Cost Estimation Techniques

Cost Estimation
• A cost estimate is the approximation of the cost of a program, project, or
operation.
• Four common types of cost estimates are:
1. Planning estimate: A rough approximation of cost within a reasonable
range of values, prepared for information purposes only.
2. Budget estimate: An approximation based on well-defined (but
preliminary) cost data and established ground rules.
3. Firm estimate: A figure based on cost data sound enough for entering
into a binding contract.
4. Not-to-exceed /Not-less-than estimate: The maximum or minimum
amount required to accomplish a given task, based on a firm cost
estimate.
 Cost Estimation methods

• Cost estimation methods can be broadly

divided into three:

1. Engineering estimates

2. Accounting analysis

3. Statistical methods
 Engineering Estimates
• The Engineering Cost Estimating method builds the overall cost
estimate by summing detailed estimates done at different levels of
the Work Breakdown Structure (WBS).
• It is a technique where the system being costed is broken down into
lower-level components (such as parts or assemblies), each of
which is costed separately for direct labor, direct material, and
other costs.
• Engineering estimates for direct labor hours may be based on
analyses of engineering drawings and contractor or industry-wide
standards.
 Accounting Analysis Method
• The accounting analysis approach requires that
each individual cost is examined, and based on
judgment is categorized as a fixed or variable
cost. Then all variable costs are totaled.

• Variable cost per unit is calculated by dividing the

total of all variable costs by the number of units
produced and sold.
 Accounting Analysis

Costs for 360 repair-days

Variable Fixed
Account Total cost cost
Office rent 3,375 1,375 2,000
Utilities 310 100 210
Administration 3,386 186 3,200
Supplies 2,276 2,176 100
Training 666 316 350
Other 613 257 356
Total 10,626 4,410 6,216
Per repair day 12.25
 Statistical cost estimating
• It depends on an analysis of past experience with
similar parts or processes.
• Formula or regressions can be produced to account for
all of the variables of each individual component.
• Calculation of times for Design, Tool design,
Programming, Estimating and Engineering duties can
also be calculated with this method.
• For Example: The Constructive Cost Model (COCOMO)
for software cost estimation.
 Direct and Indirect Cost Estimates
Direct cost examples
• Physical assets
• Maintenance and operating
costs (M&O)
• Materials
• Direct human labor (costs
and benefits)
• Scrapped and reworked
product
• Direct supervision of
personnel
Indirect cost examples
• Utilities
• IT systems and networks
• Purchasing
• Management
• Taxes
• Legal functions
• Warranty and guarantees
• Quality assurance
• Accounting functions
• Marketing and publicity
Different Approaches to Cost Estimation

15-5 © 2012 by McGraw-Hill All Rights Reserved

 Top-Down Vs Bottom-Up
• The bottom-up approach treats the required price as an
output variable and the cost estimates as input variables.
• This approach works well when competition is not a
dominant factor in pricing the product or service.
• The top-down approach treats the competitive price as an
input variable and the cost estimates as output variables.
• This approach is useful in encouraging innovation, new
design, manufacturing process improvement, and
efficiency. Example: Tata Nano
 Techniques
• Unit Method
• Cost Index
• Segmenting Model
• Power-Sizing Model
• Improvement and the Learning Curve
 Unit Method
• Commonly used technique for preliminary design stage estimates
• Total cost estimate CT is per unit cost (u) times number of units (N)
CT = u × N
• Example uses:
 Cost to operate a car at 60¢/mile for 500 miles: CT = 0.60 × 500 = $300
 Cost to build a 250 m2 house at $2250/m2: CT = 2250 × 250 = $562,500

