Addis Ababa University

Addis Ababa Institute of Technology (AAIT)

ENGINEERING ECONOMICS CEng 5211

CHAPTER ONE
INTRODUCTION TO ENGINEERING
ECONOMICS

Emnete T.
emnete.tadesse@aait.edu.et
 Engineering a profession in which knowledge of the
mathematical and natural sciences gained by study,
experience and practice is applied with judgment to develop
ways to
 Utilize the material and forces economically

 For the benefit of mankind

 Engineering is not a science but application of science

 Role of scientist - Discover the universal laws of nature /
behavior
 Role of engineer – Apply knowledge to particular situation
to produce products and services
 Engineers are confronted with two interconnected environments the
physical and economical

Engineering Production / Need

proposal consumption satisfaction
Physical
Economic
environment environment
 ECONOMICS
 Economy: original root word had a meaning of
“oikos “and “nemein”
“the management of household expenses…”
 The study of how limited resources is used to satisfy unlimited human
wants
 Gives rise to efficient utilization of scares resources
 Scarcity forces to choose and choise involves scarifies
 The study of how individuals and societies choose to use scarce
resources that nature and previous generations have provided
- Resources
Land
Labor
Capital
Land
All gifts of nature, such as:
water, air, minerals, sunshine, plant and tree growth,
as well as the land itself.
Labor
The efforts, skills, and knowledge of people which are
applied to the production process.
Capital
 Real Capital (Physical Capital )
 Tools, buildings, machinery -- things which have
been produced which are used in further production
 Financial Capital
 Assets and money which are used in the production
process
 Human Capital
 Education and training applied to labor in the production
process
 Relationship between Engineering and Economics
very close
 Engineers are not only expected to create technical
alternatives but also evaluate them for economic
efficiency.

- Incase of Construction projects , ECONOMICS

affects Decision making in many ways
 Role of Engineering Economy

 It is a decision making tool for projects in a Time frame –

future
 It includes “Sensitivity analysis”– changes in decisions with
varying estimates
 Analysis of present and past situations based on observed
data to predict the future
 Decision making process

 In the decision making process

 A decision process first recognizes a problem

 Goals and objectives are then identified

 All Relevant information is collected

 A set of alternative solutions is identified

 Decision criteria's are set

 The best alternative is then selected

 In the decision making process
 A decision process first recognizes a problem

I need a new car

 Goals and objectives are then identified

Technically reliable car, with low monthly payments

 All Relevant info is collected
gathering technical as well as financial data

 A set of alternative solutions is identified

 Option 1: Lease a Mercedes car
 Optional 2: Purchase a Toyota executive
 Decision criteria's are set
Satisfying the current and future driving needs subject to
specified constraints
 The best alternative is then selected

Option 2
 Role of Engineering Economy

 Engineering Economy also uses the same decision

making process
 Engineering economy then focuses on alternative
comparison….
 usually in a future time frame…
 And involves comparison of costs….
 Or the value of money….in relation to time

 This results in key principles of engineering economics…

 Fundamental Principles of Engineering
Economy

 Principle 1
 Money now is worth more than money in future
 Principle 2
 All that counts is the difference among alternatives
 Principle 3
 Marginal revenue must exceed marginal cost
 Principle 4
 Additional risk is not taken without expected additional return
 Money-time relation and cash flow

 The way interest operates reflects the fact that money has a
time value.
amounts of interest depend on lengths of time; interest rates. for
example, are typically given in terms of a percentage per year.
 the principle of the time value of money defined as
The economic value of a sum depends on when the sum is
received. Because money has both earning power and
purchasing power over time
(i.e., it can be put to work, earning more money for its owner).
a dollar received today has a greater value than a dollar
received at some future time
 Money-time relation and cash flow

 When we deal with large amounts of money, long periods of

time, or high interest rates, the change in the value of a sum
of money over time becomes extremely significant.
 For example, at a current annual interest rate of 10%. $1
million will earn $100,000 in interest in a year; thus, to
wait a year to receive $1 million clearly involves a
significant sacrifice.
 When deciding among alternative proposals, we must take
into account the operation of interest and the time value of
money in order to make valid comparisons of different
amounts at various times
 Money-time relation and cash flow

 When financial institutions quote lending or

borrowing interest rates in the marketplace, those
interest rates reflect the desired earning rate, as
well as any protection from loss in the future
purchasing power of money because of inflation
 interest rates, adjusted for inflation, rise and fall to
balance the amount saved with the amount
borrowed, which affects the allocation of scarce
resources between present and future uses.
 Principle 1
An instant dollar is worth more than a distant dollar…

