Cost Estimation and Indirect Cost Allocation: Graw Hill

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
ENGINEERING ECONOMY Fifth Edition Mc

Blank and Tarquin Graw
Hill
CHAPTER 15
Cost Estimation and Indirect

Cost Allocation
Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University 1

Hill
CHAPTER 15
Learning Objectives
15. Learning Objectives
1. Understanding how cost estimation is

accomplished;
2. Cost Indexes;
3. Cost Estimation Relationships and Cost
Capacity Equations;
4. Cost Estimating Relationships – The
Factor Method;
15. Learning Objectives – continued
5. Traditional Indirect Cost Rates and

Allocation;
6. Activity-Based Costing (ABC) for
Indirect Costs;
7. Chapter Summary.

Hill
CHAPTER 15
15.1
Understanding How Cost Estimation
Is Accomplished
15. Cost Estimation
For the most part, Engineering

economy analysis tends to be “cost
driven”;
Future costs are very critical to the
analysis of a project.
Engineers generally have the
responsibility of cost estimation;
Revenue generation generally comes
from marketing/sales areas.
15. Costs
Direct Costs – historically estimated

with substantial detail;
Indirect Costs – generally added later
using standard cost rates and factors;
Today, indirect costs occupy a higher
percent of total costs;
Current focus: Direct costs.
15. Learning Structure – Costs to Estimate
What costs are to be estimated?

First cost elements (P)
 Equipment cost;
 Delivery charges;
 Installation costs;
 Insurance costs (premiums);
 Training of personnel for equipment
use.
15.1 Cost of New Equipment
Delivered Equipment Costs:

 Equipment Cost +
 Delivery Costs.
Installation costs are next.
15.1 The First Important “Cost” (CRC)
Given the interest rate and the

estimated life of the asset:
Calculate the Capital Recovery Costs
CRC(i%, est. n).
15.1 The AOC Estimation
Estimate the Annual Operating Costs

using:
 Direct Labor Costs for operating personnel;
 Direct materials;
 Periodic maintenance costs;
 Rework and rebuilt;
 Other costs could be:
 On-line testing and calibration;
 “Proofing runs before actual production.
15.1 Other Industries
“Familiar” projects:
 Home construction;
 Buildings – standard designs;
 Petrochemical and energy production.
Apply standard industry-wide software
packages.
Most projects – no “canned” software
packages!
 Apply your own knowledge and experience.
15.1 Cost Estimation Approaches
Bottom-Up Approach
 Treats the final cost as an independent
(output) variable and the associated costs
as input or dependent variables.
Design-to-Cost Approach
 Treats the competitive cost as an input
variable and the associated cost estimates
as the output variables.
See Figure15-1, page 476.
15.1 Two Cost Estimating Approaches
Bottom-Up Approach
 Treats the final cost as an independent
(output) variable and the associated costs
as input or dependent variables.
 Cost components are first identified;
 Cost elements are estimated;
 Summed to = total direct cost; (DC)
 Factor in estimated indirect costs. (TIDC)
 Factor in required margin or profit.
Price = DC + TIDC + Profit.
15.1 Bottom-Up Costing
Bottom-Up Approach
 Traditional costing approach;
 Applied in industries where competition in
not the dominant factor is pricing the
product or the service.
 Treats the competitive cost as an input
variable and the associated cost estimates
as the output variables.
 Applied in the early stages of new or
enhanced product design.
 Price estimates are conducted to set
“target” values.
 Detailed design and equipment needs are
not yet defined.
 Becoming more popular especially in high
competition markets;
 Places greater emphasis on the accuracy of
the estimation process;
 Target cost estimates must be realistic;
 Design to the target price;
 Common practice in Eastern cultures (Japan
and other Asian countries).
15.1 Accuracy of Estimates
NO estimate is intended to be “exact”.

