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Figure 7-3: Form for gathering data on project resource needs.

Figure 7-3: Form for gathering data on project resource needs.

At times, firms fund projects that show a significant incremental profit over direct costs but are not profitable when fully costed. Such decisions can be justified for a number of reasons, such as:

• To develop knowledge of a technology I* To get the organization's "foot in the door"

" • To obtain the parts or service portion of the work

• To be in a good position for a follow-on contract ft* To improve a competitive position

All of these are adequate reasons to fund projects that, in the short term, may lose money but provide the organization with the impetus for future growth and profitability. It is up to senior management to decide if such reasons are worth it.

Learning Curves

If the project being costed is one of many similar projects, the estimation of each cost element is fairly routine. If the project involves work in which the firm has little experience, cost estimation is more difficult, particularly for direct labor costs. For example, consider a project that requires 25 units of a complex electronic device to be assembled. The firm is experienced in building electronic equipment but has never before made this specific device, which differs significantly from the items it routinely assembles.

Experience might indicate that if the firm were to build many such devices, it would use about seventy hours of direct labor per unit. If labor is paid a wage of \$12 per hour, and if benefits equal 28 percent of the wage rate, the estimated labor cost for the 25 units is

In fact, this would be an underestimate of the actual labor cost because more time per unit output is used early in the production process. Studies have shown that human performance usually improves when a task is repeated. In general, performance improves by a fixed percent each time production doubles. More specifically, each time the output doubles, the worker hours per unit decrease to a fixed percentage of their previous value. That percentage is called the learning rate. If an individual requires 10 minutes to accomplish a certain task the first time it is attempted and only 8 minutes the second time, that person is said to have an 80 percent learning rate. If output is doubled again from two to four, we would expect the fourth item to be produced in

8( 8) = 6.4 minutes Similarly, the eighth unit of output should require

6.4(.8) = 5.12 minutes and so on. The time required to produce a unit of output follows a well-known formula:

Tn = the time required for the nth unit of output, Ti = the time required for the initial unit of output, « = the number of units to be produced, and r — log decimal learning rate/log 2.

The total time required for all units of a production run of size N is I