What is 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 the study of industrial economics and the economic and financial factors which influence industry. ECON 401: Engineering Economics

Engineering economy is a collection of techniques that simplify comparisons of alternatives on an economic basis. Engineering economy is not a method or process for determining what the alternatives are. ECON 401: Engineering Economics

Engineering economics begins only after the alternatives have been identified. If the best alternative is actually one that the engineer has not even recognized as an alternative, then all the engineering economic analysis tools will not result in its selection. ECON 401: Engineering Economics

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. ECON 401: Engineering Economics

In today’s competitive world of business it has become essential that engineers should practice financial project analysis for engineering projects and make rational decisions. ECON 401: Engineering Economics

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, etc. ECON 401: Engineering Economics

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. ECON 401: Engineering Economics

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. ECON 401: Engineering Economics

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. ECON 401: Engineering Economics

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. ECON 401: Engineering Economics

ECON 401: Engineering Economics
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. ECON 401: Engineering Economics

SOME EXAMPLES 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. ECON 401: Engineering Economics

SOME EXAMPLES The following figure shows how engineering is composed of physical and economic components: Physical Environment Produce products and services based on physical laws (e.g. Newton’s Law) ENGINEERING Production / Construction Economic Environment Assessing the worth of these products/services in economic terms Total Environment ECON 401: Engineering Economics

SOME EXAMPLES Physical Environment: Engineers produce products and services depending on physical laws. Physical efficiency takes the form: System output(s) Physical (efficiency) = System input(s) ECON 401: Engineering Economics

SOME EXAMPLES 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. System worth Economic (efficiency) = System cost ECON 401: Engineering Economics

SOME EXAMPLES Satisfaction of the physical and economic environments is linked through production and construction processes. Engineers need to control systems to achieve a balance in both the physical and economic environments, and within the bounds of limited resources. ECON 401: Engineering Economics

Rational Decision-Making Process
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 ECON 401: Engineering Economics

Rational Decision Making Process
Rational decision making is a complex process that contains a number of essential elements. 1. Recognize a decision problem 2. Define the goals and objectives 3. Collect all relevant information 4. Identify a set of feasible decision alternatives 5. Select the decision criterion to use 6. Select the best alternative ECON 401: Engineering Economics

Which Car to Lease? Saturn vs. Honda
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 Need a car Want mechanical security Gather technical as well as financial data Choose between Saturn and Honda Want minimum total cash outlay Select Honda ECON 401: Engineering Economics

Financial Data Required to Make an Economic Decision
ECON 401: Engineering Economics

Engineering Economic Decisions
Manufacturing Profit Planning Investment Marketing ECON 401: Engineering Economics

Predicting the Future Estimating a Required investment Forecasting a product demand Estimating a selling price Estimating a manufacturing cost Estimating a product life ECON 401: Engineering Economics

Role of Engineers in Business
The present day Computer and Software companies (Apple Computer, Microsoft Corporation, Sun Microsystems) were all started in the late 1970s and 1980s by the young college students with engineering background. As the business grew, they became partnerships and were eventually converted to corporations. An Engineer should know the nature of the various business organizations, especially related with his specialization/ profession. ECON 401: Engineering Economics

Types of Business Organizations
1. Proprietorships A business owned by one person 2. Partnerships A business owned by more than one person (partners) through a contract 3. Corporations A legal entity created under the government law ECON 401: Engineering Economics

Proprietorships Advantages Disadvantages Formed easily and inexpensively Earnings are taxed at owner’s personal income tax, which will be lower than corporate income tax Personal liability Difficult to raise capital (cannot issue stocks bonds) for business expansion ECON 401: Engineering Economics

Partnerships Advantages Disadvantages Low cost (one person’s contribution is lesser) Ease of formation as the personal assets of all the partners stand behind the business Each partner is liable for a business’s debts Partnership has a limited life, as when one partner quits, partnership is to be reorganized ECON 401: Engineering Economics

Corporations Advantages Disadvantages Can raise capital from large number of investors Easy transfer of ownership interest by trading shares of stock Personal liability is limited (to the individual investment) Expensive Subject to numerous government rules and regulations ECON 401: Engineering Economics

