003 Estimating Material

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welcomes you to the world of

TOTAL COST MANAGEMENT

Arabian Gulf Section

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Cost Estimating - Session # 03

Chapters 09, 10 & 11

Prepared & Compiled by :

Nihmathullah K. Lebbe CC E, MACostE, AIQS(Affil.)

Arabian Gulf Section


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Profile of Subject Matter Expert

Nihmathullah K. Lebbe CCE, MACostE, AIQS(Affil)Manager - Quantity Surveying

MUSHRIF Trading & Contracting Co WLL

Telephone Nos : +973-39781001, +973-36629165

E-mail ID : [email protected], [email protected]

Nihmathullah Kalanther Lebbeis a Professional Quantity Surveyor & Cost Engineer

with a Bachelors Degree in Architectural Engineering- USA, Civil Engineering

Technology from University of Moratuwa - Sri Lanka, various PG studies in Construction

Cost & Contract Management

Nihmathullahis a Certified Cost Engineer (CCE), Professional Quantity Surveyor who is

also member of various International professional associations such as AACEI, RICS,

PMI, ACostE (UK), AIQS, NCMA.

Nihmathullahhas more than 17 years of experience in the fields of Construction Cost &

Contract Management. His expertise covers various Mega Projects such as Power

Plants, Process Plants, Oil&Gas, Industrial, High-rise Buildings, Infrastructure projects.

He is currently the Director Education (Bahrain) for the AACEI- Arabian Gulf Section.

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Presented by,

Josue E. Garcia, CCE

Estimating Engineer Saudi Aramco

P O Box 5397, Rastanura 31311

Ph. Off : 880 9029

Mob : 0565529730

E-mail: [email protected]


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Chapter 9 Estimating

Introduction / Learning Objectives Understand the objectives of generating an estimate.

Understand the various classifications of estimates.

Familiarize the requirements for various estimates.

Understand the timing of the estimate and its importance.

Why qualified resources are essential for a quality estimate.

Why scope definition is important for any estimate.

Understand the application of accuracy ranges for various estimates and itsimportance.

Why corporations set a typical methodology for generating estimates.

The importance of estimate analysis.

Understand the application of allowances within estimates.

Why contingency and risk analysis are undertaken. Understand the need for Work Breakdown Structure.

Importance of estimate and schedule integration.

Importance of basis of estimate.

Importance of estimate reviews.

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Cost Estimating

A predictive process used to quantify, cost, and price the resources

required by the scope of an asset investment option, activity, or project.

As a predictive process, estimatingmust address risks and uncertainties.

The outputs of estimating are used primarily as inputs for budgeting, cost or

value analysis, decision making in business, asset and project planning, or

for project cost and schedule control processes.



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Estimating Methodologies

Conceptual estimating methodologies require significant effort in data

gathering and methods development before estimate preparation begins

Deterministic estimating methods require a high degree of precision in

determination of quantities, pricing, and the completeness of scope

definition.


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Estimate (AACE):

A compilation of all the costs of the elements of a project or effort includedwithin an agreed upon scope.

Estimate Types:



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Order of Magnitude Estimate

An estimate made without detailed engineering data. Some examples would be: an estimatefrom cost capacity curves, an estimate using scale-up or down factors, and an approximateratio estimate. It is normally expected that an estimate of this type would be accurate within(plus) +50 percent or (minus) -30 percent.

Purpose: Feasibility of a project Establishing the probable costs of a program budget; Evaluating cost consequences of proposed design modifications; Selection / Screening from a number of alternative designs/projects Selection from alternative Investments Updating a previously prepared order-of-magnitude estimate; Establishing a preliminary budget for control purposes during the design phase

Order-of-magnitude estimates are based on limited information and are thus subject to

considerable variation. Their accuracy also depends on the amount and quality of information

available as well as the judgment and experience of the estimator.

The order-of-magnitude estimate category encompasses a number of methods.

More commonly used methods are:

End-product units, scale-of-operations, various ratio or factor methods, physical dimensions,

and parametric.


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Order of Magnitude Estimate

Order-of-magnitude estimates are sometimes referred to as conceptual or ballparkestimates. They have a wide range of accuracy, and have important applications, such asusing them to determine the feasibility of a project quickly or to screen several types ofalternative designs.

