Engineering Economics Principle 4: Use a Common Unit of Measure – Using a common unit of

measurement to enumerate as many of the prospective outcomes as

Lesson 1: Introduction to Engineering Economy possible will simplify the analysis of the alternatives.

I. Introduction Principle 5: Consider All Relevant Criteria – Selection of a preferred

alternative (decision making) requires the use of a criterion (or several
Engineering economy involves the systematic evaluation of the economic criteria). The decision process should consider both the outcomes
merits of proposed solutions to engineering problems. enumerated in the monetary unit and those expressed in some other unit of
measurement or made explicit in a descriptive manner.
Solutions to engineering problems:
Principle 6: Make Risk and Uncertainty Explicit – Risk and uncertainty
• promote the well-being and survival of an organization, are inherent in estimating the future outcomes of the alternatives and
• embody creative and innovative technology and ideas, should be recognized in their analysis and comparison.
• permit identification and scrutiny of their estimated outcomes, and
• translate profitability to the “bottom line” through a valid and Principle 7: Revisit Your Decisions – Improved decision making results
acceptable measure of merit. from an adaptive process; to the extent practicable, the initial projected
outcomes of the selected alternative should be subsequently compared
“The mission of engineering economy is to balance these trade-offs in the with actual results achieved.
most economical manner.”
III. Engineering Economy and the Design Process
II. Principles of Engineering Economy

We define the foundation for engineering economy to be a set of principles

that provide a comprehensive doctrine for developing the methodology.

Seven Principles of the Foundation of Engineering Economy

Principle 1: Develop Alternatives – Carefully define the problem! Then

the choice (decision) is among alternatives. The alternatives need to be
identified and then defined for subsequent analysis.

Principle 2: Focus on the Differences – Only the differences in expected

future outcomes among the alternatives are relevant to their comparison
and should be considered in the decision.

Principle 3: Use a Consistent Viewpoint – The prospective outcomes of

the alternatives, economic and other, should be consistently developed
from a defined viewpoint (perspective). Step 1: Problem Definition

A problem must be well understood and stated in an explicit form

before the project team proceeds with the rest of the analysis.
Recognition of the problem is normally stimulated by internal or external
organizational needs or requirements. An operating problem within a
company (internal need) or a customer expectation about a product or
service (external requirement) are examples.

Step 2: Development of Alternatives/Option Development

Principle 1 can be applied in this step of engineering analysis procedure.

Feasible – means that each alternative selected for further analysis is

judged.

There are two primary actions in developing alternatives, these are;

1. Searching for potential alternatives

2. Screening them to select a smaller group of feasible
alternatives for detailed analysis.

Searching for Superior Alternatives

Ways to increase efficiency:

 Concentrate on redefining one problem at a time in Step 1.

 Develop many redefinitions for the problem.
 Avoid making judgments as new problem definitions are
created. Developing Investment Alternatives
 Attempt to redefine a problem in terms that are dramatically
different from the original Step 1 problem definition. Two approaches for developing sound investment alternatives:
 Make sure that the true problem is well researched and
understood. 1. Classical Brainstorming: Classical brainstorming is the most well-
known and often-used technique for idea generation. It is based on the
Limitations in searching for superior alternatives: fundamental principles of deferment of judgment and that quantity
breeds quality.
 Lack of time and money
 Preconceptions of what will and what will not work Four rules for successful brainstorming:
 Lack of knowledge
 Criticism is ruled out.
Example:  Freewheeling is welcomed.
 Quantity is wanted.
 Combination and improvement are sought.
 Must consist of 4 to 7 people.
Steps in classical brainstorming: Incorporates principles 2, 3, and 4 in this step of engineering analysis
procedure.
a. Preparation. The participants are selected, and a preliminary
statement of the problem is circulated. A cash flow occurs when money is transferred from one organization or
b. Brainstorming. A warm-up session with simple unrelated problems individual to another.
is conducted, the relevant problem and the four rules of
brainstorming are presented, and ideas are generated and recorded The net cash flow for an alternative is the difference between all cash
using checklists and other techniques if necessary. inflows (receipts or savings) and cash outflows (costs or expenses) during
c. Evaluation. The ideas are evaluated relative to the problem. each time period.

Example of non-monetary factors final recommendation.

