Manufacturingcostestimation Manufacturing cost estimation

Learning objectives of the topic Define the total cost as the sum of fixed and variable costs Apply cost behavior estimation methods

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

Breakdownoftotalcost
For various manufacturing decisions, the industrial g y q p engineer may require to establish a relationship between the manufacturing total cost and manufacturing parameters such as volume of production, workforce size, etc. size etc Variable costs change with the parameter levels and the fixed costs do not change. Hence, the total cost can be described as C = F + VX
C = cost F = fixed cost V = variable cost (unit cost) X = parameter level
DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

Costbehaviorestimationmethods
Three methods are available for estimating the p parameter: relationship between the cost and the p 1. Engineering estimates 2. Account analysis 3. Statistical (regression) analysis

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

Engineeringmethod
Engineering cost estimation is based on measurement p g and pricing of the work involved in a task. This method requires the breakdown of work into small components and calculation of the cost associated with each component. component Consider the Acer assembly process in AEC. The assembly process has three stages: Assembly of the components Installation of the operating system p g y Packaging Then, take each stage and break it down further to smaller components.
DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 For example, the assembly stage requires simple hand , y , g, tools, assembly table, worker training, etc. Then, these small components are subsequently estimated. Engineering cost estimation suggests cost estimates that are mostly optimistic and lower than what they actually are.

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

Accountanalysismethod
This method is based on the review of each cost account g p making up the cost and the identification of each as fixed or variable. Consider the East Cement Co which operates in an 8hour orkda ho r workday. The total overhead cost in 8 hours is
Account Utilities Indirectlabor Transport Administration Others Total Fixed 210 2,000 186 100 356 2,852 Variable 100 1,300 3,200 2,172 252 7,024

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 The variable costs surely are influenced by the workday, p and the variable cost per work hour is:
7,024 = SR 878 8

If the East Cement would extend the workday to 9 hours, the total overhead cost will become:
2,852 + 878(9) = SR 10,754

Account cost estimation is subjective in its approach, hence it is not reliable.

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

Statistical(regression)costestimation
Statistical cost estimation provides estimates that are j , , less subjective, hence reliable, and more realistic. Statistical cost estimation uses past data and removes random events and reports only the true cost relations. This method is valid only on the relevant range of the activity levels. Regression analysis a statistical tool follows these analysis, tool, steps: 1. Collect past cost data 2. Fit a least squares regression line 3. Test the significance of the linear relationship.

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 To establish the regression line, the independent and the p dependent variables have to be defined. The independent variable is the activity level X and the dependent variable is the cost C. With least squares regression, we like to find the values of the fixed and unit variable costs that will make the sum of the squares of the deviations of the data from the q line as small as it can be:

deviation = ei = Ci ECi

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 The estimated cost ECi is defined by calculating the values of F and V: ECi = F + V Xi To find the values of F and V, we seek to find the minimum of

D = ei2 = (Ci F VX i ) 2
i =1 i =1

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 The minimum can be found by setting the partial g derivatives to zero and solving for F and V:
n D = 2 (Ci F VX i ) = 0 F i =1 n D = 2 (Ci F VX i )X i = 0 V i =1

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 These two equations lead to the normal equations

nF + V X i = Ci
i =1 n i =1 n

F X i + V X i2 = X i Ci
i =1 i =1 i =1

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 The normal equations can be solved by substitution:

F=

C
i =1

n
n

X
i =1

V=

X i Ci
i =1

C X
i =1 i i =1

n
2

n Xi n X i2 i =1 n i =1

S xy S xx

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

Example
Consider the production level vs repairs costs:
Repairs costs (1000riyals) Ci 256 297 329 315 283 289 301 Production level(units) Xi 50 100 150 125 88 94 103

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

Sum

Repairs cost(1000 riyals) Ci 256 297 329 315 283 289 301 2070

Productionlevel (units) Xi 50 100 150 125 88 94 103 710

Xi 2 2500 10000 22500 15625 7744 8836 10609 77814

XiCi 12800 29700 49350 39375 24904 27166 31003 214298

(2070)(710) 214298 4340.86 7 V= = = 0.75 2 (710) 5799.71 5799 71 77814 7 2070 710 F= 0.75 = 219.64 7 7
DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 The cost at any level of production is given by EC = 219 64 + 0 75 X 219.64 0.75 It can be read from the equation that the repairs cost increases by SR 750 for every product manufactured. The company plans to produce 90 units (notice 90 is in the relevant range), the repairs cost is estimated at 219.64 0.75 219 64 + 0 75 (90) = SR 287 140 287,140

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 Being a random variable, the cost has a variance and it q is equal to

=
2

S yy VS xy n2

for S yy

( C ) = C n
2 i i

For the previous cost data, the variance is

3293.43 0.75(4340.86) = = 7.56 72

2

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 The confidence interval on the value of the unit variable g y cost is given by

V t / 2,n 2

2
S xx

Hence, it is said that the value of V is in this interval with a 100(1 - )% confidence. confidence For the previous cost data, the unit variable cost is

7.56 V 2 57 2.57 = 0.09 5799.71

i.e. the unit variable cost is between 0.66 and 0.84 with 95% confidence.
DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 A measure of the overall quality of the regression line is the coefficient of determination:

R =V
2

S xy S yy

For the previous cost data, the value of R2 is

4340.86 R = 0.75 = 0.99 3293.43

2

Hence, it is said that 99% of the variability in the repairs cost is explained by changes in the production level.

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 If we can assume that the production volume and the p joint repairs cost are random variables and the j distribution of them follows a bivariate normal distribution, we assess the linear relationship between the repairs cost and the production volume by the value of the correlation coefficient . When = 0, there is no correlation between the two random variables, and we can say the two random variables are independent.

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 To test the correlation between the repairs cost and the p production volume, we can test the following hypothesis: , g yp H0 : = 0 H1 : 0 The test statistics for this hypothesis is

T0 =

R n2 1 R2

which has the t distribution with n-2 degrees of freedom.

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM

 For the previous data, the value of the test statistics is t0 = 22.25. For a confidence level = 0.05, t0.025,5 = 2.571. Since t0.025,5 < t0, we say H0 is rejected and conclude that there is a strong linear relationship between the repairs cost and the production volume.

DrMuhammadAlSalamah,IndustrialEngineering,KFUPM