Engineering Economics

Engineering Economics

Sushil Rijal
me.sushilrijal
@gmail.com
 Economics
• Economics is science of wealth. – Adam Smith
• Economics is on one side study of wealth; and on the
other side a study of human welfare based on
wealth. - Marshall
• Economics is the social science that examines how
people choose to use limited or scarce resources in
attempting to satisfy unlimited wants. –N. Gregory
Mankiw
• Economics is a science which studies human
behavior as a relationship between ends and scarce
means which have alternative uses. – Lionell Robbins
 Engineering Economics
• Engineering economics is the application of
economic techniques to the evaluation of design
and engineering alternatives. – Dr. John M.Watts

• “Engineering economics deals with the methods

that enable one to take economics decision
towards minimizing the cost or maximizing the
benefit to business organization.”
Resources: - 3M/5M
• Manpower
• Machine
• Materials
• Money
• Minute
/Management
 Example
1. Buy a Laptop for online class
2. Specifications of laptop (Core i5), laptop shops, online shopping
3. Dell, Sony, Apple, HP
4. Criteria- upto Rs. 80,000
5. Dell -75000, Sony-120000, Apple-150000, HP-80000
6. Dell
7. Dell-75,000, select Dell.
Cash flow:

• The analysis of events and transaction that affects the cash position
of company is termed as cash flow.
• Cash flow is the net amount of cash and cash-equivalents being
transferred into and out of a business.
• Positive cash flow/ Cash inflows indicates that a company is adding
to its cash reserves.
• Negative cash flow/ Cash outflows indicates cash outgoing from the
firm or project.
 Cash Flow Diagram The Picture should show
the following
1. A time interval divided
into appropriate no of
periods
2. All Cash flow
3. Interest rate
1 2 3

i%

P (Investment)
 MAJOR PRINCIPLES OF ENGINEERING ECONOMICS
How we take decisions?

• Principle 1: An earlier dollar is worth more than a later dollar.

• Principle 2: All that counts is the differences among alternatives.
• Principle 3: Marginal revenue must exceed marginal cost.
• Principle 4: Additional risk is not taken without expected
additional return.
Sources : (Chan S. Park)
Role of Engineers in Decision making:
Economic Decision making
• Service Improvement
• Equipment, project and process selection
• Equipment Replacement
• New Product and
• Product expansion
• Risk and uncertainty analysis of the project
 Time value of Money
• The relationship between money and time leads to the
concept of time value of money.
• A rupee or dollar in hand is worth more than a rupee or
dollar received 'N' years from now.
What do you Prefer ?
A. 100000 today
B. 100000 one year later
C. But why ???
 Why Time value of Money?
• Money has time value because the purchasing power of money
as well as the earning power of money changes with time.
• During inflation, purchasing power of money decreases over
time.
• Money can earn an interest for a period of time.
• Also we can invest money in shares or other platform and earn
up to certain amount.
• Even some risk is associated, which demand compensation
• Therefore, both purchasing power and earning power
(opportunity cost) of money should be considered while
taking into account the time value of money.
• Interest is the manifestation of the time value of money.
Computationally, interest is the difference between an ending
amount of money and the beginning amount. If the difference is
zero or negative, there is no interest.
 Simple Interest
• When the interest earned or charged is directly proportional to the
initial investment or principal amount (P), the interest rate (i), and
number of interest period (N), the interest (I) and the interest rate is said
to be simple interest and simple interest rate.
• I = P*N*i
• F= P+I

• It is not used in Economic Analysis.

Compound Interest
• When the interest charge for any interest period (a year) is
based on the remaining principal amount plus any
accumulated interest charges up the beginning of that period
(not withdrawn), the interest is said to the compound.
• Mostly used in Practice

•I = ?
Comparison of Simple and Compound
Interest , P= $1000, i=8%. N =3 years
 Nominal Interest rate and Effective Interest
rate
• Interest rate 10% compounded Semiannually (nominal
interest rate)
• Interest rate semiannually = 10%/2
• = 5%
If P =1000
Find Accumulated Amount after
1 year?
 Nominal interest rate ?
• In general, interest charged or earned on the principal amount is
quoted as ' i % compounded annually or i % per year’.
• Very often, the interest period or time between successive
compounding, is less than year
• For example, if the interest rate is 6% per six month, it is customary
to quote this rate as '12% compounded semi-annually.
• The basic annual interest rate, 12% in this case, is known as
nominal interest rate and denoted by 'r'.
 Effective Interest rate
• The actual or exact rate of interest rate earned on the principal during
one year is known as effective interest rate and dented by 'i’.
 Some problems
Question1: Suppose that you invest $1,000 for 1 year at
18% compounded monthly. How much interest would you
earn?
Question 2:
Suppose your savings account pays 9% interest
compounded quarterly. If you deposit $10,000 for one
year, how much would you have at the end of the year ?
Cont…
Practice problem

