Unit I

Introduction to Engineering Economics: Review of engineering economics, elements of

engineering economics, valuation of time, goals and objectives, principles of economic

analysis, Discounted cash flows: analysis of costs and benefits, methods of economic

analysis; suitability, analysis for null alternative, mechanisms to deal with risks.
Economics is the science which deals with production, distribution and consumption of goods

and services.

Microeconomics : Branch of economics that deals with the behavior of individual

economic units—consumers, firms, workers, and investors—as well as the markets that these

units comprise.

Macro economics : Branch of economics that deals with aggregate economic variables,

such as the level and growth rate of national output, interest rates, unemployment, and

inflation.
 Engineering economics is a critical discipline that enhances the decision-making
process in engineering projects. Its focus on economic principles, time value of money,
cost analysis, and quantitative techniques contributes to the successful planning,
implementation, and management of projects. The integration of economic
considerations with engineering expertise ensures a holistic approach to project
development and sustainability.

Engineering economics is a branch of economics that applies economic

principles to analyze, evaluate, and make decisions related to engineering projects and
activities. It involves the systematic assessment of the financial aspects of engineering
projects, with the goal of optimizing resource allocation and ensuring the economic
viability of the projects.
Review of Engineering Economics:
[Link] of Economics and Engineering:
Engineering economics brings together economic theories and engineering methodologies to
provide a comprehensive framework for decision-making in the field of engineering. It
recognizes the importance of both technical feasibility and economic viability.
[Link] Value of Money:
The recognition of the time value of money is fundamental in engineering economics.
Concepts such as discounting and compounding are crucial for evaluating the present and
future worth of cash flows. This ensures that financial analyses account for the temporal
nature of investments and returns.
[Link] Analysis:
Engineering economics delves into various cost concepts, including fixed costs, variable costs,
opportunity costs, and sunk costs. Understanding these concepts is essential for accurate
budgeting, cost estimation, and financial decision-making.
[Link] Analysis Techniques:
The discipline employs a range of quantitative techniques for economic analysis, such as Net
Present Value (NPV), Internal Rate of Return (IRR), Benefit-Cost Ratio, Payback Period, and
Break-even Analysis. These tools assist in evaluating the financial viability of projects and
comparing alternative solutions.
5. Decision Support:
Engineering economics serves as a valuable decision-support tool. By considering financial factors alongside technical
considerations, it helps stakeholders make well-informed choices. This is crucial for optimizing resource allocation and
ensuring the success of engineering projects.
6. Feasibility Studies:
The discipline involves conducting feasibility studies that assess not only economic factors but also technical,
environmental, and social aspects of projects. This holistic approach ensures that projects align with organizational
goals and contribute to sustainable development.
7. Optimization and Risk Management:
Engineering economics aims to optimize resource allocation to maximize returns while minimizing costs. Additionally,
it addresses risk by identifying and analyzing potential uncertainties associated with projects. This allows for the
development of strategies to manage and mitigate risks.
8. Sensitivity Analysis:
Sensitivity analysis is a valuable tool in engineering economics, helping to assess the robustness of financial models.
By examining how changes in key variables impact project outcomes, stakeholders can better understand the potential
risks and uncertainties associated with their decisions.
9. Inflation and Deflation Considerations:
Takes into account the impact of inflation or deflation on project costs and revenues. Adjusting for changes in the
purchasing power of money is crucial for accurate economic analysis.
10. Legal and Regulatory Factors:
Considers legal and regulatory requirements that may impact the financial aspects of a project, including permits,
taxes, and compliance with industry standards.
Objectives of Engineering Economics
[Link] Viability Assessment: Evaluate the financial feasibility of engineering projects to ensure they generate positive
returns on investment.
[Link] Resource Allocation: Determine the most efficient allocation of resources, including financial, human, and
material resources, to maximize project outcomes.
[Link] Estimation and Control: Develop accurate cost estimates for engineering projects and implement cost control
measures to prevent budget overruns.
[Link] Management: Incorporate time value of money principles to optimize project timelines, ensuring efficient use of
resources and timely completion.
[Link] Assessment and Management: Identify, assess, and manage risks associated with engineering projects, considering
uncertainties that may impact financial outcomes.
[Link] Analysis of Alternatives: Conduct thorough economic analysis to compare different project alternatives and
select the most economically viable option.
[Link] Decision Support: Provide decision support for investments by using financial metrics such as Net Present
Value (NPV) and Internal Rate of Return (IRR).
[Link] Studies: Conduct comprehensive feasibility studies that consider technical, economic, environmental, and social
aspects to determine project viability.
[Link] Development Integration: Integrate economic considerations with environmental and social factors to
promote sustainable development in engineering projects.
[Link] Cash Flow Analysis: Analyze and project cash flows throughout the lifecycle of a project to understand the timing
and magnitude of financial inflows and outflows.
11. Budgeting and Financial Planning: Develop and maintain realistic budgets and financial plans for engineering projects,
ensuring financial goals are met.
12. Life Cycle Cost Analysis: Consider the total cost of ownership over the entire life cycle of a project, including initial costs,
operational costs, and maintenance costs.
13. Value Engineering: Apply value engineering principles to optimize project costs without compromising performance or
quality.
14. Legal and Ethical Compliance: Ensure that engineering projects comply with relevant legal and ethical standards,
minimizing the risk of legal issues and disputes.
15. Communication of Economic Information: Effectively communicate economic information to stakeholders, providing
them with the necessary insights for decision-making.
16. Continuous Improvement: Review and learn from past projects, incorporating feedback and lessons learned to improve
the economic decision-making process.
17. Public and Stakeholder Engagement: Engage with the public and stakeholders to address economic concerns, gather
input, and ensure projects align with community expectations.
Principles Of Engineering Economic Analysis
• Opportunity Cost: The cost of an action is not just the monetary
expense but also includes the value of the best alternative forgone.
• Marginal Analysis: Decision-making should be based on comparing
the additional benefits and costs of incremental changes.
• Time Value of Money: A given amount of money has different
values at different points in time due to factors such as interest rates
and inflation.
• Incremental Principle: Evaluate the incremental changes in
benefits and costs when comparing alternatives.
• Sunk Cost Principle: Sunk costs, which are costs that have already
been incurred and cannot be recovered, should not influence future
decisions.
Principles Of Engineering Economic Analysis
• Equity and Efficiency: Economic analysis should consider both equity
(fairness) and efficiency (maximizing overall welfare).
• Diminishing Marginal Returns: As the use of a resource increases, the
additional benefits derived from each additional unit may decrease.
• Risk and Uncertainty: Decision-makers should consider the potential impact
of risk and uncertainty on outcomes.
• Pareto Efficiency : A situation is Pareto efficient when no one can be made
better off without making someone else worse off.
• Social Discount Rate: Consider the social perspective when discounting
future benefits and costs.
• Cost-Benefit Analysis: Compare the total costs and total benefits of a
decision, project, or policy to determine its economic desirability.
Time Value of Money (TVM) is a fundamental financial concept, stating that

