Unit 5 Economic Analysis, Statistics & Probability

Economics is the study of allocation of scarce resources among unlimited wants i.e
concerned with the production, distribution, and consumption of goods and
services. Our wants are unlimited or at least increasing ever and to satisfy all these
wants, we need unlimited supply of productive resources which could provide necessary
goods and services to the community. However, resources are scarce i.e. limited in supply
and obtained at some cost. In other words, resources are scarce in relation to its needs
Therefore, scarce resources should be used wisely judiciously and more effectively at
optimum level, minimizing the cost and maximizing profit and benefit without compromising
the quality of product or service.

All engineering decisions involve number of feasible alternatives or options. These

feasible alternatives must be properly evaluated before implementing them. If there is no
alternative, there is no need of economic study. Engineering economy involves the
systematic evaluation of the economic merits of proposed solutions to engineering
problems. To be economically acceptable (i.e. affordable), solutions to engineering
problems must be demonstrate a positive balance of long-term benefits over long-term
costs.

Supply and Demand: The price of a commodity is determined by the interaction of supply
and demand in a market. The resulting price is referred to as the equilibrium price and
represents an agreement between producers and consumers of the good. In equilibrium
the quantity of a good supplied by producers equals the quantity demanded by consumers.

Demand and Supply Curves:

At any given point in time, the
supply of a good brought to market is
fixed. In other words, the supply
curve, in this case, is a vertical line,
while the demand curve is always
downward sloping due to the law of
diminishing marginal utility. Sellers
can charge no more than the market
will bear based on consumer demand
at that point in time. Over longer
intervals of time, however, suppliers
can increase or decrease the quantity
they supply to the market based on
the price they expect to charge. So
over time, the supply curve slopes
upward.

Shifts:
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied
changes even though the price remains the same.
PRINCIPLES OF ENGINEERING ECONOMY

PRINCIPLE 1 - DEVELOP THE ALTERNATIVES: The choice (decision) is among

alternatives. The alternatives need to be identified. A decision involves making a choice
among alternatives. Developing and defining alternatives depends upon engineer’s
creativity and innovation.

PRINCIPLE 2 - FOUCUS ON THE DIFFERENCE: Only the differences in expected future

outcomes among the alternatives are relevant to their comparison and should be
considered in the decision. If all prospective outcomes of the feasible alternatives were
exactly the same, obviously, only the differences in the future outcomes of the alternatives
are important. Outcomes that are common to all alternatives can be disregarded in the
comparison and decision. For example, if two apartments were with same purchase price
or rental price, decision on selection of alternatives would depend on other factors such as
location and annual operating and maintenance expenses.

PRINCIPLE 3 - USE A CONSISTENT VIEWPOINT: The prospective outcomes of the

alternatives, economic and other, should be consistently developed from a defined
viewpoint (perspective). Often perspective of decision maker is owner’s point of view. For
the success of the engineering projects viewpoint may be looked upon from the various
perspective e.g. donor, financer, beneficiary group & stakeholders. However, viewpoint
must be consistent throughout the analysis.

PRINCIPLE 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 the alternatives. For economic consequences, a
monetary units such as dollars or rupees is the common measure.

PRINCIPLE 5 - CONSIDER ALL RELEVANT CRITERIA: Selection of preferred

alternative (decision making) requires the use of a criterion (or several criteria). The
decision process should consider both the outcomes enumerated in the monetary unit and
those expressed in some other unit of measurement or made explicit in a descriptive
manner. Apart from the long term financial interest of owner, needs of stakeholders should
be considered.

PRINCIPLE 6 - MAKE UNCERTAINTY EXPLICIT: Uncertainty is inherent in projecting (or

estimating) the future outcomes of the alternatives ad should be recognized in their
analysis and comparison. The magnitude & impact of future impact of any course of action
are uncertain or probability of occurrence changes from the planned one. Thus dealing
with uncertainty is important aspect of engineering economic analysis.

PRINCIPLE 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. If results
significantly different from the initial estimates, appropriate feedback to the decision
making process should occur.

