BMFG 3213/4623

Engineering Economy
and Management
Introduction to Engineering
Economy
References:
1. Blank, L and Tarquin, A. Engineering Economy,8thEdition,McGraw Hill, 2017.
2. Sullivan, W.G., Wicks,E.M., and Koelling,C.P., Engineering Economy,17th Edition, Pearson, 2018
3. Park C.S., Contemporary Engineering Economics, Pearson, 5th Edition, 2011

Nor Akramin Mohamad

Faculty of Manufacturing Engineering
Universiti Teknikal Malaysia Melaka
 LEARNING OUTCOMES
1. Define engineering economics, time value of money and describe
its role in decision making.
2. Identify the steps in an engineering economy study.
3. Identify areas in which economic decisions can present
questionable ethics.
4. Identify and use engineering economic terminology and symbols.
5. Describe cash flows and how to graphically represent them.
6. Calculate simple and compound interest amounts for one or more
time periods.
7. State the meaning and role of Minimum Attractive Rate of Return
(MARR).
WHAT IS ENGINEERING ECONOMY?
• Engineering economy is the application of economic
principles and calculations to engineering problems. Many
basic economic principles may be applied in an engineering
economic analysis, depending on their applicability.
• Engineering Economy involves
– Formulating
– Estimating, and
– Evaluating
expected economic outcomes of alternatives designed to
accomplish a defined purpose
• Easy-to-use math techniques simplify the evaluation
WHY ENGINEERING ECONOMY IS
IMPORTANT TO ENGINEERS?
1. Engineers design and create. This ideas/proposal need to make
sense economically and engineer must be able to convince
others.
2. Engineers must be able to incorporate economic analysis into
their creative efforts. Often engineers must select and implement
from multiple alternatives
The fundamental approach in engineering economy is to find
which among the many alternatives is the best choice in their
monetary terms, at an engineering standpoint
3. Understanding and applying time value of money, economic
equivalence, and cost estimation are vital for engineers
4. A proper economic analysis for selection and execution is a
fundamental task of engineering
WHAT DO WE NEED TO KNOW IN
ENGINEERING ECONOMY?
• Time value of money (TVM)
• Interest rate / Rate of Return
• Simple and Compound Interest
• Commonly used symbols
• Cash Flow Diagram
• Economics Equivalences
• Quantitative measurement of profitability
• Systematic comparisons of alternatives
1-6
TIME VALUE OF MONEY (TVM)
2020 2025 RM 150,000 RM ?
versus

2015 2020
What do you think value of RM50 in
2020 compare to RM50 in 2025?
RM 150,000 RM ?

Invest and given Invest and given

interest or rate of interest or rate of
return is 5% return is 5%

2020 2021 2022

RM 10,000 RM 10,000 + RM500 RM 10,500 + RM525
= RM10,500 = RM11,025
TIME VALUE OF MONEY (TVM)
 TVM explains the change in the amount of money over time for funds owed by or owned by a
corporation/individual.

 It indicates the relationship between time and money

 That money available at the present time is worth more than the identical sum in the future due
to its potential earning capacity. A RM 10 received today is worth more than a RM 10 to be
received tomorrow.

 This is because the money you received today can be invested to earn interest. For example,
money deposited into a savings account earns a certain interest rate/rate of return and is
therefore said to be compounding in value.
Example:
if you were given RM100 today and invested it at an annual rate of only 10%, it could be worth
RM110 at the end of one year.
So, we can say, the future value of RM 100 today is RM 110 with given a 10% interest rate a year
(this also called economic equivalent that will explain further later).

 Inflation has the reverse effect on the time value of money. Because of the constant decline
in the purchasing power of money, an uninvested dollar is worth more in the present than the
same uninvested dollar will be in the future.
TIME VALUE OF MONEY (TVM)
Another way to view the TVM is that RM 10 may purchase
more or less items at different points in time.

1995 2019 2025

.