Role of Engineers in Business
Create & Design Engineering Projects Evaluate Expected Profitability Timing of Cash Flows Degree of Financial Risk Evaluate Impact on Financial Statements Firm’s Market Value Stock Price Analyze Production Methods Engineering Safety Environmental Impacts Market Assessment ECON 401: Engineering Economics

FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS
A nearby penny is worth a distant dollar A fundamental concept in engineering economics is that money has a time value associated with it. It is better to receive money earlier than later. ECON 401: Engineering Economics

If you receive $100 now, you can invest it and have more money available six months from now. This concept will be the basic foundation for all engineering project evaluation. ECON 401: Engineering Economics

Time Value of Money ECON 401: Engineering Economics

All that counts are the differences among alternatives. An economic decision should be based on the differences among the alternatives considered. All that is common is irrelevant to the decision. ECON 401: Engineering Economics

Option Monthly Fuel Cost Monthly Maintenance Cash Outlay at Signing Monthly Payment Salvage Value at the End of Year 3 Buy $960 $550 $6,500 $350 $9,000 Lease $2,400 Irrelevant items in decision making Differential Analysis ECON 401: Engineering Economics

Marginal Revenue must exceed Marginal Cost. Each decision alternative must be justified on its own economic merits before being compared with other alternatives. Marginal revenue means the additional revenue made possible by increasing the activity by one unit. ECON 401: Engineering Economics

Marginal cost means that productive resources like natural resources, human resources, capital goods available to make goods and services are limited. Therefore, people can not have all the goods and services they want. As a result, they must choose some things and give up others. ECON 401: Engineering Economics

Marginal Cost Cost of Goods Sold $2 per unit Gross Revenue $4 per unit Marginal Revenue Marginal Analysis ECON 401: Engineering Economics

Additional Risk is not taken without the Expected Additional Return. Investors demand a minimum return that must be greater than the anticipated rate of inflation or any perceived risk. ECON 401: Engineering Economics

Expected returns from bonds and stocks are normally higher than the expected return from a savings account. ECON 401: Engineering Economics

Investment Class Potential Risk Expected Return Savings account (Cash) Low/None 1.5% Bond (Debt) Moderate 4.8% Stock (Equity) High 11.5% Risk and Return Trade Off ECON 401: Engineering Economics

Types of Strategic Engineering Economic Decisions
Equipment and process selection Equipment replacement New product and product expansion Cost reduction, and Service or quality improvement ECON 401: Engineering Economics

1. Equipment & process selection Selecting the best course of action from various alternatives to get best returns 2. Equipment replacement Decision involves considering the expenditure necessary to replace worn-out or obsolete equipments 3. New product & product expansion To increase the revenue Two common types: Through existing production/distribution, Through new product or expand to a new geographical area ECON 401: Engineering Economics

4. Cost Reduction Attempts to lower operating costs of the company Whether a company should buy equipment to perform an operation currently done manually or spend money now in order to save more money later 5. Service improvement To improve of the quality of products/ services ECON 401: Engineering Economics

Two Factors in Engineering Economic Decisions
The factors of time and uncertainty are the defining aspects of any engineering economic decision. ECON 401: Engineering Economics

The Time Value of Money McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline Time value associated with money
Determining future value at given interest rate Present value based on current value of funds to be received Determining Yield on an Investment. Compounding or discounting occurring on a less than annual basis

Relationship to The Capital Outlay Decision
The time value of money is used to determine whether future benefits are sufficiently large to justify current outlays Mathematical tools of the time value of money are used in making capital allocation decisions

Future Value – Single Amount
Measuring value of an amount that is allowed to grow at a given interest over a period of time Assuming that the worth of $1,000 needs to be calculated after 4 years at a 10% interest per year, we have: 1st year……$1,000 X 1.10 = $1, nd year…...$1,100 X 1.10 = $1, rd year……$1,210 X 1.10 = $1, th year……$1,331 X 1.10 = $1,464