Estimates made without detailed engineering data, such as an estimate made from costcapacity curves, an estimate using scale-up or scale-down factors, and an approximate ratioestimate.

These estimates are generally prepared using only basic criteria such as:

desired output, total square meters, or number of units

For Buildings the most typical measure is square meters of floor area or cubic meters ofvolume.Roadways are usually defined by kilometer of a particular type of surface.Process and power plants, the order-of-magnitude may be expressed in plant capacity forinput and/or output.



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Budget Estimate

Budget in this case applies to the owner's budget and not to the budget as a project controldocument. A budget estimate is prepared with the use of flow sheets, layouts and equipmentdetails. It is normally expected that an estimate of this type would be accurate within ( plus)+30 percent or (minus) - 15 percent.

Purpose: Establishing probable cost of a budget Evaluating general feasibility of a project Evaluating cost consequences of proposed modifications Establishing preliminary budget for control during design Screening a number of alternative projects

Timing During the planning or development phase of the project. Little or no design completed. Basic criteria such as units of output or area are known.

Why they may failInexperienced Project Managers & EstimatorsLack of Definitive Project ScopeGiving out Off-The-Cuff CostNot employing the Estimating DepartmentLimited Budget for Estimate Preparation


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Budget Estimate

The wordbudgetapplies to the owners budget and not to the budget as a project controls.

Budget estimates are prepared with the help of flow sheets, layouts, and equipment details.In other words, enough preliminary engineering has taken place to further define the projectscope.

Budget estimates are also called design development, semi-detailed, appropriation, orcontrol estimates.

Since the budget estimate is more definitive than the order-of-magnitude estimate, it is bettersuited for determining project feasibility and establishing definitive budgets.

The accuracy and usefulness of a budget estimate depends, to a large extent, on the amountand quality of information available.



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Definitive Estimate

As the name implies, this is an estimate prepared from very defined engineering data. Theengineering data includes as a minimum, nearly complete plot plans and elevations, pipingand instrument diagrams, one line electrical diagrams, equipment data sheets andquotations, structural sketches, soil data and sketches of major foundations, buildingsketches and a complete set of specifications.

This category of estimate covers all types from the minimum described above to themaximum definitive type which would be made from "approved for Construction" drawingsand specifications. It is normally expected that an estimate of this type would be accuratewithin (plus) +15 percent and (minus) -5 percent.

Purposes

Firm Price Bid

Detailed Control Budget Cost Reporting & Control

Final Feasibility Review


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Definitive Estimate

Prepared from very defined engineering data such as:

Fairly complete plot plans and elevations,

Piping and instrument diagrams,

Single-line electrical diagrams,

Equipment data sheets and quotations,

Structural sketches

Soil data and sketches of major foundations,

Building sketches, and a complete set of specifications.

Thedefinitive estimateincludes various degree of detail estimates which could be madefrom approved for construction drawings and specifications.

These estimates are also known as check, lump sum, tender, and post-contractchange estimates.



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Types of Estimates and Applications

There are numerous characteristics that can be used to categorize cost estimate types. Themost significant characteristics are degree of project definition, end usage of the estimate,estimate methodology, as well as the effort and time needed to prepare the estimate.

In 1998, AACE International published a new Recommended Practice 18R-97 CostEstimate Classification System For the Process Industries The primary characteristicused in this practice to define the estimate class is the degree of project definition.

The primary characteristic is based upon percent complete of the project definition (roughlycorresponding to percent complete of engineering).

The new AACE estimate classes and ANSI Standard Chapter 2 addresses Order-of-

Magnitude Estimate, which corresponds to AACE Class 5 estimate.

Chapter 3 focuses on Definitive Estimate, which relates to AACE Class 1 and Class 2

estimates.


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Cost Estimate Classification Matrix for the Process Industries



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Capacity Factored Estimating Method

Use of historical data

Typically used against large project elements such as processplant, utilities and infrastructure

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nC2 = C1

A2

A1

C1 = Historical Capital Cost

C2 = Proposed Capital Cost

A1 = Historical Capacity

A2 = Proposed Capacity

n = Variable (Historical Value)


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Example

Develop the estimated cost to construct a new 1,200M2 control room in Jizan

A recent project involved the construction of a 1,500 M2

control room at a cost of $ 3.5 MM.