RM10 in 1995, RM10 in 2019, RM10 in 2025,

you can you can how much can
purchase 20 purchase 10 you purchase
roti canai roti canai roti canai ?
because at that because now, it
time, it cost you cost you RM
only RM 0.50 1.00 per unit
per unit

As time flows, the value of money declines

The time value of money is the most important concept in
engineering economy
GENERAL STEPS FOR
DECISION MAKING
PROCESSES
1. Understand the problem –
define objectives
2. Collect relevant information
3. Define the set of feasible
alternatives
4. Identify the criteria for
decision making
5. Evaluate the alternatives
and apply sensitivity
analysis
6. Select the “best” alternative
7. Implement the alternative
and monitor results
 ETHICS – DIFFERENT LEVELS
 Universal morals or ethics – Fundamental
beliefs: stealing, lying, harming or murdering
another are wrong
Personal morals or ethics – Beliefs that an
individual has and maintains over time; how
a universal moral is interpreted and used by
each person
 Professional or engineering ethics – Formal
standard or code that guides a person in
work activities and decision making
INTEREST AND INTEREST RATE
• Interest – the manifestation of the time value of money
• Fee that one pays to use someone else’s money
• Difference between an ending amount of money
and a beginning amount of money
• the amount charged on top of the principal by a
lender to a borrower for the use of assets.
.
 Interest = amount owed now – principal
• Interest rate – Interest paid over a time period expressed as
a percentage of principal


INTEREST AND INTEREST RATE

Ah Seng plans to borrow RM 50 000 from a bank for 1 year at 8% interest for new
calibration equipment. Calculate the interest and the total amount due after 1 year.
Solution:
Interest = RM 50 000 x (0.08) = RM 4 000
The total amount due is the sum of principal and interest.
Total due = RM 50 000 + RM 4 000 = RM 54 000
RATE OF RETURN
Rate of return is typically used when describing the amount earned
on an investment or project.
interest accrued per time unit
Rate of return (%) = x 100%
original amount

 Borrower’s perspective – interest rate paid

 Lender’s or investor’s perspective – rate of return earned

Interest paid Interest earned

Interest rate Rate of return

COMMONLY USED SYMBOLS
t = time, usually in periods such as years or months
P = value or amount of money at a time t
designated as present or time 0
F = value or amount of money at some future
time, such as at t = n periods in the future
A = series of consecutive, equal, end-of-period
amounts of money
G = gradient; series of consecutive, end-of-period
amounts of money; change by the same
amount/percentage each period
n = number of interest periods; years, months
i = interest rate or rate of return per time period;
percent per year or month
© 2012 by McGraw-Hill, New York, N.Y All
1-16
Rights Reserved
 CASH FLOWS: TERMS
• Cash Inflows – Revenues (R), receipts, incomes, savings generated by projects and activities that
flow in. Plus sign used
• Cash Outflows – Disbursements (D), costs, expenses, taxes caused by projects and activities that
flow out. Minus sign used

• Net Cash Flow (NCF) for each time period:

NCF = cash inflows – cash outflows = R – D
• End-of-period assumption:
The end-of-period convention means that all cash inflows and all cash outflows are assumed to take
place at the end of the interest period in which they actually occur.
How to estimate/project cash flow?
The task of engineers to do cost estimation from financial department, purchasing personnel,
market pricing, and the list goes on….

 Point estimate – A single-value estimate of a cash flow element of an alternative

Cash inflow: Income = RM 5,000 per month
 Range estimate – Min and max values that estimate the cash flow
Cash inflow: Income = RM 4,200 to RM 5600 per month

Point estimates are commonly used in discussion ; however, range estimates with probabilities attached provide
a better understanding of variability of economic parameters used to make decisions
CASH FLOWS DIAGRAMS
The cash flow diagram is a graphical representation of cash flows drawn on the y
axis with a time scale on the x axis. The diagram includes what is known, what is
estimated, and what is needed.
The time scale of figure is set up for 5 years.
Since the end-of-year convention places
Cash flow time scale for 5 years cash flows at the ends of years, the “1”
marks the end of year 1.

