Engineering Economics

Wuhan University of Technology

School of Civil and Architecture Engineering

Department of Civil Engineering

Engineering Economics

Submitted by: Submitted to:

Lasiwa, Upu Rasiya Pr. Li Lei

ID No.58697 lilei1010@163.com

M.Sc. in Civil Engineering (2014 A.D) Civil Department

Date of Submission: 27th July, 2015

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 Engineering Economics

1. What are the principles of Engineering Economy?

Answer:

Economics is the study of how people and society choose to employ scarce resources that
could have alternative uses in order to produce various commodities and to distribute them for
consumption, now or in the future.

Engineering economics is the application of economic principles to engineering problems, for

example in comparing the comparative costs of two alternative capital projects or in
determining the optimum engineering course from the cost aspect.

An importance of engineering economy are:

 Individuals, small-business owners, large corporation presidents, and government

agency heads are routinely faced with the challenge of making decisions when selecting
one alternative over another.
 These are decisions of how to best invest the funds, or capital, of the company and its
owners.
 Engineering economy, quite simply, is about determining the economic factors and the
economic criteria utilized when one or more alternatives are considered for selection.
 Another way to define engineering economy is a collection of mathematical techniques
that simplify economic comparisons.
 With the techniques of Engineering Economy, a rational and meaningful approach to
evaluating the economic aspects of different methods (alternatives) of accomplishing a
given objective can be developed.

The foundation of the discipline of Engineering Economy can be seen in terms of seven
principles. These seven principles are:

 PRINCIPLE 1—DEVELOP THE ALTERNATIVES

 PRINCIPLE 2—FOCUS ON THE DIFFERENCES
 PRINCIPLE 3—USE A CONSISTENT VIEWPOINT
 PRINCIPLE 4—USE A COMMON UNIT OF MEASURE
 PRINCIPLE 5—CONSIDER ALL RELEVANT CRITERIA
 PRINCIPLE 6—MAKE UNCERTAINTY EXPLICIT
 PRINCIPLE 7—REVISIT YOUR DECISIONS

The decision has to come from the alternates developed. The more creative and resourceful the
team members are, the better the selection of alternates available for a go/no-go decision

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would be. The problem can be reformulated and restated to ease the flow of alternates. An
open mind is recommended during the development of alternates.

In Principle 2, deviation analysis is used and the focus is on the differences. The future
outcomes from the alternates are set as higher priority. Based on differences among alternates,
a future course of action is selected. Goal setting is extremely important as emphasized in
Principle 3. A common unit of measure (such as dollars and cents) totals costs or total profits
that can be generated from the alternate considered is captured in Principle 4. All relevant
criteria as mentioned in Principle 5 are important. With analyzing and comparing, uncertainty
of project can be inherited in Principle 6. In Principle 7, the initial projected outcomes of the
selected alternative should be subsequently compared with actual results achieved.

2. What is the simple interest? What is the compound interest?

Answer:

Interest is the cost of borrowing money, where the borrower pays a fee to the owner for using
the owner's money. The interest is typically expressed as a percentage and can be either simple
or compounded.

Simple interest is only based on the principal amount of a loan, while compound interest is
based on the principal amount and the accumulated interest of previous periods, and can thus
be regarded as “interest on interest.” This compounding effect can make a big difference in the
amount of interest payable on a loan if interest is calculated on a compound rather than simple
basis. On the positive side, the magic of compounding can work to your advantage when it
comes to your investments, and can be a potent factor in wealth creation. While simple and
compound interest are basic financial concepts, becoming thoroughly familiar with them will
help you make better decisions when taking out a loan or making investments, which may save
you thousands of money over the long term.

Simple Interest

Simple interest is calculated by multiplying the principal amount by the interest rate and the
number of periods in a loan. Generally, simple interest paid or received over a certain period is
a fixed percentage of the principal amount that was borrowed or lent.

The formula for calculating simple interest is:

Simple Interest = Principal x Interest Rate x Term of the loan

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=Pxixn

Thus, if simple interest is charged at 5% on a $10,000 loan that is taken out for a three-year
period, the total amount of interest payable by the borrower is calculated as: $10,000 x 0.05 x 3
= $1,500.

Interest on this loan is payable at $500 annually, or $1,500 over the three-year loan term.

Compound Interest

Compound interest, is calculated by multiplying the principal amount by one plus the annual
interest rate raised to the number of compound periods minus one. As opposed to simple
interest, compound interest accrues on the principal amount and the accumulated interest of
previous periods.

The formula for calculating compound interest is:

Compound Interest = Total amount of Principal and Interest in future (or Future Value) less
Principal amount at present (or Present Value)

= [P (1 + i) n] – P

= P [(1 + i) n – 1]

Where P = Principal, i = annual interest rate in percentage terms, and n = number of

compounding periods.

For example, suppose another student obtains a compound interest loan to pay one year of his
college tuition, which costs $20,000, and the annual interest rate on his loan is 8%. Unlike the
simple interest, the compound interest accrues on both the principal and the accumulated
interest. He repaid his loan over four years and the amount of compound interest he paid was
$7,209.77, or $20,000*((1+0.08) ^4 - 1) and the total amount he repaid was $27,209.77, or
$20,000+$7,209.77.

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3. Consider a student who could earn $20,000 for working during a year, but chooses instead
to go to school for a year and spend $5000 to do so. What is the opportunity cost of going to
school for that year?

Answer:

The opportunity cost is the cost of an alternative that must be forgone in order to pursue a
certain action or the benefits you could have received by taking an alternative action.