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C1 = $ 3.5 MMA1 = 1,500A2 = 1,200n = 0.6

Develop C2

C2 = $ 3.5MM1,200

1,500

0.6

C2 = $ 3.5MM (0.800)0.6 = $ 3.06 MM

nC2 = C1

A2

A1

The standard value for n is 0.6 (Six Digit Formula)


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Direct CostsConstructionCost of installed equipment, material and labor directly involved in the physical constructionof the permanent facility .

ManufacturingService and other non-construction industries, the portion of operating costs that isgenerally assignable to a specific product or process area .

Indirect CostsConstruction

All costs which do not become a final part of the installation, but which are required for the

orderly completion of the installation and may include, but are not limited to, fieldadministration, direct supervision, capital tools, startup costs, contractor's fees, insurance,taxes, etc .

ManufacturingCosts not directly assignable to the end product or process, such as overhead and generalpurpose labor, or costs of outside operations, such as transportation and distribution.Indirect manufacturing cost sometimes includes insurance, property taxes, maintenance,depreciation, packaging, warehousing and loading. In government contracts, indirect cost isoften calculated as a fixed percent of direct payroll cost .


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Types of Overhead

Home Office Overhead (Often called G&A Expenses)

General Overhead-the fixed cost in operation of a business.General overhead is also associated with office, plant, equipment, staffing, and expensesthereof, maintained by a contractor for general business operations. The costs of generaloverhead are not specifically applicable to any given job or project.

Project Overhead (General Conditions)

Field Cost - Engineering and Construction costs associated with the construction siterather than with the home office.

Home Office Cost - Those necessary costs involved in the conduct of everydaybusiness, which can be directly assigned to specific projects, processes, or end products,such as engineering, procurement, expediting, legal fees, auditor fees inspection, estimating,cost control, taxes, travel, reproduction, communications, etc.

Job OverheadThe expense of such items as trailer, toilets, telephone, superintendent, transportation,temporary heat, testing, power, water, cleanup, and similar items possibly including bond andinsurance associated with the particular project.



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Construction Job Indirect Checklist


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Construction

Job Indirect

Checklist



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Project Risk

Allowances

Additional resources included in estimates to cover the cost of known, but undefined,requirements for an individual activity, work item, account or subaccount.

Contingency

An amount added to an estimate to allow for items, conditions, or events for which thestate, occurrence, and/or effect is uncertain and that experience shows will likely result, inaggregate, in additional costs. Typically estimated using statistical analysis or judgmentbased on past asset or project experience.


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Contingency can include:

Planning and estimating errors and omissions,

Minor price fluctuations

Changes within the scope, and

Variations in market and environmental Conditions

Contingency usually excludes;

Major scope changes

Extraordinary events

Management reserves, and

Escalation and currency effects.



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Estimate Documentation:

An estimate should always include written documentation on how it was developed, andwhat is included or excluded. Nature of estimate is order-of magnitude, definitive, a bid, ora study, it almost always becomes a benchmark against which future estimates or costsare measured.

If litigation should develop, a court case can be won or lost based on the information thatwas used to develop an estimate;

It is often difficult to know what information was used and what assumptions were madewhen comparing against an estimate that was developed months or even years before.

To avoid such situations, the following should be included in an estimates preparation.

Estimate Purpose

Scope

Assumptions and Exclusions

Time/Cost Association

Contingency Development

Significant Findings

Review Credits


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The Good Cost Engineer.


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Chapter 10 Process Product Manufacturing

Introduction / Learning Objectives

After completing this chapter, the reader should be able to

Understand how to determine the operating and manufacturing costs of a continuousprocess on a conceptual basis,

Distinguish between direct and indirect costs in manufacturing as compared toconstruction,

Relate operating costs at full production to reduced costs at less than full plant capacity,

And

Understand depreciation rules and their relationship to operating and manufacturing costs.

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Terms to Know Direct costs

Variable costs

Semi-variable costs

Indirect costs or fixed costs

Distribution costs

General and Administrative (G & A) Expenses

Key Points for ReviewPrerequisite of Preparing Operating or Manufacturing Cost Estimate

Process flow sheets with quantity, composition, temperature, pressure etc.

