Knowledge Exam preparation Course

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 Introduction

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SECTION 1 - COST
Chapter 1―Cost Elements
Chapter 2―Pricing & Costing
Chapter 3―Materials
Chapter 4―Labor
Chapter 5―Engineering Role & Project Success
Chapter 6―Machinery, Equipment, & Tools
Chapter 7―Economic Costs
Chapter 8―Activity Based Cost Management

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SECTION 2 – COST ESTIMATING
Chapter 9: Cost Estimating
Chapter 10: Process Product Manufacturing
Chapter 11: Discrete Part Manufacturing

SECTION 3 – PLANNING AND SCHEDULING

Chapter 12: Project Planning
Chapter 13: Scheduling

SECTION 4 – Progress and Control

Chapter 14 – Earned Value Overview
Chapter 15 – Performance and Productivity Management

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 SECTION 5 – Project Management
Chapter 16 – Project Management Fundamentals
Chapter 17 – Project Organization Structure
Chapter 18 – Project Communications
Chapter 19 – Project Labor Cost Control
Chapter 20 – Leadership and Management of Project People
Chapter 21 – Quality Management
Chapter 22 – Value Engineering
Chapter 23 – Contracting for Capital Projects
Chapter 24 – Strategic Asset Management
Chapter 25 – Change Management Practical Guide
Chapter 26 – Overview of Construction Claims and Disputes

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 SECTION 6 – ECONOMIC ANALYSIS, STATISTICS, PROBABLILITY
AND RISK
Chapter 27 – Financial and Cash Flow Analysis
Chapter 28 – Practical Corporate Investment Decision-Making
Guide
Chapter 29 – Statistics and Probability
Chapter 30 – Optimization
Chapter 31 – Risk Management Fundamentals
Chapter 32 – Risk Management Practical Guide
Chapter 33 – Total Cost Management Overview
Chapter 34 – The International System of Units (SI)

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 Section 1

Knowledge Exam preparation Course

Real Exam Course Simulations

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Ali Kortam PfMP, CPD, PMP, CCP,PSP
 Section 1
Costs

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 SECTION 1 - COST

Chapter 1―Cost Elements

Chapter 2―Pricing & Costing
Chapter 3―Materials
Chapter 4―Labor
Chapter 5―Engineering Role & Project Success
Chapter 6―Machinery, Equipment, & Tools
Chapter 7―Economic Costs
Chapter 8―Activity Based Cost Management

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 Chapter 1―Cost Elements

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* Cost is the value of an activity or asset.
This value is determined by the cost of the resources that are
expended to complete the activity or produce the asset.
Resources utilized are categorized as:
 Material, labor, other

- Although money and time are sometimes thought of as resources, they

only implement and/or constrain the use of the physical resources just
listed

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Example 1—
A homeowner decides to build a deck on the back of the house.
The homeowner
 draws up plans for the project,
 gets the building permit from the city,
 buys the material,
 hauls it home, and
 constructs the deck.
A representative sample of the cost elements and categories associated with building this
asset are shown in Table 1.1.
Notice:
 Some of these cost elements are not part of the physical deck,
but are necessary in order to complete the project.
 Some of the cost elements are not part of the work activity needed to get the deck built,
but are essential to support the project.

In the next section, we will see how these cost categories are structured.

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To maintain some kind of order in the estimate (and later in project execution), it is
necessary to segregate costs into various categories

 Structuring the cost elements into:

1) Direct costs
2) Indirect costs
3) Fixed costs
4) Variable costs
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* Direct Costs
- Direct costs are those resources that are expended solely to complete the
activity or asset.

- Direct cost of a foundation for a house includes:

 trenching for the footings,
 the wooden forms,
 the concrete, and the
 labor to place and
 finish the concrete.

- Direct costs for making a metal bowl would be the

 metal sheet stock and the
 stamping machine operator labor cost.

- The material cost for manufacturing the bowl would include the
- scrap from the stamping process less any salvage value.
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 * Indirect Costs
- Indirect costs are those resources that need to be expended to support the
activity or asset, but are also associated with other activities and assets.
- In other words, “Any cost not directly identified with a single final cost
objective, but identified with two or more final cost objectives…” [3]..
- Indirect costs also may be referred to as “overhead costs” or “burden costs.”

- Indirect costs include:

 Sales & Administration associated with operating the business,
 General Overheads
 Financial Expenses
 Expenses for utilities, taxes, legal services, etc.

- In some industry circles the indirect and fixed cost are called “hotel costs”,
which represent the cost items necessary in order to conduct business.

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 * Fixed Costs
- Fixed costs are those cost elements that must be provided independent of the
volume of work activity or asset production that they support.

-These can be either direct or indirect costs.

- Direct Fixed cost:

 The tool used to stamp the metal bowl is a direct fixed cost that is
incurred whether 100 or 1,000 items are produced.

- Indirect Fixed Costs:

 The tools used to finish the concrete foundation are an indirect fixed cost
since they can be reused on other concrete finishing work.

