An innovative Cost Engineering Model for ETO

Companies
Piero Lunghi, Marco Botarelli, David Brizioli
University of Perugia, Via Duranti 67, 06125 Perugia, Italy, lunghi@unipg.it

Abstract
The new product cost estimation activity is considered by enterprises as a very critical issue. In our work we are
going to analyse the situation of Engineering To Order (ETO) firms, i.e. of those firms in which design and
production phases are pulled by a specific customer order. By the term designing phase we include also light or
heacy customization of a specific product. One of the problems that those firms have to face during their activity is
the correct economic evaluation of a job order. In this work we present an innovative cost engineering model to
estimate customized product cost; based on the division of costs in two categories, “variant” (the dependent variable)
and “invariant” (the independent variable), and the definition of a relationship between them. The paper is supported
by a case study describing the implementation of the proposed model in an ETO company.

Keywords
Cost engineering, Cost estimating, Detailed method, Parametric method, Analogy Method, Engineering To Order.

1 Introduction
One of the main trends characterizing the modern production systems is the increasing
importance of customized products. Today, a high level of customization can be found in most
industries: automotive, personal computer, fashion, household appliance and many services are
offered with an increasing number of versions on which customer can directly express their
preferences. We can find two main reasons that make enterprises extend their products’
portfolio: to enhance competition and increasing customer expectations.
In such a scenario, the Small and Medium Enterprises (SMEs), representing the main economic
structure not only in Italy, but also in Europe, are in a very tricky situation, given the opportunity
to lever their traditional features (competence on products and operations flexibility) to deliver a
very personalized offer. Building a business model on customized product can lead to significant
problems due to the fact that product costs can be highly variable and not easily foreseeable. The
consequence of this situation is that the margin of a job offer, already limited by the global
competition, can be strongly reduced. Hence we can understand how critical the cost estimating
phase is in order to carry out a correct estimate, especially because many times this activity has
to be completed very quickly. In such a situation we can understand the growing importance of
Cost Engineering issue to support this critical phase. The concept of Cost Engineering include, as
well as the cost estimate, the definition of a production process cost control model in order to
improve the estimation procedure, organizational learning and decisional support. The first
studies in this field go back to the ‘80s, but their significant applications came in the late ‘90s.
Nowadays, Cost Engineering represents an emerging research field as well as an important
management tool, as demonstrated by the project V-CES (Virtual Cost Engineering Studio),
involved in the development of a Cost Engineering software for SMEs. Existing Cost
Engineering model has been developed, used and optimized, considering new product cost
estimating issues, but it has been rarely applied to evaluate a customized products job orders.
The aim of this paper is the to illustrate the development and the application of a Cost
Engineering model in manufacturing companies producing personalized product, where design
and production phases are pulled by a specific customer order. In particular, our work is focused
on those companies having ETO (Engineer to Order) as production process with a high level of
product in catalogue and the possibility, for the customer, to define a customization of a specific
component as well as the entire product, which in turn can lead to a partial or even total re-design
of the product itself.

2 Cost Engineering Methodologies

Cost Engineering is defined by Humpherys and Wellman [1995] as an application of scientific
principles and engineering methodologies aimed to resolve problems related to cost evaluation
and control, business planning and managerial science. In other words, Cost Engineering helps
enterprises in the decisional phase, in cost budget definition and management, within the new
product development process [Roy, 2003]. Wiedels et al. [1998] assert that the function of Cost
Engineering is the realization of an objective, accurate, reliable estimate of operative costs and
investments in order to support the project and investment control decision process (for example
to make decisions like make or buy).
Several model of Cost Engineering has been developed in recent years in order to facilitate its
implementation in complex systems like the manufacturing filed [Weustink et al., 2000; Letters
et al., 1997; Pahl, Beitz, 1996; Wiedels et al., 1998]. The model that we are going to describe in
the following paragraph are composed mainly by the following phases: (1) Cost Estimating; this
is the main activity of Cost Engineering and it generates cost estimates that are based on the
specification of a solution on behalf of a decision maker, in conjunction with a cost model with
defined cost rates; (2) Production Control; it provides the relevant information and data from the
execution of the production plan, to the cost calculation, evaluation and accounting; (3) Cost
calculation and evaluation; the manufacturing input data is used to generate the actual costs,
which are then compared with the cost estimates and their underlying assumptions; (4) Cost
Modelling; the previous one then becomes the basis of the cost modelling that learns, while the
cost accounting generates the cost rates based on the manufacturing data.