Example:
You wreck your car! And you absolutely need one to get around  A wholesaler offers
$2,000 for the wrecked car, and $4,500 if it is repaired. The car’s standing mileage is
58,000 miles  Your insurance company offers $1,000 to cover the cost of the accident 
To repair the car costs $2,000  A newer second–hand car costs $10,000 with a standing
mileage of 28,000 miles  A part–time technician can repair the car for $1,100, but it
takes a month. In the meantime, you need to rent a car, which costs $400 per month. What
should you do?

Apply the engineering economic analysis procedure.

Step 1: Define the problem In this case, you need a car!

Step 2: Develop alternatives You have several options.

(A) Sell the wrecked car and buy the second-hand car. (Of course you would not just
dispose the wrecked car.)
(B) Repair the car and keep it.
(C) Repair the car, sell it, and then buy the second-hand car.
(D) Let the part-time technician repair the car and rent in the meantime. Afterwards, keep
the car.
(E) Let the part-time technician repair the car and rent in the meantime. Afterwards, sell
the car and buy the second-hand car.

Step 3: Develop prospective outcomes via cash flows

(A) Sell the wrecked car and buy the second-hand car.
$2,000 + $1,000 – $10,000 = –$7,000

(B) Repair the car and keep it.

$1,000 – $2,000 = –$1,000

(C) Repair the car, sell it, and then buy the second-hand car.
$1,000 – $2,000 + $4,500 – $10,000 = –$6,500

(D) Let the part-time technician repair the car and rent in the meantime. Afterwards, keep
the car.
$1,000 – $1,100 – $400 = –$500

(E) Let the part-time technician repair the car and rent in the meantime. Afterwards, sell
the car and buy the second-hand car.
$1,000 – $1,100 – $400 + $4,500 – $10,000 = –$6,000

Step 4: Use a consistent criterion Let us just focus on your asset value immediately after
the decision is made. (We are ignoring other things, such as higher future insurance costs,
resell value of the second-hand car, etc.)

Step 5: Compare the alternatives

(A) Sell the wrecked car & buy the 2nd-hand car.
$10,000 – $7,000 = $3,000

(B) Repair the car and keep it.

$4,500 – $1,000 = $3,500

(C) Repair the car, sell it, and then buy the second-hand car.
$10,000 – $6,500 = $3,500
(D) Let the part-time technician repair the car and rent in the meantime. Afterwards, keep
the car.
$4,500 – $500 = $4,000

(E) Let the part-time technician repair the car and rent in the meantime. Afterwards, sell
the car and buy the second–hand car.
$10,000 – $6,000 = $4,000

Step 6: Choose a preferred alternative after considering risk and uncertainties From the
asset value point-of-view, (D) and (E) are equally good. To differentiate them, we need
other criteria. Say, if the repaired car has a higher risk of failing, then we would prefer (E).

Step 7: Revisit the decision Road test the newer car and confirm your decision.

Demand Forecasting:
Demand forecasting is a technique used for the estimation of what can be the
demand for the upcoming product or services in the future. It is based upon the real-time
analysis of demand which was there in the past for that particular product or service in the
market present today. Demand forecasting must be done by a scientific approach and
facts, events which are related to the forecasting must be considered.
Hence, in simple words, information about different aspects of the market and demand
which is dependent on the past, an attempt might be made to analyse the future demand.
This whole concept of analysing and approximations are collectively called demand
forecasting. In order to understand it more clearly, we can consider the following equation
so that we can understand the concept of demand forecasting more easily.
For example, if we sold 100,150, 200 units of product Z in January, February, and March
respectively, now we can approximately say that there will be a demand for 150 units of
product Z in April. However, there is also a clause that the condition of the market should
remain the same.
Methods of Demand Forecasting
There are two main methods of demand forecasting:
1) Based on Economy and
2) Based on the period.

1. Based on Economy
There is a total of three methods of demand forecasting based on the economy:

Macro-level Forecasting: It generally deals with the economic environment which is

related to the economy as calculated by the Index of Industrial Production(IIP), national
income and general level of employment, etc.