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 * Variable Costs
- Variable costs are those cost elements that must be provided and are
dependent on the volume of work activity or asset production that they support.

- These can be either Direct or Indirect costs.

- Direct Variable cost:
 material used to form the metal bowl since the amount varies with
the quantity produced.

- Indirect Variable cost:

 electricity used to operate the stamping machine since it also varies
with the quantity produced but is considered to be an
overhead cost.
In business practice, cost element information may be grouped in a variety of ways to
provide the basis for management decisions.
Some of these groupings are listed in Table 1.2

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Example 2—The homeowner tries to better understand the costs associated with building
the deck. The homeowner structures the costs as shown in Table 1.3.

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 A company’s code of accounts is configured to support the recording of
cost data in the general ledger.

Cost Accounting:
Definition
• Cost accounting is defined as the historical reporting of disbursements, costs
and expenditures on a project.

• Recording of cost information is nothing more than the mechanical gathering

of data in a routine manner.

• Become familiar with the Code of Accounts structure.

Every business enterprise has an established approach for classifying and summarizing costs that is
organized around their business practices.
This approach is called a “code of accounts” by which all recorded cost elements are classified.
A code of accounts (sometimes referred to as a chart of accounts) is a systematic numeric method
of classifying various categories of costs incurred in the progress of a job; the segregation of
engineering, procurement, fabrication, construction, and associated project costs for accounting
purposes.
A company’s code of accounts is configured to support the recording of cost
data in the general ledger. An example of summary-level accounts is shown in Table 1.4
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Cost Accounting:
• Activity Based Costing assigns resources to activities.
An alternate method of cost element classification is called activity-based
costing (ABC).

In the ABC approach, resources that are used are assigned to activities that are
required to accomplish a cost objective.
ABC makes cost accounts understandable and logical, and much more useful for the
cost engineer.

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Cost Accounting:
• Work Breakdown Structure (WBS) can be used with Code of Accounts.
Be familiar with the WBS.

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Example 3—The homeowner recognizes that the deck being built is an improvement to the home,
and that it would be considered a capital investment. The homeowner decides that there needs to be a
structure of cost accounts to provide data for future maintenance estimates. Table 1.7 shows the code of
accounts the owner developed: Notice that the homeowner hired some of the labor and has cost
records (invoices) for the work. For the labor the homeowner performed, fair market value might be
used to account for the cost of these activities. Also, values of indirect cost elements are not shown on
the list. For, example, the homeowner could have included the rental value of the tools used in the
construction. This valuation approach would have allowed the homeowner to get a better understanding
of the total value of the deck.

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The homeowner’s code of accounts allows for grouping material and labor costs to find the
total cost of the footings, deck structure, and painting. Table 1.8 shows how the homeowner
rearranges the cost elements to get this visibility.

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 Cost Management
There are many ways that cost elements and cost structure can be displayed to provide
information for cost management

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 Cost Management
 Cost Estimating
Cost Estimating predicts the quantity and cost of resources needed to accomplish an
activity or create an asset.
 Cost Trending
Cost trends are established from historical cost accounting information.
* Examine historical information for future decision.

 Cost Forecasting
Forecasts are much like estimates.
An estimate is always establishes the Budget at Completion (BAC) for performance
baselines; whereas
forecasts are predictions of the Cost to Complete or Estimate to Complete (ETC) for
cost elements in progress, or that have not started.
* Predict what remains.

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 Cost Management
 Life-Cycle Costing
Life-Cycle Costs (LCC) are associated with an asset.
They extend the cost management information beyond the acquisition
(creation) of the asset to the use and disposal of the asset.
Asset acquisition consists of the:
 design/development phase and the
 production/construction phase.

These are called “gates” to ensure all the

- required tasks for the phase have been completed, and/or to make
- project go/no-go decisions in the early phases.
Once the asset is created,
it enters the
 Operation and Support (O&S) phase, (Operations &Maintenance (O&M) phase).
The final phase is disposal of the asset

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 Chapter 2―Pricing & Costing
Abstract
This chapter highlights the difference between pricing and costing.
It is very important to distinguish between the terms “price” and “cost.”

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Pricing
Pricing can be defined as the determination of the amount to be charged to the client.
Pricing fully include everything necessary to provide a service or product, plus profit.
Therefore, the cost includes all direct and indirect cost, plus any allowable contingency.

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 Costing
Direct costs are those that are specific and tangible to the project, and include the costs of
materials, labor, equipment, etc.
Indirect costs are those costs not directly accountable or tangible to the project, such as
business taxes, home office overhead, or transportation fleet distributed cost, but
necessary for the business to remain solvent.