the current value of money is higher than its future value, given its potential to

earn in the years to come. Thus, it suggests that a sum of money in hand is

greater in value than the same sum of money received in the next couple of

years. The idea focuses on identifying the real value of cash flows expected in

the future due to the business or individual investment decisions made from

time to time.
Firms use this idea of TVM for the following purposes:
•It helps in comparing the investment alternatives available in the market.
Investors assess the returns and other conditions to make a final decision
on what option to choose.
•Investors choose the best investment proposals based on the evaluation,
considering the TVM.
•Lenders decide the interest rates for loans, mortgages, etc., based on the
present and future value of an amount.
•The value of money, when known, helps in fixing appropriate wages and
prices of products.
Investment Evaluation Criteria
The capital budgeting process begins with assembling of investment proposals of different
departments of a firm. The departmental head will have innumerable alternative projects
available to meet his requirements.
Steps involved in the evaluation of an investment:
1) Estimation of cash flows
2) Estimation of the required rate of return
3) Application of a decision rule for making the choice
ECONOMIC ANALYSIS
Economic analysis is a process that evaluates the costs and benefits of a project,
program, or business venture. It assesses whether resources are being used effectively
and appropriately.
steps for performing an economic analysis:
[Link] the project's benefits and costs
[Link] and value the benefits and costs
[Link] the costs and benefits to reflect their economic values
[Link] the gross economic benefits with the economic costs
METHODS OF ECONOMIC ANALYSIS
[Link] Analysis: Summarizing and presenting economic data in a way that
facilitates understanding. Graphs, charts, and tables are often used to visually represent
economic trends, patterns, and relationships.
[Link] Analysis: Using statistical techniques to analyze data, make predictions,
and test hypotheses.
[Link]-Series Analysis: To identify trends, seasonality, and cyclical patterns in
variables such as GDP, inflation, or unemployment. Time-series analysis helps in
making forecasts and understanding the dynamics of economic phenomena over
different time periods.
[Link]-Sectional Analysis: Involves examining data at a specific point in time for
different individuals, groups, or entities, Regional differences.
[Link] Statics: Compares different equilibrium states before and after a change
in a particular economic variable.
[Link] Analysis: Microeconomic analysis focuses on the behavior of
individual economic units, such as consumers, firms, or markets, how individual
decision-making processes impact resource allocation, prices, and market outcomes.
9. Macroeconomic Analysis: Macroeconomic analysis examines aggregated
economic variables at the national or global level. It includes studying variables like
GDP, inflation, unemployment, and interest rates to understand the overall
performance of an economy.
8. Cost-Benefit Analysis: Cost-benefit analysis evaluates the costs and benefits
associated with a decision, project, or policy. Cost-benefit analysis is often used in
project evaluation and policy-making.
9. Input-Output Analysis: Input-output analysis examines the interdependencies
between different sectors of an economy. It is commonly used for economic planning
and policy impact assessment.
10. Game Theory: Game theory analyzes strategic interactions between rational
decision-makers, to study situations where outcomes depend on the choices of
multiple participants.
11. Econometric Modeling: Econometric modeling combines economic theory with
statistical methods to analyze economic relationships, allowing for hypothesis testing,
policy simulations, and forecasting.
12. Scenario Analysis: Scenario analysis involves considering different plausible future
scenarios and assessing their potential economic impacts.
13. Policy Impact Assessment: Policy impact assessment evaluates the potential effects
of policy changes on the economy. Impact on variables such as employment, inflation,
and economic growth.
14. Social Cost-Benefit Analysis: This method aims to assess the overall welfare
implications of a decision or policy, accounting for both economic and non-economic
factors.
15. Computational and Simulation Models: Computational models and simulations
use computer-based algorithms to analyze complex economic systems. These models
allow economists to experiment with different scenarios, simulate dynamic interactions,
and explore the emergent properties of economic systems.
SUITABILITY ANALYSIS
Suitability analysis is often applied to assess the appropriateness or feasibility of certain
economic activities, policies, or interventions in a specific context. This analytical
approach helps decision-makers evaluate various factors and criteria to determine the
suitability of different options.
•Investment Site Selection: Assessing the suitability of locations for new investments,
such as manufacturing plants, offices, or retail outlets. Criteria may include
infrastructure availability, labor force, market demand, and regulatory environment.
