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Cost Estimation and Indirect Cost Allocation

Learn about the importance of cost estimation and indirect cost allocation in engineering economy analysis. Explore different cost estimation approaches and understand how to accurately estimate costs for equipment, labor, materials, and more.

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Cost Estimation and Indirect Cost Allocation

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  1. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 15 Cost Estimation and Indirect Cost Allocation Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

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

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

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

  5. 15.1 Cost of New Equipment • Delivered Equipment Costs: • Equipment Cost + • Delivery Costs. • Installation costs are next. Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

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

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

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

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

  10. 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. • 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. Bottom-Up Approach • Traditional costing approach; • Applied in industries where competition in not the dominant factor is pricing the product or the service. Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

  11. 15.1 Cost Estimation Approaches • Design-to-Cost Approach • 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. Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

  12. 15.1 Cost Estimation Approaches • Design-to-Cost Approach • 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). Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

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

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

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

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

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

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

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

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

  21. 15.2 Index Example • Base time, t0 = 5 years ago; • The present estimate then would be: Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

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

  23. 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 A model that relates the cost of an asset or activity to its capacity. Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

  24. 15.3 Cost Capacity Models • Other names: • Power-law or, • Sizing models. • Assume two different capacity levels: • Capacity level Q1, • Capacity level Q2 Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

  25. 15.3 Cost Capacity Models • CCE is: • Where x is the correlating exponent. Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

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

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

  28. 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; See Example 15.3 on page 482 Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

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

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

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

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

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

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

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

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

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

  38. 15.4 IDC applied to TDC Equation • Total Cost if IDC applied to TDC. See examples 15.5 and 15.6! Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

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

  40. 15.5 Cost Center Overview Allocate the IC’s to each Cost center in Some manner. MFG. System Cost Center 1 Total Indirect Costs – Total System $$$$ Cost Center 2 Cost Center “j” Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

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

  42. 15.5 Traditional IDC Allocations Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

  43. 15.5 Common Basis for Allocations • Direct labor cost; • Direct labor hours; • Space (ft2, volume…); • Direct materials. Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

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

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

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

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

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

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

  50. 15.5 Misallocations… • Over- or underallocation will result is what is termed: • Allocation Variance. • Carefully study example 15.8 on pages 487–488. Blank & Tarquin: 5th edition. Ch.15 Authored by Dr. Don Smith, Texas A&M University

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