Chapter 1

Fundamentals of Engineering Economics

1.1 Engineering Economy

Economics, as a science, deals with the problem of allocation of scarce
resources among competing ends and giving maximum satisfaction at minimum
cost. The role of engineers today, apart from planning and building, also
includes problem solving, managerial decision making, etc. An engineering
economist draws on the accumulated knowledge of engineering and economics
to identify the alternative uses of limited resources and select the most suitable
course of action. So, Engineering Economics is devoted to problem solving,
decision making, optimization and determination of equilibrium. The decision
maker’s objective is to arrive at the best combination of goods to be consumed
or produced, or of inputs to be employed. This helps in the efficient and
effective functioning of an organization enabling it to fix a lower price for its
goods/services.

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.

Engineering economics plays a vital role in all engineering decisions. It is the

application of economic techniques to the evaluation of design and engineering
alternatives, its role being to assess the appropriateness of a given project,
estimate its value and justify it from an engineering standpoint. Engineering
economics deals with the methods that enable engineers’ to make economic
decisions towards minimising costs and/or maximising profits to business
organizations. The role of engineering economists in decision − making is

 to identify alternative uses for limited resources and obtain appropriate data.
 to analyse the data to determine the better alternative.
1.2 Principles of Engineering Economics
The basic principles of engineering economics guide the structuring of
alternatives so they may be compared to determine which should be selected.

1. Equivalence of Kind: In order to make realistic investment decisions, all

alternatives must have a common value unit. For example, consider two
alternative irrigation projects, one provides water for grapes and the second
for cotton. Construction of the first project will produce x tons of grapes.
Construction of the second project will produce y bales of cotton. The projects
cannot be compared using these different units. The proper approach is to
convert both tons and bales into a currency unit.

2. Equivalence of Time: Monetary amounts at different times should not be

directly compared or combined.
Future amount, F, may be made equivalent to present amount, P, by
multiplying by a discounting factor 1/(1 + i)N where i is discount rate or
return rate or interest rate, N is the number of unit time.

( )

( ) ( )

( )
( )

An investment of a dollar at an annual rate of return of 5 % would yield $1.05

a year later. Similarly, $1.05 a year from now is equivalent to $1.00 now
when discounted at 5%.

3. Intangible Values: Items that cannot be expressed in monetary units such as:
• Market pressures, such as need for an increased international presence.
• Availability of certain resources, e.g., skilled labour force, water, power.
• Government laws that dictate safety, environmental, legal, social aspects.
• Corporate management’s or director’s interest in a particular alternative.
• Goodwill offered by an alternative toward a group: employees, county, etc.

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4. Whose Viewpoint? Monetary value depends on the viewpoint taken in the
evaluation. In an engineering economy study, three viewpoints are possible:
• Considering only consequences affecting the group sponsoring or financing
the project.
• Considering only consequences affecting the people living in a specific
area such as a city, country or region.
• Considering all consequences to whomever they may accrue.

5. Sunk Cost: Past expenditure or sunk costs are past events that should have no
influence on deciding among alternatives except as they affect future cash
flow. Suppose $5 million have been spent on a hydropower installation
ultimately costing $10 million. A steam plant costing an estimated $3 million
is subsequently found to be capable of supplying the same energy. Which
facility should be selected, assuming all other future costs to be the same? The
$5 million already spent on the hydropower facility is a sunk cost, and the
remaining cost is less than the cost of the steam plant. Therefore, the steam
plant should be selected.

6. Incremental Cost: According to this principle, the decision to enlarge a

project should be justified by the increasing benefits more than costs.
Consider a 10,000 acre-ft reservoir which a city determined to build for $1
million. Before construction begins, increasing the storage to 20,000 acre-ft
and the cost to $1.5million is found to achieve $600,000 in flood control
benefits. The correct incremental-cost approach would include flood control
since the additional $500,000 expenditure is exceeded by $600,000 benefits.

