ECONOMIC

FEASIBILITY ANALYSIS
OF ENGINEERING
PROJECTS

CHAPTER 1
INTRODUCTION

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In this course, you will learn: k i n g
n- ma C ost-be
c i s io an
neft
De alysis
 The fundamentals of engineering economy (time
value of money, interest, economic equivalence)
 To perform the steps in the economic decision
making process
– To financially evaluate engineering projects under
certainty, risk, uncertainty, and multiple options
– Numerous methods in which to determine the best
choice from a feasible set with multi-attributes
 To solve a variety of problems dealing with
capital investments
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You will appreciate:

 The difficulty of making a capital investment

decision.
 The risk associated with capital investments.
 The level at which most companies invest.
 The variety of industries affected by engineering.
 The entire decision-making process.

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An influential statement in Adam Smith’s Wealth of
Nations is the conviction that “economic power stems
from the ability to produce” (Smith, 1937 in Alcorn,
1997).

A viable economy depends on the ability of the nation

to maintain and develop this capacity.

An economy experiences growth through industrial

development that called for investments in the means of
production namely plants, equipment, human resource,
information technology, and others.

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 Factors of Production
 Physical resources (natural resources, land, production facilities, etc)

 Labour (human resource)

 Capital (financial resources to operate an enterprise)

 Entrepreneurship (creative ability of an individual to seek profits by

using the factors of production)

 Information resources (include market forecasts, specialized

knowledge of the human resource, other economic data. Time Warner
Entertainment: movies, television programs. CNN: broadcasting of world
events . . . They are in information business)

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 Economics is a study of scarcity and choice.
 Scarcity – a situation whereby human wants/needs are
forever greater than the supply of time, goods and
resources (land, labor, and capital).
 Entrepreneurs take risks to create products/services for
consumers out of these limited resources.

Two branches of economics:

1 Microeconomics: study on the behavior of individuals and
organization in a particular market.
2 Macroeconomics: study on the operation of the economy
as a whole

 Engineering economics is closely aligned with

microeconomics. 6
 An engineering economist draws upon the accumulated
knowledge of engineering and economics:

1 Devoted to problem solving / decision making at operational

level
2 Identify alternative uses of limited resources
3 Select preferred course of action through evaluations using
mathematical model and cost data

CO:
ENG E ication device
n
•Commu making tool
n
•Decisio echanism l ders
tr ol m a r e ho
•Con
e ati on for sh
r
•Value c

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DECISION MAKING MODEL

When we are making a choice in problem solving

activities in organization, we are supposed:

 To know all the possible alternatives of action.

 To foresee the consequences (or the probabilities of the
consequences) that will arise from the final choice of each
alternative.
 Have a complete system of preference, enabling us to rank
all consequences from the most to the least preferred, thus
making an optimal choice.

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 However, in the process of the rational decision making,
one encounters all sorts of limitations that reduce the
quality and quantity of the foundation on which the
decisions are based. Among others, the limitations include:

 the skills, habits, and reflexes that are more or less

unconscious and which determine automatically an
individual’s performance and decisions.
 the motivations, values, and loyalties of the individual
might limit the individual behavior.
 the amount of basic knowledge and information available.

H. A. Simon (1961), Administrative Behavior

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 How organization influences the decision of
individual member:
 Division of work is the most fundamental mechanism by which
organization sets limits to the decision environment of the individual. It
directs and limits his attention only to the problems which are relevant
to his task.
 Standards and procedures
 Hierarchy of authority. Broad and crucial policy decisions are taken at
the top of the hierarchy which become the premises by which the
subordinates’ decisions are based.
 Communication system in the organization. Information that is
indispensable for establishing the factual premises of a decision is
transmitted
 Training and indoctrination are powerful devices for influencing
individual decision-making.