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THE COSTING-PRICING PROCESS

Costing and pricing strategies include:

• Cost estimating
• Budgeting
• Cost forecasting
Financial Management
• Return on Investment
• Return on Assets
• Net Profit Margin

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Return on Investment (ROI)
Calculating simple ROI, for cash flow and capital investment analysis, measures the profitability in dollars
invested. It is easy to understand and simple to use. It works well in situations where both the profits
from the projects and the costs of the investment are easily known. Investments yielding a higher ROI
will be the better investment; however, this calculation does not recognize any risk factor. Benefits are
returns on the investment coming in as a result of the investment made into the project. (See Table 2.2)

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Return on Assets (ROA)
This number tells you how effective your business has been at putting its assets to work. The
ROA is a test of capital utilization – how much profit (before interest and income tax) a
business earned on the total capital expended to achieve that profitability.
ROA is recognized here to determine the anticipated return from a project. ROA is also applied
to determine the viability of a project.
Projects may not be considered viable in which the ROA is lower than the cost of funding the
project. ROA is a ratio of the earnings generated from a project compared to the assets spent
to generate that revenue. (See Table 2.3)

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 Chapter 3―Materials

Learning Objectives
After completing this chapter, the reader should be able to:
• Identify types of project materials.
• Understand the issues involved in selecting and handling materials.
• Understand the principles of materials purchasing and management, including the
proper amount of stock to save money and avoid waste or production delay.
• Understand possible safety hazards associated with materials and be aware of
regulations governing worker and materials safety.

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 MATERIALS COMPETITION
 MATERIALS HANDLING
 Materials Handling Principles
Each materials manufacturing situation is somewhat different; however, there are some
basic principles in this area that find wide application.
These basic principles include the following:
• Material movement should be over the shortest distance possible;

• Terminal time should be in the shortest time possible.

• Eliminate manual material handling when mechanized methods are feasible;

• Avoid partial transport loads, since full loads are more economical; and,

• Materials should be readily identifiable and retrievable.

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 TYPES OF MATERIALS AND RELATED INFORMATION

 Raw Materials
 Bulk Materials
 Fabricated Materials
 Engineered/Designed Materials

 PRODUCTION MATERIALS PURCHASE AND MANAGEMENT

 Materials Quality

 Materials Vendor Surveillance and Materials Traceability

 Materials Quantity
 Economic Order Quantity
 Just-In-Time Inventory Techniques

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 • Economic Order Quantity
This EOQ number is determined based upon:
- materials costs, storage costs, order costs, and annual demand.
A garden tractor manufacturer has a requirement for 15,000 engines per year.
The engines each cost $75.
The order cost for a purchase order is $250.
The storage costs for the engine are $12 per year which includes space
costs and financing costs.
The standard formula for EOQ is:
_____________
EOQ = [√ (2 x D x O) / S]
Where:-
D = annual demand,
P = purchase order costs, and
S = storage/carrying costs.
Thus, in this example:
_____________________
EOQ = [√(2 x 15,000 x $250) / $12] = 790
Therefore, in this case, the manufacturer should order 790 engines at a time which is the
EOQ value.
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The formula for computing reorder point (RP) is:
RP = (O x R) + I
Where:-
RP = reorder point,
O = order time,
R = production rate, and
I = minimum inventory level or safety stock.
Assume that the production process uses 60 engines per day for the 60 garden tractors
produced per day.

If the lead time for an order is 5 days, and the safety stock level is 180 engines
(minimum level), then the reorder formula in this example yields:
RP = (5 days x 60 units/day) + 180 units = 480 units

Thus the EOQ value of 790 engines should be ordered whenever inventory drops to 480
units.

Cycle stock levels maintained at very low levels can almost ensure the potential for
production delays.

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 Expediting:
Expediting involves the monitoring of all steps in the procurement cycle to ensure on-
time delivery of the necessary materials.
This monitoring includes:
-checking design status,
- material status,
- production status, and
- shipping status.
Analysis of potential delays is a key element in the expediting process.
If shipping delays take place, alternative forms of delivery may be necessary to avoid
production delays.
By continually reviewing status, the expediting process helps to avoid unpleasant
interruptions of the production process.

Expediting communication is conducted through telephone, fax, and e-mail methods.

Personal visits to vendors as part and parcel of vendor surveillance efforts can also be
helpful.

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 Chapter 4―Labor
Abstract
Labor is one of the most important resources for a project.
An owner, employer, or project manager from any industry needs to have a complete
understanding of how the labor force works. This chapter provides an overview of the
different classifications of labor, the different types of labor wages and benefits and also
indirect and overhead labor and other costs.
This chapter also illustrates the procedure to estimate the work hours for a given work
scope at a given location; and how the labor hours can be used to monitor the progress of
work.