7. Predictive Uncertainty: Economic analysis usually compares future

consequences of engineering alternatives. The reliability of decisions depends
on the ability to predict future events. A project may only appear to be
economically feasible because of incorrect predictions. No matter how much
data or experience one has, predicting the future is uncertain.

8. Planning Horizons: The planning horizon is the most distant future time
considered in an engineering economy study. Actually, four different periods
of time must be considered in any economic analysis:
 Economic Life: ends when the incremental benefits from continued use no
longer exceed the incremental costs of continued operation.
 Physical life: ends when a facility can no longer physically perform its
intended function.
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  Period of Analysis: is the time period over which the project consequences
are included in a particular study. The period of analysis for comparing
alternatives has the project economic life as its upper limit but may be
shortened to exclude the highly uncertain events of the very distant future.
 Construction Horizon: is reached when the constructed facilities are no
longer expected to satisfy the future demands. For example, the electricity
supply alternatives for a community may be studied for a period of analysis
of 40 years even though the original facilities may be planned to supply
electricity for only 20 years. The longer period of analysis helps integrate
present action into the long-run solution. The shorter construction horizon
adds flexibility to deal with unforeseen changes.

9. Structuring Alternatives: The analyst should clearly define all alternatives

that are capable of achieving the design objective. Benefits and costs, the
physical consequences, and intangible values of each alternative must be
identified. One alternative is to “do nothing” if none of the other proposals is
economically feasible. Economic alternatives are categorized as follows:
• Mutually exclusive: Only one of the viable projects can be selected by the
economic analysis. Each viable project is an alternative.
• Independent. More than one viable project may be selected by the
economic analysis. (There may be dependent projects requiring a particular
project to be selected before another, and contingent projects where one
project may be substituted for another.)

1.3 Time Value of Money

It is a mechanics which involve the compound interest factors to express cash
flows (payments) occurring at different times to a single equivalent payment.

We use an interest rate (i), so that the effect of time is proportional to the total
amount of money involved and positively related with the length of time
(Equation 1, 2 and 3).

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1.4 Uniform Annual Series
It is the series of annual cash flow of equal amounts, A, at the end of each year
of the N years. A may be made equivalent to P and vice versa:

( )
[ ] ( )
( )

( )
[ ] ( )
( )

P = is the value of cash flows at present (time 0).

A = measure of cash flows in terms of equivalent equal payment occurring on a

yearly amount.

Furthermore, uniform series of annual cash flow, A, may be made equivalent to

F and vice versa:

( )
[ ] ( )

[ ] ( )
( )

F = is the value of cash flows at future.

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1.5 Uniform Gradient Series
It is the annual cash flow that increases or decreases by some constant amount,
G, between years.

G1
G = G2 –G1

Increasing Gradient GN

G may be made equivalent to P as:

( )
[ ] ( )
( ) ( )

Uniform gradient series may be converted to uniform annual series, A, by:

[ ] ( )
( )

[ ] ( )
( )

GN

G1 Decreasing Gradient
G = G1 –G2

1.6 Cash Flow Diagram

It is the graphic presentation of the monetary values plotted by time. Benefits are
represented by arrows pointing upward, while costs by arrows pointing
downward. The length of the arrow is made proportional to the cost or benefit.
The assignment of a monetary value to physical consequences is a very
complicated process. Cash flow patterns for economy studies are based on future
events and cannot be known with real certainty. Sometimes it may be better to
approximate a future cash flow pattern by using gradients over different periods.

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1.7 Nominal and Effective Interest Rates
In all engineering economy relations developed so far, the interest rate has been
a constant annual value. For many projects evaluated by professional engineers
in practice, the interest rate is compounded more than once a year; such as
semiannually, quarterly, and monthly. This requires the introduction of two new
terms—nominal and effective interest rates.

Nominal interest rate is also defined as a stated interest rate. This interest
works according to the simple interest and does not take into account the
compounding periods.

