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EC 0441 Engineering Management

Narasimha KAULGUD

Unit-2
Engineering Economics
And
Financial management

|| tejaswi naavadheeta-mastu ||
(What we study, let it be invigorating) 1
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 1. Law of demand and Supply
Demand varies with the price though there are many other
factors which has influence over demand (Banga, Sharma)
● Law of demand: Relation between price and demand –
higher the price lower the demand and vice-versa
– Range? How much decrease --> how much decreas?
– Elasticity of demand: degree of responsiveness of quantity
demanded to a change in price
Ep = [(Q2-Q1)/Q1] / [(P2-P1) / P1]
Ep – Elasticity of demand
Q1,Q2 quantity demanded before and after price rise
P1,P2 – price before and after the price rise
https://www.investopedia.com/video/play/law-demand/
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 1. Law of demand and Supply
1. Perfect elastic demand : Increase in demand without
reducing price --> horizontal curve
2. Perfect inelastic demand: No change in demand even with
change in pricing --> Vertical curve
3. Demand with unit elasticity: Poportionate change in price
leads to equal change in demand --> Rectangular
hyperbola
4. Relative inelastic demand: Reduction in price leads to
more than proportional increase in demand
5. Relative elastic demand: Reduction in price leads to less
than the proportionate increase in demand

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 1. Law of demand and Supply
● Law of supply: As the price of a commodity rise, its supply
increases and price falls, its supply declines
● demonstrates the quantities that will be sold at a certain price.
● But unlike the law of demand, the supply relationship shows an
upward slope
● Increase and decrease in supply: Change in quantity
supplied without any change in price

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 2. Market equilibrium
●
A market is said to have reached equilibrium price when the
supply of goods matches demand
●
A market in equilibrium demonstrates three characteristics:
the behavior of agents is consistent, there are no incentives
for agents to change behavior, and a dynamic process
governs equilibrium outcome
●
Disequilibrium is the opposite of equilibrium and it is
characterized by changes in conditions that affect market
equilibrium

Equilibrium1: #https://www.investopedia.com/terms/e/equilibrium.asp

#https://www.youtube.com/watch?v=VFNk7NoiwXg

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 Price determination
1.Cost factor
2.Nature of market
3. Competetirors' price
4. Channel distribution
5. Warranty and after-sale service
6. Margin for rebate and concession
7. Government policies
8.Buying habits of customers
9.Nature/season of sale
10. Demand and supply
Banga Sharma pp 895

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 3.1 Simple interest
● Directlyproportionl to time and the total interest payable at
the end of the specified period (usually one year)
I=Pxnxi
● I: (simple) Interest amount; P:Principle amount; i:interest
rate; n:No. Of years, the period
● Entier amount S will be
S = P + I = P + P x n x i = P(1 + ni)
● (1+ni) is the interest factor
● Ordinary Simple interest: When it is required to compute
interest due to fraction of year, a year is taken as 360 days
● Exact simple interest: year is taken a 365 days
Banga sharma pp 952
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 3.2 Compound interest
● #https://www.investopedia.com/terms/c/compoundinterest.
asp
● When the interest due at the end of the period becomes a
part of the principal and itself earns interest along with the
principal, it is compound interest
S = P(1+i)^n
● Factor (1+i)^n is compound amount factor or CAF
● If interest paid is more than once in a year say semi-
annually, (quaterly, monthly etc), then
CAF = (1 +i/m)^n
● I: interest rate per year; n: No. Of years, the period, m =
periods per year
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 4. Net Present Value (NPV)
● Net present value (NPV) is the diffrence between current
cash inflow and outflow over a period of time
● used in capital budgeting and investment planning to
analyze the profitability of a projected investment or
project.
● NPV = sum from{t=1} to n {{R_t} over {(1-i)^t }}
● Rt: Net cash inflow, i: Returns that could be earned (in
alternative investments) and t: No of timer periods

● #https://www.investopedia.com/terms/c/compoundinterest https://www.investopedia.com/terms/n/npv.asp NPV Video 11

