SEEM2440 Engineering Economics

Tutorial 1

Guo Weiwei

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 1 / 19

Principles of engineering economics

Principle 1: Develop the alternatives

Principle 2: Focus on the differences
Principle 3: Use a consistent viewpoint
Principle 4: Use a common unit of measure
Principle 5: Consider all relevant criteria
Principle 6: Make uncertainty explicit
Principle 7: Revisit your decisions

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 2 / 19

Engineering economic analysis: seven-step
procedure

Problem recognition and formulation.

Development of the feasible alternatives.
Development of the outcomes for each alternative.
Selection of criteria.
Analysis and comparison of the alternatives.
Selection of the preferred alternative.
Performance monitoring and post-evaluation of results.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 3 / 19

Indexes

Simple Index: Estimate of the cost in year n is

In
Cn = Ck ( )
Ik
where Cn is the estimated cost of the item in year n and Ck is
the cost of item in reference year k.
Composite Index: we obtain an over all index by using a
weighted average approach
 
w1 (Cn1 /Ck1 ) + ... + wm (Cnm /Ckm )
In = Ik
w1 + ... + wm

where Cnm is the cost of the m-th item in year n.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 4 / 19

Parametric Cost Estimating
Power-sizing technique
Exponential Model
X: cost capacity factor

SA X
CA = CB ( )
SB
where SA is the size of Plan A and CA is the cost of plan A.
Learning curve: the number of input resource unites needed to
produce output unit u is
Zu = K (u n )
where K is the number of input resource unites needed to
produce the first output unit and n = (logs)/(log 2) where s is
the learning curve slope parameter.
Linear regression
Guo Weiwei (CUHK) SEEM2440 Engineering Economics 5 / 19
Linear regression

y=a+bx
Pn Pn Pn
n i=1 xi yi − ( i=1 xi ) ( i=1 yi )
b= Pn Pn 2
2
n i=1 xi − ( i=1 xi )
Pn Pn
i=1 yi −b i=1 xi
a=
n

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 6 / 19

Question 1(Example 1-2)

Your friend is considering investing in a two-year MBA program. Tuition costs

will be $60,000 for two years while living expenses will be $25,000 per year. She
has $10,000 in savings, which she can spend on her education, and will need to
borrow the rest from her bank. Her annual loan repayment will be $10,500 for
ten years. She currently works as an analyst and makes $60,000 a year; after she
gets her degree she hopes to work as a manager for $150,000 a year. Use the
seven-step procedure to answer these questions:
(a) How should your friend formulate her problem?

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 7 / 19

Question 1(Example 1-2)

Your friend is considering investing in a two-year MBA program. Tuition costs

will be $60,000 for two years while living expenses will be $25,000 per year. She
has $10,000 in savings, which she can spend on her education, and will need to
borrow the rest from her bank. Her annual loan repayment will be $10,500 for
ten years. She currently works as an analyst and makes $60,000 a year; after she
gets her degree she hopes to work as a manager for $150,000 a year. Use the
seven-step procedure to answer these questions:
(a) How should your friend formulate her problem?

Solution: Your friend is debating whether or not to invest in an MBA degree.

The benefit from the degree is a higher income stream for the rest of her working
life, but she cannot be certain of getting her dream job. Her problem, therefore,
is that of risk: she takes on a large loan of $100,000 to finance the MBA, but
cannot find a job afterwards that allows her to pay it off.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 7 / 19

Question 1(Example 1-2)

(b) What are her projected costs?(Identify all costs)

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 8 / 19

Question 1(Example 1-2)

(b) What are her projected costs?(Identify all costs)

Solution:
Her costs include tuition and living expenses over two years of
$110,000($60,000+$25,000×2).
She also faces annual loan repayment of $10,500 over ten years,
generating an interest cost of $5,000($105,000-$100,000).
Finally, she also loses earning of $120,000($60,000×2) over two
years, because she quits her job.(Opportunity cost(Chapter 2))

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 8 / 19

Question 1(Example 1-2)

(c) Suggest alternatives to your friend to reduce the uncertainty associated with
finding a high-income job to pay of her loan

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 9 / 19

Question 1(Example 1-2)

(c) Suggest alternatives to your friend to reduce the uncertainty associated with
finding a high-income job to pay of her loan

Solution:
Option 1: To do a lower-cost degree, such as a part-time MBA, so that she
can work at the same time. This will reduce the direct and indirect costs of
the MBA program, as well as the size of the debt she will have to take on.
However, her expected income after this degree is also likely to be lower.
Option 2: She could postpone the MBA and save more money for it. This
will reduce the size of the loan she has to take on as well as the interest
costs associated with the loan. However, she will continue to earn at a
lower level until she completes the MBA.
Option 3: She could choose not to do the MBA at all and continue to work
at her current income level.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 9 / 19

Question 1(Example 1-2)

(d) Select a criterion for discriminating among alternatives, and use it

to advise your friend on which course of action to pursue.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 10 / 19

Question 1(Example 1-2)

(d) Select a criterion for discriminating among alternatives, and use it

to advise your friend on which course of action to pursue.

