IME 345

En g i n eer i n g Ec o n o m i c A n al y si s

CHAPTER 1
Engineering Economic Analysis
(Introduction and Overview)

Principles of Engineering Economic Analysis, 5th edition

 Why Engineering Economy Is
Important to Engineers
Ø Engineers are planners, builders, problem solvers, managers
and decision makers.
v Engineers are trained to provide answers.
Ø Through the rigorous study of science and its application to
various problems, an engineer learns to design and
implement solutions in his/her field of study.
v Simply put, engineers design and develop solutions to problems and also
formulate alternatives to take advantage of opportunities.
Ø To implement a solution, we generally have to make an
investment (spend money) in hopes of increasing profits or
achieving some level of savings.
Ø Problems are eventually defined by dollar dimensions and
decisions are evaluated by their monetary consequences.

IME 345 Engineering Economic Analysis 2

Principles of Engineering Economic Analysis, 5th edition
 Why Engineering Economy Is
Important to Engineers
qWhat are the ultimate goals of an engineering
design?
1. Technical Considerations
Ø Technical Feasibility: In order to ensure the implementation
of the design, the solutions provided must obey the laws of
nature and science
Ø Technical Efficiency: Because there may be many solutions
to a problem, the best technical solution should be sought.
Examples include designing solutions that
§Generate the least waste
§Consume the least energy
§Perform reliably in adverse conditions
§Allow for easy production or maintenance

IME 345 Engineering Economic Analysis 3

Principles of Engineering Economic Analysis, 5th edition
 Why Engineering Economy Is
Important to Engineers
qWhat are the ultimate goals of an
engineering design?
2. Economic Considerations
Ø Economic Feasibility: The solutions provided
must not exceed monetary budget limits
Ø Economic Efficiency: The most economical of
the many technical solutions to a problem should
be chosen

IME 345 Engineering Economic Analysis 4

Principles of Engineering Economic Analysis, 5th edition
 A Project Engineering Activity
Design and Construction of an Airplane
qA very expensive process that takes input
from a number of professionals, including
many engineers:
Ø Aerospace engineers may design the body and
wings for optimal lift and minimal wind resistance
Ø Chemical engineers may analyze and reduce the
corrosiveness of the jet fuel such that tanks do not
rupture
Ø Civil engineers may reduce the weight of the plane’
s shell without compromising the structural
integrity of the vessel.
IME 345 Engineering Economic Analysis 5
Principles of Engineering Economic Analysis, 5th edition
 A Project Engineering Activity
Design and Construction of an Airplane
Ø Computer Science engineers may develop
software for automated takeoff and landing
procedures
Ø Electrical and computer engineers may
design the hardware, circuitry, and sensors
used to control the aircraft
Ø Environmental engineers may design filters to
reduce the pollutants dispersed through the
plane’ s exhaust system.
Ø Engineering managers may coordinate the
activities of the entire team.

IME 345 Engineering Economic Analysis 6

Principles of Engineering Economic Analysis, 5th edition
 A Project Engineering Activity
Design and Construction of an Airplane
Ø Industrial and manufacturing engineers may
design the process to build the airplane
(including job and personnel scheduling) as
well as locate the facility.
Ø Material science engineers may develop new
composites to reduce the weight of the plane.
Ø Mechanical engineers may design the turbine
engines such that the plane is quieter and
more fuel efficient.

IME 345 Engineering Economic Analysis 7

Principles of Engineering Economic Analysis, 5th edition
 Co u r s e Ob j ec ti v es
Course objectives are for you to
§be prepared for the economic justification
portion of the FE exam
§be able to prepare economic justifications
for engineering proposals
§be able to manage personal finances and
make wise investment decisions
§be able to evaluate economic justifications
performed by others

Principles of Engineering Economic Analysis, 5th edition

 Co u r s e Ob j ec ti v es
Other course objectives are for you to
§be comfortable using financial language
§be aware of tradeoffs involving expenses
and capital costs under tax and inflation
conditions
§have fun!

