Engineering Economic
Hany Osman
KFUPM- Term 181
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Definition of Engineering Economy
Engineering economics is the application of economic approaches in
evaluating engineering projects/alternatives.
Engineering economy also refers to the study of the economic and
financial factors which influence industry.
Engineering economy includes the study of accounting practices for
manufacturing concerns, i.e. process costing, batch costing, cost
allocation, etc.
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Why Economics to Engineers??
Engineers are the people who are familiar with all the technicalities
of machinery and production. Therefore they are the best judges of
the useful life of an asset, they also have the technical knowledge to
calculate the number of units a proposed plant would produce, and
can introduce cost effective measures more effectively.
Engineers are able to give the precise break up of all variable and
fixed costs relating to each marginal unit produced.
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Why Economics to Engineers?
In order to perform all these functions with the ultimate objective of
making a profit for the organization it is necessary for engineers to
know financial analysis and evaluation methodologies.
Better decision making capabilities; engineering economics focuses
on those economic and financial aspects which affect the decision
making capacity of the engineer.
The purpose of teaching economics to engineers is to enable them
assessing the feasibility of projects, estimating its values and
returns, and justifying the accomplishment of a given project
from the viewpoint of engineering.
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Integration of physical and economic
environments in engineering
Economic factors have significant importance in determining/justifying what
can be accomplished with engineering. The following figure shows how
engineering is composed of physical and economic components:
Physical Produce products / services
Environment based on physical laws
Engineering
Assess the value of these
Economic
products / services based on
Environment
economic laws
There are two kinds of efficiency that engineers must be concerned with;
Physical efficiency = System output / System input
Economic efficiency = System worth / System cost
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Applications
Engineering economy is a useful tool that facilitates the decision making process in any
of these situations;
Business Environment: A small manufacturing company needs to buy a forklift
truck for material handling. Two different brands, say A and B, are being considered.
Which truck should be bought? The decision will probably be based on two
conflicting objectives; minimization of cost and maximization of efficiency.
Non-profit Organizations: A project for widening a two lane highway to four
lanes is being considered by the county board. A four lane highway may reduce the
traffic accident rate but is expected to lower property values in the immediate
neighborhood of the highway. Should the proposed highway be built? The county
board must weigh the relative benefit of lower accident rates against the possible
loss in value of homes as well as the construction cost.
Individual decisions: A new college graduate needs a new car. Should this new
car be bought or leased? Methods from engineering economy can be used for
determining the best choice.
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Applications
Real world examples
In December of 2004, Japan Airlines (JAL) announced that it would purchase
30 7E7 aircraft from Boeing Co. to replace aging Boeing 767s and Airbus
A300-600s. The planes, which carry a per-unit list price of $120 million, are to
be delivered starting in 2008. Six planes are to be delivered at the end of
years 2008 through 2012. If the annual rate of interest is 12.5% and list prices
are paid, what is the present worth of this transaction?
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Basic terminology
Interest: It is the cost of having money available for use.
Time Value of Money: It is a fact that money makes money. This
concept explains the change in the amount of money over time for
both owned and borrowed funds.
Economic Equivalence: A combination of time value of money and
interest rate that makes different sums of money at different times
have equal economic value .
Cash Flow: The flow of money into and out of a company, project, or
activity. Revenues are cash inflows and carry a positive (+) sign;
+
expenses are cash outflows and carry a negative (−) sign. −
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Basic terminology
End-of-Period Convention: To simplify calculations, cash flows
(revenues and costs) are assumed to occur at the end of a time period .
Opportunity Cost: A forgone opportunity caused by the inability to
pursue a project. Numerically, it is the largest rate of return of all the
projects not funded due to the lack of capital funds. Stated differently, it
is the return of the first project rejected because of unavailability of
funds.
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Rational Decision-Making Process
1. Recognize a decision problem
2. Define the goals or objectives
3. Collect all the relevant information
4. Identify a set of feasible decision
alternatives
5. Select the decision criterion to use
6. Select the best alternative
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Data Required to Make an Economic
Decision – an example of auto leasing
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Which Car to Lease?