Estimating form serving as a check list,

Obtaining company internal data for similar process

External published data sources but use it with care



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Types of Operating Cost Estimates

The purpose of an operating cost estimate is the controlling factor indetermining the type of estimate to be performed.

Preliminary or order-of-magnitude estimates are often used to screen

projects and to eliminate uneconomical alternatives.

Good judgment is necessary to avoid excessive attention to minor

items, which, even if severely over or underestimated, will not have a

significant effect on the overall estimate.

It is also necessary to calculate costs at reduced production rates as

well as at design capacity.

Operating costs are decidedly nonlinear with respect to production rate.The fact that virtually no plant or process operates all of the time at full

design production rate make it imperative that reduced production ratesbe considered


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Operating Cost Estimates

Operating cost estimates can be performed on a daily, unit of production, or

annual basis. Of these, the annual basis is preferred for the following reasons:

It damps out seasonal variations.

It considers equipment operating time.

It is readily adapted to less-than-full capacity operation.

It readily includes the effect of periodic large costs (scheduledmaintenance, vacation shutdowns, catalyst changes, etc).

It is directly usable in profitability analysis.

It is readily convertible to the other bases, daily cost and unit-of-production, yielding mean annual figures rather



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Variable costs: include the following:

Raw materials,

Utilities,

Royalties (if applicable),

Packaging (if applicable),

Marketing, and

Catalysts and Chemicals.

Semi-variable costs: those which are partially proportional to production level:

Direct labor,

Supervision,

General expense, and

Plant overhead

Fixed-cost items: in addition to royalties if applicable, include the following: Depreciation

Property taxes, and

Insurance.


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Four Ways to Handle Royalties:

Capitalized cost if it is paid in a lump sum,

Fixed cost if it is paid in equal annual increments,

Variable cost if a fee is paid based on per unit of production,

Semi-variable cost if it is paid in a sliding scale (based on per unit of production butdecreases as production increases).

Understand How to Calculate:

Minimum return point

Breakeven point

Shutdown point

Raw Material Costs

External raw material costs

Internal raw material costs transferred at market value or company book value

By Product Credits and DebitsEstimate salable by-product credit from the anticipated selling prices less costs ofprocessing, packaging, selling and transportingto market.

By-product debits include all costs to remove, eliminate, or reduce wastes and pollutants.



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Utility Costs (Total Consumption and Demand) Electricity

Natural gas

Water

Fuel

Equipment losses

Mobile equipment fuels and lubricants

Labor Costs

Straight time

Overtime premium

Supervision

Overhead

Maintenance Costs (Part of Semi-variable Costs)

Direct maintenance labor

Direct maintenance supervision

Maintenance materials

Contract maintenance


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Operating Supplies & Overhead Costs

Operating supplies include lubricant oil, wiping clothes etc

Overhead (burden) costs are associated with payroll or general and administrative expenses.

Expenses of testing and research laboratories

General Work Expense (Factory Overhead)

Indirect cost of operating a plant or factory and is dependent on both investment and labor

Excluding general expense (i.e. marketing or sales cost) and administrative cost.

Depreciation (Treated as Fixed, Indirect Cost) Straight line Method

Double-decline balance method

Accelerated cost recovery system (For US Installation Only)

Modified accelerated cost recovery system (For US Installation Only)

Distribution Costs

Cost of containers

Transportation costs

Applicable labor and overhead for packaging and shipping



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Typical Production

Cost EstimatingForm

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Cost Effects of Operations at Less Than Full Plant Capacity

Point at which the sales and total costlines cross is the breakeven point for theplant and is equal to the level of output atwhich sales is equal to total cost.


Production Rate/year, % Capacity


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Graphically demonstrates the implications of operating at less than full capacity.In this figure, at 100 percent of capacity, the following apply:

Fis the fixed expense;

Vis the variable expense;

Ris the semi-variable expense;

Cis total operating cost;

Sis sales income; and

Nis the income required to achieve the minimum acceptable return on investment before taxes(P) for the capital investment (I).

The variable expense declines to zero at 0 percent of capacity, fixed expense isconstant, and semi-variable expense declines at 0 percent of capacity to from 20to 40 percent of its value at full capacity.