Here, the opportunity cost of going to school is the money she would have earned if she
worked instead. On the one hand, she loses a year of salary while going to school; on the other
hand, she hopes to earn more during her career.

So, if neglecting the influence of income taxes and assumes that she has no earning capability
while in school, the opportunity cost of going to school for that year is

= $20000 + $5000

= $25000.

4. Joe finds a motorcycle he likes and pays $40 as a down payment, which will be applied to
the $1300 purchase price, but which must be forfeited if he decides not to take the cycle.
Over the weekend, Joe finds another motorcycle he considers equally desirable for a
purchase price of $1230. For the purpose of deciding which cycle to purchase, what is the
sunk cost?

Answer:

A cost that has already been incurred and thus cannot be recovered or money that has already
been spent and cannot be recovered is SUNK COST. Logic dictates that because sunk costs will
not change no matter what actions are taken and they should not play a role in decision-
making. Emotionally, however, the more someone invests time, effort and money on
something, the harder it becomes to leave it and move on.

A sunk cost differs from other, future costs that might be faced, such as inventory costs or R&D
expenses, because it has already happened. Sunk costs are independent of any event that may
occur in the future.

So here, in the given case, Joe finds and likes and also pays for a motorcycle as a down
payment, which will be applied to the $1300 purchase price. But later on, he doesn’t like to
take the cycle and finds another motorcycle for a purchase price of $1230.

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But he already pays $40 and remains to pay

= $1300 - $40

= $1260

Whereas, he can buy another desired motorcycle in $1230 which is cheaper or $70 cheaper
from previous one. And, he could save $30 though he already pays for previous motorcycle.

So, we can say $40 is a sunk cost which cannot be recovered though he does not want to take
first one motorcycle coz he already pays and that is nonrefundable.

Therefore, in this case $40 is sunk cost.

5. A plant has a capacity of 4,100 hydraulic pump per month. The fixed cost is $504,000 per
month. The variable cost is $166 per pump, and the sales price is $328 per pump (assume that
sales equal output volume).

(a) What is the breakeven point in number of pumps per month?

(b) What percentage reduction will occur in the breakeven point if fixed costs are reduced
by 18% and unit variable costs by 6%?
Solution:
Given,
Capacity of plant = 4100 pump/month
Fixed cost = $504,000/month
Variable cost = $166/pump
Sale price = $328/pump
Now,

a). We know that,

Contribution margin = sales price – variable cost
= 328 – 166
= $162/pump
¿ cost
Breakeven point =
contribution margin
504000
= 162
= 3111.111pump/month
≈ 3112 pump/month

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 Engineering Economics

b). When fixed cost is reduced by 18%, then fixed cost will be,

= 504000 – 504000 * 18%

= $413280/month

And, when variable cost reduced by 6%, then variable cost will be,

=166 – 166 * 6%

= $156.04/pump

Now, contribution margin = sales price – variable cost

=328 – 156.04

= $171.96/pump

¿ cost
Breakeven point =
contribution margin

413280
= 171.96

= 2403.350 pump/month
So,
breakeven point −reduced breakeven point
Reduced breakeven point = * 100%
breakeven point
3111.111−2403.350
=
111.111
* 100%
= 22.749%

Therefore, 22.75% reduction will occur in the breakeven point if fixed costs are reduced by 18%
and unit variable costs by 6%.

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6. Before evaluating the economic merits of a proposed investment, the XYZ Corporation
insists that its engineers develop a cash-flow diagram of the proposal. An investment of
$10,000 can be made that will produce uniform annual revenue of $5310 for five years and
then have a market value of $2000 at the end of year five. Annual expenses will be $3000 at
the end of each year for operating and maintaining the project. Draw a cash-flow diagram for
the five-year life of the project. Use the corporation’s viewpoint.

Answer:

Here, in question it is clearly mentioned that $10000 is to invest to get annual revenue of $5310
for five years and annual expenses of $3000 at the end of each year and also have a market
value of $2000 at the end of year five.

So, the cash flow diagram of above mention incoming and outgoing can be drawn as:

2000

5310 5310 5310 5310 5310

0 1 2 3 4 5

3000 3000 3000 3000 3000

10000

Here,

 0,1,2,3,4,5 are the numbers of year, N

 $5310 is the uniform annual revenue for five years
 $2000 is the market value at the end of year five
 $3000 is the annual expenses at the end of each year for operating and maintaining the
project
 $10000 is an investment
 Arrow facing upwards are incoming whereas, arrow facing downwards are outgoing.

7. Suppose that a father, on the day his son is born, wishes to determine what lump amount
would have to be paid into an account bearing interest of 12% per year to provide
withdrawals of $2000 on each of the son’s 18th, 19th, 20th, and 21st birthdays.

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 Engineering Economics

Solution:

Given,

Interest, I =12%

Delayed annuity, A = $2000

Principal, P0 =?

Now,

Present value of delayed annuity (PV 17) at the start of 17 th month of annual payment at the end
of each year from 17th year to 21st year at a rate of I is,

(1+i)n −1
PV17 = A * ( n
i ( 1+i )

1.124 −1
= 2000 * 0.12∗1.124

= 2000 * 3.037

= $6074
Now,

Future value at 17th year of present value P0 = $836937.745

Then,

We have, F = P0 (1+i) n

Or, 6074 = P0 *1.12^17

Or, P0 = $884.644 ≈ $885

Therefore, lump amount of $885 would have to be paid into an account bearing interest of 12%
per year to provide withdrawals of $2000 on each of the son’s 18th, 19th, 20th, and 21st
birthdays.