36
IT-390
Cost Estimating Handouts
Table of Contents
Reference
Page Number
Chapter I Introduction 3
Types Of Estimates 3 Chapter II Labor Analysis 4
Variable & Fixed Labor Costs 4
Standard Direct Labor Cost vs. Actual Direct Labor Cost 4
Chapter III Material Analysis 6
Variable & Fixed Material Costs 6
Impact Of Repetition On Material Cost - The Learning Curve 6
Standard Direct Material Cost vs. Actual Direct Material Cost 6
Chapter IV Accounting Analysis 7
The Accounting Cycle 7
Cost Breakdown 7
Cost Behavior 8
Overhead (Burden) 8
High-Low Method for Overhead Cost Segregation 10
Chapter V Forecasting 12
Linear Least Squares Regression 12
Curvilinear Least Squares Regression 12
Cost Indexes 13
Chapter VI Preliminary and Detailed Methods 15
Time and Cost Estimating Methods - The Learning Curve 15
Power Law and Sizing Model 17
Chapter VII Operation Estimating 18
Uses Of Operation Cost Information 18
Chapter VIII Product Estimating 20
Product Standard Cost Estimating vs. Learning Curve Cost Estimating 20
Product Standard Cost Estimating (Estimating For High Volume - Low Cost Items) 20
Break-Even and Cost-Volume-Profit Analysis (For High Volume - Low Cost Items) 25
Product Learning Curve Cost Estimating (Estimating For Low Volume - High Cost Items) 27
Break-Even and Cost-Volume-Profit Analysis (For Low Volume - High Cost Items) 30 Constructing a Composite Learning Curve 30
Chapter IX Project Estimating 31
Important Cash Flow Formulas 31
The Impact Of Taxes 33
Project Evaluation Format & Methodology 35
Project Evaluation & Ranking Techniques 37
Chapter X System estimating --
Revised: 10/98
Chapter I
Introduction to Cost Estimating
* Types of Estimates
A. Operation Estimate: The process of producing a change in value or a way of working establishes the content of an operation estimate. An operation estimate is a forecast of labor and material required for an operation design. The design may be a toy or radio or building, and work, a worker, and a tool are involved. The definition of an operation estimate includes one worker with one tool, one worker with multiple machines , or crew work. The definition is appropriate for the factory, construction site, office, service station, hospital, or government.
B. Product Estimate: In a product estimate an entire product, rather than subassembly or component part (i.e., and operation design & operation estimate), is estimated. A component part refers to the smallest component of a product subassembly. A subassembly, composed of two or more parts, may be joined with other subassemblies to ultimately form a complicated product. In a product estimate there is duplication and production of the same item. Volume may range from two items to many millions of items. Some suggested product designs and estimates would be for automobile production, suitcase production, and pre-stressed concrete beam production.
C. Project Estimate: A project estimate, whether the design is a plan, plant, equipment, capital tooling for a product, or a prototype, is one of a thing. The design is custom and there will be only one manufactured or constructed. Usually, the dollar amount is considered capital rather than expense. That is, it normally involves capitalization of the money expended. The money expenditure required to do the project is capitalized and carried as an asset on the books of the company and then depreciated over future time periods in order to better match income with expenses. Project designs usually require a significant period of time for manufacturing or construction. Examples are: a high-rise apartment building, bridge construction, and an airplane. Methods used in project estimating are essentially different from those used for other types of estimates; however, they may require operation and product estimates as input information.
Another distinction between product and project estimating is found in the buyer-seller viewpoint. For example, if a factory producing numerically controlled machine tools were manufacturing many units, the factory cost estimator would associate the problem with product design and use methods of product estimating. However, an estimator in evaluating the machine for purchase would approach the problem as a project design because of the single object and apply methods of project estimating.
D. System Estimate: System estimating involves elements of operations, products, and/or project designs and is the most comprehensive. The fundamental characteristic of a system design is configuration. In our terminology the system design deals in the public, government, or not-for-profit domain of enterprise. In these areas there are factors that are political, altruistic, and provide for general needs and goals of society. Profit is not determined explicitly for the system estimate. One example of a system design is a public rapid transit system and the estimator represents the public authority spending the money.
