Chapter 15

Cost Estimation
and
Indirect Cost Allocation

Understanding Cost Estimate

edintheinitialstage
opedforeitheraprojectorasystem
esphysicalitems,suchasbuilding,manufacturingplant
erationaldesignthatinvolvesprocesses,services,software,an

Cost

blymeasuredandallocatedtoaspecificoutputorworkactivitysm
toattributeorallocatetoaspecificoutputorworkactivitylarger

Costs to estimate

asfirstcostandannualoperatingcost(AOC)alsocalledM&O
costelements.Exampleelementsofthefirstcost:

pmentuse

Cost Estimation Approach

approach

requiredpricesasanoutputvariableandthecostestimatesasi
lwhencompetitionisnotthedominantfactorinpricing

approachordesigntocost
ecompetitivepriceasaninputvariable
ostestimatesasoutputvariable
whenaccuracyisimportant

Bottom-up approach
Required price

Total cost

Desired
profit
Indirect
cost

Maintenance +
and operations
Cost
component
estimates

Direct
labor
Direct
materials

+
+

Equipment and +
capital recovery
At design stage

Direct cost

Top-down approach
Design-to-cost approach
Competitive price

Target cost

Allowed
profit
Indirect
cost

+
Direct cost

Maintenance +
and operations
Cost
component
estimates

Direct
labor
Direct
materials

+
+

Equipment and +
capital recovery
Before design stage

Accuracy of the Estimates

No cost estimates expected to be exact

Cost estimates expected to be reasonable
Cost estimates expected to be accurate enough to support
The accuracy needed:
economic evaluation
detailed design
preliminary design

higher
accuracy
required

Cost estimation techniques

Expertopinion
Unitmethod
Costindexes
Factormethod
Costcapacityequations

Unit method

pularpreliminaryestimationtechnique

CT=uxN[15.1]

talestimatedcost,CT,isobtainbymultiplyingnumberofunit

Example 15.1

gaspipeusingandadvancedcentrifugalcastingmethod.Sincea20%estima

Solution

Cost indexes

saratioofthecostofsomethingtodaytoitscostsometimeinthep

= C0 (It/I0)

=estimatedcostatpresenttime
=costatprevioustimet0
=indexvalueattimet
=indexvalueattimet0

[15.1]

andpastcostsformanyofthethingsthat'typical'consumers
ntcostindexChemicalEngineeringplantcostindex(CEPCI

Example 15.2

larcomplexityandmagnitudewascompleted5yearsagoataskill

Cost-Estimating Relationship:
Cost capacity equation

ht,physicalsize)forplant,equipment,andconstructionaredeterm
(CERs)usethesetopredictcosts

[15.2]

costcapacityequationiscommonlyintherange0<x1.
caleprovideacostadvantageforlargersizes
onshipispresent
conomiesofscalepresentinthatalargersizeismorecostlythanth
nethetimeadjustmentofthecostindex(It/I0)fromequation{15.2
x(It/I0)[15.4]

Example 15.4

2010.Estimatethecosttodayforaflowrateof2.0MGD.Theexpo

Cost estimating relationship:

factor method

liabletotalplantcostcanbeobtainedbymultiplyingthecost
[15.5]

lcostfactor

Example 15.5

essplantisexpectedtohaveadeliveredequipmentcostof$2.08m

e of the factors apply to equipment cost only, while others appl

h can be written as
[15.6]

hcostcomponent
ents,includingindirectcostn
i=1

aldirectcost,onlythedirectcostfactorsareaddedtoobtainh.

I)[15.7]

nts

n
i=1

solution

bothdirectandindirectcostfactorsareappliedtoonlyequipmentc

,951,250
t,andeq[15.7]isusedtoestimatetotalcost

,138,675

Example 15.7

ement,support,etc.,is0.49.Theconstructionfactoris0.53,andthe

aditional Indirect Cost Rates and Allocati

tem

ostsofgoodssoldisoneendproductofthissystem
smaterialcosts,laborcosts,andindirectcosts(overheadcost

ystemneedonlyidentifyandtrackthesecosts
ecessarytoallocatethemseparatelytodepartments,processesand

cedepartments,personnel,legal,quality,supervision,purchas

Table 15-7

Sample Indirect Cost Allocation Bases

Commonallocationbases:
Directlaborcost
Directlaborhours
Machinehours
Numberofemployees
Space
Directmaterials
Usingrelation

Indirectcostrate=[ 15.8]

Estimatedtotalindirectcosts
Estimatedbasislevel

Example 15.8

achinesusedtoprocessbeautylotions.Thefollowinginformationwaso

Solution
Applyingeq.[15.8]foreachmachine,theannualratesare:
Machine1rate=indirectbudget/directlaborcost

