CHAPTER 1

INTRODUCTION TO
ENGINEERING ECONOMY
Learning Objectives:

Purpose: → Understand the fundamental concepts of engineering economy.

This chapter will help you:

1. Questions → Understand the types of questions engineering economy can answer

2. Decision making → Determine the role of engineering economy in the decision

making process.

3. Study approach → Identify what is needed to successfully perform an engineering

economy study
WHAT IS ECONOMICS ?

The study of:

 How to allocate resources efficiently
to satisfy unlimited human wants

 How individuals and societies

choose to use scarce resources
Resources

• Land
• Labor
• Capital
 LAND
All gifts of God, such as:
 Water, air, minerals, sunshine
 Plant and tree growth
 Land itself which is applied to the
production process.
LABOR
The efforts, skills, and knowledge of
people which are applied to the
production process.
 CAPITAL
 Real Capital (Physical )
Dollar Bills
 Tools, buildings, machinery -- things which have been produced which are
used in further production
 Financial Capital
 Assets and money which are used in the production process
 Human Capital
 Education and training applied to labor in the production process
ENGINEERING ECONOMY/ECONOMICS DEFINED

 As defined by Arreola

Engineering economy is that branch of economics which involve the application of definite laws of
economics, theories of investment and business practices to engineering problems involving cost

It is also defined to be the study of economic theories and their application to engineering problems
with concept of obtaining the maximum benefit at the least cost as a basis for decision.

It also involves the study of cost features and other financial data and their application in the field of
engineering as a basis for decision.
ENGINEERING ECONOMY/ECONOMICS
DEFINED
 As defined by Kasner

Engineering economics is equated with practicality and economic feasibility. It is also the search for
the recognition of alternatives which are then compared and evaluated in order to come up with the
most practical design and creation

 As defined by Sullivan, et al.

Engineering economy is the systematic evaluation of the economic merits of proposed solutions to
engineering problems.
IMPORTANT USES OF ENGINEERING
ECONOMY
1. Seeking new objectives for the application of engineering
2. Discovery of factors limiting the success of a venture or enterprise
3. Comparison of alternatives as a basis for decision
4. Analysis of possible investment of capital
5. Determination of bases for decision
PRINCIPLES OF ENGINEERING
ECONOMY
1. Develop the Alternatives
2. Focus on the Differences
3. Use a Consistent Viewpoint
4. Use a Common Unit of Measure
5. Consider All Relevant Criteria
6. Make Uncertainty Explicit
7. Revisit Your Decisions
PRINCIPLES OF ENGINEERING
ECONOMY

1. DEVELOP THE ALTERNATIVES

 The final choice (decision) is among

alternatives.
 Alternatives need to be identified and then
defined for subsequent analysis.
PRINCIPLES OF ENGINEERING
ECONOMY

2. FOCUS ON THE DIFFERENCES

Only the differences in expected future outcomes among the
alternatives are relevant to their comparison and should be
considered in the decision.
PRINCIPLES OF ENGINEERING ECONOMY

3. USE A CONSISTENT VIEWPOINT

The prospective outcomes of the alternatives, economic and other, should be

consistently developed from a defined viewpoint (perspective).
PRINCIPLES OF ENGINEERING
ECONOMY

4. USE A COMMON UNIT OF MEASURE

Using a common unit of measurement to enumerate as many of the prospective

outcomes as possible will make easier the analysis and comparison of alternatives.
PRINCIPLES OF ENGINEERING
ECONOMY

5.CONSIDER ALL RELEVANT CRITERIA

 Selection of a preferred alternative (decision making) requires the use of a
criterion (or several criteria).
 The decision process should consider the outcomes enumerated in the monetary
unit and those expressed in some other unit of measurement or made explicit in a
descriptive manner.
PRINCIPLES OF ENGINEERING
ECONOMY

6. MAKE UNCERTAINTY EXPLICIT

Uncertainty is inherent in projecting (or estimating) the future outcomes of the

alternatives and should be recognized in their analysis and comparison.
 PRINCIPLES OF ENGINEERING
ECONOMY

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.
ENGINEERING ECONOMY AND THE DESIGN
PROCESS

 An engineering economy study is accomplished

using a structured procedure and mathematical
modeling techniques.
 The economic results are then used in a decision
situation that involves two or more alternatives
and normally includes other engineering
knowledge and input.
 Why is Engineering Economy Important to
Engineers?