2.1 Cost Estimating

As previously mentioned, Cost Estimating is one of the main activities of Cost Engineering and
it is defined as the process of output (product or work activity) cost forecast using historical data.
The estimating process is a critical factor influencing the survival of organization developing,
producing and selling product in the actual competitive market [Shtub and Versano, 1999]. This
activity requires many types of input: experience, data, manufacturing process and components
information and, for its efficiency, it should be integrated in a formalized procedure of cost
engineering [Rajkumar, Jose, Ingo, Lars, 2006].
Some of the main cost estimating methodologies are: (i) the Analogy Method, which is based on
the concept of similarities/analogies between old and new products and their cost differences; (ii)
the Parametric Method, which is based on statistical models applied to historical data to
determine the new product cost; (iii) the Detailed/Bottom-up Method, which is based on the
estimation of each activity and material consumed by the product.
2.1.1 The Analogy Method
The Analogy Method is one of the most applied methods to define product and production costs
structures [Hughes, 1996; Shepperd, Schofield, Kitchenham, 1996; Shepperd, Schofield, 1997;
Bashir, Thompson, 2001; Tessem, Modeling, 1997; Klein, 1998; Boehm, 1984]. It typically
required a supporting tool to store data on past projects; such a tool allows users to report and
analyse those data to find similarities with new project costs. Consequently, the development
entails capturing the knowledge from domain experts in order to formalize it into similarity
functions and analogy rules [Briand, Emam, Surmann, Maxwell, Wieczorek, 1998; Briand,
Wieczorek 2000]. The main criticalities of this method are the following [Bashir, Thompson,
2001; Cavalieria, Maccarrone, Pinto, 2004; Myrtveit, Stensrud, 1999]: the difficulty to define a
“similarity rate” between the new and past projects; the introduction of subjectivity in some parts
of the estimation processes; the difficulty to introduce parameters related to technological
improvement and environmental factors; typically all the similarity dimension are equally
weighted.
2.1.2 The Parametric Method
Following the definition of Parametric Cost Estimating Handbook [International Society of
Parametric Analysts, 2003], “a parametric cost estimate is one that uses Cost Estimating
Relationship (CERs) and associated mathematical algorithms (or logic) to establish cost
estimates”. The parameters are usually identified as “cost drivers”, given they heavily influence
costs. The main factors influencing the quality of the resulting cost model are the following
[Cuadrado-Gallego, Fernàndez-Sanz, Sicilia, 2006]: (i) The choice of CERs, obtained by a
regression analysis (for example linear, multiple or curvilinear regression) and by a correct
definition of input variables, as demonstrated by several works [Farr, Zagorski, 1965; Putnum,
1978; Bailei, Basil, 1981; Boehm, 1984; Jensen, 1983; Boehm, Clark, Horowitz, Madachy,
Selby, Westland, 1995]; (ii) The statement of the model; several studies introduce different
methodologies to increase model quality and to manage uncertainty [Shrum, 1997; Chulani,
Clark, Boehm, Steece, 1998; Chulani, Boehm, Steece, 1999; Ferens, Christensen, 1999; Sicilia,
Cuadrado-Gallego, Crespo, Garcìa-Barriocanal, 2005]. For example, many commercially
available cost estimating packages [Ferens, 1999] use weight as the baseline cost driver and then
generate measures of differential cost driver to refine the cost estimate; (iii) The methodologies
used to select cost drivers for a new project. This aspect has received probably little attention by
researchers since now, even if the Parametric Estimating Handbook [International Society of
Parametric Analysts, 2003] shows how a correct cost driver selection represents a critical success
factor for a parametric estimation.
2.1.3 The Detailed Method
The Detailed (or Bottom-up) Method identifies the single components of a product and
aggregates the estimation of their cost (material and production) to define the total cost of the
final product with a high degree of detail. This method can be applied only when detailed
information on project, production process and product are available [Younossi, Arena, Moore,
Lorell, Mason, Graser, 2002; Bashir, Thomson, 2001]. The most important features of this
method are the following: it uses for the analysis the work breakdown structure (WBS) of all
activities needed to develop, produce and manage the final product and their cost; the material
cost is estimated or obtained directly by suppliers; the method needs accurate data that have to be
managed by skilled personnel. Given its characteristic, this method is applied when all the
specifications on project and product are clearly defined [Cavalieria, Maccarrone, Pinto, 2004].
For this reason a typical process implies a mixed approach: the application of the Parametric or
the Analogy Method during the early stage of a project and then the implementation of a
Detailed Method when the project became more defined. The main disadvantage of the Detailed
Method is that it is very resources and time consuming given that every component involved in
the final product is analysed [Koelle, 2002].

