Engineering Economy 2012

388 Chapter 15 Cost Estimation and Indirect Cost Allocation
(maintenance and operating) of equipment. Each component will have several cost elements .
Listed below are sample elements of the first cost and AOC components.
First cost component P:
Elements:
Equipment cost
Delivery charges
Installation cost
Insurance coverage
Initial training of personnel for equipment use
Delivered-equipment cost is the sum of the first two elements in the list above; installedequipment
cost adds the third element.
AOC component (part of the equivalent annual cost A):
Elements: Direct labor cost for operating personnel
Direct materials
Maintenance costs (daily, periodic, repairs, etc.)
Rework and rebuild
Some of these elements, such as equipment cost, can be determined with high accuracy; others,
such as maintenance costs, are harder to estimate. When costs for an entire system must be estimated,
the number of cost components and elements is likely to be in the hundreds. It is then
necessary to prioritize the estimation tasks.
For familiar projects (houses, office buildings, highways, and some chemical plants) there are
standard cost estimation software packages available. For example, state highway departments
utilize software that prompts for the cost components (bridges, pavement, cut-and-fill profiles,
etc.) and estimates costs with time-proven, built-in relations. Once these components are estimated,
exceptions for the specific project are added. However, there are no “canned” software
packages for a large percentage of industrial, business, service and public sector projects.
Cost Estimation Approach Historically in industry, business, and the public sector, a
bottom-up approach to cost estimation was applied. For a simple rendition of this approach, see
Figure 15–1 (left side). The progression is as follows: cost components and their elements are
identified, cost elements are estimated, and estimates are summed to obtain total direct cost. The
price is then determined by adding indirect costs and the profit margin, which is usually a percentage
of the total cost.
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.
Figure 15–1 (right side) shows a simplistic progression for the design-to-cost , or top-down, approach.
The competitive price establishes the target cost.
The design-to-cost, or 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. These are some of the essentials
of value engineering and value-added systems engineering.
This approach places greater emphasis on the accuracy of the price estimation activity. The target
cost must be realistic, or else it can be a disincentive to design and engineering staff. The designto-cost
approach is best applied in the early stages of a new or enhanced product design. The
detailed design and specific equipment options are not yet known, but the price estimates assist
in establishing target costs for different components.
Usually, the resulting approach is some combination of these two philosophies. However, it is
helpful to understand up front what approach is to be emphasized. Historically, the bottom-up
approach was more predominant in Western engineering cultures, especially in North America.
The design-to-cost approach is considered routine in Eastern engineering cultures; however,