Future Value – Single Amount (Cont’d)
A generalized formula for Future Value: Where FV = Future value PV = Present value i = Interest rate n = Number of periods; In the previous case, PV = $1,000, i = 10%, n = 4, hence;

Future Value of $1(FVIF)
Table 9–1

Future Value – Single Amount (Cont’d)
In determining future value, the following can be used: Where = the interest factor If $10,000 were invested for 10 years at 8%, the future value would be:

Present Value – Single Amount
A sum payable in the future is worth less today than the stated amount The formula for the present value is derived from the original formula for future value: The present value can be determined by solving for a mathematical solution to the formula above, thus restating the formula as: Assuming

Present Value of $1(PVIF)
Table 9–2

Relationship of Present and Future Value

Future Value – Annuity Annuity: Future Value of an Annuity:
A series of consecutive payments or receipts of equal amount Future Value of an Annuity: Calculated by compounding each individual payment into the future and then adding up all of these payments

Future Value – Annuity (cont’d)
A generalized formula for Future Value of Annuity: FVA = A × FVIFA Where: FVA = Future value of the Annuity FVIFA = Annuity Factor = {[(1+i)n – 1] ÷ i} A = Annuity value i = Interest rate n = Number of periods; Assuming, A = $1,000, n = 4, and i = 10%

Compounding Process for Annuity

Future Value of an Annuity of $1(FVIFA)
Table 9–3

Present Value – Annuity
Calculated by discounting each individual payment back to the present and then adding up all of these payments A generalized formula for Present Value of Annuity: PVA = A × PVIFA Where: PVA = Present value of the Annuity PVIFA = Annuity Factor = {1 – [1 ÷ (1+i)n] ÷ i} A = Annuity value i = Interest rate n = Number of periods

Present Value of an Annuity of $1(PVIFA)
Assuming that A = $1,000, n = 4, i = 10%, we have: Table 9–4

Time Value Relationships
Comparisons include: The relationship between present value and future value Inverse relationship exists between the present value and future value of a single amount The relationship between the Present Value of a single amount and the Present Value of an Annuity The Present Value of an Annuity is the sum of the present values of single amounts payable at the end of each period The relationship between the Future Value and Future Value of Annuity The Future Value of an Annuity is the sum of the future values of single amounts receivable at the end of each period

Determining the Annuity Value
A re-look at the variables involved in time value of money: FV/PV : Future/Present value of money N : no. of years I : Interest or YIELD A : Annuity Value / payment per period in an annuity Given the first three variables, and determining the fourth variable “A” (unknown ).

Annuity Equaling a Future Value
Assuming that at a 10% interest rate, after 4 years, an amount of $4,641 needs to accumulated: For n = 4, and i = 10%, is Thus, A equals $1,000 as below :

Annuity Equaling a Present Value
Determining what size of an annuity can be equated to a given amount: Assuming n = 4, i = 6%:

Relationship of Present Value to Annuity
Annual interest is based on the beginning balance for each year as shown in the following table that shows flow of funds: Table 9–5

Loan Amortization A mortgage loan to be repaid over 20 years at 8% interest:

Loan Amortization Table
In such a case the part of the payments to the mortgage company will go toward the payment of interest, with the remainder applied to debt reduction, as indicated in the following table: Table 9–6

Six Formulas

Determining the Yield on Investment
Determining the unknown variable “ i “, given the following variables : FV/PV : Future/Present value of money N : no. of years A : Annuity Value / payment per period in an annuity

Yield – Present Value of a Single Amount
To calculate the yield on an investment producing $1,464 after 4 years having a present value of $1,000: We see that for n = 4 and = 0.683, the interest rate or yield is 10%

Yield – Present Value of a Single Amount (Cont’d)
Interpolation may also be used to find a more precise answer Difference between the value at the lowest interest rate and the designated value The exact value can be determined as:

Yield – Present Value of an Annuity
To calculate the yield on an investment of $10,000, producing $1,490 per annum for 10 years: Hence:

Yield – Present Value of an Annuity (Cont’d)
Flip back to the table containing the Present Value-Annuity factors on Slide 9-16 Read across the columns for n = 10 periods, one can see that the yield is 8 percent Interpolation applied to a single amount can also be applied here for a more precise answer