=$50,000/$100,000
=$0.50perdirectlabordollar
Machine2rate=indirectbudget/directlaborhours
=$50,000/2000=$25perdirectlaborhour
Machine3rate=indirectbudget/materialcost
=$50,000/$250,000
=$0.20perdirectmaterialdollar

Example 15.9

hetotalfactorycostforamonth.Performthecomputationsusingthed

solution

dssold(factorycost)relationgivenbyeq.[B.1]inAppendixB,whichis
directmaterials+directlabor+indirectcosts
t,theratesfromexample15.8areapplied:
(laborcost)(rate)=$2500(0.50)=$1250
(laborhours)(rate)=759($25.00)=$18750
(materialcost)(rate)=$19500(0.20)=$3910
=$23,910
actualmaterialandlaborcostsfromtable158of$31,850andtheindirectcostcha

thethreemachinesrepresentsa91.3%underallocationofindirectcosts.Th

Example 15.10

mponentinhousehasbeenmade.Forthethreedepartmentsinvolved,thean
makealternative,assumingthatamarketrateof15%peryearistheMARR

solution

Ciscomprisedofdirectlabor,directmaterial,andindirectcosts.Usethedataoftab
,000
,000
,000
,000

AOC=$500,000+$300,000+$525,000=$1,325,000
Themakealternativeannualworthis
Awmake=P(A/P,i,n)+S(A/F,i,n)AOC
=$2000,000(A/P,15%,10)+$50,000(A/F,15%,10)
$1,325,000
=$1,721,037
CurrentlythecarafesarepurchasedwithAWof
AWbuy=$2,200,000
Itischeapertomake,becausetheAWofcostsisless

Activity-Based Costing (ABC) for indirect cost

drivers
tion are called cost centers or cost pools. They receive the allocated indirec
ng, maintenance) that generate the indirect cost which are then distributed to
nsumption of a shared resource. Example: number of purchase orders, num

ImplementingABCinvolvesseveralsteps:

Identifyeachactivityanditstotalcost

Identifythecostdriversandtheirusagevolumes

Calculatetheindirectcostrateforeachactivity

ABCindirectcostrate=

Total cost of activity

Usetheratetoallocateindirectcosttocostcenter
Total volume of cost driver

Example 15.11

tsEuropeandivision.However,accountssuchasbusinesstravelhaveh
temischosentoaugmentthetraditionalmethodtomorepreciselyallo

otheplantsusingatraditionalbasisofworkforcesizeissufficient.Ift

Solution (a)

ase,eq[15.8]takestheformofablanketrateperemployee
rectcostrate=travelbudget/totalworkforce
=$500,000/29,100employees
=$17.1821peremployee
histraditionalbasisofratetimesworkforcesizeresultsinaplantbyplantall
$17.1821(12,500)=$214,777
e$17.1821(8600)=$147,766
rg$17.1821(4200)=$72,164
na$17.1821(3800)=$65,292

allocatetravelcoststomajorproductlines.Annualplantsupportbudgetsind

lof500travelvoucherswereprocessedbythemanagementofthemajorfive

,25for2

,30for3,30for5

20for4
rline5
ductlinesdrivetravelcostsattheplants

Solution (b)

he4stepproceduretoallocatetravelcoststothefiveproducts
1.Thetotalamounttobeallocatedisdeterminedfromthe
percentageofeachplant'ssupportbudgetdevotedtotravel
Thenumberisdeterminedfromthepercentofbudgetdataasfo
0.5($2,000,000)+....+0.30($500,000)=$500,000

Step2.Thecostdriveristhenumberoftravelvoucherssubmitted
bythemanagementunitresponsibleforeachproductline
ateachplant.Theallocationwillbetotheproductsdirectly,
nottotheplants.However,thetravelallocationtothe
Plantscanbedeterminedafterwardsinceweknowwhat
Productlinesareproducedateachplant.

Step3.Eq.[15.9]determinesanABCallocationrate.
ABCallocationrate=
Total cost of travel
=$500,000/500
Total number of vouchers
=$1000pervoucher

Step4.Table1510summarizesthevouchersandaalocationby
productlineandbycity.Product1($230,000)andproduct
5($170,000)drivethetravelcostsbasedontheABC
analysis.Comparisonofthebyplanttotalintable1510
(farrightcolumn)withtherespectivetotalsinpart(a)
indicatesasubstantialdifferenceintheamountsallocated,
especiallytoParismHamburgandBarcelona.This
comparisonverifiesthepresident'sstatementthatproduct
lines,notplants,drivetravelrequirement