Engineering Finance
Lessons


Introduction
Capital Cost

A characteristic common to most projects is that they involve money and, as the course title suggests, money is emphasized in this course. The life-cycle-cost (LCC) diagram shown below indicates that decisions made early in the project commit expenditures much earlier than they actually occur. Thus, estimation of the costs made for the purposes of decision making are very important. Revenues are not shown in the diagram, but they are equally important in the decision to accept or reject a project solution and also merit careful estimation.

Project LCC

 

Many projects are complete at the end of the production or construction phase and do not include the remaining parts of operation and retirement. Our textbook is mostly concerned with such projects. Examples are the construction of a building, the design and construction of the prototype for an airplane, or the design and installation of a production line. The organization entrusted with the project may only be concerned about those aspects leading through the completion of the design, construction or installation. In this case we call the estimation process capital budgeting and the costs involved are called the capital costs.

In other cases the organization sponsoring a project may be the ultimate users of the building, design or production line. Although the cost of acquisition may be a large and important element, the majority of costs occur after acquisition and during operation. The purpose of some projects is to yield a profit or obtain savings in operating costs. For these projects the entire life cycle must be considered and we must estimate the life-cycle costs. We use the term costs primarily, because many projects must meet some functional goal. The revenues are not relevant as long as the project meets the goal. For other cases revenue is important and must be included in a life-cycle analysis.

In this lesson we learn the phases of the life cycle and how to estimate capital costs. In the next lesson we focus on life-cycle cost estimation.

Goals
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  • Identify the phases of a system through its life cycle.
  • Understand the concept of Work Breakdown Schedule (WBS).
  • Construct a WBS for a simple system.
  • Estimate capital costs given the WBS.
  • Use the top-down and bottom-up estimation procedures.
  • Create a cash flow over time for a project.
  • Use the Estimate add-in to estimate capital costs and cash flows.
Text

Section 4.1 draws the distinction between a project and a system or product. A project usually terminates at the beginning of the operational phase, while a system or product generally continues far beyond the project completion. Construction or installation of a project primarily involves cost, while the remainder of the life cycle involves revenues or savings as well as operating costs. Although we concentrate on life-cycle cost estimation in the next lesson, the text assignment discusses capital cost in the context of the life cycle.

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4.1-4.3 Life Cycle Costing
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Section 7.4 is about the Work Breakdown Schedule or WBS. This is our primary tool for organizing the tasks of a project and estimating its capital costs.

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Chapter 7.4 Project Scope
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The Life Cycle

A system is born, it lives and then it dies. Each phase of the project's life contributes to the project cost and has different requirements for cost estimation. Click on the icon to see a presentation.

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Phases of the Life Cycle
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Work Breakdown Schedule

To illustrate the concepts in this lecture we consider a project to design and build an assembly line for custom built electronic cards. The cards are to be used in computers or other electronic devices. The example is described starting on page 303 in the text. In the presentation we add costs to illustrate the top-down and bottom-up cost estimation processes. Figures in the presentation were generated from the Estimate add-in. Click the icon to see the presentation.

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Work Breakdown Schedule
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The WBS describes the tasks that comprise a project. A two level WBS for the example is shown below. The first level is for the project, here named A_Line1. The second level divides the project into the major tasks as illustrated. Individual tasks are identified by integer indices. Thus we refer to the entire project as "1.0 Assembly Line". The material handling step is "1.3 Material Handling". The table below shows only level 2, L2, because the first level index is 1 for all tasks. The WBS must include all tasks associated with the project and none of the tasks overlap in purpose.

The tasks in the WBS may be divided to create additional levels of detail. Click the icon to see the three-level representation.

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3-Level WBS
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The four-level WBS divides the tasks into elemental tasks that can be performed by an individual or an organization. A task at the lowest level of detail is called a work package or WP. The window opened by clicking the icon shows only part of the four-level WBS because it has 132 tasks.

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4-Level WBS
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The WBS is used for a variety of purposes in project management. Here we use it to determine the capital cost of the project. In later lessons we use it to schedule the tasks of a project.

Capital Costs

In view of the WBS, costs can be estimated by either the top-down or bottom-up approach. In the top-down approach, the project manager estimates the costs of tasks at the higher levels of the WBS using experience, statistics or models. In the two-level WBS below, hypothetical costs have been added using the top-down approach. The bottom line of the figure indicates that the total capital cost for the example is $308,000.

A bottom-up approach requires a detailed WBS that allows the estimation of the materials, labor and indirect costs for the individual work packages. The figure below shows estimates for the Process design task in the four-level WBS.

The total project cost is the sum of the costs of the tasks. The summary below shows the project capital costs and the major tasks at level 2.

The text points out the positive and negative aspects of the two approaches. The top-down approach might be better at the beginning of the project to provide rough estimates of the capital costs; the bottom-up approach is more appropriate in the later stages of the project where bids or contracts require careful consideration.

This course uses the Estimate add-in for computing the capital cost for a project described by a WBS. Click on the icon for instructions for that add-in. Read particularly the index page and the pages on capital budgeting and time dimension. The computations section of this site tells how to download and install add-ins.

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Estimate Add-in
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The Excel file holding the examples on this page is the "Demo Workbook" file for the add-in and can be downloaded from the web site reached through the above link.

Cash Flow

It is useful to know the timing of the expenditures associated with a project. This can be provided if the tasks are scheduled and the expenditures of each task are allocated to the time intervals during which the project will be performed. Click the icon to see the schedule and the cost-time matrix associated with the two-level WBS.

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2-Level Schedule
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The schedule columns in the display show when the tasks begin and end. The time/cost matrix shows the distribution of the costs over the six months of the project. For now, neglect the entries labeled P/F and NPW. We consider these terms later. Note the cash flow shown as the bottom row of the display. These numbers are the estimated expenditures for the six month duration. The numbers are summarized in the table below.

Month
Cash Flow
1
$29,000
2
70,167
3
63,667
4
86,667
5
42,000
6
16,500

We will see that cash flows play a significant role in the lessons that follow.

Summary
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Capital Cost Summary
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Engineering Finance
by Paul A. Jensen
Copyright 2005 - All rights reserved

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