Special Considerations in Time Value Analysis
Compounding frequency Certain contractual agreements may require semiannual, quarterly, or monthly compounding periods In such cases, N = No. of years × No. of compounding periods during the year I = Quoted annual interest / No. of compounding periods during the year

Special Considerations in Time Value Analysis
Patterns of Payment Problems may evolve around a number of different payment or receipt patterns Not every situation involves a single amount or an annuity A contract may call for the payment of a different amount each year over the stated period or period of annuity

Compounding frequency : Cases
Case 1: Determine the future value of a $1,000 investment after 5 years at 8% annual interest compounded semiannually Where, n = 5 × 2 = 10; i = 8% / 2 = 4% (using Table 9–1 FVIF = 1.480) Case 2: Determine the present value of 20 quarterly payments of $2,000 each to be received over the next 5 years, where i = 8% per annum Where, n = 20; i = 2%

Patterns of Payment : Cases
Assume a contract involving payments of different amounts each year for a three-year period To determine the present value, each payment is discounted to the present and then totaled (Assuming 8% discount rate)

Deferred Annuity Situations involving a combination of single amounts and an annuity. When annuity is paid sometime in the future

Deferred Annuity : Case
Assuming a contract involving payments of different amounts each year for a three year period : An annuity of $1,000 is paid at the end of each year from the fourth through the eighth year To determine the present value of the cash flows at 8% discount rate To determine the annuity

Deferred Annuity : Case (Cont’d)
To discount the $3,993 back to the present, which falls at the beginning of the fourth period, in effect, the equivalent of the end of the third period, it is discounted back three periods, at 8% interest rate

Deferred Annuity : Case (Cont’d)

Alternate Method to Compute Deferred Annuity
Determine the present value factor of an annuity for the total time period, where n = 8, i = 8%, the PVIFA = 5.747 Determine the present value factor of an annuity for the total time period (8) minus the deferred annuity period (5). Here, 8 – 5 = 3; n = 3; i = 8%. Thus the value is 2.577 Subtracting the value in step 2 from the value of step 1, and multiplying by A;

Alternate Method to Compute Deferred Annuity (Cont’d)
$3,170 is the same answer for the present value of the annuity as that reached by the first method The present value of the five-year annuity is added up to the present value of the inflows over the first three years to arrive at:

Chapter 3 Learning Objectives
Recognize relationships among financial documents and money management activities Design a system for maintaining personal financial records Develop a personal balance sheet and cash flow statement Create and implement a budget Relate money management and savings activities to achieve financial goals 3-84

Successful Money Management
Objective 1: Recognize relationships among financial documents and money management activities Daily spending and saving decisions are the heart of financial planning Decisions must be coordinated with needs, goals, and personal situations 3-85

Successful Money Management
Money management is the day-to-day financial activities needed to manage personal economic resources, while working toward long-term financial security 3-86

Successful Money Management (continued)
OPPORTUNITY COST AND MONEY-MANAGEMENT Spending money on current living expenses reduces the amount you can save and invest Saving and investing for the future reduces the amount you can spend now Buying on credit ties up future income Using savings for purchases results in lost interest and depletes savings Comparison shopping can save money but takes valuable time 3-87

COMPONENTS OF MONEY MANAGEMENT
3-88

A System for Personal Financial Records
Objective 2: Design a system for maintaining personal financial records Benefits of an Organized System of Financial Records Handling daily business affairs, including payment of bills on time Planning and measuring financial progress Completing required tax reports Making effective investment decisions Determining available resources for current and future buying 3-89

A System for Personal Financial Records (continued)
ITEMS IN YOUR HOME FILE Personal and employment records Money management records Tax records Financial services records Consumer purchase, auto and credit records Housing records Insurance records Investment records Estate planning and retirement records 3-90

ITEMS IN THE SAFE DEPOSIT BOX Records that would be hard to replace Birth, marriage and death certificates, copy of will Citizenship and military papers Adoption and custody papers Serial numbers and photos of valuables CDs and credit and banking account numbers Mortgage papers and titles List of insurance policy numbers Stock and bond certificates Coins and other collectibles 3-91