Solution: One criterion could be to minimize risk, in which case you

would advise her to take on either the second or the third option,
involving less or no debt.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 10 / 19

Question 1(Example 1-2)

(e) Attempt to analyze and compare the alternatives in view of at

least one criterion in addition to cost.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 11 / 19

Question 1(Example 1-2)

(e) Attempt to analyze and compare the alternatives in view of at

least one criterion in addition to cost.

Solution: ”Credit worthiness” could be an additional criterion,

whereby she is concerned about her credit rating. In this case, taking
on any kind of debt without a guaranteed job at the end of the MBA
would be ruled out. Hence, option (3) may be her only option.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 11 / 19

Question 1(Example 1-2)

(f) What should your friend do based on the information you and she
have generated?

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 12 / 19

Question 1(Example 1-2)

(f) What should your friend do based on the information you and she
have generated?

Solution: In order to reduce uncertainty regarding employment, your

friend should gather information on the state of the job market in
both the geographical area and the sector in which she wants to
work. She should find out which MBA programs are particularly
strong at driving recruitment in her chosen job sector. She could also
try to negotiate a job with a desired employer before starting the
MBA program.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 12 / 19

Question 2(1-4)

Tyler just wrecked his new Nissan, and the accident was his fault. The owner of
the other vehicle estimated that the costs for repairing was for $803. Tyler is
thinking of keeping the insurance companies out of the incident to keep his
driving record ”clean”. Tyler’s deductible on his comprehensive coverage
insurance is $500, and he does not want his premium to increase because of the
accident. In this regard, Tyler estimates that his annual premium will rise by $60
if he files a claim against his insurance company. In view of the above
information, Tyler’s initial decision is to write a personal check for $803 payable
to the owner of the other vehicle. Did Tyler make the most economical decision?
What other options should Tyler have explored? In your answer, be sure to state
your assumptions and quantify your thinking.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 13 / 19

Solution

Tyler is facing with two alternatives:

1) Pay the owner of the other car himself
2) File the claim against his insurance company

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 14 / 19

Solution

Tyler is facing with two alternatives:

1) Pay the owner of the other car himself
2) File the claim against his insurance company

If Tyler wants to keep his Nissan for five more years (an assumption), costs:
1) $803
2) (803 − 500) + 5 × 60 = $603

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 14 / 19

Solution

Tyler is facing with two alternatives:

1) Pay the owner of the other car himself
2) File the claim against his insurance company

If Tyler wants to keep his Nissan for five more years (an assumption), costs:
1) $803
2) (803 − 500) + 5 × 60 = $603

If Tyler wants to keep his Nissan for ten more years (an assumption), costs:
1) $803
2) (803 − 500) + 10 × 60 = $903

Assumption: The insurance premium will never drop no matter what.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 14 / 19

Solution

Other option for Tyler:

What we don’t know in this problem is the age and condition of
the other car. If we assume it’s an clunker, another option for
Tyler is to offer to buy the other car and fix it himself and then
sell it over the internet.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 15 / 19

Question 3

Prepare a composite (weighted) Index for housing construction costs

in 2008, using the following data

Type of Housing percent reference year 2008

Single Units 70 41 62
Duplex Units 5 38 57
Multiple 25 33 53

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 16 / 19

Solution

70 × (62/41) + 5 × (57/38) + 25 × (53/33)

I2008 = = 1.54
100

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 17 / 19

Question 4

If 2,722 labor hours are required for the first production unit and
1000 labor hours are required for the seventh production unit,
determine the learning curve parameter s.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 18 / 19

Solution

K=2,722
s is unknown
n=log s/log 2
The time needed to produce 7th term is

Z7 = K (7n ) = 2, 722 × 7n = 1000.

We have
n = logs/log 2 = −0.5146
and s = 0.7.

Guo Weiwei (CUHK) SEEM2440 Engineering Economics 19 / 19