2. Nominal Group Technique (NGT): The NGT, developed by Andre P. 1. Meeting or exceeding customer expectations
Delbecq and Andrew H. Van de Ven, involves a structured group 2. Safety to employees and to the public
meeting designed to incorporate individual ideas and judgments 3. Improving employee satisfaction
into a group consensus. By correctly applying the NGT, it is possible 4. Maintaining production flexibility to meet changing demands
for groups of people (preferably, 5 to 10) to generate investment 5. Meeting or exceeding all environmental requirements
alternatives or other ideas for improving the competitiveness of the 6. Achieving good public relations or being an exemplary member of
the community.
The technique, when properly applied, draws on the creativity of the
individual participants, while reducing two undesirable effects of most Step 4: Selection of a Decision Criterion
group meetings: (1) the dominance of one or more participants and (2)
the suppression of conflicting ideas. This step incorporates principle 5 in the engineering analysis procedure.

The basic format of an NGT session is as follows: The decision maker will normally select the alternative that will best serve
the long-term interests of the owners of the organization. It is also true that
1. Individual silent generation of ideas the economic decision criterion should reflect a consistent and proper
2. Individual round-robin feedback and recording of ideas viewpoint (Principle 3) to be maintained throughout an engineering
3. Group clarification of each idea economy study.
4. Individual voting and ranking to prioritize ideas
5. Discussion of group consensus results Step 5: Analysis and Comparison of Alternatives

Which is much better, classical brainstorming or NGT? It incorporates principle 6 in this step og engineering analysis procedure.

So, if you need a quick burst of ideas and value spontaneity, classical Analysis of the economic aspects of an engineering problem (Step 5) is
brainstorming might be the way to go. But if you're looking for a more largely based on cash-flow estimates for the feasible alternatives selected
structured approach that ensures equal participation and deeper thinking, for detailed study. A substantial effort is normally required to obtain
NGT could be the better choice. Ultimately, the best method depends on reasonably accurate forecasts of cash flows and other factors in view of, for
your specific situation and objectives. example, inflationary (or deflationary) pressures, exchange rate
movements, and regulatory (legal) mandates that often occur.
Step 3: Development of Prospective Outcomes
Step 6: Selection of the Preferred Alternatives

When the first five steps of the engineering economic analysis procedure
have been done properly, the preferred alternative (Step 6) is simply a
result of total effort. Thus, the soundness of the technical-economic
modeling and analysis techniques dictates the quality of the results
obtained and the recommended course of action. Step 6 is included in
Activity 5 of the engineering design process (specification of the preferred
alternative) when done as part of a design effort.

Step 7: Performance Monitoring and Post-evaluation of Results

This final step incorporates principle 7 and is accomplished during and

after the time that the results achieved from the selected alternative are
collected. Step 7 is also the follow-up step to a previous analysis,
comparing actual results achieved with the previously estimated outcomes.
The aim is to learn how to do better analyses, and the feedback from
postimplementation evaluation is important to the continuing improvement
of operations in any organization.

Example:
 I. Cost Terminology

Fixed costs are those unaffected by changes in activity level over a

feasible range of operations for the capacity or capability available.

Variable costs are those associated with an operation that varies in total
with the quantity of output or other measures of activity level.

An incremental cost (or incremental revenue) is the additional cost (or

revenue) that results from increasing the output of a system by one (or
more) units.

IV. Using Spreadsheets in Engineering Economic Analysis

Spreadsheets are a useful tool for solving engineering economy problems.

Most engineering economy problems are amenable to spreadsheet
solution for the following reasons:

1. They consist of structured, repetitive calculations that can be

expressed as formulas that rely on a few functional relationships.
2. The parameters of the problem are subject to change.
3. The results and the underlying calculations must be documented.
4. Graphical output is often required, as well as control over the format
of the graphs.

Spreadsheets allow the analyst to develop an application rapidly, without

being inundated by the housekeeping details of programming languages.
They relieve the analyst of the drudgery of number crunching but still focus
on problem formulation.

Lesson 2: Cost Concepts and Design Economics

 A sunk cost is one that has occurred in the past and has no relevance to
estimates of future costs and revenues related to an alternative course of
action.

An opportunity cost is incurred because of the use of limited resources,

such that the opportunity to use those resources to monetary advantage in
an alternative use is foregone.

Direct costs are costs that can be reasonably measured and allocated to a
specific output or work activity.

Indirect costs are costs that are difficult to allocate to a specific output or
work activity.

Standard costs are planned costs per unit of output that are established in
advance of actual production or service delivery.

