CE 436

ENGINEERING
ECONOMY
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 First Exam Coverage
 Introduction
 Definitions; Principles of Engineering

Economy
 Engineering Economy and Design Process

 Cost Concepts for Decision Making

 Present Economy Studies

 Money-Time Relationships and Equivalence

 Interest and the Time Value of Money

 The Concept of Equivalence; Cash Flows

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 What is Economics?
 The study of how to allocate resources
efficiently to satisfy unlimited human wants

 On how individuals and societies choose to use

scarce resources.

 What are the resources

 Land

 Labor

 Capital
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 Land
 All gifts of God such as
 Water, air, minerals, sunshine

 Plants and tree growth

 Land itself which is applied to the

production process
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 Labor
 The efforts, skills, and knowledge of people which are
applied to production process.
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 Capital
 Real Capital (Physical)
 Tools, buildings, machinery – things which

have been produced which are used in

further production.
 Financial Capital
 Assets and money which are used in the

production process
 Human Capital
 Education and training applied to labor in

the production process

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 What is Engineering?
 Is the profession in which knowledge of the
mathematical and natural sciences gained by
study, experience, and practice with judgment
to develop ways to utilize, economically, the
materials and forces of nature for the benefit
of mankind.
 Economic aspects of engineering
 Physical aspects of engineering
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 What is Engineering Economy?

 Is the collection of techniques that simplify

comparisons of alternatives on an economic
basis.
 It is not a method or process for determining
what alternatives are but on the contrary it
only begins after the alternatives have been
defined.
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 What is Engineering Economy?
 While economics will be the sole criterion for
selecting the best alternatives.
 Real-world decisions usually include many
other factors in decision making process.
 Ex. In determining whether to build a nuclear-
powered, gas-fired or coal-fired power plant,
factors such as safety, air pollution, public
acceptance, water demand, waste disposal,
global warming and many others would be
considered in identifying the best alternative.
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 Basic Terminologies.
 Alternatives
 Is a stand-alone solution for a given
situation. There are always several ways of
accomplishing a given task, it is necessary to
be able to compare them in a rational
manner so that the most economical
alternative can be selected.
 Alternatives in engineering considerations

 Purchase costs (first costs)

 Anticipated useful life, yearly costs of

maintaining assets (annual maintenance
and operating costs).
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 Basic Terminologies.
 Alternatives in engineering considerations

 Anticipated resale value (salvage value)

 Interest rate

o An engineering economy analysis can be

conducted to determine which is best from
an economic point of view.
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 Basic Terminologies.
 Cash Flows
 The estimated inflows (revenues) and
outflows (costs) of money are called cash
flows. These estimates are truly the heart of
an engineering economic analysis. They also
represent the weakest part of the analysis,
because most of the numbers are judgments
about what is going to happen in the future.
Who can predict the price of oil next week,
next month or next year. No matter how
sophisticated the analysis technique, the end
result is only as reliable on the data.
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 Basic Terminologies.
 Alternative Selection
 Every situation has at least two alternatives.
There is always the alternative of inaction,
called the do-nothing (DN) alternative. This
is the as-is or status quo condition. If the
status quo alternative is selected the
decision making process should not indicate
that doing nothing is the most favorable
economic outcome at the time the evaluation
is made.
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 Basic Terminologies.
 Evaluation Criteria
 We use criteria everyday to choose between
alternatives.
 Ex. When driving to work or school, you decide to
take the best route.
“ How do you define the best?”
Was the best route the safest, shortest, fastest,
cheapest, most scenic, or what?
In economic analysis, financial units (dollar or any
other currency) are generally use as tangible basis
for evaluation. The alternative with the lowest
overall cost or highest overall net income.
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 Basic Terminologies.
 Intangible Factors
 Alternatives have non-economic or
intangible factors that are difficult to
quantify. When alternatives under
consideration are hard to distinguish
economically, intangible factors may tilt the
decisions in the direction of one of the
alternatives.
 Ex. of noneconomic factors are goodwill,
convenience, friendship, and morale.
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 Basic Terminologies.
 Time Value of Money
 It is often said that money makes money.

