Engineering
Economy
By: VKIS Caingles
To create economically viable projects,
engineers must create products whose cost is
competitive in the marketplace and design plants
in which there is an economic balance between
capital investment and production cost.
Why do companies exist?????
Companies exist for one reason —
to make money.
THE ENGINEER’S ROLE IN PROFIT CREATION
Making money requires that a company turn a profit after it pays taxes.
Engineers affect profits in a number of ways:
They create the opportunity for new sales by developing new or improved
products. In addition, they develop the processes that make these products.
They create the opportunity for reducing expenses by developing processes
that reduce costs.
They design and build or modify plants or processes that will:
 Produce new or improved products
 Increase production capacity, enabling increased sales
 Reduce expenses
What is ENGINEERING ECONOMY?
Engineering economy involves the systematic evaluation of the economic
merits of proposed solutions to engineering problems. To be economically
acceptable (i.e., affordable), solutions to engineering problems must
demonstrate a positive balance of long-term benefits over long-term costs,
and they must also:
promote the well-being and survival of an organization,
embody creative and innovative technology and ideas,
permit identification and scrutiny of their estimated outcomes, and
translate profitability to the “bottom line” through a valid and acceptable
measure of merit.
Engineering Economic Decisions
PRINCIPLES OF ENGINEERING ECONOMICS
Principle 1: Develop the Alternatives
Carefully define the problem! Then the choice (decision) is among alternatives. The
alternatives need to be identified and then defined for subsequent analysis.
Principle 2: Focus on the Differences
Only the differences in expected future outcomes among the alternatives are relevant to
their comparison and should be considered in the decision.
Principle 3: Use a Consistent Viewpoint
The prospective outcomes of the alternatives, economic and other, should be
consistently developed from a defined viewpoint (perspective).
PRINCIPLES OF ENGINEERING ECONOMICS
Principle 4: Use a Common Unit of Measure
Using a common unit of measurement to enumerate as many of the prospective
outcomes as possible will simplify the analysis of the alternatives.
Principle 5: Consider All Relevant Criteria
Selection of a preferred alternative (decision making) requires the use of a criterion (or
several criteria). The decision process should consider both the outcomes enumerated
in the monetary unit and those expressed in some other unit of measurement or made
explicit in a descriptive manner.
Principle 6: Make Risk and Uncertainty Explicit
Risk and uncertainty are inherent in estimating the future outcomes of the alternatives
and should be recognized in their analysis and comparison.
PRINCIPLES OF ENGINEERING ECONOMICS
Principle 7: Revisit Your Decision
Improved decision making results from an adaptive process; to the extent practicable,
the initial projected outcomes of the selected alternative should be subsequently
compared with actual results achieved.
Engineering Economy and the Design Process
An engineering economy study is accomplished using
a structured procedure and mathematical modeling
techniques. The economic results are then used in a
decision situation that normally includes other
engineering knowledge and input.
Engineering Economy and the Design Process
The General Relationship between the Engineering Economic Analysis Procedure and the
Engineering Design Process
Engineering Economic Analysis Procedure
1. Problem recognition, definition, and
evaluation.
2. Development of the feasible alternatives.
3. Development of the outcomes and cash flows
for each alternative.
4. Selection of a criterion (or criteria).
5. Analysis and comparison of the alternatives.
6. Selection of the preferred alternative.
7. Performance monitoring and post evaluation
of results.
Engineering Design Process
1. Problem/need definition.
2. Problem/need formulation and evaluation.
3. Synthesis of possible solutions
(alternatives).
4. Analysis, optimization, and evaluation.
5. Specification of preferred alternative.
6. Communication.
Engineering Economic Analysis Procedure
A friend of yours bought a small apartment building for $100,000 in a college town. She spent
$10,000 of her own money for the building and obtained a mortgage from a local bank for the
remaining $90,000. The annual mortgage payment to the bank is $10,500. Your friend also expects
that annual maintenance on the building and grounds will be $15,000. There are four apartments
(two bedrooms each) in the building that can each be rented for $360 per month.
(a) Does your friend have a problem? If so, what is it?
(b) What are her alternatives?
(c) Estimate the economic consequences and other required data for the alternatives in Part (b).