Some typical uses of standard cost:

1. Estimating future manufacturing costs life-cycle cost refers to a summation of all the costs related to a product,
2. Measuring operating performance by comparing actual cost per unit structure, system, or service during its life span.
with the standard unit cost
The priorities for engineering economy studies during the operation
3. Preparing bids on products or services requested by customers
4. Establishing the value of work in process and finished inventories
phase are:
Cash costs are cost the involved payment of cash.
1. Achieving efficient and effective support to operations
2. Determining whether (and when) replacement of assets should
Noncash/Book costs are cost does not involved cash transactions and is
occur
reflected in the accounting system.
3. Projecting the timing of retirement and disposal activities.
Investment cost is the capital required for most of the activities in the As the selling price per unit (p) is increased, there will be less demand (D)
acquisition phase. for the product, and as the selling price is decreased, the demand will
increase. The relationship between price and demand can be expressed as
Operation and maintenance cost (O&M) includes many of the recurring the linear function:
annual expense items associated with the operation phase of the life cycle.
p=a−bD
Disposal cost includes those nonrecurring costs of shutting down the
operation and the retirement and disposal of assets at the end of the life where a is the intercept on the price axis and −b is the slope. Thus, b is the
cycle. amount by which demand increases for each unit decrease in p. Both a
and b are constants. It follows, of course, that:
II. The general economic environment
a− p
Consumer and Producers Goods and Services D=
b
Two classes of goods and services:

1. Consumer goods and services are those products or services

that are directly used by people to satisfy their wants. Food,
clothing, homes, cars, television sets, haircuts, opera, and medical
services are examples.
2. Producers goods and services are used to produce consumer
goods and services or other producer goods. Machine tools, factory
buildings, buses, and farm machinery are examples.

Measures of Economic Worth

Necessities, Luxuries, and Price Demand Competition

Goods and services may be divided into two types: necessities and Perfect competition occurs in a situation in which any given product is
luxuries. For example, a person living in one community may find that an supplied by a large number of vendors and there is no restriction on
automobile is a necessity to get to and from work. If the same person lived additional suppliers entering the market.
and worked in a different city, adequate public transportation might be
available, and an automobile would be a luxury.
Monopoly is at the opposite pole from perfect competition. A perfect Thus,
monopoly exists when a unique product or service is only available from a
single supplier and that vendor can prevent the entry of all others into the ^ a
D=
market 2b
The Total Revenue Function To guarantee that Dˆ maximizes total revenue, check the second derivative
to be sure it is negative:
The total revenue, TR, that will result from a business venture during a
given period is the product of the selling price per unit, p, and the number 2
d TR
of units sold, D. Thus, 2
=−2b
dD
TR=pD
Also, recall that in cost-minimization problems, a positively signed second
If the relationship between price and demand as given in Equation is used, derivative is necessary to guarantee a minimum-value optimal cost
solution.
TR=( a−bD ) D
Cost, Volume, and Breakeven Point Relationships
2
TR=aD−bD Fixed costs remain constant over a wide range of activities, but variable
costs vary in total with the volume of output. Thus, at any demand D, total
The relationship between total revenue and demand for the condition cost is:
expressed in the following Equation may be represented by the curve
shown in Figure 2-3. From calculus, the demand, Dˆ, that will produce C T =C F +C V
maximum total revenue can be obtained by solving;
where CF and CV denote fixed and variable costs, respectively. For the
dTR
=a−2 bD=0 linear relationship assumed here,
dD
C V =c v D

where cv is the variable cost per unit. In this section, we consider two
scenarios for finding breakeven points.
 2
d ( profit )
=−2 b
d D2

An economic breakeven point for an operation occurs when total revenue

equals total cost. Then for total revenue and total cost, as used in the
development of Equations (2-9) and (2-10) and at any demand D,

total revenue=total cost → breakeven point

2
aD−bD =C F +c v D
2
Scenario 1 When total revenue, as depicted in Figure 2-3, and total cost, −bD + ( a−c v ) D−C F =0
as given by the two equation above, are combined, the typical results as a
function of demand are depicted in Figure 2-4. At breakeven point D′1, total
revenue is equal to total cost, and an increase in demand will result in a
profit for the operation. Then at optimal demand, D∗, profit is maximized Example:
[Equation (2-10)]. At breakeven point D′2, total revenue and total cost are
again equal, but additional volume will result in an operating loss instead of
a profit. Obviously, the conditions for which breakeven and maximum profit
occur are our primary interest. First, at any volume (demand), D,

Profit (loss)=total revenue−total cost

2
Profit ( loss )=aD−bD −C F +c v D
2
Profit ( loss )=−bD + ( a−c v ) D−C F

Note: As you can see on the above equation, you can solve for demand by
using quadratic formula.