The statement if true, if we invest money

today, we inherently expect to have more
money in the future.
 Ex. If a person or company borrows money

today, by tomorrow more than the original

loan principal.
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 Basic Terminologies
 Investment
 means using resources to create an addition

to the present facilities

 In the economist’s standpoint it is the

diversion of resources from consumption to
uses that will improve the efficiency of the
production of the process. Consumption is
postponed so that more consumption will be
possible in the future.
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 Basic Terminologies
 Opportunity Cost
 It is one of the principal foundations on
which the whole discipline rests.
 Ex. When you make a choice between two
actions that are both beneficial to you but
you cannot do both but give up the other.
The lost pleasure may be thought of as a
cost. A benefit forgone is the same as a cost.
 Ex. An engineer prefers to work as a
consultant for 55,000 dollars compare to a
job with 67,000. Therefore the opportunity
cost is 12,000.
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 Basic Terminologies
 Cost of Capital
 This other concept is the financial cost of

capital.
 Ex. When a businessman does not have

enough funds to finance the alternative

selected. He borrows money from the bank at
20% interest per annum. When the project is
done he will earn 30% per annum.
 The 20% rate is the financial cost of capital

 The 30% is the opportunity cost of capital.

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 Basic Terminologies
 Income Tax
 Investment normally have income tax
consequences. Because income taxes are
costs to the investor, they must be included
in any economic analysis where they are
significant. In major industrialized countries
they are always taken into accounts.
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 Basic Terminologies
 Inflation
 It means that prices of goods and services

increase over time

 Deflation – means prices decrease as time

passes.
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 Principles Engineering Economy
 Develop Alternatives
 Focus on the Differences
 Use a consistent Viewpoint
 Use a Common Unit of Measure
 Consider all Relevant Criteria
 Make Uncertainty Explicit
 Revisit your decisions
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 Principles Engineering Economy
 Develop the Alternatives
 the final choice (decision) is among
alternatives. The alternatives need to be
identified and then defined for subsequent
analysis
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 Principles Engineering Economy
 Focus on the Differences
 only the differences in expected future

outcomes among the alternatives are

relevant to their comparison should be
considered in the decision.
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 Principles Engineering Economy
 Use a Consistent Viewpoint
 the prospective outcomes of the alternatives,

economic and other, should be consistently

developed from a defined viewpoint
(perspective).
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 Principles Engineering Economy
 Use a Common Unit of Measure
 using a common unit of measurement to

enumerate as many of the prospective

outcomes as possible will make easier the
analysis and comparison of alternatives.
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 Principles Engineering Economy
 Consider All relevant criteria
 Selection of preferred alternative requires

the use of a criterion/criteria. The decision

process should consider the outcomes
enumerated in the monetary unit and those
expressed in some other unit of
measurement or made explicit in a
descriptive manner
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 Principles Engineering Economy
 Make Uncertainty Explicit
 Uncertainty is inherent in projecting (or

estimating) the future outcomes of the

alternatives and should be recognized in
their analysis and comparison.
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 Principles Engineering Economy
 Revisit Your Decisions
 Improved decision making results from an