• Cost factors must be updated periodically to remain timely

When several components are involved, estimate cost of each

component and add to determine total cost estimate CT
 Example
• You may be interested in a new home to be
constructed with a certain type of material and
has a specific construction style.
• Based on this information a contractor may quote
a cost of Rs. 2500 per square foot for your home.
If you are interested in a 1200 square foot floor
plan, your cost would be: Rs. 3000000.
 Other examples
• Service cost per customer
• Safety cost per employee
• Fuel cost per Kilometer
• Cost of defects per batch
• Maintenance cost per window
• Utility cost per square foot of floor space
• Housing cost per student
 Cost Indexes
 Definition: Cost Index is ratio of cost today to cost in the past
• Indicates change in cost over time; therefore, they account for
the impact of inflation
• Index is dimensionless
• CPI (Consumer Price Index) is a good example

Formula for total

cost
Formula for is cost
total
is
 Example: Cost Index Method
Problem: Estimate the total cost of labor today in US dollars for a
maritime construction project using data from a similar project in
Europe completed in 1998.

Labor index, 1998: 789.6 Cost in 1998: €3.9 million

Labor index, current: 1165.8 Currently, 1 € = 1.5 US$

Solution: Let t = today and 0 = 1998 base

Ct = 3.9 million × (1165.8/789.6) = €5.76 million

= €5.76 × 1.5 = $8.64 million
 Finding Cost Indexes
Cost indexes are maintained in areas such as
construction, chemical and mechanical industries
• Updated monthly and annually; many include regionalized and
international project indexes
• Indexes in these areas are often subdivided into smaller
components and can be used in preliminary, as well as
detailed design stages

Examples are:
 Chemical Engineering Plant Cost Index (CEPCI)
www.che.com/pci
 McGraw-Hill Construction Index
www.construction.com
 Segmenting Model
• Under segmenting model an estimate is
decomposed into its individual components,
estimates are made at those lower levels, and
then the estimates are aggregated (added) back
together.
• It is much easier to estimate at the lower levels
because they are more readily understood.
 Power Sizing Model
Also called as Cost Capacity Equations (CCE)

Exponent defines relation between capacities

x = 1, relationship is linear
x < 1, economies of scale (larger capacity is less costly than linear)
x > 1, diseconomies of scale
 Cost-Capacity Combined with Cost Index
Multiply the cost-capacity equation by a cost index (It/I0) to adjust for time
differences and obtain estimates of current cost (in constant-value dollars)

Example: A 100 hp air compressor costs $3000 five years ago when
the cost index was 130. Estimate the cost of a 300 hp compressor
today when the cost index is 255. The exponent for a 300 hp air
compressor is 0.9.
Solution: Let C300 represent the cost estimate today

C300 = 3000(300/100)0.9(255/130)
= $15,817
Example Power-Sizing Exponent Values
 Improvement and the Learning Curve
• Regardless of the task being performed, as the number
of repetitions increases, performance becomes faster
and more accurate.
• The learning curve captures the relationship between
task performance and task repetition.
• In general, as output doubles the-unit production time
will be reduced to some fixed percentage, the learning
curve percentage or learning curve rate.
 Example

• For example, it may take 300 minutes to

produce the third unit in a production run
involving a task with a 95% learning time
curve.
• In this case the sixth (2 x 3) unit will take
300(0.95) = 285 minutes to produce.
• where TN =time requirement for the Nth unit of
production
• T initial= time requirement for the first (initial)
unit of production
• N = number of completed units (cumulative
production)
• b = learning curve exponent (slope of the learning
curve on a log-log plot)
• Learning curve is often referred to by its
percentage, learning slope.
• Thus, a curve with b = -0.074 is a 95% learning
curve because 2-0.074 = 0.95. This equation uses 2
because the learning curve percentage applies for
doubling cumulative production.

• .
 Example
• Calculate the time required to produce the
hundredth unit of a production run if the first
unit took 32.0 minutes to produce and the
learning curve rate for production is 80%.

• T100 = T1 X 100Iog0.80/log2.0

• T100= 32.0 X 100-0.3219

• T100 = 7.27 minutes

 Indirect Costs
Indirect costs (IDC) are incurred in production, processes and
service delivery that are not easily tracked and assignable to a
specific function.