.asp
 4.1 IRR – Initial Rate of Return
0=sum from{ t=1 } to T { {C_t} over {(1+IRR)^t} - C_0 } = NPV
C_t nett cash inflow during the period t; C_0 total initial
investment cost IRR initial rate of return; t the number of time
periods

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 4. Net Present Value (NPV)
● IRR or Internal Rate of Return is a form of metric applicable in capital
budgeting.
● It is used to estimate the profitability of a probable business venture. The
metric works as a discounting rate that equates NPV of cash flows to
zero.
● Under the NPV approach, the present value can be calculated by
discounting a project’s future cash flow at predefined rates known as cut
off rates.
● However, under the IRR approach, cash flow is discounted at suitable
rates using a trial and error method that equates to a present value.
● The present value is calculated to an amount equal to the investment
made.
● If IRR is the preferred method, the discount rate is often not
predetermined as would be the case with NPV

https://corporatefinanceinstitute.com/resources/knowledge/valuation/npv-vs-irr/ https://www.investopedia.com/terms/i/irr.asp video 13

 NPV and IRR
● NPV takes cognizance of the value of capital cost or the
market rate of interest.
– It obtains the amount that should be invested in a project in
order to recover projected earnings at current market rates
from the amount invested.
● IRR approach doesn’t look at the prevailing rate of interest
on the market, and its purpose is to find the maximum
rates of interest that will encourage earnings to be made
from the invested amount.
● NPV’s presumption is that intermediate cash flow is
reinvested at cutoff rate while under the IRR approach, an
intermediate cash flow is invested at the prevailing internal
rate of return.
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 Depreciation

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 5. Depreciation concept
● Depreciation is an accounting method of allocating the
cost of a tangible or physical asset over its life expectancy
or useful life (The useful life of an asset is an accounting
estimate of the number of years it is likely to remain in service
for the purpose of cost-effective revenue generation)
– Represents how much of an asset's value has been used
up.
– Depreciating assets helps companies earn revenue from an
asset while expensing a portion of its cost each year the
asset is in use.
● If not taken into account, it can greatly affect profits
● Companies can take a tax deduction for the cost of the asset,
meaning it reduces taxable income

https://www.investopedia.com/terms/d/depreciation.asp https://www.youtube.com/watch?v=laPtTeDgzeQ&t=54s 16
 5.1 Types of depreciation
● Straight-Line: It reports equal depreciation expense each
year throughout the entire useful life until the entire asset is
depreciated to its salvage value.
Depreciation Expense = (Cost – Salvage value) / Useful life
● The declining balance method: is an accelerated
depreciation method. This method depreciates the machine
at its straight-line depreciation percentage times its
remaining depreciable amount each year.
– Because an asset's carrying value is higher in earlier years,
the same percentage causes a larger depreciation expense
amount in earlier years, declining each year.

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 5.1 Types of depreciation
● After taking the reciprocal of the useful life of the asset and
doubling it, this rate is applied to the depreciable base,
book value, for the remainder of the asset’s expected life.
Periodic Depreciation Expense = Beginning book value x Rate of depreciation
● For example, an asset with a useful life of five years
would have a reciprocal value of 1/5 or 20%. Double the
rate, or 40%, is applied to the asset's current book value
for depreciation.
● Although the rate remains constant, the dollar value will
decrease over time because the rate is multiplied by a
smaller depreciable base each period

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 5.1 Types of depreciation
● Units of production:The units-of-production depreciation
method depreciates assets based on the total number of
hours used or the total number of units to be produced by
using the asset, over its useful life
Depreciation Expense = (Number of units produced / Life in number of units) x (Cost – Salvage value)

● Sum-of-the-years-method:In the sum-of-the-years digits

depreciation method, the remaining life of an asset is divided
by the sum of the years and then multiplied by the
depreciating base to determine the depreciation expense.
Depreciation Expense = (Remaining life / Sum of the years digits) x (Cost – Salvage value)

https://corporatefinanceinstitute.com/resources/knowledge/accounting/types-depreciation-methods/
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Cost

