Unit 4 Engg Economics

What is Engineering Economy?
• Economic decision making for engineering

systems is called engineering economy.
• This definition may seem restricted to

engineering projects and systems only,
engineering economy however is also the
study of industrial economics and the
economic and financial factors which
influence industry.
ECON 401: Engineering Economics 1
• Engineering economy is a collection of
techniques that simplify comparisons of
alternatives on an economic basis.
• Engineering economy is not a method or

process for determining what the alternatives
are.

• Engineering economics begins only after the
alternatives have been identified.
• If the best alternative is actually one that the

engineer has not even recognized as an
alternative, then all the engineering economic
analysis tools will not result in its selection.

Engineers are the people who are familiar
with all the technicalities of machinery and
production therefore they are the best judges
of:
a)the useful lives of an asset, and
b)they also have the technical knowledge to
calculate the number of units a proposed
plant would produce when operational.

• In today’s competitive world of business it has
become essential that engineers should
practice financial project analysis for
engineering projects and make rational
decisions.

• Engineering economy also includes the study
of accounting practices for manufacturing
concerns.
• Unique features of accounting for

manufacturing concerns are process costing,
batch costing, cost allocation, etc.

• Engineering economy deals with justification
and selection of projects.
• Many engineers work on projects which
address a specified activity or a problem.
• Any decision regarding the project must be
justified.

• In business environments, many if not all,
decisions are justified using monetary criteria
such as “profit”.
• Such decisions are made at the managerial
level and many engineers become managers
in manufacturing environment.

• Therefore, all engineers, regardless of their
employment, should know methods and tools
used in evaluation of projects.
• The purpose of engineering economy is to
expose all engineering students to the
methods which are widely used for evaluation
of projects.

• Even though, engineering economy deals
mostly with selection of projects in business
environment, the tools and methods can be
and are used by individuals and non-profit
organizations such as government, hospitals,
and charitable entities, etc.

SOME EXAMPLES
Let us present few examples in different
environments where engineering economy can
facilitate the decision making process.
• Business Environment:
A small manufacturing company needs to buy a
forklift truck for material handling. Two different
brands, say A and B, are being considered. Which
truck should be bought? The decision will
probably be based on minimization of cost.
SOME EXAMPLES
• Individuals:
A new college graduate needs a new car.
Should this new car be bought or leased?
Methods from engineering economy can be
used for determining the best choice.

SOME EXAMPLES
The following figure shows how engineering is
composed of physical and economic components:
Physical Produce products and services based

Environment on physical laws (e.g. Newton’s Law)
ENGINEERING Production / Construction
Economic Assessing the worth of these

Environment products/services in economic terms
Total Environment

SOME EXAMPLES
Physical Environment:
Engineers produce products and services
depending on physical laws. Physical efficiency
takes the form:
System output(s)
Physical (efficiency) = ------------------------
System input(s)

SOME EXAMPLES
• Economic Environment:
Much less of a quantitative nature is known about
economic environments -- this is due to economics
being involved with the actions of people, and the
structure of organizations.
System worth
Economic (efficiency) =
------------------------
System cost
SOME EXAMPLES
• Satisfaction of the physical and economic
environments is linked through production
and construction processes.
• Engineers need to control systems to achieve

a balance in both the physical and economic
environments, and within the bounds of
limited resources.

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

Rational Decision Making Process

Which Car to Lease?
Saturn vs. Honda
1. Recognize a decision problem • Need a car
2. Define the goals or objectives • Want mechanical security
3. Collect all the relevant • Gather technical as well

information as financial data
4. Identify a set of feasible • Choose between Saturn
decision alternatives and Honda
5. Select the decision criterion • Want minimum total cash
to use outlay
6. Select the best alternative • Select Honda

Financial Data Required to Make an Economic
Decision

Engineering Economic Decisions
Manufacturing Profit
Planning Investment
Marketing
Predicting the Future
• Estimating a Required
investment
• Forecasting a product
demand
• Estimating a selling price
• Estimating a
manufacturing cost
• Estimating a product life

