Course Title : Engineering Economy

Course Title : Engineering Economy

& Management Course Number : EMEH 2450

Credits : 4

Dr. M Shaaban Hussain

Syllabus

• UNIT – I : Introduction to Engineering Economy:

Necessities and Luxuries, Market segments, Supply and Demand, Diminishing returns, Economic Indicators (GDP, GNP, GNI, Fiscal Deficit etc.); Time Value of Money: Time value equivalence, Cash flow diagrams, Conversion factors, Nominal and effective interest rates; Evaluating & Comparing Alternatives: Present, Future & Equivalent annual worth, Comparison with unequal lives, Perpetuities and Capitalized costs

contd…

• UNIT – II : Breakeven Analysis; Demand Forecasting, Financial Management, Process, Balance sheet and financial ratios; General Replacement Studies:

Defender and challenger (both equal and unequal lives), When to replace; Benefit-Cost Analysis:

Benefit/cost criterion, Benefit/cost comparisons;

Depreciation: Purpose and use, Declining value and replacement of assets, Depreciation and tax, Straight line method, Declining and double declining balance method; Inflation and its effects, Inflation, its causes and consequences.

contd…

• UNIT–III : Introduction to Management: Management Process: Planning, organizing, leading and controlling, Types of managers, Managerial levels and skills, Role of managers; Environmental and Ethical issues; Decision Making, Types of decisions, Decision making environments (certainty, uncertainty and risk), Techniques for decision making (payoff matrix, decision trees); Marketing Management: Process, Marketing Mix and strategies

contd…

• UNIT - IV : Planning & Strategic Management: Need and importance, Vision, mission, goals and strategies, Type of plans (operational and strategic); Organizing: Principles of Organizational design (Division of work, departmentalization, hierarchy and coordination), Unity of command, span of control, chain of command, Tall and flat organizational structures, Power and authority;

Leadership and Motivation: Leadership styles, managerial grid, Importance of Motivation,Maslow’sand Hertzberg’s theories; Controlling, Importance, Control Process; Operations Management: Process, Framework (capacity planning and scheduling, process, quality, inventory and workforce).

Economics

• Economics is the science that deals with the production and consumption of goods and services and the distribution and rendering of these for human welfare.

The following are the economic goals

o A high level of employment

o Price stability Efficiency

o An equitable distribution of income

o Growth Some of the above goals are interdependent

• The economic goals are not always complementary; in many cases they are in conflict.

• For example, any move to have a significant reduction in unemployment will lead to an increase in inflation.

Engineering Economics

• Engineering economy involves formulating, estimating, and evaluating the expected economic outcomes of alternatives designed to accomplish a defined purpose.

Mathematical techniques simplify the economic evaluation of alternatives.

• Decisions are made routinely to choose one alternative over another by engineers on the job; by managers who supervise the activities of others; by corporate presidents who operate a business;

and by government ofcials who work for the public good.

• Most decisions involve money, called capital or capital funds, which is usually limited in amount. The decision of where and how to invest this limited capital is motivated by a primary goal of adding value as future, anticipated results of the selected alternative are realized.

• The factors upon which a decision is based are commonly a combination of economic and noneconomic elements. Engineering economy deals with the economic factors.

• Because the formulas and techniques used in engineering economics are applicable to all types of money matters, they are equally useful in business and government, as well as for individuals.

• Engineering economy are engineering economic analysis, capital allocation study, economic analysis, and similar descriptors.

• Since most decisions affect what will be done, the time frame of engineering economy is primarily the future. Therefore, the numbers used in engineering economy are best estimates of what is expected to occur. The estimates and the decision usually involve four essential elements:

• Cash flows

• Times of occurrence of cash flows

• Interest rates for time value of money

• Measure of worth for selecting an alternative

• The criterion used to select an alternative in engineering economy for a specific set of estimates is called a measure of worth. The measures developed and used in this text are

Present worth (PW) Future worth (FW) Annual worth (AW)

Rate of return (ROR) Beneft/cost (B/C) Capitalized cost (CC)

Payback period Proftability index Economic value added (EVA)

• An engineering economic analysis can be performed on future estimated amounts or on past cash flows to determine if a specific measure of worth, e.g., rate of return, was achieved. Engineering economics is applied in an extremely wide variety of situations.

• Equipment purchases and leases

• Chemical processes

• Construction projects

• Sales and marketing projects

• Transportation systems of all types

• Product design

• Manufacturing processes

• Hospital and healthcare operations

• Quality assurance

• Government services for residents and businesses

Engineering Economy Analysis

• An engineering economy study involves many elements: problem identification, definition of the objective, cash flow estimation, financial analysis, and decision making. Implementing a structured procedure is the best approach to select the best solution to the problem.

