Engineering Economics| ME 2001 | 3 Credits | 3 0 0 3

Engineering Economics
Course Outcomes
Understand various economic decision-making concepts applicable to engineering.
Estimate the present, annual and future worth, rate of return for various types of cash flows.
Evaluate uncertainty and risk analysis in future events.
Analyses for replacement analysis and break-even analysis.
Calculate depreciation and expenses.
Course Instructor
Dr. Vijay S. Kumawat
Assistant Professor, Department of Mechanical Engineering
Engineered Biomedical Materials Research and Innovation Centre (EnBioMatRIC)
SAMM, Manipal University Jaipur
Ph: +91-9001225135

Email: vijayshankar.Kumawat@jaipur.manipal.edu
: https://scholar.google.com/citations?user=3g9gCscAAAAJ&hl=en
: https://www.linkedin.com/in/vijay-shankar-kumawat-24a02a195
Website: https://www.jaipur.manipal.edu
https://www.enbionac.in/

1
 Syllabus
Thesis Outline
Unit-1: Economic Decision Making Unit-3: Uncertainty in Future Events
Overview, problems, role, decision making Estimates and their use in economic analysis
process. Economic decision tree
Indian industries: introduction, pattern of Risk, Risk vs Return.
industrialization, large scale industries Unit-4: Depreciation
Labour problems and policies, unorganized Depreciation and expenses
sector. Depreciation calculation fundamentals
Unit-2: Engineering Cost & Estimation Depreciation and capital allowance methods
Fixed and Variable Costs Common elements of tax regulations for
Marginal & Average Costs depreciation and capital allowances.
Sunk Costs, Opportunity Costs Unit 5: Replacement and forecasting Analysis
Recurring & Nonrecurring Costs Replacement Analysis
Incremental Costs, Cash Costs Vs Book Costs, Inflation and Price Change
Life- Cycle Costs Forecasting
Types of Estimate, Estimating Models Break Even Analysis
Improvement & Learning Curve, Benefits
Economic Order Quantity

2
 Study Material Resources
Thesis Outline
Text Books Reference Books
T1. R. Panneerselvam, Engineering R1. E.L. Grant, W.G. Ireson and R.S.
Economics, Prentice Hall of India. Leavenworth, Principles of Engineering
T2. J.L. Riggs, D.D. Bedworth and S.U. Economic Analysis, John Wiley.
Randhawa, Engineering Economics, R2. G,J. Tuesen, W.J. Fabrycky and H.G.
McGraw Hill Education. Tuesen, Engineering Economy, Prentice
T3. P.L. Mehta, Managerial Economics, Hall of India.
Sultan Chand & Sons. R3. L. Blank and A. Tarquin, Engineering
Economy, McGraw Hill Education.

3
 Assessment Rubrics
Thesis Outline
Maximum
Criteria Description
Marks
Mid Term Examination 30
Internal Assessment Quizzes and Assignments,
30
(Summative) Activity feedbacks (CWS)

End Term Exam

End Term Examination 40
(Summative)
Total 100
A student must have maintained a 75%
Attendance attendance rate in order to eligible for the End
(Formative) Term Examination. The 25 % allowance covers
all leaves, not just medical ones.
4
 Lecture Plan
Thesis Outline
L/T No. Topics
L1 Introduction to course, Read Course Handout and provide to the students
L2 Economic Decision Making – Overview, Definition
L3 Economic Decision Making – Problem and Role
L4 Economic Decision Making – Indian Industries Introduction
L5 Pattern of Industrialization, Large Scale Industries.
L6 Labor Problems and Policies
L7 Introduction to Unrecognized sector
L8 Engineering Cost & Estimation - Introduction
L9 Fixed, Variable, Marginal and Average Cost
L10 Sunk Cost, Opportunity Cost
L11 Recurring & Non Recurring Cost
L12 Incremental Cost, Cash Cost Vs Book Costs
L13 Life Cycle Costs
L14 Types of Estimates - Introduction
L15 Estimating Model Improvement & Learning Curves
5
 Lecture Plan
Thesis Outline
L16 Estimating Model Improvement & Learning Curves
L17 Benefits, Economic Order Quantity
L18 Uncertainty in future events – Introduction
L19 Estimates and their uses in economic analysis
L20 Economic Decision Tree
L21 Risk – Definition and Scope
L22 Risk Vs Return
L23 Depreciation – Introduction
L24 Depreciation and Expenses
L25 Depreciation Calculation Fundamentals
L26 Depreciation and Capital Allowance Methods
L27 Common elements of tax regulation and Capital Allowance
L28 Replacement analysis - Meaning and Reasons
L29 Evaluation of replacement alternatives involving sunk costs - Problems.
L30 Replacement analysis for unequal lives - Problems.
L31 & Economic life of an asset - Meaning & Replacement based on economic life -
L32 Problems.

6
 Lecture 1

Introduction to Engineering Economics

Nature, Scope, Basic problems of an economy

Micro Economics and Macro Economics.

7
 Crux of Economics

Imagine a small, remote village situated in a hot and arid desert region. This village relies on a single well as its
primary source of water. Over time, the population has grown, and the demand for water has increased
significantly. However, the water supply from the well remains limited and is becoming increasingly insufficient to
meet the needs of the villagers.
Want: The villagers "want" an abundant and continuous water supply to sustain their livelihoods comfortably.
They desire water for various purposes, such as drinking, cooking, agriculture, and sanitation. With an adequate
water supply, they envision improved living standards, healthier communities, and better prospects for economic
growth. They dream of a well-maintained water system that does not run dry during droughts and allows them to
engage in more agricultural activities and other income-generating ventures.
Scarcity: The village faces the harsh reality of "scarcity." The available water supply from the single well is limited
and barely enough to meet the basic needs of the growing population. During the dry seasons, water becomes
even scarcer, leading to long queues at the well, competition for limited resources, and conflicts among villagers.
Insufficient water hinders agricultural productivity, causing crop failures and financial distress for farmers.
Moreover, the lack of clean water leads to health issues, as villagers are forced to use contaminated water sources.

Engineering Economics-ME2001
 Lecture 1
Lecture 1
Lecture 1
Challenges:
1. Balancing Demand and Supply
2. Infrastructure and Technology: The village lacks proper infrastructure and technology to store, distribute, and
manage water efficiently.
3. Financial constraints
4. Environmental factors: The desert region's climate makes it challenging to find alternative water sources, and
climate change might further exacerbate water scarcity in the future.
Solutions:
1. Water Conservation
2. Community awareness
3. Diversifying water sources
4. Government and NGO support
5. Some Methodical Distribution

Engineering Economics-ME2001
Economics - Definitions Lecture 1
Wants

Human UNLIMITED SCARE CHOICE

needs. WANTS RESOURCES (allocation of
(for goods and (limited resources
services) possibilities of among goods
producing for and services to
Vs goods and achieve
services) maximum
satisfaction
When wants exceed the
Scarcity

Fig. 1: The economic problem

resources available to
satisfy them, there is
Economics is the study of choices
scarcity.
people make to cope with scarcity

Scarcity : Extensive Economic Problem Economics deals with the allocation of

scarce resources among alternative uses
Faced with scarcity, people must make choices.
to satisfy human wants.
10
Basic Economics Problems Lecture 1

What communities are being produced

and in what quantities ?
(What to produce ?)
Resource
Allocation

By what methods are these

commodities produced?
(How to produce ?)
Labor Intensive; Capital Intensive

How is society’s output of goods and

services divided among its members?
(For whom to produce ?)
Distribution
of Income Production Possibilities Curve of a Country

11
Basic Economics Problems Lecture 1

Change
Changein
intechnology
resources

Improvement
Increase in in Degradation
Decrease inin
available
technology
resources available
technology
resources

12
Production Possibilities Curve of a Country
 Basic Economic Goals, Micro/Macro-economics Lecture 1

Economics is the science that deals with the Microeconomics

production and consumption of goods and Branch of economics that deals with
services and the distribution and rendering of the behavior of individual economic
these for human welfare. units—consumers, firms, workers,
and investors—as well as the
High level of employment
markets that these units comprise.
Economic Goals

Price stability
Equitable distribution of income
Growth Macroeconomics
Some of the above goals are interdependent, not
Branch of economics that deals with
always complementary and may be conflicting.
Eg. Any move to have a significant reduction in aggregate economic variables, such
unemployment will lead to an increase in as the growth rate of nation, gross
inflation. output, interest rates,
unemployment, and inflation.

13
 Engineering Economics Lecture 1

Engineering is an application of science.

Engineering

It is an art composed of the skill and simplicity in adopting knowledge to the

uses of the humanity.

Engineering is primarily a producer activity. Essentially a physical process

Physical Production or Economic

Environment Construction Environment
Engineering

Wants
Economics

Engineering
proposals satisfaction

Engineering Economics –
deals with decisions to be taken based on need/want recognition to its
satisfaction, through series of steps involving developing alternative solutions,
evaluating them & decision-making and its efficient execution. 14
Economic System: Working Lecture 1

An economic system is an entire set of arrangements and institutions meant for

meeting the two fold objectives of a society:

– increasing the availability of resources

– ensuring best economic use
Types of Economic systems are based following:
per capita income,
prioritization of individuals to spend their resources, and
scarcity of both income and resources

Types of economy system

Capitalist Economy:
Socialist Economy
Mixed Economy
15
Capitalist Economy Lecture 1

Capitalist Economy: characterized by free markets and the absence of any

government intervention in the economy.

Merits: Demerits:
Self regulatory. Capitalism generates inequalities of income
Decides ‘what to produce’ and ‘how to and wealth.
produce’ in consonance with the forces of Wide differences in economic opportunities.
demand and supply. Distortion in the production pattern.
Ensure a high degree of operative efficiency Capitalism exploits its productive resources.
in the system. Production of merit goods is not profitable.
Provides flexibility to adapt to the changed Business units produce only those goods and
circumstances. services which are profitable.
Economic growth is faster Loss of human values and welfare.
Increases the wastage of natural resources as
a result of competition.

16
Socialist and Mixed Economy Lecture 1

Socialist economy discards the use of market mechanism and replaces it with some
form of regulatory authority, such as the planning commission.
It also abolishes the institutions of private property and inheritance.
Merits: Demerits:
Distributive justice Low Productivity
Social security Suffers from slow growth rate, Poor productivity
Coordinated development of labour and Low per capita income.
Elimination of social disputes. Cyclical fluctuations of national income and prices
Elimination of fluctuations of economy Not able to provide economic incentives and
disincentives for hard work.

Mixed economy:
– Avoid the ill-effects of both capitalism and socialism
– Strives to secure the benefits of both
Selection of detailed features of a mixed economy is made with reference to the working of market
mechanism, and its expected effects (both beneficial and harmful) on the society as a whole.
17
Thank you

18
Engineering Economics| ME 2001 | 3 Credits | 3 0 0 3

Lecture 2

Theory of demand and supply analysis

Course Instructor
Dr. Vijay S. Kumawat
Assistant Professor, Department of Mechanical Engineering
Engineered Biomedical Materials Research and Innovation Centre (EnBioMatRIC)
School of Automobile, Mechanical and Mechatronics Engineering (SAMME)
Manipal University Jaipur
Ph: +91-9001225135
Email: vijayshankar.Kumawat@jaipur.manipal.edu
: https://scholar.google.com/citations?user=3g9gCscAAAAJ&hl=en
: https://www.linkedin.com/in/vijay-shankar-kumawat-24a02a195
Website: https://www.jaipur.manipal.edu
https://www.enbionac.in/
1
Nature of Demand Lecture 2

The desire, ability, and

willingness to buy a
product or service

Desire? Ability? Willingness?