indicate what is
Positive and negative cash flows unknown and to be
determined.
A vertical arrow pointing up
indicates a positive cash flow

A down-pointing arrow
indicates a negative cash flow
CASH FLOWS DIAGRAMS
Before the diagramming of cash flows, a perspective must be determined so that
(+) or (–) signs can be assigned and the economic analysis performed correctly.
Assume you borrow RM 20 000 from a bank today to purchase an RM 18 000 used
car for cash next week, and you plan to spend the remaining RM 2 000 on a new
paint job for the car two weeks from now.
There are several perspectives possible when developing the cash flow diagram;
those of the borrower (that’s you), the banker, the car dealer, or the paint shop
owner.
The cash flow signs and amounts for these perspectives are as follows.

Perspective Activity Cash flow with sign, RM Time, week

You Borrow + 20 000 0
Buy car - 18 000 1
Paint job - 2 000 2
Banker Lender - 20 000 0
Car Dealer Car sale + 18 000 1
Painter Paint job + 2 000 2
CASH FLOWS DIAGRAMS
One, and only one, of the perspectives is selected to develop the diagram.
For your perspective, all three cash flows are involved and the diagram appears as shown in
figure below with a time scale of weeks.

you have a receipt of +

RM 20 000 now (time 0)

cash outflows (buy car)

paint job – RM 2 000 at
of – RM 18 000 at the
the end of week 2.
end of week 1

Figure: Cash flow from perspective of borrower.

CASH FLOWS DIAGRAMS: Example
Consider a machine that is going to be purchased for RM50,000. It will cost RM 3,500
each year to operate including maintenance. It will need to have its main component
recalibrate in year 3 for a cost of RM4,000 and it will be sold at year 7 for RM10,000.
Here is the cash flow diagram:
Sold at
year 7
RM10,000

Machine
purchased Operating cost and
RM50,000 maintenance every year,
Recalibrate at RM3500
year 3
RM4,000
CASH FLOWS DIAGRAMS: Example
Akramin deposits RM 10,000 into an account which pays interest at a rate of
10% per year. The amount in the account after 4 years is
amount in the
account after
4 years
Interest rate, Arrow up
10% for inflow,
shows the
amount
that
depositor
Deposit
will get
RM 10,000
Time line for 4
years
Arrow down for outflow,
from akramin (depositor)
perspective
ECONOMIC EQUIVALENCE
Definition: Combination of interest rate (rate of return) and time value of
money to determine different amounts of money at different points in
time that are economically equivalent

How it works: Use rate i and time t in upcoming relations to move money
(values of P, F and A) between time points t = 0, 1, …, n to make them
equivalent (not equal) at the rate i

Example of Equivalence: Different sums of money at different

times may be equal in economic value at a given rate

Rate of return = 10% per year

RM1000 now is economically equivalent to RM1100 one year from now,

if the RM1000 is invested at a rate of 10% per year.
SIMPLE AND COMPOUND INTEREST
• SIMPLE INTEREST
Interest is calculated using principal only
Simple Interest = (principal)(number of periods)(interest rate)
I=Pxnxi

• COMPOUND INTEREST
Interest is based on principal plus all accrued interest
That is, interest compounds over time
Compound Interest = (principal + all accrued interest) (interest rate)
I = P x (1+i)^n - P
 SIMPLE AND COMPOUND INTEREST
Simple Interest Example Simple Interest = (principal)(number of periods)(interest rate)
Pxnxi
RM100,000 lent for 3 years at simple i = 10% per year. Calculate the repayment after 3 years.