(d) Select a criterion for discriminating among alternatives, and use it to advise your friend on
which course of action to pursue.
(e) Attempt to analyze and compare the alternatives in view of at least one criterion in addition
to cost.
(f) What should your friend do based on the information you and she have generated?
Engineering Economic Analysis Procedure
(a) Does your friend have a problem? If so, what is it?
Amount received = 4 × $360 × 12
= $17,280
Amount spend = 10,500 + $15,000 = $25,500
Losing
= $8,220
(Now, that’s a
problem!)
Engineering Economic Analysis Procedure
(b) What are her alternatives?
Option (1). Raise the rent. (Will the market bear an increase?)
Option (2). Lower maintenance expenses (but not so far as to cause
safety problems).
Option (3). Sell the apartment building. (What about a loss?)
Option (4). Abandon the building (bad for your friend’s reputation)
Engineering Economic Analysis Procedure
(c) Estimate the economic consequences and other required data for the
alternatives in Part (b).
Option (1). Raise total monthly rent to cover the $8,220 per year
Additional monthly fee per apartment is:
8,220per year /12months = 685 per month
685 per month/ 4 doors = 171.25 per door
Thus, total monthly rental is:
$ 360 + $ 171.25 = $ 531.25
47.6% increase!!!
Engineering Economic Analysis Procedure
(c) Estimate the economic consequences and other required data for the
alternatives in Part (b).
Option (2). Lower monthly expenses to $2,125
Option (3). Try to sell the apartment building for $X, which recovers the original
$10,000 investment and (ideally) recovers the $685 per month loss ($8,220 ÷ 12)
on the venture during the time it was owned.
Option (4). Walk away from the venture and kiss your investment good-bye. The
bank would likely assume possession through foreclosure and may try to collect
fees from your friend. This option would also be very bad for your friend’s credit
rating
Engineering Economic Analysis Procedure
(d) Select a criterion for discriminating among alternatives, and use it to advise
your friend on which course of action to pursue.
One criterion could be to minimize the expected loss of money. In this case,
you might advise your friend to pursue Option (1) or (3).
(e) Attempt to analyze and compare the alternatives in view of at least one
criterion in addition to cost.
Option (4) is immediately ruled out. Exercising Option (3) could also harm
your friend’s credit rating. Thus, Options (1) and (2) may be her only realistic
and acceptable alternatives.
Engineering Economic Analysis Procedure
(f) What should your friend do based on the information you and she have
generated?
Your friend should probably do a market analysis of comparable housing
in the area to see if the rent could be raised (Option 1). Maybe a fresh
coat of paint and new carpeting would make the apartments more
appealing to prospective renters. If so, the rent can probably be raised
while keeping 100% occupancy of the four apartments
Cost Concepts and Design Economics
Cost Terminology
Fixed costs are those unaffected by changes in activity level over a feasible range of
operations for the capacity or capability available. Typical fixed costs include insurance and
taxes on facilities, general management and administrative salaries, license fees, and interest
costs on borrowed capital.
Variable costs are those associated with an operation that varies in total with the quantity of
output or other measures of activity level. For example, the costs of material and labor used
in a product or service are variable costs, because they vary in total with the number of output
units, even though the costs per unit stay the same.
An incremental cost (or incremental revenue) is the additional cost (or revenue) that results
from increasing the output of a system by one (or more) units
Cost Concepts and Design Economics
Cost Terminology
Direct costs are costs that can be reasonably measured and allocated to a specific output or
work activity. The labor and material costs directly associated with a product, service, or
construction activity are direct costs. For example, the materials needed to make a pair of
scissors would be a direct cost.
Indirect costs are costs that are difficult to allocate to a specific output or work activity.
Normally, they are costs allocated through a selected formula (such as proportional to direct
labor hours, direct labor dollars, or direct material dollars) to the outputs or work activities. For
example, the costs of common tools, general supplies, and equipment maintenance in a plant
are treated as indirect costs.
Standard costs are planned costs per unit of output that are established in advance of actual
production or service delivery. They are developed from anticipated direct labor hours,
materials, and overhead categories (with their established costs per unit).
Cost Concepts and Design Economics
Cost Terminology
A cost that involves payment of cash is called a cash cost (and results in a cash flow).