2
Nature of Demand Lecture 2
Desire There are three important points to remember
about the ‘Quantity Demanded’:
Desire is just a wish on the part of the consumer to
First, the Quantity demanded is the quantity
possess a commodity.
desired to be purchased. It is the desired
purchase. The quantity actually bought is
Want referred to as Actual purchase.

Secondly, quantity demanded is always

If the desire to take a commodity is backed by the considered as a flow measured over a period of
purchasing power and the consumer is also willing time.
to buy that commodity, it becomes want. If the quantity demanded of oranges is 10, it
must be per day or per week, etc.

Demand Thirdly, the quantity demanded will have an

Economic meaning only at a given price.
Demand is the wish of the consumer to get a definite
quantity of a commodity at a given price in the For example, the demand for oranges equal to
market backed by a sufficient purchasing power. 10 units per week, at a price of Rs. 100 per
dozen is a full and meaningful statement, as
used in micro-economic theory 3
Economic Analysis Lecture 2
Variables are not dated
Economic The Demand-Supply model of market behaviour is a

Static Model
Analysis static model.
In this model, Demand depends on own price, Supply
Static Dynamic depends on own price, with an equilibrium condition
model model that demand must equal supply, time does not enter into
the picture at all and the variables are all undated.

Variables are dated According to some economists, even if the variables

are dated the model does not become dynamic.
Dynamic Model

If the demand-supply model is

restructured as follows, then the According to this definition, variables must be dated
model would become dynamic and a time lag must exist in their relationships. With
according to this criterion: this criterion, a dynamic model would be:

4
Where, ‘t’ is the relevant time unit.
Determinants of Demand Lecture 2
The demand for a commodity depends on a number of factors. These are mentioned as follows:

1 Price of the commodity: Normally, higher the price of the commodity, the lower the
demand of the commodity. This is the Law of Demand.

Price Per # of CDs 30

CD Demanded
$1 300 25
$2 162
20
$3 94
$4 58 15
$5 37
$6 25 10
$10 18
5
$15 13
$20 10 0
0 100 200 300
5
Determinants of Demand by a Consumer Lecture 2

Law of demand.

P= Price QD= Quantity Demanded

P QD P
2

Price
P QD  P
1
Q Q
Quantity Demanded
D D
Determinants of Demand by a Consumer Lecture 2

Size of consumers income/ Buyer’s income:

2 When the increase in income leads to an increase in the Quantity demanded, the commodity
is called a ‘normal good’. If an increase in income leads to a fall in the quantity demanded, we
call that commodity an ‘inferior good’.

Income  Demand
Income  Demand
Events leading to Change in purchasing Power:
Minimum Wage/ Salary Revision
Economic Recession
The Great Depression

7
Determinants of Demand by a Consumer Lecture 2

Prices of related commodities: (Competitor/ Supplementer)

3 A consumer’s demand for a commodity may also be influenced by the prices of some
other commodities. Some are Complementary goods, which are consumed along with the
commodity, while others may be used in place of this commodity. This category is called
Substitutes.

8
Determinants of Demand by a Consumer Lecture 2

Taste of the consumers:

4 If a consumer has developed a taste for a particular commodity, he/she will demand more of
that commodity. Similarly, if a consumer has changed his taste against a particular
commodity, less of it will be demanded at any particular price. This development of tastes
may be related to seasons of the year as well.

9
Demand Function Lecture 2

Demand function refers to the rule/relation, that shows how the quantity demanded
depends upon above factors.

A demand function can be shown as:

where,
Dx is quantity demanded of X commodity
Px is the price of X commodity If all the factors influencing the demand for
a commodity X vary simultaneously, the
Py is the price of substitute commodity
picture would be highly complicated.
Pz is price of a complement good
Therefore, normally we allow only one of
M stands for monetary income
the factors to change, assuming that all
T is the taste of the consumer other factors remain unchanged

10
Determinants of Market Demand Lecture 2

The factors determining the demand for a commodity in a market are the same as those which
determine the demand for the commodity on the part of a consumer.

Besides that two additional factors are also to be included. These two factors are:

Size of the population:

All other factors remaining
unchanged, the greater is the size of
the population, more of a commodity
ill b d d d
Income distribution:
People in different income groups show marked
differences in their preferences.
So if larger share out of national income goes to the rich,
demand for the Luxury goods may rise,
while a rise in income share of the poor will increase
demand for the Wage goods.

11
12
Engineering Economics Lecture 2
Engineering economics deals with the methods that enable one to take economic decisions
for Minimizing Costs and/or Maximizing Profits/benefits for business organizations.
Key points
Produce Example: Technical efficiency of a
Physical Goods/Services diesel engine is less than 100%.
environment depending on This is mainly due to frictional loss
and incomplete combustion of fuel
Engineering

physical stuffs & law

Technical efficiency can never be
more than 100%.

Worth: Annual revenue generated by

Economic Assessing the worth way of operating the business.
environment of these products in Cost: Total annual expenses incurred in
economic terms carrying out the business.
For the survival and growth of any
business, the economic efficiency
should be more than 100%.
13
Thank you

14
Engineering Economics| ME 2001 | 3 Credits | 3 0 0 3

Lecture 3

Theory of demand and supply analysis

Course Instructor
Dr. Rahul Goyal
Professor, Department of Mechanical Engineering
School of Automobile, Mechanical and Mechatronics Engineering (SAMME)
Manipal University Jaipur

1
Law of Demand Lecture 2
The inverse relationship between the quantity of a commodity and its price, given all
other factors that influence the demand is called ‘law of demand’.

It gives us a demand curve that slopes downwards to the right. We can explain this idea
with help of a demand schedule
Demand curve

The demand curve graphically shows

the relationship between the quantity
of a good that consumers are willing to
buy and the price of the good.
pp p y
Kg. Apples
(i 100
R ) (i K 15 k)

200 12
300 8
400 3

2
Why does a Demand Curve Slope Downwards? Lecture 2
Substitution Effect: Substitution effect results Income Effect: This is the effect of a change
from a change in the relative price of a in total purchasing power of the money
commodity. income of the consumer.
Suppose a Pepsi Can and a Coke Can are As price of mango falls the purchasing
priced at Rs. 90 and Rs. 70 each. If the price of power of the given money income rises, or
Coke is raised to Rs. 75, and the price of Pepsi his real income rises. Thus, he can buy more
is not changed, Pepsi will become relatively of the mangoes with the same money
cheaper to Coke, i.e. although the absolute income.
price of Pepsi has not changed, the relative His demand for other commodities may also
price of Pepsi has gone down. rise. This is called the ‘Income effect’.
The change in the relative price of commodity
causes Substitution effect.
It is important to note that substitution effect and
Price Effect: Price Effect is the sum total of the income effect operate simultaneously along with
Substitution effect and Income effect, i.e. the change in the price of the given commodity.
PE = SE + IE
Where PE = Price Effect. ‘Substitution effect’, and ‘income effect’ taken
SE = Substitution Effect together give ‘Price Effect.’
IE = Income Effect
3
CHANGE IN QUANTITY DEMANDED Vs. CHANGE IN DEMAND
When the demand for a commodity changes Change in Demand
due to the change in its price, it is called The shift of the demand curve to the right shows
‘Change in quantity demanded’. ‘increase in demand’ and a movement of the
On the other hand, when the change in demand curve to the left of the initial demand
demand is due to the factors other than its curve is a ‘decrease in demand’.
price cause, it is called ‘Change in Demand’.
Expansion and Contraction in Demand (Change in
quantity demanded)

4
Concept of Supply Lecture 2

Supply refers to the quantity of a commodity that producers are willing to sell
at different prices per unit of time.

A higher price would mean more profits. The producer will supply more at a higher price.
Similarly, a producer will supply smaller quantity at a lower price.
This is a direct relationship between the price and the quantity supplied of a commodity and is
called the ‘Law of Supply’.

A producer aims to ‘Maximize Profits’

Profit is estimated through difference between total revenue and total cost incurred.
Total revenue is the Price of the product multiplied by its quantity sold.
Total cost is the cost of production.
Profit = TR – TC
TR = Total Revenue (q.P)
TC = Total Cost (q.AC)
where AC is average cost.

5
Determinants of Supply Lecture 2

1. Price of the commodity supplied

The price is most immediate determinant of supply.
A firm will make quick check whether the costs will be recovered by the price.
As the price goes up, a firm/person will be willing to sell larger quantity.

2. The prices of factors of production or cost of production

These affect the cost of production and possible profits of the firm. A rise in the
prices of factors of production (raw material, labour, machinery) discourages
the production and supply of the commodity.
3. Prices of other goods
As the prices of other commodities rise, they become more attractive to
produce for a profit maximising firm. Hence supply of commodity whose price
is unchanged will decline.

6
Determinants of Supply Lecture 2
4. The state of technology
The improvement in the means and the methods of production can lead to
lower costs of production and helps increasing output.
5. Goals of the producer
The objective with which the producer undertakes production also influences
his production and supply decisions.

Price (in Rs) per Quantity Supplied (in thousand per

Pen Month
2 25
3 40
4 50
5 60
6 70

7
Concept of Supply Lecture 2
Supply refers to the quantity of a commodity that producers are willing to sell
at different prices per unit of time.

The supply of a commodity is a function of its price, the price of all other
commodities, the prices of factors of production, technology, the objectives of
producers and other factors remaining unchanged. So:

Where: Qs stands for the quantity of the commodity supplied;

P1 is the price of that commodity,
P2, P3...Pn are the prices of other commodities;
F1 …… Fn are the prices of all factors of production;
T is the state of technology;
G is the goal of the producer.
8
 Engineering Economics| ME 2001 | 3 Credits | 3 0 0 3

Lecture 4
Theory of demand and supply analysis
(Numerical Problems)

Course Instructor
Dr. Rahul Goyal
Professor, Department of Mechanical Engineering

Engineering Economics-ME2001 1
 Problem No: 1

Q1 The demand and supply equations of a commodity are given as

Xd =½ (5-P) and Xs =2P -3.

i. Find the equilibrium price and quantity?

ii. Find the new price & quantity, if a tax of Rs. 6/5 per unit is imposed on the commodity?
iii. Find the total tax revenue generated by the government?
iv. Find the price actually realized by the seller?