Principles of Engineering Economic Analysis, 5th edition

 En g i n eer i n g eco n o m i c an al y si s: using a
combination of quantitative and
qualitative techniques to analyze
economic differences among
engineering design alternatives in
selecting the preferred design

Principles of Engineering Economic Analysis, 5th edition

 Wh at Is In c l u d ed i n Ch ap ter 1
1. The importance of the time value of
money (TVOM)
2. Four discounted cash flow rules
3. Ten principles of engineering
economic analysis
4. A 7-step approach for performing
engineering economic analyses
5. When the TVOM can be ignored

Principles of Engineering Economic Analysis, 5th edition

 Fundamental Concept

Money has a time value

Principles of Engineering Economic Analysis, 5th edition

 Ti m e Val u e o f Mo n ey
• Would you rather receive $1000 today or $1000 a year from
today?
• Would you rather receive $1000 today or $1050 a year from
today?
• Would you rather receive $1000 today or $1100 a year from
today?
• Would you rather receive $1000 today or $1500 a year from
today?
• Would you rather receive $1000 today or $2000 a year from
today?
• Would you rather receive $1000 today or $5000 a year from
today?
• Would you rather receive $1000 today or $10,000 a year from
today?
• Would you rather receive $1000 today or $100,000 a year
from today?

Principles of Engineering Economic Analysis, 5th edition

 Ti m e Val u e o f Mo n ey
• Regardless of the value of inflation, money
has a time value due to its “earning power”
• Suppose you arrive in a city by airplane and
need a car
§you can buy a car
§you can rent a car
• Suppose you arrive in a city and need a place
to stay
§you can buy a house or condominium
§you can rent a house, apartment, or hotel room
• Suppose you arrive in a city and need money
§you can rent money from a business or person

Principles of Engineering Economic Analysis, 5th edition

 Fo u r Di s c o u n ted Cas h Fl o w Ru l es
1. Money has a time value;
2. Money cannot be added or
subtracted unless it occurs at the
same point(s) in time;
3. To move money forward one time
unit, multiply by one plus the
discount or interest rate;
4. To move money backward one time
unit, divide by one plus the discount
or interest rate.
Principles of Engineering Economic Analysis, 5th edition
 Pr i n c i p l es o f En g i n eer i n g
Ec o n o m i c A n al y s i s
1. Money has a time value.
2. Make investments that are
economically justified.
3. Choose the mutually exclusive
investment alternative that maximizes
economic worth.
4. Two investment alternatives are
equivalent if they have the same
economic worth.

Principles of Engineering Economic Analysis, 5th edition

 Pr i n c i p l es o f En g i n eer i n g
Ec o n o m i c A n al y s i s
5. Marginal revenue must exceed
marginal cost.
6. Continue to invest as long as each
additional increment of investment
yields a return that is greater than the
investor’s TVOM.
7. Consider only differences in cash
flows among investment alternatives.

Principles of Engineering Economic Analysis, 5th edition

 Pr i n c i p l es o f En g i n eer i n g
Ec o n o m i c A n al y s i s
8. Compare investment alternatives over
a common period of time.
9. Risks and returns tend to be positively
correlated.
10. Past costs are irrelevant in
engineering economic analyses,
unless they impact future costs.

Principles of Engineering Economic Analysis, 5th edition

 Ec o n o m i c J u sti f i c ati o n
Sev en Qu esti o n s to A n sw er
" Wh at i n v es tm en t al ter n ati v es ar e av ai lab l e?
" Wh at i s th e l en g th o f ti m e o v er w h i c h th e
d ec i s i o n i s to b e m ad e?
" Wh at TVOM w i l l b e u s ed to m o v e m o n i es
f o r w ar d an d /o r b ac k w ar d in t im e?
" Wh at ar e th e b es t es ti m ates o f th e c as h f l o w s
f o r eac h alt er n at iv e?
" Wh i c h i n v es tm en t al ter n ati v e s eem s b es t,
b as ed o n th e ec o n o m i c c r i ter i o n c h o s en ?
" Ho w s en s i ti v e i s th e d ec is io n t o c h an g es o r
er r o r s in t h e es ti m ates u s ed i n th e an al y s i s ?
" Wh i c h i n v es tm en t i s r ec o mm en d ed ?
Principles of Engineering Economic Analysis, 5th edition
 SEA T
Sy s tem ati c Ec o n o m i c A n al y s i s Tec h n i q u e
Sev en -St ep Pr o c ed u r e
§Id en ti f y th e i n v estm en t al ter n ati v es
§Def i n e th e p l an n i n g h o r i zo n
§Sp ec i f y th e d i sc o u n t r ate
§Esti m ate th e c ash f l ow s
§Co m p ar e th e al ter n ati ves
§Per f o r m su p p l em en tar y an al ys es
§Sel ec t th e p r ef er r ed al ter n ati v e
Principles of Engineering Economic Analysis, 5th edition
 Step 1: Identify the Feasible Alternatives

