System Engineering & Economy Analysis Lecturer Maha Muhaisen College of Applied Engineering& Urban Planning

Principles of Engineering Economy

Cash Flows

Cash flow Cash flow diagram (CFD) summarized the cost and benefit of the project occur over time. CFD is created by first drawing a segmented time – based horizontal line, divided onto appropriate time units. At each time at which cash flow will occur a vertical arrow is added. Pointing down for cost , pointing up for revenues or benefit.

Key Concepts Cash Flow Diagram: the financial description (visual) of a project Time Value of Money: the value of money changes with time Money provides utility (value) when spent Value of money grows if invested Value of money decreases due to inflation Interest: used to move money through time for comparisons

Cash Flow Movement of money in (out) of a project Inflows: revenues or receipts Outflows: expenses or disbursements Net Cash Flow: receipts - disbursements

Cash Flows Discrete: Movement of cash to or from a project at a specific point in time. Continuous: Rate of cash moving from or to a project over some period of time.

Cash Flow Diagram Financial representation of a project. Describes type, magnitude and timing of cash flows over some horizon.

Cash Flow Diagram Describes type, magnitude and timing of cash flows over some horizon 1 2 3 4 5 Time Periods over the Horizon

Cash Flow Diagram Describes type, magnitude and timing of cash flows over some horizon 1 2 3 4 5 50$ 100$ 500$ Discrete Cash Outflow (Disbursement, Expense) Note the direction of the arrow!

Cash Flow Diagram Describes type, magnitude and timing of cash flows over some horizon 500$ 200$ 200$ 200$ 1 2 3 4 5 Discrete Cash Inflow (Revenue)

Cash Flow Diagram Describes type, magnitude and timing of cash flows over some horizon 500$ 200$ 200$ 200$ 1 2 3 4 5 50$ 100$ 500$

Cash Flow Diagram Net cash flows add expenses and disbursements at same point in time. 500K 200K 200K 200K 1 2 3 4 5 50K 100K Can write as net cash flow 500K

Cash Flow Diagram Net cash flows add expenses and disbursements at same point in time. 500$ 200$ 200$ 100$ 1 2 3 4 5 50$ 500$

Cash Flow Diagram Continuous cash flows define a rate of movement of cash over time. 500$ 200$ 200$ 1 2 3 4 5 Continuous Cash Inflow (Revenue) 200$ Rate of Flow per unit time 500$

Cash Flow Diagram Continuous cash flows define a rate of movement of cash over time. While good for analysis, not used often. 500$ 200$ 200$ 1 2 3 4 5 Continuous Cash Inflow (Revenue) 200$ Rate of Flow per unit time 500$

Cash Flow Diagram Can describe any investment opportunity. Typical investment:

Cash Flow Diagram Can describe any investment opportunity. Typical investment: P Make an initial investment (purchase)

Cash Flow Diagram Can describe any investment opportunity. Typical investment: 1 2 3 N P Receive revenues over time.

Cash Flow Diagram Can describe any investment opportunity. Typical investment: 1 2 3 N P Pay expenses over time.

Cash Flow Diagram Can describe any investment opportunity. Typical investment: Receive salvage value at time N. F 1 2 3 N P

Cash Flow Diagram Can describe any investment opportunity. Typical investment: AN A3 A2 1 2 3 N A1 P Write as a NET cash flow in each period.

Example (Nothing to Sneeze At!) Tissue paper company Svenska Cellulosa announced an investment of $490 million for a new tissue machine at its Valls, Spain plant to expand capacity by 60,000 tons/year. Most product is for retail private labels. Assume: Investment in 2006 with operations beginning in 2007. The machine has a service life of 10 years and a salvage value of $25M. Fixed O&M costs are $10 million in year 1, increase 8% per year. Revenues are $6,400/ton against costs of $4,600/ton. Draw the cash flow diagram.

Cash Flow Diagram Timeline 1 2 3 10

Cash Flow Diagram Individual cash flows: Investment Cost 1 2 3 10 490M

Cash Flow Diagram Individual cash flows: Per Unit Revenues 384M 384M 1 2 3 10 490M

Cash Flow Diagram Individual cash flows: Per Unit Costs 384M 384M 384M 1 2 3 10 276M 276M 276M 276M 490M

Cash Flow Diagram Individual cash flows: Fixed Costs 384M 384M 384M 1 2 3 10 276M 276M 276M 276M 10M 10.8M 11.7M 20M 490M

Cash Flow Diagram Individual cash flows: Salvage Value 25M 384M 384M 1 2 3 10 276M 276M 276M 276M 10M 10.8M 11.7M 20M 490M

Cash Flow Diagram Net Cash Flow Diagram 113M 98.0M 97.2M 96.4M 89.5M 1 2 3 9 10 490M

Cash Flow Diagram Net Cash Flow Diagram 1 2 3 9 10 This is a “typical” investment. (Invest at zero, returns later.) 490M

Cash Flow Diagram Net Cash Flow Diagram 1 2 3 9 10 This is a “typical” investment. (Invest at zero, returns later.) Can also use a spreadsheet! 490M

Spreadsheet Basics Sheet defined by rows and columns of cells.