When is the maximum effective

interest rate?
Numerical problem
 Economic Equivalence
• Two things are said to be equivalent when they have the same effect.
• Economic equivalence refers to the fact that a cash flow - whether
single payment or series of payments - can be converted to an
equivalent cash flow at any point in time.
 Economic Equivalence

• PRINCIPLE 1 : - Equivalence calculations made to compare alternatives

require common time basis.
• PRINCIPLE 2 : - Equivalence depends on interest rate.
• PRINCIPLE 3 :- Equivalence calculations may require converting
multiple cash flow to a single cash flow.
• PRINCIPLE 4 :- Equivalence is maintained regardless of point of view.
Types of Cash Flow
Also Called Compounding
Factor !!
Annuities
Annuities: are essentially a series of fixed payments required
from you or paid to you at a specified frequency over the course
of a fixed time period.
• Ordinary Annuity: Payments or receipts occur at the end of each
period.
• Annuity Due: Payments or receipts occur at the beginning of each
period.
• Perpetuity : Annuities that go forever.
• Deffered Annuity : Student loan ( Payments are made after certain
gap or interval)

Some Examples of Annuities

Student Loan Payments, Car Loan Payments , Insurance Premiums
Numerical…
Capital Recovery factor
Four cases of geometric Gradient
Numerical
Continuous Compounding Single Cash Flow

THANK YOU !!
 Basic Methodologies of
Engineering Economics Analysis
and Risk Analysis
Sushil Rijal
 MARR (Minimum Acceptable/Attractive Rate of Return)
• MARR is that interest rate at which an investor can accept to earn or borrow money easily.
MARR is determined by top management from policy level. So, it may be different from time
to time and firm to firm.
MARR is determined by taking into numerous considerations. They are:
• The amount of money available for investment, and the source and cost of these funds (i.e.
equity funds and borrowed funds).
• The number of good projects available for investment and their purpose
• The amount of perceived risk that is associated with investment opportunities
• The type of organization involved (i.e., government, public utility, or competitive industry).
• MARR gov < MARR public < MARR private
Methods of Engineering Economic
Analysis
 Pay Back Period Method
• Payback period is defined as the number of years required to
recover the initial investment.
• It focus on liquidity i.e. how fast an initial investment can be
recovered (easy recovery). It is not measure of profitability.
• It does not consider cash flows of entire life of project. i.e. ignores
cash flow information after payback period.

SIMPLE PAYBACK PERIOD

Simple Payback Period is the payback period which ignores the time
value of money. i.e. i = 0.
It does not consider the time value of money.
 Simple Payback period
• EQUAL OR UNIFORM CASH FLOW
Simple Payback Period = Initial Investment /Annual net cash flow
If Calculated Payback Period < Standard Payback Period, Accept the project,
Or If Calculated Payback Period > Standard Payback Period, Reject the Project

• Initial Investment = 10,000. Annual cash inflow = 5,000. Annual cash outflow
= 3,000. Standard Payback Period = 4 years

• Since Calculated Payback Period > Standard Payback Period,

Reject the Project.
 Discounted Pay back Period
• Simple Payback Period ignores the time value of money. i.e. i = 0. To remedy this
defect of simple payback period, time value of money is considered in the
Discounted Payback period.
• Cash flows are discounted at certain MARR and determine the number of years
required to recover the initial investment.
If MARR= i =10%, and Standard Pay back period = 3.5 years, evaluate discounted
payback period and acceptability of project
 MERITS OF PAYBACK PERIOD
• Simple to understand
• Easy to calculate
• Inexpensive to use
• Focus on liquidity i.e. how fast an initial investment can be
recovered (easy recovery)
• Easy and crude way to tackle/cope with riskiness of
investment.
• Based on cash flow information
 Demerits of Payback Period
• Simple payback period ignores the time value of money. Use
discounted payback period to take into account the time value of
money.
• Does not consider cash flows of entire life of project. i.e. ignores cash
flow information after payback period
• Is not measure of profitability.
• No rational basis to set/determine a maximum/minimum acceptable
standard payback period. It is generally, a subjective decision.
• fails to consider the pattern of cash flow. i.e. timing and magnitude
Comparisons between alternative
Choose the one project among given alternative if MARR = 10%
a)By Simplified Payback method
b)By Discounted Payback method
Equivalent Worth (EW) Method
• Equivalent worth methods convert all cash flows into equivalent
present, future, or annual amounts at the MARR. If a single project is
under consideration,