Minimum production rateat which desired return on investment will be achieved (C)

Breakeven point, (point at which income will exactly equal total operating cost) (B)

Shutdown point, or that point at which it is advisable to shut down the plant rather thanoperating at lower production rates (A).


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The plot readily identifies the range of

production rates at which the

following apply:

The return on investment will equal or exceedthe desired minimum (all production rates C);

The return on investment will be less than thedesired value but will be greater than zero(production rates < C b u t > B);

The process will result in a loss, but losses willbe minimized by continuing to operate the plantrather than shutting it down (production rates B but > A);

Losses will become so large that it is lessexpensive to close the plant and pay fixedexpenses out of pocket rather than to continueoperations (production rates A)

The breakeven and shutdown points can alsobe determined mathematically as follows:

B (breakeven point)= (F + nR)

S - V - (1 - n)R

A (shutdown point)= ( nR )

S - V - (1 - n)R

Where

n = decimal fraction of semi-variable costs

incurred at 0 production (usually about 0.3)

Similarly, the total cost line can be expressedas:

Cp = [V + (1 - n)R] p + F + nR

Where

Cp = total cost at production rate pp = actual annual production rate as a

fraction of plant capacity



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Since total annual sales are proportional to production (assuming no stock-piling ofproduction), and, therefore, have no value at zero output, the equation for the sales line is

Sp= ( S x p)

Where

Sp= sales income at production ratep.


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Raw Materials CostsRaw materials costs can constitute a major portion of operating costs.Complete list of all raw materials must be developed using the process flow-sheet as a guide.In developing the raw materials list, the following information must be obtained for each rawmaterial:

Units of purchase (tons, pounds, etc),

Unit cost,

Available sources of the material,

Quantity required per unit of time and/or unit of production, and

Quality of raw materials (concentration, acceptable impurity levels, etc.).

Major factor to be considered in Raw Material CostAppropriate allowance must be made into estimates for:

Losses in handling and storage

Process waste, and

Process yield.

Raw material costs vary with quality (concentration, surface finish of metals, impurities.)

and decrease in unit cost as quantity increases.

Availability of the raw material. Does sufficient productive capacity exist such that the

market can supply the demands of the proposed process?

In pricing raw materials, it must also be remembered that the prices are generally

negotiated & discounts obtained can result in prices substantially less than quoted.



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A Common Notes in Raw materials Cost:

In operating and manufacturing cost estimates is to neglect the cost of raw materialsmanufactured or obtained in-house or from another company division because they arenot purchased.

Fuels that are used as raw materials (eg, natural gas in methane conversion processes)

Periodic makeup of losses to catalysts and other processing materials. In the case ofcatalysts and similar materials

It must be recognized that prices are usually quoted FOB the suppliers plant or basingpoint, not at the point of use.

Thus freight to the point of use & local handling costs must be added to quoted prices.


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Utility CostsRapidly increasing energy costs is a critical area of operating cost estimation.

In estimating utility costs, it is necessary first to determine the requirements for each utilityincluding a reasonable allowance for non-production items, such as plant lighting, sanitarywater, allowance should also be made for miscellaneous usage and contingencies.

Typical utility summary of the nature that is required.



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Utility Costs

If consumption rates fluctuate, utility pricing may be based not only on total consumption,but also in the peak demand rateand, in some cases, the time of day in which the peakoccurs.

Electric power charges are usually based upon a demand factor the maximum power drawduring a 15- to 30-min period in any given month.

A load factor is computed as the ratio of average usage to the demand factor and rates areestablished to give preference to high load factors (i.e., steady consumption).

Natural gas prices depend on quantity required. Steam costs are dependent upon many factors,including pressure, cost of fuel, temperature, credit for heating value of condensate, etc.

Water costs are highly variable depending upon the water quality needed and the quantityrequired. Purification costs, if contamination occurs before disposal, must also be included, asmust cooling costs if the process results in heating of process water.

Water may not be discharged into streams or the natural water table unless it is equal or

better in quality, temperature as when it was withdrawn from the stream

Fuel costs vary with the type of fuel used, Btu value of the fuel, and the source of supply.