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 6 Elements of cost
● Cost of manufaturing cost decides the selling price
– Need to consider all the items for manufacturing cost
● Cost can be divided into different headings – Elements of
cost
– Materials,
– labors
– expenses

Banga & Sharma p 997

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 6.1 Material cost
● Direct and indirect materials
– Direct materials: materials which when operated or
processed form the final product or part of the final product
– Indirect material: Which are essentially needed in various
depatments helping the direct materials.
● Calculation of Material cost
– Calculate the volume of each component by mensuration
– Add the volume of all components to get the total volume of
the product
– Multiply this this volume by density to get the weight of
material
– Multiply cost/weight to the total weight of material to get cost
of the material
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 6.2 Labour cost
● Direct and indirect
– Direct labour: Who work directly – productive labours
– Indirect labour: Who helps in productive labours to perform
duties. Ex. Supervisors, Securities, etc
● Labour cost depends on
– Setup time,
– operation time – Handling time, machine time
– Tearsown time
– Miscellaneous allowance – Personal allowance, fatigue
allowance, Tool changing and finding allowance, other
allowance like cleaning, oiling etc

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 6.3 Expenes
● Direct for chargable expenses and indirect expenses
– Direct expenses: Expenses which can be charged directly to a
particular (specific) job
– Indirect expenses: Overhead charges – factory expenses,
administrative expenses, selling expenses and distribution
expenses
● Factory expenses: Includes indirect material, labour aka works-on-
cost
● Administrative expenses: Salaries of office staff, telephone, internet
charges, depreciation of office building furniture etc. - estalbishment
or office expenses
● Selling expenses: Salaraies in sales dept., advertising, agency
expenses/commision
● Distribution expenses: holding finished stock, despatching, packaging
etc.
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 7. Fixed and variable cost/overheads
● Fixed overheads: Indiect expenses, which remain
constant irrespective of volume of production
– Salaries of staff: supervisors, engineers etc. Known as
spupervisory charges; calculated in terms of expenses per
machine hour
– Depreciation of machine and equipment:
– Interest on capital invested: Assuming interest from the bank
– Rend of building and insurance

https://www.investopedia.com/terms/f/fixedcost.asp
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 7.1 Fixed and variable cost/overheads
● Variable overheads: Indirect expenses, which vary with
volume of production.
– Power or fuel consumed
– Consumable store supplies
– Repairs and maintainance
– Expenditure on tools
● Production cost : Production or product costs refer to all
the costs incurred by a business from manufacturing a
product or providing a service

https://www.investopedia.com/terms/v/variablecost.asp https://www.investopedia.com/terms/p/production-cost.asp 26
Marginal cost, breakeven

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 8. Marginal cost
● The marginal cost of production and marginal revenue are
economic measures used to determine the amount of
output and the price per unit of a product that will
maximize profits.
– say the total cost of producing 100 units of a good is $200.
The total cost of producing 101 units is $204. The average
cost of producing 100 units is $2, or $200 ÷ 100. However,
the marginal cost for producing unit 101 is $4, or ($204 -
$200) ÷ (101-100)
● Marginal revenue increases whenever the revenue
received from producing one additional unit of a good
grows faster—or shrinks more slowly—than its marginal
cost of production

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 8. Marginal cost
● marginal cost of production is the change in total
production cost that comes from making or producing one
additional unit.
● To calculate marginal cost, divide the change in production
costs by the change in quantity.
● The purpose of analyzing marginal cost is to determine at
what point an organization can achieve optimize
production and overall operations.
● If the marginal cost of producing one additional unit is
lower than the per-unit price, the producer has the
potential to gain a profit

