Engineering Economy

What is Engineering Economy?

• Economic decision making for engineeringsystems is called engineering economy.

• This definition may seem restricted toengineering projects and systems only,engineering economy however is also thestudy of industrial economics and theeconomic and financial factors whichinfluence industry.

1ECON 401: Engineering Economics


• Engineering economy is a collection oftechniques that simplify comparisons ofalternatives on an economic basis.

• Engineering economy is not a method orprocess for determining what the alternativesare.



• Engineering economics begins only after thealternatives have been identified.

• If the best alternative is actually one that theengineer has not even recognized as analternative, then all the engineering economicanalysis tools will not result in its selection.



Engineers are the people who are familiarwith all the technicalities of machinery andproduction therefore they are the best judgesof:

a) the useful lives of an asset, and

b) they also have the technical knowledge tocalculate the number of units a proposedplant would produce when operational.



• In today’s competitive world of business it hasbecome essential that engineers shouldpractice financial project analysis forengineering projects and make rationaldecisions.



• Engineering economy also includes the studyof accounting practices for manufacturingconcerns.

• Unique features of accounting formanufacturing concerns are process costing,batch costing, cost allocation, etc.



• Engineering economy deals with justificationand selection of projects.

• Many engineers work on projects whichaddress a specified activity or a problem.

• Any decision regarding the project must bejustified.



• In business environments, many if not all,decisions are justified using monetary criteriasuch as “profit”.

• Such decisions are made at the manageriallevel and many engineers become managersin manufacturing environment.



• Therefore, all engineers, regardless of theiremployment, should know methods and toolsused in evaluation of projects.

• The purpose of engineering economy is toexpose all engineering students to themethods which are widely used for evaluationof projects.



• Even though, engineering economy dealsmostly with selection of projects in businessenvironment, the tools and methods can beand are used by individuals and non-profitorganizations such as government, hospitals,and charitable entities, etc.


SOME EXAMPLES

Let us present few examples in differentenvironments where engineering economy canfacilitate the decision making process.

• Business Environment:

A small manufacturing company needs to buy aforklift truck for material handling. Two differentbrands, say A and B, are being considered. Whichtruck should be bought? The decision willprobably be based on minimization of cost.


SOME EXAMPLES

• Individuals:

A new college graduate needs a new car.Should this new car be bought or leased?Methods from engineering economy can beused for determining the best choice.


SOME EXAMPLESThe following figure shows how engineering iscomposed of physical and economic components:


ENGINEERING

Economic Environment

Physical Environment

Produce products and services based on physical laws (e.g. Newton’s Law)

Assessing the worth of these products/services in economic terms

Production / Construction

Total Environment

SOME EXAMPLES

Physical Environment:

Engineers produce products and servicesdepending on physical laws. Physical efficiencytakes the form:

System output(s)

Physical (efficiency) = ------------------------System input(s)


SOME EXAMPLES

• Economic Environment:

Much less of a quantitative nature is known abouteconomic environments -- this is due to economicsbeing involved with the actions of people, and thestructure of organizations.

System worth

Economic (efficiency) = ------------------------System cost


SOME EXAMPLES

• Satisfaction of the physical and economicenvironments is linked through productionand construction processes.

• Engineers need to control systems to achievea balance in both the physical and economicenvironments, and within the bounds oflimited resources.


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Rational Decision-Making Process

1. Recognize a decision problem

2. Define the goals or objectives

3. Collect all the relevant information

4. Identify a set of feasible decision alternatives

5. Select the decision criterion to use

6. Select the best alternative

ECON 401: Engineering Economics

Rational Decision Making Process

Rational decision making is a complex process that contains a number of essential elements.


2. Define the goals

and objectives

3. Collect all relevant

information

4. Identify a set of

feasible decision

alternatives

5. Select the decision

criterion to use

6. Select the best

alternative


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Which Car to Lease?Saturn vs. Honda


2. Define the goals or objectives

3. Collect all the relevant information

4. Identify a set of feasible decision alternatives

5. Select the decision criterion to use

6. Select the best alternative

• Need a car

• Want mechanical security

• Gather technical as well as financial data

• Choose between Saturn and Honda

• Want minimum total cash outlay

• Select Honda


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Financial Data Required to Make an Economic Decision


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Engineering Economic Decisions

Planning Investment

Marketing

ProfitManufacturing


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Predicting the Future

• Estimating a Required investment

• Forecasting a product demand

• Estimating a selling price

• Estimating a manufacturing cost

• Estimating a product life


Role of Engineers in Business

An Engineer should know the nature of the various business organizations, especially related with his specialization/ profession.