•Industry Location Planning: Analyzing the suitability of different regions or
countries for the establishment of specific industries. Criteria may include access to
raw materials, transportation infrastructure, skilled labor, and government policies.
•Policy Impact Assessment: Evaluating the suitability of economic policies or
interventions. This may involve assessing the impact of fiscal policies, monetary
policies, or trade agreements on various economic indicators such as employment,
inflation, and GDP.
• Market Expansion Strategy: Determining the suitability of entering new markets for
businesses. Criteria may include market size, consumer preferences, competition, and
regulatory conditions.
• Land Use Planning for Economic Development: Assessing the suitability of land for
different types of economic development, such as residential, commercial, industrial, or
agricultural uses. Criteria may include soil quality, topography, and infrastructure
availability.
• Resource Allocation in Agriculture: Analyzing the suitability of different areas for
specific crops or agricultural activities. Criteria may include soil fertility, climate
conditions, water availability, and market demand.
• Trade Policy Analysis: Evaluating the suitability of different trade policies for a
country or region. Criteria may include the impact on export-import balances,
industries, and overall economic growth.
• Infrastructure Development Planning: Assessing the suitability of locations for the
construction of infrastructure projects such as highways, airports, or ports. Criteria
may include geographical features, population density, and connectivity.
• Technology Adoption in Industries: Evaluating the suitability of adopting specific
technologies within industries. Criteria may include costs, compatibility with existing
systems, and potential productivity gains.
• Government Subsidy Allocation: Assessing the suitability of allocating government
subsidies to specific sectors or industries. Criteria may include the potential for job
creation, innovation, and overall economic impact.
• Impact of Environmental Policies: Analyzing the suitability of environmental
policies on different economic activities. Criteria may include the cost of compliance,
impact on production processes, and overall sustainability.
• Economic Development Planning: Assessing the suitability of different strategies
for promoting economic development in a region. Criteria may include education
levels, infrastructure development, access to finance, and regional disparities.
 •
Risk Identification: This involves systematically identifying potential risks and
uncertainties that may impact objectives or outcomes.
•Risk Assessment and Analysis: This involves analyzing the potential consequences of
each risk and evaluating the probability of occurrence. Quantitative methods, such as risk
matrices and qualitative methods like risk scoring, are commonly used.
•Risk Mitigation: Develop strategies to reduce the likelihood or impact of identified risks.
Risk Transfer: Transfer the financial consequences of risks to another party.
•Risk Avoidance: It may involve reevaluating project scopes, business ventures, or
investments.
•Risk Acceptance: Acknowledge and accept certain risks when their potential impact is
minimal or when mitigation efforts are not cost-effective. This is a conscious decision to
tolerate the risk without taking specific actions to mitigate it.
• Contingency Planning: This involves creating alternative courses of action or
response plans that can be implemented quickly to minimize the impact of unforeseen
events.
• Scenario Analysis: By considering multiple scenarios, organizations can better
prepare for a range of possible outcomes and develop flexible strategies.
• Monitoring and Surveillance: Continuously monitor the environment, project
progress, or market conditions for changes that may affect the risk landscape. Early
detection of new risks or changes in existing risks allows for timely adjustments to
risk management strategies.
• Crisis Management: Develop and implement crisis management plans that outline
specific actions to be taken in the event of a risk materializing. This includes
communication plans, resource allocation, and coordination of response efforts.
• Continuous Improvement: Regularly review and improve risk management
processes. This involves learning from past experiences, updating risk assessments,
and adapting strategies to changing conditions.
• Risk Communication: Establish clear communication channels to share information
about identified risks and mitigation strategies.
• Risk Culture and Training: Foster a risk-aware culture within an organization
through training programs, awareness campaigns, and the integration of risk
management principles into decision-making processes. An informed and risk-
conscious workforce is better equipped to identify and respond to potential risks.
• Diversification: Diversify invest\ents or business activities to spread risk across
different assets or markets.
• Legal and Regulatory Compliance: Ensure compliance with relevant laws and
regulations to minimize legal and regulatory risks.
Net Present Value (NPV) – NPV is the present value of that surplus which the
investor can earn over and above the expected rate of return