Engineering Economics-ME2001 2
 Solution

Given: Find the equilibrium quantity

Demand equation: Xd = ½ (5 - P) Demand equation: Xd = ½ (5 - P)
Supply equation: Xs = 2P - 3 Xd = ½ (5 – (11/5))
Xd = ½ (14/5)
i. Find the equilibrium price and quantity: Xd = 7/5 = Equilibrium quantity
At equilibrium, Xd = Xs
Therefore,
½ (5 - P) = 2P - 3
Now solve for P:
5 - P = 4P - 6
5 + 6 = 4P + P
11 = 5P
P = 11 / 5 = Equilibrium price (P)

Engineering Economics-ME2001 3
 Solution

i. Find the new price and quantity if a tax of Rs. Find the equilibrium quantity
6/5 per unit is imposed: Xs' = 2P' – (27/5) (P'= 79/25)
When a tax is imposed on the commodity, the Xs' = 2*(79/25) – (27/5)
New Supply equation becomes Xs' = (158/25) – (27/5)
Xs' = 2{P‘- T} - 3 (where, T is the tax Xs' = (23/25) = New equilibrium quantity
It can be obtained from either S or D Eqn
per unit)
Xs' = 2{P‘- (6/5)} – 3
Xs' = 2P' – (12/5) – 3
Xs' = 2P' – (27/5) (New Supply
Equation)
At equilibrium, Xd = Xs’
½ (5 - P') = 2P'– (27/5)
5 - P' = 4P'- (54/5)
3P'= 5 + (54/5)
P'= 79/25 = New equilibrium price

Engineering Economics-ME2001 4
 Solution

i. Find the total tax revenue generated by the i. Find the price actually realised by the seller:
government: Price realized by seller = New equilibrium
Tax revenue = Tax per unit*Quantity sold with price - Tax per unit
tax Price realized by seller = 79/25 - 6/5
Tax revenue = (6/5) * Xs' Price realized by seller = 49/25
= (6/5) * (23/25)
Tax revenue = 138/125

Engineering Economics-ME2001 5
 Problem No: 2

Q2 Solve the following problem: The Demand Function is P =5 - 2X and the supply function is
P = ½(X + 5) respectively.

i. Find the equilibrium price and quantity?

ii. Find the new price and quantity if a subsidy of Rs. 5/2 per unit is granted on the
commodity?
iii. Find the total amount of subsidy granted by the government?

Engineering Economics-ME2001 6
 Solution

Given: i. Find the new price and quantity if a subsidy of

Demand equation: P = 5 - 2X Rs. 5/2 per unit is granted
Supply equation: P = ½(X + 5) When a subsidy is granted on the commodity,
i. Find the Equilibrium quantity: the new demand equation becomes:
At equilibrium, f(P) = g(P) {P’ - S} = 5 – 2X’ (where S is the subsidy per unit)
5 - 2X = ½(X + 5) {P’ - (5/2)} = 5 – 2X’ S=5/2
0 - 4X = X + 5 (2P’- 5)/2 = 5 – 2X’
5X = 5 (2P’- 5) = 10 – 4X’
X = 1 = Equilibrium quantity P’ = (15 – 4X’)/2
The Equilibrium price At equilibrium, f(P) = g(P)
Demand equation: P = 5 - 2X (15 – 4X’)/2 = ½(X’ + 5)
P = 5 – 2(1) 15 – 4X’ = X’ + 5
Equilibrium price = P = 3 5X’ = 10
X’ = 2 = Equilibrium quantity

Engineering Economics-ME2001 7
 Solution

Substitute the new equilibrium quantity back i. Find the total amount of subsidy granted by the
into either the demand or supply equation to government?
find the new equilibrium price (P'). Total subsidy = New quantity demanded *
Let's use the supply equation: subsidy per unit
P' = 5 – 2X = 2 * (5/2)
P' = 5 – 2(2) Total subsidy = 5
P' = 1

So, with the subsidy granted, the new price is

approximately 1 and the new quantity is 2.

Engineering Economics-ME2001 8
 Problem No: 3

i. Suppose the value of demand and supply curves of a Commodity-X is given by the
following two equations simultaneously:
Qd = 200 –10P; Qs = 50 + 15P
Find the equilibrium price and equilibrium quantity of commodity X.

ii. Suppose that the price of a factor inputs used in producing the commodity has
changed, resulting in the new supply curve given by the equation
Qs’ = 100 + 15P’
Analyze the new equilibrium price and new equilibrium quantity as against the original
equilibrium price and equilibrium quantity.

Engineering Economics-ME2001 9
 Solution

Given: i. If the price of factor of production has

Demand equation: Qd = 200- 10P changed, then under the new conditions
Supply equation: Qs = 50 +15P Given;
New supply chain equation;
i. Find the equilibrium price and quantity: Qd = Qs’
Qd = Qs 200- 10P’ = 100 + 15P’
200- 10P = 50 +15P 25P’ = 100
150 = 25P Equilibrium Price P’ = 4
P = 6 = Equilibrium price
Qs = 200 – (10)(4) = 160 units
Find the equilibrium quantity
Qd = 200- 10P Thus, as the equilibrium price is decreasing
Qd = 200 – (10) (6) = 140 units the equilibrium quantity is increased.

Engineering Economics-ME2001 1
 Problem No: 4

The demand function = 3Q +4P =24 and the supply function is P=¼Q+3 respectively.
i. Find the equilibrium price and quantity?
ii. Find the new price and quantity if a tax of Rs. 1/3 per unit is imposed on the
commodity?
iii. Find the total tax revenue generated by the government?
iv. Find the price actually realised by the seller?

Engineering Economics-ME2001 11
 Solution

Given: i. Find the new price and quantity if a tax of Rs.

Demand equation: Dx = 3Q + 4P = 24 1/3 per unit is imposed:
4P = 24 – 3Q When a tax is imposed on the commodity, the
P = 6 – (3/4)Q………..(1) new supply equation becomes
Supply equation: P = ¼Q+3 …………..(2) {P’ – T} = ¼Q+3 (where, T is the tax per unit)
i. Find the equilibrium price and quantity: P’ – 1/3 = ¼Q+3
At equilibrium, Dx = Sx P’ = ¼Q + 10/3………..(3) (New Supply Equation)
6 – (3/4)Q = (1/4)Q +3 At equilibrium,
Q= 3 = quantity demanded ¼Q + 10/3 = 6 – (3/4)Q (Eq3 = Eq1)
P = (1/4)Q +3 Q'= 6 – (10/3) = 8/3
P = ¼ (3) +3
P = ¾ +3 P’ = ¼Q + 10/3
P = 15 / 4 = Equilibrium price (P) P’ = ¼ (8/3) + 10/3 = 8/12 + 10/3
P’ = 4

0
Engineering Economics-ME2001 1
 Solution

i. Find the total tax revenue generated by the i. Find the price actually realised by the seller:
government: Price realized by seller = New equilibrium
Tax revenue = Tax per unit*Quantity sold with price - Tax per unit
tax Price realized by seller = 4- 1/3
Tax revenue = (1/3) * Xs' Price realized by seller = 11/3
= (1/3) * (8/3)
Tax revenue = 8/9

Engineering Economics-ME2001 1
Engineering Economics| ME 2001 | 3 Credits | 3 0 0 3

Lecture 5

Cost Analysis

Course Instructor
Dr. Rahul Goyal
Professor, Department of Mechanical Engineering
School of Automobile, Mechanical and Mechatronics Engineering (SAMME)
Manipal University Jaipur

1
ELEMENTS OF COSTS Lecture 5
Cost can be broadly classified into Variable cost and Overhead cost (Fixed). Variable cost varies
with the volume of production while overhead cost is fixed, irrespective of the production
volume.
Variable Cost can be further classified into direct material cost, direct labour cost, and direct
expenses.
Overhead Cost can be classified into factory overhead, administration overhead, selling
overhead, and distribution overhead.

The Selling Price SP of a product is derived as shown below:

(a) Direct material costs + Direct labour costs + Direct expenses = Prime cost
(b) Prime cost + Factory overhead = Factory cost
(c) Factory cost + Office and administrative overhead = Costs of production
(d) Cost of production + Opening finished stock – Closing finished stock = Cost of Goods sold
(e) Cost of goods sold + Selling and distribution overhead = Cost of sales
(f) Cost of sales + Profit = Sales (Sales Revenue)
(g) Sales/Quantity sold = Selling Price per unit
2
OTHER COSTS/REVENUES Lecture 4
Marginal Cost
Marginal cost of a product is the cost of producing an additional unit of that product. Let the cost of
producing 20 units of a product be Rs. 10,000, and the cost of producing 21 units of the same
product be Rs. 10,045. Then the marginal cost of producing the 21st unit is Rs. 45.
Marginal Revenue
Marginal revenue of a product is the incremental revenue of selling an additional unit of that
product. Let, the revenue of selling 20 units of a product be Rs. 15,000 and the revenue of selling 21
units of the same product be Rs. 15,085. Then, the marginal revenue of selling the 21st unit is Rs.
85.
Sunk Cost
This is known as the past cost of an equipment/asset. Let us assume that an equipment has been
purchased for Rs. 1,00,000 about three years back. If it is considered for replacement, then its
present value is not Rs. 1,00,000. Instead, its present market value should be taken as the present
value of the equipment for further analysis. So, the purchase value of the equipment in the past is
known as its sunk cost. The sunk cost should not be considered for any analysis done from now-
onwards.
3
Opportunity Cost Lecture 4

In practice, if an alternative (X) is selected from a set of competing alternatives (X,Y), then the
corresponding investment in the selected alternative is not available for any other purpose. If
the same money is invested in some other alternative (Y), it may fetch some return. Since the
money is invested in the selected alternative (X), one has to forego the return from the other
alternative (Y). The amount that is foregone by not investing in the other alternative (Y) is
known as the opportunity cost of the selected alternative (X).
So the Opportunity Cost of an alternative is the return that will be foregone by not investing
the same money in another alternative.

Invested in a fixed deposit, a bank will pay a return of 9%. Then, the corresponding total return
per year for the investment in the bank is Rs. 9,000. This return is greater than the return from
shares. The foregone excess return of Rs. 1,500 by way of not investing in the bank is the
opportunity cost of investing in shares.

4
BREAK-EVEN Lecture 5
ANALYSIS
Break Even Point:
This point is also called the no-loss or no-gain
situation.
For any production quantity which is less than the
break-even quantity, the total cost is more than
the total revenue. Hence, the firm will be making
Loss.

For any production quantity which is more than

the break-even quantity, the total revenue will be
more than the total cost. Hence, the firm will be
making Profit.

5
If, s = selling price per unit
v = variable cost per unit
FC = fixed cost per period
Q = volume of production
The total Sales Revenue (S) of the firm is given by the following formula: (Collections)
S=s Q
The total cost of the firm for a given production volume is given as (Kharcha)
TC = Fixed cost + Total variable cost = FC + v Q
Profit = Sales revenue – (Fixed cost + Variable cost)
= s Q – (FC + v Q)
Break-even quantity = Fixed cost/Selling price per unit - Variable cost/unit
=FC/s-v (in units) [By putting profit=0 in above eqn]
Break-even sales
= {Fixed cost/Selling price per unit - Variable cost/unit }* Selling price/unit
= {FC/s-v }*s (Rs)
Contribution = Sales – Variable costs
Contribution/unit = Selling price/unit – Variable cost/unit
Margin of Safety [M.S.] = Actual sales – Break-even sales
= {Profit/Contribution}*sales
M.S. as a per cent of sales = (M.S./Sales)*100
6
 Problem No: 1
Alpha Associates has the following details:
i. Fixed cost = Rs. 20,00,000
ii. Variable cost per unit = Rs. 100
iii. Selling price per unit = Rs. 200
Find
(a) The break-even sales quantity,
(b) The break-even sales
(c) If the actual production quantity is 60,000, find
(i) contribution; and
(ii) margin of safety by all methods.