But must be reasonable and accurate
enough to provide a robust economic
analysis.
In Preliminary Design Phase:
 Estimates are viewed as “first cut”
estimates.
 Serve as inputs to the project initial budget.
 The “unit method” is often applied here.
15.1 Unit Method
Unit Method:
 Popular,
 Very preliminary in nature,
 Multiply the number of units times a per
unit cost factor.
Examples:
 Cost per operating mile (autos, trucks, etc.)
 Cost of construction (per sq. foot)
 Cost per mile (highways, cable, etc.)
15.1 Accepted Range of Accuracy
Per Unit approaches should fall into the

5% to 15% range for total costs.
Estimates outside of the 15% range
are not reliable!
15.1 Cost Estimation Techniques
Expert Opinion;
Comparisons with known installations;
Past experience in the field;
Cost Indexes where available;
Cost Estimating Relationships (forms of
regression analysis based upon
historical data);
Combinations of the above.

Hill
CHAPTER 15
15.2
Cost Indexes
15.2 Cost Index
Cost Index is a ratio of a cost NOW to

some cost back in time.
The index is a dimensionless number.
Example: The Consumer Price Index
(CPI).
A basic cost index and notation is
shown on the next slide.
15.2 Cost Index Notation
Ct = estimated cost now;

C0 = the cost at pervious time t0
It = index value at time t;
Io = index value at time t0
 It 
Ct  C0   {15.1}
 I0 
15.2 Cost Indexes…
See Table 15.1, page 478;

Sources:
 Chemical Engineering plant cost index;
 Engineering News Record;
 Marshall & Swift equipment cost index;
 Many others……
Most are web-based but require a
subscription fee to access detailed
values.
15.2 Index Example
Need to estimate skilled labor for a

construction project;
5 years ago the cost was documented
to be $360,000.
Skilled labor index then was 3,496.27.
Today the index is 4,038.44.
What is the estimated labor cost today
based upon this information?
15.2 Index Example
Base time, t0 = 5 years ago;

The present estimate then would be:
 4038.44 
C t  360, 000    $415,826.
 3496.27 
15.2 Warnings to Heed
For manufacturing and servicing

industries tabulated cost indexes are
not readily available.
Cost indexes may vary with the region
of the country.
Cost indexes are very sensitive over
time to technological changes.
 Index creeping.

Hill
CHAPTER 15
15.3
Cost Estimating Relationships:
Cost Capacity Equations
15.3 Cost Estimating Relationships ( CER )
CER’s use design variables to predict

costs.
CER’s are more quantitative in nature
than cost indexes.
Developed from statistical approaches;
 Usually linear or non-linear regression
models.
A common model: Cost-Capacity Model
15.3 Cost Capacity Models
A model that relates the cost of an

asset or activity to its capacity.
Other names:
 Power-law or,
 Sizing models.
Assume two different capacity levels:
 Capacity level Q1,
 Capacity level Q2
15.3 Cost Capacity Models
CCE is:
x
 Q2 
C2  C1   [15.2]
 Q1 
Where x is the correlating exponent.
15.3 The Exponent in the CCE - x
Normally 0  x  1.
For x < 1 the economies of scale are
applied.
For x = 1, the model is linear.
For x > 1, a larger size is expected to
be more costly than a linear model.
If x is unknown, common to assume x
= 0.6
15.3 CCE Information
The Chemical Engineering area has well

documented CCE parameters.
See Table 15-3 for sample x values.
Other sources:
 Plant Design and Economics for Chemical
Engineers;
 Chemical Engineers Handbook;
 EPA publications;
 Equipment companies.
15.3 Combining CCE’s With Index Values
Combining the cost-index approach

with CCE’s add the time adjustment
factor to better estimate costs that
change over time.
Specifically;
 Q  x
 I 
C2  C1  2   t  [15.3]
 Q1    I 0 
See Example 15.3 on page 482

Hill
CHAPTER 15
15.4
Cost Estimating Relationships:
Factor Method
15.4 Factor Method
Originally developed for estimating

total plant costs;
Identify the major equipment items,
then multiply by certain factors;
Premise:
 Major equipment costs are readily available;
 Using the proper factors, then a rapid
estimate of total plant cost can be achieved.
Factors: Called “Lang Factors” (1947).
15.4 Lang Factors (Hans J. Lang, 1947)
Let CT = Total Estimated Cost

