Engineering Economics

Lecture # 1

Lecture Topics

Introduction to engineering economics Basic cost concepts Decision Making Process Time value of money & discounted cash flow calculations Comparing alternatives Public sector engineering economics private sector engineering economics

What is Economics?

Economics is the social science that analyzes the production, distribution, and consumption of goods and services. Social science that analyzes and describes the consequences of choices made concerning scarce productive resources. Economics is the study of how individuals and societies choose to employ those resources: what goods and services will be produced, how they will be produced, and how they will be distributed among the members of society.

Introduction to Engineering Economy

Engineering Economy is about making decisions.

It is based on the systematic evaluation of the costs and benefits of proposed technical projects.

Introduction to Engineering Economy

The principles and methodology of engineering economy are utilized to analyze alternative uses of financial resources, particularly in relation to the physical assets and the operation of an organization.

Difference b/w Eco. & Eng. Eco.

Economics is the theory of how to best divide resources between agents to maximize their utility. WHILE Engineering economics would be the theory of how to design a product in the most cost-efficient and reliable way.

ENGINEERING COSTS

Fixed Cost
The costs which are constant or unchanging regardless of the level of output or activity.
Typical fixed costs include insurance & taxes on facilities, general management & administrative salaries etc.

Variable Cost
The costs associated with an operation that vary in total with the quantity of output or other measures of activity level. Variable cost depends on output or activity. For example: costs of material & labor.

Total cost
Total cost is the addition of total fixed cost & total variable cost.
Total cost = total fixed cost +total variable cost

Incremental Cost
Incremental cost is the additional cost that results from increasing the output of a system by one unit or more units.
This cost is also subjective in nature like variable cost.

Marginal cost
In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit.
MC = d TC/d Q

Average cost
Average cost is the total cost divided by the number of units. AC = TC/Q

Sunk cost
A sunk cost is a money already spent as a

result of a past decision.

Money once invested cant be recovered called the sunk cost.

Life-Cycle Cost
This is cost for the entire life-cycle of a product, and includes feasibility, design, construction, operation and disposal costs.

Breakeven point
The level of business activity at which the

total costs to provide the product , good, service are equal to the revenue generating by the service.

Revenue
In business, revenue or revenues is income that a company receives from its normal business activities, usually from the sale of goods and services to customers.
Revenue = Cost + Profit

Profit
Profit generally is the making of gain in business activity for the benefit of the owners of the business.
Profit = revenue-cost

Opportunity cost
Opportunity cost or economic opportunity loss is the value of the next best alternative foregone as the result of making a decision.

Engineering Economic Analysis

Engineering Economy

It deals with the concepts and techniques of analysis useful in evaluating the worth of systems, products, and services in relation to their costs

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Decision Making Process

Recognize Problem Define The Goal/Objective Assemble Relevant Data Identify Feasible Alternatives Select The Criterion to Determine the Best Alternative Construct A Model

Predict Each Alternatives Outcomes

Choose The Best Alternative Audit The Result

Recognize The Problem

How we can recognize the problem?

Why the recognition is important?

Some helping programs like TQM or CI

Define Goal or Objective

Defining the objective is the act of exactly describing the task or goal. Goal can be Grand or can be Narrow. Presence of multiple goals represents complex problems.

Assemble Relevant Data

Availability of data:- Certain & Uncertain Source of data:- Accounting System Financial & Cost Accounting are designed

to show accounting values & flow of money----specifically costs & Benefits.

Difference between Direct Cost & Indirect

Identify Feasible Alternatives

What are feasible alternatives?

Do nothing alternatives are feasible. Feasible alternatives for next period.

What are infeasible alternatives?

Violate fundamental laws Require resources which cant be obtained Not available in time

Select the Criterion to Determine the Best Alternative

How can be choice made?
What is best? Best in relative terms not in absolute terms There are different criteria such as: Create the least disturbance to the environment Improve the distribution of wealth among people Minimize the expenditures of money Minimize the time to accomplish the goal Minimize unemployment Maximize profit

Continue

Best criterion is the MAXIMIZE PROFIT in engineering decision making. All problems are fall into one of three categories: Fixed Input Fixed Output Neither fixed input nor output

Constructing the Model

Constructing the interrelationships between the decision making elements is frequently called model building.

Predicting the Outcomes For Each Alternative

Outcomes for each alternative are stated in terms of money.
The Resolution of Consequences is done with all monetary & nonmonetary consequences:

Market consequences Extra-market consequences Intangible consequences

Choosing the Best Alternative

The alternative to be chosen is the one that best meets the choice criterion after considering both the numerical consequences & the consequences not included in the monetary analysis. Who is the decision maker?

Audit the Results

An audit of the results is a comparison of what happened against the predictions.
The audit may help ensure that projected operating advantages are ultimately obtained.

Cash Flow Diagram

Cash Flow

Engineering projects generally have economic consequences that occur over an extended period of time

For example, if an expensive piece of machinery is installed in a plant were brought on credit, the simple process of paying for it may take several years The resulting favorable consequences may last as long as the equipment performs its useful function

Each project is described as cash receipts or disbursements (expenses) at different points in time

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Categories of Cash Flows

The expenses and receipts due to engineering projects usually fall into one of the following categories:

First cost: expense to build or to buy and install Operations and maintenance (O&M): annual expense, such as electricity, labor, and minor repairs Salvage value: receipt at project termination for sale or transfer of the equipment (can be a salvage cost) Revenues: annual receipts due to sale of products or services Overhaul: major capital expenditure that occurs during the assets life

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Cash Flow diagrams

The costs and benefits of engineering projects over time are summarized on a cash flow diagram (CFD). Specifically, CFD illustrates the size, sign, and timing of individual cash flows, and forms the basis for engineering economic analysis A CFD is created by first drawing a segmented time-based horizontal line, divided into appropriate time unit. Each time when there is a cash flow, a vertical arrow is added pointing down for costs and up for revenues or benefits. The cost flows are drawn to relative scale
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Drawing a Cash Flow Diagram

In a cash flow diagram (CFD) the end of period t is the same as the beginning of period (t+1) Beginning of period cash flows are: rent, lease, and insurance payments End-of-period cash flows are: O&M, salvages, revenues, overhauls The choice of time 0 is arbitrary. It can be when a project is analyzed, when funding is approved, or when construction begins One persons cash outflow (represented as a negative value) is another persons inflow (represented as a positive value) It is better to show two or more cash flows occurring in the same year individually so that there is a clear connection from the problem statement to each cash flow in the diagram

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An Example of Cash Flow Diagram A man borrowed $1,000 from a bank at 8%

interest. Two end-of-year payments: at the end of the first year, he will repay half of the $1000 principal plus the interest that is due. At the end of the second year, he will repay the remaining half plus the interest for the second year. Cash flow for this problem is:
End of year 0 1 2 Cash flow +$1000 -$580 (-$500 - $80) -$540 (-$500 - $40)
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Cash Flow Diagram

$1,000

1 0

$580

$540

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Purchasing an Equipment

Ernie's Earthmoving is considering the purchase of a piece of heavy equipment. What is the cash flow diagram if the following cash flows are anticipated? (each team has 5 minutes)

First Cost O&M Cost Overhaul Cost Salvage value

$120K $30K per year $35K per year $40K after 5 years

Purchasing an equipment cash flow diagram

$40.00

$30K

$30K $30K + $35K

$30K

$120K

Time Value of Money

Money has value

Money can be leased or rented

The payment is called interest If you put $100 in a bank at 9% interest for one time period you will receive back your original $100 plus $9

Original amount to be returned = $100 Interest to be returned = $100 x .09 = $9

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