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Learning Objectives
After completing this chapter, the reader should be able to:
• Identify different classifications of labor and how each contributes to the completed
project.
• Develop labor rates for estimating.
• Develop and use weighted average rates/composite crew rates.
• Include indirect and overhead labor and other costs.
• Estimate work hours for a given work scope at a given location.
• Use labor hours to monitor work progress.
LABOR CLASSIFICATIONS
The following definitions were taken or adapted from AACE International’s Cost Engineer’s Notebook
[1].
• Direct Labor―The labor involved in the work activities that directly produce the product or complete
the installation being built.
• Indirect Labor—The labor needed for activities which do not become part of the final installation,
product, or goods produced but that are required to complete the project.
• Overhead Labor—The labor portion of costs inherent in the performing of a task (such as:
engineering, construction, operating, or manufacturing), which cannot be charged to, or identified with a
part of the work, and therefore must be allocated on some arbitrary basis believed to be equitable, or
handled as a business expense independent of the volume of production.

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 Table 4.1 provides examples of different labor classifications and costs.
The examples are not all-inclusive and only serve to illustrate the
elements of each type of labor

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 DEVELOPING LABOR RATES
 Base Wages
The following are examples of base wages:
• Craft personnel―$27.00 per hour
• Supervision―$1,400 per week divided by 40 hours/week = $35.00 per hour and
• Engineering―$80,000 per year divided by 2,080 hours/year = $ 38.46 per hour

NOTE: 2,080 hours = 5 days per week @ 8 hours per day for 52 weeks
The examples above can be used to calculate the direct amount that each employee will
earn and be paid for each hour worked.
 Fringe Benefits
Paid Time-Off (PTO)

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Paid Time-Off (PTO) ― Most employees have additional benefits of time off for local
and national holidays, vacation, sick time, etc.

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Medical and Life Insurance Benefits―Some firms and labor contracts include
contributions to a medical and life insurance program.
These are usually calculated on an hourly, weekly, or monthly cost basis and added to the
per hour work cost.
If the company that employs the engineer, in the example above, contributes $500 per
month for medical and other insurances, the following should be added to the hourly costs:

$500/month x 12 months = $6,000/year divided by 1,880 hours = $3.19 per hour

Furthermore, if the company also contributes $400 per month to a 401k plan (a U.S.
recognized company retirement plan) and/or any other retirement plans for the engineer,
the following should be added:

$400/month x 12 months = $ 4800/year divided by 1880 hours = $2.55 per hour

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Government Mandated Benefits:
These benefits include items such as: government retirement funds, unemployment
insurance, retirement healthcare insurance, etc.
In the U.S., these funds include Social Security, Medicare, state unemployment insurance,
etc.
These costs are usually calculated on a straight percent of the worked hours. Continuing
with our example engineer, we will add the
following:

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Summary of Engineer’s Wages Example
The cost basis for an Engineer who makes $80,000 is summarized in Table 4.2:

 Engineering/Contractors Overhead and Profit

The breakdown includes the following:
• Base wages, including fringes;
• Worker’s compensation, (if applicable);
• Overhead; and,
• Profit, (if applicable for time and material situations).
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 Fully Loaded or Billing Rate
A fully loaded rate is the base wage, plus adders for an hour’s work on the job.
An owner employing a contractor on a time and material basis only pays for the worker’s
time when he or she is on the job.
If he or she is sick, on vacation, or it is a holiday, the contractor cannot bill the owner.
 Overtime Wages
There are many different overtime wage situations and there are several aspects that
need to be evaluated in developing an
overtime wage structure. Overtime can range from straight time pay for the additional
hours, beyond the standard workweek of 40 hours, or 8 hours per day, to 1.5 and 2.0
times the regular pay.

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  WEIGHTED AVERAGE RATES/CREW COMPOSITE RATES

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Example Calculation:
A contractor needs to make up time in the schedule. If the contractor works the concrete
crew, shown in Table 4.4―10 hours per day, Monday through Saturday for two weeks, how
much extra will it cost the contractor?
Overtime is paid for all hours over eight Monday through Friday, and the first eight hours on
Saturday.
Double-time is paid for hours greater than eight on Saturday and all Sunday work.

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 Special Direct Labor Estimating Adjustments
Example:
In response to a need to improve project safety, Company A has instituted a weekly one
hour safety meeting, and increased turnover meetings by 15 minutes at the beginning of
each shift. A review of the commercial industry work hour database that Company A uses
reveals that none of these activities are included in their commercial estimating database
that they use.
The project is currently working a five day, 40 hour per week schedule.
Estimated work hours to set forms for Foundation B = 150 work hours

Thus, six percent needs to be added to all required work hour calculations
The adjustment for setting forms for Foundation B = 150 hours x 1.06 = 159.0 hours
required

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 INDIRECT AND OVERHEAD LABOR
There are two methods of determining these costs that will be addressed here.
The first method is to do a direct estimate of the indirect staff required and cost them out the same
way as the direct work crews.
For example, if we were building a manufacturing facility that will take a year, the indirect support
could consist of the personnel listed in Table 4.5, using wage rates determined by methods explained
earlier:

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The second method will be to use historical job percentages to determine an appropriate
allowance for indirect labor. Typical examples would include applying a percentage of direct
labor, based upon historical data, or applying a percentage of the total direct costs for
indirect labor, material, and other costs.