Today 6 months later

 Principle 2
Only the cost (resource) difference among alternatives counts

Option Monthly Monthly Cash paid Monthly Salvage

Fuel Cost Maintenance at signing payment Value at end
(cash of year 3
outlay )

Buy $960 $550 $6,500 $350 $9,000

Lease $960 $550 $2,400 $550 0

The data shown in the green fields are irrelevant items for decision making,
since their financial impact is identical in both cases
 Principle 3
Marginal (unit) revenue has to exceed marginal cost, in order to
increase production

Marginal
cost
Manufacturing cost 1 unit

Marginal
revenue
Sales revenue 1 unit
 Principle 4
Additional risk is not taken without a suitable expected additional
return

Investment Class Potential Expected

Risk Return

Savings account Lowest 1.5%

(cash)
Bond (debt) Moderate 4.8%
Stock (equity) Highest 11.5%

A simple illustrative example. Note that all investments imply

some risk: portfolio management is a key issue in finance
 Decision making in Engineering Economy

 Engineering takes design ideas to development

 Decisions made during design stage will affect the
cost of the product
 In this process engineers will make decisions
involving money, and the advantage one may
obtain in the future as a result of this decision …
 Decision making in Engineering Economy

 Engineering decisions however differ from

Economic Decisions
 Engineering decisions are usually time invariant
 Economic decisions however involve future
predictions, which may be different
 Engineers would therefore be involved in decision making
involving design, production, marketing , sales etc leading to
Engineering Economic Decisions
 Engineering Economy

 Therefore Engineering Economy deals with the

concepts and techniques of analysis useful in
evaluating the worth of systems, products, and
services in relation to their costs
 Engineering Economy

 It is used to answer many different questions

 Which engineering projects are worthwhile?
 Has the mining or petroleum engineer shown that the mineral or
oil deposits is worth developing?
 Which engineering projects should have a higher priority?
 Has the industrial engineer shown which factory improvement
projects should be funded with the available dollars?
 How should the engineering project be designed?
 Has civil or mechanical engineer chosen the best thickness for
insulation?
 The decisions making Process.

With the same logic engineering projects go through

stages of decision making that includes…
 An assessment of their
 technical feasibility
 Financial feasibility
 Environmental impact etc..
 Out of this decisions the economic feasibility of
projects is one key consideration
 Engineering economic decisions..

 Engineering economic decisions includes

 Choosing an appropriate Design

 the measurement of investment attractiveness,

 involves predicting or forecasting product sales, product

selling price, and
 various costs over some future time frame- such as 5 years, 10
years, 25 years, etc.
 Engineering decisions..(Cont…)

 In general engineering economy deals with justification

and selection of projects.
 The purpose of this course is therefore to expose
engineering students to the methods which are widely
used for evaluation of projects.
Importance of Engineering Economic Decisions

 Engineers “Design”
 Engineers must be concerned with the
economic aspects of designs and projects they
recommend and perform
 Analysis
 Design
 Synthesis
 Engineering Economy

Engineers must work within the realm of economics

and justification of engineering projects
 Work with limited funds (capital)
 Capital is not unlimited – ration
 Capital does not belong to the firm
 Belongs to the Owners of the firm
 Capital is not “free”…it has a “cost”
 Engineering Economy

 Engineering economy is involved with the

 formulation,
 estimation, and
 evaluation of economic outcomes when
 alternatives to accomplish a defined purpose are available.
 Engineering economy is involved with the application of
defined mathematical relationships that aid in the
comparison of economic alternatives
 Engineering economy is based mainly on estimates of future events
and must deal with the future and risk and uncertainty
 Engineering Economy

 One issue of concern in Engineering Economy is…

 The parameters within an engineering economy

problem can and will vary over time…

 Therefore Parameters that can vary will dictate a

numerical outcome hence applying and understanding
“Sensitivity Analysis” plays a major role in the
assessment of most, if not all, engineering economy
problems.
 Engineering Economy : Problem-Solving Approach

1. Understand the Problem

2. Collect all relevant data/information
3. Define the feasible alternatives
4. Evaluate each alternative
5. Select the “best” alternative
6. Implement and monitor