If EW ≥ 0; Accept the project,

If EW < 0, Rejected the project.
❑Future Worth Method ( FW)
❑ Present Worth Method or Present Value Method (PW/PV)
❑Annual Worth Method (AW)
Future Worth (FW) Method or Future Value
• Future worth criterion has become popular because a primary
objective of all time value of money is to maximize the future wealth of
the owners of the firm. i.e. how much it worth at the end of given
number of years.
• FW methods convert all cash flows into equivalent future amounts at
the MARR. All cash inflows and outflows are compounded forward to a
reference point called the future, at the interest period rate MARR.
 Present Worth Methods or Present Value
• PW methods convert all cash flows into equivalent present amounts at the
MARR. All cash inflows and outflows are discounted to the base or beginning
point in time at the interest period rate MARR.
• Present worth of project is a measure of how much fund will have to be put
aside now to provide all future expenditures during the project period. It is
assumed that such fund placed in reserve earns interest rate equal to MARR.
Annual Worth Method (AW)
• Annual worth of a project is uniform series of amount that is
equivalent to the cash inflows and outflows occur during the project
duration.
• AW methods convert all cash flows into equivalent annual amounts
at the MARR.

• If a single project is under consideration,

If AW ≥ 0; Accept the project,
If AW < 0, Rejected the project.
 Capital Recovery Cost (CR)
• Capital Recovery Cost (CR) of a project is the equivalent uniform cost of the capital
invested. It covers both depreciation and interest on invested capital (MARR). It can
be calculate by following formulas.
• CR = I (A/P, i, N) - S (A/F, i, N)

AW = R - E - CR
where R = Annual equivalents receipts or savings, E = annual equivalent expenses,
CR = Capital Recovery Cost.
• If CR = R - E
i.e. Capital to be recovered per year = net annual cash flow. No gain/No loss.
If CR < R - E
i.e. Capital to be recovered per year < net annual cash flow. There is gain.
If CR > R - E
i.e. Capital to be recovered per year > net annual cash flow. There is loss.
 Numerical
• The initial investment is Rs. 25,000, and salvage value is 10% of the initial investment
at the end of its useful life 10 years. Annual revenue and expenses are Rs 14,000 and
Rs. 10,000 respectively. Evaluate the investment proposal by EW (FW/PW/AW)
methods. MARR = 10%.
Rationale for the EW Method
EW=0 → Project’s inflows are “exactly sufficient to repay
the invested capital and provide the required rate of
return.”
• Choose between mutually exclusive projects on basis of higher Worth/
Value( Future Worth/ Present Worth / Annual worth )

• Meets all desirable criteria

• Considers all CFs
• Considers TVM
• Can rank mutually exclusive projects

18
Rate of Return
Rate of Return Method
• If the return on investment is expressed in terms of rate of
return or percentage, even common layman can readily
understand.
• In this method, the interest is found out that equates the
equivalent worth of an all cash inflows (receipts or
savings) and cash outflows (investment and expenditure).
• In other word IRR is the interest rate at which given cash
flow becomes zero. IRR can be found out by any of EW
(PW or FW or AW) Method.
• Once IRR is computed, it is compared with MARR.
If IRR ≥ MARR, Accept the project,
If IRR < MARR, Rejected the project
NET PRESENT VALUE (NPV)
• Net present value (NPV) is the difference between the present value
of cash inflows and the present value of cash outflows over a period
of time.
• Net Present Value (NPV) is the value of all future cash flows (positive and
negative) over the entire life of an investment discounted to the present.
• NPV analysis is a form of intrinsic valuation and is used extensively
across finance and accounting for determining the value of a business,
investment security, capital project, new venture, cost reduction program,
and anything that involves cash flow.
NPV=TVECF−TVIC
where:
TVECF=Today’s value of the expected cash flows
TVIC=Today’s value of invested cash​

NPV is ……………proportional to discount rate

A) Directly B) Inversely C) Constant D) All of the above
 IRR
• IRR is the term for rate of return that stresses the interest earned on
the portion of project that is internally invested.

IRR = the discount rate(%) that forces

“ PV inflows = cost”
 Equating NPV = 0

• Methods of Calculations of IRR

• A) Direct Solution Method
• B) Trial and Error Method
• C) Computer Solution Method
Calculate IRR ( i = ? )
IRR for Project L
?%
t = 0 1 2 3 4

L's CFs -1000 100 300 400 600

-1000
PV(1)
PV(2)
PV(3)
PV(4)
NPV = $0.00
 Disadvantages of IRR
• The IRR method assumes that the recovered funds, if not consumed at the end of the year,
are reinvested at IRR rather than at MARR. Greater the IRR, at much higher rate of return, it
may not be practically possible to reinvest net cash proceeds from the project within the firm.

