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Engineering Economic Decisions

Week #1 (1)
Suhaida Mohd Sood Institute of Energy Policy and Research
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Introduction and Motivation


Discussion Topics
Rational decision-making process The role of engineers in business What makes engineering economics decisions difficult? Strategic decisions The fundamental principles in engineering economics

Opening Story: Google

A Little Google History

1995

Developed in dorm room by Larry Page and Sergey Brin, graduate students at Stanford University Nicknamed BackRub (reflecting great taste ) Raised $25 million to set up Google, Inc. Ran 100,000 queries a day out of a garage in Menlo Park Over 4,000 employees worldwide Over 8 billion pages indexed Estimated market value over $100 billion As of today, the value of Google is likely to be in the hundreds of billions range

1998

2005

Figure 1.1 A helicopter lowers towers for high-voltage power lines into place. Many say the country needs to build more of these lines to move renewable power and become more efficient.

Types of business organisations

Sole proprietorships - single owner who will be legally responsible for all the business debts. Partnerships - shared ownership by two or more partners. The business profit/loss and debts are shared according to their agreed proportion.

Types of business organisations


Limited companies or Corporation Created by law and are regarded as separate entity from the owner. The liabilities of the business debts are limited to the amount of investment in the business. Two types:

Private limited - ownership limited to amongst family member or friends. Public limited - ownership is open to the public.
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Types of business

Trading - the business which buy products and then selling those products to customers e.g. wholesalers and retailers Service industries - provide service to customers such as doctors, lawyers, accountants etc. Manufacturing - the business which convert raw material into finished product and sell the finished products to customers e.g. factory manufacturing electrical goods, foods, cars etc.
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Rational Decision-Making Process


1. Recognize the decision problem 2. Collect all needed (relevant) information 3. Identify the set of feasible decision alternatives 4. Define the key objectives and constraints 5. Select the best possible and implementable decision alternative
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A Simple Illustrative Example: Car to Lease Saturn or Honda?


Recognize the decision problem Collect all needed (relevant) information Identify the set of feasible decision alternatives Define the key objectives and constraints Select the best possible and implementable decision alternative

Need to lease a car Gather technical and financial data Select cars to consider Wanted: small cash outlay, safety, good performance, aesthetics, Choice between Saturn and Honda (or others) Select a car (i.e., Honda, Saturn or another brand)
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Engineering Economic Decisions


Needed e.g. in the following (connected) areas: Profit! Then continue at the next stage Manufacturing Design

Financial planning

Investment and loan

Marketing
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What Makes Engineering Economic Decisions Difficult? Predicting the Future

Estimating the required investments Estimating product manufacturing costs Forecasting the demand for a brand new product Estimating a good selling price Estimating product life and the profitability of continuing production
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The Role of Engineers in Business


Create & Design

Engineering Projects

Analyze Production Methods Engineering Safety Environmental Impacts Market Assessment

Evaluate Expected Profitability Timing of Cash Flows Degree of Financial Risk

Evaluate Impact on Financial Statements Firms Market Value Stock Price

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Accounting vs. Engineering Economy

Evaluating past performance

Evaluating and predicting future events

Accounting
Past

Engineering Economy
Future Present

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Key Factors in Selecting Good Engineering Economic Decisions

Objectives, available resources, time and uncertainty are the key defining aspects of all engineering economic decisions

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Large-Scale Engineering Projects


These typically require a large sum of investment can be very risky take a long time to see the financial outcomes lead to revenue and cost streams that are difficult to predict All the above aspects (and some others not listed here) point towards the importance of EEA

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Types of Strategic Engineering Economic Decisions in the Manufacturing Sector

Service Improvement Equipment and Process Selection Equipment Replacement New Product and Product Expansion

Cost reduction or profit maximization can be seen as generic (common, eventual) objectives In the most general sense, we have to make decisions under resource constraints, and in presence of uncertainty not only in the EEA context
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Example 1: Healthcare Service Improvement


1 Traditional Plan: Patients visit the service providers 2 New Strategy: Service providers visit the patients Which one of the two plans is more economical? The answer typically depends on the type of patients and the services offered. Examples?

service providers

patients

2
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Example 2: Equipment Replacement Problem

Key question: When is the right time to replace an old machine or equipment?

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Example 3: New Product and Product Expansion

Shall we build or acquire a new facility to meet the increased (increasing forecasted) demand? Is it worth spending money to market a new product?

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Example 4: Cost Reduction

Should a company buy new equipment to perform an operation that is now done manually? Should we spend money now, in order to save more money later? The answer obviously depends on a number of factors.

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Further Areas of Strategic Engineering Economic Decisions in the Service Sector

Commercial Transportation Logistics and Distribution Healthcare Industry Electronic Markets and Auctions Financial Engineering and Banking Retail Hospitality and Entertainment Customer Service and Maintenance

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Gross Domestic Product (GDP) Distribution by Sector (U.S. Example)


Manufacturing 14% Healthcare 14% Agriculture 2% Total 30%

Service sector 70%

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The Four Fundamental Principles of Engineering Economics

1: An instant dollar is worth more than a distant dollar 2: Only the relative (pair-wise) difference among the considered alternatives counts 3: Marginal revenue must exceed marginal cost, in order to carry out a profitable increase of operations 4: Additional risk is not taken without an expected additional return of suitable magnitude

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Principle 1
An instant dollar is worth more than a distant dollar

Principle 2 Only the cost (resource) difference among alternatives counts

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Principle 3 Marginal (unit) revenue has to exceed marginal cost, in order to increase production
Marginal cost Manufacturing cost

1 unit

Marginal revenue Sales revenue 1 unit

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Principle 4 Additional risk is not taken without a suitable expected additional return
Investment Class Potential Risk Lowest Moderate Expected Return 1.5% 4.8%

Savings account (cash) Bond (debt)

Stock (equity)

Highest

11.5%

A simple illustrative example. Note that all investments imply some risk: portfolio management is a key issue in finance
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Summary

The term engineering economic decision refers to any investment or other decision related to an engineering project The five main types of engineering economic decisions are (1) service improvement, (2) equipment and process selection, (3) equipment replacement, (4) new product and product expansion, and (5) cost reduction The factors of time, resource limitations and uncertainty are key defining aspects of any investment project Notice that all listed decision types can be seen and modeled as a constrained decision (optimization) problem

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