Role of Engineers in Business

Types of Business Organizations

Proprietorships
Advantages Disadvantages
• Formed easily and • Personal liability
inexpensively • Difficult to raise capital
• Earnings are taxed at (cannot issue stocks bonds)
owner’s personal income for business expansion
tax, which will be lower
than corporate income tax

Partnerships
• Low cost (one person’s • Each partner is liable for a
contribution is lesser) business’s debts
• Ease of formation as the • Partnership has a limited
personal assets of all the life, as when one partner
partners stand behind the quits, partnership is to be
business reorganized

Corporations
• Can raise capital from large • Expensive
number of investors • Subject to numerous
• Easy transfer of ownership government rules and
interest by trading shares of regulations
stock
• Personal liability is limited
(to the individual
investment)

Role of Engineers in Business
Create & Design
• Engineering Projects
Analyze Evaluate Evaluate
• Production Methods • Expected • Impact on

• Engineering Safety Profitability Financial Statements
• Environmental Impacts • Timing of • Firm’s Market Value
• Market Assessment Cash Flows • Stock Price
• Degree of
Financial Risk

FUNDAMENTAL PRINCIPLES OF ENGINEERING
ECONOMICS
PRINCIPLE 1:
A nearby penny is worth a distant dollar
• A fundamental concept in engineering
economics is that money has a time value
associated with it.
• It is better to receive money earlier
than later.

ECONOMICS
• If you receive $100 now, you can invest it and
have more money available six months from
now.
• This concept will be the basic foundation for

all engineering project evaluation.

ECONOMICS
Time Value of Money

ECONOMICS
PRINCIPLE 2:
All that counts are the differences among
alternatives.
• An economic decision should be based on the
differences among the alternatives considered.
• All that is common is irrelevant to the decision.

ECONOMICS
Cash Salvage
Monthly Monthly Outlay at Monthly Value at
Option Fuel Cost Maintenance Signing Payment the End of
Year 3
Buy $960 $550 $6,500 $350 $9,000
Lease $960 $550 $2,400 $550 0
Irrelevant items in
decision making
Differential Analysis

ECONOMICS
PRINCIPLE 3:
Marginal Revenue must exceed Marginal Cost.
• Each decision alternative must be justified on
its own economic merits before being
compared with other alternatives.
• Marginal revenue means the additional
revenue made possible by increasing the
activity by one unit.

ECONOMICS
• Marginal cost means that productive resources like
natural resources, human resources, capital goods
available to make goods and services are limited.
Therefore, people can not have all the goods and
services they want.
• As a result, they must choose some things and give

up others.

ECONOMICS
Marginal
Cost
Cost of Goods Sold $2 per unit
Gross Revenue $4 per unit

Marginal
Revenue
Marginal Analysis

ECONOMICS
PRINCIPLE 4:
Additional Risk is not taken without the
Expected Additional Return.
• Investors demand a minimum return that
must be greater than the anticipated rate of
inflation or any perceived risk.

ECONOMICS
• Expected returns from bonds and stocks are
normally higher than the expected return
from a savings account.

ECONOMICS
Investment Class Potential Risk Expected Return
Savings account (Cash) Low/None 1.5%
Bond (Debt) Moderate 4.8%
Stock (Equity) High 11.5%
Risk and Return Trade Off

Types of Strategic Engineering
Economic Decisions
1) Equipment and process selection
2) Equipment replacement
3) New product and product expansion
4) Cost reduction, and
5) Service or quality improvement

Economic Decisions

Economic Decisions

Two Factors in Engineering Economic
Decisions
The factors of time and uncertainty are

the defining aspects of any engineering
economic decision.

