What is Economics?
Reasons for studying Engineering Economy
 The study of how limited or scarce
resources is used to satisfy resources is
used to satisfy unlimited human wants
unlimited human wants
 The study of how individuals and societies
choose to use scarce to use scarce
resources that nature and previous
generations have provided
Resources
 Land – all gifts of nature, such as: water,
air, minerals, sunshine, plant and tree
growth, as well as the land itself which is
applied to the production process.
 Labor – the efforts, skills, and knowledge of
people which are applied to the production
process.
 Capital
o Real Capital (Physical Capital) –
Tools, buildings, machinery -- things
which have been produced which
are used in further production
o Financial Capital – Assets and
money which are used in the
production process
o Human Capital – Education and
training applied to labor in the
production process
Engineering Economy Defined
 Branch of Economics which involves the
application of definite laws of economics,
theories of investment and business
practices to engineering problems involving
cost.
 Study of economic problems with the
concept of obtaining the maximum benefit at
the least cost.
 Study of cost features & other financial data
& applications in the field of engineering as
bases for decision making.
An engineering economy study involves technical
considerations and it is a comparison between
technical alternatives in which the differences
between the alternatives are expressed so far as
practicable in money terms (Grant and Ireson)
Origins of Engineering Economy
The perspective that ultimate economy is a concern
to the engineer and the availability of sound
techniques to address this concern differentiate this
aspect of modern engineering practice from that of
the past.
 it benefit mankind due to the more efficient
use of wealth – ex. engineers in their
inventions & applications of scientific
principles are guided with the terms of
interest payment (short term/long term);
make/buy; rent/buy, etc.
 For those who will ultimately become
managers of their own enterprise or those of
others who will finally realize that
engineering does not merely concern itself
with technical aspects, but will ultimately
leads to economic considerations – thus
knowledge of engineering economy is very
important.
Why Engineering Economy is Important to
Engineers
 Engineers design and create
 Designing involves economic decisions
 Engineers must be able to incorporate
economic analysis into their creative efforts
 Often engineers must select and implement
from multiple alternatives
 Understanding and applying time value of
money, economic equivalence, and cost
estimation are vital for engineers
 A proper economic analysis for selection
and execution is a fundamental task of
engineering
Important Applications of Engineering
Economy
 Seeking of new objectives for the
applications of engineering – ex. market
surveys are made to learn what people
need & want and from that future needs or
forecasts are derived, etc.
 Discovery of factors limiting the success
of a venture or enterprise – strategic
factors such as inadequacy of capital for
new enterprise; methods of production, etc.
 Analysis of possible investment of
capital – capital is invested to earn profit,
thus knowledge on ROR, BEP, Annual
Cost, Payout, etc. is necessary to determine
which investment is worthwhile.
 Comparison of alternatives as a basis for
decision – quantitative & qualitative data
are converting into figures/money values to
determine which alternative is the best
 Determination of cost / benefit as bases
for decision – decisions on future actions
are more valid & their chances for accuracy
are improved when the principles of
engineering economy is correctly applied.
 Knowledge of engineering economy should
improve the ability of engineers to make
correct decisions on all technical matters
involving cost.
Principles of Engineering Economy
1. Develop the Alternatives - The final choice
(decision) is among alternatives. The
alternatives need to be identified and then
defined for subsequent analysis. The final
choice (decision) is among alternatives. The
alternatives need to be identified and the
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.
3. Use a Consistent Viewpoint - the
prospective outcomes of the alternatives,
economic and other, should be consistently
developed from a defined viewpoint
(perspective).
4. Use a Common Unit of Measure – using a
common unit of measurement to enumerate
as many of the prospective outcomes as
possible will make easier the analysis and
comparison of alternatives
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 the outcomes enumerated in the
monetary unit and those expressed in some
other unit of measurement or made explicit
in a descriptive manner.
6. Make Uncertainty Explicit – uncertainty is
inherent in projecting (or estimating) the
future outcomes of the alternatives and
should be recognized in their analysis and
comparison.
7. Revisit Your Decisions – 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 involves two
or more alternatives and normally includes other
engineering knowledge and input.
Engineering Economic Analysis Procedure
1. Problem recognition, formulation, and
evaluation.
2. Development of the feasible alternatives.
3. Development of the 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 results.
Cost Concepts for Decision Making
A relevant cost is a cost that differs between
alternatives.
Principles of Accounting
 Accounting – is the process of recording all
transactions of the company. It provides all
the necessary financial information to the
management for the proper & efficient
operation of the enterprise.
 Transaction – consist of an exchange of
values (value received & value parted with).
Recording of transactions results in a
change in assets, liabilities and ownership.
 Assets – anything of value possessed by
an enterprise. They may be property, right
to property, tangible or intangible, which
may be used for payment of debt.
1. Fixed Asset – used in the operation
& not intended for sale. (land,
machine, furniture, etc)
2. Current Assets – are those which
can be converted into cash in less
than 1 yr. (Accounts receivables,
Cash, Inventories, etc)
3. Intangible Asset – has no physical
substance but has a value in the
future (goodwill, copyright, patent,
etc)
4. Investment – temporary or
permanent in nature & not used in
the operation (share of stocks with
other co, land & building not used in
the operation, etc)
5. Other Asset – not classified above
 Liabilities – are debts / claims of anyone
other than the owners of the property upon
the assets of the co.
1. Current Liabilities – payable within
1 yr (Accounts payables, income tax
payable, notes payables)
2. Long-term liabilities – payable for
more than a year (mortgage
payable, bonds payable, etc)
 3. Deferred liabilities – obligation to
deliver goods or render service to
other party.
4. Other liabilities – not classified
above
 Equity – (ownership / proprietorship) are
claims of anyone against the assets of the
co. It is the excess of assets & liabilities.
Break-Even Analysis
Break Even Point (BEP) – is when total income
will just equal to the total expenses, resulting in no
profit. Below this point a loss will result and above
this a profit will be realized. Thus it is the
responsibility of the management to know at all
times the value at which break-even occurs, and to
see to it that production will exceed this value, if
profit is to be realized.