§Most important step!

§Beware the “Do Nothing”alternative
§Consider a range of alternatives
§Be objective!

Principles of Engineering Economic Analysis, 5th edition

 Example 1.5
A firm is considering three investment
proposals (A,B, & C). A requires $1M
investment, B requires $2.5M, and C
requires $3M. The firm has $4.5M to
invest. C is contingent on A; B and C
are mutually exclusive. The “ do
nothing”alternative is not feasible.
Form the set of mutually exclusive
investment alternatives that exists.

Principles of Engineering Economic Analysis, 5th edition

 Example 1.5 Forming Investment
Alternatives from Investment Proposals

Principles of Engineering Economic Analysis, 5th edition

 Example 1.5 Forming Investment
Alternatives from Investment Proposals

Principles of Engineering Economic Analysis, 5th edition

 Step 2: Define the Planning Horizon*

§The width of the window

§U.S. < 5 yrs; Japan > 15 yrs
§Planning horizon vs. working life vs.
depreciable life
§Standard planning horizons
§Impact of too short a planning horizon
§Impact of too long a planning horizon

Principles of Engineering Economic Analysis, 5th edition * See Chapter 4

 Step 3: Specify the Discount Rate*

§Hurdle rate, interest rate, return on

investment (ROI), minimum attractive
rate of return (MARR)
§Money has a time value!
§Opportunity cost for money

Principles of Engineering Economic Analysis, 5th edition * See Chapter 4

 Step 4: Estimate the Cash Flows*
§Examples of cash flows
§Depreciation is not a cash flow
§Annual cash flows
§“Best estimates”
§Tangibles and intangibles
§Future estimates, not past estimates
§Costs and revenues
§Incremental cash flows
§Don’ t forget the competition!

Principles of Engineering Economic Analysis, 5th edition *see Chapter 16

 Step 5: Compare the Investment Alternatives*
§Present worth method (PW) (* Ch. 5)
§Capitalized worth method (CW) (* Ch. 5)
§Discounted payback period method (DPBP)
(* Ch. 5)
§Payback period method (PBP) (* Ch. 5)
§Future worth method (FW) (* Ch. 6)
§Annual worth method (AW) (* Ch. 7)
§Internal rate of return method (IRR) (* Ch. 8)
§External rate of return method (ERR) (* Ch. 8)
§Incremental rate of return (ΔROR) (* Ch. 8)
§Benefit/Cost ratio method (B/C) (* Ch. 14)

Principles of Engineering Economic Analysis, 5th edition

 Step 6: Perform Supplementary Analyses*
§Breakeven analysis
§Sensitivity analysis
§Risk analysis
§Going the extra mile!
§Beware of “paralysis of analysis”

Principles of Engineering Economic Analysis, 5th edition *see Chapter 13

 Break-even, Sensitivity, and Risk Analyses
§Break-even analysis
determining the value of one or more
parameters that will make the PW=0
§Sensitivity analysis
determining the impact of a range of values for
one or more parameters on the measure of
merit
§Risk analysis
determining the probability the PW>0, given
probability distributions for one or more
parameters

Principles of Engineering Economic Analysis, 5th edition

 Step 7: Select the Preferred Alternative*
§Obtain the support of the users of the
recommended system
§Pre-sell the recommendation
§Eliminate surprises
§Do not over-sell the technical aspects of the
recommended system
§Technical aspects seldom convince
management to make the required investment
§The decision-makers’ perspectives are broad
§Know their priorities and tailor the economic
justification package accordingly

