Engineering Economics

Definitions
ENGINEERING
• The profession in which the knowledge
gained in physics, chemistry, life
sciences, and mathematics is applied to
make products in large scale that
increase the prosperity of man.
• This must be achieved with a judicious
choice of materials, at the lowest cost in a
manner that is benign to the environment,
and that keeps all stakeholders safe.
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Economics Defined
Economics is:
• The study of how limited resources are
used to satisfy unlimited human wants.
• The study of how people, institutions, and
society make economic choices under
conditions of scarcity.
• The social science that studies the
production, distribution, and consumption
of goods and services.
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 Economics Defined
• Microeconomics is the branch of
economics that studies how people make
decisions and how these decisions
interact.
• Macroeconomics is the branch of
economics that is concerned with overall
ups and downs in the economy.

Economics Defined
An economy is:
• A system for coordinating society’s
productive activities.
• Consists of the sum total of all income from
goods produced and services offered in a
state or nation.
• The size of the economy is measured by the
GDP (Gross Domestic Product - The total
market value of final output (goods and
services) produced within a nation’s borders
in a given time period.)
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 Definitions
ENGINEERING ECONOMICS
• It is a subset of economics that deals with the
analysis and evaluation of the factors that will
affect the economic success of engineering
projects to the end that a recommendation can be
made which will ensure the best use of capital.
• It is the application of economic techniques to the
evaluation of design and engineering alternatives.
• It is the study of feasibility and evaluation of the
cost of possible solutions to engineering
problems.
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Course Description
This course presents the methods of economic
analysis in engineering that systematically evaluate
the costs and benefits of technical project proposals.
Students will be exposed to the different economic
and financial concepts and techniques that include
the time value of money, economic equivalence,
measures of worth of investment, rate of return of
investment, investment risk assessment, and capital
budgeting. These will enhance their understanding of
the factors that affect the economic success of
engineering projects, to the end, will enable them to
formulate recommendations that will ensure the best
use of capital.
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 Course Objectives
• Describe and apply the fundamental concepts of Engineering
Economics and the basic principles of the time value of money.
• Calculate economically equivalent values for time-based cash flows
of varying complexities.
• Evaluate the cost and benefits of technical project proposals and
compare different alternatives using different economic and financial
criteria.
• Develop and evaluate projects cash flows.
• Apply the fundamental principles of Engineering Economics in the
decision making process involving technical project proposals.
• Formulate analytical recommendations on the different areas where
the strategic Engineering economic decisions apply.

Topics
• Introduction to Engineering Economics
• Time Value of Money and Economic
Equivalence
• Evaluating Business and Engineering Assets
– Development of Project Cash Flows
– Using Project Evaluation Tools and Interpreting
Results
– Benefit-Cost Analysis and Economic Decisions
in the Public Sector
• Formulating and Justifying
Recommendations 10

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 Principles of Individual Choice
• Individual choice is the decision by an
individual of what to do, which necessarily
involves a decision of what not to do.
• Principle #1 People must make choices

because resources are scarce.

– A resource is anything that can be used to
produce something else.
– Resources are scarce—not enough of the
resources are available to satisfy all the
various ways a society wants to use them.
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Principles of Individual Choice

• The opportunity cost of an item is
Principle #2

its true cost.

– Opportunity cost is what you must give up in
order to get it.
– Resources are scarce—not enough of the
resources are available to satisfy all the
various ways a society wants to use them.
– You make a trade-off when you compare the
costs with the benefits of doing something.
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 Principles of Individual Choice
• “How much” decisions require
Principle #3

making trade-offs at the margin:

comparing the costs and benefits of doing
a little bit more of an activity versus doing
a little bit less.
– Decisions about whether to do a bit more or
a bit less of an activity are marginal
decisions.
– The study of such decisions is known as
marginal analysis. 13

Principles of Individual Choice

• People usually respond to
Principle #4

incentives, exploiting opportunities to

make themselves better off.
– An incentive is anything that offers rewards
to people who change their behavior.
– Because people usually exploit opportunities
to make themselves better off, incentives can
change people’s behavior.

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 Principles of Interaction
• The interaction of choices—my choices
affect your choices, and vice versa—is a
feature of most economic situations
• The results of this interaction are often
quite different from what the individuals
intend.