Steps involved

• The steps in an engineering economy study are as follows:

1. Identify and understand the problem; identify the objective of the project.

2. Collect relevant, available data and define viable solution alternatives.

3. Make realistic cash flow estimates.

4. Identify an economic measure of worth criterion for decision making.

5. Evaluate each alternative; consider noneconomic factors;

use sensitivity analysis as needed.

6. Select the best alternative.

7. Implement the solution and monitor the results.

Necessities and Luxuries

• Necessity is “an indispensable thing” – something that everyone needs. There are some things that everyone clearly needs just to survive, such as food, water, shelter, and clothing.

• Yet even within those categories, there’s a surprising amount of wiggle room. For instance, you need food to live, but that doesn’t mean you need a gourmet meal at a four-star restaurant. You need shoes to protect your feet, but that doesn’t mean you need a $400 pair of Italian leather boots.

• If a necessity is something that everybody needs, it seems logical that a luxury must be something that nobody really needs, but many people want.

Therefore,

• Luxury is “an inessential, desirable item that is expensive or difficult to obtain.”

• Note that this definition has two parts. A luxury isn’t just something that’s “desirable” – it also has to be expensive. This suggests that luxuries are valuable not just for the enjoyment they provide, but also as a sign of status.

Market Types/Segment

• Market structure can be defined as the characteristics of the market which can be either competitive or organizational, which outlines the nature of the competition and the pricing procedure in the market. It is, therefore, describes the number of entities producing similar goods and services in the market, whose structure is determined by the current competition in the market.

• There are three types of economic market structures (organized by least competitive to most competitive):

1.Monopoly, 2. Oligopoly, 3. Perfect competition

Monopoly

• A monopoly is a market that consists of a single firm that produces goods that have no close substitutes. Often, this market has many barriers to entry. For instance, providers of water, natural gas, telecommunications, and electricity are often granted exclusive rights to service.

• A monopoly is a profit maximizer.

• Monopolies are price makers.

• Price discrimination: Monopolies can change both the price and quality of their products.

• There are very high barriers to entry for other firms.

• There is a single seller that controls the whole market.

• Pure monopolies are regulated by the government.

Oligopoly

• An oligopoly market consists of a small number of firms that are relatively large firms that produce products that are similar but slightly different. Under oligopolies, there also exist some barriers to entry of other enterprises into the business. Good examples include industries like oil &

gas, airline, and automakers.

• Only a few numbers of firms operate in the market.

• Profit maximization is a condition in this market.

• Monopolies set their own prices.

• Barriers to entry are high.

• Firms make abnormal profits in the long-run.

• Products may be homogeneous.

• There is a relatively small number of firms supplying the market.

Perfect Competition

• Perfect competition refers to a market that has many buyers and sellers, many similar products, and many substitutes. A good example is agriculture, where all rice farmers sell homogeneous products to consumers.

• There exist a very large number of buyers

• There exist a very large number of sellers willing to supply their products at given market prices.

• No single seller/producer is large enough to influence the market price.

• Homogeneous products: The products being sold in this market are perfect substitutes for each other.

• The quality and characteristicsdon’tvary from each other.

• Perfect information: Every consumer and producer is aware of the market prices, and the utility derived from the use of any of the products.

• No barriers to entry.

Interest Rate and Rate of Return

• Interest is the manifestation of the time value of money. Computationally, interest is the difference between an ending amount of money and the beginning amount. If the difference is zero or negative, there is no interest.

• There are always two perspectives to an amount of interest—interest paid and interest earned.

• Interest is paid when a person or organization borrowed money (obtained a loan) and repays a larger amount over time.

• Interest isearnedwhen a person or organization saved, invested, or lent money and obtains a return of a larger amount over time.

• The numerical values and formulas used are the same for both perspectives, but the interpretations are different.

• Interest paidon borrowed funds (a loan) is determined using the original amount, also called the principal, Interest = amount owed now–principal

• When interest paid over a specific time unit is expressed as a percentage of the principal, the result is called theinterest rate.

• From the perspective of a saver, a lender, or an investor, interest earnedis the final amount minus the initial amount, or principal.

• Interest earned = total amount now - principal

• Interest earned over a specific period of time is expressed as a percentage of the original amount and is calledrate of return (ROR).

• Rate of return (%)=interest accrued per time unitX100%

principal

Inflation

• Inflation can significantly increase an interest rate, some comments about the fundamentals of inflation are warranted at this early stage. By definition, inflation represents a decrease in the value of a given currency. That is, $10 now will not purchase the same amount of gasoline for your car (or most other things) as $10 did 10 years ago. The changing value of the currency affectsmarket interest rates.