7
Solution (ii) Margin of safety
Fixed cost (FC) = Rs. 20,00,000 METHOD I
Variable cost per unit (v) = Rs. 100 M.S. = Actual Sales – Break-even sales
Selling price per unit (s) = Rs. 200 = 60,000 *200 – 40,00,000
(a) Break-even quantity = FC/(s-v) = 1,20,00,000 – 40,00,000 = Rs. 80,00,000
= 20,00,000/100 = 20,000 units METHOD II
(b) Break-even sales = [FC/s-v] *s (Rs.) M.S. = Profit/Contribution * Sales
= 20 00 000/100 * 200 Profit = Sales – (FC + v Q)
= Rs. 40,00,000 = 60,000 *200 – (20,00,000 + 100 * 60,000)
(c) (i) Contribution = Sales – Variable cost = 1,20,00,000 – 80,00,000 = Rs. 40,00,000
= s *Q – v *Q M.S. =40,00,000/60,00,000 *1,20,00,000
= 200 *60,000 – 100 *60,000 = Rs. 80,00,000
= 1,20,00,000 – 60,00,000 M.S. as a per cent of sales = (M.S./Sales)*100
= Rs. 60,00,000 = 80,00,000/ 1,20,00,000 *100
= 67%

8
 PROFIT/VOLUME RATIO (P/V RATIO)

P/V ratio is a valid ratio which is useful for further analysis.

P/V ratio = Contribution/Sales
= Sales - Variable costs/ Sales

The relationship between BEP and P/V ratio is as follows:

BEP = Fixed cost/(P/V ratio)

Following formula helps us find the M.S. using the P/V ratio:
M.S. = Profit / (P/V ratio)

9
 Problem No: 2
Consider the following data of a company for the year 1997:
(i) Sales = Rs. 1,20,000
(ii) Fixed cost = Rs. 25,000
(iii) Variable cost = Rs. 45,000
Estimate the following:
(a) Contribution
(b) Profit
(c) BEP
(d) M.S.

10
Solution
Given: BEP = Fixed cost/ (P/V ratio)
(i) Sales = Rs. 1,20,000 = 25000/62.50* 100
(ii) Fixed cost = Rs. 25,000 = Rs. 40,000
(iii) Variable cost = Rs. 45,000
(a) Contribution = Sales – Variable costs M.S. = Profit/ P/V ratio
= Rs. 1,20,000 – Rs. 45,000 = 50 000/62 50 * 100
= Rs. 75,000 = Rs. 80,000
(b) Profit = Contribution – Fixed cost
= Rs. 75,000 – Rs. 25,000
= Rs. 50,000
(c) BEP
P/V ratio = Contribution / Sales
= 75,000/1,20,000 = 62.50%

11
 Problem No: 3
Consider the following data of a company for the year 1998:
(i) Sales = Rs. 80,000
(ii) Fixed cost = Rs. 15,000
(iii) Variable cost = 35,000
Find the following:
(a) Contribution
(b) Profit
(c) BEP
(d) M.S.

12
Solution
Given: BEP = Fixed cost/ (P/V ratio)
(i) Sales = Rs. 80,000 = 15000/56.25* 100
(ii) Fixed cost = Rs. 15,000 = Rs. 26,667
(iii) Variable cost = Rs. 35,000
(a) Contribution = Sales – Variable costs M.S. = Profit/(P/V ratio)
= Rs. 80,000 – Rs. 35,000 = 30 000/56.25 * 100
= Rs. 45,000 = Rs. 53,333.33
(b) Profit = Contribution – Fixed cost
= Rs. 45,000 – Rs. 15,000
= Rs. 30,000
(c) BEP
P/V ratio = Contribution / Sales
= 45,000/80,000
= 56.25%

13
 Engineering Economics

Estimation and Types

1
 Types of Estimates

Estimates are used to predict values that are not yet known.
There are various types of estimates, depending on the context and the level
of information available:

Rough Order of Magnitude (ROM) Estimate

Budget Estimate
Definitive Estimate
Parametric Estimate
Analogous Estimate
Bottom-Up Estimate

2
 Rough Order of Magnitude (ROM) Estimate

Rough Order of Magnitude (ROM) Estimate: Also known as a ballpark estimate, this is a
very broad-level estimate made very early in the project planning phase. It provides
a rough idea of the cost or effort involved, often with a wide range of uncertainty.
A Rough Order of Magnitude estimate is a Preliminary, Approximate assessment of the
cost, time, or resources required for a project, task, or endeavour. It is intended to
provide a general sense of the magnitude of these factors without going into detailed
analysis or calculations.
ROM estimates are typically used in the early stages of project planning when there is
limited information available and when more accurate estimates would be impractical or
premature.

3
Here are a few Key points about ROM estimates:

Approximate Nature: ROM estimates are deliberately imprecise and are often
given as a range (e.g., 1,00,000 to 2,00,000) rather than a specific value. This
acknowledges the uncertainty and variability inherent in early project stages.

Limited Detail: ROM estimates are based on very basic information & high-level
assumptions. They do not take into account the full scope, specific requirements,
or potential risks that could impact the project.

Quick Assessment: ROM estimates are used to quickly gauge the feasibility of a
project or to provide a ballpark figure for budgeting and decision-making without
investing a lot of time or effort into detailed planning.

Communication: ROM estimates are very basic & useful for communicating with
stakeholders, clients, or team members to give them an initial idea of what to
expect in terms of cost, time, or effort.

4
Key points about ROM estimates:

Basis for Further Planning: As the project progresses and more information becomes
available, ROM estimates can be refined and replaced with more accurate estimates
based on detailed analysis and specifications.
Subject to Change: Since ROM estimates are based on limited information and
assumptions, they are subject to change as more data becomes available or as the
project's scope and requirements evolve.

► It's important to note that while ROM estimates are valuable for Initial Planning and
decision-making, they should not be used as the sole basis for making Critical Project
Decisions. As the project advances and more details are gathered, it’s essential to
replace ROM estimates with more accurate estimates to ensure successful project
execution.

5
Example 1: Construction Project

You're tasked with estimating the cost of building a new office building. Based on your
experience and knowledge, you estimate that the cost per square foot for construction
will be around 150 to 200 INR. The building is expected to have a total area of 10,000
square feet. Calculate the rough order of magnitude cost estimate.
Solution:
Average cost per square foot = (150 + 200) / 2 = 175
Total cost estimate = Average cost per square foot * Total area = 175 * 10,000 =
1,750,000 INR
So, the ROM estimate for the construction of the office building is approximately
1,750,000 INR. Or [15 Lac to 20 Lac]

6
Example 2: Software Development Project

You're leading a software development project and need to estimate the duration of
the project. Based on your knowledge, similar projects have taken between 6 to 9
months to complete. Estimate the rough order of magnitude duration for your
project.
Solution:
Average duration = (6 + 9) / 2 = 7.5 months
So, the ROM estimate for the duration of the software development project is
approximately 7.5 months.

7
Example 3: Product Manufacturing
You're working on estimating the production cost for a new electronic gadget. Based on your
understanding of the components and manufacturing processes involved, you estimate that the
cost per unit will be between 50 and 70 INR. You anticipate producing around 5,000 units.
Calculate the rough order of magnitude cost estimate.
Solution:
Average cost per unit = (50 + 70) / 2 = 60 INR
Total cost estimate = Average cost per unit * Number of units = 60 * 5,000 = 3,00000
The ROM estimate for the production cost of the electronic gadgets is approximately 3,00000
INR. 3 Lac

Remember, the key to ROM estimates is to provide a broad, Preliminary idea of the
potential costs or timelines.
These estimates can be refined and made more accurate as more detailed information
becomes available during the planning and development phases.

8
 Types of Estimate -- Budget Estimate

Budget Estimate: This estimate is more refined than a ROM estimate but is
still based on limited information. It is used for preliminary budgeting
purposes.

A budget estimate is a Preliminary calculation/approximation of the costs

associated with a project, task, or plan. It provides an early assessment of the
financial resources required to complete the project or achieve a certain goal.
Budget estimates are typically created before ‘detailed planning’ takes place and
serve as a starting point for decision-making and resource allocation. They are
useful in determining the feasibility of a project and setting initial funding limits.

9
Budget Estimate -- Construction Project:

Imagine a construction company planning to build a new office building. Before they start
developing detailed architectural plans, they need a rough idea of the potential costs
involved. They create a ‘Budget Estimate’ that includes factors such as land
acquisition, construction materials, labor costs, permits, and other expenses. This initial
estimate helps the company decide whether the project is financially viable and secure
funding from stakeholders.
A construction company is estimating the budget for a new building project. The
estimated costs are as follows:
Materials: 2,00000 INR
Labor: 3,00000 INR
Equipment: 1,00000 INR
Overhead (10% of total direct costs): 60,000 INR
► Total Estimated Budget = Materials + Labor + Equipment + Overhead
► Total Estimated Budget = 2,00000 + 3,00000 + 1,00000 + 60,000
Total Estimated Budget = 6,60,000 INR

10
Product Development Budget Estimate

Example- A Tech company is planning to develop a new software product. The estimated costs are as follows:
Research and Development: 1,50,000 INR
Testing and Quality Assurance: 80,000 INR
Marketing and Promotion: 50,000 INR
Miscellaneous Expenses: 20,000 INR
Solution : Total Estimated Budget = R&D + Testing + Marketing + Miscellaneous
= 1,50,000 + 80,000 + 50,000 + 20,000
Total Estimated Budget = 3,00,000 INR
These examples showcase different scenarios where budget estimates are calculated for various engineering and business projects.
Keep in mind that these figures are fictional and simplified for illustration purposes.
► Real-world budget estimates can be much more complex & involve additional factors like inflation, interest rates,
and project duration.

11
Types of Estimate -- DEFINITIVE ESTIMATE

Definitive Estimate: This is the most accurate estimate and is typically produced later in
the project lifecycle, when detailed information is available.
It involves a comprehensive breakdown of costs and resources.

A Definitive estimate is a type of cost estimate that is prepared with a high degree of
Accuracy and Detail. It is typically produced when the Project scope is well-defined,
Detailed plans and specifications are available, and there is a High level of certainty
about the project’s requirements and execution.

12
Definitive Estimate

Key characteristics of a Definitive Estimate include:

Detailed Scope: The project scope is clearly defined and documented, leaving little room for ambiguity or
uncertainty.
Comprehensive Plans and Specifications: Detailed Engineering plans, Drawings, and Specifications are
available, providing a clear understanding of the project's technical requirements.
Accurate Quantities: Quantities of materials, labour, and other resources needed for the project are
accurately determined based on the detailed plans and specifications.
Accurate Cost Breakdown: This estimate breaks down costs into various components, such as materials,
labour, equipment, overhead, and Contingencies, with each component being well-defined and duly
supported.
Reliable Data: The estimate is based on reliable data, including current market prices for materials and
labour, as well as historical cost data from similar projects.

13
 Contd..

Limited Assumptions: Assumptions made in the estimate are minimal and well-
documented. The estimate is largely driven by actual data and concrete information.
Low Level of Risk: The level of Uncertainty and Risk associated with the estimate is
minimal, due to the detailed nature of the plans and specifications.
High Accuracy: Definitive estimates are expected to have a high degree of accuracy,
typically within a narrow range (e.g., within 5% of the actual costs).
Approval and Funding: Definitive estimates are often used to secure ‘Project Funding’
and obtain necessary approvals from stakeholders due to their high reliability.
Final Stage: Definitive estimates are typically prepared during the final stages of
Project Planning, after the project Scope and requirements have been fully defined.

