Engineering Economics

10)
(EC-31

CHAPTER ONE
BASIC CONCEPTS OF ENGINEERING ECONOMY

By:- Muliye T.
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Content
Basic Concepts in Engineering Economy
Definition of engineering economy
Rational Decision-Making Process
Economic decision
Fundamental principles of engineering

economy

What is Engineering Economy?

Economic decision making for engineering systems is called engineering

economy. This definition may seem restricted to engineering projects and

systems only, engineering economy however is also study the industrial
economics and the economic and financial factors which influence industry.
Engineers are the people who are familiar with all the technicalities of
machinery and production therefore they are the best judges of the useful
lives of an asset and they also have the technical knowledge to calculate the
number of units a proposed plant would produce when operational.
In todays competitive world of business it has become essential that
engineers should practice financial project analysis for engineering projects
and make rational decisions.
Engineering economy also includes the study of accounting practices for
manufacturing concerns. Unique features of accounting for manufacturing
concerns are process costing, batch costing, cost allocation.

 Engineering economy deals with justification and selection of projects.

Many engineers work on projects which address a specified activity or a

problem. Any decision regarding the project must be justified.
In business environments, many if not all, decisions are justified using
monetary criteria such as profit. Such decisions are made at the
managerial level and many engineers become managers in manufacturing
environment.
Therefore, all engineers, regardless of their employment, should know
methods and tools used in evaluation of projects.
The purpose of engineering economy is to expose all engineering students
to the methods which are widely used for evaluation of projects.
Even though, engineering economy deals mostly with selection of projects
in business environment, the tools and methods can be and are used by
individuals and non-profit organizations such as government, hospitals, and
charitable entities, etc.
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SOME EXAMPLES
Let us present few examples in different environments where engineering
economy can facilitate the decision making process.
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 minimization of cost.
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.
Individuals: 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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Economic factors are as important as regard for the physical laws and science that
determine what can be accomplished with engineering. The following figure shows
how engineering is composed of physical and economic components:

Physical Environment: Engineers produce products and services

depending on physical laws. Physical efficiency takes the form:

System output(s)
Physical (efficiency) = -------------------------

System input(s)

Economic Environment: Much less of a quantitative nature is known

about economic environments -- this is due to economics being

involved with the actions of people, and the structure of organizations.
Satisfaction of the physical and economic environments is linked

through production and construction processes. Engineers need to

manipulate systems to achieve a balance in attributes in both the
physical and economic environments, and within the bounds of
limited resources.
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Following are some examples where engineering economy plays

a crucial role:
1. Choosing the best design for a high-efficiency gas furnace
2. Selecting the most suitable robot for a welding operation on
an automotive assembly line
3. Making a recommendation about whether jet airplanes for an
overnight delivery service should be purchased or leased
4. Considering the choice between reusable and disposable
bottles for high-demand beverages
With items 1 and 2 in particular,Note that coursework in
engineering should provide sufficient means to determine a good
design for a furnace, or a suitable robot for an assembly line, but
it is the economic evaluation that allows the further definition of
a best design or the most suitable robot.
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Rational Decision-Making Process

1.
2.
3.
4.
5.
6.

Recognize a decision problem

Define the goals or objectives
Collect all the relevant information
Identify a set of feasible decision alternatives
Select the decision criterion to use
Select the best alternative

1. Recognize the Problem

The starting point in rational decision making is recognizing that

a problem exists.
In typical situations, recognition is obvious and immediate.
An auto accident, an overdrawn check, a burned-out motor, an
exhausted supply of parts all produce the recognition of a
problem.
Once we are aware of the problem, we can solve it as best we
can. Many firms establish programs for total quality
management (TQM) or continuous improvement (CI) that are
designed to identify problems, so that they can be solved

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2.Define the Goal or Objective

The goal or objective can be a grand, overall goal of a person or a firm.
For example, a personal goal could be to lead a pleasant and

meaningful life, and a firm's goal is usually to operate profitably.

The presence of multiple, conflicting goals is often the foundation of
complex problems.
But an objective need not be a grand, overall goal of a business or an
individual.
It may be quite narrow and specific: "I want to payoff the loan on my
car by May," or "The plant must produce 300 golf carts in the next 2
weeks," are more limited objectives.
Thus, defining the objective is the act of exactly describing the task or
goal.
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3. Collect all the relevant information

To make a good decision, one must first collect

information.
In addition to all the published information, there is a
vast quantity of information that is not written down
anywhere
but is stored as individuals' knowledge and experience.
There is also information that remains un gathered.
A question like "How many people in your town would be
interested in buying a pair of left-handed scissors?"
cannot be answered by examining published data or by
asking anyone person.
Market research or other data gathering would be
required to obtain the desired information
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4.Identify Feasible Alternatives

One must keep in mind that unless the best alternative is

considered, the result will always be suboptimal.