The Time Value of Money
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
• Time value associated with money
• Determining future value at given interest
rate
• Present value based on current value of funds
to be received
• Determining Yield on an Investment.
• Compounding or discounting occurring on a
less than annual basis
Relationship to
The Capital Outlay Decision
• The time value of money is used to determine
whether future benefits are sufficiently large
to justify current outlays
• Mathematical tools of the time value of
money are used in making capital allocation
decisions
Future Value – Single Amount
• Measuring value of an amount that is allowed
to grow at a given interest over a period of
time
– Assuming that the worth of $1,000 needs to be
calculated after 4 years at a 10% interest per year,
we have:
1st year……$1,000 X 1.10 = $1,100
2nd year…...$1,100 X 1.10 = $1,210
3rd year……$1,210 X 1.10 = $1,331
4th year……$1,331 X 1.10 = $1,464
(Cont’d)
A generalized formula for Future Value:
Where
FV = Future value
PV = Present value
i = Interest rate
n = Number of periods;
In the previous case, PV = $1,000, i = 10%, n = 4, hence;

Future Value of $1(FVIF)
Table 9–1
(Cont’d)
• In determining future value, the following can be used:
Where = the interest factor
• If $10,000 were invested for 10 years at 8%, the future value

would be:
Present Value – Single Amount
• A sum payable in the future is worth less today
than the stated amount
– The formula for the present value is derived from the original formula for
future value:
– The present value can be determined by solving for a mathematical

solution to the formula above, thus restating the formula as:
– Assuming
Present Value of $1(PVIF)
Table 9–2
Relationship of Present
and Future Value
Future Value – Annuity
• Annuity:
– A series of consecutive payments or receipts of equal
amount
• Future Value of an Annuity:
– Calculated by compounding each individual payment
into the future and then adding up all of these
payments
Future Value – Annuity (cont’d)
• A generalized formula for Future Value of Annuity:
FVA = A × FVIFA
Where:
FVA = Future value of the Annuity
FVIFA = Annuity Factor = {[(1+i)n – 1] ÷ i}
A = Annuity value
i = Interest rate
n = Number of periods;
• Assuming, A = $1,000, n = 4, and i = 10%
Compounding Process for Annuity
Future Value
of an Annuity of $1(FVIFA)
Table 9–3
Present Value – Annuity
• Calculated by discounting each individual payment back to the
present and then adding up all of these payments
• A generalized formula for Present Value of Annuity:
PVA = A × PVIFA
Where:
PVA = Present value of the Annuity
PVIFA = Annuity Factor = {1 – [1 ÷ (1+i)n] ÷ i}
A = Annuity value
i = Interest rate
n = Number of periods
Present Value
of an Annuity of $1(PVIFA)
Assuming that A = $1,000, n = 4, i = 10%, we have:
Table 9–4
Time Value Relationships
• Comparisons include:
– The relationship between present value and future value
• Inverse relationship exists between the present value and future
value of a single amount
– The relationship between the Present Value of a single
amount and the Present Value of an Annuity
• The Present Value of an Annuity is the sum of the present values of
single amounts payable at the end of each period
– The relationship between the Future Value and Future
Value of Annuity
• The Future Value of an Annuity is the sum of the future values of
single amounts receivable at the end of each period
Determining the Annuity Value
• A re-look at the variables involved in time value of
money:
1. FV/PV : Future/Present value of money
2. N : no. of years
3. I : Interest or YIELD
4. A : Annuity Value / payment per period in an annuity
• Given the first three variables, and determining the

fourth variable “A” (unknown ).
Annuity Equaling a Future Value
– Assuming that at a 10% interest rate, after 4 years, an amount
of $4,641 needs to accumulated:
– For n = 4, and i = 10%, is 4.641. Thus, A equals $1,000 as

below :
Annuity Equaling a Present Value
– Determining what size of an annuity can be equated to a given
amount:
– Assuming n = 4, i = 6%:
Relationship of Present
Value to Annuity
Annual interest is based on the beginning balance
for each year as shown in the following table that
shows flow of funds:
Table 9–5
Loan Amortization
• A mortgage loan to be repaid over 20 years
at 8% interest:
Loan Amortization Table
•In such a case the part of the payments to the mortgage
company will go toward the payment of interest, with the
remainder applied to debt reduction, as indicated in the
following table:
Table 9–6
Six Formulas
Determining the Yield on
Investment
• Determining the unknown variable “ i “,
given the following variables :
1. FV/PV : Future/Present value of money
2. N : no. of years
3. A : Annuity Value / payment per period in an
annuity
Yield – Present Value
of a Single Amount
• To calculate the yield on an investment producing $1,464 after 4
years having a present value of $1,000:
• We see that for n = 4 and = 0.683, the interest rate or yield is