To find the optimal demand at which maximum profit will occur;

a−c v
D=
2b

To ensure that we have maximized profit (rather than minimized it), the
sign of the second derivative must be negative.
Scenario 2 When the price per unit (p) for a product or service can be
represented more simply as being independent of demand [versus being a
linear function of demand, as assumed in Equation (2-1)] and is greater
than the variable cost per unit (cv), a single breakeven point result. Then,
under the assumption that demand is immediately met, total revenue (TR)
= p · D. If the linear relationship for costs in Equations (2-7) and (2-8) is
also used in the model, the typical situation is depicted in Figure 2-6. This
scenario is typified by the Airbus example presented at the beginning of the
chapter.

III. Cost-Driven Design Optimization

The two main task of cost-driven design optimization:

1. Determine the optimal value for a certain alternative’s design

variable. For example, what velocity of an aircraft minimizes the
total annual costs of owning and operating the aircraft?
2. Select the best alternative, each with its own unique value for the
design variable. For example, what insulation thickness is best for a
home in Virginia: R11, R19, R30, or R38?
A simplified format of a cost model with one design variable is Rules used to select the preferred alternative when defect-free output
is variable or constant among the alternatives:
b
Cost =aX + +k Rule 1: When revenues and other economic benefits are present
X
and vary among alternatives, choose the alternative that maximizes
Where a is a parameter that represents the directly varying cost(s), overall profitability based on the number of defect-free units of a
product or service produced.
b is a parameter that represents the indirectly varying cost(s),
Rule 2: When revenues and other economic benefits are not
k is a parameter that represents the fixed cost(s), present or are constant among all alternatives, consider only the
costs and select the alternative that minimizes total cost per defect-
X represents the design variable in question (e.g., weight or free unit of product or service output.
velocity).

The following steps outline a general approach for optimizing a design with
respect to cost:

1. Identify the design variable that is the primary cost driver (e.g., pipe Total Cost in Material Selection
diameter or insulation thickness).
2. Write an expression for the cost model in terms of the design
variable.
3. Set the first derivative of the cost model with respect to the
continuous design variable equal to zero. For discrete design
variables, compute the value of the cost model for each discrete
value over a selected range of potential values.
4. Solve the equation found in Step 3 for the optimum value of the
continuous design variable. For discrete design variables, the
optimum value has the minimum cost value found in Step 3. This
method is analogous to taking the first derivative for a continuous
design variable and setting it equal to zero to determine an optimal
value.
5. For continuous design variables, use the second derivative of the
cost model with respect to the design variable to determine whether
the optimum value found in Step 4 corresponds to a global
maximum or minimum.

IV. Present Economy Studies

Care should be taken in making economic selections between materials to
ensure that any differences in shipping costs, yields, or resulting scrap are
taken into account.

In addition to deciding what material a product should be made of, there

are often alternative methods or machines that can be used to produce the
product, which, in turn, can impact processing costs. Processing times may
vary with the machine selected, as may the product yield.
Making versus Purchasing (Outsourcing) Studies

Trade-Offs in Energy Efficiency Studies

Lesson 3: Cost-Estimation Techniques

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 evaluating contracts.
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.

Two fundamental approaches to cost estimating:

1. Top-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.
2. Bottom-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 and clarified.
 The Work Breakdown Structure (WBS)

The first basic component in an integrated approach to developing cash

flows is the work breakdown structure (WBS).