• Inflation means that cost and revenue cash flow estimates increase over time. This increase is due to the changing value of money that is forced upon a country’s currency by inflation, thus making a unit of currency (such as the dollar) worth less relative to its value at a previous time. We see the effect of inflation in that money purchases less now than it did at a previous time. Inflationcontributes to

• A reduction in purchasing power of the currency

• An increase in the CPI (consumer price index)

• An increase in the cost of equipment and its maintenance.

• An increase in the cost of salaried professionals and hourly employees.

• A reduction in the real rate of return on personal savings and certain corporate investments.

In other words, inflation can materially contribute to changes in corporate and personal economic analysis.

Cash Flows

• Cash flows are the amounts of money estimated for future projects or observed for project events that have taken place. All cash flows occur during specific time periods, such as 1 month, every 6 months, or 1 year. Annual is the most common time period.

• Engineering economy bases its computations on the timing, size, and direction of cashflows.

• Cash inflows are all types of receipts, including sales, revenues, incomes, money from a loan when received from the lender, and savings generated by project and business activity. Aplus signindicates a cash inflow.

• Cash outflows are all types of costs, including disbursements, expenses, deposits into retirement or savings accounts, loan repayments, and taxes caused by projects and business activity.

• A negative or minus sign indicates a cash outflow.

When a project involves only costs, the minus sign may be omitted for some techniques, such as benefit/cost analysis.

• Cash Inflow Estimates

Income: +$150,000 per year from sales of solar-powered watches Savings: +$24,500 tax savings from capital loss by equipment salvage value

Receipt: +$750,000 received on large business loan plus accrued interest

Savings: +$150,000 per year saved by installing more efcient air conditioning

Revenue: +$50,000 to +$75,000 per month in sales for extended battery life iPhones

Cash Outflow Estimates

Operating costs: -$230,000 per year annual operating costs for software services

First cost: -$800,000 next year to purchase replacement earthmoving equipment

Expense: -$20,000 per year for loan interest payment to bank Initial cost: -$1 to -$1.2 million in capital expenditures for a water recycling unit

•

All of these are

that is,

for cash

elements of an alternative, except for the last revenue and cost estimates listed above. They provide a

because the persons estimating the revenue and cost do not have enough knowledge or experience with the systems to be more accurate.

•

Once all cash

and

are estimated

(or determined for a completed project), the

for each time period is calculated.

• The cash flow diagram is a very important tool in an economic analysis, especially when the cashflowseries is complex. It is a graphical representation of cashflows drawn on the y axis with a time scale on thex axis. The diagram includes what is known, what is estimated, and what is needed. That is, once the cash flow diagram is complete, another person should be able to work the problem by looking at the diagram.

Problem

• Assume you borrow $8500 from a bank today to purchase an $8000 used car for cash next week, and you plan to spend the remaining $500 on a new paint job for the car 2 weeks from now.

Problem

• An electrical engineer wants to deposit an amount P now such that she can withdraw an equal annual amount of A1 = $2000 per year for the first 5 years, starting 1 year after the deposit, and a differentannual withdrawal of A2 = $3000 per year for the following 3 years. How would the cash flow diagram appear if i = 8.5% per year?

Problem

• A rental company spent $2500 on a new air compressor 7 years ago. The annual rental income from the compressor has been $750. The $100 spent on maintenance the first year has increased each year by $25. The company plans to sell the compressor at the end of next year for $150. Construct the cash flow diagram from the company’s perspective and indicate where the present worth now is located.

Economic Equivalence

• Economic equivalence is a combination of interest rate and time value of money to determine the different amounts of money at different points in time that are equal in economic value.

• As an illustration, if the interest rate is 6% per year, $100 today (present time) is equivalent to $106 one year from today.

• Amount accrued = 100 + 100(0.06) = 100(1 + 0.06) = $106

• Two sums of money are equivalent to each other only when the interest rate is 6% per year. At a higher or lower interest rate, $100 today is not equivalent to $106 one year from today.

• In addition to future equivalence, we can apply the same logic to determine equivalence for previous years. A total of

$100 now is equivalent to $100∕1.06 = $94.34 one year ago at an interest rate of 6% per year. From these illustrations, we can state the following: $94.34 last year, $100 now, and

$106 one year from now are equivalent at an interest rate of 6% per year. The fact that these sums are equivalent can be verified by computing the two interest rates for 1-year interest periods.