Utility consumption generally is not proportional to production due to economies of scale andreduced energy losses per unit of volume or production on larger process units.


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Labor Costs



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Supervision and Maintenance Costs

Supervision costs should be established, through astaffing table and tabulation of associated costs.

Costs of supervision can be roughly estimated bytaking a fixed percentageof direct labor costs basedupon company experience. In the absence of prior dataon similar operations, a factor of 15 to 20 percent isgenerally satisfactory.

One front-line supervisor can effectively manage nomore than 8 to 10 workers,

i.e., supervision work-hours of 0.100 to 0.125 per directlabor work-hour.

Frontline supervision (i.e., foremen) at labor ratesapproximately 50 to 60 percent above general laborrates, 15 to 20 percent supervision factor is evident.

Maintenance costs are often estimated as a fixedpercentage of depreciable capital investment per year.

Complex plantsand severe corrosive conditions, thisfactor can be 10 to 12 percentor higher.

Simple plantswith relatively mild, non-corrosiveconditions, 3 to 5 percentshould be adequate.

Maintenance & Depreciation Costs Over the Plant Life


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Chapter 11 Discrete Product Manufacturing

Introduction / Learning Objectives

Discrete product manufacturing refers to the production of separate, individualproducts.

Whereas continuous manufacturing is concerned with large units to be furtherprocessed.

Discrete manufacturing employs specialized tools for the various products, soset-up and tooling changes are much more frequent in discrete manufacturingthan in continuous manufacturing.

After completing this chapter, the reader should be able to:

Understand the operations, terms and philosophies used in discrete product manufacturing;

Understand basic cost relationships, cost bases, and classification of costs; and

Understand time-based and quantity-based break-even analysis and when it is best to useeach approach.


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Terms to Know


Administrative expense Indirect costs

Contingency Indirect material costs

Cost Indirect labor costs

Cost estimating Indirect engineering costs

Costing (cost accounting) Indirect burden expenses

Direct costs

Direct material costs

Direct labor costs Mark-up Rate (Profit)

Direct engineering costs 1. Gross Profit

Direct burden expenses 2. Operating Profit Factory expense 3. Net Profit

Production Cost

Marketing, selling and

distribution expense

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Key Points for Review


Introduction Production cost

Concurrent engineering Total cost

Computer aided process planning Selling price

Discrete part manufacturing philosophies Cost estimating guide form

Group technology Break-even analysis

Just-in-time Cost bases

Lean manufacturing Time basedMaterials requirements planning Quantity based

Supply chain management Break-even points

Total quality management Shutdown point

Basic cost relationships Cost point

Prime cost Required return point

Manufacturing cost Required return after taxes point


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There are several manufacturing philosophies/techniques introduced during the

last 50 years to assist in reduction of manufacturing costs CAPP Computer aided process planning is able to automatically generate the

process plan to produce component from the component drawing andspecifications

Concurrent engineering is a systematic approach to the integrated, concurrentdesign of products and their related processes, including manufacturing andsupport

Group technology identifies and exploits the underlying sameness of thecomponent parts and manufacturing process

Just-in-time requires the supplies (raw materials) are delivered when required ,and, thus, inventory costs are theoretically driven to zero.

Lean manufacturing leads to shortened lead times, reduced costs and reduceswaste. (Through reducing waste, improving yields, training for employee skills ,improve processes etc)

Material requirements planning uses bills of materials, inventory and open data

order and master production schedule information to calculate requirements formaterials

Supply chain management requires the integration of many different componentsfrom a variety of suppliers to produce complex products.

TQM aims ate continuous improvement in products, services and processes


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Operations in Discrete Part Manufacturing

There are a wide variety of products produced in discrete manufacturing, and, thus, anextreme variety of operations performed to obtain the desired shape and properties requiredof the product.

The operations performed vary considerably depending on the material being used for thespecific component.