• Engineers design and create

• Designing involves economic decisions
• Engineers must be able to incorporate economic analysis into
their creative efforts
• Often engineers must select and implement from multiple
alternatives
• Understanding and applying time value of money, economic
equivalence, and cost estimation are vital for engineers
• A proper economic analysis for selection and execution is a
fundamental task of engineering
• Engineering Economy involves
→ Formulating
→ Estimating, and
→ Evaluating

• expected economic outcomes of alternatives

designed to accomplish a defined purpose

• Easy-to-use math techniques simplify the

evaluation

• Estimates of economic outcomes can be

deterministic or stochastic in nature
 THE BIG PICTURE
Engineering economy is
at the heart of making
decisions.
ENGINEERING ECONOMIC ANALYSIS
PROCEDURE
1. Problem recognition, formulation, and evaluation.
2. Development of the feasible alternatives.
3. Development of cash flows for each alternative.
4. Selection of a criterion ( or criteria).
5. Analysis and comparison of alternatives.
6. Selection of the preferred alternative.
7. Performance monitoring and post-evaluation results.
ACCOUNTING AND ENGINEERING
ECONOMY STUDIES

Modern cost accounting may satisfy any or all of the following objectives:

1. Determine the cost of products or services

2. Provide a rational basis for pricing goods or services
3. Provide a means for controlling expenditures
4. Provide information on which operating decisions may be based and the results
evaluated
 THE BIG PICTURE
Engineering economy is at the heart of making
decisions.

These decisions involve the fundamental elements of cash

flows of money, time and interest rates.

The next section introduces the basic concepts and terminology necessary for an
engineer to combine these three essential elements in organized, mathematically
correct ways to solve problems that will lead to better decisions.
 An Engineering Economic Decision:
A local Manufacturing Firm produces crankshafts. They have been using a
lathe that was purchased twelve years ago. As the production engineer in
charge of producing the crankshafts, you expect demand to continue into the
foreseeable future. Over the past two years the lathe has broken frequently
and has now stopped operating altogether. You must now decide to repair
the lathe or purchase a new lathe or if a more efficient lathe will be available
in the future you may wait to buy the new lathe in a couple of years. The
economic decision is whether you should make the considerable investment in
a new lathe now or later. Complicating the decision is the fact that the
demand for crankshafts has begun to decline.
What do we need to know to make a decision?
We basically have two alternatives:
→ 1) Repair the existing lathe
→ 2) Purchase a new lathe now or later
For the existing lathe we need to know:
→ The cost of repairing the lathe.
→ Frequency or Probability of break down of the
lathe.
→ Time when the lathe becomes obsolete.
→ Estimate the future demand for the crankshafts.
→ Estimate the salvage value or cost to remove the
old lathe
For the new lathe we need to know:

→ The cost of the new lathe including installation.

→ The cost of educating the operator to use the new lathe.
→ How often will the lathe require repairs and how much will cost?
→ The estimated economic and service life of the new lathe.
→ The estimated salvage value of the new lathe.
→ Are there any additional operational costs to the new lathe over the old
lathe?
→ Will the operational costs increase as the new lathe ages?
→ If so how much will they increase over the years?
→ Will the new lathe produce more crankshafts to increase income?
→ What are the tax implications of purchasing the new lathe?
→ Will the new lathe enhance or lower employee morale?
→ What are the financing costs of purchasing the new lathe?
ECONOMIC DECISION MAKING PROCESS:
1) Collect relevant information regarding the project:

→ Initial Costs: Design, Manufacturing, Marketing, Testing,

Installation, Construction, Taxes, Down payments, etc.

→ Annual Costs: Operating, Maintenance, Finance Payments,

Insurance, Income Taxes, etc.

→ Periodic Costs: Overhauls, Improvements and Modifications.

→ Annual Receipts: Income generated and Savings due to

increased Productivity.

→ Salvage Value: Income generated by sale or cost to remove

obsolete equipment.

→ Financing Method and Interest Rate.

2) Recognize and Define Feasible Alternatives:

→ Consider all possible options including the “DO NOTHING” alternative.

→ The generated alternatives may not be economically viable.
→ Examine each alternative and remove any overlapping options.
→ If the productivity is the about the same for each alternative, focus only on
the costs.

3) Consider the future consequences of each alternative:

→ Look at environmental impacts, effects on employee productivity, marketing

potential, public relations, etc.

4) Determine whose viewpoint is to be selected when evaluating alternatives:

→ Private vs. Governmental viewpoint. Very important when the public sector
is involved.
5) The consequences of each alternative must be expressed in monetary units.

→ You must consider the “time value of money”. It is sometimes very difficult to
put a monetary value on a consequence.

6) When comparing alternatives, focus on the differences between the

alternatives:

→ The past is common to all alternatives: look towards the future when
comparing alternatives. There can be no consequences before the moment of
decision.

7) Develop several criteria to be used in evaluating the alternatives:

→ Primary criterion: Economic analysis of alternatives based on a Minimum
Attractive Rate of Return (MARR) value.
→ Secondary criterion: Look at “intangibles” and “side-effects”.
8) Evaluate each alternative, using a sensitivity analysis to
enhance the evaluation:

→ Evaluation methods include:

Present Worth (PW), Annual Worth (AW), Future Worth (FW),

Rate of Return (ROR), Capitalized Cost (CC), Benefit/Cost Ratio
(B/C) and Payback Period Analysis using a Minimum Attractive
Rate of Return (MARR).

9) Select the best alternative based on the economic analysis while

remembering the secondary criterion.