As the business grew, they became partnerships and were eventually converted to corporations.

The present day Computer and Software companies (Apple Computer, Microsoft Corporation, Sun Microsystems) were all started in the late 1970s

and 1980s by the young college students with engineering background.


Types of Business Organizations

• A business owned by one person1.

Proprietorships

• A business owned by more than one person (partners) through a contract2. Partnerships

• A legal entity created under the government law3. Corporations


Proprietorships

Advantages Disadvantages

• Formed easily and inexpensively

• Earnings are taxed at owner’s personal income tax, which will be lower than corporate income tax

• Personal liability

• Difficult to raise capital (cannot issue stocks bonds) for business expansion


Partnerships


• Low cost (one person’s contribution is lesser)

• Ease of formation as the personal assets of all the partners stand behind the business

• Each partner is liable for a business’s debts

• Partnership has a limited life, as when one partner quits, partnership is to be reorganized


Corporations


• Can raise capital from large number of investors

• Easy transfer of ownership interest by trading shares of stock

• Personal liability is limited (to the individual investment)

• Expensive

• Subject to numerous government rules and regulations


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Create & Design

• Engineering Projects

Evaluate

• Expected Profitability• Timing of Cash Flows• Degree of

Financial Risk

Analyze

• Production Methods• Engineering Safety

• Environmental Impacts• Market Assessment

Evaluate

• Impact on Financial Statements• Firm’s Market Value

• Stock Price

Role of Engineers in Business


FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS

PRINCIPLE 1:

A nearby penny is worth a distant dollar

• A fundamental concept in engineering economics is that money has a time value associated with it.

• It is better to receive money earlier

than later.



• If you receive $100 now, you can invest it and have more money available six months from now.

• This concept will be the basic foundation for all engineering project evaluation.



Time Value of Money



PRINCIPLE 2:

All that counts are the differences among

alternatives.

• An economic decision should be based on the differences among the alternatives considered.

• All that is common is irrelevant to the decision.



OptionMonthly Fuel Cost

Monthly Maintenance

Cash Outlay at Signing

Monthly Payment

Salvage Value at

the End of Year 3

Buy $960 $550 $6,500 $350 $9,000

Lease $960 $550 $2,400 $550 0

Irrelevant items in decision making

Differential Analysis



PRINCIPLE 3:

Marginal Revenue must exceed Marginal Cost.

• Each decision alternative must be justified onits own economic merits before beingcompared with other alternatives.

• Marginal revenue means the additionalrevenue made possible by increasing theactivity by one unit.



• Marginal cost means that productive resources likenatural resources, human resources, capital goodsavailable to make goods and services are limited.Therefore, people can not have all the goods andservices they want.

• As a result, they must choose some things and giveup others.



Cost of Goods Sold $2 per unit

Gross Revenue $4 per unit

Marginal Cost

Marginal Revenue

Marginal Analysis



PRINCIPLE 4:

Additional Risk is not taken without the

Expected Additional Return.

• Investors demand a minimum return thatmust be greater than the anticipated rate ofinflation or any perceived risk.



• Expected returns from bonds and stocks arenormally higher than the expected returnfrom a savings account.



Investment Class Potential Risk Expected Return

Savings account (Cash) Low/None 1.5%

Bond (Debt) Moderate 4.8%

Stock (Equity) High 11.5%

Risk and Return Trade Off


Types of Strategic Engineering Economic Decisions

1) Equipment and process selection

2) Equipment replacement

3) New product and product expansion

4) Cost reduction, and

5) Service or quality improvement



• Selecting the best course of actionfrom various alternatives to get bestreturns

1. Equipment & process selection

• Decision involves considering theexpenditure necessary to replaceworn-out or obsolete equipments

2. Equipment replacement

• To increase the revenue

• Two common types:

• Through existing production/distribution,

• Through new product or expand to a newgeographical area

3. New product & product expansion



• Attempts to lower operating costsof the company

• Whether a company should buyequipment to perform anoperation currently done manuallyor spend money now in order tosave more money later

4. Cost Reduction

• To improve of the quality ofproducts/ services

5. Service improvement


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Two Factors in Engineering Economic Decisions

The factors of time and uncertainty are

the defining aspects of any engineeringeconomic decision.


Engineering Economy

Economy & Finance

Transcript of Engineering Economy