10%
Yield – Present Value
of a Single Amount (Cont’d)
• Interpolation may also be used to find a more precise answer
• Difference between the value at the lowest interest rate and the
designated value
• The exact value can be determined as:

Yield – Present Value of an Annuity
• To calculate the yield on an investment of $10,000, producing
$1,490 per annum for 10 years:
• Hence:
Yield – Present Value of an Annuity
(Cont’d)
• Flip back to the table containing the Present
Value-Annuity factors on Slide 9-16
• Read across the columns for n = 10 periods,
one can see that the yield is 8 percent
• Interpolation applied to a single amount can
also be applied here for a more precise
answer
Special Considerations
in Time Value Analysis
• Compounding frequency
– Certain contractual agreements may require
semiannual, quarterly, or monthly compounding
periods
– In such cases,
N = No. of years × No. of compounding periods
during the year
I = Quoted annual interest / No. of
compounding periods during the year
Special Considerations
in Time Value Analysis
• Patterns of Payment
– Problems may evolve around a number of
different payment or receipt patterns
– Not every situation involves a single amount or an
annuity
– A contract may call for the payment of a different
amount each year over the stated period or
period of annuity
Compounding frequency : Cases
• Case 1: Determine the future value of a $1,000 investment after 5 years at 8%
annual interest compounded semiannually
– Where, n = 5 × 2 = 10; i = 8% / 2 = 4% (using Table 9–1 FVIF = 1.480)
• Case 2: Determine the present value of 20 quarterly payments of $2,000 each

to be received over the next 5 years, where i = 8% per annum
– Where, n = 20; i = 2%
Patterns of Payment : Cases
• Assume a contract involving payments of different amounts each year for
a three-year period
• To determine the present value, each payment is discounted to the
present and then totaled
(Assuming 8% discount rate)
Deferred Annuity
• Situations involving a combination of single
amounts and an annuity.
• When annuity is paid sometime in the future
Deferred Annuity : Case
• Assuming a contract involving payments of different amounts each year for a three
year period :
– An annuity of $1,000 is paid at the end of each year from the fourth through the eighth year
– To determine the present value of the cash flows at 8% discount rate
– To determine the annuity

Deferred Annuity : Case (Cont’d)
• To discount the $3,993 back to the present, which falls at the beginning of the fourth
period, in effect, the equivalent of the end of the third period, it is discounted back
three periods, at 8% interest rate
Deferred Annuity : Case (Cont’d)
Alternate Method to Compute
Deferred Annuity
1. Determine the present value factor of an annuity for the total time period, where n =
8, i = 8%, the PVIFA = 5.747
2. Determine the present value factor of an annuity for the total time period (8) minus
the deferred annuity period (5). Here, 8 – 5 = 3; n = 3; i = 8%. Thus the value is 2.577
3. Subtracting the value in step 2 from the value of step 1, and multiplying by A;
Alternate Method to Compute
Deferred Annuity (Cont’d)
4. $3,170 is the same answer for the present value of the annuity as that reached by
the first method
5. The present value of the five-year annuity is added up to the present value of the
inflows over the first three years to arrive at:
Money Management Strategy:
Financial Statements and
Budgeting
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
3-83
Chapter 3
Learning Objectives
1. Recognize relationships among financial
documents and money management activities
2. Design a system for maintaining personal
financial records
3. Develop a personal balance sheet and cash
flow statement
4. Create and implement a budget
5. Relate money management and savings
activities to achieve financial goals
3-84
Successful Money Management
Objective 1: Recognize relationships among
financial documents and money management
activities
• Daily spending and saving decisions are the

heart of financial planning
• Decisions must be coordinated with needs,

goals, and personal situations
3-85
• Money management is the day-to-day
financial activities needed to manage personal
economic resources, while working toward
long-term financial security
3-86
(continued)
OPPORTUNITY COST AND MONEY-MANAGEMENT