Six major groups of component operations and a few of the manufacturing operations of eachgroup are presented in following Table:



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Operations in Discrete Part Manufacturing

Six (06) Major groups of Component Operations Classification for Discrete Manufacturing


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Basic Cost Relationships

Prime Cost* = direct material cost + direct labor cost +direct engineering cost + direct expense

*prime cost is also called direct cost

Manufacturing cost** = prime cost + factory expense

**manufacturing cost is also called factory cost

Production cost = manufacturing cost + administ rative expense

Total cost = production cost + marketing, selling, and distribu tion expense

Selling price = total cost + mark-up (profit and taxes)



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Cost Estimating for Discrete Part Manufacturing

Direct & Indirect Cost

Direct costs are those costs that can be directly related to an specific part and these mostcommonly are direct materials and direct labor.

There can be other direct costs, such as direct engineering or direct burden expenses, butthese are often not separated (even though they should be) and are thus included in theoverhead components.

The direct labor and direct material costs are also referred to as the out-of pocket costs;they are costs which are being directly paid to others and do not cover any of the direct orindirect overhead costs.

The direct labor represents the fully burdened labor costs; that is the benefits as well as thewages.


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Basic Cost Relationship for Discrete Part Manufacturing



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Ladder of Costs for Discrete Part Manufacturing


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General Discrete

Costs Estimating

Form with Illustrative

Example Rates



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Break-Even Analysis

Two critical issues in break-even analysis that must be considered and they are

(a) the cost base and

(b) the various break-even points.

The two different cost bases are the time base and the quantity base.

The quantity-based break-even analysis:

This determines the production quantity at the specific break-even point, and this has workedfor marketing, sales, and top management for forecasting yearly sales and other long-rangeplanning activities. However, it provides little assistance at the plant management level wherethe production quantity is not a variable, but is a quantity specified by the customer.

Time-based break-even analysis:

Focuses on the time to produce the order, which is something under the control of the plant

supervision. Time-based break-even analysis determines the production time for the specificbreak-even point, and this is what can be controlled at the plant level.

The same break-even points can be used in either system, but the costs must be consideredcarefully as the different basestime and quantityresult in different conclusions with respectto the variability of the costs.


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Break-Even Points

The four break-even points that are considered in the profitability evaluation of products oroperations: These points can be evaluated on either the time based or quantity based system.

Shutdown Point (SD)

The shutdown point is the quantity or time where the manufacturing costs equals the revenues.

In the production quantity system the production quantity at which the revenues equal themanufacturing costs.

In the production time system the production time at which the revenues equals themanufacturing costs.

The manufacturing costs include the material costs, tooling costs, labor costs, and plant/shopoverhead costs.

Cost Point (C)

The cost point is the quantity or time where the total costs equals the revenues.

In the production quantity system, it is the production quantity at which the revenues equal thetotal costs

In the production time systemit is the production time at which the revenues equal the totalcosts.

The total costs include the manufacturing costs plus all other costs such as the administrativecosts, selling and marketing, research and development expenses, and etc.



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Break-Even Points

Required Return Point (RR)

The required return point is the quantity or time where the revenues equals the total costs plusthe required return.

In the production quantity systemthe production quantity at which the revenues equal the totalcosts plus the required return.

Required Return after Taxes Point (RRAT)

The required return after taxes point is the quantity or time where the revenues equals the totalcosts plus the required return and the taxes on the required return.

In the production quantity systemit is the production quantity at which the revenues equal thetotal costs plus the required return plus the taxes on the required return.

In the production time system the required return after taxes point is the time at which therevenues equals the total costs plus the required return plus the taxes on the required return.


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Break-Even Points

The quantity-based break-even analysis:

This determines the production quantity at the specific break-even point, and this has worked formarketing, sales, and top management for forecasting yearly sales and other long-rangeplanning activities. However, it provides little assistance at the plant management level wherethe production quantity is not a variable, but is a quantity specified by the customer.

Time-based break-even analysis:Focuses on the time to produce the order, which is something under the control of the plantsupervision. Time-based break-even analysis determines the production time for the specificbreak-even point, and this is what can be controlled at the plant level.

The same break-even points can be used in either system, but the costs must be consideredcarefully as the different basestime and quantityresult in different conclusions with respectto the variability of the costs.



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Break-Even Example ProblemA new job is being considered in the foundry. The order is for 40,000 castings, and the tentativeprice is $ 3.00/casting. The pattern will be designed for 4 castings per mold, and the pattern costhas been quoted at $ 10,000. The molding line is the rate controlling step in the productionprocess in this particular foundry, and the production rate is 125 molds/hr. The estimated timefor the production of the 40,000 castings would be determined by:

(40,000 castings)/(4 castings/mold x 125 molds/hr) = 80 hr

The costs and overheads are included in Table 11.4, and the corporate tax rate is estimated at40 percent.