• IRR may not be uniquely defined. There is possibility of multiple rate of return, in case of non-
simple investment (i.e. cash flow stream of a project has more than one changes in sign).
• Find the IRR for the following cashflow:
EOY 0 1 2
Cashflow -1,600 +10,000 -10,000
Disadvantages of IRR
• When choosing among mutually exclusive projects, IRR may be
misleading:
External Rate of Return (ERR) or Modified IRR
• The ERR method takes into account the external reinvestment rate (Ԑ) at which net cash flows
generated (or required) by the project over its life can be reinvested (or borrowed) outside the
firm.
• (∑ PW of negative net cash flows at Ԑ%) * (1+ERR)^N = (∑ FW of positive net cash flows at Ԑ%).
•
Since, ERR (35.91%) > MARR (30%),
Accept the project.
 Benefit/ Cost Ratio (BCR)
• Benefit Cost Relation is a special tool of cost Benefit analysis (CBA) and it is used to evaluate
public sector projects, although it can be extended to any private sector projects.
• B/C ratio can be defined as the ratio of the equivalent worth of benefits to the equivalent
worth of costs.
 For PSc, we focus on PV only

While the minimum value of

b/c ratio for selection of any
project is 1.

B/C ratio is …….. proportional to discount rate

C/B ratio ??
COMPARISON OF EXCLUSIVE ALTERNATIVES
HAVING SAME USEFUL LIFE
• 4.1.1 Payback period and Equivalent Worth method
❑ For this method, calculate as earlier and just compare the result
of every project
❑project with Equivalent worth < 0 are rejected
❑Project with highest worth among project worth >0 is accepted
❑Payback period > Standard pay back period are rejected
❑Project with smallest Payback period among project payback <
Standard pay back period is accepted
Numerical
Numerical

Also compare the projects with both type of Pay back periods
if Standard payback is 4 years
Rate of Return Method and BCR Method
Steps for Incremental Analysis
Rate of Return Method and BCR Method
Capitalized worth and Externalities
• Capitalized worth is the present worth of an alternative for overall study period.
• CW method is introduced as a special case of PW criterion when revenue and expenses
occur over an infinite length of time.
• Perpetuity: Infinite annuity is called perpetuity.
• CW(i%) = A/I
Externalities
• An externality is referred to as an external effect, is a special class of goods which is not
deliberately created by project sponsor but is an incidental outcome of legitimate
economic activity.
Positive /Negative externalities:
• The approach road built by a company may improve the transport of that area.
• Nearly constructed airport will increase the sound level of surrounding
 Some Qns
1. Benefit cost ratio is the ratio of
• A) PVB/PVC B) PVC/PVB c) FVB/FVC d) FVC/FVB
2. the average cost incurred in supplying a particular benefit over the
entire life time of the project is
A) project cost b) Lifecycle cost
c) Maintenance cost d) none
3. Find the effective interest rate if 10% is compounded 3 times per year
• A) 10.11 b) 10.22 c)10.33 d)10.44
4. Find the effective interest rate if 12% is compounded quarterly
• A) 12.22 b) 12.33 c)12.44 d)12.55
Compound rate: Rate used to calculate Future value of Present cash
flow.
Discount rate: Rate used to calculate present value of series of
future cash flow. Inverse of compound rate
Accounting Rate of return
(does not consider time value of money)
• ARR = Average Income/ Average Investment
• ARR> MARR
Sensitivity Analysis
• Determining how sensitive
our NPV analysis is.
• Can be called Spider plot
• If used for infinite period, it
is called Monte Carlo
Simulation
 Some Definitions
Cost Terminologies
Fixed cost:
• Cost which are associated with fixed factors of production like land, plant, building, equipment
etc.
• It remains constant in the production process for certain level of output capacity.
Variable cost:
• Cost which are associated with variable factors of production and vary with change in level of
output like labour, raw materials, fuel etc.
Total cost/ Sum cost: Sum of fixed and variable cost
Sunk cost:
• All the past cost which cannot be recovered when a firm leave from an industry.
• Cost of engineering design, wages, decoration, depreciation, registration, license etc.
Breakeven Analysis
• Break even quantity
= Fixed costs / (Sales price per unit –
Variable cost per unit)
• Total Revenue = Total cost
• Revenue sufficient to cover all expense
• Organization is neither in gain nor in loss.
Other: Export = Import; Supply = Demand;
Cost of two products being equal