3 Cost Engineering in Engineer To Order Enterprises

We have already pointed out the importance of customized products for manufacturing firms,
especially for SMEs, to compete in the actual global environment. Existing Cost Engineering
model has been developed, used and optimized, considering new product cost estimating issue,
but it has been rarely applied to evaluate a customized products job orders.
Our approach was developed with the aim to provide a tool capable of obtaining an estimating
process not only rapid but also accurate enough. As we have already said that process is very
critical because on the one hand, it determines the definition of a sales price (the upper limit of
which is affected by the market and which, usually, can’t be modified after customer
acceptatance) and on the other, it has to consider all the adding activities and resources
consumed by the customization. In particular we focused on ETO enterprises having a large
number of items on catalogue and producing highly personalized components.
The various Cost Engineering methodologies we presented differ essentially from the Cost
Estimating method adopted. The application of the Analogy Method implies resolving a problem
related to the evaluation of the “difference grade” between the standard product and the
personalization required by the specific customer. Given that the level of such a personalization
can be very high and can be varied every time; this method can lead to sensitive errors in the cost
evaluation process. The Parametric Method could be rapidly applied as well as the previous one;
at the same time this method could be difficult to implement given the variability between
different orders and this could lead to an estimation which is not accurate enough. Finally, the
Detailed/Bottom Up Method allows a very accurate cost evaluation but it requires, to be
correctly applied, technical skills and a considerable amount of time, that people who are in
charge to manage this particular process could not have.

3.1 Description of the model

The object of our model is to support the cost estimation and control it in order to: (i) make an
estimate for a job order with a detailed understanding of the job order costs; (ii) speed up the job
order estimation activity; (iii) obtain a gap between estimation and real costs; (iv) support the
realization of the budget for the new products. Conceptually, the basic idea of the problem is the
definition of a product structure identifying which parts of it could be subjected to modification.
Subsequently it should be developed a specific relation linking how those parts can be modified
and how these modifications influence cost variation. The simplification of the model is given by
the definition of a sub-set of costs that have to be analysed during the negotiating phase.
3.1.1 Costs classification
The innovative point of the proposed model is based on the classification of the total cost (Ctot)
in two categories: (i) “variant” (Cv), which represents costs influenced by the personalization
(the dependent variable of our model); (ii) “invariant” (Ci), which represents costs subjected to
negligible variations so they can be considered unaffected by the personalization compared to
the standard product (the independent variable).
Conceptually, we have:
n z
Ctot = ∑ Cv i + ∑ Ci h
i =1 h =1

Where n and z are respectively the number of defined variant and invariant costs.
Such a classification allows to manage and to analyse a portion (the variable costs) of the whole
product cost speeding up the estimating time. As we can see from the abovementioned, a new
product development can be read as a particular case of our model where all costs are variable.
3.1.2 The cost estimating model
Once the costs are classified in those categories, we can proceed to define the relationship
between them. Each variant cost is then given by each product variation due to the
customization, so we have:
k
Cv i = ∑
j =1
f ij (M j ) , j = 1, ……., n

Where:
Cvi variant cost i (dipendente variable);
fij function linking the product feature j (Mj) with the variant cost i (Ci);
Mj independent variable j representing one of the product feature that determine variant
costs;
n number of defined variant costs;
k number of identified product feature that determine variant costs.
The functions fij in the model can be defined both by statistical analysis from historical data and
by accurate definition. The application of this last option, necessary for example when the firm
has to manage a new product/personalization or it doesn’t have enough historical data, has to be
carefully valuated. Since it can be compared to a Detailed Method, even considering the
application to a subset of costs, it has the same problems in terms of complexity and application
time. Otherwise it entails the application of Cost Estimating Relationships (CERs) using linear
regression as well as multiple or curvilinear regressions [Taylor, 1997; Hamaker, Stewart,
Wyskida, Johannes, 1995; Farr, Zagorski, 1965; Putnum, 1978; Bailei, Basil, 1981; Boehm,
1984; Jensen, 1983; Boehm, Clark, Horowitz, Madachy, Selby, Westland, 1995].