“h” = overall cost factor, or sum of
individual cost factors;
CE = Total cost of major equipment;
Then,
 CT = hCE [15.4]
15.4 Cost Factors – “h” Value(s)
“h” can be:

 One overall cost factor or,
 The sum of individual cost factors, e.g.,
 Construction factor,
 Maintenance factor,
 Overhead factor,
 Direct Labor,
 Materials,
 Etc.
15.4 Cost Factors – “h” Value(s)

From Lang’s work in the chemical
processing industry it was found:
 “h” =3.10 for solid-processing plants;
 “h” = 3.63 for solid-fluid processing plants;
 “h” = 4.74 for fluid-processing plants.
If one has a reliable value for the cost
of all of the major equipment, CE, then
multiplication of CE by “h” provides a
total cost estimate for the facility.
15.4 Example 15.4
See Example 15.4 on page 483;

Total Equipment cost: $1.55 million;
CF = 3.63
CT = 3.63(1.55 mil) = 5.63 million.
15.4 Indirect Costs
Indirect costs (IC’s) are not directly

attributable to a single function;
IC’s are shared by many functions
because they are necessary to perform
the overall objective of the firm.
Indirect costs make up a significant
percentage of the overall costs in many
organizations today!
15.4 Indirect Costs
IC factors to consider:
 General administration;
 Computer and Information services;
 Quality control and management;
 Safety and security;
 Other support functions.
Factors are developed for:
 Delivered-equipment costs or,
 Installed-equipment costs.
15.4 Equipment Costs vs. Total Direct Cost
Some factors will apply to total

equipment costs and,
Some apply to total direct costs.
 Add the direct and indirect cost factors
before multiplying by the delivered
equipment costs. (Assume “n” components)
 Specifically (fi = factor for each component):
n
h=1+ f i [15.5]
i=1
15.4 For Total Direct Cost Application
IF the indirect cost factor is applied to

total direct cost;
Add only the direct cost factors to
obtain “h”.
Let fI = indirect cost factor;
Let fi = factors for direct cost
components, then…..
15.4 IDC applied to TDC Equation
Total Cost if IDC applied to TDC.
  n

CT  CE 1   fi   1  f I  [15.6]
  i 1  
See examples 15.5 and 15.6!

Hill
CHAPTER 15
15.5
Traditional Indirect Cost Rates
and Allocation
15.5 Cost Accounting Overview
Costs incurred within a system are

tracked by the cost accounting system.
Cost accounting system accumulates:
 Material costs,
 Labor costs,
 Indirect costs (overhead or factory expense)
And allocates these cost to defined cost
centers.
15.5 Cost Center Overview
Allocate the
MFG. System IC’s to each
Cost center in
Cost Center 1 Some manner.
Total Indirect
Cost Center 2
Costs – Total
System
$$$$
Cost Center “j”
15.5 Allocating IDC’s to Cost Centers
A difficult problem, when required, is to

properly allocate the IDC’s to the
various cost centers, departments,
processes, and product lines.
Cost centers do utilize a portion of the
total indirect costs.
Thus, some allocation scheme needs to
be applied to the cost centers.
15.5 Traditional IDC Allocations
Cost Category Allocation Basis

Taxes Space occupied
Heat, AC, light Space, usage, outlets
Power Space, direct labor hrs
Receiving/Purchasing $$ of Mtls; No. orders
Personnel, Machine Direct labor hours or
shop DL cost.
Building Maintenance Space occupied
Software/Networks Number of accesses
Quality Control No. of inspections
15.5 Common Basis for Allocations
Direct labor cost;

Direct labor hours;
Space (ft2, volume…);
Direct materials.
15.5 Indirect Cost Rates

Most allocations are set using a
predetermined indirect cost rate.
Defined as:
Indirect Cost Rate (ICR)
= (est. indirect costs)/(est. basis level)
An est. cost is what’s allocated to a
given cost center.
Remember, the allocation is never
precise!
 Only an estimate or approximation!
15.5 Example 15.7
A firm has 3 cost centers:

 Machine 1;
 Machine 2;
 Machine 3.
The indirect cost budget for each cost
center is $50,000 per time period.
Each cost center has a different cost
allocation basis defined.
15.5 Example 15.7 – Allocation Basis
Allocation Basis Table
Source Basis Est.

