Finance

CHAPTER 3
Cost-Estimation Techniques

The objective of Chapter 3 is to present an assortment of methods for estimating important factors in an engineering economy study.

The High Cost of Office Rental Space
n 2008, your multinational firm needs to acquire a total of 50,000 square feet of additional office space in London, Hong Kong, and New York City. You have been tasked with developing a costestimate for 20,000 square feet of space in London, 10,000 square feet of space in Hong Kong, and 20,000 square feet of space in New York City. While researching this topic, you find an article in USA Today (April 10, 2007, page B-1) that provides the following annual cost estimates per square foot of rental space in the three cities: London, $233.57; Hong Kong, $201.29; and New York City, $175.00.How much should your firm expect to pay per year for the 50,000 square feet of office space? In Chapter 3, you will learn about several techniques that are highly useful in estimating the costs of engineering projects.

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Decisions, both great and small, depend in part on estimates. “Looking down the barrel” need not be an embarrassment for the engineer if newer techniques, professional staffing,and a greater awareness are assigned to the engineering cost estimating function. —Phillip F. Ostwald (1992)

3.1 Introduction
In Chapter 1, we described the engineering economic analysis procedure in terms of seven steps. In this chapter, we address Step 3, development of the outcomes and cash flows for each alternative. Because engineering economy studies deal with outcomes that extend into thefuture, estimating the future cash flows for feasible alternatives is a critical step in the analysis procedure. Often, the most difficult, expensive, and time-consuming part of an engineering economy study is the estimation of costs, revenues, useful lives, residual values, and other data pertaining to the alternatives being analyzed. A decision based on the analysis is economically sound only tothe extent that these cost and revenue estimates are representative of what subsequently will occur. In this chapter, we introduce the role of cost estimating in engineering practice. Definitions and examples of important cost concepts were provided in Chapter 2. Whenever an engineering economic analysis is performed for a major capital investment, the cost-estimating effort for that analysis shouldbe an integral part of a comprehensive planning and design process requiring the active participation of not only engineering designers but also personnel from marketing, manufacturing, finance, and top management. Results of cost estimating are used for a variety of purposes, including the following: 1. Providing information used in setting a selling price for quoting, bidding, or evaluatingcontracts 2. Determining whether a proposed product can be made and distributed at a profit (for simplicity, price = cost + profit) 3. Evaluating how much capital can be justified for process changes or other improvements 4. Establishing benchmarks for productivity improvement programs There are two fundamental approaches to cost estimating: the “top-down” approach and the “bottom-up” approach. Thetop-down approach basically uses historical data from similar engineering projects to estimate the costs, revenues, and other data for the current project by modifying these data for changes in inflation or deflation, activity level, weight, energy consumption, size, and other factors. This approach is best used early in the estimating process when alternatives are still being developed and refined. Thebottom-up approach is a more detailed method of cost estimating. This method breaks down a project into small, manageable units and estimates their economic consequences. These smaller unit costs are added together with other types of costs to obtain an overall cost estimate. This approach usually works best when the detail concerning the desired output (a product or a service) has been defined...