14
NOTES

► It's important to note that while a definitive estimate provides a high level of
accuracy, it also requires a significant amount of time, effort, and resources to
prepare.
eg DPR of Bullet Train Project (18 months)
► Additionally, it may not be suitable for projects with uncertain or evolving scopes,
as changes to the scope could significantly impact the accuracy of the estimate.

Next slides will explain the examples of Definitive Estimate..

15
Example 1: Enterprise Resource Planning (ERP) System Implementation

A software company is tasked with implementing a comprehensive ERP system for a large
manufacturing client. The project involves integrating various modules like finance, Inventory,
procurement, production, and human resources. The company follows a detailed estimation
process:
Scope Definition: The project team collaborates with the client's stakeholders to define the scope,
requirements, and functionalities of the ERP system. A detailed list of features and
modules is compiled.
Work Breakdown Structure (WBS): The project team creates a comprehensive WBS, breaking
down the project into smaller tasks and sub-tasks. Each module and feature is allocated a
specific task or set of tasks.
Resource Estimation: The company identifies the human resources, equipment, software
licenses, and infrastructure required for the project. This includes developers, QA
engineers, project managers, hardware, and software.

16
Contd..

Cost Estimation: Based on the resource requirements, the company estimates costs for
labour, equipment, licenses, and any other project-related expenses. Vendor quotes are
obtained for software licenses and hardware procurement.
Risk Analysis: Potential risks are identified, analyzed, and quantified. ‘Contingency Plans’ are
devised to mitigate these risks, and additional costs are factored into the estimate.
Scheduling: A Detailed Project Schedule is created, taking into account Task dependencies,
Resource availability, and milestones. The Gantt chart illustrates the project
timeline.
Quality Assurance: The QA process is outlined, detailing the types of testing (functional,
integration, performance) and the resources required for thorough testing.
Client Review: The comprehensive estimate is presented to the client for review and
approval. Any discrepancies or concerns are addressed in collaboration with the client.
Final Estimate: After incorporating client feedback, the company provides a definitive
estimate that includes Accurate costs, A detailed project schedule, and
A breakdown of resource allocations.

17
Gantt Chart

18
Example 2: Mobile App Development for E-Commerce Startup

A software company is hired to develop a mobile app for a startup e-commerce business. The app should support both iOS
and Android platforms and include features like product catalog, user authentication, shopping cart, and payment
integration.
Requirement Analysis: The project team works closely with the startup's stakeholders to gather and analyze requirements. Detailed
user stories and use cases are documented.
Platform Selection: The company evaluates technology stacks for both iOS and Android development, considering factors like language
(Swift/Kotlin), framework, and third-party libraries.
Feature Breakdown: Each feature of the app is broken down into tasks, such as UI design, backend development, API integration, and
testing.
Resource Allocation: The company allocates designers, developers, QA engineers, and project managers to the project. Hardware and
software requirements are identified.
Cost Calculation: Using hourly rates for each resource and considering the estimated time for each task, the company calculates the
overall cost of development.
Timeline Creation: The project timeline is created, highlighting key milestones such as UI design completion, backend development
completion, and testing phases.

19
 Contd..

Testing Strategy: The testing plan is outlined, detailing how different aspects of the app will be tested,
including functionality, performance, and security.
Client Collaboration: The company collaborates closely with the startup to ensure alignment with the
evolving business needs and to make any necessary adjustments to the project plan.
Risk Management: Potential risks like technical challenges or delays are identified, and contingency plans
are developed. These plans may involve additional resources or schedule adjustments.
Client Approval: The definitive estimate is presented to the startup, allowing them to review the costs
timelines, and project details. Feedback is incorporated into the final estimate.
Final Proposal: The software company provides the startup with a comprehensive definitive estimate that
includes a detailed breakdown of costs, timelines, resource allocation, testing plans, and risk
management strategies.

20
Types of Estimate -- Parametric Estimate

This type of estimate uses Statistical Relationships to estimate a value based on

historical data or Parameters. It's particularly useful when estimating based on Similar
past projects.
A parametric estimate is a type of Cost or Time estimation technique used in project
management, engineering, and various other fields. It involves making an
estimate based on a set of parameters or variables that are known to influence the
cost or time of a project, task, or activity. These parameters could include
factors such as size, complexity, resources, and historical data.
The key idea behind a parametric estimate is to establish a mathematical relationship
between the parameters and the project's cost or duration. This relationship is often
derived from historical data or industry benchmarks. Once the relationship is
established, it can be used to calculate estimates for new projects or tasks based on
the values of the relevant parameters.

21
Here's a simplified example:
Let's say you're estimating the cost of building a house. You might find that the cost per square
foot for a house in your area is Rs 200, and you know that the house you're planning to build is
2,000 square feet. Using a parametric estimate, you can calculate the cost as:
Cost = Cost per square foot × Square footage
Cost = 200 × 2,000 = 4,00000
In this example, the ‘cost per square foot’ is the parameter, and the ‘square footage’ is the value of
that parameter for the specific project.
Parametric estimates can be useful when you have limited data or time to perform a detailed
analysis. However, they rely on the assumption that the relationship between the parameters and
the cost or time is consistent and applicable to the new project.
► It's important to note that while parametric estimates can provide quick & rough estimates,
they might not be as accurate as more detailed estimation methods, especially for projects with
unique characteristics or those that significantly deviate from the historical data used to
establish the parameters.

22
Types of Estimate -- Analogous Estimate

Similar to Parametric Estimation, this approach relies on Comparing the current

project to a Past project with similar characteristics.
Analogous estimating is a project management technique used to estimate the
duration, cost, or other relevant metrics of a project by drawing comparisons with
similar projects that have been completed in the past. It's a ‘Top-down
approach’ that relies on historical data and expert judgment to provide a rough
estimate for a new project based on the characteristics and outcomes of previous,
similar projects.
Analogous estimating can be a useful technique when there's limited information
available for the new project, especially during the early stages of project planning.
However, it's important to note that this method provides only a rough estimate and
should be used in conjunction with other estimation techniques for more accurate
results. As with any estimation approach, the Accuracy of the
estimate depends on the Quality of the data, the Expertise of the individuals involved,
and the degree of Similarity between the reference project and the project being
estimated.

23
Process Flow - Analogous Estimate
Identify a Reference Project: The first step is to identify a project that is similar in nature, scope,
and complexity to the one you are trying to estimate. This reference project should have historical
data available, including information on its duration, cost, resources used, & any other relevant
factors.
Gather Data: Collect all available data related to the reference project, including project plans,
budgets, schedules, and any other documentation. The more detailed and accurate the data, the
better your estimate is likely to be.
Analyze Similarities and Differences: Compare the reference project to the project you're
estimating. Look for similarities in terms of size, scope, objectives, constraints, and other relevant
aspects. Identify any differences that might affect the estimate, such as changes in technology,
market conditions, or regulatory requirements.
Adjustment Factors: Apply adjustment factors to account for the differences between the reference
project and the project being estimated. These factors could be based on expert judgment or
quantitative analysis. For example, if the new project has stricter Regulatory Requirements, you might
add a percentage to the estimate to reflect the additional effort required for compliance.
Calculate Estimate: Based on the adjustments made, calculate the estimated duration, cost, or other
metrics for the new project. The estimate is derived from the historical data of the reference project,
adjusted by the identified factors.

24
Example - Analogous Estimate

Suppose you are tasked with estimating the effort (in person-hours) required for a new
software development project that involves building a content management system (CMS
like our DMS) similar to one you've previously worked on. The previous CMS project had
the following characteristics:
Project Size: 10,000 lines of code
Effort Required: 1,000 person-hours
Development Time: 3 months
Now, you have a new project to estimate, which involves building a similar CMS with the following
characteristics:
Project Size: 15,000 lines of code (larger than the previous project)
Unknown Effort
Desired Development Time: 4 months

25
 Contd..

Using the analogous estimating technique, you can estimate the effort
required for the new project based on the historical data from the previous
project. The basic formula for analogous estimating is:
Estimated Effort = (Previous Effort) x (New Size) / (Previous Size)
Plugging in the values from our example:
Estimated Effort = (1,000 person-hours) x (15,000 lines) / (10,000 lines)
Estimated Effort = 1,500 person-hours
So, based on the historical data from the previous project, you estimate that
the new project would require approximately 1,500 person-hours of effort to
complete.

26
 Contd..

It's important to note that analogous estimating provides a rough estimate based on
similarities between projects. The accuracy of the estimate can vary depending on
the degree of similarity between the projects, changes in technology, team
experience, and other factors.

27
Types of Estimate -- Bottom-Up Estimate

This estimate involves breaking down a project into smaller components, estimating
each component individually, and then aggregating the estimates to get a total estimate.
A Bottom-Up Estimate is a project estimation technique commonly used in Software
Engineering and Project Management. It involves breaking down a project
into smaller, more manageable components or tasks and estimating the effort &
resources required for each individual task. These individual estimates are then
aggregated to provide an overall estimate for the entire project.
Keep in mind that while ‘Bottom-Up Estimation’ offers increased Accuracy, it can also
be More Time-consuming compared to other estimation techniques. It's
important to strike a balance between the level of details and the time available for
estimation. Additionally, regular review and adjustment of estimates as the project
progresses are essential for maintaining accuracy.

28
Here's how the Bottom-Up Estimate process typically works

Task Identification: Identify and list all the tasks or components required to complete the project. These
tasks should be as granular as possible, breaking down the project into smaller units of work.
Task Estimation: Estimate the effort, time, and resources required for each individual task. This estimation
can be done using various techniques such as expert judgment, historical data analysis, or analogy with
similar past projects.
Aggregation: Once you have estimated all the individual tasks, sum up the estimates to calculate the total
effort, time, and resources required for the entire project. This gives you a more accurate estimate because
it takes into account the specifics of each task.
Contingency: It's advisable to include a Contingency Buffer in the estimate to account for uncertainties,
risks, and unexpected events that might arise during the project. This helps to ensure that the estimate
remains realistic even if things don't go exactly as planned.
Validation: Review and validate the estimates with relevant stakeholders, including team members, project
managers, and clients. This step helps to identify any discrepancies or potential issues early on.
Documentation: Document the estimation process, including the breakdown of tasks, individual estimates,
assumptions, and the contingency buffer. This documentation serves as a reference point throughout the
project and helps in tracking progress.

29
Example - Bottom-Up Estimate

Eg: Consider a hypothetical software engineering project: building a content management system (CMS)
for a small business. The project will be break down using a bottom-up estimation approach.
Step 1: Identify Tasks
First, we need to identify the tasks required to complete the project. These tasks might include:
Requirements gathering and analysis
Database design
User interface design
Backend development
Frontend development
Testing and quality assurance
Deployment and launch

30
Contd..
Step 2: Estimate Task Efforts
Next, we estimate the effort required for each task. Let's consider the "Backend development" task as an
example. The backend development task can be further broken down into sub-tasks:
Setup project environment
Design and implement database scheme
Develop API endpoints
Implement user authentication
Implement data storage and retrieval logic
Error handling and validation
Documentation
For simplicity, let's assume we are estimating in hours and each sub-task takes a certain number of hours
to complete.