Industry-level Forecasting: Industry-level forecasting usually deals with the demand

issued for the industry’s products as a whole. We can consider the example where there is
a demand for cement in India, Demand for clothes in India, etc.

Firm-level Forecasting: It is a major type of demand forecasting. Firm-level forecasting

means that we need to forecast the demand for a specific firm’s product. We can consider
the following examples as Demand for Birla cement, Demand for Raymond clothes, etc.
2. Based on the Time
Forecasting based on time may be either short-term forecasting or long-term forecasting.

Short-term Forecasting: It generally covers a short period which depends upon the
nature of the industry. It is done generally for six months or can be less than one year.
Short-term forecasting is apt for making tactical decisions.

Long-term Forecasting: Long-term forecasts are generally for a longer period. It can be
from two to five years or more. It gives data for major strategic decisions of the company.
We can consider the example of the expansion of plant capacity or on opening a new unit
of business, etc.

Steps Used in Demand Forecasting

The process of demand forecasting can be divided into five simple steps:

1. Setting an Objective: The first step involves clearly deciding on the purpose of the
analysis. That is, the manufacturers define their goals that are achievable through
the analysis and compatible with their needs.

2. Determining the Time Period: In this step, the manufacturer decides whether the
analysis will be carried out for a short or long duration of time. Many forecasts run
for a long duration as they offer more and consistent data.

3. Selecting a Demand Forecasting Method: In the next step, the manufacturer

decides along with the analysts which method will give the best results.

4. Collection of Data: In the penultimate step, the data is collected according to the
preconceived attributes for the analysis.

5. Evaluation of Data: In the last step, the collected data is evaluated to obtain
conclusions for the forecast.

5 Demand forecasting methods

There are many different ways to create forecasts. Here are five of the top demand
forecasting methods.
1. Trend projection
Trend projection uses your past sales data to project your future sales. It is the simplest
and most straightforward demand forecasting method.

Trend Projection Method is the most classical method of business forecasting, which is
concerned with the movement of variables through time. This method requires a long time-
series data.
The trend projection method is based on the assumption that the factors liable for the past
trends in the variables to be projected shall continue to play their role in the future in the
same manner and to the same extent as they did in the past while determining the
variable’s magnitude and direction.

i) Graphical Method: It is the most simple statistical method in which the annual sales
data are plotted on a graph, and a line is drawn through these plotted points. A free hand
line is drawn in such a way that the distance between points and the line is the minimum.
Under this method, it is assumed that future sales will assume the same trend as followed
by the past sales records. Although the graphical method is simple and inexpensive, it is
not considered to be reliable. This is because the extension of the trend line may involve
subjectivity and personal bias of the researcher.

ii) Fitting Trend Equation or Least Square Method: The least square method is a formal
technique in which the trend-line is fitted in the time-series using the statistical data to
determine the trend of demand. The form of trend equation that can be fitted to the time-
series data can be determined either by plotting the sales data or trying different forms of
the equation that best fits the data. Once the data is plotted, it shows several trends. The
most common types of trend equations are:
• Linear Trend: when the time-series data reveals a rising or a linear trend in sales,
the following straight line equation is fitted:
S = a + bT
Where S = annual sales; T = time (years); a and b are constants.
• Exponential Trend: The exponential trend is used when the data reveal that the
total sales have increased over the past years either at an increasing rate or at a
constant rate per unit time.

Iii) Box-Jenkins Method: Box-Jenkins method is yet another forecasting method used for
short-term predictions and projections. This method is often used with stationary time-
series sales data. A stationary time-series data is the one which does not reveal a long
term trend. In other words, Box-Jenkins method is used when the time-series data reveal
monthly or seasonal variations that reappear with some degree of regularity.