N. P. Mouzelis (1967), Organization and Bureaucracy

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 The decision–making process

1. Define problem
2. Choose objective(s)
3. Identify alternatives
4. Evaluate consequences
5. Select
6. Implement
7. Audit

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 Every technical solution has financial
consequences.
 Engineering economic analysis
determines whether a proposed
solution is financially viable.
– Will it pay?
– Is this the minimum cost solution?
– Will it generate an acceptable return?

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 Engineering and Economics
Before 1940, Engineers were mainly concerned
with the design, construction, and operation of
machines, structure, and processes. Less
attention were given to the resources, human and
physical, that produce the final product.

However, now Engineers are expected to make

skillful financial analyses of the effects of
implementation as well.

Manpower management forms one of the most

challenging tasks faced by management

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Engineering project must be:
physically realizable
economically affordable

Economic factors of a design weigh heavily in the design

process.

Engineering economy is an integral part of that process.

Engineering, without economy, makes no sense at all.

(building LRT system in the city of Ipoh . . . physically possible, but is it

economically viable?)

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Bi-environmental nature of engineering
Engineers are confronted with two important environment,
the physical and the economic environment.

Engineers must operate successfully in both sectors and be

able to cope effectively with the bi-environmental nature of
engineering application.

Efficiency (physical) = output / input

Efficiency (economic) = worth / cost [benefit/cost]

In final evaluation of most venture, economic efficiencies

must take precedence over physical efficiencies.

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Power plant is profitable in economic terms even
though its physical efficiency in converting units of energy in
coal to electrical energy is relatively low.

Conversion of coal to electrical energy

physical efficiency = 36 %

economic efficiency = worth/cost

= 36 % x $14.65/$1.80
= 293 %

(OUTPUT Btu: electricity energy has economic worth of $14.65 per

million Btu, INPUT Btu: Coal has economic cost of $1.80 per million Btu)

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 Economic Feasibility Analysis of
Engineering Projects

 Involves the dollars-and-cents side of the decisions that

engineers make or recommend as they work to position a
firm to be profitable in a highly competitive marketplace.
 To ensure benefits of investment exceed its costs.
 Involves systematic evaluation of the economic aspects of
the engineering project proposal
 Involves significant technical considerations and technical
analysis
 Demonstrate a positive balance of long-term benefits over
long-term costs

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 Inherent in these decisions are tradeoffs between costs and
performance [such as response time, safety, weight,
reliability] provided by the proposed design or solution

 Economic analysis balances this tradeoffs so that the

solution or design is economically acceptable and affordable
to meet the needs

 Economic analysis consists of techniques for assessing the

worth of prospective projects, investments opportunities, or
design choices. The reason for worth assessment is to
support decisions.

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 WHAT IS INVESTMENT
Two categories:
 FINANCIAL INVESTMENT: investors allocate their resources
to some form of financial instrument [stocks or bonds]. A deposit
in a savings account at a bank is also an investment.
 REAL INVESTMENT (capital investment): investment in
physical asset such as new plant, new equipment, expansion of
an existing facility.

Two different factors involved: time and risk.

Sacrifice takes place in the present and is certain.
Reward comes later, if at all, and the magnitude is uncertain.

Our primary concern is with real (capital / project) investments.

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Any propose investment requires evaluation to
ensure or indicate, with reasonable confidence,
that the expected benefits exceed costs.

This economic evaluation is variously referred

to as economic analysis, or economic decision
analysis.
The application of this economic analysis
techniques in the comparison of engineering
design alternatives is referred to as
engineering economy.

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 Engineering Design Decisions vs.
Economic Decisions
In Engineering Design Decisions, Engineers
utilises known physical properties, the principles of
chemistry and physics, engineering design
correlations, and engineering judgement to arrive
at a workable and optimal design.
If judgement is sound, calculation is correct, the
design does not vary with time.
If the design is done today, it will not change
significantly in the next few years.

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 In considering Economic Decisions, information required in the
evaluations always involves predicting or forecasting product
sales, product selling price, various costs over some future
time frame . . . 5, 10, 25 years, etc.

