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

2. Principles of Engineering Economy

3. Cash Flows

4. 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.

5. 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

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

7. 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.

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

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

10. 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!

11. 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)

12. 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$

13. 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

14. 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$

15. 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$

16. 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$

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

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

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

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

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

22. 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.

23. 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 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.

24. Cash Flow Diagram
Timeline 1 2 3 10

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

26. Cash Flow Diagram Individual cash flows: Per Unit Revenues 384M 384M1 2 3 10
490M

27. Cash Flow Diagram Individual cash flows: Per Unit Costs 384M 384M 384M1 2 3 10
276M
276M
276M
276M
490M

28. Cash Flow Diagram Individual cash flows: Fixed Costs 384M 384M 384M1 2 3 10
276M
276M
276M
276M
10M
10.8M
11.7M
20M
490M

29. Cash Flow Diagram Individual cash flows: Salvage Value 25M 384M 384M1 2 3 10
276M
276M
276M
276M
10M
10.8M
11.7M
20M
490M

30. Cash Flow Diagram Net Cash Flow Diagram 113M 98.0M 97.2M 96.4M 89.5M1 2 3 9 10
490M

31. Cash Flow Diagram Net Cash Flow Diagram1 2 3 9 10
This is a “typical” investment.
(Invest at zero, returns later.)
490M

32. Cash Flow Diagram Net Cash Flow Diagram1 2 3 9 10
This is a “typical” investment.
(Invest at zero, returns later.)
Can also use a spreadsheet!
490M

33. Spreadsheet Basics
Sheet defined by rows and columns of cells.

34. 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!

35. 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.

36. 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!

37. Return to our Example

38. Return to our Example
Data Center with Data

39. 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).

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

41. Return to our Example

42. Lecture (6)
Chapter (2)

43. 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

44. 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.

45. 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.

46. 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

47. 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 $ Ticket $12.50
Gas Expense $ Refreshments $
Other Fuel Costs $20
Bus Driver $50
Total Costs $ 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?

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

49. 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

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 – ( n) = 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

51. 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.

52. 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?

53. 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

54. 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

55. Sunk and Opportunity Cost
Example 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

56. 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 

57. 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 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?

58. 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.

59. 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.

60. 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  

61. Life-Cycle Costs

62. 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.

63. 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