Major Role of Engineering

Economy
 Engineering Economy : Problem-Solving Approach

1. Understand the Problem

2. Collect all relevant data/information
3. Define the feasible alternatives
4. Evaluate each alternative
5. Select the “best” alternative
6. Implement and monitor

One of the more difficult

tasks
 Engineering Economy : Problem-Solving Approach

1. Understand the Problem

2. Collect all relevant data/information
3. Define the feasible alternatives
4. Evaluate each alternative
5. Select the “best” alternative
6. Implement and monitor Where the major tools of
Engr. Economy are
applied
 Engineering Economy : Problem-Solving Approach

1. Understand the Problem

2. Collect all relevant data/information
3. Define the feasible alternatives
4. Evaluate each alternative
5. Select the “best” alternative
6. Implement and monitor Tools
Present Worth, Future Worth
Annual Worth, Rate of Return
Benefit/Cost, Payback,
Capitalized Cost, Value Added
 Performing An Engineering Economy Study

• In order to apply economic analysis techniques

below terms and concepts need to be
understood well.
• Alternatives
• Cash flows
• Alternative selection
• Evaluation criteria
• Intangible factors
• Time value of money
 Performing An Engineering Economy Study

• To have a problem, one must have alternatives (two

or more ways to solve a problem)
• Alternative ways to solve a problem must first be
identified
• Estimate the cash flows for the alternatives
• Analyze the cash flows for each alternative
 Performing An Engineering Economy Study: Alternatives

• To analyze, one must have:

• Concept of the time value of $$
• An Interest Rate
• Some measure of economic worth
• Evaluate and weigh
• Factor in noneconomic parameters
• Select, implement, and monitor
 Performing An Engineering Economy Study:
Needed Parameters

• First cost (investment amounts)

• Estimates of useful or project life
• Estimated future cash flows (revenues and
expenses and salvage values)
• Interest rate
• Inflation and tax effects
 Performing An Engineering Economy Study:
Cash Flows

• Estimate flows of money coming into the firm –

revenues salvage values, etc. (magnitude and
timing) – positive cash flows
• Estimates of investment costs, operating costs,
taxes paid – negative cash flows
Performing An Engineering Economy Study: Alternatives

• Each problem will have at least one alternative – DO

NOTHING
• May not be free and may have future costs
associated
• Do not overlook this option!
 Performing An Engineering Economy Study:
Alternatives

•Goal: Define, Evaluate, Select and Execute

The Question:
Do Which One do we
Alt. 1
Nothing accept?
 Performing An Engineering Economy Study:
Mutually Exclusive

• Select One and only one from a set of

feasible alternatives
• Once an alternative is selected, the
remaining alternatives are excluded at that
point.
 Performing An Engineering Economy Study: More
Alternatives

• Goal: Define, Evaluate, Select and Execute

Do
Nothing
Alt. 1
………... Alt. j

Which one do we accept?

 Performing An Engineering Economy Study:
Default Position

• If all of the proposed alternatives are not

economically desirable then…
• One usually defaults to the DO-NOTHING
alternative
 Principles of economic decision
1. Develop an alternatives;
 The final choice (decision) is among alternatives. The
alternatives need to be identified and then defined for
subsequent analysis.
2. Focus on the Differences
 Only the differences in expected future outcomes among the
alternatives are relevant to their comparison and should be
considered in the decision
3. Use a Consistent Viewpoint;
 The prospective outcomes of the alternatives, economic and
other, should be consistently developed from a defined
viewpoint (perspective).
4. Use a Common Unit of Measure;
 Using a common unit of measurement to enumerate as many of the
prospective outcomes as possible will make easier the analysis and
comparison of alternatives
5. Consider All Relevant Criteria;
 Selection of a preferred alternative (decision making) requires
the use of a criterion (or several criteria). The decision process
should consider the outcomes enumerated in the monetary
unit and those expressed in some other unit of measurement or
made explicit in a descriptive manner.
6. Make Uncertainty Explicit;
 Uncertainty is inherent in projecting (or estimating) the future
outcomes of the alternatives and should be recognized in their
analysis and comparison
7. Revisit Your Decisions
 Improved decision making results from an adaptive process; to
the extent practicable, the initial projected outcomes of the
selected alternative should be subsequently compared with
actual results achieved.
 Decision-Making Process

 Typical decisions
 Cost reduction
 (e.g., equipment, tooling, facility layout)
 Plant expansion
 (e.g., to increase capacity, sales)
 Equipment selection
 Lease or buy decisions
 Make or buy decisions
 Equipment replacement
Thank you