 Indirect costs (IDC) are Sample indirect costs

shared by many functions
because they are necessary
to perform the overall
objective of the company
 Indirect costs make up a
significant percentage of
the overall costs in many
organizations – 25 to 50%
 IT services
 Quality assurance
 Human resources
 Management
 Safety and security
 Purchasing; contracting
 Accounting; finance; legal
 Indirect cost allocation

• One of the primary and more difficult tasks of

cost accounting is the allocation of indirect
costs when it is necessary to allocate them
separately to departments, processes, and
product lines.
 Sample Indirect Cost Allocation Bases
Cost Category Possible Allocation Basis
Taxes Space Occupied
Heat, Light Space, usage, no of outlets
Space, direct labour or horse-power
Power or machine hours,
Cost of materials, no of orders
Receiving, Purchasing placed
Personnel, machine Shop Direct labor hours/cost
Building maintenance Space Occupied
Software number of accesses
Quality Control Number of inspections
 Indirect Cost Allocation- Traditional Method
 Cost center -- Department, function, or process used by the cost accounting system
to collect both direct and indirect costs
 Indirect-cost rate – Traditionally, a predetermined rate is used to allocate indirect
costs to a cost center using a specified basis. General relation is:
Estimated total indirect costs
Indirect-cost rate =
Estimated basis level

Example:
Allocating
$150000
amongst 3
machines.
Allocation rates Machine 1: Rate = $50,000/100,000 = $0.50 per DL $
for $50,000 to Machine 2: Rate = $50,000/2,000 = $25 per DL hour
each machine Machine 3: Rate = $50,000/250,000 = $0.20 per DM $
 ABC Allocation
 Activity-Based Costing ─ Provides excellent allocation strategy and analysis of
costs for more advanced, high overhead, technologically-based systems
 Cost Centers (cost pools) ─ Final products/services that receive allocations
 Activities ─ Support departments that generate indirect costs for distribution to cost
centers (maintenance, engineering, management)
 Cost drivers ─ These are the volumes that drive consumption of shared resources (#
of POs, # of machine setups, # of safety violations, # of scrapped items)

Steps to implement ABC:

1. Identify each activity and its total cost (e.g., maintenance at $5 million/year)
2. Identify cost drivers and expected volume (e.g., 3,500 requested repairs and 500
scheduled maintenances per year)
3. Calculate cost rate for each activity using the relation:
ABC rate = total activity cost/volume of cost driver
4. Use ABC rate to allocate IDC to cost centers for each activity
 Example: ABC Allocation

Use ABC to allocate safety program costs to plants in US and Europe

Cost centers: US and European plants
Activity and cost: Safety program costs $200,200 per year
Cost driver: # of accidents
Volume: 560 accidents; 425 in US plants and 135 in European plants

Solution:
ABC rate for accident basis = 200,200/560 = $357.50/accident
US allocation: 357.50(425) = $151,938
Europe allocation: 357.50(135) = $48,262
 Example: Traditional Allocation Comparison

Use traditional rates to allocate safety costs to US and EU plants

Cost centers: US and European plants
Activity and cost: Safety program costs $200,200 per year
Basis: # of employees
Volume: 1400 employees; 900 in US plants and 500 in European plants

Solution:
Rate for employee basis = 200,200/1400 = $143/employee
US allocation: 143(900) = $128,700
Europe allocation: 143(500) = $71,500

Comparison: US allocation went down;

European allocation increased
 Traditional vs. ABC Allocation
o Traditional method is easier to set up and use
o Traditional method is usually better when making
cost estimates
o ABC is more accurate when process is in operation
o ABC is more costly, but provides more information
for cost analysis and decision making
o Traditional and ABC methods complement each
other:
 Traditional is good for cost estimation and
allocation
 ABC is better for cost tracking and cost control