Production Quantity based Calculations:

The calculations for the four break-even points will be made using X as the variablerepresenting the number of units of production.


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The results from the production quantity

model can be summarized as follows:

If the production quantity is less than 16,068units do not accept the order as themanufacturing costs will not be recovered.

If the production quantity is between 16,068 and26,324 units, the manufacturing costs will berecovered, but not all of the overhead costs.

If production quantity is between 26,424 and

34,530 units, all costs will be recovered, but notall of the required return will be recovered.

If the production quantity is between 34,530 and40,000 units, all of the costs and the requiredreturn will be recovered, but not all of the taxesfor the required return will be recovered. (Thus,the required return will not be recovered aftertaxes as the government will take its share fortaxes).

If the production quantity is more than 40,000units, the required return will exceed the desiredrequired return on an after tax basis.



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Cost Data for Time-Based and Quantity-Based Break-Even Example Problem


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Total Cost and Revenues Versus Production Quantity


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Unit Cost Versus Production Quantity

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Time Based Calculations The results from the production Timebased model can be summarized as

follows:

If the production time is more than 181.8hours, do not accept the order as themanufacturing costs will not be recovered.

If the production time is between 117.6 and181.8 hours, the manufacturing costs will berecovered, but not all of the overhead costs.

If production time is between 91.7 and 117.6

hours, all of the costs will be recovered, butnot all of the required return will be recovered.

If the production time is between 91.7 and80.0 hours, the costs and the required returnwill be recovered, but not all of the taxes forthe required return will be recovered. (Thus,the required return will not be recovered aftertaxes as the government will take its share fortaxes).

If the production time is less than 80.0 hours,the required return will exceed the desiredrequired return level on an after tax basis.



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Total Cost and Revenues Versus Production Time

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Profitability Plot for Time-Based System


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The advantage of the time-based break-even analysis is that it can answer questions such as

what is the effect of a 4 hour delay due to a machine breakdown.

The effect is not obvious from the quantity break-even analysis, but the time based break-evenanalysis indicates that 84 hours is between the required return and required return after taxesbreak-even times; that is all costs are recovered and the required return will be exceeded beforetaxes but not after taxes.

This can be evaluated by determining the profit from the following:Profit = Revenues - CostsProfit = $120,000 - ($70,000 + 425$/hr x time (hr))Profit = $50,000 - 225$/hr x 84hrProfit = $14,300Profit after taxes = (1-TR) x 14,300 = 0.6 x 14,300 = 8,580

Since the required return after taxes was 9,600 and the required return before taxes was$16,000, the $ 14,300 amount is between the two expected values. The loss on the time-basesystem could also be evaluated at $ 425 (165 + 110 + 150 = 425) per hour, and for 4 hoursdown the loss would be $1,700.

The loss in the quantity-based system can be obtained by using some of the conversion factors;the loss of 4 hours is equivalent to the production loss of 2,000 units. This loss would be thelabor lost plus the plant overhead and the overhead costs for four hours; thus the loss would be2,000 units x 0.33$/unit + 4hr x (110 + 150) =$660 + $1,040 = $1,700


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The time-based approachis much easier to determine and more straightforward.

Time-based break-even analysis would also be useful in evaluating the cost of bottleneck delaysand provide data for the economic justification of new equipment to improve productivity.

The high cost of delays indicate that one of the factors to consider is the evaluationmanagements performance, and this can be done using a time-based system.

The evaluation of bottlenecks and delays is critical in the theory of constraints and supply-chain management, and the focus is upon time in these situations.

The quantity-based approachis appropriate for marketing and sales forecasting as they needto estimate the revenues obtained and predict the sales quantities. However, at the plant level,where scheduling of the daily operations are concerned, the focus is upon time and time-basedbreak-even analysis is more appropriate.



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Questions:

What is the prime cost?

What is the factory cost?

What is the production cost?

What is the selling price?

What is the manufacturing cost?

What is the selling price per unit?

Documents

003 Estimating Material