• Comparison of alternative cashflowseries requires the use of equivalence to determine when the series are economically equal or if one is economically preferable to another. The keys to the analysis are the interest rate and the timing of the cashflows.

• The concept of equivalence helps in understanding how different sums of money at different times are equal in economic terms. The differences between simple interest (based on principal only) and compound interest (based on principal and interest upon interest) have been described in formulas, tables, and graphs.

Minimum Attractive Rate of Return (MARR)

• The Minimum Attractive Rate of Return (MARR) is a reasonable rate of return established for the evaluation and selection of alternatives. A project is not economically viable unless it is expected to return at least the MARR. MARR is also referred to as the hurdle rate, cutoff rate, benchmark rate, and minimum acceptable rate of return.

• The MARR is not a rate that is calculated as a ROR. The MARR is established by (financial) managers and is used as a criterion against which an alternative’s ROR is measured, when making the accept/reject investment decision.

• The MARR is a reasonable rate of return established as a hurdle rate to determine if an alternative is economically viable. The MARR is always higher than the return from a safe investment and the cost to acquire needed capital.

• The MARR is used as a criterion to decide on investing in a project, the size of MARR is fundamentally connected to how much it costs to obtain the needed capital funds.

Terminology and Symbols

• The symbolsPandFrepresent one-time occurrences

• Aoccurs with the same value in each interest period for a specified number of periods.

• It should be clear that a present value Prepresents a single sum of money at some time prior to a future value F or prior to the first occurrence of an equivalent series amountA.

• It is important to note that the symbol A always represents a uniform amount (i.e., the same amount each period) that extends through consecutive interest periods. Both conditions must exist before the series can be represented byA.

• The interest rate iis expressed in percent per interest period, for example, 12% per year.

Engineering economy factors to account for the time value of money.

**Engineering economy factors that take the time value of money into account.

Single-Amount Factors (F∕P and P∕F )

•

Problem

• Sandy, a manufacturing engineer, just received a year-end bonus of $10,000 that will be invested immediately. With the expectation of earning at the rate of 8% per year, Sandy hopes to take the entire amount out in exactly 20 years to pay for a family vacation when the oldest daughter is due to graduate from college. Find the amount of funds that will be available in 20 years.

Solution

Problem

• As discussed in the introduction to this chapter, the HBNA plant will require an investment of $200 million to construct. Delays beyond the anticipated implementation year of 2020 will require additional money to construct the plant. Assuming that the cost of money is 10% per year compound interest, determine the following for the board of directors of the Italian company that plans to develop the plant.

(a) The equivalent investment needed in 2023 if the plant is delayed for 3 years.

(b) The equivalent investment needed in 2023 if the plant is constructed sooner than originally planned.

Uniform Series Present Worth Factor and

Capital Recovery Factor (P∕A and A∕P) Problem

• How much money should you be willing to pay now for a guaranteed $600 per year for 9 years starting next year, at a rate of return of 16% per year?

• Solution

A = $600, i = 16%, and n = 9. The present worth is P = 600(P∕A,16%,9) = 600(4.6065) = $2763.90

Sinking Fund Factor and Uniform Series

Compound Amount Factor (A∕F and F∕A) Problem

• The president of Ford Motor Company wants to know the equivalent future worth of a $1 million capital investment each year for 8 years, starting 1 year from now. Ford capital earns at a rate of 14% per year.

Solution Problem

• Determine the P∕A factor value for i = 7.75%

and n = 10 years

• Solution

Arithmetic Gradient Factors (P∕G and A∕G)

• An arithmetic gradient series is a cashflow series that either increases or decreases by a constant amount each period. The amount of change is called the gradient.

• Assume a manufacturing engineer predicts that the cost of maintaining a robot will increase by $5000 per year until the machine is retired. The cash flow series of maintenance costs involves a constant gradient, which is $5000 per year.

Problem

• A local university has initiated a logo-licensing program with the clothier Holister, Inc. Estimated fees (revenues) are $80,000 for the first year with uniform increases to a total of $200,000 by the end of year 9.

Determine the gradient and construct a cash flow diagram that identifies the base amount and the gradient series.

Solution

• The year 1 base amount is CF1 = $80,000, and the total increase over 9 years is

CF9 - CF1 = 200,000 –80,000 = $120,000 Equation [2.18], solved for G, determines the arithmetic gradient.

• G = (CF9 - CF1) n - 1

= 120,000 9 - 1

= $15,000 per year

Solution

Problem

• A person deposits a sum of Rs. 20,000 at the interest rate of 18% compounded annually for 10 years. Find the maturity value after 10 years.