I. Integrated Approach The WBS is a basic tool in project management and is a vital aid in an
engineering economy study. The WBS serves as a framework for defining
Three basic components of integrated approach: all project work elements and their interrelationships, collecting and
organizing information, developing relevant cost and revenue data, and
1. Work breakdown structure (WBS) This is a technique for explicitly integrating project management activities.
defining, at successive levels of detail, the work elements of a project
and their interrelationships (sometimes called a work element
structure).
2. Cost and revenue structure (classification) Delineation of the cost
and revenue categories and elements is made for estimates of cash
flows at each level of the WBS.
3. Estimating techniques (models) Selected mathematical models are
used to estimate the future costs and revenues during the analysis
period.
Characteristics of WBS project:

1. Both functional (e.g., planning) and physical (e.g., foundation) work

elements are included in it:
a. Typical functional work elements are logistical support,
project management, marketing, engineering, and systems
integration.
b. Physical work elements are the parts that make up a
structure, product, piece of equipment, or similar item; they
require labor, materials, and other resources to produce or
construct.
2. The content and resource requirements for a work element are the
sum of the activities and resources of related subelements below it.
3. A project WBS usually includes recurring (e.g., maintenance) and
nonrecurring (e.g., initial construction) work elements.

Cost and Revenue Structure

The second basic component of the integrated approach for developing

cash flows is the cost and revenue structure. This structure is used to
identify and categorize the costs and revenues that need to be included in
the analysis.

The life-cycle concept and the WBS are important aids in developing the
cost and revenue structure for a project. The life cycle defines a maximum
time period and establishes a range of cost and revenue elements that
need to be considered in developing cash flows. The WBS focuses the
analyst’s effort on the specific functional and physical work elements of a
project and on its related costs and revenues.

List of some categories of costs and revenues:

1. Capital investment (fixed and working)

2. Labor costs
 3. Material costs historical records and are usually done at Level 3 and successive levels in
4. Maintenance costs the WBS.
5. Property taxes and insurance
6. Overhead costs The level of detail and accuracy of estimates should depend on the
7. Disposal costs following:
8. Revenues based on sales, etc.
9. Quality (and scrap) costs 1. Time and effort available as justified by the importance of the study.
10. Market (or salvage) values 2. Difficulty of estimating the items in question
3. Methods or techniques employed.
Estimating Techniques Model 4. Qualifications of the estimator(s).
5. Sensitivity of study results to particular factor estimates.

Classifications of Cost and Revenue Estimates:

1. Order-of-magnitude estimates: used in the planning and initial

evaluation stage of a project.
2. Semidetailed, or budget, estimates: used in the preliminary or
conceptual design stage of a project.
3. Definitive (detailed) estimates: used in the detailed
engineering/construction stage of a project.

Order-of-magnitude estimates are used in selecting the feasible

alternatives for the study. They typically provide accuracy in the range
of±30 to 50% and are developed through semiformal means such as Sources of Estimating Data
conferences, questionnaires, and generalized equations applied at Level 1
or 2 of the WBS. The four major sources of information:

Budget (semidetailed) estimates are compiled to support the preliminary 1. Accounting records. Accounting records are a prime source of
design effort and decision making during this project period. Their accuracy information for economic analyses; however, they are often not
usually lies in the range of ±15%. These estimates differ in the fineness of suitable for direct, unadjusted use
cost and revenue breakdowns and the amount of effort spent on the 2. Other sources within the firm. The typical firm has a number of
estimate. Estimating equations applied at Levels 2 and 3 of the WBS are people and records that may be excellent sources of estimating
normally used. information. Examples of functions within firms that keep records
useful to economic analyses are engineering, sales, production,
Detailed estimates are used as the basis for bids and to make detailed quality, purchasing, and personnel.
design decisions. Their accuracy is ±5%. They are made from 3. Sources outside the firm. There are numerous sources outside
specifications, drawings, site surveys, vendor quotations, and in-house the firm that can provide helpful information. The main problem is in
 determining those that are most beneficial for particular needs. The Estimates can be prepared in a number of ways, such as the following
following is a listing of some commonly used outside sources: examples:
a. Published information. Technical directories, buyer
indexes, U.S. government publications, reference books, 1. A conference of various people who are thought to have good
and trade journals offer a wealth of information. For information or bases for estimating the quantity in question. A
instance, Standard and Poor’s Industry Surveys gives special version of this is the Delphi method, which involves cycles
monthly information regarding key industries. The Statistical of questioning and feedback in which the opinions of individual
Abstract of the United States is a remarkably participants are kept anonymous.
comprehensive source of cost indexes and data. The 2. Comparison with similar situations or designs about which there is
Bureau of Labor Statistics publishes many periodicals that more information and from which estimates for the alternatives
are good sources of labor costs, such as the Monthly Labor under consideration can be extrapolated. This is sometimes called
Review, Employment and Earnings, Current Wage estimating by analogy. The comparison method may be used to
Developments, Handbook of Labor Statistics, and the approximate the cost of a design or product that is new. This is
Chartbook on Wages, Prices and Productivity. done by taking the cost of a more complex design for a similar item
b. Personal contacts are excellent potential sources. as an upper bound and the cost of a less complex item of similar
Vendors, salespeople, professional acquaintances, design as a lower bound. The resulting approximation may not be
customers, banks, government agencies, chambers of very accurate, but the comparison method does have the virtue of
commerce, and even competitors are often willing to furnish setting bounds that might be useful for decision making.
needed information on the basis of a serious and tactful 3. Using quantitative techniques, which do not always have
request. standardized names. Some selected techniques, with the names
4. Research and development (R&D). If the information is not used being generally suggestive of the approaches, are discussed
published and cannot be obtained by consulting someone, the only in the next section.
alternative may be to undertake R&D to generate it. Classic
examples are developing a pilot plant and undertaking a test market
program.
II. Selected Estimating Techniques (Models)
The Internet can also be a source of cost-estimating data, though you
should assure yourself that the information is from a reputable source. Indexes
The following Web sites may be useful to you both professionally and
personally. The cost of a product or service is the total of the resources, direct and
indirect, required to produce it. The price is the value of the good or
service in the marketplace. In general, price is equal to cost plus a profit.
Construction
Engineering News- Costs and prices vary with time for a number of reasons, including (1)
www.enr.com and labor
Record technological advances, (2) availability of labor and materials, and (3)
costs
Automobile inflation. An index is a dimensionless number that indicates how a cost or
www.kbb.com Kelley Blue Book a price has changed with time (typically escalated) with respect to a base
pricing
www.factsonfuel.co American Petroleum year. Indexes provide a convenient means for developing present and
Fuel costs future cost and price estimates from historical data.
m Institute