31
Contd..

Step 3: Summing Up Efforts

Now we sum up the estimated efforts for all sub-tasks to get the total effort for the "Backend
development" task. Let's say the total effort for the backend development task is 300 hours.
Similarly, we estimate efforts for all the other tasks, such as frontend development, testing, and
deployment.

32
Contd..

Step 4: Summing Up All Tasks

Finally, we sum up the efforts of all the tasks to get the overall effort for the entire project. Let's
assume the total efforts for all tasks are as follows:
Requirements: 40 hours
Database design: 20 hours
User interface design: 30 hours
Backend development: 300 hours
Frontend development: 250 hours
Testing and QA: 80 hours
Deployment and launch: 20 hours
The total effort for the project would be 740 hours.

33
Contd..

Step 5: Contingency and Review

It's important to include a contingency factor to account for unforeseen delays, changes, or
additional tasks that may arise during the project.
For example, adding a 20% contingency buffer would increase the total estimated effort to
888 hours (740 * 1.20).
Remember that these estimates are based on assumptions and experience.
Actual project timelines may vary due to factors such as Team efficiency, External
dependencies, and Scope changes.
Bottom-up estimation allows you to create a detailed and granular estimation by breaking
down the project into smaller tasks. This approach can help in Better Resource allocation,
Project Planning, and Identifying Potential Bottlenecks early in the project lifecycle.

34
Engineering Economics

Estimating Models
Benefits of Estimating:

Accurate estimating is crucial for effective project management and decision-making.

Some key benefits of Estimation include:
Resource Allocation: Proper estimates help allocate resources effectively, ensuring that projects have the
necessary Manpower, Materials, and Budget.
Risk Management: Accurate estimates allow for better identification and management of Potential Risks,
helping to mitigate negative impacts.
Project Planning: Estimates are essential for creating Realistic Project Schedules, setting up Milestones, and
defining project objectives.
Cost Control: Accurate cost estimates help control project budgets and prevent Cost Overruns.
Client Communication: Clear & accurate estimates enhance communication with clients, establishing Trust
and Transparency.
Economic Order Quantity (EOQ):
EOQ is a term used in Inventory Management to determine the ‘Optimal order quantity’ that
minimizes total inventory costs. It balances the ‘cost of holding’ inventory (storage, handling,
etc.) against the ‘costs of ordering’ more inventory (order processing, setup, etc.). The
formula considers factors such as Demand rate, Ordering cost, and Carrying cost.
The EOQ formula is:
EOQ = √((2 * D * S) / H),
Where:
D = Demand rate (units per period)
S = Ordering cost per order (Co)
H = Holding cost per unit per period (Ch)
By calculating the EOQ, a company can find the Order Quantity that minimizes the combined costs of holding
inventory and ordering. This helps in Optimizing Inventory management and Cost efficiency.
Estimating Models

Estimating models for engineering economics involve using various Mathematical and Analytical Techniques to
predict and evaluate the financial performance of engineering projects and investments. These models help
engineers and decision-makers make informed choices about whether to proceed with a project based on its
potential economic returns. Here are some common estimating models used in engineering
economics:
Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Period
Benefit-Cost Ratio (BCR)
Sensitivity Analysis
Scenario Analysis
Monte Carlo Simulation
Capital Budgeting Techniques
Internal Rate of Return (IRR)
Replacement Analysis
Real Options Analysis
Net Present Value (NPV)

NPV is a fundamental concept in Engineering Economics. It involves estimating the present value of all
expected cash inflows and outflows associated with a project or investment. The NPV is calculated by
discounting future cash flows to their present value using a predetermined discount rate.
If the NPV is Positive, the project is usually considered Economically Viable.

Eg. You are considering an Investment Proposal /opportunity to purchase a piece of equipment for your
manufacturing business. The initial cost of the equipment is 1,50,000 INR. The equipment is expected to
generate cash flows of 50,000 INR at the end of each year for the next 5 years. The Cost of Capital for your
business is 10%. Calculate the Net Present Value (NPV) of the investment and determine
whether it's a financially viable decision.
The Net Present Value (NPV) of an investment is calculated by discounting the future cash flows generated by the investment back to
their present value and subtracting the initial investment cost.
What NPV Can Tell You

NPV accounts for the time value of money and can be used to compare the rates of return of different projects or to
compare a projected rate of return with the hurdle rate , required to approve an investment.
The time value of money is represented in the NPV formula by the ‘discount rate’ , which might be a hurdle rate for a
project based on a company’s cost of capital. No matter how the discount rate is determined, a negative NPV shows
that the expected rate of return will fall short of it, meaning that the project will not create Value.
For evaluating corporate securities, the net present value calculation is often called discounted cash flow (DCF)
analysis. It’s the method used by Warren Buffett to compare the NPV of a company’s future DCFs with its current
price.
The ‘discount rate’ is central to the formula. It accounts for the fact that, as long as interest rates are positive, a
dollar today is worth more than a dollar in the future. Inflation erodes the value of money over time. Meanwhile,
today’s dollar can be invested in a safe asset like Government Bonds; investments riskier than Treasurys must offer
a higher rate of return. How so ever it’s determined, the discount rate is simply the baseline rate of return that a
project must exceed to be worthwhile.

For example, an investor could receive $100 today or a year from now. Most investors would not be
willing to postpone receiving $100 today. However, what if an investor could choose to receive $100
today or $105 in one year? The 5% rate of return might be worthwhile if comparable investments of equal
risk offered less over the same period.
If, on the other hand, an investor could earn 8% with no risk over the next year, then the offer of $105 in a
year would not suffice. In this case, 8% would be the discount rate.
Practice Problem

You are considering investing in a real estate project. The project involves purchasing a
piece of land for 2,00,000 INR. You anticipate that the project will generate cash flows of
30,000 INR at the end of each year for the next 8 years. However, the cost of capital for
this type of project is 12%. Calculate the Net Present Value (NPV) of the investment and
determine whether it's financially feasible.
Ans: NPV = -50970.85
Since the calculated NPV is negative (-22,578.67 INR), it indicates that the investment is
Not Financially Feasible. A negative NPV suggests that the project's potential
returns do not exceed the ‘Cost of capital’, making it an ‘Unfavorable investment
decision’.
In such cases, it's generally advisable to avoid pursuing the investment as it may not
provide satisfactory returns.
Internal Rate of Return (IRR):

IRR is the ‘discount rate’ that makes the NPV of a project equal to Zero. It represents the
effective interest rate at which an investment breaks even.
Projects with an IRR higher than the required rate of return are generally considered
attractive.
 Problem: Calculating Internal Rate of Return (IRR) for a Software
Engineering Project

Suppose a software engineering company is evaluating an investment in a new project that involves
developing a cutting-edge software product. The project requires an initial investment of
3,00,000 INR for development costs and equipment purchase. The company expects to generate cash
flows of 1,00,000 INR at the end of each year for the next five years from selling licenses of the software.
After five years, the company plans to sell the project at an estimated net cash flow of 1,50,000 INR.
The company's required rate of return is 12%.
Calculate the Internal Rate of Return (IRR) for this project and determine whether the company should
proceed with it or not.
Step 1: Identify the cash flows for each year, including the initial investment and future cash flows:

Initial Investment: -3,00000 (outflow)

End of Year 1: 1,00000 (inflow)
End of Year 2: 1,00000 (inflow)
End of Year 3: 1,00000 (inflow)
End of Year 4: 1,00000 (inflow)
End of Year 5: 1,00000 (inflow)
End of Year 6 (sale of project): 1,50,000 (inflow)
Step 2: Calculate the Net Cash Flows for each year:

Year 1: 1,00000 – 3,00000 = -2,00000

Year 2: 1,00000
Year 3: 1,00000
Year 4: 1,00000
Year 5: 1,00000
Year 6: 1,50000
Step 3: Set up the equation to find the IRR. The IRR is the discount rate that makes the present
value of cash inflows equal to the initial investment:
NPV = 0 = (1,00000 / (1 + IRR)^1) + (1,00000 / (1 + IRR)^2) + (1,00000 / (1 + IRR)^3) + (1,00000 / (1 + IRR)^4)
+ (1,00000 / (1 + IRR)^5) + (1,50000 / (1 + IRR)^6) – 3,00,000

Step 4: Solve for IRR using trial and error or by using computational tools (e.g., financial calculators,
spreadsheet software). In this case, the calculated IRR is approximately 16.35%.

Step 5: Compare the calculated IRR (16.35%) with the company's required rate of return (12%). Since the
calculated IRR (16.35%) is greater than the required rate of return (12%), the project is considered
financially viable.

► Thus, The company should proceed with the software engineering project as it is expected to provide
returns that exceed the company's cost of capital.
Conclusion:

The software engineering company should proceed with the project because the calculated Internal Rate
of Return (IRR) of approx. 16.35% is higher than the company's required rate of return of 12%. ►
IRR 16.5% > CoC 12%
This indicates that the project is expected to generate a return that justifies the initial investment and
generates additional monetary value for the company.
Payback Period

The Payback period is the time required for an investment to generate sufficient cash flows to recover the
Initial Investment Cost. Projects with shorter payback periods are often preferred as they provide quicker
returns.
The Payback Period is a Financial Metric used to evaluate the time it takes for an investment to generate
enough cash flows to recover the initial investment cost. In the context of an engineering project, it helps
assess the time it will take for the project to recoup its initial costs through the cash flows it generates.

The formula to calculate the payback period is:

Payback Period = Initial Investment / Annual Cash Flow
Here's how you can calculate the Payback Period for an Engineering Project:

Determine the Initial Investment: Identify all the costs associated with starting the engineering project. This
could include expenses like equipment costs, labor costs, research and development expenses, etc. Add up all
these costs to get the Initial Investment.
Estimate Annual Cash Flows: Estimate the cash flows the project is expected to generate on an annual basis. This
could include revenue from sales, cost savings, or any other relevant income generated by the project.
Calculate the Payback Period: Divide Initial Inv. by Annual Cash Flow to calculate the payback period in years.
Payback Period = Initial Investment / Annual Cash Flow
It's important to note that the Payback Period Metric has its limitations. It doesn't take into account the
Time Value of Money (the fact that money received in the future is worth less than money received today due to
inflation and the opportunity cost of not investing the money elsewhere). Additionally, it doesn't provide insights
into the profitability of the project beyond the payback period itself.
In Engineering projects, it's advisable to use the Payback Period in conjunction with other financial metrics like Net
Present Value (NPV), Internal Rate of Return (IRR), and Discounted Payback Period to get a more comprehensive
view of the project's financial viability and potential risks. These metrics consider the time value of money and
provide a better understanding of the project's long-term profitability.
Benefit-Cost Ratio (BCR)

The BCR is the ratio of the present value of benefits to the present value of costs. A BCR greater than
1 indicates that the benefits outweigh the costs, making the project Potentially desirable.