NPV is determined in the following manner:

NPV= Total PV of Cash inflow-Total PV of Cash Outflow

• The present value of any future cash inflow will be obviously less than the cash flow
itself. Such present value is therefore also known as Discounted Cash flow.
• The rate of interest which is used for determining the present value of cash flow is also
known as Discounting Rate.
• The Discounting rate indicates the expected rate of return for the investor. It is also
known as cut-off rate which indicates the minimum rate of return that is expected.
• If the investment project is capable of generating rate of return higher than cut-off rate,
then investing is such project is definitely beneficial. It indicates positive NPV.
• When NPV is positive, it indicates that the project is capable of generating rate of return
which is higher than cut-off rate.
• If NPV is positive, it indicates that the investor is earning more than expected.
• If NPV is negative, it indicates that the investor is earning less than expected.
• If NPV is Zero, it indicates that the investor is earning exactly what is expected.
• If NPV is negative, the investment proposal should not be accepted because of
rate of return of the project is less than expected rate of return.
• If NPV is Zero, the investor should accept the investment proposal because the
investor still earns that rate of return which is expected by such investor.
ILLUSTRATION
COMPUTE the net present value for a project with a net investment of ₹ 1,00,000 and net
cash flows year one is ₹ 55,000; for year two is ₹ 80,000 and for year three is ₹ 15,000.
Further, the company’s cost of capital is 10%?
ILLUSTRATION
Internal Rate of Return (IRR)

