The University of the West Indies

Faculty of Engineering
Notes for: ENGR1000/MENG1006 - INTRODUCTION TO ENGINEERING
Prepared by Dr T.M.Lewis

FUNDAMENTALS OF ENGINEERING PROJECT ECONOMICS

LECTURE 1

1. Introduction
1.1 Engineering is basically the profession in which a knowledge of the mathematical and natural
sciences is applied with judgement to develop ways to utilise, economically, the materials and
forces of nature for the benefit of man. Engineers use science and technology to solve problems
and meet the needs of society. "The scientist explores what is: the engineer creates what had
not been" Theodore Von Karman

1.2 In any definition of engineering, the harnessing of resources takes place within the context of
economic purpose. By that, it is intended that the objectives of an engineering project should be
achieved at minimum cost.

1.3 The need for economy in the use of resources stems from the fact that such resources are
necessarily limited and that there are competing uses for them, which means that if a resource is
used for one purpose it is denied to another. Thus, there is competition for scarce resources:
(a) between alternative projects designed to serve the same purpose,
(b) between projects which serve different purposes, and
(c) between engineering projects and other potential modes of investment.

1.4 The decision on how to employ resources often lies with politicians, administrators, bankers and
others. If they are to make a wise choice they must be properly informed not only of the
comparative technical merits of alternatives but also of their relative costs and benefits. This
responsibility rests with professional engineers.

2 Technical Considerations
2.1 The technical planning and design of an engineering project is concerned with the establishment
of goals and objectives, the gathering of technical data and the application of mathematics and
the principles of engineering science to analysis, design and synthesis in the development of
alternatives. This work also includes preliminary drawings, outline specifications, and,
increasingly, a statement of the environmental impact of the project.

3 Economic Evaluation
3.1 The aim of economic evaluation is to secure the greatest benefit from the resources available.
More specifically, economic evaluation is an assessment of the costs and benefits of carrying out
a project as compared with doing nothing. This is to establish if any of the proposed schemes is
economic, and if they are, to establish a priority ranking for the competing proposals.

3.2 Where projects require related investments to be made in order to be effective, these must be
taken into account. For example, the evaluation of proposals for the provision of electrical
power must take into account the cost of building and operating the power stations and also the
comparative costs of developing their respective distribution systems.

3.3 Public sector projects must also take into account factors such as the impact they are likely to
have on the national economy, and on employment, and the demands that they will make on
foreign exchange reserves, for example.
4 Financial Planning
4.1 Financial planning is concerned with the movement of money arising from the project. Its
objective is specific, not comparative. It is directed at assessing the cash inflows and outflows
during the life of the project and ensuring that the financial implications are accounted for.

5 Need for Judgement

5.1 Planning relates to the future. Even the most sophisticated forecasting techniques, however,
have fundamental uncertainties associated with them. Technological change can have the most
profound effect on the future course of events, but it is difficult to predict. As a result, when it is
necessary to make assumptions about the technological capabilities and needs of the future,
personal judgement and experience are the best guides.

6 Components of Cost
6.1 The cost of a project may be divided into two major components:
capital cost
annual costs

6.2 Capital Cost

6.2.1 The capital cost is defined as the sum of expenditures required to bring the project to completion
and has both direct and indirect items.

(a) Direct Items

These are the costs which are associated directly with elements of the project and are
generated from the items in the Bill of Quantities prepared from the preliminary designs.
The direct costs tend to vary in proportion to the quantity of work that needs to be done.

(b) Indirect Items

These are the costs that are not associated directly with any specific element of work,
but with the project as a whole. They tend to be relatively fixed in scale and are often
called 'overheads'. Indirect costs cannot usually be associated with any particular Bill
item so they are either 'absorbed' by the other items or accounted for separately. Costs
associated with engineering services and supervision, insurance and interest on loans
are typical indirect items.

6.3 Annual Costs

6.3.1 The annual costs of a project are those costs associated with maintaining the project in productive
order during its working life. There are a number of elements which can be included:

(a) Interest
Interest is either the cost of obtaining a loan, or the interest lost by using money on a
project rather than investing it.

(b) Depreciation
Depreciation represents the gradual decrease in the value of equipment or other
facilities. It is not a cash flow it is an allowance which reduces tax liability.

(c) Operation and Maintenance Costs

The cost of operation and maintenance of a project is determined by analysing
the various activities and services that have to be carried out. Often such costs
are estimated and presented as percentages of the capital cost.
 (d) Insurance
Annual payments include allowances for insurance against liability, accident or fire
during the working life of the project.

7. Project Life
7.1 In the economic analysis of a project, a limited period is assigned as the useful life of the project.
This may mean that the project components will have perished, or that the project will have
become obsolete, perhaps due to advances in technology. The useful life of a private sector
project depends heavily on predictions made about technological change; for public works
projects the useful life is normally not taken to be more than 50 years. The useful life assumed
for the project determines the period over which its economic viability has to be established.