In the second example, material and other indirect costs would have to be estimated
separately.
The choice of methods will depend upon how much detailed information is available for
the estimator to use in developing the estimate.

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 ESTIMATING WORK HOURS TO COMPLETE A GIVEN WORK SCOPE
Work Package Development (or Work Breakdown Structure―WBS)
The first step is to review the project and develop meaningful work packages. Often,
several summary level estimates are completed before enough of the project is designed
to provide the estimator with detailed quantities of material, so that a detailed labor
estimate can be developed. An example of a WBS for construction of a small
manufacturing facility consisting of a main building, warehouse and office building, and
site work area including entrance roads and utilities, is shown in Table 4.6.

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As seen in Table 4.6, the work hour estimates will be done at the Level 3. We will use the
main building concrete foundation as an example.
• The building is 300 ft. (m) x 100 ft. (m);
• The concrete foundation consists of wall footings, foundation walls, and a slab;
• The slab will be our example, and it is 1 foot (meter) thick; and,
• The quantity of concrete in the slab is: 200 ft. (m) x 100 ft. (m) x 1 ft. (m) = 20,000 Cubic
Ft (Cubic Meters) = 741 CY (CM).

For example, the database you are using indicates that to place this slab it will take:
0.026 labor hours/m2
For this example:
20,000 m2 x .026 labor hours/m2 = 520 labor hours
In this example, measurements are in feet or meters and are designated by ft (m)
(feet/meters), sf (m2) (square feet/meters squared), etc. Please note that this example
uses 0.026 labor hours for both sf and m2 solely so that the numbers stay the same.
There was no attempt to convert hours for sf to hours for m2.

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 Factors Affecting Productivity
• Will union or non-union craft labor be used?
• Is sufficient labor available locally, or will workers have to come from a long distance
away?
• If area is remote, do workers have to be bused in?
• What will the weather conditions be like? (hot, cold, rainy, etc.).
• Are there any local holidays?
• Are temporary living quarters needed?
• Is overtime necessary to attract workers?
• What are the standard work hours and work days?

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Productivity Improvements
The discussion above was meant to make the reader aware of various conditions that
affected both the cost and schedule duration of the project.
Learning Curve―One of the most important items affecting the learning curve is the
productivity improvement that results from a crew performing repetitive type operations.
In a manufacturing environment, or a construction project where similar kinds of work
are done, the more the crew does the work, the faster and more efficient they become as
they gain familiarity of working together, using the tools, possibly fabricating special
tooling to make the work easier and faster, etc. This needs to be encouraged and
factored into any budget or estimate made.
Using Commercially Available Data for Location Estimating and Comparisons

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 PERFORMANCE MONITORING
 Work Packaging/Work Breakdown Structure (WBS)
Estimate is usually assembled in work packages.
We will start with a simple construction related WBS for a project to install a
 new boiler at an existing manufacturing facility.
• Mobilization
• Excavation
• Sub Foundation
• Slab Placement
• Support Steel
• Piping
• Boiler Installation
• Utilities
• Startup
• Cleanup
• Demobilization

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 PERFORMANCE MONITORING

Since each of these activities has different units of work, one cannot add the units for each
piece together.
However, work hours can be added together. So, if 100 CY (CM) of the slab is to be placed
and is half or 50 percent completed, one has earned 135 work hours
(50 percent x 270 estimated work hours). Adding the earned hours up for each of the work
packages will then allow a composite percent complete for the entire project to be
determined.
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 PERFORMANCE MONITORING

 Performance Monitoring Calculation Examples:

The example in Table 4.10 illustrates how the overall percent complete is calculated using
work completed at any given time.

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 PERFORMANCE MONITORING
 Performance Monitoring Calculation Examples:
In Table 4.11, each activity of the slab placement is estimated and the work hours are
allocated to each of the five days in the plan.

In Table 4.12, the status through Day three is reported, for both the
physical completion, and the work hours expended.

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 PERFORMANCE MONITORING
 Performance Monitoring Calculation Examples:
Graphic Presentation of Earned Value Data
Cost Performance Index (CPI) and Schedule Performance Index (SPI) calculations provides
a numerical calculation to further define the status.
CPI = hours earned/hours expended = 243/200 = 1.22 > 1 (Under Budget)
SPI = hours earned/hours planned = 243/189 = 1.29 > 1 (Ahead of Schedule)

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 PERFORMANCE MONITORING
 Performance Monitoring Calculation Examples:
Earned Value Data: (Graphic Presentation)

CPI = hours earned/hours expended = 164/198 = 0.83 < 1 (Over Budget)

SPI = hours earned/hours planned = 164/243 = 0.67 > 1 (Behind Schedule)

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 Chapter 5―Engineering Role & Project Success