Problem: Inefficient Resource Allocation for Infrastructure Projects

Many government agencies and organizations struggle with the efficient allocation of resources for
infrastructure projects. Limited budgets and competing project options often lead to decisions that may
not yield the best outcomes in terms of societal benefits & costs.
Without a proper assessment of projects, there is a risk of investing in projects with low returns and
missing out on those with higher potential.
Solution: Benefit-Cost Ratio (BCR) Analysis
The Benefit-Cost Ratio (BCR) analysis is a valuable tool for evaluating and comparing the economic feasibility
of different infrastructure projects. It helps decision-makers make informed choices by quantifying the ratio of
the benefits derived from a project to the costs incurred.
The BCR is calculated by dividing the Present value of the project's benefits by the Present value of its costs.
Steps for BCR Analysis:

Identify and quantify benefits: Identify the positive impacts that the project will bring to society, such as
increased productivity, reduced travel time, improved safety, and environmental benefits. Quantify these
benefits in monetary terms whenever possible.
Estimate project costs: Consider all relevant costs associated with the project, including construction costs,
operational costs, maintenance costs, and any other direct or indirect expenses.
Timeframe and discounting: BCR analysis takes into account the time value of money by discounting future
benefits and costs to present value. This ensures that the impact of money over time is properly considered.
Calculate BCR: Divide the present value of the Benefits by the present value of the Costs to calculate the
BCR. A BCR greater than 1 indicates that the benefits outweigh the costs, making the project economically
viable.
Compare projects: Rank and compare different projects based on their BCR values. Projects with higher BCR
values are generally preferred, as they indicate a higher return on investment.
Sensitivity Analysis: Since BCR analysis involves assumptions and estimates, it's important to perform
sensitivity analysis to assess the impact of variations in key parameters. This helps decision-makers
understand the robustness of their decisions.
Benefits of BCR Analysis:

Informed Decision-making: BCR analysis provides a clear and quantitative basis for comparing projects,
helping decision-makers allocate resources to projects with the highest potential benefits relative to
costs.
Efficient Resource Allocation: By prioritizing projects with higher BCR values, organizations can
maximize the impact of their limited resources.
Accountability and Transparency: BCR analysis provides a transparent method for justifying project
choices to stakeholders and the public, enhancing accountability.
Risk Assessment: BCR analysis encourages the consideration of potential risks and uncertainties,
fostering better risk management practices.
In conclusion, the Benefit-Cost Ratio (BCR) analysis is a powerful tool for addressing the problem of
inefficient resource allocation for infrastructure projects. By utilizing BCR analysis, decision-makers
can ensure that the projects they choose to invest in are economically sound and deliver the greatest
societal benefits, relative to the costs incurred.
Num. A city is considering a road construction project that aims to improve traffic flow and
reduce congestion. The estimated costs and benefits of the project are as follows:
Estimated construction cost: Rs. 50,00,000
Annual operational and maintenance cost: Rs. 2,00,000
Project duration: 10 years
Annual benefits in reduced travel time/Fuel savings: Rs. 15,00,000
Salvage value of the project at the end of 10 years: Rs. 5,00,000
The city uses a discount rate of 8% for project evaluations. Calculate the Benefit-
Cost Ratio (BCR) to determine whether the road construction project is economically
viable.
Solution:
Step 1: Calculate Present Value of Costs and Benefits
To perform the BCR analysis, we need to calculate the present value of both costs and benefits over the project's
duration.
Present Value (PV) formula: PV = Future Value / (1 + Discount Rate)^Number of Years
Present Value of Construction Cost:
PV of Construction Cost = 50,00000 / (1 + 0.08)^0 = 50,00000
Present Value of Annual Operational and Maintenance Costs (for 10 years):
PV of Annual Costs = 2,00000 * [1 - (1 + 0.08)^-10] / 0.08 = 14,64097.28
Present Value of Annual Benefits (for 10 years):
PV of Annual Benefits = 15,00000 * [1 - (1 + 0.08)^-10] / 0.08 = 1,10,40,328.51
Present Value of Salvage Value:
PV of Salvage Value = 5,00000 / (1 + 0.08)^10 = 2,80,785.371
Step 2: Calculate Net Present Value (NPV)
Net Present Value (NPV) = PV of Benefits - PV of Costs
NPV = (11040328.51 + 280785.37) - (5000000 + 1464097.28) = 5857016.6
Step 3: Calculate BCR
BCR = (PV of Benefits + PV of Salvage Value) / (PV of Costs)
BCR = (11040328.51 + 280785.37) / (5000000 + 1464097.28) ≈ 2.22

Interpretation:
The calculated BCR is approximately 2.22. Since the BCR is greater than 1, it indicates that the benefits of the road
construction project outweigh the costs. A BCR greater than 1 indicates that for every INR invested, there are 2.22
INR in benefits. Therefore, the road construction project is economically viable and would likely provide positive
returns.
This analysis helps the city make an informed decision by quantifying the economic feasibility of the project and
demonstrating its potential to generate significant benefits relative to the costs involved.
Sensitivity Analysis:

This involves analysing how changes in key input parameters (such as cost estimates, revenue
projections, and discount rates) affect the financial viability of a project.

Sensitivity analysis helps identify the sensitivity of the project's outcome to variations in these
parameters.
Case Study: Sensitivity Analysis in Financial Investment

Background:
ABC Investments is a financial firm that offers investment advice and manages portfolios for their clients.
They have recently proposed an investment strategy to a high-net-worth client, Mr. Smith, which involves
allocating his portfolio across various assets such as Stocks, Bonds, and Real estate.
Mr. Smith is concerned about the potential risks and uncertainties associated with this strategy, and he wants
to understand how sensitive his returns would be to changes in certain key variables.

Objective: The objective of this Sensitivity Analysis is to assess the impact of changes in key variables on the
overall returns of Mr. Smith's investment portfolio. This analysis will help Mr. Smith understand the potential
risks and uncertainties associated with the proposed investment strategy.
Variables of Interest:
Stock Market Performance: This variable represents the annual return of the stock market, which directly
influences the returns from the stocks in Mr. Smith's portfolio.
Interest Rates: Fluctuations in interest rates affect the returns from bonds and other fixed- income
investments.
Real Estate Market: Changes in the real estate market impact the value and returns of the real estate holdings
in the portfolio.
Inflation Rate: Inflation erodes the purchasing power of investments, affecting their real returns.

Methodology:
ABC Investments uses a Financial modelling tool to perform Sensitivity Analysis. They create a model that simulates
the performance of Mr. Smith's portfolio based on historical data, economic forecasts, and assumptions.
Monte Carlo simulation is employed to generate multiple scenarios by randomly varying the input variables within
defined ranges.
Steps in SA:

Data Collection: ABC Investments gathers historical data on stock market returns, interest rates, real estate market
trends, and inflation rates. They also collect information about Mr. Smith's portfolio allocation.
Scenario Definition: ABC Investments defines ranges for each key variable. For instance, they might consider a range
of -2% to +2% for stock market returns, ±0.5% for interest rates, etc.
Model Development: Using the collected data and assumptions, ABC Investments builds a financial model that
calculates the overall returns of Mr. Smith's portfolio based on different combinations of input variables.
Monte Carlo Simulation: They run the model through thousands of iterations, randomly selecting values for each key
variable within their defined ranges. For each iteration, the model calculates the portfolio returns.
Results Analysis: ABC Investments analyses the simulation results to identify patterns and trends. They create various
visualizations, such as histograms and scatter plots, to demonstrate the distribution of possible portfolio
returns under different scenarios.
Sensitivity Metrics: ABC Investments calculates Sensitivity Metrics such as the Standard Deviation of portfolio
returns, Correlation Coefficients, and value-at-risk (VaR) to quantify the impact of each variable on the
portfolio's overall performance.
Recommendations: Based on the analysis, ABC Investments provides Mr. Smith with insights into the potential
range of returns and risks associated with the proposed investment strategy. They discuss strategies to mitigate
risks, such as Diversification and Hedging.
Conclusion: Sensitivity analysis helps Mr. Smith and ABC Investments understand the potential vulnerabilities and
uncertainties in the proposed investment strategy.
By quantifying the impact of key variables on portfolio returns, they can make more informed decisions and
tailor the strategy to Mr. Smith’s Risk tolerance and Financial goals.
Scenario Analysis:

Similar to Sensitivity Analysis, Scenario Analysis involves examining different Scenarios that could
impact the project's financial performance.
It goes beyond single-variable changes and considers multiple variables together.
Ex.
Suppose you are a financial analyst, evaluating an Investment opportunity in a Startup company.
The company is developing a new product, and its success will depend on various market conditions.
You've identified three Potential Scenarios with associated Probabilities and projected Cash flows.
You want to use Scenario Analysis to assess the investment's potential returns.
Scenarios:
Optimistic Market (Probability: 40%)
Projected Cash Flow: Rs 3,00000
Moderate Market (Probability: 50%)
Projected Cash Flow: Rs 1,50000
Pessimistic Market (Probability: 10%)
Projected Cash Flow: Rs -50,000 (Negative value indicates a loss)

Calculate the expected cash flow and standard deviation of cash flows to assess the investment's potential
outcomes.
Solution:
Expected Cash Flow = (Probability of Scenario 1 * Cash Flow of Scenario 1) + (Probability of Scenario 2 * Cash Flow of
Scenario 2) + (Probability of Scenario 3 * Cash Flow of Scenario 3)
Expected Cash Flow = (0.40 * 300000) + (0.50 * 150000) + (0.10 * -50000) = 120000 + 75000 - 5000 = 190000
The expected cash flow for the investment is Rs 190000.
Standard Deviation of Cash Flows = √[ (Probability of Scenario 1 * (Cash Flow of Scenario 1 - Expected Cash Flow)^2) +
(Probability of Scenario 2 * (Cash Flow of Scenario 2 - Expected Cash Flow)^2) + (Probability of Scenario 3 * (Cash Flow
of Scenario 3 - Expected Cash Flow)^2) ]
Standard Deviation of Cash Flows = √[ (0.40 * (300000 - 190000)^2) + (0.50 * (150000 - 190000)^2) + (0.10 * (-50000 -
190000)^2) ]
Standard Deviation of Cash Flows = √[ (40000)^2 + (-40000)^2 + (240000)^2 ] = √[ 1600000000 + 1600000000 +
57600000000 ] = √60160000000 = 245148.68
The Standard Deviation of cash flows for the investment is approximately 245148.68 INR.
Conclusion: Based on scenario analysis, the expected cash flow from the investment is 190000 INR, with a standard
deviation of approximately 245148.68 INR. This indicates that while the investment has a Positive expected outcome,
there is a Notable level of Uncertainty associated with the potential cash flows.
Monte Carlo Simulation:

This advanced technique involves running thousands of simulations using probability distributions for key
input parameters. It provides a range of possible outcomes and their associated probabilities, offering a more
comprehensive understanding of project risk.
Monte Carlo simulation is a computational technique used to estimate outcomes or analyze complex systems
by generating random samples and analyzing their statistical properties. The technique is named after the
famous casino in Monaco because of the element of randomness involved, similar to the random outcomes in
gambling.
Monte Carlo simulation is widely used in various fields, including physics, engineering, finance, statistics, and
more.
Monte Carlo Simulation: Process Flow

Problem Formulation: Start with a problem that involves uncertainty or randomness. This could be anything from
calculating the value of a financial option to predicting the behavior of a physical system.
Modeling: Create a mathematical or computational model that represents the system you're analyzing. This model
should include variables with uncertain values or parameters.
Random Sampling: Generate a large number of random samples for the uncertain variables. These samples are often
drawn from probability distributions that reflect the uncertainty of the real-world system.
Simulation: For each set of random samples, use the model to simulate the behavior of the system. This might
involve performing calculations, running simulations, or following a set of rules based on the model.
Statistical Analysis: Collect data from the simulations and perform statistical analysis on the results. This could
include calculating averages, standard deviations, percentiles, and other relevant measures.
Interpretation: The statistical analysis provides insights into the behavior of the system and the potential
outcomes. You can use these results to make predictions, assess risks, or make informed decisions.
Monte Carlo simulations are particularly useful when dealing with complex systems that are difficult to
model analytically. They can handle a wide range of scenarios, including situations with multiple
interacting variables and uncertainties.
One classic example is using Monte Carlo simulation to estimate the value of π (pi), where random points
are generated within a square and the ratio of points falling within a quarter circle to the total number of
points gives an approximation of π/4.
In finance, Monte Carlo simulations are used to model the behavior of financial instruments like options,
bonds, and portfolios under various market conditions. This helps investors and analysts make informed
decisions about risk management and investment strategies.
Overall, Monte Carlo simulation is a powerful tool for gaining insights into complex systems and making
informed decisions in the presence of uncertainty.
Capital Budgeting Techniques:

Techniques like the Profitability Index, Equivalent Annual Cost, and Modified Internal Rate of Return
(MIRR) take into account the time value of money and are used to evaluate the financial performance of
complex projects with varying cash flows over time.