https://corporatefinanceinstitute.com/resources
/knowledge/modeling/break-even-analysis/
Decision tree Analysis
COST, RISK ANAlYSIS
,RATIO & Others
SUSHIL RIJAL
 Capitalized worth and Externalities
• Capitalized worth is the present worth of an alternative for overall study period.
• CW method is introduced as a special case of PW criterion when revenue and expenses occur
over an infinite length of time.
• Perpetuity: Infinite annuity is called perpetuity.
CW(i%) = A/I
Externalities
• An externality is referred to as an external effect, is a special class of goods which is not
deliberately created by project sponsor but is an incidental outcome of legitimate economic
activity.
Positive /Negative externalities:
• The approach road built by a company may improve the transport of that area.
• Nearly constructed airport will increase the sound level of surrounding
 Some Qns
1. Benefit cost ratio is the ratio of
A) PVB/PVC B) PVC/PVB c) FVB/FVC d) FVC/FVB
2. the average cost incurred in supplying a particular benefit over the entire life time of the
project is
A) project cost b) Lifecycle cost
c) Maintenance cost d) none
3. Find the effective interest rate if 10% is compounded 3 times per year
A) 10.11 b) 10.22 c)10.33 d)10.44
4. Find the effective interest rate if 12% is compounded quarterly
A) 12.22 b) 12.33 c)12.44 d)12.55
Compound rate: Rate used to calculate Future value of Present cash flow.
Discount rate: Rate used to calculate present value of series of future cash flow. Inverse of
compound rate
Accounting Rate of return
(does not consider time value of money)
ARR = Average Income/ Average Investment
ARR> MARR
Sensitivity Analysis
• Determining how sensitive
our NPV analysis is.
• Can be called Spider plot
• If used for infinite period, it
is called Monte Carlo
Simulation
 Some Definitions
Cost Terminologies
Fixed cost:
• Cost which are associated with fixed factors of production like land, plant, building, equipment etc.
• It remains constant in the production process for certain level of output capacity.
Variable cost:
• Cost which are associated with variable factors of production and vary with change in level of
output like labour, raw materials, fuel etc.
Total cost/ Sum cost: Sum of fixed and variable cost
Sunk cost:
• All the past cost which cannot be recovered when a firm leave from an industry.
• Cost of engineering design, wages, decoration, depreciation, registration, license etc.
Breakeven Analysis
• Break even quantity
= Fixed costs / (Sales price per unit –
Variable cost per unit)
• Total Revenue = Total cost
• Revenue sufficient to cover all expense
• Organization is neither in gain nor in loss.
Other: Export = Import; Supply = Demand;
Cost of two products being equal

https://corporatefinanceinstitute.com/resources
/knowledge/modeling/break-even-analysis/
Decision tree Analysis
 COST
Q. The benefit that is forgone by engaging the resource in a chosen activity instead of engaging
the same resource in forgone activity is known as:
A)Marginal cost, B)Opportunity cost,
C) Incremental cost D) Life cycle cost
Marginal Cost: The cost of producing one more unit of good
Opportunity cost: Opportunity costs represent the potential benefits an individual, investor, or
business misses out on when choosing one alternative over another
Element of cost
 Cont…
➢Material; the substance from which a product is made is known as material.
It may be in a raw or a manufacture state.
➢Labour; For conversion of material into finish goods, human effort is needed
and such human effort is called labour.
➢Expenses; these include cost of special design, drawing, layout, cost of
purchase or hire of tools and plants for a particular job and maintenance of
such tools and equipment etc.
➢Types of cost
➢Direct cost; Direct costs are those costs that can be identified specifically with a
particular project, or that can be directly assigned to such activities relatively
easily with a high degree of accuracy.
➢Indirect cost; Indirect Costs are those that are incurred for common or joint
objectives and therefore cannot be identified readily and specifically with a
particular project.
 Classification of cost

❖Total Cost= Total prime cost+ total overhead cost

❖Prime cost: Prime cost is those costs that can be reasonably
measured and allocated to specific output or work activity.
❖Total prime cost= Direct material cost+ Direct Labor cost+
Direct Expenses.
❖Overhead cost: Overhead costs are those that occur but
cannot be reasonably measured and allocated to a specific
output or activity.
❖Total Overhead cost= Indirect material cost+ Indirect Labor
cost+ Indirect Expenses.
 Some Definitions
Direct cost/Prime cost:
• Cost which can be reasonably measured and allocated with specific output or work activity.
• Direct Material: The cost of material that can be allocable to production.
Example: Raw material consumed during production of the unit.
• Direct Labor: Wages to the laborers that can be identified with a cost object.
Example: The term wages include bonus, gratuity, provident fund, incentives, etc.
• Direct Expenses: It includes all the other expenses that are directly linked to the production
of a product.
Example: Job processing charges, hire charges for tools and equipment, subcontracting
expenses.
 Some Definitions
Indirect and Overhead cost:
• All cost other than direct cost.
• Cost that cannot be reasonably measured and allocated to a specific output or work activity.
• Indirect Material: Material Cost which cannot be identified with a particular product or
project.
Example: Fuel, lubricants, small tools etc.
• Indirect Labor: Salary to the employees that cannot be allocable to a particular cost object.
Example: Overtime pay, holiday pay, maintenance charge, material handlers, supervisor etc.
• Indirect Expenses: All the expenses other than indirect material and labor are included in
this category.
Example: Interest, Rent, Tax, Duty, etc.
 Cost variance analysis
❖When actual performance are recorded and compared with a standard set, some deviations are
observed. These deviations are popularly called variance.
❖Variance(V)= Actual cost(AC) – Estimated Cost or Standard cost(SC)
❖If AC< SC, Favorable condition and
❖If AC> SC, Adverse condition.