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 Constructability
Constructability is the optimum use of construction knowledge and experience
in planning, design, procurement, and field operations to achieve overall project
objectives
An increasingly-popular trend in constructability analysis is design evaluation through
computerized Building Information Modeling (BIM) software.
Evaluation of engineering
Constructability designspre-planning
and construction through BIMareanalysis
oftencan
usedpoint out routing conflicts
interchangeably.
between structural
Constructability elements
is largely and mechanical/electrical/plumbing
concerned with the systems.
BIM is increasingly
technology, methods being used to notand
of installation, onlythe
achieve constructability
associated goals, butdeals
costs. Pre-planning to reduce
with the
project delivery
scheduling time. organization, site
of resources,
access, and infrastructure.
 Constructability Both are intended to reduce time and costs by considering
Planning
alternative designand
Constructability and/or installation
construction pre-planning are often used interchangeably.
methods.
Constructability is largely concerned with the technology, methods of installation, and the
associated costs. Pre-planning deals with the scheduling of resources, organization, site
access, and infrastructure. Both are intended to reduce time and costs by considering
alternative design and/or installation methods.
 Prototypes
Organizations will typically develop prototypes prior to large-scale production.
Prototypes are developed to test designs and also test customer reaction.
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 Chapter 6―Machinery, Equipment, & Tools

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INTRODUCTION
Selecting, purchasing, tracking, storing, maintaining, and selling machinery, equipment,
and tools is an important project management function that can greatly impact a project’s
cost and schedule. This chapter outlines current issues and industry practices regarding
equipment from a cost engineer’s perspective.

Learning Objectives
After completing this chapter, the reader should be able to:
• Establish an equipment valuation database and identify the different equipment value
categories and subcategories.
• Research equipment price and cost information.
• Understand the factors that affect current and residual values for new and used
equipment.

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 ESTABLISHING AN EQUIPMENT VALUATION DATABASE
Equipment Value Categories
Equipment values can be divided into two major categories:
• Replacement cost (the cost new of an item having the same or similar utility)
• Market value (used equipment, secondary market value)

The first category, Replacement Cost, has the following subcategories:

• Reproduction Cost―is the cost new of an identical item.

• Fair Value―is the adjusted cost of a n ew item, giving consideration for the cost of
similar items, and taking into
account utility and all standard adjustments and discounts to list price.

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The second category, Market Value, also contains several subcategories:
• Fair Market Value-in-Place―is amount that may reasonably be expected for an installed property
in an exchange between a willing buyer and a willing seller, with equity to both, neither under any
compulsion to buy or sell, and both fully aware of all relevant facts, including installation as of a specified
date. This amount includes all normal direct and indirect costs, such as installation and other assemblage
costs necessary to make the property fully operational.
• Fair Market Value-in-Exchange―is the estimated amount that may be reasonably expected for a
property in an exchange between a willing buyer, and a willing seller, with equity to both, neither under
any compulsion to buy or sell, and both fully aware of all relevant facts, as of a specific date (also
referred to as retail value).
• Orderly Liquidation Value―is the estimated gross monetary amount that could typically be
realized from a liquidation sale, given a reasonable period of time to find a purchaser (or purchasers),
with the seller being compelled to sell on an as-is, where-is basis, as of a specific date (also referred to as
wholesale value).
• Forced Liquidation Value―is the estimated gross monetary amount that could typically be realized
from a properly advertised and conducted p u b l i c auction, with the seller being compelled to sell with
a sense of immediacy on an as-is, where-is basis, as of a specific date (also referred to as “under the
hammer” or “blow-out” value).
• Salvage Value/Part-Out Value―is the estimated monetary amount that may be expected for the
whole property or a component of the whole property that is retired from service for possible use
elsewhere, as of a specific date.

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Scrap Value―is the estimated monetary amount that could be realized for the property if
it were sold for its material content, not for productive use, as of a specific date.
For example, dollars per ton of steel or pound of copper.

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Market Valuation Example
To better illustrate the basis for some of the subcategories of market value (how equipment is
bought and sold) review the example of a 10-year old metal turning lathe shown in Table 6.2.
This is followed by Table 6.2, an example summary of the relationship of subcategories of
market value to one another.

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 Residual Value Curves

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 Depreciation and Depletion
• It must be realized that depreciation is not a cash flow.
• Depreciation instead is a non-cash expense that reduces taxable income.