Activity Level
Machine 1 Direct Labor $100,000
Cost
Machine 2 Direct Labor 2,000 hours

Hours
Machine 3 Direct Material $250,000

Cost
What are the cost rates for each cost center?

15.5 Cost Rates for Example 15.7
Machine 1 Rate:
 $50,000/$100,000 = $0.50/Direct Labor $
Machine 2 Rate:
 $50,000/2,000 Hrs = $25.00/Direct Labor $
Machine 3 Rate:
 $50,000/$250,000 (mtls) = $0.20/Direct
Material $.
15.5 Applying the IDC factors – Ex. 15.7
Production is started;
The system records the activity levels
for the time period;
 For M1 – Track Direct Labor Cost;
 For each $ of DLC, $0.50 of IDC is
generated;
 If DLC = $100,000 then $50,000 of IDC is
added in to obtain a base cost for the M1
cost center.
15.5 Cost Blanket Rates

Assume a facility has multiple lines;
Assume the same allocation basis applies
to all of the lines in question;
Then a “blanket rate” is applied since the
allocation basis is the same for all of the
cost sources (activities.)
Easy to calculate and apply, BUT…
Can fail to account for the differences in
the types of activities that go on in the cost
centers.
15.5 Applying Cost Blanket Rates
Assume there is $500,000 of IDC to

allocate over multiple activity lines;
The basis for allocations is determined
to be “Total Direct Materials” used in
the processes;
Then:
 IDC = $500,000/Total Direct Material Cost
 Assume $3,000,000 of direct material cost
will apply, then……..
15.5 Applying Cost Blanket Rates
The blanket rate over the multiple cost

centers will calculate as:
 $500,000/$3,000,000 = $0.167/Mtl. Cost $.
Production begins and over time it is
know what the Direct Material Cost
(DMC) “was.”
The IDC charge can now be determined
since DMC has been tracked.
15.5 Allocation of IDC’s
The Direct costs have been tracked;

Then the IDC is calculated from the
rate;
Direct Costs + IDC = Total Cost of
Production (goes by several titles)…
 Cost of Goods Sold or,
 Factory Cost.
DC + IDC is accumulated by the cost
center.
15.5 Allocation Variance

If all of the previous estimating was
“correct,” then;
Total IDC for each cost center should
equal the IDC budget (was estimated).
Budgeting is not a perfect science;
Errors are made!
Could have:
 Overallocated or,
 Underallocated.
15.5 Misallocations…
Over- or underallocation will result is

what is termed:
 Allocation Variance.
Carefully study example 15.8 on pages
487–488.
15.5 Allocation Variances
If, at the end of a tracking period a

large allocation variance is discovered,
then:
 Triggers a review of:
 The allocation rate and or,
 The IDC budget.
Small variances are to be expected, but
large variances send a “signal” to
review and take action!