Chapter II
Labor Analysis
* Variable & Fixed Labor Costs: Some costs vary in total as volume of activity increases or decreases. These are known as variable cost because they characteristically change in total as volume changes. An example of variable costs would be direct labor. Direct labor employees being those employees that work directly on converting raw material or components into the finished product. The more units produced the more labor hours, and therefor people, that must be used in production. Conversely, if production is decreased, these employees can be discharged and the total labor cost decreased. The characteristic of variable cost is that it is constant on a per unit basis but varies in total amount dependent upon total volume. Direct labor is almost always considered to be a variable cost.
Example: If the standard direct labor rate for an operation is $9.00/hour and the production standard for the particular operation is 100 pieces/hour, then:
Standard Direct Labor Cost/Unit = $9.00/100 = $.09 Each Unit
and, depending on total volume, total cost would be as follows:
100 Units Produced = (100 units)($.09 each) = $ 9.00 Total
1,000 Units Produced = (1,000 units)($.09 each) = $ 90.00 Total
1,000,000 Units Produced = (1,000,000 units)($.09 each) = $90,000.00 Total
However, unit cost is constant in each case at $.09 each unit
Fixed costs, on the other hand, are constant in total, irrespective of the total volume, but vary on a per unit basis dependent upon the volume of production. An example of fixed cost would be the salary of the plant manager. His contract amount will probably not change if 1,000 or 1,000,000 units are produced in a year. As production volume increases his cost to the organization will not change. It is fixed with respect to volume of activity. The plant manager would be considered a fixed cost and the salary amount would be an overhead or burden account. Fixed costs are constant in total amount but vary on a per unit basis dependent upon the volume of activity or production.
Example: If the Plant Manager’s annual salary is $60,000/Year then the total is fixed at that level and does not vary or change as volume may change. However, if we look at the prorated cost (i.e., on a per unit basis) we will see that the cost depends on the volume level.
$60,000 Annual/100 Units Produced = $600.00 Each Unit
$60,000 Annual/1,000 Units Produced = $60.00 Each Unit
$60,000 Annual/1,000,000 Units Produced = $.06 Each Unit
* Standard Direct Labor Cost vs. Actual Direct Labor Cost: Standard direct labor cost is the amount it should cost at an operation or for a finished product if the employee(s) worked at 100% to standard. That is if the employee(s) worked at 100% tempo or pace. Standard cost is what it should cost if everything were to go as designed. Standard cost is the benchmark or starting point for many estimating activities.
In contrast, actual cost is what it will or has cost in the past and it reflects inefficiencies that occur in any process. For example, employees do not always perform at 100% or at standard for a variety of reasons. Therefor, actual and standard cost are seldom the same. For estimating, if we know that employee efficiency is historically 80% to standard, then we can adjust standard cost by a factor of 100/80 = 1.25 to determine what actual cost might be.
An example should help clarify this.
Standard Direct Labor Time = 1.000 labor hour/unit (i.e., 100% Operator Performance)
Standard Direct Labor Rate = $10.00/hour
Standard Direct Labor Cost = (1.000 hour)($10.00/hour) = $10.00/unit (i.e., 100% Performance)
If, Historical Performance To Standard Is 80%, then
Actual Direct Labor Cost = $10.00/.80 = $12.50/unit
Chapter III
Material Analysis
* Variable & Fixed Material Costs: Variable and fixed material costs are similar to variable and fixed labor costs. Some material cost vary as volume varies. For example, the raw material that is actually in the product is considered direct material. It cost a certain amount for the material that is actually in each unit produced. If we do not make a unit then we need not pay for the material. But the more units made, then the higher the total direct material cost. Direct material cost is a variable cost because it changes in total dependent upon volume, but is fixed on a per unit basis.
For example, if standard usage is 1 lb./unit and it cost $10.00/lb, then:
Standard Direct Material Cost/Unit = (Amount Used)(Cost Per Measure)
Standard Direct Material Cost/Unit = (1 lb./unit)($10.00/lb.) = $10.00 Each Unit
and, depending on total volume, total direct material cost would be as follows:
100 Units Produced = (100 units)($10.00 each) = $1,000. Total
1,000 Units Produced = (1,000 units)($10.00 each) = $10,000. Total
1,000,000 Units Produced = (1,000,000 units)($10.00 each) = $10,000,000. Total
However, unit cost is constant in each case at $10.00 each unit
Fixed material cost is just the opposite. It is fixed in total but varies on a per unit basis dependent upon volume.