Two types of alternatives are sometimes ignored.
First, in many situations a do-nothing alternative is feasible.This
may be the "Let's keep doing what we are now doing," or the
"Let's not spend any money on that problem" alternative.
Second, there are often feasible (but unglamorous) alternatives,
such as "Patch it up and keep it running for another year before
replacing it."
There is no way to ensure that the best alternative is among the
alternatives being considered.
One should try to be certain that all conventional alternatives
have been listed and then make a serious effort to suggest
innovative solutions.
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5.Select the decision criterion to use

The central task of decision making is choosing from among

alternatives.
How is the choice made? Logically, to choose the best
alternative, we must define what we mean by best.
There must be a criterion, or set of criteria, to judge which
alternative is best.
Since we are dealing in relative terms, rather than absolute
values, the selection will be the alternative that is relatively the
most desirable.

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6.Select the best alternative

Earlier we indicated that choosing the best alternative may be

simply a matter of determining which alternative best meets the

selection criterion.
But the solutions to most problems in economics have market
consequences, and intangible consequences.
Since the intangible consequences of possible alternatives are
left out of the numerical calculations, they should be
introduced into the decision-making process at this point.
The alternative to be chosen is the one that best meets the
choice criterion after considering both the numerical
consequences and the consequences not included in the
monetary analysis.
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Engineering Economic Decisions

Manufacturing

Planning

Profit

Investment
Marketing
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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 life

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Role of Engineers in Business

Create & Design
Engineering Projects

Analyze

Evaluate

Evaluate

Production Methods
Engineering Safety
Environmental Impacts
Market Assessment

Expected
Profitability
Timing of
Cash Flows
Degree of
Financial Risk

Impact on
Financial Statements
Firms Market Value
Stock Price

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Types of Strategic Engineering Economic

Decisions
Service Improvement
Equipment and Process Selection
Equipment Replacement
New Product and Product Expansion
Cost Reduction

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Service improvement

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Equipment & Process Selection

How do you choose between the Plastic SMC and the Steel

sheet stock for an auto body panel?

The choice of material will dictate the manufacturing process
for an automotive body panel as well as manufacturing costs.

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Equipment Replacement Problem

Now is the time to replace

the old machine?

If not, when is the right time
to replace the old
equipment?

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New Product and Product expansion

Shall we build or acquire a

new facility to meet the

increased demand?
Is it worth spending money to
market a new product?

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Cost Reduction
Should a company buy

equipment to perform an
operation now done
manually?
Should spend money now in
order to save more money
later?

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Types of Strategic Engineering Economic

Decisions in Service Sector

Commercial Transportation
Logistics and Distribution
Healthcare Industry
Electronic Markets and Auctions
Financial Engineering
Retails
Hospitality and Entertainment
Customer Service and Maintenance

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Example - Healthcare
Delivery
Which plan is more economically viable?

Traditional Plan: Patients visit each

service provider.

New Plan: Each service provider visits

patients

: patient
: service provider
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Fundamental Principles of
Engineering Economics
Principle 1: A nearby dollar is worth

more than a distant dollar

Principle 2: All it counts is the
differences among alternatives
Principle 3: Marginal revenue must
exceed marginal cost
Principle 4: Additional risk is not taken
without the expected additional return

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Principle 1: A nearby dollar is worth more than

a distant dollar
A fundamental concept in engineering economics is that money has
a time value associated with it. Because we can earn interest on
money received today, it is better to receive money earlier than
later. This concept will be the basic foundation for all engineering
project evaluation.

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Principle 2: All it counts is the

differences among alternatives
Option

Monthly
Fuel
Cost

Monthly Cash
Maintena outlay at
nce
signing

Monthly
payment

Salvage
Value at
end of
year 3

Buy

$960

$550

$6,500

$350

$9,000

Lease

$960

$550

$2,400

$550

Irrelevant items in decision making

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Principle 3: Marginal revenue

must exceed marginal cost
Marginal
cost
1 unit

Manufacturing cost

Sales revenue

Marginal
revenue
1 unit

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 marginal revenue must exceed marginal cost

Marginal revenue is the additional revenue made
possible by increasing the activity by one unit (or a
small unit).
Similarly, marginal cost is the additional cost incurred
by the same increase in activity.
Productive resources such as natural resources, human
resources, and capital goods available to make goods
and services are limited. Therefore, people cannot have
all the goods and services they want; as a result. they
must choose those things that produce the most.

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Principle 4: Additional risk is not taken

without the expected additional return
Investment Class

Potential
Risk

Expected
Return

Savings account Low/None

(cash)

1.5%

Bond (debt)

Moderate

4.8%

Stock (equity)

High

11.5%

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