How Estimates are Accomplished

 Where;

Estimate cost formula or the ratio technique of updating costs and M = total number of items in the index (1 ≤ m ≤ M);
prices:
Cnm = unit cost (or price) of the mth item in year n;

C n=C k
()
In
Ik
Ckm = unit cost (or price) of the mth item in year k;

Wm = weight assigned to the mth item;

Where;
Ik = composite index value in year k.
k = reference year (e.g., 2000) for which cost or price of item is
known;

n = year for which cost or price is to be estimated (n > k);

Cn = estimated cost or price of item in year n;

Ck = cost or price of item in reference year k.

Use of this technique allows the cost or potential selling price of an item to
be taken from historical data with a specified base year and updated with
an index.

The general weighted index is given by:

I n=
W1
( ) ( )
Cn 1
Ck 1
+W 2
Cn2
Ck 2
+...+W M
( )
C nM
CM 2 Unit Technique
W 1 +W 2 +...+W M
The unit technique involves using a per unit factor that can be estimated
effectively. Examples are as follows:

1. Capital cost of plant per kilowatt of capacity

2. Revenue per mile
3. Capital cost per installed telephone
4. Revenue per customer served
5. Temperature loss per 1,000 feet of steam pipe
6. Operating cost per mile
7. Construction cost per square foot

Factor Technique

The factor technique is an extension of the unit method in which we sum

the product of several quantities or components and add these to any
components estimated directly.

C=∑ C d + ∑ f m U m
d m

Where;

C = cost being estimated;

Cd = cost of the selected component d that is estimated directly;

fm = cost per unit of component m;

Um = number of units of component m.

 Power-Sizing Technique

The power-sizing technique, which is sometimes referred to as an

exponential model, is frequently used for developing capital investment
estimates for industrial plants and equipment.

( )
x
CA S A
=
CB SB

III. Parametric Cost Estimating

Parametric cost estimating is the use of historical cost data and statistical
techniques to predict future costs.

Parametric models are used in the early design stages to get an idea of

how much the product (or project) will cost, on the basis of a few physical
attributes (such as weight, volume, and power).
Learning and Improvement

A learning curve is a mathematical model that explains the phenomenon

of increased worker efficiency and improved organizational performance
with repetitive production of a good or service. The learning curve is
sometimes called an experience curve or a manufacturing progress
function; fundamentally, it is an estimating relationship.

Most learning curves are based on the assumption that a constant

percentage reduction occurs in, say, labor hours, as the number of units
produced is doubled.