Depreciation Techniques
Given that governments allow firms to depreciate their investments, there are
numerous methods to accomplish the depreciation process.
These standard methods simplify accounting for the depreciation expenses.
Some of the more common depreciation techniques are:
• straight-line (SL) method,
• double-declining balance (DDB) method,
• sum-of-years digits (SOYD) method,
• modified accelerated cost recovery system

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  Straight-Line (SL) Methods
Straight-Line (SL) Methods take an equal amount of depreciation
every year.
The SL Method takes the original cost, less the salvage value, divided
by the number of years of life by the formula:
D = (C-S)/N
Where:
D = depreciation charge
C = asset original cost
S = salvage value
N = asset depreciable life (years)
Example :
An asset with a $5,000 original cost, five-year life, and $1,000
residual salvage value,
SL depreciation of $800 per year: ($5,000 - $1,000) / 5 years = $800.
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  Double-Declining Balance Depreciation
Double-Declining Balance Depreciation applies a constant depreciation rate to the assets’
declining value. The DDB formula is:
D = (2/N) (BVr-1)
Where:
D = depreciation charge, C = asset original cost, BVr-1 = book value of asset at end of rth year
BV0 = book value at beginning of first year = C
N = asset depreciable life (years)

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  Sum-Of-Years Digits Depreciation
The SOYD depreciation formula is:
Dr = (C – S)*[(2(N-r+1))/(N(N + 1)]
Where:
Dr = depreciation charge for the rth year
C = asset original cost
S = salvage value
N = asset depreciable life (years)
r = rth year
Calculating the SOYD numerator: SOYD = [(N/2)*(N + 1)] = [(5/2)*(5 + 1)] = 15

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Modified Accelerated Cost Recovery System Depreciation
The Modified Accelerated Cost Recovery System (MACRS) method is unique to the U.S.
Tax Code. Depreciation under this MACRS method is based on original asset cost, asset
class, asset recovery period, and asset in-service date. Asset classes are differentiated
based on three-year, five-year, seven-year, ten-year, and other property lives depending
on asset type.
An agricultural corporation that paid 53% in income tax wanted to build a grain elevator
designed to last twenty-five (25) years at a cost of $80,000 with no salvage value. Annual
income generated would be $22,500 and annual expenditures were to be $12,000.
Answer the question using a straight line depreciation and a 10% interest rate. How many
years will it take to earn $400 in interest on $800 at 4% compounded annually

A. The Federal IRS Reform Act (FIRSRA)

B. Generally Accepted Accounting Practices (GAAP)
C. Accelerated Cost Recovery System (ACRS)
D. Modified Accelerated Cost Recovery System (MACRS) D
Units of Production Depreciation
The units of production (UOP) Method is utilized when depreciation more accurately
based on usage instead of time.
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 Chapter 7―Economic Costs

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 TYPES OF COSTS
 Depletion
is analogous to depreciation, but for natural resources.
 Opportunity Costs
An opportunity cost represents the foregone benefit by choosing one alternative over
another.
 You have Project A $100,000 and Project B $ 40,000, you decided to bid for A.
The opportunity cost is $40,000.
 Sunk Costs
Sunk costs represent funds already spent by virtue of past decisions.
Since these expenditures are in the past, by definition, they should not influence current
decisions.
The past expenditure is considered to be a sunk cost and is ignored in current and future
decision making.
 You have a project budgeted for $200,000. In mid of execution it is expensed the
whole $200,000. This is not a reason to end off the project.
 Book Costs
•Assets are carried on the firm’s books at original cost less any depreciation.
The underlying land values may have significantly escalated over a period of years;
however, the asset will still be carried at its original or book costs.
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 TYPES OF COSTS

 Incremental Costs
In economic analysis decisions, focus must be on incremental costs or those cost
differences between alternatives yearly.
Two alternatives have annual maintenance costs of $2,500
if a third piece of processing equipment has annual maintenance costs of $1,500, then
there is an obvious incremental cost difference of $1,000, which then must be considered in
the analysis between the three alternative units.

The most common cost changes concepts are:

• inflation,
• deflation,
• escalation, and
• currency variation.

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 Inflation
Inflation is a rise in the price level of a good or service.
There are four effects that can result in inflation either by themselves or in combination
with other effects.
These four effects are:
• Money supply, (influenced by the central bank of a country)

• Exchange rates, (influencing the price of imported goods and services).

• Demand-pull inflation, (excessive quantities of money are chasing a limited

amount of goods and services resulting in what is essentially a “seller’s market” as
sellers receive premium prices).

• Cost-push inflation (Cost-push inflation takes place when product producers

encounter higher costs and then push these costs along to others in the
production chain through higher prices).
 Deflation
Deflation is the opposite of inflation with a fall in the general price level for goods and
services

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 Escalation
Escalation is a technique to accommodate price increases or decreases during the life of
the contract.
• An escalation or de escalation clause is incorporated into the contract so that the
purchaser will compensate the supplier in the event of price changes.

For instance, an aircraft maintenance firm may sign a five-year contract for the
maintenance and fueling of a firm’s aviation fleet. If aviation fuel increases in cost during
the contract, the escalation will be paid for by the purchaser
as an additional contract amount.

Similarly, if the price of fuel declines or de-escalates during the contract, the supplier will
rebate a like amount to the purchaser.

Without such clauses, suppliers would include contingency amounts that

might later be found to be unrealistically high.

The supplier would gain from this windfall while the purchaser would be
the loser..