• Spending money on current living expenses reduces
the amount you can save and invest
• Saving and investing for the future reduces the
amount you can spend now
• Buying on credit ties up future income
• Using savings for purchases results in lost interest
and depletes savings
• Comparison shopping can save money but takes
valuable time
3-87
COMPONENTS OF MONEY
MANAGEMENT
3-88
A System for Personal Financial
Records
Objective 2: Design a system for maintaining
personal financial records
Benefits of an Organized System of Financial Records
– Handling daily business affairs, including payment of
bills on time
– Planning and measuring financial progress
– Completing required tax reports
– Making effective investment decisions
– Determining available resources for current and
future buying
3-89
Records (continued)
ITEMS IN YOUR HOME FILE
– Personal and employment records
– Money management records
– Tax records
– Financial services records
– Consumer purchase, auto and credit records
– Housing records
– Insurance records
– Investment records
– Estate planning and retirement records
3-90
Records (continued)
ITEMS IN THE SAFE DEPOSIT BOX
• Records that would be hard to replace
– Birth, marriage and death certificates, copy of will
– Citizenship and military papers
– Adoption and custody papers
– Serial numbers and photos of valuables
– CDs and credit and banking account numbers
– Mortgage papers and titles
– List of insurance policy numbers
– Stock and bond certificates
– Coins and other collectibles
3-91
Records (continued)
RECORDS ON YOUR PERSONAL COMPUTER
– Current and past budgets
– Summary of checks written and other banking
transactions
– Past income tax returns prepared with tax
preparation software
– Account summaries and performance
results of investments
– Computerized versions of wills,
estate plans, and other documents
3-92
Records (continued)
HOW LONG SHOULD RECORDS BE KEPT?
• Birth certificates, wills, and Social Security
information should be kept indefinitely
• Keep records on personal property and
investments as long as you own them
• Keep documents related to the purchase and sale
of real estate indefinitely
• Copies of tax returns and supporting data should
be kept six years
3-93
Personal Financial Statements
Objective 3: Develop a personal balance sheet and

cash flow statement
Purpose of Personal Financial Statements
• Report your current financial position in relation to
the value of the items you own and the amounts
you owe
• Measure your progress toward your financial goals
• Maintain information on your financial activities
• Provide data you can use when preparing tax forms
or applying for credit
3-94
Personal Financial Statements (continued)
BALANCE SHEET: WHERE ARE YOU NOW?
Also called the Net Worth Statement or Statement of
Financial Planning
Preparation of Balance Sheet requires using the following
Steps
STEP 1: LISTING ITEMS OF VALUE
• Assets - what you own
• Liquid assets
– Real estate
– Personal possessions
– Investment assets
3-95
(continued)
STEP 2: DETERMINING THE AMOUNTS OWED

• Liabilities - what you owe
– Current liabilities (< 1 year)
– Long term liabilities
STEP 3: COMPUTING NET WORTH

• Assets – Liabilities = Net Worth
• Assets = Net Worth + Liabilities
• Insolvency is the inability to pay debts when they
are due
3-96
(continued)
Net Worth is an indication of the financial position at

any given date
Ways to increase Net Worth

• Increasing your savings
• Reducing spending
• Increasing the value of investments and other
possessions
• Reducing the amounts you owe
3-97
Personal Financial Statements (continued)
THE CASH FLOW STATEMENT

• Cash Flow is the actual inflow, outflow for a
given time period
• The Cash Flow statement is also called

personal income and expenditure statement
3-98
(continued)
THE CASH FLOW STATEMENT

The process of preparing cash flows statement follows
these steps
STEP 1: RECORD INCOME
– Wages, salaries, and commissions
– Self-employment business income
– Savings and investment income
– Gifts, grants, scholarships and educational loans
– Government payments, such as Social Security, public
assistance, and unemployment benefits
– Amounts received from pension and retirement
programs
– Alimony and child support payments
3-99
(continued)
STEP 2: RECORD CASH OUTFLOWS

