1. Engineering Economic Analysis
Chapter 1
MAKING ECONOMIC DECISIONS
This course is basically about how to decide to do things, or compare alternatives, specifically in terms of money.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

2. People are Surrounded by Problems
Which career to pursue?
What level of preparation is required for the career chosen?
Where may the preparation be obtained?
There are lots of problems in the world.
The problems are often not isolated from each other.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

3. Organizations Have Opportunities
Do we make part A or B today?
Should we use a drilling or boring machine?
Should we purchase a boring machine?
When must we replace the drilling machine?
Would a mechanized or computerized drilling machine be the preferred alternative?
Where do we locate machinery in the plant?
Decisions concerning these opportunities may be arrived at with the help of economic analysis.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

4. Simple Problems
Can generally be worked in one’s head without extensive analysis.
Do I risk getting a ticket by parking in “the wrong” lot?
If I use x pounds of tomatoes a week, how many pounds do I buy?
Typical simple problems are deciding to pay cash or use a credit card. Or
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

5. Intermediate Problems
Must be organized and analyzed
Are sufficiently important to justify serious thought and action
Have significant economic aspects
Are primarily economic
Are the principal subject of this course
Assume an economic situation in equilibrium
Are generally adequately solved with single-criteria decision making
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

6. Complex Problems
Such problems represent a mixture of 3 elements: economic, political and humanistic.
Complex problems are beyond the scope of this course from a decision-making criteria point of view, but the economic aspects of complex problems will be discussed.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

7. Role of Engineering Economic Analysis
Assists in making decisions where:
The decision is sufficiently important that serious thought and effort is required.
Careful analysis requires that the decision variables be carefully organized and the consequences be understood.
ECONOMIC ISSUES are a significant component of the analysis leading to a decision.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

8. The Decision Making Process
Recognize problem;
Define the goal or objective;
Assemble relevant data;
Identify feasible alternatives;
Select criterion to determine the best alternative;
Construct a model;
Predict each alternative’s outcomes or consequences;
Choose the best alternative; and
Audit the result.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

9. 1. Recognize the Problem A problem exists when:
A standard or expectation is not being met.
A new standard or expectation is established and needs to be achieved. (An opportunity.)
In the beginning the problems are a given.
Later you might have to analyze the information provided to determine the real problem.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

10. 2. Define the Goal or Objective
A goal or objective is the standard or expectation we wish to meet.
A goal is a general statement about what we expect.
Pay all our bills on time.
An objective is narrow and specific.
Pay the auto loan on Tuesday morning at the bank.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

11. 3. Assemble Relevant Data
Information may be published or individual knowledge.
Deciding which data is relevant may be a complex process.
In engineering decision making two important sources of data are the organization’s accounting and purchasing departments.
Accounting records are used to document past costs and to support documentation of the flow of money in a company’s operations
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

12. 3. Assemble Relevant Data – cont’d
Example 1-1 Scenario:
A printing department charges other departments $26.45 for 1000 copies, based on the following costs:
Direct labor: salary, benefits
Materials & supplies: toner, paper
Overhead: share of utilities, based on area
Assume the manager of the shipping department needs 30,000 copies, and has found an outside printer who can satisfy this order for $ ($22.95 per 1000 copies). The printing department would charge $ Should the shipping department be allowed to use an outside printer?
Direct labor $
Materials & supplies $
Overhead costs $
Total $
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

13. 3. Assemble Relevant Data – cont’d
Example 1-1 Discussion:
From a company point of view, the shipping department should be forced to use the printing department. (What?!?)
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

14. 3. Assemble Relevant Data – cont’d
Example 1-1 Discussion:
From a company point of view, the shipping department should be forced to use the printing department. (What?!?)
Most of the costs of the printing department will not be lowered even if the outside company makes the 30,000 copies.
Direct Labor: If the printing department can save the labor costs, then the company can save $7.60*30 = $228
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

15. 3. Assemble Relevant Data – cont’d
Example 1-1 Discussion:
From a company point of view, the shipping department should be forced to use the printing department. (What?!?)
Most of the costs of the printing department will not be lowered even if the outside company makes the 30,000 copies.
Direct Labor: If the printing department can save the labor costs, then the company can save $7.60*30 = $228
Materials & Supplies: All can be saved, so $9.8*30 = $294
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

16. 3. Assemble Relevant Data – cont’d
Example 1-1 Discussion:
From a company point of view, the shipping department should be forced to use the printing department. (What?!?)
Most of the costs of the printing department will not be lowered even if the outside company makes the 30,000 copies.
Direct Labor: If the printing department can save the labor costs, then the company can save $7.60*30 = $228
Materials & Supplies: All can be saved, so $9.8*30 = $294
Overhead: None can be saved – all utilities must be paid.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