Basic Accounting Equation Based on the assumptions below, the relations

Assets = Liabilities + Equity
Fundamentals of Cost Accounting
It is the process of determining the actual cost of
manufacturing a product or rendering a service. A
good knowledge of cost accounting for an engineer
engaged in manufacturing would indicate ways on
how costs may be reduced, thus maximizing profit.
Elements of Cost
1. Material cost
2. Labor cost
3. Overhead expenses – are other expenses
not included in material and labor cost,
these are indirect expenses.
among income, costs, and profit may be expressed
mathematically:
 All units produced are sold at a constant
price per unit.
 There is no income other than that from
operations.
 The variable costs are directly proportional
to production rate from zero to 100%
capacity.
 Fixed costs are constant regardless of the
number of units produced.

Material/Inventory Costing
1. FIFO – first in first out, materials issued are
taken from the oldest stock and should be
priced at the cost when they were
purchased. Applicable where materials used
have the tendency to deteriorate if not used
as soon as possible.
2. LIFO – last in first out, material last obtained
are the first to be issued.
3. Average method – all materials in the
warehouse are mixed and no attempt is
made to determine which materials came
first or last, and therefore all materials
issued are to be priced at the average of all
the materials in the warehouse at that time.
This is not widely used because of the
difficulty in computed an average unit price.

Classifications of Cost
1. Fixed cost – remains constant regardless
of the level of production. Examples: rental,
depreciation, insurance, interest on
borrowed capital, etc.
2. Variable cost – vary with output or change
in activities of an enterprise. Examples:
material cost, labor cost, etc.
3. Semi variable – are those cost which varies
beyond the minimum range.
Break-Even Chart – is a graphical representation
of break-even analysis.
The break-even point – is the quantity of
production at which the income is equal to total
cost. It is the intersection of the income line and the
total cost line in the break-even chart.
***When 2 alternatives are compared, the BEP
is the intersection of the (TC) total cost line for
each alternative on the BE chart.

Present Economy Studies

 When the influence of time on money is not
a significant consideration, analyses are
referred to as present economy studies
o Time horizon is one year or less
o No opportunity for earning interest or
profit
 The criterion for selection is usually
o Select the alternative that maximizes
profit
o Select the alternative that minimizes
cost

Present Economic Studies

Involves the analysis of problems for manufacturing
a product or rendering a service based on present
or immediate costs. Present economy studies occur
in the following situations:
1. Selection of materials
2. Selection of methods
3. Selection of design
4. Selection of site location for a project
5. Comparison of proficiency among workers
6. Economy of tool & equipment
7. Economy of number of workers

Sample Problems
The Time Value of Money
Money has a time value
 Capital refers to wealth in the form of money
or property that can be used to produce
more wealth.
 A dollar today is worth more than a dollar
one or more years from now (for several
reasons).