adaptive process; to the extent practicable,

the initial projected outcomes of the selected
alternative should be subsequently
compared with actual results achieved.
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 Engineering Economy and the Design Process
 An engineering economy study is
accomplished using a structured procedure
and mathematical modeling techniques. The
economic results are then used in a decision
situation that involves two or more
alternatives and normally includes other
engineering knowledge and input.
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 Engineering Economic Analysis Procedure
 Steps:
 Problem recognition, formulation and
evaluation.
 Development of the feasible alternatives
 Development of the cash flows for each
alternative
 Selection of criterion (or criteria)
 Analysis and comparison of the alternatives
 Selection of the preferred alternative
 Performance monitoring and post-evaluation
results.
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 Engineering Design Process
 1 – Problem / need definition.
 2 – problem / need formulation and evaluation
 3 – Synthesis of possible solutions (alternatives)
 4 - Analysis, optimization and evaluation
 5 – Specification of preferred alternative
 6 - Communication
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 EEA(Eng’g. Economy Analysis) Procedure Steps
 Problem Definition
 Search for Alternatives/option development
 Development of investment alternatives
 Development of perspective outcomes
 Selection of Decision criteria and analysis of
alternatives
 Selection of the preferred alternative
 Performance monitoring and post evaluation of
results.
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 Problem Definition

 must be well understood and stated in an

explicit form before the engineer proceeds with
the rest of analysis.

 is particularly important, since it provides the

basis for the rest of the analysis.
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 Problem Definition
 the term problem includes all decision
situations for which EE analysis is required.
 problem recognition: stimulated by internal

or external organizational needs or

requirements.
 problem formulation: boundary or extent of

situation is defined.
 problem evaluation: refinement of needs

and requirements.
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 Search for Alternatives/Option Development

 1 – Searching for potential alternatives and

 2 – screening them to select a smaller group of
feasible alternatives for detailed analysis and
comparison in step 5.
 Limitations:
 lack of time and money

 preconceptions of what will and what will

not work and
 lack of knowledge
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 Development of Investment Alternatives
 Most of the feasible alternatives require
investment of money, hence it becomes a
crucial step.
 The 2 most accepted approaches for
developing sound investment alternatives.
 1 – Classical Brainstorming

 2 – Nominal Group Technique

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 Classical Brainstorming
 it is based on the fundamental principles of
deferment of judgement and that quantity
breeds quality
 Four Rules of Brainstorming
 Criticism is ruled out

 Freewheeling is welcomed

 Quantity is wanted

 Combination and improvement are sought

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 Classical Brainstorming
 The most well-known and often-used technique

 Steps:

 Preparation: participants selected, preliminary

statement of problem is circulated.
 Brainstorming: a warm-up session with simple
problems is conducted, the relevant problem
and the 4 rules of Brnstmg are presented and
ideas are generated and recorded using
checklists and other techniques,
 Evaluation: the ideas are evaluated relative to
the problem.
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 Nominal Group Technique (NGT)
 involves a structured group meeting designed
or incorporate individual ideas and judgments
into group consensus.
 Sort of Group Discussion
 Facilitator is required.
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 Decision Making Procedure
 the first step is to set an objectives that we
wish to reach by means of our investment.
 Ex. For an individual investor the objective is
to have a maximum annual profit.
 For companies, annual profit and market
expansion.
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 Decision Making Procedure
 2nd step is examine alternative ways of reaching the
objectives already set.
 Ex. For individual investor the objective of annual
profit is through investment in common stocks or
bonds.
 For companies might have new logistic systems of
trucks or warehouses, expands sales program or new
product line.
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 Decision Making Procedure
 3rd step is to predict the consequences of each
alternative path to the desired objectives.
 Ex. For individual investors buy bonds, she
can predict how much he receives each year. If
the investment is 10,000 with 12% bond, he
will receive 1,200 each year.
 For companies the trucks and warehouse all
cost money, but they will bring money and
expand the market as well. Determine just
how much is the cost and the profit.
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 Decision Making Procedure
 4th step is evaluation. Once the stream of costs and
benefits for each alternative has been predicted, the
next task is to apply the method of evaluation to
determine which alternative should be selected.
 In order to evaluate examine the cash flow of each
alternatives.
 Cash flow means the stream of payments each year
either cash inflows (revenues) or cash outflows (cost).
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 Decision Making Procedure
 The 5th step is the decision itself. All that has
gone before in the process has led up to this
step.
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