Capital budgeting techniques are methods used by businesses and organizations to evaluate and prioritize
potential investment projects or expenditures that involve significant financial resources. These
techniques help in assessing the feasibility, profitability, and overall value of different investment
opportunities.
Here are some common capital budgeting techniques:
Net Present Value (NPV): NPV calculates the present value of future cash flows generated by an investment project,
taking into account the initial investment cost. If the NPV is positive, it indicates that the project is expected to
generate more cash inflows than outflows and is potentially a profitable investment.
Formula: NPV = Σ [CFt / (1 + r)^t] - Initial Investment
Where CFt = Cash flow at time t, r = discount rate, and t = time period.
Decision rule: Accept the project if NPV > 0; reject if NPV < 0.
Internal Rate of Return (IRR): IRR is the discount rate at which the NPV of an investment becomes zero. It represents
the rate of return the project is expected to generate. Comparing the IRR to the company's required rate of return
helps determine project feasibility.
Decision rule: Accept the project if IRR > Required Rate of Return; reject if IRR < Required Rate of Return.
Payback Period: The payback period is the time it takes for an investment to recover its initial cost through generated
cash flows. It's a simple measure of liquidity and risk. Shorter payback periods are generally preferred, as they indicate
quicker recovery of the initial investment.
Decision rule: Accept the project if Payback Period < Preset Time; reject if Payback Period > Preset Time.
Discounted Payback Period: Similar to the payback period, this method considers the time it takes for an
investment to recover its initial cost, but it takes into account discounted cash flows. This accounts for the
time value of money.
Decision rule: Accept the project if Discounted Payback Period < Preset Time; reject if Discounted Payback
Period > Preset Time.
Profitability Index (PI): The profitability index is the ratio of the present value of future cash flows to the initial
investment. It measures the bang for the buck—the higher the index, the more desirable the investment.
Formula: PI = Present Value of Future Cash Flows / Initial Investment
Decision rule: Accept the project if PI > 1; reject if PI < 1.
Modified Internal Rate of Return (MIRR): MIRR overcomes some of the limitations of the traditional IRR by
assuming that intermediate cash flows are reinvested at a specified rate, rather than at the project's IRR. It
provides a more realistic estimate of an investment's profitability.
These techniques have their strengths and weaknesses, and they may be used in combination to make well-
informed decisions about capital investments. The choice of which technique(s) to use depends on the
specific circumstances of the investment and the company's preferences for risk, return, and other factors.
Replacement Analysis:

Used for deciding when to replace an existing asset, this analysis considers factors such as the asset's
current value, future maintenance costs, and the value of the replacement asset.
Replacement analysis, also known as capital budgeting or asset replacement analysis, is a financial
evaluation technique used by businesses to decide whether to replace an existing asset or piece of
equipment with a new one. This analysis is typically performed when an existing asset becomes outdated,
inefficient, or no longer cost-effective to maintain, and the business is considering investing in a
replacement.
The primary objective of replacement analysis is to determine whether the benefits and cost savings
associated with the new asset justify the investment required. The analysis involves comparing the costs
and benefits of keeping the existing asset versus replacing it with a new one.
Here's a general process for conducting replacement analysis:
Identify the Existing Asset: Determine the characteristics, current condition, and operational costs of the
existing asset that needs replacement.
Estimate the Remaining Useful Life: Estimate how much longer the existing asset can continue to provide
value before it becomes obsolete or its maintenance costs outweigh its benefits.
Identify the New Asset: Identify the potential replacement asset and gather information about its cost,
expected useful life, operating costs, and any other relevant factors.
Estimate Costs and Benefits: Calculate the total costs associated with keeping the existing asset,
including maintenance, repair, and any other relevant expenses. Similarly, calculate the total costs
associated with acquiring and operating the new asset.
Quantify Benefits: Identify and quantify the benefits that the new asset will bring, such as increased
efficiency, reduced operating costs, improved quality, increased production capacity, and other potential
advantages.
Discounted Cash Flow Analysis: Apply techniques like discounted cash flow (DCF) analysis to
assess the net present value (NPV) of both the existing asset and the new asset over their
respective useful lives. This involves discounting future cash flows back to their present value to
account for the time value of money.
Compare NPVs: Compare the NPV of the existing asset with the NPV of the new asset. A positive
NPV indicates that the investment in the new asset is likely to be financially beneficial, while a
negative NPV suggests that sticking with the existing asset may be a better option.
Sensitivity Analysis: Perform sensitivity analysis by varying key assumptions (such as useful life,
discount rate, maintenance costs, and benefits) to assess the impact on the decision. This helps
understand the robustness of the decision under different scenarios.
Make the Decision: Based on the comparison of NPVs and the results of sensitivity analysis, make
an informed decision on whether to replace the existing asset with the new one.
It's important to note that replacement analysis can be complex, as it involves predicting future
costs and benefits over the life of the assets. Different industries and businesses may have
unique factors to consider. Therefore, careful consideration of assumptions, accurate data, and
sound financial analysis are crucial for making the best decision.
Problem: Replacement Analysis in Software Engineering
Company XYZ is considering whether to replace an old software system with a new one. The old system was purchased 5
years ago for 150000 INR and has an expected remaining useful life of 3 years. The new system is expected to cost
250000 INR and has an expected useful life of 5 years. The salvage value of the old system is negligible, while the salvage
value of the new system is estimated to be 50000 INR after 5 years. The company's required rate of return is 10%. Should
the company replace the old system with the new one?
Solution: To determine whether the company should replace the old system with the new one, we can use the Net
Present Value (NPV) method. NPV helps us calculate the present value of cash flows associated with each option and
compare them to make an informed decision.
Calculate the Cash Flows:
For the old system:
Initial cost: 150000
Salvage value: 0 Cash flows for the old system:
Remaining useful life: 3 years Year 0: -150000
Year 1: 0
Year 2: 0
Year 3: 0
For the new system:
Calculate Present Values:
Initial cost: 250000
Using the formula for present value:
Salvage value: 50000
PV = CF / (1 + r)^n
Useful life: 5 years
Where:
Cash flows for the new system:
PV = Present Value
Year 0: -250000
CF = Cash Flow
Year 1: 0
r = Required rate of return
Year 2: 0
n = Time period
Year 3: 0
Present value of each cash flow for the old system (r = 10%):
Year 4: 0
Year 0: -150000 / (1 + 0.10)^0 = -150000
Year 5: 50000
Year 1: 0 / (1 + 0.10)^1 = 0
Year 2: 0 / (1 + 0.10)^2 = 0
Year 3: 0 / (1 + 0.10)^3 = 0
 Present value of each cash flow for the new system (r = 10%):
Year 0: -250000 / (1 + 0.10)^0 = -250000 Calculate Net Present Value (NPV):
Year 1: 0 / (1 + 0.10)^1 = 0 NPV = Sum of Present Values of Cash Flows -
Year 2: 0 / (1 + 0.10)^2 = 0 Initial Cost
Year 3: 0 / (1 + 0.10)^3 = 0
Year 4: 0 / (1 + 0.10)^4 = 0 For the old system: NPV = (-150000) + 0 + 0 + 0 -
Year 5: 50,000 / (1 + 0.10)^5 = 50,000 / 1.61051 ≈ 31,026.55 (-150000) = 0
For the new system: NPV = (-250000) + 0 + 0 + 0
+ 0 + 31026.55 ≈ -218973.45

Since the NPV of the new system is negative (-218973.45), it means that the new system's expected cash flows do
not cover the initial investment and are not sufficient to generate a return greater than the required rate of return.
Therefore, the company should not replace the old system with the new one based on the NPV analysis.

Keep in mind that other factors like strategic alignment, technological advancements, and qualitative
considerations may also influence the decision-making process.
Real Options Analysis:
This approach applies option pricing principles from finance to evaluate projects with uncertainty. It
considers the flexibility to adapt and change course as new information emerges.
Real Options Analysis (ROA) is a decision-making framework used in finance and investment to evaluate
projects or investment opportunities that possess embedded "real options." These real options refer to the
strategic choices available to a business or investor regarding their investments, operations, or projects in
response to changing market conditions, uncertainty, and future developments. Unlike financial options,
which are tradable securities, real options are the non-financial choices that can affect the value of an
investment.
The concept of real options emerged as a way to address the limitations of traditional discounted cash flow
(DCF) methods, which are commonly used to evaluate investment projects. DCF methods typically assume
that once an investment decision is made, it cannot be changed and that cash flows are certain and known.
However, in reality, managers often have flexibility to adapt and change their decisions based on new
information and changing market conditions.
Real Options Analysis takes into account the flexibility to adjust or change investment decisions over time.
It involves estimating the value of real options within an investment by considering various factors, including:
Timing Options: The option to delay or accelerate an investment decision based on the timing of market
developments.
Expansion or Contraction Options: The option to expand or contract the scale of an investment based on
market conditions.
Abandonment or Shutdown Options: The option to abandon or shut down an investment if it becomes
unprofitable or unfavorable.
Switching Options: The option to switch between different lines of business or projects based on changing
circumstances.
Growth Options: The option to invest in additional stages or phases of a project if the initial stages are
successful.
The real options approach involves using various quantitative techniques to estimate the value of these
options and incorporating them into the investment evaluation process. Some common methods and
models used in Real Options Analysis include the Binomial Option Pricing Model, Black-Scholes Option
Pricing Model (adapted for real options), Decision Trees, Monte Carlo Simulation, and others.
Real Options Analysis can provide a more nuanced understanding of the value of an investment
opportunity, especially in situations where uncertainty is high, and the ability to adapt to changing
circumstances is crucial. However, it's worth noting that implementing ROA can be complex and data-
intensive, requiring accurate estimates of various parameters and assumptions. As a result, it's often
applied to significant investment decisions where the potential benefits of incorporating real options
outweigh the added complexity.
The choice of estimating model depends on the complexity of the project, the availability of data, and the
level of accuracy required in the economic evaluation. It's important to carefully select and apply the
appropriate model(s) to ensure that investment decisions are well-informed and aligned with the
organization's goals.