Principles of Engineering Economic Analysis, 5th edition *see Chapter 15

 Step 7: Select the Preferred Alternative
§Relate the proposed investments to the well-
being of the firm
§Show how the investment relates to the firm’ s
strategic plan and stated corporate objectives
§Your proposal will be only one of many
submitted and many will not be funded
§Failure to fund your proposal does not mean
management is stupid
§Management’ s decision to fund your proposal
does not mean they are brilliant

Principles of Engineering Economic Analysis, 5th edition

 Step 7: Select the Preferred Alternative
§Don’ t confuse unfavorable results with destiny
§Timing is everything!
§Profit maximization is not always the “name of
the game,”but “selling”is!
§A firm’ s ability to finance the proposal is as
important as its economic merit
§Finally, remember the following three things:
Ø Think big - you get what you pay for, so don’t be
penny-wise and dollar-foolish
Ø The “Golden Rule,”those with gold make the rules!
Ø The less you bet the more you stand to lose in case
you win!

Principles of Engineering Economic Analysis, 5th edition

 Weighted Factor Comparison of Alternatives

Example 1.8
Three investment alternatives (A,B,C) are being considered
by the Ajax Mfg. Co. The PWs are $25K, $20K, and $18K,
respectively. There are differences in the quality (Q) of the
tools being considered, the time (T) to fill a customer’
s
order, and the reputations (R) of the tool suppliers.

Principles of Engineering Economic Analysis, 5th edition

 Weighted Factor Comparison Form
Company: Prepared by: Date:
Description of investment:

Principles of Engineering Economic Analysis, 5th edition

 Weighted Factor Comparison Form
Company: Ajax Tool Co. Prepared by: JAW Date: April 1, 2009
Description of investment: order picking equipment for distribution center

Principles of Engineering Economic Analysis, 5th edition

 Weighted Factor Comparison Form
Company: Ajax Tool Co. Prepared by: JAW Date: April 1, 2009
Description of investment: order picking equipment for distribution center

Principles of Engineering Economic Analysis, 5th edition

 Wh en th e TVOM Need No t B e
Co n si d er ed
1. When no investment of capital is required
2. When all cash flows occur in a limited time period,
e.g., less than a year
3. When annual cash flows are roughly proportional
to cash flows the first year
4. When the same capital investment is required for
all alternatives
5. When there are no essential differences in cash
flows among the alternatives after the first year

Principles of Engineering Economic Analysis, 5th edition

 Example 1.9
Six college students are making plans for spring break. They are
considering traveling 1200 miles to Florida by bus, train, plane, rental
cars, or rental van. Due to bus and train schedules, they limited their
options to plane, two rental cars, or a rental van.

The final data used in their analysis of transportation options are as

follows: round-trip airfare per person ($300); daily rental rate for each
car, all charges except fuel ($50); rental car gas mileage (20
miles/gallon); drop charge for each car ($150); daily rental rate for a van,
all charges except fuel ($80); rental van gas mileage (12 miles/gallon);
drop charge for the van ($225); cost to travel to or from the airport at the
spring break destination ($50 per cab, two cabs required); and average
price of gasoline ($4.25/gallon). If they keep the rental vehicle, the
charges will be for 7 days; if they drop the rental vehicle, the charges
will be for 2 days.

Principles of Engineering Economic Analysis, 5th edition

 Example 1.9 (Continued)
Alternatives
1. fly to/from spring break
2. use two rental cars and incur drop charges
3. use two rental cars and do not incur drop charges
4. use a rental van and incur drop charges
5. use a rental van and do not incur drop charges.

Economic Analysis
1. Total cost = 6 passengers ($300/passenger)
+ 2 taxis($50/taxi)(2 trips) = $2200.00
2. Total cost = 2 rental cars ($50/day)(2 days) + 4 drops ($150/drop)
+ 2,400 miles/car (2 cars)($4.25/gallon)/(20 miles/gallon) = $1820.00
3. Total cost = 2 rental cars ($50/day)(7 days)
+ 2,400 miles/car (2 cars)($4.25/gallon)/(20 miles/gallon) = $1720.00
4. Total cost = 1 rental van ($80/day)(2 days) + 2 drops ($225/drop)
+ 2,400 miles/van (1 van)($4.25/gallon)/(12 miles/gallon) = $1460.00
5. Total cost = 1 rental van ($80/day)(7 days)
+ 2,400 miles/van (1 van)($4.25/gallon)/(12 miles/gallon) = $1410.00