A. Direct material variances: 1+2

1. Direct material price variance(DMPV)
DMPV= (AQ*AR)- (AQ*SR)= AQ(AR-SR)
2. Direct material usage variance(DMUV)
DMUV= AQ*SR- SQ*SR= SR(AQ-SQ)
where, AQ=Actual Quantity, SQ= Standard Quantity for actual production,
AR= Actual Rate, SR= Standard Rate
 Cont…
B. Direct wages variance (Labour variance): 1+2
1. Direct wages(labour) rate variance(DWRV)
DWRV= AH(AR-SR)
2. Direct labour efficiency variance(DLEV)
DLEV= SR(AH-SH)
C. Variable overhead variance: 1+2
1. Variable overhead expenditure variance(VOEV)
VOEV= AH(AR-SR)
2. Variable overhead efficiency variance(VOEV1)
VOEV1= SR(AH-SH)
Where, AH=Actual Hour, SH= Standard Hour,
AR= Actual Rate, SR= Standard Rate.
 Cont..
D. Fixed overhead variance:
1. Fixed overhead expenditure variance(FOEV)
FOEV= Actual fixed overhead(AH*AR)-
budgeted fixed overhead

2. Fixed overhead capacity variance(FOCV)

FOCV= Budgeted fixed overhead- (AH*SR)

3. Fixed overhead efficiency variance(FOEV)

FOEV= (AH*SR)-(SH*SR) = SR*(AH-SH)
4. Fixed overhead volume varience(FOVV)
FOVV= Capacity variance(FOCV)+ Efficiency variance(FOEV)

Where, AH=Actual hour, SH= Standard hour,

AR= Actual rate, SR= Standard Rate.
Some Definitions
Inflation
• Loss in purchasing power of money over time.
• If the supply of money were to grow faster than demand for it.
• When demand exceeds supply, because of less supply, the net prices of the services or goods
increases and this kind of situation is known as inflation.
• Because of inflation rupees in one time are not equivalent to rupees in another time.
A) Cost Push Inflation B) Demand Pull Inflation
Deflation:
• Opposite of inflation.
• Increase in value of currency.
• Deflation encourages individuals and corporations to hoard their money.
• Deflation is cause of recession, that slowdown the economic activities
HYPERINFLATION !!
STAGFLATION !!
 Some Definitions
Depreciation:
• Decline in value of capital assets due to wear and tear, passage of time, obsolescence.
• Allocation of the cost of fixed asset over its recovery period.
Depletion:
It is defined as the reduction of the value of certain natural resources such as mines, oil,
timber, quarries etc. due to the gradual extraction of its contents.

Q. What is defined as the reduction or fall of the value of an asset due to constant use and
passage of time? Depletion, Inflation, Depreciation, Deflation
 Some Definitions
Any assets will have following cost components:
i) Capital recovery cost – Earning back of the initial funds.
ii) Average operating and maintenance cost
iii) Total cost
The point where the total cost is minimum is called economic life of machine.
Economic life is the period of time that results in the minimum equivalent uniform annual cost of owning and
operating an asset.
Life cycle cost: Sum of all expenditure associated with the project during its entire service life.
i) First cost: Land, Design and development, Building, Machine and installation, Training and special tooling,
Supporting equipment, computer and transportation, Manufacturing and fabrication cost etc.
ii) Operating and Maintenance cost: Labour, Material, Overhead, Transportation etc.
iii) Disposal cost: Labour for removal, Material, Transportation for disposal.

Marginal cost/ Incremental cost: Marginal cost is the change in the total cost that arises when the quantity produced is
incremented by one unit; that is, it is the cost of producing one more unit of a good.
Marginal revenue: The change in total revenue due to one extra unit of quantity sold.
 Some Definitions
Salvage Value:
It is the estimated value of the property at the end of its useful life or recovery period. It is the expected selling
price of a property when the asset can no longer be used productively by its owner.
Market value:
The amount that will be paid by a willing buyer to a willing seller for a property where each has equal
advantage and it is under no compulsion to buy or sell.
Scrap value/Residual value/Break-up value:
Scrap value is the worth of a physical asset's individual components when the asset itself is deemed no longer
usable.
The main difference between scrap and salvage is that a salvage vehicle has the potential to be
repaired and then returned to the road. Whereas a scrap vehicle cannot be returned to the road and
will be crushed and sold for materials.
Cash cost and Book cost: Cost that involves payment of cash from is called cash cost. Cost
that doesn’t involve cash transaction but is reflected in the accounting system is called book
cost or non-cash cost. Eg. Depreciation charge of equipment.
Job (Specific order) Costing:Job costing refers to calculating the cost of a special contract,
work order where work is performed as per client’s or customer’s instruction or specification.
• Eg. Building construction, Furniture etc.
Process costing: It refers to costing of one or more processes involved while converting a
raw material to finished output.
• This method is used where it is not possible to trace the items of prime cost to a particular
order, because its identity is lost.
• Eg. Chemical plant, Oil refining, dairy etc.
•Uniqueness of product. Job costing is used for unique products, and process costing is used
for standardized products.
•Size of job. Job costing is used for very small production runs, and process costing is used for
large production runs.
 Cont..
Job costing Process costing