Interest = 100,000(3)(0.10) = RM30,000

Total due = 100,000 + 30,000 = RM130,000

Compound Interest Example

Compound Interest = (principal + all accrued interest) (interest rate)
P x (1+i)^n - P
RM100,000 lent for 3 years at i = 10% per year compounded. Calculate the repayment
after 3 years.
Interest, year 1: I1 = 100,000(0.10) = RM10,000
Total due, year 1: T1 = 100,000 + 10,000 = RM110,000
Interest, year 2: I2 = 110,000(0.10) = RM11,000 Simple: RM 30,000
Total due, year 2: T2 = 110,000 + 11,000 = RM121,000 Compounded: RM 33,100
Interest, year 3: I3 = 121,000(0.10) = RM12,100
Total due, year 3: T3 = 121,000 + 12,100 = RM133,100

I3 = P x (1+i)^n – P = 100,000(1+0.10)^3 – 100,000 = RM33,100

SIMPLE AND COMPOUND INTEREST
Comparison Between Simple Interest vs Compound Interest

Simple Compound
Meaning It is the interest which is a percentage of It is the interest which is a percentage of
the total principal amount both principal and accrued interest

Principal The principal is constant for simple interest Principal for compound interest keeps on
changing due to the addition of accrued
interest in the entire period

Growth Principal and interest growth is constant Principal and interest growth is rapid and
increase at a fast pace
Interest charged Interest is charged on the principal Interest is charged on the principal and the
amount only interest amount
Total Interest Pxnxi P x (1+i)^n - P
Formula P= Principal P= Principal
i= Rate per period i= Rate per period
n= No. of periods n= No. of periods

Calculation Very easy and it is also easy to understand Compared to the simple interest
calculation of compound interest is difficult
as it involves different periods of
compounding
SIMPLE AND COMPOUND INTEREST
Simple Interest Example Simple Interest = (principal)(number of periods)(interest rate)
Pxnxi
RM200,000 lent for 4 years at simple i = 5% per year. Calculate the simple interest after 4 years.

Interest = 200,000(4)(0.05) = RM40,000

Compound Interest Example

Compound Interest = (principal + all accrued interest) (interest rate)
P x (1+i)^n - P
RM200,000 lent for 4 years at i = 5% per year compounded. Calculate the compound
interest rate after 4 years.
Interest, year 1: I1 = 200,000(0.05) = RM10,000
Total due, year 1: T1 = 200,000 + 10,000 = RM210,000
Interest, year 2: I2 = 210,000(0.05) = RM10,500
Total due, year 2: T2 = 210,000 + 10,500 = RM220,500
Interest, year 3: I3 = 220,500(0.05) = RM11,025 Simple: RM 40,000
Total due, year 3: T3 = 220,500 + 11,025 = RM231,525 Compounded: RM 43,101
Interest, year 4: I4 = 231,525(0.05) = RM11,576.25
Total due, year 4: T4 = 231,525 + 11,576.25 = RM243,101.25

I3 = P x (1+i)^n – P = 200,000(1+0.05)^4 – 200,000 = RM43,101.24

SIMPLE AND COMPOUND INTEREST
Test your knowledge with the quiz below:

1) You invest RM 5000 for 8 years and get 7% interest. Simple interest =
a. 3000
b. 2000
c. 2800
d. 3500

2) You invest RM 5000 for 8 years and get 7% interest compounded at the end
of each year. Compound interest =
a. 3500
b. 3210
c. 3361
d. 3591
MINIMUM ATTRACTIVE RATE OF RETURN
 MARR is a reasonable rate
of return (percent)
established for evaluating
and selecting alternatives
 An investment is justified
economically if it is expected
to return at least the MARR
 Also termed hurdle rate,
benchmark rate and cutoff
rate
MARR Characteristics
• MARR is established by the financial managers
of the firm
• MARR is fundamentally connected to the cost
of capital
• Both types of capital financing are used to
determine the weighted average cost of capital
(WACC) and the MARR
• MARR usually considers the risk inherent to a
project
CHAPTER SUMMARY
• Engineering Economy fundamentals
 Time value of money (TVM)
 Economic equivalence
 Introduction to MARR

• Interest rate and rate of return

 Simple and compound interest
• Cash flow estimation
 Cash flow diagrams
 End-of-period assumption
 Net cash flow
 Perspectives taken for cash flow estimation
• Ethics
 Universal morals and personal morals