Principles of Engineering Economic Analysis, 5th edition

 Example 1.9 (Continued)
Alternatives
1. fly to/from spring break
2. use two rental cars
a. incur drop charges
b. do not incur drop charges
3. use a rental van
a. incur drop charges
b. do not incur drop charges
Economic Analysis
1. Total cost = 6 passengers ($300/passenger)
+ 2 taxis($50/taxi)(2 trips) = $2200.00
2. Driving cost = 2,400 miles/car (2 cars)($4.25/gallon)/(20 miles/gallon)
+ 2 rental cars ($50/day)(2 days) = $1220.00
a. Cost = 4 drops ($150/drop) = $600.00
b. Cost = 2 rental cars ($50/day)(5 days) = $500.00
Lowest cost = $1720.00
3. Driving cost = 2,400 miles/van (1 van)($4.25/gallon)/(12 miles/gallon)
+ 1 rental van ($80/day)(2 days) = $1010.00
a. Cost = 2 drops ($225/drop) = $450.00
b. Cost = 1 rental van ($80/day)(5 days) = $400.00
Lowest cost = $1410.00

Principles of Engineering Economic Analysis, 5th edition

 Pit Stop #1—Checking Your Pulse
• True or False: If someone offers you the choice of receiving $1000 today
versus receiving $1000 a year from today, you should take the money
today if your time value of money is greater than zero.

• True of False: A strength of the weighted factor comparison technique is

its scientific foundation and its elimination of subjectivity from decision
making.

• True or False: If your time value of money is 10% annually, then you will
be indifferent between receiving $1000 today and receiving $1100 one
year from today.

• True or False: Based on the principles of engineering economic

analysis, you should bet on the horse with the lowest odds to win,
because risk and returns tend to be positively correlated.

• True or False: Every economic decision should be based on the time

value of money.

Principles of Engineering Economic Analysis, 5th edition

 Pit Stop #1—Checking Your Pulse
• True or False: If someone offers you the choice of receiving $1000 today
versus receiving $1000 a year from today, you should take the money
today if your time value of money is greater than zero. TRUE

• True of False: A strength of the weighted factor comparison technique is

its scientific foundation and its elimination of subjectivity from decision
making. FALSE

• True or False: If your time value of money is 10% annually, then you will
be indifferent between receiving $1000 today and receiving $1100 one
year from today. TRUE

• True or False: Based on the principles of engineering economic

analysis, you should bet on the horse with the lowest odds to win,
because risk and returns tend to be positively correlated. FALSE

• True or False: Every economic decision should be based on the time

value of money. FALSE

Principles of Engineering Economic Analysis, 5th edition

 Class Practice Problem 1
(Present Economic Studies)

A company produces and sells a consumer product, and thus far

has been able to control the volume of the product by varying
the selling price. The company is seeking to maximize its net
profit. It has been concluded that the relationship between price
and demand, per month, is approximately D = 500 –5p, where p
is the price per unit in dollars. The fixed cost is $1,000 per
month, and the variable cost is $20 per month. Obtain the
answer mathematically to the following questions:

Ø What is the optimal number of units that should be produced and

sold per month?
Ø How do you know that your answer in part (a) maximizes profit?
Ø What are the breakeven sales quantities?

Principles of Engineering Economic Analysis, 5th edition

 Class Practice Problem 2
(Present Economic Studies)

An oil company is considering adding an additional grade of fuel at

its service stations. To do this, an additional 6000-gallon (about
800 cubic feet) tank must be buried at each station. Discussions
with tank fabricators indicate that the least expensive tank would
be cylindrical with minimum surface area. What size tank (in
feet) should be ordered? Express your answer in terms of the
diameter and length of the cylinder.

Ø [Hint: You may find the following information useful for this
problem:]

Ø Circumference of a circle = 2πr

Ø Area of a cirlce = πr 2

Principles of Engineering Economic Analysis, 5th edition