Return to capital in the form of interest and

profit is an essential ingredient of engineering
economy studies.
 Interest and profit pay the providers of
capital for forgoing its use during the time
the capital is being used.
 Interest and profit are payments for the risk
the investor takes in letting another use his
or her capital.
 Any project or venture must provide a
sufficient return to be financially attractive to
the suppliers of money or property

Simple Interest
When the total interest earned or charged is linearly
proportional to the initial amount of the loan
(principal), the interest rate, and the number of
interest periods, the interest and interest rate are
said to be simple.

Computation of Simple Interest

The total interest, I, earned or paid may be
computed using the formula below.

The total amount repaid at the end of n interest

periods is P + I.
If $5,000 were loaned for five years at a simple
interest rate of 7% per year, the interest earned
would be

So, the total amount repaid at the end of five years

would be the original amount ($5,000) plus the
interest ($1,750), or $6,750.

Types of Simple Interest

 Ordinary Simple Interest – computed on
the basis of one banker’s year (12 months,
each consisting of 30 days or 360 days a
year)
 Exact Simple Interest – based on the
exact number of days, 365 for ordinary year
and 366 for leap year.
***Leap year are those which are exactly
divisible by 4, except century years such as
1900, 2000, etc.
Compound interest reflects both the remaining
principal and any accumulated interest. For $1,000
at 10%…

Compound Interest
Compound interest is commonly used in personal
 Interest on top of interest and professional financial transactions.
 Occurs when interest earned by the
principal is not paid at the end of the interest We can apply compound interest formulas to “move”
period, thus considered as added principal
cash flows along the cash flow diagram.
and therefore will also earned interest for
the succeeding periods.
Using the standard notation, we find that a present
 F = P(1 + i)n = P(F/Pri%rn)
amount, P, can grow into a future amount, F, in N time
periods at interest rate i according to the formula
below.

In a similar way we can find P given F by

It is common to use standard notation for interest

factors.

This is also known as the single payment compound

amount factor. The term on the right is read “F given P
at i% interest per period for N interest periods.”

is called the single payment present worth factor.


We can use these to find economically equivalent
values at different points in time. $2,500 at time zero is
equivalent to how much after six years if the interest
rate is 8% per year?
$3,000 at the end of year seven is equivalent to how
much today (time zero) if the interest rate is 6% per
year?
 The more frequent the compounding the
greater the effective interest.
The effect of more frequent compounding can be easily
determined.
Let r be the nominal, annual interest rate and M the
number of compounding periods per year. We can find,
i, the effective interest by using the formula below.

Economic equivalence allows us to compare alternatives Finding effective interest rates.

on a common basis. For an 18% nominal rate, compounded quarterly, the
 Each alternative can be reduced to an effective interest is.
equivalent basis dependent on
o interest rate
o amount of money involved, and
o timing of monetary receipts or
expenses.
For a 7% nominal rate, compounded monthly, the
 Using these elements we can “move” cash flows
effective interest is.
so that we can compare them at particular
points in time.

We need some tools to find economic equivalence.

 Notation used in formulas for compound
interest calculations.
o i = effective interest rate per interest
period
o n = number of compounding (interest)
periods
o P = present sum of money; equivalent
value of one or more cash flows at a
reference point in time; the present
o F = future sum of money; equivalent
value of one or more cash flows at a
reference point in time; the future
o A = end-of-period cash flows in a
uniform series continuing for a certain
number of periods, starting at the end
of the first period and continuing
through the last
Interest can be compounded continuously.
 Interest is typically compounded at the end of
discrete periods.
 In most companies cash is always flowing, and
should be immediately put to use.
 We can allow compounding to occur
continuously throughout the period.
 The effect of this compared to discrete
compounding is small in most cases.
We can use the effective interest formula to derive the
interest factors.

Nominal and effective interest rates. As the number of compounding periods gets larger (M
 More often than not, the time between gets larger), we find that
successive compounding, or the interest period,
is less than one year (e.g., daily, monthly,
quarterly).
 The annual rate is known as a nominal rate.
 A nominal rate of 12%, compounded monthly,
means an interest of 1% (12%/12) would accrue
each month, and the annual rate would be
effectively somewhat greater than 12%.