Costs and Cash Flows Estimation

Engineering Economic Analysis - Seven Steps 1. Recognition and formulation of the problem. 2. Development of the feasible alternatives. 3. Development of the net cash flows (and other prospective outcomes) for each alternative. 4. Selection of a criterion (or criteria) for determining the preferred alternative. 5. Analysis and comparison of the alternatives. 6. Selection of the preferred alternative. 7. Performance monitoring and post-evaluation.

Developing Net Cash Flows for Each Alternative Because engineering economy studies deal with outcomes that extend into the future, estimating the future cash flows for feasible alternatives is a critical step in the analysis procedure.

An Integrated Approach for Estimation 1. Baseline –consistent point of reference used to compare alternatives (e.g., do nothing alternative) 2. Analysis period –Study period determined based on Life-Cycle, Tax Life, Useful life, etc

An Integrated Approach (cont’d) 3. Work Breakdown Structure (WBS) –technique for explicitly defining, at successive levels of detail, the work elements of a project and their interrelationships 4. Cost and Revenue Structure (Classification) –delineation of cost and revenue categories and elements that will be estimated in developing the cash flows. 5. Estimating Techniques (Models) –select mathematical models used to estimate the future costs and revenues during the analysis period.

Integrated Approach Describe project using Work Break- down Structure form Determine - perspective (owner) - baseline - study period Determine cost/rev. categories Describe first feasible alternative

Determine WBS levels for estimating estimating techniques (models) Search revenue/cost sources Develop cash flows Describe next alternative Done? Yes No End

Work Breakdown Structure (WBS) This technique 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 all project work elements and their interrelationships, –collecting and organizing information, –developing relevant costs and revenue data, and –integrating project management activities. Describe project using Work Break- down Structure form

WBS Example Level A : Coal-Fired Power Plant Level A-1: Site Level A-1-A: Land Improvements Level A-1-B: Roads, Parking, and Paved Areas Level A-1-C: Railroads Level A-2: Boiler Level A-2-A: Furnace Level A-2-B: Pressure Vessel Level A-2-C: Heat Exchange System Level A-3: Boiler Support System Level A-3-A: Coal Transport System Level A-4: Coal Storage Facility … Level A-9: Project Integration Level A-9-A: Project Management Level A-9-B: Environmental Management

Cost and Revenue Structure This second basic component is used to –identify and –categorize the costs and revenue that need to be included in the analysis. We use –the Life-Cycle Concept, and –the Cost and Revenue Checklist Determine cost/rev. categories

Cost and Revenue Structure Checklist 1. Capital investment – Fixed capital investment, such as for design and feasibility studies, design and engineering, land purchase and improvement, buildings, equipment, installation, promotional and legal fees, and start-up costs. – Working capital, such as for inventories, accounts receivable, cash for wages, materials. 2. Labor costs, as a function of skill level, labor supply, time required. Standards for the normal amount of output per labor hour have been developed for many classes of work.

Checklist (cont’d) 3. Material costs 4. Maintenance costs 5. Property taxes and insurance 6. Quality (and scrap) costs

Checklist (cont’d) 7. Overhead costs costs that cannot be conveniently charged to products or services normally prorated among the products or cost centers on some arbitrary basis 8. Disposal costs 9. Revenues 10. Salvage or market values

Estimating Techniques (Models) 1. Order of magnitude estimates –used in the planning and initial evaluation stage of a project –accuracy in the range of +/- 30% to 50% 2. Semi-detailed or budget estimates –used in the preliminary or conceptual design stage of a project –accuracy is about +/- 15% 3. Definitive or detailed estimates –used as a basis for bids and to make details design decisions –accuracy is about +/-5% Determine WBS levels for estimating estimating techniques (models)

Factors involved in choosing a level of detail 1. Time and effort available and justified by the importance of the study. 2. Difficulty of estimating the items in question. 3. Methods and techniques employed. 4. Qualification of the estimator(s). 5. Sensitivity of study results to particular factor estimates.

Sources of Estimating Data 1. Accounting records. 2. Other sources within the firm. –a number of people and records in engineering, sales, production, quality, purchasing, and personnel can help 3. Sources outside the firm –Published information, such as technical directories, buyers indexes, U.S. government publications, reference books, trade journals –Personal contacts, such as vendors, salespeople, customers, and even competitors 4. Research and Development Search revenue/cost sources

Estimating Techniques Indexes Unit Technique Factor Technique Estimating Relationships –Power-Sizing Technique –Learning Curve

Indexes An index is a dimensionless number that indicates how a cost or a price has changed with time (typically escalated) with respect to the base year. C n = cost or selling price of an item in year n C k = cost or price of the item at an earlier point in time (say year k ) I n = index value in year n I k = index value in year k C n = C k (I n /I k ) Do Problem 1

Example 1 A certain index for the cost of purchasing and installing utility boilers is keyed to 1974, where its baseline value was set at 100. Company XYZ installed a 50,000 lb/hr in 1989 for $350,000 when the index had value of 312. This same company must install another boiler of the same size in The index in 1996 is 468. Approximate cost of new boiler = C 1996 = $350,000 (468/312) = $525,000

Unit Technique Involves a “per unit factor” that can be estimated effectively. Examples: –Capital cost of a plant per kilowatt of capacity –Revenue per customer served –Operating cost per mile –Construction cost per square foot –Maintenance cost per hour Do problem 2

Example 2 We need a preliminary estimate of the cost of a particular house. Use the factor of, say, $55 per square foot and assume that the house is approximately 2,000 square feet. Estimated cost of the house = $55 x 2,000 = $110,000

Factor Technique The factor technique is an extension of the unit technique C = cost being estimated C d = cost of the selected component d that is estimated directly f m = cost per unit of component m U m = number of units of component m C =  C d +  f m U m d m

Example 3 We need a refined estimate of the cost of the house. Assume that the house is approximately 2,000 square feet of living space, has one porch and two garages Use the factor of, say, $50 per square foot of living space, $5,000 per porch and $8,000 per garage. Estimated cost of the house = $50 x 2,000 + $5,000 + ($8,000 x 2)= $121,000

Next Time We Consider more Models Determine WBS levels for estimating estimating techniques (models) Search revenue/cost sources Develop cash flows Describe next alternative Done? Yes No End

WBS (cont’d) WBS is essential in – ensuring the inclusion of all work elements, –eliminating duplications and overlaps between work elements, –avoiding non related activities. Both –functional, e.g., logistical support, project management, marketing, engineering, systems integration, and –physical, e.g., elements making up structure and product, piece of equipment like labor, materials work elements are included.

Order of magnitude estimates used in selecting feasible alternatives for the study provide accuracy in the range of +/- 30% to 50% developed through semi formal means such as conferences, questionnaires, etc.

Semi-detailed or budget estimates compiled to support the preliminary design effort and decision making accuracy list in the range of +/- 15%

Definitive or detailed estimates used as a basis for bids and to make details design decisions. their accuracy is about +/-5% they are made from specifications, drawings, site surveys, vendor quotations, in-house historical records

Indexes (cont’d) Costs and prices vary with time for a number reasons –technology advances –availability of labor and materials –inflation Indexes provide a convenient means for developing present and future cost estimates from historical data Many indexes are periodically published. – Engineering News-Record Construction Index – Statistical Abstract of the United States