2/2)
Introduction
• Two critical issues must be considered: (1)Cost base, (2)Various break-even points.
• Cost bases are:
1. Time base: Determines production time at specific break-even point, and this is
what can be controlled at the plant level.
2. Quantity-based: Determines production quantity at specific break-even point for
marketing, sales, and top management to forecast yearly sales. It provides little
assistance at plant management level where quantity is specified by customer.
• Variable cost in quantity-based system is fixed in time-based system, and vice-versa.
• Increased quantities are desired in the quantity-based system.
• Decreased times are desired in the time-based system.

Note that 20% of selling price = [20/(100-20)] % of Total Cost = 25% of Total Cost.
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Section 2 : Cost Estimating Chapter 11 : Discrete Production Section 2 : Cost Estimating Chapter 11 : Discrete Production

Break-Even Analysis Break-Even Analysis

Cost Basis:
A. Quantity-based system: (Fixed Time)
• Fixed Costs: Costs not vary with production quantity such as property taxes,
administrative salaries, research and development expenses, and insurance.
• Variable costs: Costs that vary with production quantity, such as direct material
costs and direct labor costs.
• Semi-Variable Costs: Costs that are not fixed or variable like maintenance cost.
B. Time-based system: (Fixed Quantity)
• Fixed costs: Costs that do not vary with time such as the direct material costs.
• variable Costs: Costs that vary over time such as property taxes, administrative
Break -Even Points :
A. Shutdown Point (SD): Quantity/time where manufacturing costs equals revenues.
B. Cost Point (C): Quantity/time where total costs equals revenues.
C. Required Return Point (RR): Quantity/time where revenues equals total costs plus
required return.
D. Required Return after Taxes Point (RRAT): Quantity/time where revenues equals
total costs + required return and the taxes on the required return.
Notes:
In the production quantity-based system : Breakeven points increase in quantity as one
proceeds from the shutdown point to the required return after taxes point, which
implies higher production quantities are desired.

salaries, research and development expenses, and insurance.
• Direct labor may be fixed or variable costs depending upon policies used.
49
In the time-based system: Breakeven points decrease in time as one proceeds from the
shutdown point to the required return after taxes point, which indicates the
importance of decreasing production time to increase profitability.
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Section 2 : Cost Estimating Chapter 11 : Discrete Production Section 2 : Cost Estimating Chapter 11 : Discrete Production

Break-Even Analysis Break-Even Analysis

Example: Solution :
Anew job is being considered in the foundry ‫اﻟﻣﺳﺑك‬. The order is for 40,000 castings,
and the tentative price is $ 3.00/casting. The pattern will be designed for 4 castings
per mold, and the pattern cost has been quoted at $ 10,000. The molding line is the
rate controlling step in the production process in this particular foundry, and the
production rate is 125 molds/hr.

Solution:
Estimated time for the production of the 40,000 castings would be determined by:
(40,000 castings)/(4 castings/mold x 125 molds/hr) = 80 hr

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Section 2 : Cost Estimating Chapter 11 : Discrete Production Section 2 : Cost Estimating Chapter 11 : Discrete Production

Break-Even Analysis Break-Even Analysis

Solution: A . Production Quantity-Based Calculations Solution: A . Production Quantity-Based Calculations
1. Shutdown Point Conclusion:
Revenues = Production Costs 1. If Q < 16,068 , don’t accept order as manufacturing costs not recovered.
3X = Material Costs + Labor Costs + Tooling Costs + Plant Overhead Costs 2. If 16,068 < Q < 26,324, manufacturing costs recovered, but not all overhead costs.
3X = 1.50X + 0.33X + 10,000 + 8,800 à 3X = 1.83X + 18,800 à X = 16,068 units 3. If 26,324 < Q < 34,530, all costs recovered, but not all required return recovered.
4. If 34,530 < Q < 40,000, costs & RR recovered, but not all of taxes recovered.
2. Cost Point
5. If Q > 40,000, required return will exceed the desired required return after taxes.
Revenues = Total Costs
3X = Production Costs + Overhead Costs
3X = 1.83X + 18,800 + 12,000 à 3X = 1.83X + 30,800 à X = 26,324 units
3. Required Return Point
Revenues = Total Costs + Required Return
3X = 1.83X + 30,800 + 9,600 à 3X = 1.83X + 40,400 à X = 34,530 units
4. Required Return After Taxes
Revenues = Total Costs + Required Return + Taxes for Required Return
3X = 1.83X + 40,000 + 9,600 x (TR/(1-TR))
3X = 1.83X + 40,400 + 6,400 à X = 40,000 units
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Section 2 : Cost Estimating Chapter 11 : Discrete Production Section 2 : Cost Estimating Chapter 11 : Discrete Production

Break-Even Analysis Break-Even Analysis

Solution: B . Time-Based Calculations Solution: B . Time-Based Calculations
1. Shutdown Point Conclusion:
Revenues = Production Costs 1. If Time > 181.8 , don’t accept order as manufacturing costs not recovered.
120,000 = Material Costs + Labor Costs + Tooling Costs + Plant Overhead Costs 2. If 181.8 > Time > 117.6, manufacturing costs recovered, but not all overhead costs.
120,000 = 60,000+165Y+10,000+110Y à 120,000 = 70,000 + 275Y à Y = 181.8 hrs 3. If 117.6 > Time > 91.7, all costs recovered, but not all required return recovered.
4. If 91.7 > Time > 80, costs & RR recovered, but not all of taxes recovered.
2. Cost Point 5. If Time < 80, required return will exceed the desired required return after taxes.
Revenues = Total Costs Time-based method can answer questions
120,000 = Production Costs + Overhead Costs such as what is the effect of a 4 hour delay.
120,000 = 70,000 + 275Y + 150Y à 120,000 = 70,000 + 425Y à Y = 117.6 hrs @ 80 Hrs
Profit = Revenues – Costs
3. Required Return Point
Profit = $120,000 - $70,000 - 425$/hr x 80hr
Revenues = Total Costs + Required Return
Profit = $16,000
120,000 = 70,000 + 425Y + 120Y à 120,000 = 70,000 + 545Y à Y = 91.7 hrs
Profit after taxes = 0.6 x $16,000 = $9,600
4. Required Return After Taxes @84 Hrs
Revenues = Total Costs + Required Return + Taxes for Required Return Profit = $120,000 - $70,000 - 425$/hr x 84hr
120,000 = 70,000 + 545Y + 120Y + [ 120Y x (TR/(1-TR)) ] Profit = $14,300
120,000 = 70,000 + 425Y + 120Y + 80Y à Y = 80.0 hrs Profit after taxes = 0.6 x $14,300 = $8,580
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