3.2 The methodology application

The application of the model needs a preliminary analysis where managers have to define the
variable used in the model; in particular this phase we have three main activities: product costs
analysis; definition of all the features changeable by customers, definition of the acceptable error
of the analysis. In the following phase managers have to classify cost in variant and invariant
and, for the latter, they have to translate customizable feature in geometrical and production
process variables independent variables). After the definition of the input needed by the model
and their source, the cost function has to be defined, i.e. how the variation of cost is after an
alteration of independent variables previously defined. At the same time it is very critical
[International Society of Parametric Analysts, 2003] to define the range of such a variable within
which the function can be applied.
After the implementation of the model, that is the estimate of a customized product cost, a gap
analysis should be created between the estimation and the real costs. If the variance is higher
than the acceptable errors, managers should carefully analyse the model, especially the cost
function and eventually modify it.

4 Case study
The proposed model has been applied in an Italian ETO company producing mechanical
component (face seals) for companies in mechanical, automotive and household appliance
industry. After an analysis of the product the following variant costs were defined: engineering,
prototyping activities, test, special equipment used during the manufacturing phase, materials
used for face seals components. Subsequently, the following variables were defined:
− M1, face seals height proportional variation;
− M2, surface proportional variation between the fase and its support;
− M3, support roughness proportional variation;
− C1, time spent for the re-engineering phase;
− C2, time spent for prototyping phase;
− C3, time spent for tests;
− C4, cost of specific equipment purchasing;
− C5, material cost.
The functions cost were defined as following:
C = ∑d x a + e x M
i
j
ij j ij j
i = 1, …., 4

( + ) x ]x
1
p p
C = ∑∑∑∑{[Pr
5
l m n p n
x l +
ps ps Pr
x
n p
x m
ps 1 M ps M
x 2 p }
l , m − n, p
l m

Where
aj the binary variable indicating if the variation j has been included in the personalization;
dij the constant term (the intercept) related to the variables Ci and Mj;
eij the parameters of the independent variables Mj;
pi the weight of material i;
Pri the price/volume unity of material i;
psi the specific weight of material i.
Ml,m-n,p the binary variable indicating if the material has been changed
In every project we have:
∑∑∑∑ M
l m n p
l ,m−n , p
≤1

G xa ≥ M j = 1,...,3
j j

a ≤Mj j j = 1,...,3

Where G is a positive number whose value is higher compared to the other variables. As we can
see, the previous functions were defined using both a CERs using linear regression and a detailed
valuation to define the material cost.

Job Variances
orders C1 C2 C3 C4 Mean Standard deviation
1 -7,2% -4,9% -8,7% 10,3% -2,6% 8,7%
2 9,7% 8,6% 11,1% 9,8% 1,2%
3 7,0% 11,1% 67,0% 28,4% 33,5%
4 -2,0% -8,3% -2,7% -4,3% 3,4%
5 3,2% 4,2% 3,0% -12,2% -0,5% 7,9%
6 10,2% 8,3% -9,7% 3,0% 11,0%
7 2,9% -4,8% -3,9% 12,7% 1,7% 8,1%
Tab. 1. Variances of estimated costs (blank cells means the cost was not modify respect to a
standard product)

The model was applied in 7 job orders. The valuation of costs C1, C2, C3 and C4 compared to the
variables M1, M2 and M3, evidenced a linear regression coefficient greater than 0,74. In Tab. 1
shows the variances of those costs respect to real values.
As we can see, the error in the estimating process is below the value of 15 % proposed by many

1
The formula considers the substitution of face and support material from the combination (l, m) to the combination
(n, p), under the hypothesis that just the support height can be changed and that it has a cylindrical shape.
authors [Rajkumar, Jose, Ingo, Lars, 2006] as a reference, except for the order n°3 where a
particular customization leads to an unexpected increasing time required for the engineering and
prototyping phase.

5 Conclusions
The main result of this analysis is the creation of a product costs structure composed by the two
mentioned cost categories. One of the benefits of the model is that it moves the estimation
problem from the job order negotiating phase (when time represent a very critical factor) to the
product design/development phase. Furthermore, the model itself can represent for sellers a
useful contracting tool: ideally they could use it by performing a “what if” analysis to quickly
propose possible alternatives to customers in terms of solutions and prices.
In this way the resulting model will be faster to apply respect to Detailed Method given that we
do not need to analyse every single component of the product. At the same time, its output will
be more accurate compared to a Parametric Method: given that it is based on the valuation of the
relationship linking variant cost rather than the entire generic product cost, it allows a more
detailed analysis level with a comparable level of effort required.
The paper is supported by a case study describing the implementation of the proposed model in
an ETO company producing mechanical component for companies in mechanical, automotive
and household appliance industry. The case study evidenced the possible results obtainable by
the model even if the limited number of job order considered during this first part of the filed
test. The development of the research project provides further analysis of data covering a longer
period of time and a greater number of job orders.

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