Effective interest rate is the one which caters the compounding periods during
a payment plan. It is used to compare the annual interest between loans with
different compounding periods like week, month, year etc.

In general stated or nominal interest rate is less than the effective one. And the
later depicts the true picture of financial payments. The nominal interest rate is
the periodic interest rate times the number of periods per year. For example, a
nominal annual interest rate of 12% based on monthly compounding means a
1% interest rate per month (compounded).

( ) ( )

where: n is the number of divisions per year.

is the effective interest rate.

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For example, if a bond pays 6% annually and compounds semiannually, an
investor who places $1,000 in this bond will receive $30 of interest payments
after the first 6 months ($1,000 x 0.03), and $30.90 of interest after the next
six months ($1,030 x 0.03). In total, this investor receives $60.90 for the year. In
this scenario, while the nominal rate is 6%, the effective rate is 6.09%.

1.8 Payback Period NP

This method estimates the number of years required for positive cash flows to
equal the initial investment. There are two types of payback analysis:

1- Simple payback (No return; i= 0%): this is the recovery of only the initial
investment.

∑ ( )

( )

where NCF is the annual net cash flow = cash inflows − cash outflows.

2- Discounted payback (i>0%): it considers the time value of money in

addition to recovering the initial investment.

∑ ( ) ( )

( )
( )

Payback analysis neglects all cash flows after the payback period of NP years.
Consequently, it is preferable to use payback as a supplemental risk assessment
method rather than as the primary means to select an alternative.
The information obtained from discounted payback analysis performed at an
appropriate i>0% can be very useful in that a sense of the risk involved in
undertaking an alternative is provided. For example, if a company plans to
utilize a machine for only 3 years and payback is 6 years, indication is that the
equipment should not be obtained. Even here, the 6-year payback is considered
supplemental information and does not replace a complete economic analysis.

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 Chapter 1

Fundamentals of Engineering
Economics

Tutorial

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Example (1):

An engineering project is to be constructed that will increase the net annual

revenue by 4,415,000 ID. The project’s economical life is 15 years and i = 18%,
what is the net present worth for the revenue summation along the project life?

Example (2):

Recalibration of sensitive measuring device costs $800 per year. If the device
will be recalibrated for each of 6 years starting 3 years after purchase, calculate
the 8-year equivalent uniform series at 15% per year.

Example (3):

A contractor bought a construction machine for 25 million ID and paid 15

million ID in advance and the rest as 10 uniform annual payments started after 3
years from now with i = 20%. What is the amount of uniform annual payment?

Example (4):

The maintenance cost for a machine in the first year is $200, in the second year
is $250, in the third year is $300, in the fourth year is $350, and in the fifth year
is $400. What is the uniform annual maintenance cost when i = 5%?

Example (5):

An engineering project produces benefits of $12,000 in year 1 and incre ase on a

uniform gradient to $120,000 in year 10. Thereafter, they increase on another
uniform gradient of $5,000 per year to $200,000 in year 26, at which point they
remain constant at $200,000 each year until the end of project life in year 50.
What is the present worth of these benefits at a 4% discount rate?

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Example (6):

One million dollars are invested in a project at a return rate of 8% per year.
Calculate the total amount at the end of 10 years if the return is compounded at:
A) The end of each year.
B) The end of 6 months.
C) The end of 3 months.
D) The end of each month.

Example (7):

Company C is planning to undertake a project requiring initial investment of

$105 million. The project is expected to generate $25 million per year for 7
years. Calculate the payback period of the project.

Example (8):

Company C is planning to undertake another project requiring initial investment

of $50 million and is expected to generate $10 million in Year 1, $13 million in
Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5.
Calculate the payback value of the project.

Example (9):

An initial investment of $2,324,000 is expected to generate $600,000 per year

for 6 years. Calculate the discounted payback period of the investment if the
discount rate is 11%.

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