Spreadsheet Basics Can enter the following into a cell: Data: Input that is fixed. Variables: Input that can change. Accomplished by references. Absolute references are fixed when copied. Relative references change when copied. Functions: Accept input (arguments) and return pre-defined output. Combinations: Data, Variables, and Functions. Labels: Formatting that makes it easy to read!

Good Spreadsheet Form Give your spreadsheet a title. Put data in a “data center” and reference it (so you can change it easily). Label units, scales, time, etc. Use formatting to make it easy to read.

If you don’t, you will just end up doing it again! Good Spreadsheet Form Give your spreadsheet a title. Put data in a “data center” and reference it (so you can change it easily). Label units, scales, time, etc. Use formatting to make it easy to read. If you don’t, you will just end up doing it again!

Return to our Example

Return to our Example Data Center with Data

Return to our Example Relative Reference: A13: Copies relative distance between cell and copied cell to the new cell. Absolute Reference: $G$4: Copies the cell reference exactly (fixed).

Return to our Example Function Call: SUM(argument1, argument2,…) = argument1+argument2…

Return to our Example

Lecture (6) Chapter (2)

Engineering Costs and Cost Estimating Fixed and Variable Direct and Indirect Marginal and Average Sunk and Opportunity Recurring and Non-Recurring Incremental Cash and Book Life-Cycle Cost Indices Estimating Benefits Cash Flow Diagrams

Engineering Costs and Cost Estimating Fixed Costs: are constant and unchanging regardless of the level of the activity over a feasible range of operations for the capacity or capability available. Variable costs: operating costs that vary in total with the quantity of output or other measures of activity level. Direct Costs: cost that can be reasonably measured and allocated to a specific output or work activity. Indirect/Overhead Cost: cost that it is difficult to attribute or allocate to a specific output or work activity.

Engineering Costs and Cost Estimating Average cost : dividing the total cost for all units by the total number of units. DM use cost to attain an overall cost picture of the investment on a per unit analysis. Marginalized cost : is used to decide whether the additional unit should be made, purchase, or enrolled in (for full time student, marginal cost of another credit is 0$ or 120 $ depend in how many credits has already signed up.

Engineering Costs and Cost Estimating Key Question: Where do the numbers come from that we use in engineering economic analysis? Cost estimating is necessary in an economic analysis When working in industry, you may need to consult with professional accountants to obtain such information

Engineering Costs and Cost Estimating Example 2-1. an industrialist DK was considering the money making potential plans to charter a bus to take people to see a wrestling match show in Jacksonville. His wealthy uncle will reimburse him for his personal time, so his time cost can be ignored. Item Cost Item Cost Bus Rental $80 Ticket $12.50 Gas Expense $75 Refreshments $ 7.50 Other Fuel Costs $20 Bus Driver $50 Total Costs $225.00 Total Costs $20.00 Which of the above are fixed and which are variable costs? How do we compute total cost if he takes n people to Jacksonville?

DK’s Charter Bus Venture (example) Answer: Total Cost = $225 + $20 per person.  Graph of Total Cost Equation:   Total cost n

DK’s Charter Bus Venture (example) marginal cost -The cost to take one more person average cost - Average cost: the cost per person Avg. Cost = TC/n Avg. Cost = ($225+$20n)/n For n = 30, TC = $885 Avg. Cost = $885/30 = $29.50 Total cost cannot be calculated from an average cost value For n =35, TC  35*($29.50) = $ 1,032.50

DK Charter Bus Venture (example) Question: Do we have enough information yet to decide how much money he will make on his venture? What else must we know? he needs to know his total revenue he knows that similar ventures in the past have charged $35 per person, so that is what he decides to charge Total Revenue = 35n (for n people) Total profit = Total Revenue – Total Cost: 35n – (225 + 20n) = 15n – 225 Question: How many people does DK need to break even? (not lose money on his venture) Solve 15 n – 225 = 0 => n=15 more than 15, he makes money  

Break-even point : the level of business activity at which the total costs provide the product, good, or services are equal to revenue (or saving) generated by providing services. This is he level at which one “just break even) Profit region : the output level of the variable x (or n) greater than the breakeven point, where the total revenue is greater than the total cost. Loss region : the output level of variable x (n) less than the breakeven point, where total cost are greater than the total revenue.