https://www.investopedia.com/terms/m/marginalcostofproduction.asp 29
 9 Sunk cost
● A sunk cost refers to money that has already been spent and
which cannot be recovered.
– In business, the axiom that one has to "spend money to make
money" is reflected in the phenomenon of the sunk cost.
– A sunk cost differs from future costs that a business may face.
● Sunk costs are excluded from future business decisions
because the cost will remain the same regardless of the
outcome of a decision
– To make an informed decision, a business only considers the
costs and revenue that will change as a result of the decision at
hand.
● Because sunk costs do not change, they are not considered

https://www.investopedia.com/terms/s/sunkcost.asp 30
 10 Break even analysis
● Break-even analysis entails calculating and examining the
margin of safety for an entity based on the revenues
collected and associated costs.
● analysis shows how many sales it takes to pay for the cost
of doing business.
● Analyzing different price levels relating to various levels of
demand, the break-even analysis determines what level of
sales are necessary to cover the company's total fixed
costs.
● A demand-side analysis would give a seller significant
insight into selling capabilities.

https://www.investopedia.com/terms/b/breakevenanalysis.asp
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 Break even point
● Level of output or sales at which no profit or no loss is
achieved
– Mathematical method: Let cost be the common variable in
two situation. Then cost equation will be
C1=f1(x) (1)
C2=f2(x) (2)
Then C1=C2 or f1(x) = f2(x) (3)
● Graphical: Cost & sales v/s Quantity

Banga & Sharma pp958 https://www.investopedia.com/terms/b/breakevenpoint.asp 32

 10.1 Break even point calculation
Let S be sales price, V variable cost, F fixed cost and P Profit
S = F+V+P or S-V = F + P
At break even point, P = 0
S-V = F ==> S(S-V) = SxF
==> S = SxF/(S-V) = F/((S-V)/S)
= Fixed cost / contribution per unit
Sales at BEP: Rs.(FxS)/(S-V)
No. of units at BEP = Fixed cost/Contribution per unit
= Fixed cost / Marginal profit unit

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 Break-Even (cost) Analysis
● Break-even analysis entails calculating and examining the
margin of safety for an entity based on the revenues
collected and associated costs.
– the analysis shows how many sales it takes to pay for the
cost of doing business.
● Analyzing different price levels relating to various levels of
demand, the break-even analysis determines what level of
sales are necessary to cover the company's total fixed
costs.
● A demand-side analysis would give a seller significant
insight into selling capabilities

https://www.investopedia.com/terms/b/breakevenanalysis.asp
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 Break even chart
● Graphical representation of the relation between costs and
revenue at a given time and determines the break-even-
point and profit potential under varying conditions of output
and cost
● Functions of breakeven chart is to
– Repesent economical position of the production on graph
– Estimate likely profits or losses at various levels of output
– Help the management to decide the production level
– Indicate margin of safety

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 Determination of break even point(BEP)
In terms of physical units or sales value (in rupees)
● In terms of Physical units: No of units of a product which
must be sold to earn enough revenue just to cover all
expenses. BEP is reached when sufficient nuber of units
have been sold so that the total contribution margin of the
units sold is equal to the fixed costs
BEP = fixed costs/(selling price – variable cost per unit)
● In terms of sales value: Contribution margin (sales value-
variable costs)would be equal to fixed costs contribution.
BEP = fixed costs/contribution ratio
Where
contribution ration = (sales value – variable cost)/sales value
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BEP

Profit zone

Variable cost
Loss zone

Fixed cost

X axis: quantity; Y axis: cost

Red: Sales revenue, Blue total cost
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 Position of BEP
● In terms of physical units: Convenient for single poduct
firm. Number of units to be sold to earn revenue just to
cover all expenses
● In terms of sales value: For multi product firms. BEP in
terms of total rupee sales

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 Applications of BEP
1. Safety margin:
2. Volume needed to attain target profit
3. Change in price and its effect
4. To expand production capacity or not
5. To add new product or drop exisitng product
6. Selection of production mchinary so as to get maximum pofit for
a particular volume of the product out of the available machinary
7. Improving profit margin by
1. Increase volume or selling price
2. Reducing variable expenses per unit
3. Reducing fixed costs

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