2. Barometric Method of Forecasting

The Barometric Method of forecasting was developed to forecast the trend in the
overall economic activities. This method can nevertheless be used in forecasting the
demand prospects, not necessarily the actual quantity expected to be demanded. A time-
series of several indicators is developed to study the future trend. These can be classified
as:

a)Leading Series: The leading series is comprised of indicators which move up or down
ahead of some other series The most common examples of leading indicators are- net
business investment index, a new order for durable goods, change in the value of
inventories, corporate profits after tax, etc.

b)Coincidental Series: The coincidental series include indicators which move up and down
simultaneously with the general level of economic activities. The examples of coincidental
series – the rate of unemployment, the number of employees in the non-agricultural sector,
sales recorded by manufacturing, retail, and trading sectors, gross national product at
constant prices.

c)Lagging Series: A series consisting of those indicators, which after some time-lag follows
the change. Some of the lagging series are- outstanding loan, labor cost per unit
production, lending rate for short-term loans, etc.

3. Econometric
The econometric method requires some number crunching. This technique combines
sales data with information on outside forces that affect demand. Then you create a
mathematical formula to predict future customer demand.

The econometric demand forecasting method accounts for relationships between

economic factors. For example, an increase in personal debt levels might coincide with an
increased demand for home repair services.

4. Sales force composite

The sales force composite demand forecasting method puts your sales team in the driver’s
seat. It uses feedback from the sales group to forecast customer demand.

Your salespeople have the closest contact with your customers. They hear feedback and
take requests. As a result, they are a great source of data on customer desires, product
trends, and what your competitors are doing.

This method gathers the sales division with your managers and executives. The group
meets to develop the forecast as a team.

5. Market research
Market research demand forecasting is based on data from customer surveys. It requires
time and effort to send out surveys and tabulate data, but it’s worth it. This method can
provide valuable insights you can’t get from internal sales data.
Delphi method
The Delphi method, or Delphi technique, leverages expert opinions on your market
forecast. This method requires engaging outside experts and a skilled facilitator.

You start by sending a questionnaire to a group of demand forecasting experts. You create
a summary of the responses from the first round and share it with your panel. This process
is repeated through successive rounds. The answers from each round, shared
anonymously, influence the next set of responses. The Delphi method is complete when
the group comes to a consensus.

This demand forecasting method allows you to draw on the knowledge of people with
different areas of expertise. The fact that the responses are anonymized allows each
person to provide frank answers. Because there is no in-person discussion, you can
include experts from anywhere in the world on your panel. The process is designed to
allow the group to build on each other’s knowledge and opinions. The end result is an
informed consensus.
You can do this research on an ongoing basis or during an intensive research period.
Market research can give you a better picture of your typical customer. Your surveys can
collect demographic data that will help you target future marketing efforts. Market research
is particularly helpful for young companies that are just getting to know their customers.

Economic Order Quantity:

Economic order quantity (EOQ) is the ideal order quantity a company should
purchase to minimize inventory costs such as holding costs, shortage costs, and order
costs. This production-scheduling model was developed in 1913 by Ford W. Harris and
has been refined over time. The formula assumes that demand, ordering, and holding
costs all remain constant.
• The economic order quantity (EOQ) is a company's optimal order quantity that
minimizes its total costs related to ordering, receiving, and holding inventory.
• The EOQ formula is best applied in situations where demand, ordering, and holding
costs remain constant over time.
• One of the important limitations of the economic order quantity is that it assumes
the demand for the company’s products is constant over time.

Example: A retail clothing shop carries a line of men’s jeans, and the shop sells 1,000 pairs
of jeans each year. It costs the company $5 per year to hold a pair of jeans in inventory,
and the fixed cost to place an order is $2.
The EOQ formula is the square root of (2 x 1,000 pairs x $2 order cost) / ($5 holding cost)
or 28.3 with rounding. The ideal order size to minimize costs and meet customer demand
is slightly more than 28 pairs of jeans. A more complex portion of the EOQ formula
provides the reorder point.

Limitations of EOQ:
The EOQ formula assumes that consumer demand is constant. The calculation also
assumes that both ordering and holding costs remain constant. This fact makes it difficult
or impossible for the formula to account for business events such as changing consumer
demand, seasonal changes in inventory costs, lost sales revenue due to inventory
shortages, or purchase discounts a company might realize for buying inventory in larger
quantities.