1. Production is made by specific 1. Uniform production in continuous

orders. flow.
2. The different jobs may be 2. Being manufactured in a continuous
independent of each other flow, product loses their individual
3. Each job is allotted a number and identity.
costs are collected against the same 3. The unit cost of process which is
job number. computed by dividing the total costs for
4. Job costing is computed when the the period by the total output, is an avg.
job is completed. cost of the period.
4. Process cost is calculated at the end
of the cost period.
Assets, Capital, Liabilities
Asset:
• An economic resource of an entity.
• Real asset: Land, building, plant, machinery,
equipment etc.
• Financial asset: cash, shares, securities etc.

Capital:
• Factors of production
• Term for describing wealth.
• Man-made factor that contribute to the production of goods and services.
• Non-human ingredients that contribute to the production of goods and services including land,
buildings, raw and semi-finished materials, finished product, inventories etc.
Assets = Liabilities + Owner's Equity (Capital)
When a business is put up, its resources (assets) come from two sources: contributions by owners (capital) and those acquired
from creditors or lenders (liabilities).
The fund invested by the owner in the business or the net amount claimable by the owner from the
business is known as the Capital or Owner's Equity or Net Worth
Some Definitions
Asset: Tangible assets vs Non tangible assets
Tangible asset
Fixed assets: Physical or infrastructure assets which are not intended for resale in the normal course of
business and provide benefit over a long period of time to the business. Ex. Land and Building, Equipment,
Furniture, Vehicles etc.
Current asset: The assets which are in the form of cash or can be converted into cash within a year. Ex.
Cash in hand, cash in bank, bill receivable, inventories, marketable securities, accrued income etc.
Non tangible : Goodwill, Trademark, copyrights
Liabilities: Liabilities are borrowed debts and payable obligation of organization.
• Long term Liabilities: Raised for more than one year. Bond/Debenture, Bank loan etc.
• Current (Short term) Liabilities: To be repaid within one year. Bill payable, advance income etc. A liability
is considered current if it is due within 12 months after the end of the balance sheet date

Total debt = Long term debt + Current liability

Using Financial Ratios
Debt ratio (Solvency/Leverage/Capital structure ratio):
Debt ratio : debt ratio divides total debt by total assets.
Debt to equity ratio(DER): Total debt/ Shareholder’s equity : Measures
long term solvency. Also called Interest coverage ratio
• Lower ratio indicates more security to the creditors.
Interest coverage ratio =
• Higher ratio represents more risk to creditors and owners.
Operating income / Interest
expenses
Current ratio measures company ability to pay short
term obligations
 Ratio
Current ratio: Current asset/Current Liabilities ; cash asset ratio
Represents ability of firm to pay its short-term debt.
Current ratio of 2:1 is regarded as an acceptable standard.
Less than 2:1 represents firm has not paid its urgent debt on time, which shows bad
business performance.

Quick ratio or Acid test ratio or Liquid ratio:

Quick asset/Current liabilities
Quick asset = Current asset – stock – prepaid expenses
Higher the quick ratio, better the liquidity position. Ideal quick ratio is 1:1
Economic system
Economical System
a)Capitalistic Economic sytem / Free Market Economy
b) Socilastic System/ Controlled Economy
c) Mixed System

Utility : Satisfaction that the consumer derived from the good and service consumed. Measure
of satisfaction
Sunk cost: Capital already invested that for some reason cannot be retrieved. Expense which
has happened in the past. No relevance to alternatives being considered.
 Law of Diminishing..
Law of Diminishing Marginal Utility:
According to Marshall: The additional benefit which a person
derives from an increase of his stock of a thing diminishes with the
growth of the stock that he already has.
Law of Diminishing Returns:
It states that when more and more units of variable input are
applied to a given quantity of fixed inputs, the total output may
initially increase and then will be constant and it will eventually
decrease.
 Market and Law of Demand
A market is a group of buyers and sellers of a particular good or service.
The buyers as a group determine the demand for the product, and the
sellers as a group determine the supply of the product.
The quantity demanded of any good is the amount of the good that
buyers are willing and able to purchase.
Law of demand:
Other things being equal, when the price of a good rises, the quantity
demanded of the good falls, and when the price falls, the quantity
demanded rises.
demand schedule : a table that shows the relationship between the
price of a good and the quantity demanded
Demand curve & Schedule
Law of Supply
Other things being equal, when the price of a good rises, the quantity supplied of the
good also rises, and when the price falls, the quantity supplied falls as well.
Equilibrium of Supply and Demand
Shifts in
Price of commodity
Demand/ Factors affecting Qd
Income of Consumer
Price of related goods
Change in Taste
Weather
Future Expectations
Nos of Buyers
Shifts vs movement
 Elasticity
Elasticity is a measure of how much buyers and sellers respond to changes in market conditions
a measure of how much
the quantity demanded
of a good responds to a
change in the price of
that good, computed as
the percentage change
in quantity demanded
divided by the percentage
change in price.
Necessities??