Hill
CHAPTER 15
15.6
Activity-Based Costing
for Indirect Costs
ABC
15.6 Activity-Based Costing (New Concept)
ABC has become an alternative approach

to IDC allocation;
Past, Direct Labor Hours (DLH) was a
driving force in manufacturing;
Advancing technology has aided in
reducing the number of DLH in the
production process;
15.6 ABC:
In the past, much of the total cost of a

manufactured product was made up of:
 Direct Labor ( 35 – 40%) and,
 Materials.
Today, the indirect costs can represent
approximately 35% of total costs:
 Labor represents 5%-10% of total costs.
15.6 ABC:
Today, we see a reversal in the role of

indirect costs as a percentage of total cost.
IDC’s now tend to occupy a greater
percentage of the total cost to produce.
The problem today:
 Historical approaches (DLH, DM’s, etc.) are not
providing accurate enough estimates of IDC
allocations to cost centers.
15.6 ABC:
It has been shown that products that the

firm thinks are profitable are not really
profitable at all!
Firms involved with a wide variety of
products with small lot production are
finding that traditional allocation methods
are underestimating or underallocating the
IDC’s to small lot production.
15.6 ABC:
Underallocations of IDC’s distort the true

cost of the product.
Underallocation thus can contribute to a
firm selling a product at a “loss” rather than
a profit.
Needed: New approach combined with the
traditional allocation schemes to more
accurately reflect “true costs.”
15.6 ABC: A Supplemental Approach
Goal of ABC:
 Develop cost centers – Cost Pools;
 Cost pool for each event or activity;
 The cost pool and the activity define cost
drivers.
 Cost drivers drive the consumption of a shared
resource;
 Charge accordingly.
15.6 ABC: Cost Pools – Functional Activities
Cost Pools:
 Departments;
 Functions;
 Inspection,
 Maintenance,
 Information Technology,
 Etc.
15.6 ABC: Activities
Activities represent “events,” e.g.,

 Purchase Orders,
 No. of reworks,
 No. of repairs,
 No. of software activations,
 Machine setups,
 Waiting time,
 Engineering charges,
 Etc.
15.6 ABC: Properly Defined
ABC is not a complete cost-accounting

system;
Traditional methods still have their place;
The best approach is to:
 Apply traditional methods when the basis is
identifiable (Direct Labor) then,
 Combine with ABC to allocate IDC’s to support
services cost.
15.6 ABC: Methodology
Two-step Process:
1. Define the Cost Pools – usually the support
functions.
2. Identify the Cost Drivers – help trace costs to
the cost pools.
Example 15.10 clearly illustrates the
application of an ABC approach to the
allocation of management travel time to
various product lines.
15.6 ABC: Example 15.10, Pages 491–493
Carefully review this example and

problems 15.35–15.38
Understanding the key concepts in ABC is
important;
ABC is embedded in many industries today;
Engineers will require training on the
proper application of ABC in conjunction
with traditional methods.
15.6 ABC: Summary
ABC (Notes):
 More expensive and time-consuming to apply as
opposed to traditional methods;
 Software packages available to support ABC
analysis of IDC allocation;
 Should not become a stand-alone cost-
accounting type system;
 Apply ABC in conjunction with the traditional
approaches.
 Can assist in reducing allocation variances.

Hill
CHAPTER 15
Chapter Summary
15 Summary
Cost estimation is not an exact science –

it’s not intended to be!
Estimates should be accurate enough to
support robust engineering economy cost
analysis.
Two Approaches: (Treat costs differently)
 Bottom-Up,
 Top-Down.
15 Summary
Cost Indexes are used to estimate and

update costs
Cost Estimating –
 Apply Cost-estimating Relationships
 Cost-Capacity Equations,
 Cost estimation from design variables for material,
equipment, and construction.
 Factor Method
 Used to estimate total plant costs.
15 Summary
Traditional Cost Allocation

 Applies an indirect cost rate to a machine,
department, line, etc.
 Typically uses:
 Direct Labor cost,
 Direct Material cost,
 Direct Labor Hours.
15 Summary
ABC assists in the allocation of IDC’s to

shared service units where cost pools and
cost drivers are defined.
Activities drive costs:
 More activity – more cost.
 Less activity – less cost.
ABC is a good tool to aid in the
understanding of cost allocation to certain
functions.
15 Summary
ABC:
 Should be used in conjunction with traditional
methods.
 Time-consuming and requires training.

Hill
CHAPTER 15
End of Slide Set

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ENGINEERING ECONOMY Fifth Edition Mc