17. 3. Assemble Relevant Data – cont’d
Example 1-1 Discussion:
From a company point of view, the shipping department should be forced to use the printing department. (What?!?)
Most of the costs of the printing department will not be lowered even if the outside company makes the 30,000 copies.
Direct Labor: If the printing department can save the labor costs, then the company can save $7.60*30 = $228
Materials & Supplies: All can be saved, so $9.8*30 = $294
Overhead: None can be saved – all utilities must be paid.
Total maximum savings: $522, if spend an additional $
Net “savings” is -$ – the company loses $166.50, even though the shipping department saves about $105.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

18. 4. Identify Feasible Alternatives
The best alternative should be implemented. Occasionally this is to maintain the existing situation.
Alternatives considered should include both conventional and innovative approaches.
Only feasible alternatives should be retained for further analysis.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

19. 5. Select the Criterion to Determine the Best Alternative
A criterion, or a set of criteria, is used to evaluate the alternatives to determine which is best.
The “best” alternative is relative.
Selecting criteria to use is not easy because different groups often support different criteria.
The criterion most often used in economic decision-making is to “use money in the most efficient manner.”
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

20. Economic Decision-Making Problems Fall Into Three Categories
For fixed input situations, maximize the benefits or other outputs.
For fixed output situations, minimize the costs or other inputs.
Where inputs and outputs vary, maximize (benefits – costs).
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

21. 6. Construct the Model
Requires merging the various elements: objective, relevant data, feasible alternatives and selection criteria.
In economic decision making the models are usually mathematical.
A model is a representation of reality.
A model must represent the important parts of the system at hand.
Be adequate to solve the problem.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

22. 7. Predicting the Outcomes for Each Alternative
To avoid complications, we assume that a decision is based on a single criterion. If necessary, multiple criteria are combined into a single criterion.
Usually the consequences or alternatives are stated in the form of money, i.e., costs/benefits.
Costs and benefits may occur over a short or long time period.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

23. 8. Choosing the Best Alternative
When choosing the best alternative both economic and non-economic criteria must be considered.
During the prior steps in the decision making process, only dominant alternatives may be included based on either economic or non-economic criteria.
The elimination of feasible alternatives may predetermine the outcome of the decision making process.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

24. 9. Audit the Results
Compare the results of changes to the predictions to assure that the chosen alternative was implement as planned and the results are as expected.
Fix deviations from planned changes.
Make sure prediction errors are not repeated.
Identify added opportunities.
Audits promote realistic economic analysis and implementation.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

25. An example of Engineering Decision Making
Ex 1-3 Scenario: A machine part is manufactured at a unit cost of 40¢ for material and 15¢ for direct labor. An investment of $500,000 in tooling is required. The order calls for 3 million pieces. Half-way through the order, a new method is developed that will reduce costs to 34¢ for material and 10¢ for direct labor, but an additional investment of $100,000 for tooling is required. Should the new method be used, or should the old method be continued?
Let’s apply the 9 steps of engineering decision making.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

26. An example - cont’d Step 1: Recognize the problem
The problem is that there is an order to fill.
Step 2: Define the goal
Make money
Step 3: Assemble data
Given in the problem. Usually the case in this class
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

27. An example - cont’d
Step 4: Identify alternatives, then filter to feasible alternatives
Don’t fill the order
Use old method (40¢ material, 15¢ direct labor)
Use new method
(34¢ material, 10¢ direct labor, $100,000 for tooling)
Since we have made 1.5 million parts, let’s assume that we will finish the order
Step 5: Select criterion
Once we decide to finish the order, we have fixed output. Therefore, we need to minimize cost (minimize input)
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

28. An example - cont’d Step 6: Construct a (general) model
total cost is made of material cost + labor cost + tooling cost
Step 7: Predict the outcome for each alternative
(apply the model to each alternative)
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

29. Step 6 version 2: the data in Excel
In Excel: We have model parameters and Inputs
We have an Input Parameter with a Range Name (B9 = numPieces)
See the video on BlackBoard for more info on nice Spreadsheets

30. Step 6 version 2: the model and its application in Excel
The model is the same, but we use Excel to build it

31. An example - cont’d Step 8: Select the better alternative
Using the new method will cost $760,000 to make the rest of the order, which is less than the cost of continuing to use the old method, so we should use the new method.
Step 9: Audit the result
We can’t here.
Engineering Economic Analysis - 9th Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.