RECORDS ON YOUR PERSONAL COMPUTER Current and past budgets Summary of checks written and other banking transactions Past income tax returns prepared with tax preparation software Account summaries and performance results of investments Computerized versions of wills, estate plans, and other documents 3-92

HOW LONG SHOULD RECORDS BE KEPT? Birth certificates, wills, and Social Security information should be kept indefinitely Keep records on personal property and investments as long as you own them Keep documents related to the purchase and sale of real estate indefinitely Copies of tax returns and supporting data should be kept six years 3-93

Personal Financial Statements
Objective 3: Develop a personal balance sheet and cash flow statement Purpose of Personal Financial Statements Report your current financial position in relation to the value of the items you own and the amounts you owe Measure your progress toward your financial goals Maintain information on your financial activities Provide data you can use when preparing tax forms or applying for credit 3-94

Personal Financial Statements (continued)
BALANCE SHEET: WHERE ARE YOU NOW? Also called the Net Worth Statement or Statement of Financial Planning Preparation of Balance Sheet requires using the following Steps STEP 1: LISTING ITEMS OF VALUE Assets - what you own Liquid assets Real estate Personal possessions Investment assets 3-95

STEP 2: DETERMINING THE AMOUNTS OWED Liabilities - what you owe Current liabilities (< 1 year) Long term liabilities STEP 3: COMPUTING NET WORTH Assets – Liabilities = Net Worth Assets = Net Worth + Liabilities Insolvency is the inability to pay debts when they are due 3-96

Net Worth is an indication of the financial position at any given date Ways to increase Net Worth Increasing your savings Reducing spending Increasing the value of investments and other possessions Reducing the amounts you owe 3-97

THE CASH FLOW STATEMENT Cash Flow is the actual inflow, outflow for a given time period The Cash Flow statement is also called personal income and expenditure statement 3-98

THE CASH FLOW STATEMENT The process of preparing cash flows statement follows these steps STEP 1: RECORD INCOME Wages, salaries, and commissions Self-employment business income Savings and investment income Gifts, grants, scholarships and educational loans Government payments, such as Social Security, public assistance, and unemployment benefits Amounts received from pension and retirement programs Alimony and child support payments 3-99

STEP 2: RECORD CASH OUTFLOWS Fixed Expenses Variable expenses STEP 3: DETERMINE NET CASH FLOWS The difference between income and outflows can either be positive or negative Cash flow statement provides the foundation for preparing and implementing a spending, saving, and investment plan 3-100

Budgeting for Skilled Money Management
Objective 4: Create and implement a budget A budget is a spending plan The main purposes of a budget are to help you Live within your income Spend your money wisely Reach your financial goals Prepare for financial emergencies Develop wise financial management habits 3-101

Budgeting for Skilled Money Management (continued)
STARTING THE BUDGETING PROCESS Insert Exhibit 3-5 3-102

Budgeting for Skilled Money Management (continued)
CHARACTERISTICS OF SUCCESSFUL BUDGETING Well-planned Realistic Flexible Clearly communicated 3-103

Selecting a Budgeting System
Which one works for you? Mental budget – it is all in your head Physical budget-use envelopes for your expenses such as food, rent, etc. Written budget – use spreadsheets Computerized budget – use software such as Quicken ( Online budget- ( Budget App-using your phone to track expenses. 3-104

Money Management and Achieving Financial Goals
Objective 5: Relate money management and savings activities to achieve financial goals Reasons for saving include… Setting aside money for irregular and unexpected expenses Paying for the replacement of expensive items, such as cars or a down payment on a house Buying special items like recreational equipment or to pay for a vacation Providing for long-term expenses such as retirement or the education of children Earning income from the interest on savings for use in paying living expenses 3-105

Money Management and Achieving Financial Goals (continued)
SELECTING A SAVINGS TECHNIQUE Payroll deductions into savings accounts Automatic payments from checking into savings accounts or mutual funds Saving regularly in 401(k) plans Also save coins, make periodic deposits Write a check each payday as a % of income and deposit into savings 3-106

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