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  ECONOMIC ANALYSIS TECHNIQUES
 Time Value of Money

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 Net Present Worth Method

Unit A
has a purchase price of $10,000 with a four-year life and zero salvage value.
Annual maintenance costs are $500 per year.
Unit B
Has a purchase price of $20,000 with a twelve-year life and $5,000 salvage value. In Year
1, maintenance costs are zero.
In Year 2 maintenance costs are $100 and increase by $100 per year thereafter.
The firm’s cost of capital is 8 percent.
Solution:
NPW Unit A:
NPW = $10,000 + $10,000(P/F,8%,4) +$10,000(P/F,8%,8) + $500(P/A,8%,12)
= $10,000 = + $10,000(0.7350) + $10,000(0.5403) + $500(7.536)
= $26,521

NPW Unit B:
NPW = $20,000 + $100(P/G,8%,12) - $5000(P/F,8%,12)-$100
= $20,000 + $100(34.634) - $5000(0.3971)-$100
= $21,347
Unit B since $21,478 < $26,521
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Capitalized Cost Method
In some cases, problems have an infinite analysis period.
The need for a structure such as a road or a bridge, for example, is perpetual.
With these types of situations, the capitalized cost method is chosen.
Capitalized cost (CC) represents the present sum of money that needs to be set
aside now, at some interest rate, to yield the funds required to provide the service
indefinitely.
The capitalized cost formula is A = PI.

Example CC Problem: A bridge is built for $5,000,000 and will have maintenance
costs of $100,000 per year.
At 6 percent interest,
what is the capitalized cost of perpetual service?

Solution: The $5,000,000 is a present

cost with the $100,000 per year maintenance costs as ongoing.
Therefore,
Capitalized Cost = $5,000,000 + ($100,000) / 0.06
= $5,000,000 + $1,666,667 = $6,666,667
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  Equivalent Uniform Annual Cost or Benefit
• For some types of analysis, it may be preferable to resolve the comparison to annual
cash flow analysis.
• The comparison may be made on the basis of equivalent uniform annual cost
(EUAC), equivalent uniform annual benefit (EUAB) or on the EUAB-EUAC difference.
Example EUAC Problem:
Assume that the two units, Unit A and Unit B, are compared on the basis of EUAC. Unit
A has an initial cost of $20,000 and $3,000 salvage value, while Unit B has an initial cost
of $15,000 and $2,000 salvage value. Unit A has a life of 10 years, whereas Unit B has a
5-year life. Cost of capital is 10%
Example EUAC Solution: The relevant EUAC formula is: (P-S)(A/P,I,n) + SI.
EUAC Unit A:
EUACA = ($20,000-$3,000)(A/P,10%,10) + $3,000(0.10)
= ($17,000)(0.1627) + $300
= $2765.90 + $300 = $3065.90
EUAC Unit B:
EUACB = ($15,000-$2,000)(A/P,10%,5) + $2,000(.10)
= ($13,000)(0.2638) + $200
= $3429.40 + $200 = $3629.40
On the basis of the EUAC comparison between Unit A and Unit B,
Unit A has the lower EUAC by $563.50 ($3629.40 - $3065.90) ok choice.
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  Rate of Return Analysis
• Many organizations in making investment choices often set hurdle rates.
• The hurdle rate is the benchmark rate of return that a capital investment decision must achieve to be
acceptable.
• A rate of return (ROR) is computed from the projected cash flows of the project.
• ROR values provide a ready basis for the comparison of alternatives.
• In the case where capital investment funds are limited, projects with the highest ROR values can be
selected for the organization.

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Benefit-Cost Ratio Analysis Method
Benefit Cost (B/C) Ratio Analysis involves the simple comparison between benefits and
costs of a proposed action. Benefits are placed in the numerator and costs are placed in
the denominator. If the ratio of benefits to costs is greater than one, the project is viable.
Comparisons can be made between projects to select those projects with the
highest B/C ratio.

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On the basis of the above B/C analysis, both Projects A and B have a positive B/C ratio, but
Project A would be selected as its 1.25 ratio is greater than the Project B 1.17 ratio. The key
question in this analysis is whether the benefits and costs have been evaluated
on an accurate basis. If the benefits for Project A are really $1,300,000, then Project A is less
attractive than Project B. B/C analysis is commonly used in the public sector in evaluating
major capital projects such as dams, waterways, bridges, and other similar public
works endeavors. In the public sector, politics can therefore unfairly select one project
versus another more attractive alternative.
 Payback Period Method
As an example, an investment of $400,000 with benefits of $100,000 per year would have a
payback period of 4 years ($400K/$100K = 4 years). However, a $4,000,000 investment with
benefits of $800,000 per year and a payback period of 5 years ($4,000K/$800K =
5 years) might be the better choice on other criteria. The $400K investment may be scrap
after the end of the fourth year, whereas the $4,000K investment, once the five-year
payback period is complete, could yield comparable returns of $800K per year through
ten years. Simple payback analysis in this case would lead to the fastest payback period
rather than the best overall investment choice.

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 Chapter 8―Activity Based Cost Management

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