1/25/2016

MS-291: Engineering Economy/Economics

(3 Credit Hours)

Chapter 1
Foundations Of
Engineering Economy

MS291: Engineering

Economy/Economics
Lecture 4
Course Instructor: Dr. Muhammad Sabir

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Sinking fund
A sinking fund is a fund established by
an economic entity(such as a firm) by setting
aside revenue over a period of time to fund a
future capital expense, or repayment of a longterm debt
Sinking funds can also be used to set aside money
for purposes of replacing capital equipment as it
becomes obsolete, or major maintenance or renewal
of elements of a fixed asset, typically a building

Engineering Costs

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Operation and Maintenance Cost

(O&M Costs)
Operation and Maintenance Cost is the group of costs
experienced continually over the useful life of the
activity any example ?
This includes costs like, labour costs for operating &
maintenance personal, fuel and power costs, spare
and repair part costs, costs for taxes etc.
These costs can be substantial and can exceed the initial
costs

Recurring &
Non-recurring costs
Recurring costs known, anticipated and
occurs at regular intervals.
Purchasing food, paying rent.

Non-recurring costs - one-of-a-kind event

that occurs at an irregular interval (some
time called extra-ordinary costs too).
Emergency maintenance expenses.
Sometimes we attempt to plan for large non-recurring costs
by buying insurance. Paying the periodic insurance
premium turns this expense into a recurring cost.

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Capital Cost
Some time also called first cost, initial costs
Capital costs are fixed, one-time expenses incurred on the
purchase of land, buildings, construction and equipment
used in the production of goods or in rendering of services
Capital costs include expenses for tangible goods such as the
purchase of plants and machinery, as well as expenses for
intangibles assets such as trademarks and software
development.
Unlike O&M Costs capital costs are one-time expenses but
payment may be spread out over many years in financial
reports and tax returns. Capital costs are fixed and are
therefore independent of the level of output.

Incremental Costs
An incremental cost is the difference between the
costs of two alternatives.
Example
Choose between alternative models A and B. What
incremental costs occur with model B?
Costs
Model
Cost Items
Purchase price
Installation costs
Annual maintenance costs
Annual utility expenses
Disposal costs after useful life

A
$ 10,000.00
$ 3,500.00
$ 2,500.00
$ 1,200.00
$ 700.00

B
$ 17,500.00
$ 5,000.00
$ 750.00
$ 2,000.00
$ 500.00

Incremental
$ 7,500.00
$ 1,500.00
$(1,750.00)
$ 800.00
$ (200.00)

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Life-cycle Costs
Life-cycle of a product ?
all the costs from the initial conception of an
idea to the death of a product (process)
Life-cycle costs - sum total of all the costs
incurred during the life cycle
Life-cycle costing - designing a product with
an understanding of all the costs associated
with a product during its life-cycle

Product Life-cycle
Begin

Needs
assessment
and
justification

Time

Conceptual or
preliminary
design phase

Impact Analysis

Allocation of
resources

Proof of
concept

Detailed
specification

Requirements
Overall
Feasibility
Conceptual
Design
Planning

Detailed
design
phase

Prototype
Development
and testing
Detailed design
planning

Component
and supplier
selection
Production
or
construction
phase

Production
or
Construction
Phase
Product,
goods and
service
built
All
supporting
facilities
built
Operation
al use
planning

End

Operational
Phase

Decline and
retirement
phase

Operational Use
Use by ultimate
customer
Maintenance
and support
Process,
materials and
methods use
Declined and
retirement
planning

Decaling
Use
Phase out
Retirement
Responsibl
e disposal

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Time Value of Money

(TVM)
A Rupee (or dollar) received today is worth
more than a rupee received tomorrow
because a dollar received today can be
invested to earn interest/return
The amount of interest earned depends on the
rate of return that can be earned on the
investment

Time value of money quantifies the value

of a dollar through time
The time value of money is the most important concept in
engineering economy

Interest

What is Interest ?