The internal rate of return or IRR is a discounting cash flow method to determine the rate of

return earned by the project excluding the external factor. By definition, IRR is the

discounting rate at which the present value of all future cash inflows is equal to the initial

investment, that is the rate at which the company investments break even.
When the cash inflows are not uniform over the life of the investment, the determination of
the discount rate can involve trial and error and interpolation between discounting rates.
However, IRR can be found out by using the following procedure:
Step 1: Discount the cash inflow at any random rate, say 10%, 15% or 20%.
Step 2: If the resultant NPV is negative, then discount cash flows again by lower discounting
rate to make NPV positive. Conversely, if resultant NPV is positive, then again discount cash
flows by higher discounting rate to make NPV negative.
Step 3: Use the following interpolation formula to calculate IRR.

Where:
LR= Lower Discount Rate
HR = Higher Discount Rate.
Calculate the Internal Rate of Return of an investment of ₹ 1,36,000 which yields the

following cash inflows:

The Internal Rate of Return is more than 10% but less than 12 %. In order to know the

exact rate, IRR can be obtained by applying interpolation formula.

Type equation here.

Acceptance Rules
Profitability Index (PI) or Benefit Cost Ratio (B/C Ratio)

Profitability Index is one of the time-adjusted technique for evaluating investment proposals.

It is also known Benefit Cost Ratio because the numerator measures benefits and the

denominator measures costs. PI is the relation between present value of future net cash

flows and the initial cash outlays and is expressed either in per rupee or in percentage. It is

computed as under.
𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
PI (per rupee)= 𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠 (𝑐𝑜𝑠𝑡)

𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
PI (%) = 𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠 (𝑐𝑜𝑠𝑡)
x100
From the following information calculate NPV and PI of the project assuming that the

discount factor is 10%

Initial Investment Rs. 25,000

Cash Inflows(End of the Year)

1 10,000

2 7,500

3 12,500

4 5,000
Calculation of NPV and PI of the project assuming that the discount factor is 10%
NPV Calculation
Discount factor @
Year Cash Inflows (Rs.) PV of NCF (Rs.)
10 %
1 10,000 0.909 9,090
2 7,500 0.826 6,195
3 12,500 0.751 9,388
4 5,000 0.683 3,415
Total 28,088
Initial Investment 25,000
NPV 3,088
 𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
PI (%) = 𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠 (𝑐𝑜𝑠𝑡)
x100

28,088
PI (%) = x100
25,000)

PI (%) = 1.12

Hence the project is accepted because the profitability index (PI) is greater than

one.
Risk management
Risk management is the act of identifying, understanding
and reacting to potential factors that could cause a
project to delay or fail.

•Technological issues
•Financial uncertainties
•Legal liabilities
•Natural disasters
Importance of Risk Management

•Financial benefits

•Safety

•Efficiency

•Communication

•Decision-making
 Probability and impact matrix
Risk management tools • Risks probability
Time tracking • Impact scores
• Input the task and its deadline for transparency.
• Remind team members Budget tracking
• Get up-to-date information • Project's total budget
• Spending so far
Risk data quality assessment
• Amount remaining
• Accuracy
• Reliability
Root cause analysis
• Quality
• What happened?
Risk register • Why did this happen?
• Prioritize risks • How did this happen?
• Assign team members to resolve those risks SWOT analysis
• Add notes and updates on risk progress and resolution • Strengths and opportunities
- high-quality tasks on time
Resource management
- within budget.
• Schedules
• Weaknesses
• Skills
- areas to improve
• Availability
• Threats
- external factors
- restrictions