B313 – ENGINEERING ECONOMICS The numbers used in engineering economy are best

estimates of what is expected to occur.

INTRODUCTION
Four essential elements:
Engineering Economics & Role in Decision Making
1. Cash flows
Engineering economy involves formulating, estimating,
2. Times of occurrence of cash flows
and evaluating the expected economic outcomes of
3. Interest rates for time value of money
alternatives designed to accomplish a defined purpose.
4. Measure of economic worth for
Mathematical techniques simplify the economic
selecting an alternative
evaluation of alternatives.
What is cash flow?
Because the formulas and techniques used in
engineering economics are applicable to all types of → The amount of cash or cash-equivalent which the
money matters, they are equally useful in business and company receives or gives out by the way of
government, as well as for individuals. The study of payment(s) to creditors is known as cash flow.
economics teaches us a way of thinking and helps us Cash flow analysis is often used to analyze the
make decisions. liquidity position of the company.
The study of economics is an essential part of the study Performing an Engineering Economy Study
of society.
The steps in an engineering economy study are as follows:
Engineering economy is not a method or process for
1. Identify and understand the problem; identify
determining what the alternatives are.
the objective of the project.
Engineering economics begins only after the alternatives 2. Collect relevant, available data and define viable
have been identified. solution alternatives.
3. Make realistic cash flow estimates.
Engineers are the people who are familiar with all the
4. Identify an economic measure of worth criterion
technicalities of machinery and production therefore
for decision-making.
they are the best judges of:
5. Evaluate each alternative; consider
a) the useful lives of an asset, and noneconomic factors; use sensitivity analysis as
b) they also have the technical knowledge to needed.
calculate the number of units a proposed plant 6. Select the best alternative.
would produce when operational.

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.
• 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.

Examples:

I. 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
II. 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.
Which Car to Lease? PRINCIPLE 3: Marginal Revenue must exceed Marginal
Cost.
Saturn vs. Honda
⎯ E a c h decision alternative must be justified on
1. Recognize a decision problem
its own economic merits before being compared
→ Need a car
with other alternatives.
2. Define the goals or objectives
⎯ Marginal revenue means the additional revenue
→ Want mechanical security
made possible by increasing the activity by one
3. Collect all the relevant information
unit.
→ Gather technical as well as financial data
⎯ Marginal cost is how much money it costs your
4. Identify a set of feasible decision alternatives
company to produce one additional unit of your
→ Choose between Saturn and Honda
product or merchandise.
5. Select the decision criterion to use
For example, let’s say a company produces 5,000
→ Want minimum total cash outlay watches in 1 production run at $100 per piece.
6. Select the best The manufacturer will want to analyze the cost
→ Select Honda of another multiunit run to determine the
FUNDAMENTAL PRINCIPLES OF ENGINEERING marginal cost. The average cost of producing a
ECONOMICS watch in the first run is $100, but the marginal
cost is the additional cost to produce one more
PRINCIPLE 1: A nearby penny is worth a distant dollar unit.
⎯ A fundamental concept in engineering The business finds the marginal cost to produce
economics is that money has a time value one more watch is $90. Ifthe business has a lower
associated with it. The time value of money marginal cost, it can see higher profits. Ifthe
explains the change in the amount of money business charges $150 per watch, they will earn
over time for funds that are owned (invested) or a $50 profit per watch on the first production
owed (borrowed). This is the most important run, and they’d earn a $60 profit on the
concept in engineering economy. additional watch.
Marginal cost =change in cost / change in
⎯ If you receive $100 now, you can invest it and
quantity
have more money available six months from
The total cost of the second batch of 5,000
now.
watches is $450,000. Dividing the change in cost
⎯ This concept will be the basic foundation for all
by the change in quantity produces a marginal
engineering project evaluation
cost of $90 per additional unit of output.

PRINCIPLE4: 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.
⎯ Expected returns from bonds and stocks are
normally higher than the expected return from a
savings account.

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

Types of Strategic Engineering Economic Decisions

1. Equipment and process selection

✓ Selecting the best course of action from various
alternatives to get best returns
2. Equipment replacement
✓ Decision involves considering the expenditure
necessary to replace worn-out or obsolete
equipment
 3. New product and product expansion 1 leap year = 366 days
✓ To increase the revenue
✓ Two common types:
• Through existing production/distribution, COMPOUND INTEREST
• Through new product or expand to a new
geographical area Compound Interest – the interest for an interest period
4. Cost reduction is calculate on the principal plus total amount of interest
✓ Attempts to lower operating costs of the accumulated in the previous period. means top of
company Compound interest “the interest on interest.”
✓ Whether a company should buy equipment to RATES OF INTEREST
perform an operation currently done manually
or spend money now in order to save more Rate of Interest – it is the cost of borrowing money.
money later Nominal Rate of Interest – it specifies the rate of
5. Service or quality improvement interest and a number of interest periods in one year.
✓ To improve of the quality of products/ services
Effective Rate of Interest – it is the actual or exact rate
Professional Ethics and Economic Decisions of interest on the principal during one year.
i. Universal or common morals EQUATION OF VALUE
These are fundamental moral beliefs held by
virtually all people. Most people agree that to An equation of value is obtained by setting the sum of
steal, murder, lie, or physically harm someone is the values on a certain comparison or local date (or
wrong. focal date) of one set of obligations equal to the sum of
ii. Individual or personal morals the values on the same date of another set of
These are the moral beliefs that a person has and obligations.
maintains over time. These usually parallel the
DISCRETE PAYMENTS
common morals in that stealing, lying,
murdering, etc. are immoral acts The solution of discrete payments or number of
iii. Professional or engineering ethics transactions occurring at different periods is taking each
Professionals in a specific c discipline are guided transaction to the base year and equating each value.
in their decision making and performance of
Steps in Solving Discrete Payments:
work activities by a formal standard or code. The
code states the commonly accepted standards of 1. Draw the cash flow diagram.
honesty and integrity that each individual is 2. Select any convenient focal date.
expected to demonstrate in her or his practice. 3. Years on the left of the focal date have a
There are codes of ethics for medical doctors, positive sign while years on the right of the focal
attorneys, and, of course, engineers. date have a negative sign.
4. Use the principle: Cash Inflow = Cash Outflow
When an engineering economy study is performed, it is
important for the engineer performing the study to BANKER’S DISCOUNT
consider all ethically related matters to ensure that the
cost and revenue estimate reflect what is likely to happen Certain banks lend money in such a way that they
once the project or system is operating. deduct the interest on the money. They actually don’t
lend you money you asked for. This type of computing
MODULE 2 money is called banker’s discount. The money received
by the borrower after the discount has been deducted is
INTEREST & MONEY – TIME RELATIONSHIPS
called proceeds.
Simple Interest
INFLATION
Interest – is the return on capital or cost of using capital.
It is the increase in the prices for goods and services
It is the amount of money paid for the use of borrowed
from one year to another, thus decreasing the
capital or the income produced by money, which has
purchasing power of money.
been loaned.

Simple Interest – is calculated using the principal only,

ignoring any interest that had been accrued in preceding
period.

Types of Simple Interest

1. Ordinary Simple Interest – simple interest in

which it is assumed that each month contains 30
days and consequently each year has 360 days.
1 month = 30 days
1 year = 360 days (banker’s year)
2. Exact Simple Interest – simple interest in which
the exact number of days per month is used.
1 ordinary year = 365 days