Also Called Relatively Inelastic Demand

Availability of close Substitutes

Also Called Relatively elastic Demand

Total Revenue
Other Elasticities
Income Elasticity
So If Qd increases when Price decrease, Good is
NORMAL
So If Qd increases when Income increase, Good is
NORMAL
Giffen goods are rare forms of inferior goods that have no
ready substitute or alternative such as bread, rice, and
potatoes. The only difference from traditional inferior goods is
that demand increases even when their price rises, regardless
of a consumer's income.
If Qd decreases when Income increase, Good is INFERIOR
If Qd increases when Price Increase, Good is Giffen
(Irrespective of Change in Income )
questions
Q. If the percentage fall in quantity demanded is greater than the percentage rise in price
charged, the revenue will…….
Rise, fall , not related, none of the above
Q. If the change in quantity demanded is LESSER than change in price, it is said to be
a) Perfectly elastic demand
b) Unitary elastic demand
c) Relatively inelastic demand
d) Relatively elastic demand
 GDP & GNP
In economics, Gross Domestic Product (GDP) is used to calculate the total value of the
goods and services produced within a country’s borders,
while Gross National Product (GNP) is used to calculate the total value of the goods and
services produced by the residents of a country, no matter their location.
Essentially, GDP looks for the amount of economic activity within a nation’s economy,
while GNP looks at the value of the economic activity generated by the nation’s people.
GDP Nepal ko, GNP kasko ?? Nepali ko !!

Approach for GDP Calculation

◦ Expenditure approach
◦ Income approach
◦ Product approach
1. Final product approach
2. Value added approach
 Methods of GDP Calculation
The expenditure approach takes into account adding up all the amount spent on
goods and services during the period.
GDP = C + I + G + (X – M)
Where,
C = Consumption spending
I = Investments
G = Government purchases
X = Exports
M = Imports
X-M = Net Exports
 GNP
GNP is known as gross national product and represents the total value of goods and services
produced by the residents of a country during a financial year.
It takes the income earned by the citizens of the country present within or outside the country
into consideration. It excludes the income generated by the foreign nationals who are residing in
the country. It can be calculated as:
GNP = GDP + NR – NP
Where,
GDP = Gross domestic product
NR = Net income receipts
NP = Net outflow to foreign assets
 Qns
Q. The more critical or severe test of the firm’s liquidity can be judged by…..

A) Liquidity ratio, b) Current ratio

C) Acid test ratio, D) Debt ratio

THANK YOU !!
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Engineering Economics
MCQ
Collection by Sushil Rijal
 questions
• In a cash-flow diagram:
(A) Time 0 is considered to be the present
(B) Time 1 is considered to be the end of time period 1
(C) A vertical arrow pointing up indicates a positive cash flow
(D) All of these
Cost that are not borne by the parties to the economic….. Are called
externalities..
a) Gain b)transaction c)transfer d)loss
• In the process of selecting public project the criterial usually adopted
are
a) Economic evaluation b) financial evaluation c) both
• The benefit cost ratio is
A. Directly proportional to discount rate
B. Inversely proportional to discount rate
C. No any relation with discount rate
D. All of the above

• Q. If one has deposited Rs. 10,000 in bank and pay Rs 11025 after one year,
the interest rate could be…
A10% compounded semiannually
B 10.25% annually
C Both of above
D None of above
Q. Which of the following is not direct cost for the project
a) Wages of labor b) cost of materials c) insurance costs d) sub contract cost
• Q. The numerical value of MARR is
A. Equal to IRR
B. Less than IRR
C. Greater than IRR
D. All of the above
• Q. IRR should be…
A. Less than borrowing rate
B. More than borrowing rate
C. Equal to borrowing rate
D. All of the above
Qn. In case of construction industry, the cost of material is normally
• A) more than cost of labour
• B) equal to
• C) less than
2.The difference between actual cost of the project with
standard/targeted cost is called…..
3. For selection of any project the NPV should be…

Thank you