Saturn vs. Honda
1. Recognize a decision problem Need a car
2. Define the goals or objectives Want mechanical security/
minimum cost, etc..
3. Collect all the relevant Gather technical as well
information as financial data
4. Identify a set of feasible Choose between Saturn
decision alternatives and Honda
5. Select the decision criterion Want minimum total cash
to use outlay
6. Select the best alternative Select Honda
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Difference between economic
decisions and other design decisions
Design decisions are basically based on physical properties, principles
of chemistry and physics, engineering design correlations while
economic decisions are based on forecasting future product sales,
selling prices, and various cost over a time period.
Design decisions are time invariant while economic decisions are not
necessarily time invariant, due to the errors in forecasting.
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Predicting the Future
Estimating a required investment
Forecasting a product demand
Estimating a selling price
Estimating a manufacturing cost
Estimating a product/equipment life
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Two Factors in Engineering
Economic Decisions
The factors of time and uncertainty
are the defining aspects of any
engineering economic decisions
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Engineering Economic Decisions
Making capital budgeting decisions is a primary function of an engineer
Design Manufacturing Profit
Planning Investment
Marketing
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Role of Engineers in Business
Create & Design
Engineering Projects
Analyze Evaluate Monitor
• Production Methods • Expected Profitability • Impact on
• Engineering Safety • Timing of Cash Flows Financial Statements
• Environmental Impacts • Degree of Financial • Firm’s Market Value
• Market Assessment Risk • Stock Price
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Types of engineering economic
decisions
The term engineering economic decision refers to all
investment decisions relating to engineering projects.
The five main types of engineering economic decisions are;
(1) new product and product expansion
(2) equipment and process selection
(3) cost reduction
(4) equipment replacement
(5) service improvement
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1- New Products/Product Expansion
Two types of expansion decisions
1- Decisions about expenditures to increase the output of an
existing facility. Is it better to build or acquire a new facility?
2- Decisions about expenditures to produce a new product or
to expand into a new geographic area.
Example
Investment in iPad A4 is estimated to be $1 billion. The cost for
Apple to build the $500 base model is $229.35.
Will there be enough demand?
Will it repeat iPhone history?
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2- Equipment, labors and Process
Selection
What material will be used for manufacturing a given product?
What kind of labors skills is required for a given manufacturing
process or a service?
Which equipment/technology shall we purchase for a given purpose?
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3- Cost Reduction
Deciding whether to produce in-house or to buy from a supplier in
order to reduce the total production cost. (make-or-buy analysis)
The expected future cash inflows from cost reduction decisions are
savings from lower operating costs
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Make or Buy Example
B & S Company manufactures several lines of pressure washers. One unique part, an
axial cam, requires specialized tools that need to be replaced. Management has decided
that the only alternative to replacing these tools is to acquire the axial cam from an
outside source. B & S’s average usage of the axial cam is 120,000 units each year over
the next five years.
Buy Option: A supplier is willing to provide the axial cam at a unit sales price of $35 if
at least 100,000 units are ordered annually.
Make Option: If the specialized tools are purchased, they will cost $2,200,000 and will
have a salvage value of $120,000 after their expected economic life of five years. With
these new tools, the direct labor and variable factory overhead will be reduced,
resulting the following estimated unit production cost:
Assuming that the firm’s interest Direct material $8.50
rate is 12%, calculate the unit cost Direct labor $5.50
under each option and determine
Variable factory overhead $4.80
whether the company should
replace the old tools or purchase Fixed factory overhead $7.50
the axial cam from an outside Total unit cost $26.30
source.
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4- Equipment replacement
This decision involves considering the cash outflows necessary to
replace obsolete equipment.
Due to market competitions and changes in technology, company’s
may decide to retire an existing equipment before it worn out.
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Equipment Replacement (example)
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5- Service or Quality Improvement
Investments in this category includes any activities that improve the
productivity, quality, or customer satisfaction in service sector, such
as banking, healthcare, insurance, security, etc… organizations
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Four Fundamental Principles in
Engineering Economics
An earlier dollar is worth more than a later dollar
All that counts is the differences among alternatives
Marginal revenue must exceed marginal cost
Additional risk is not taken without expected additional
return
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