It is the manifestation (or display) of the time value of

money
Fee that one pays to use someone elses money
Computationally, interest is the difference between an
ending amount of money and a beginning amount of
money
There are two perspectives for interest:
1- Borrowers perspective Interest paid
Interest Paid= amount owed now principal
2-

Lenders or investors perspective Interest Earned

Interest Earned= Total amount now principal

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Interest
Borrowers perspective

Lenders or investors
perspective
Interest earned

Interest paid

Interest rate (i)

Rate of Return
(ROR)

Interest Rate &

Rate of Return (ROR)
Interest rate Interest paid over a time period
expressed as a percentage of principal
% =

100%

ROR refers to Interest earned over a period of

time expressed as a percentage of the original
amount (principal)
Rate of return (%) =

interest accrued per time unit

x 100%
original amount

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Benefits
So far we have focused on costs only.
However, you may often need to estimate benefits.
Example benefits include sales of products,
revenues from bridge tolls and electric power sales,
cost reductions from reduced material or labor
costs, reduced time spent in traffic jams, and
reduced risk of flooding.
These benefits are the reasons that many
engineering projects are undertaken.

Salvage Value
to estimate the total cost of doing a project
Cost is reduced if we can sell the equipment at
end of project.
Salvage value is the money that can be obtained
at the end of the project by selling equipment.
Salvage value is a benefit rather than a cost.
Can Salvage value be negative ?
Yes its possible.for instance after project
instead of getting money for leftover you need
money to spend it on dumping it.

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Cash Flows (CFs): Basics

The costs and benefits of engineering projects occur over time and are
summarized on a Cash Flow Diagram (CFD).
Specifically, a CFD illustrates the size, sign, and timing of individual
cash flows. In this way the CFD is the basis for engineering economic
analysis.
CFs are amount of money estimated for future projects or observed for
project events that have taken place
CFs are during specific time period
CF is difficult to estimate as its predicting future
There are three important concepts related to Cash flows: Cash Inflows,
Cash Outflows, Net Cash flows

Cash Flows: Terms

Cash Inflows Revenues (R), receipts, incomes,

savings generated by projects and activities that flow in.

represented with a plus sign and upward arrow

Cash Outflows Disbursements (D), costs, expenses,

taxes caused by projects and activities that flow out.
Represented with a minus sign and downward arrow
Net Cash Flow (NCF) for each time period:
NCF = cash inflows cash outflows = R D
End-of-period assumption:
Funds flow at the end of a given interest period (its
important because cash may not flow in/out at the end
of period always)

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Cash Flows: Estimating

There are two ways for estimating Cash flows:
Point estimate A single-value estimate of a cash
flow element of an alternative
Cash inflow: Income = $150,000 per month

Range estimate Min and max values that

estimate the cash flow
Cash outflow: Cost is between $2.5 M and $3.2 M
- Point estimates are commonly used;
- however, range estimates with probabilities attached provide a better
understanding of variability of economic parameters used to make
decisions

Cash Flow: Diagrams

Draw a time line

Always assume end-of-period cash flows

Time
0

---

---

--- --- ---

n-1

One time
period

Remember: One

Show the cash flows (to approximate scale)

---

---

--- --- ---

n-1

Cash flows are shown as directed arrows: + (up) for inflow

(down) for outflow

and only one of the

perspectives is
selected to develop CF
diagramsEither
lender or borrower

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Cash Flow Diagram: Example

Draw CF diagram for CFs observed over last 8 years
and estimated sale next year for $150. Draw a Net
Cash flow diagram
Net Cash
flow is equal
to What ?

$650

-7

-6

$625

-5

$600

-4

$600
$575

-3

$550

$525

-2

-1

$500

1 Years

Rate of return = 10% per year

$-2500

Class Practice: Cash Flow

3 Minutes Time
An electrical engineer wants to deposit an amount
P now such that she can withdraw an equal annual
amount of A1 $3000 per year for the first 5 years,
starting 1 year after the deposit, and a different
annual withdrawal of A2 $5000 per year for the
following 3 years. How would the cash flow
diagram appear if i 8.5% per year?

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Cash Flow Diagram: Example

An electrical engineer wants to deposit an amount P now such that
she can withdraw an equal annual amount of A1 $3000 per year for
the first 5 years, starting 1 year after the deposit, and a different
annual withdrawal of A2 $5000 per year for the following 3 years. How
would the cash flow diagram appear if i 8.5% per year?

A2 = $5000
A1 = $3000

Rate of return = 8.5% per year

$P

THANK YOU

8 Years