– Fixed Expenses
– Variable expenses
STEP 3: DETERMINE NET CASH FLOWS

– The difference between income and outflows can
either be positive or negative
– Cash flow statement provides the foundation for
preparing and implementing a spending, saving, and
investment plan
3-100
Budgeting for Skilled Money
Management
Objective 4: Create and implement a budget
• A budget is a spending plan
• The main purposes of a budget are to help you
– Live within your income
– Spend your money wisely
– Reach your financial goals
– Prepare for financial emergencies
– Develop wise financial management habits
3-101
Management (continued)
STARTING THE BUDGETING PROCESS
Insert Exhibit 3-5
3-102
Management (continued)
CHARACTERISTICS OF SUCCESSFUL BUDGETING
– Well-planned
– Realistic
– Flexible
– Clearly communicated
3-103
Selecting a Budgeting System
Which one works for you?
• Mental budget – it is all in your head
• Physical budget-use envelopes for your
expenses such as food, rent, etc.
• Written budget – use spreadsheets
• Computerized budget – use software such as
Quicken (http://www.quicken.com/)
• Online budget- (http://www.mint.com/)
• Budget App-using your phone to track
expenses.
3-104
Money Management and Achieving
Financial Goals
Objective 5: Relate money management and savings
activities to achieve financial goals
Reasons for saving include…
– Setting aside money for irregular and unexpected
expenses
– Paying for the replacement of expensive items,
such as cars or a down payment on a house
– Buying special items like recreational equipment or
to pay for a vacation
– Providing for long-term expenses such as
retirement or the education of children
– Earning income from the interest on savings for use
in paying living expenses
3-105
Money Management and Achieving
Financial Goals (continued)
SELECTING A SAVINGS TECHNIQUE
• Payroll deductions into savings accounts
• Automatic payments from checking into savings
accounts or mutual funds
• Saving regularly in 401(k) plans
• Also save coins, make periodic deposits
• Write a check each payday as a % of income and
deposit into savings
3-106

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Unit 4 Engg Economics

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What is Engineering Economy?

• Economic decision making for engineering

• This definition may seem restricted to

• Engineering economy is not a method or

ECON 401: Engineering Economics 2

• If the best alternative is actually one that the

ECON 401: Engineering Economics 3

ECON 401: Engineering Economics 4

ECON 401: Engineering Economics 5

• Unique features of accounting for

ECON 401: Engineering Economics 6

ECON 401: Engineering Economics 7

ECON 401: Engineering Economics 8

ECON 401: Engineering Economics 9

ECON 401: Engineering Economics 10

ECON 401: Engineering Economics 12

Physical Produce products and services based

ENGINEERING Production / Construction

Economic Assessing the worth of these

ECON 401: Engineering Economics 13

ECON 401: Engineering Economics 14

• Engineers need to control systems to achieve

ECON 401: Engineering Economics 16

ECON 401: Engineering Economics 17

ECON 401: Engineering Economics 18

2. Define the goals or objectives • Want mechanical security

3. Collect all the relevant • Gather technical as well

ECON 401: Engineering Economics 19

ECON 401: Engineering Economics 20

ECON 401: Engineering Economics 22

ECON 401: Engineering Economics 23

ECON 401: Engineering Economics 24

ECON 401: Engineering Economics 25

ECON 401: Engineering Economics 26

ECON 401: Engineering Economics 27

Analyze Evaluate Evaluate

• Production Methods • Expected • Impact on

ECON 401: Engineering Economics 28

ECON 401: Engineering Economics 29

• This concept will be the basic foundation for

ECON 401: Engineering Economics 30

Time Value of Money

ECON 401: Engineering Economics 31

ECON 401: Engineering Economics 32

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

ECON 401: Engineering Economics 33

ECON 401: Engineering Economics 34

• As a result, they must choose some things and give

ECON 401: Engineering Economics 35

Gross Revenue $4 per unit

ECON 401: Engineering Economics 36

ECON 401: Engineering Economics 37

ECON 401: Engineering Economics 38

Bond (Debt) Moderate 4.8%

Stock (Equity) High 11.5%

Risk and Return Trade Off

ECON 401: Engineering Economics 39

ECON 401: Engineering Economics 40

ECON 401: Engineering Economics 41