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Principles of Interaction
• Principle #5 There are gains from trade.
– In a market economy, individuals engage in
trade: they provide goods and services to
others and receive goods and services in
return.
– There are gains from trade: people can get
more of what they want through trade than
they could if they tried to be self-sufficient.
– This increase in output is due to
specialization: each person specializes in the
task that he is good at performing.
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 Principles of Interaction
• Because people respond to
Principle #6

incentives, markets move toward

equilibrium.
– An economic situation is in equilibrium when
no individual would be better off doing
something different.
– The concept of equilibrium is extremely
helpful in understanding economic
interactions because it provides a way of
cutting through the sometimes complex
details of those interactions.
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Market
Equilibrium A
situation in which
quantity
demanded
equals quantity
supplied.
Surplus: A situation in
which the quantity
supplied is greater than
the quantity demanded.

Shortage: A situation
in which the quantity
demanded is greater
than the quantity
supplied.

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 Principles of Interaction
• Resources should be used as
Principle #7

efficiently as possible to achieve society’s

goals.
– An economy is efficient if it takes all
opportunities to make some people better off
without making other people worse off.
– Equity means that everyone gets his or her
fair share. Since people can disagree about
what’s “fair,” equity isn’t as well defined a
concept as efficiency.
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Principles of Interaction
– Productive efficiency: The situation in which
a good or service is produced at the lowest
possible cost.
– Allocative efficiency: A state of the economy
in which production is in accordance with
consumer preferences; in particular, every
good or service is produced up to the point
where the last unit provides a marginal
benefit to society equal to the marginal cost
of producing it.
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 Principles of Interaction
• Because people usually exploit
Principle #8

gains from trade, markets usually lead to

efficiency.
– The incentives built into a market economy
ensure that resources are usually put to good
use and that opportunities to make people
better off are not wasted.
– In cases of market failure, the individual
pursuit of self-interest found in markets
makes society worse off—that is, the market
outcome is inefficient.
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Principles of Interaction
• When markets don’t achieve
Principle #9

efficiency, government intervention can

improve society’s welfare.
– When markets go wrong, an appropriately
designed government policy can sometimes
move society closer to an efficient outcome
by changing how society’s resources are
used.
– Why markets fail and what policies should be
adopted to improve social welfare?
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 Economy-Wide Interactions
• One person’s spending is another
Principle #10
person’s income.
– In a market economy, people make a living
selling things—including their labor—to other
people. If some group in the economy decides,
for whatever reason, to spend more, the income
of other groups will rise. If some group decides
to spend less, the income of other groups will
fall.
– Because one person’s spending is another
person’s income, a chain reaction of changes in
spending behavior tends to have repercussions
that spread through the economy.
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Why Do Engineers Need to Study Economics?

1. For each project, there are usually many possible
alternatives. The opportunity cost of making one choice
over another must be considered.

Trade-offs force engineers to make choices, particularly when answering

the following fundamental questions:

• Which engineering projects are worthwhile?

• Which engineering projects should have a higher priority?

• How should the engineering project be designed?

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 Why Do Engineers Need to Study Economics?
2. Some other topics that may be addressed in
engineering economics are inflation, uncertainty,
replacements, depreciation, resource depletion,
accounting, cost estimations, or capital financing.

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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

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 Why Do Engineers Need to Study Economics?

3. Costs as well as revenues are considered, for

each alternative, for an analysis period that is
either a fixed number of years or the estimated
life of the project.
 Cost: the value of money that has been used
up to produce something or deliver a service
 Revenue: the income that a business has from
its normal business activities, usually from the
sale of goods and services to customers

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Why Do Engineers Need to Study Economics?

4. Since engineering is an important part of

the manufacturing sector of the economy,
engineering industrial economics is an
important part of industrial or business
economics.

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 Law of Diminishing Returns
The principle that, at
some point, adding
more of a variable
input, such as labor,
to the same amount
of a fixed input, such
as capital, will cause
the marginal product
of the variable input
to decline.

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 Why Do Engineers Need to Study Economics?

5. The time value of money is central to most

engineering economic analyses.
– The factors of time and uncertainty are the
defining aspects of any engineering economic
decisions
– A large-scale engineering project
• requires a large sum of investment
• takes a long time to see the financial outcomes
• difficult to predict the revenue and cost streams

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Roles of Engineers in Business

1. Participate in a variety of decision-making

processes, ranging from manufacturing,
through marketing, to financing decisions
2. Plan for the acquisition (purchase) of
equipment (capital)
3. Design products from the concept to
shipping

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 Roles of Engineers in Business

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Roles of Engineers in Business

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 Guide to Engineering Economic Analysis
1. Develop the Alternatives

The final choice (decision)

is among alternatives. The
alternatives need to be
identified and then defined
for subsequent analysis.