These forecasts have two things in common:

 Not accurate when compared with actual values realized at
future time,
 Forecasts made today will be different than one made at some
point in the future.

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Unlike Eng Design Decisions, Economic
Decisions has to be based on the best
information available at the time of decision
and a thorough understanding of the
uncertainties in the forecast data.
To certain extend, they are time variant.

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 Strategic Engineering Economic
Decisions
Project ideas can be classified as:

 Discretionary (to generate added profit): New

product development, product/service capacity
expansion, new equipment and process
selection
 Sustaining investment (preventing loss of
profit): Service or quality improvement, cost
reduction/control, equipment replacement.
 Policy or non-economic reasons: such as
items required by law, waste treatment
facilities, safety to meet regulations or prevent
disasters.
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Profit Enhancing Examples

 Posco (Korea) said it would invest $12 billion to build an

integrated steel plant in India --- capacity of 12 million
tons/yr.

 Matsushita and Toray (Japan) will invest 180 billion yen

to build a plasma display panel (PDP) plant, increasing
production by 6 million panels/yr.

 Cargill (USA) announced a $20 million investment to

increase capacity of liquid chocolate and a production
line for chocolate flakes, drops and chunks in Mouscron,
Belgium.
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 CostControl Programs:
projects designed to generate
savings.

– Improving efficiency
– Streamlining operations (rationalization)
– Eliminating waste
– Reducing liabilities

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 Role of Engineers in Engineering Economic
Decisions
 In manufacturing, Engineers involved in the production of
products, from conceptual design to the shipping.
Engineering decisions account for the majority of the
product costs.

Consider the effective use of capital assets (building,

machinery, equipment).

Plan for the acquisition of equipment (capital expenditure)

to enable the firm to design and produce products
economically.

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Need to estimate the cash flows that the
assets will generate during its service period.
Inaccurate estimates of asset needs can
have serious consequences to the profitability
of the firm.

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 The importance of Engineering Economic
Decision Analysis
 Companies must invest to grow.
 Companies must invest to improve.
 Investments cost (lots of) money!
– Economic Analysis considers the economic
viability of each and every investment project
such that money is made, not lost.

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 PRINCIPLES OF ENGINEERING
ECONOMY
Firstly, the problem (opportunity) to be solved has to be
recognised and the needs have to be identified.
Then the following principles shall be followed:
 Develope (identify and define) the alternatives
 Focus on the differences of the expected future outcomes
among the alternatives
 Use consistent viewpoint
 Use a common unit of measure
 Consider all relevant criteria
 Recognise the uncertainty of the future outcomes
 Revisit your decisions (compare the actual results)

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 SEVEN-STEP ECONOMIC ANALYSIS
PROCEDURE
 Problem (opportunity) recognition, definition, and
evaluation
 Development of the feasible alternatives
 Development of prospective outcomes (use the basic
cash flow approach employed in Engineering
Economy)
 Selection of a Decision Criterion
 Analysis and comparison of alternatives
 Selection of the preferred alternative
 Performance monitoring and post-evaluation of
results

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 Examples of decisions supported by Engineering
Economy calculation

1. A chemical engineer determines the appropriate

diameter of a pipeline, knowing that a greater
diameter will decrease pumping costs throughout
the life of the line but will increase purchase and
installation costs.
2. A warehouse manager reviews stock levels of
various stocked items, wanting to minimise the
sum of holding costs and stockout costs.
3. A mechanical engineer determines the appropriate
balance between adding insulation to a building
and increasing the capacity of its cooling plant.
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4. A corrosion engineer estimates whether it is
better to use stainless steel and replace a
tank every five years or use carbon steel
and replace it every three years.

5. An electrical engineer estimates the costs of

installing capacitor bank to alleviate the
phase lag that lowers power factor and
leads to high electricity bill.

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