To compute resource requirement

Zu =K ( ux )
Developing a Cost Estimation Relationship P = present sum of money; the equivalent value of one or more
cash flows at a reference point in time called the present;
A CER is a mathematical model that describes the cost of an engineering
project as a function of one or more design variables. CERs are useful F = future sum of money; the equivalent value of one or more cash
tools because they allow the estimator to develop a cost estimate quickly flows at a reference point in time called the future;
and easily.
A = end-of-period cash flows (or equivalent end-of-period values) in
Four basic steps in developing a CER: a uniform series continuing for a specified number of periods,
starting at the end of the first period and continuing through the last
1. Problem definition period.
2. Data collection and normalization
3. CER equation development II. Relating Present and Future Equivalent Values of Single
4. Model validation and documentation Cash Flows

Lesson 4: The Time Value of Money Finding F when given P

I. Simple and Compound Interest F=P ( 1+ i )

N

Simple Interest
( 1+i )N – is a single payment compound amount factor.
I =PNi
Finding P when given F
Where;
( )
N
1 −N
P=F =F ( 1+i )
P = principal amount lent or borrowed; 1+i

N = number of interest periods (e.g., years); ( 1+i )− N – is the single payment present worth factor
i = interest rate per interest period. Finding the Interest Rate given P, F, and N

Compound Interest
i=
√
N F
P
−1

N
F=P ( 1+ i )

Where;

i = effective interest rate per interest period;

N = number of compounding (interest) periods;

Finding N when given P, F, and i

N=
log ( FP )
log ( 1+i )

III. Relating a Uniform Series (Annuity to its Present and

Future Equivalent Values

Finding F when given A

F= A [ ( 1+i )N −1
i ]
[ ]
( 1+i ) N −1
i
– is the uniform series compound factor
Finding A when given F

A=F
[ i
( 1+i )N −1 ]
[ i
( 1+i ) N −1 ]
– is the sinking fund factor

Finding A when given P

[ ]
N
i ( 1+i )
A=P
( 1+i )N −1

[ ]
N
i ( 1+i )
– is the capital recovery factor
( 1+i ) N −1

IV. Summary of Interest Formulas and Relationships of

Discrete Compounding
Find Given Formula Factor name (bracket)
SI PNi I =PNi
CI PNit N
F=P ( 1+ i )
Single Cash Flows

F P ( 1+ i )
N is a single payment compound amount
P
factor
−N
F ( 1+i ) is the single payment present worth
P F
Finding P when given A factor
i √ F / P−1
N

[ ] ( FP )
N
( 1+i ) −1 log
P= A N N
i ( 1+i )
log ( 1+ i )

[ ]
( 1+i ) N −1 Uniform Series
N
– is the uniform series present worth factor
i ( 1+i )
 F A A [ ( 1+i )N −1
i ] is the uniform series compound factor

P A A
[
( 1+i )N −1
i ( 1+ i )
N
] is the uniform series present worth
factor

A F F
[ i
( 1+i )N −1 ] is the sinking fund factor

[ ]
N
i (1+i )
A P P is the capital recovery factor
( 1+i ) N −1

V. Deferred Annuities (Uniform Series)

Ordinary Annuities are the first cash flow being made at the end of the
first period.

Deferred Annuity are the cash flow does not begin until some later date.
 Finding A when given G

A=G
[ 1
−
N
i ( 1+ i )N −1 ]
[ 1
−
N
i ( 1+i )N −1]– is the gradient to uniform series conversion factor

Finding F when given G

{[ ]}
N
1 ( 1+i ) −1
F=G −N
i i

VI. Uniform (Arithmetic) Gradient of Cash

Finding P when given G (uniform gradient amount)

{[ ]}
N
1 ( 1+i ) −1 N
P=G N
− N
i i ( 1+i ) ( 1+i )

{[ ]}
N
1 ( 1+i ) −1 N
N
− N – is the gradient to present equivalent conversion
i i ( 1+i ) ( 1+i )
factor
 VII. Interest may Vary with Time Nominal and Effective Interest
Rates

The present equivalent value of a cash flow occurring at the end of period
N can be computed using Equation (4-31), where ik is the interest rate for
the kth period (the symbol Π means “the product of”):

FN
P= N

∏
k =1
( 1+i k )

VIII. Nominal and Effective Interest Rates

Relationship between nominal and effective interest rate

( ) −1
M
r
i= 1+
M

IX. Interest Formulas for Continuous Compounding and

Discrete Cash Flows