Example: If office supplies cost about $10,000 annually, then the total is fixed at that level and does not vary or change as volume may change. However, if we look at the prorated cost (i.e., on a per unit basis) we will see that the cost depends on the volume level.
$10,000 Annual/100 Units Produced = $100.00 Each Unit
$10,000 Annual/1,000 Units Produced = $10.00 Each Unit
$10,000 Annual/1,000,000 Units Produced = $.01 Each Unit
* Impact Of Repetition On Material Cost - The Learning Curve: Material does not learn
anything. However, the cost of material may exhibit a decrease as volume of production increases because management and employees learn how to make better use of materials (i.e., less scrap). Management also learns how to improve design and to use substitute materials that cost less and provide better utility. Therefor, material costs may decrease over time and exhibit the same characteristic as does labor. The learning curve is particularly important with respect to material costs for relatively low volume, high cost items.
* Standard Direct Material Cost vs. Actual Direct Material Cost: Standard direct material cost is the amount it should cost at an operation or for a finished product if the standard or planned amount of material were used. For example, if standard usage is 1 lb./unit and it cost $10.00/lb, then:
Standard Direct Material Cost/Unit = (1 lb./unit)($10.00/lb.) = $10.00 Unit
Actual Direct Material Cost/Unit is what it will or has historically cost. If actual cost or material usage has historically been 20% higher than standard or planned then we can adjust standard to actual for estimating purposes as follows:
Actual Direct Material Cost/Unit = ($10.00/unit)(1.20) = $12.00/Unit
Chapter IV
Accounting
* The Accounting Cycle: The accounting cycle is the sequence of accounting activities that occur over a period of time. In general it will flow as follows:
1. Record business transactions
2. Record income and expenses for the period
3. Measure profit or loss for the period by generating an Income Statement
4. Transfer profit or loss to the appropriate Balance Sheet Account
5. Publish the Income Statement
6. Publish the Balance Sheet Statement
Note:
* The Balance Sheet - Is a statement of the financial position or condition as of a point
in time. (example, As of December 31, 1996)
* The Income Statement - Is a measure of the results of business operations for a
period of time. (example, January 1 through December 31, 1996)
* Cost Breakdown: Typically, costs in a manufacturing business can be depicted as follows:
Variable Costs:
Standard Direct Labor Cost/Unit
Standard Direct Material Cost/Unit
Standard Variable Overhead Cost/Unit
Fixed Cost:
Standard Fixed Overhead Cost/Unit
Note: There are additional costs for marketing, sales, and administrative that could also be divided into variable and fixed components.
* Cost Behavior: We have already covered variable cost and fixed cost as related to direct labor and direct material. There is an additional category of cost recognized as semivariable cost. Semivariable costs contain both a variable and fixed component. That is, as volume goes up, costs also increase, but not on a direct one-to-one basis. Semivariable costs have to do with overhead. The two components of overhead (i.e., variable & fixed) actually contain the semivariable component mentioned above. The high-low method will clarify how the overhead is divided into the variable and fixed component.
We have already looked at direct labor and direct material. Both of these are variable costs. The remaining category is overhead which actually contains three characteristics with respect to volume. The following accounts typically fall into these categories.
Variable Factory Overhead:
Supplies Spoilage & Salvage Factory Traveling Costs
Fuel Receiving Costs Communication Costs
Power Hauling Within Plant Overtime Premium
Small Tools Royalties Payroll Taxes
Fixed Factory Overhead:
Salaries of Managers Taxes on Plant Equipment Maintenance on Building
Depreciation Patent Amortization Insurance-Property
Taxes on Real Estate Wages of Watchmen & Janitors Rent
Semivariable Factory Overhead:
Supervision Office services Compensation Insurance
Inspection Inventory Services Health & Accident Insurance
Payroll Dept. Services Cost Dept. Services Social Security Taxes