Book costs are costs that do not involve cash payments but rather represent the recovery of
past expenditures over a fixed period of time. The most common example of book cost is the
depreciation charged for the use of assets such as plant and equipment.
A sunk cost is one that has occurred in the past and has no relevance to estimates of future
costs and revenues related to an alternative course of action. Thus, a sunk cost is common to
all alternatives, is not part of the future (prospective) cash flows, and can be disregarded in an
engineering economic analysis. For instance, sunk costs are nonrefundable cash outlays,
such as earnest money on a house or money spent on a passport.
Cost Concepts and Design Economics
Cost Terminology
An opportunity cost is incurred because of the use of limited resources, such that the
opportunity to use those resources to monetary advantage in an alternative use is foregone.
In engineering practice, the term life-cycle cost is often encountered. This term refers to a
summation of all the costs related to a product, structure, system, or service during its life
span. The life cycle may be divided into two general time periods: the acquisition phase and
the operation phase.
The acquisition phase begins with an analysis of the economic need or want— the analysis
necessary to make explicit the requirement for the product, structure, system, or service.
In the operation phase, the production, delivery, or construction of the end item(s) or service
and their operation or customer use occur. This phase ends with retirement from active
operation or use and, often, disposal of the physical assets involved.
Phases of the
Life Cycle and
Their relative
Cost
The cumulative committed life-cycle cost curve increases rapidly during
the acquisition phase. In general, approximately 80% of life-cycle costs
are “locked in” at the end of this phase by the decisions made during
requirements analysis and preliminary and detailed design. In contrast,
as reflected by the cumulative life-cycle cost curve, only about 20% of
actual costs occur during the acquisition phase, with about 80% being
incurred during the operation phase.
Cost Concepts and Design Economics
Cost Terminology
The investment cost is the capital required for most of the activities in the acquisition phase.
In simple cases, such as acquiring specific equipment, an investment cost may be incurred as
a single expenditure. On a large, complex construction project, however, a series of
expenditures over an extended period could be incurred. This cost is also called a capital
investment.
Operation and maintenance cost (O&M) includes many of the recurring annual expense
items associated with the operation phase of the life cycle. The direct and indirect costs of
operation associated with the five primary resource areas—people, machines, materials,
energy, and information—are a major part of the costs in this category.
Disposal cost includes those nonrecurring costs of shutting down the operation and the
retirement and disposal of assets at the end of the life cycle. Normally, costs associated with
personnel, materials, transportation, and one-time special activities can be expected.
Cost Concepts and Design Economics
Cost Terminology
The goods and services that are produced and utilized maybe divided conveniently into two
classes:
(a) Consumer goods and services are those products or services that are directly used by
people to satisfy their wants. Food, clothing, homes, cars, television sets, haircuts, opera, and
medical services are examples.
(b) Producer goods and services are used to produce consumer goods and services or
other producer goods. Machine tools, factory buildings, buses, and farm machinery
are examples.
Cost Concepts and Design Economics
Cost Terminology
Perfect competition occurs in a situation in which any given product is supplied by a large
number of vendors and there is no restriction on additional suppliers entering the market.
Under such conditions, there is assurance of complete freedom on the part of both buyer and
seller.
A perfect monopoly exists when a unique product or service is only available from a single
supplier and that vendor can prevent the entry of all others into the market. Under such
conditions, the buyer is at the complete mercy of the supplier in terms of the availability and
price of the product. Perfect monopolies rarely occur in practice, because (1) few products are
so unique that substitutes cannot be used satisfactorily, and (2) governmental regulations
prohibit monopolies if they are unduly restrictive.
Present economy studies
Present economy studies are engineering economic analyses where
alternatives for accomplishing a specific task are being compared over one
year or less and the influence of time on money can be ignored.
Two rules shall be followed in economic studies.
Rule 1: When revenues and other economic benefits are present and vary
among alternatives, choose the alternative that maximizes overall profitability
based on the number of defect-free unit of product or service produced.
Rule 2: When revenues and the economic benefits are not present or are
constant among all alternatives, consider only the cost and select the
alternative that minimizes total cost per defect free unit of product or service
output.
Thank you!