Probability & Statistics:

Probability And Statistics are the two important concepts in Maths. Probability is all
about chance. Whereas statistics is more about how we handle various data using
different techniques. It helps to represent complicated data in a very easy and
understandable way. The professionals use the stats and do the predictions of the
business. It helps them to predict the future profit or loss attained by the company.

Probability:
Probability implies 'likelihood' or 'chance'. When an event is certain to happen then
the probability of occurrence of that event is 1 and when it is certain that the event cannot
happen then the probability of that event is 0.
Hence the value of probability ranges from 0 to 1. Probability has been defined in a varied
manner by various schools of thought. Some of which are discussed below.
If there are n exhaustive, mutually exclusive and equally likely cases out of which m
cases are favourable to the happening of event A, Then the probabilities of event A is
defined as given by the following probability function

Statistics:
Statistics is the study of the collection, analysis, interpretation, presentation, and
organization of data. It is a method of collecting and summarising the data. This has many
applications from a small scale to large scale. Whether it is the study of the population of
the country or its economy, stats are used for all such data analysis.

The data collected here for analysis could be quantitative or qualitative. Quantitative data
are also of two types such as: discrete and continuous. Discrete data has a fixed value
whereas continuous data is not a fixed data but has a range. There are many terms and
formulas used in this concept. See the below table to understand them.

Terms utilised in the probability and statistics concepts, Such as:

•Random Experiment
•Sample Space
 •Random variables
•Expected Value
•Independence
•Variance
•Mean
•Median
•Mode

Random Experiment:
An experiment whose result cannot be predicted, until it is noticed is called a random
experiment. For example, when we throw a dice randomly, the result is uncertain to us. We
can get any output between 1 to 6. Hence, this experiment is random.

Sample Space:
A sample space is the set of all possible results or outcomes of a random experiment.
Suppose, if we have thrown a dice, randomly, then the sample space for this experiment
will be all possible outcomes of throwing a dice, such as;
Sample Space = { 1,2,3,4,5,6}

Random Variables:
The variables which denote the possible outcomes of a random experiment are called
random variables. They are of two types:
1.Discrete Random Variables
2.Continuous Random Variables
Discrete random variables take only those distinct values which are countable. Whereas
continuous random variables could take an infinite number of possible values.

Independent Event:
When the probability of occurrence of one event has no impact on the probability of
another event, then both the events are termed as independent of each other. For
example, if you flip a coin and at the same time you throw a dice, the probability of getting
a ‘head’ is independent of the probability of getting a 6 in dice.

Mean:
Mean of a random variable is the average of the random values of the possible outcomes
of a random experiment. In simple terms, it is the expectation of the possible outcomes of
the random experiment, repeated again and again or n number of times. It is also called
the expectation of a random variable.
The Median:
If the total number of observations (n) is an odd number, then the formula is given below:
Mode:
The Mode is the most frequently occurring Variable.

Expected Value
Expected value is the mean of a random variable. It is the assumed value which is
considered for a random experiment. It is also called expectation, mathematical
expectation or first moment. For example, if we roll a dice having six faces, then the
expected value will be the average value of all the possible outcomes, i.e. 3.5.

Standard Deviation:

A standard deviation (or σ) is a measure of how dispersed the data is in relation to

the mean. Low standard deviation means data are clustered around the mean, and high
standard deviation indicates data are more spread out.

Variance:
Basically, the variance tells us how the values of the random variable are spread around
the mean value. It specifies the distribution of the sample space across the mean.
Control charts:
Control charts are used to routinely monitor quality. Depending on the number of
process characteristics to be monitored, there are two basic types of control charts. The
first, referred to as a univariate control chart, is a graphical display (chart) of one quality
characteristic. The second, referred to as a multivariate control chart, is a graphical display
of a statistic that summarizes or represents more than one quality characteristic.

Characteristics of Control Chart:

If a single quality characteristic has been measured or computed from a sample, the
control chart shows the value of the quality characteristic versus the sample number or
versus time. In general, the chart contains a center line that represents the mean value for
the in-control process. Two other horizontal lines, called the upper control limit (UCL) and
the lower control limit (LCL), are also shown on the chart. These control limits are chosen
so that almost all of the data points will fall within these limits as long as the process
remains in-control. The figure below illustrates this.

