How do you apply the engineering approach?


Definition

The engineering approach consists in (1) identifying the resources consumed to make a product or provide a service, (2) measuring the quantity of each resource consumed to make a product or provide a service and finally (3) valuing this resource consumption with the price of these resources. Because of this strong emphasis on measurement (of outputs, inputs per output, and input prices), the method is also called the measurement method. The engineering approach typically produces estimates based on the following kinds of equations:

\[ V_c^d = \sum_{m=1}^{f} MU_m^d \times MP_m + \sum_{l=1}^{g} LU_l^d \times LP_l \\ \quad \\ FC_p = \sum_{k=1}^{h} EA_k \]

where \(V_c^d\) is the unit variable cost associated with the cost driver \(d\), \(MU_m^d\) is the usage (i.e. quantity consumed) of materials of type \(m\) by the cost driver \(d\), \(MP_m\) is the price of materials of type \(m\), \(LU_l^d\) is the usage of labor of type \(l\) by cost driver \(d\), \(LP_l\) is the price of the labor of type \(l\), \(FC_p\) refers to the committed fixed costs of the period p and \(EA_k\) the available equipment of type \(k\).

Labor usage is probably one of the most difficult estimate to obtain. Published tables of standard times for specific movement can be used to estimate the total time required to complete a task. Another approach is for industrial engineers to do it time and motion study, clocking the time required for each task.


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Advantages

The first advantage of the engineering approach is that it does not require historical data. It is therefore the only estimation technique which can be used before a new activity even starts (new company, new products, new technologies and processes). The second advantage is that it allows the inclusion of a wide variety of cost drivers. The third advantage is that the detailed decomposition of unit costs it provides is extremely useful to production managers: it shows all the levers (usages and prices) upon which they can act to control their costs. These three advantages explain why the engineering approach is the backbone of budgeting and variance analysis in manufacturing environments. Finally, some governments impose the use of this technique to justify the prices they have to pay for products or services they buy.


Limitations

This analytic method relies on highly qualified personnel and is highly time consuming because it requires going into the details of product design and conducting a lot of measurements. The quality of the estimates is highly dependent on the expertise of the people involved. Moreover, this approach works best for direct materials and direct labor consumption in manufacturing firms, because in these settings the relationship between input and output can be analysed and is stable given a technology. However, it becomes unreliable for services, because customer behavior, an uncontrollable factor, affects the level of service costs. It is also unusable for discretionary costs (e.g. research and development, training, marketing) which are characterized by an unknown relationship between input and output.


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