DK’s Charter Bus Venture (example) Where is the Loss Region? Where is the Profit Region?  Where is the Breakeven point? Can you make this chart in Excel?

Sunk Costs A sunk cost is money already spent due to a past decision. As engineering economists we deal with present and future opportunities We must be careful not to be influenced by the past Disregard sunk costs in engineering economic analysis Example: Suppose that three years ago your parents bought you a laptop PC for $2000. How likely is it that you can sell it today for what it cost? Suppose you can sell the laptop today for $400. Does the $2000 purchase cost have any effect on the selling price today? The $2000 is a sunk cost. It has no influence on the present opportunity to sell the laptop for $400

Opportunity Cost An opportunity cost is the benefit that is foregone by engaging a business resource in a chosen activity instead of engaging that same resource in the foregone activity. Example: Suppose your wealthy uncle gives you $75,000 when you graduate from high school. It is enough to put you through college (5 years at $15,000 per year). It is also enough for you to open a business making web pages for small companies instead of going to college. You estimate you would make $20,000 per year with this business. If you decide to go to college you give up the opportunity to make $20,000 per year Your opportunity cost is $20,000 Your total cost per year is $35,000

Sunk and Opportunity Cost Example 2-3. A distributor has a case of electric pumps. The pumps are unused, but are three years old. They are becoming obsolete. Some pricing information is available as follows. Item Amount Type of Costs Price for case 3 years ago $7,000 Sunk cost Storage costs to date $1,000 Sunk cost List price today for a case of new and up to date pumps $12,000 Can be used to help determine what the lot is worth today. Amount buyer offered for case 2 years ago $5,000 A foregone opportunity Case can currently be sold for $3,000 Actual market value today

Recurring and Non-Recurring Costs Recurring costs are those expenses that are known, anticipated, and occur at regular intervals. These costs can be modeled as cash flows. Non-recurring costs are one-of-a-kind and occur at irregular intervals. They are difficult to plan for or anticipate. Example. You decide to landscape a lot of ground and then care for it. Which are recurring and which are non-recurring costs you incur?  Remove existing trees, vegetation Have land graded with bulldozer Have yard planted with grass Plant vegetation, trees trim grass Fertilize grass, shrubs Water grass, shrubs 

Incremental Cost Incremental Cost is the additional cost that results from: Increasing the output of a system by one (or more) units Selecting one alternative over another Example 2-4. Philip can choose between model A or model B. The following information is available. Cost Items Model A Model B Incremental Cost of B Purchase price $10,000 $17,500 $7,500 Installation cost $3,500 $5,000 $1,500 Annual maintenance cost $2,500 $750 $-1,750/yr $800/yr Annual utility expense $1,200 $2,000 Disposal cost after useful life $700 $500 $-200 Can we conclude that model B is more expensive than model A?

Notice that the cost for the cost categories given, the incremental costs of B are both (+) and (-). Positive incremental costs mean that B costs more than A and negative incremental costs indicate that there would be a saving (reduction of the cost) if B were chosen. Because B has more features, a decision would also have to reflect consideration the incremental benefits offered by model.

Cash Costs vs. Book Costs require the cash transaction of dollars from “one pocket to another”. Book costs are cost effects from past decisions that are recorded in the books (accounting books) of a firm Do not represent cash flows Not included in engineering economic analysis One exception is for asset depreciation (used for tax purposes). Example: You might use Edmond’s Used Car Guide to conclude the book value of your car is $6,000. The book value can be thought of as the book cost. If you actually sell the car to a friend for $5,500, then the cash cost to your friend is $5,500.

Life-Cycle Costs Life-cycle costs are the summation of all costs, both recurring and nonrecurring, related to a product, structure, system, or service during its life span Products go through a life cycle, just like people   Assessment & Justification Phase Conceptual or Preliminary Design Phase Detailed Design Phase Production or Construction Phase Operational Use Phase Decline and Retirement Phase  

Life-Cycle Costs

Life-Cycle Costs Comments: The later design changes are made in the life-cycle, the higher the costs. Decisions made early in the life-cycle tend to “lock in” costs incurred later in the life cycle: Nearly 70 to 90% of all costs are set during the design phases, while only 10 to 30% of the cumulative life-cycle costs have been spent. Bottom Line. Engineers should consider all life-cycle costs when designing products and the systems that produce them.

Estimating Benefits For the most part, we can use exactly the same approach to estimate benefits as to estimate costs: Fixed and variable benefits Recurring and non-recurring benefits Incremental benefits Life-cycle benefits Rough, semi-detailed, and detailed benefit estimates Difficulties in estimation Segmentation and index models Major differences between benefit and cost estimation: Costs are more likely to be underestimated Benefits are most likely to be overestimated Benefits tend to occur further in the future than costs