Control Charts for Continuous Data

Individuals and Moving Range Chart:
The individuals and moving range (I-MR) chart is one of the most commonly used control
charts for continuous data; it is applicable when one data point is collected at each point in
time. The I-MR control chart is actually two charts used in tandem (Figure 7). Together
they monitor the process average as well as process variation. With x-axes that are time
based, the chart shows a history of the process.
The I chart is used to detect trends and shifts in the data, and thus in the process.
The individuals chart must have the data time-ordered; that is, the data must be entered in
the sequence in which it was generated. If data is not correctly tracked, trends or shifts in
the process may not be detected and may be incorrectly attributed to random (common
cause) variation. There are advanced control chart analysis techniques that forego the
detection of shifts and trends, but before applying these advanced methods, the data
should be plotted and analyzed in time sequence.
The MR chart shows short-term variability in a process – an assessment of the
stability of process variation. The moving range is the difference between consecutive
observations. It is expected that the difference between consecutive points is predictable.
Points outside the control limits indicate instability. If there are any out of control points, the
special causes must be eliminated.
The I-MR chart is best used when:
• The natural subgroup size is unknown.
• The integrity of the data prevents a clear picture of a logical subgroup.
• The data is scarce (therefore subgrouping is not yet practical).
• The natural subgroup needing to be assessed is not yet defined.
Xbar-Range Charts:
Another commonly used control chart for continuous data is the Xbar and range (Xbar-R)
chart (Figure 8). Like the I-MR chart, it is comprised of two charts used in tandem. The
Xbar-R chart is used when you can rationally collect measurements in subgroups of
between two and 10 observations. Each subgroup is a snapshot of the process at a given
point in time. The chart’s x-axes are time based, so that the chart shows a history of the
process. For this reason, it is important that the data is in time-order.
The Xbar chart is used to evaluate consistency of process averages by plotting the
average of each subgroup. It is efficient at detecting relatively large shifts (typically plus or
minus 1.5 σ or larger) in the process average.

The R chart, on the other hand, plot the ranges of each subgroup. The R chart is used to
evaluate the consistency of process variation. Look at the R chart first; if the R chart is out
of control, then the control limits on the Xbar chart are meaningless.

Control Charts for Discrete Data

C-Chart:
Used when identifying the total count of defects per unit (c) that occurred during the
sampling period, the c-chart allows the practitioner to assign each sample more than one
defect. This chart is used when the number of samples of each sampling period is
essentially the same.

U-Chart:
Similar to a c-chart, the u-chart is used to track the total count of defects per unit (u) that
occur during the sampling period and can track a sample having more than one defect.
However, unlike a c-chart, a u-chart is used when the number of samples of each sampling
period may vary significantly.
nP Chart:
Use an nP-chart when identifying the total count of defective units (the unit may have one
or more defects) with a constant sampling size.

P-Chart:
Used when each unit can be considered pass or fail – no matter the number of defects – a
p-chart shows the number of tracked failures (np) divided by the number of total units (n).

How to Select a Control Chart:

A number of points may be taken into consideration when identifying the type of control
chart to use, such as:
• Variables control charts (those that measure variation on a continuous scale) are
more sensitive to change than attribute control charts (those that measure variation
on a discrete scale).
• Variables charts are useful for processes such as measuring tool wear.
• Use an individuals chart when few measurements are available (e.g., when they are
infrequent or are particularly costly). These charts should be used when the natural
subgroup is not yet known.
• A measure of defective units is found with u– and c-charts.
• In a u-chart, the defects within the unit must be independent of one another, such
as with component failures on a printed circuit board or the number of defects on a
billing statement.
• Use a u-chart for continuous items, such as fabric (e.g., defects per square meter of
cloth).
• A c-chart is a useful alternative to a u-chart when there are a lot of possible defects
on a unit, but there is only a small chance of any one defect occurring (e.g., flaws in
a roll of material).
• When charting proportions, p– and np-charts are useful (e.g., compliance rates or
process yields).