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Guide to Engineering Economic Analysis

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.

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 Guide to Engineering Economic Analysis
3. Use a Consistent Viewpoint

The prospective outcomes

of the alternatives,
economic and other,
should be consistently
developed from a defined
viewpoint (perspective).

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Guide to Engineering Economic Analysis

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.

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 Guide to Engineering Economic Analysis
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.

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Guide to Engineering Economic Analysis

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.

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 Guide to Engineering Economic Analysis
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.
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Engineering Economy and the

Design Process
An engineering economics 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.

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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
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Which Car to Lease? Focus vs. Honda

1. Recognize a decision • Need a car

problem
2. Define the goals or • Want mechanical
objectives security
3. Collect all the relevant • Gather technical as well
information as financial data
4. Identify a set of feasible • Choose between Focus
decision alternatives and Honda
5. Select the decision criterion • Want minimum total
to use cash outlay
6. Select the best alternative • Select Honda

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 The Steps in an Engineering Economics Study

• Identify and understand the problem; identify the objective

1 of the project.

• Collect relevant, available data and define viable solution

2 alternatives.

• Make realistic cash flow estimates.

3

• Identify an economic measure of worth criterion for decision

4 making.

• Evaluate each alternative; consider noneconomic factors;

5 use sensitivity analysis as needed.

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• Select the best alternative.

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• Implement the solution and monitor the results.
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Types of Strategic Engineering Economic Decisions

in Manufacturing Sector

1. Service Improvement
2. Equipment and Process Selection
3. Equipment Replacement
4. New Product and Product Expansion
5. Cost Reduction

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 Service or Quality Improvement
Investments in this category include any activity to
support the improvement of productivity, quality and
customer satisfaction in the service sector.

How many more

jeans would Levi
need to sell to justify
the cost of additional
robotic tailors?

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Equipment & Process Selection

Decision problem involves selecting the best course
of action when there are several ways to meet a
project’s requirements.
How do you choose
between the Plastic
SMC and the Steel
sheet stock for an auto
body panel?
The choice of material
will dictate the
manufacturing process
for an automotive body
panel as well as
manufacturing costs.
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 Equipment Replacement
Investment decision involves considering the
expenditure necessary to replace worn-out or
obsolete equipment.

• Now is the time to

replace the old
machine?
• If not, when is the
right time to
replace the old
equipment?

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New Product and Product Expansion

Investment in this category are those that increase
the revenue of a company if output is increased
either by (1) increasing the output of existing
production / distribution facilities or (2) producing a
new product or to expand to into a new geographic
area.

• Shall we build or • R&D investment: $750 million

acquire a new • Product promotion through advertising:
facility to meet $300 million
the increased • Priced to sell at 35% higher than Sensor Excel
demand? (about $1.50 extra per shave).
• Is it worth • Question 1: Would consumers pay $1.50
spending money extra for a shave with greater smoothness
and less irritation?
to market a new
product? • Question 2: What would happen if the blade
consumption dropped more than 10% due to
the longer blade life of the new razor? 50

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 A decision whether a
company should buy Cost Reduction
equipment to perform
an operation now done
manually, or in some
other way spend
money now in order to
save more money later.

• Should a company buy equipment

to perform an operation now done
manually?
• Should spend money now in order
to save more money later?

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Fundamental Principles of Engineering Economics

• Principle 1: A nearby dollar is worth more

than a distant dollar
• Principle 2: All it counts is the differences
among alternatives
• Principle 3: Marginal revenue must
exceed marginal cost
• Principle 4: Additional risk is not taken
without the expected additional return

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 Fundamental Principles of Engineering Economics
• Principle 1: A nearby dollar is worth more
than a distant dollar

Today 6-month later

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Fundamental Principles of Engineering Economics

• Principle 2: All it counts is the differences
among alternatives

Option Monthly Monthly Cash Monthly Salvage

Fuel Mainten outlay at payment Value at
Cost ance signing end of
year 3

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

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

Irrelevant items in decision making 54

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 Fundamental Principles of Engineering Economics
• Principle 3: Marginal revenue must
exceed marginal cost

Marginal
cost

Manufacturing cost 1 unit

Marginal
Sales revenue 1 unit revenue
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Fundamental Principles of Engineering Economics

• Principle 4: Additional risk is not taken
without the expected additional return

Investment Potential Expected

Class Risk Return
Savings Low/None 1.5%
account (cash)

Bond (debt) Moderate 4.8%

Stock (equity) High 11.5%
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