Solution

• P = Rs. 20,000

i= 18% compounded annually n = 10 years

F = P(1 + i)ⁿ= P(F/P, i, n)

= 20,000 (F/P, 18%, 10)

= 20,000 5.234 = Rs. 1,04,680

The maturity value of Rs. 20,000 invested now at 18%

compounded yearly is equal to Rs. 1,04,680 after 10 years.

Problem

• A person wishes to have a future sum of Rs.

1,00,000 for his son’s education after 10 years from now. What is the single-payment that he should deposit now so that he gets the desired amount after 10 years? The bank gives 15% interest rate compounded annually.

Solution

• F = Rs. 1,00,000

i= 15%, compounded annually n = 10 years

P = F/(1 + i)ⁿ= F(P/F, i, n)

= 1,00,000 (P/F, 15%, 10)

= 1,00,000 0.2472

= Rs. 24,720

The person has to invest Rs. 24,720 now so that he will get a sum of Rs. 1,00,000 after 10 years at 15% interest rate compounded annually.

Problem: Comparison with unequal lives

GDP: Gross Domestic Product

• Gross Domestic Product (GDP) is the monetary value of all finished goods and services made within a country during a specific period.

• GDP provides an economic snapshot of a country, used to estimate the size of an economy and growth rate.

• GDP can be calculated in three ways, using expenditures, production, or incomes. It can be adjusted for inflation and population to provide deeper insights.

• Though it has limitations, GDP is a key tool to guide policymakers, investors, and businesses in strategic decision making.

GNP: Gross National Product

• GNP measures the output of a country's residents regardless of the location of the actual underlying economic activity.

• Income from overseas investments by a country's residents counts in GNP, and foreign investment within a country's borders does not. This is in contrast to GDP which measures economic output and income based on the location rather than nationality.

• GNP and GDP can have different values, and a large difference between a country's GNP and GDP can suggest a great deal of integration into the global economy.

GNI: Gross national income

• Gross national income is an alternative to gross national product as a measure of wealth. It calculates income instead of output.

• GNI can be calculated by adding income from foreign sources to gross domestic product.

• Nations that have substantial foreign direct investment, foreign corporate presence, or foreign aid will show a significant difference between GNI and GDP.

Fiscal Deficit

•

A fiscal deficit is a shortfall in a government's income compared with its spending. The government that has a fiscal deficit is spending beyond its means.

•

A fiscal deficit is calculated as a percentage of gross domestic product (GDP), or simply as total dollars spent in excess of income.

•

In either case, the income figure includes only taxes and other revenues and excludes money borrowed to make up the shortfall.

Law of Supply and Demand

• The law of supply and demand is a theory that explains the interaction between the sellers of a resource and the buyers for that resource.

• The theory defines what effect the relationship between the availability of a particular product and the desire (or demand) for that product has on its price.

Generally, low supply and high demand increase price and vice versa.

• In practice, supply and demand pull against each other until the market finds an equilibrium price. However, multiple factors can affect both supply and demand, causing them to increase or decrease in various ways.

•

The law of demand says that at higher prices, buyers will demand less of an economic good.

•

The law of supply says that at higher prices, sellers will supply more of an economic good.

•

These two laws interact to determine the actual market prices and volume of goods that are traded on a market.

•

Several independent factors can affect the shape of market supply and demand, influencing both the prices and quantities that we observe in markets.

• The determinants of supply are:

1. Production costs: How much a good costs to be produced.

Production costs are the cost of the inputs

2. Firms' expectations about future prices 3. Number of suppliers

• The determinants of demand are:

1. Income

2. Tastes and preferences

3. Prices of related goods and services

4. Consumers' expectations about future prices and incomes that can be checked

5. Number of potential consumers

Law of Diminishing Returns

• Diminishing returns, also called law of diminishing returns or principle of diminishing marginal productivity, economic law stating that if one input in the production of a commodity is increased while all other inputs are held fixed, a point will eventually be reached at which additions of the input yield progressively smaller, or diminishing, increases in output.

• The law of diminishing marginal returns states that, at some point, adding an additional factor of production results in smaller increases in output.

• The law of diminishing marginal returns states that adding an additional factor of production results in smaller

increases in output.

• The addition of a larger amount of one factor of production inevitably yields decreased per-unit incremental returns, the law says.

• The law of diminishing marginal returns is also known as the law of diminishing returns, the principle of diminishing marginal productivity, and the law of variable proportions.

• For example, a factory employs workers to manufacture its products, and, at some point, the company operates at an optimal level. With other production factors constant, adding additional workers beyond this optimal level will result in less efficient operations.