Chapter

INTRODUCTION TO ENGINEERING ECONOMY

1
OBJECTIVE:
The purpose of Chapter 1 is to present the concepts and principles of
Engineering Economy.

The Accreditation Board for Engineering and Technology states that

engineering “is the profession in which a knowledge of the mathematical and
natural sciences gained by study, experience, and practice is applied with judgment
to develop ways to utilize, economically, the materials and forces of nature for the
benefit of mankind.” In this definition, the economic aspects of engineering are
emphasized as well as the physical aspects. Clearly, it is essential that the
economic part of engineering practice be accomplished well. Thus, engineers use
knowledge to find new ways of doing things economically.

Definition
Engineering Economy involves the systematic evaluation of the
economic merits of proposed solutions to engineering problems. To be
economically acceptable, solutions to engineering problems must demonstrate a
positive balance of long-term benefits over long-term costs, and they must also
 promote the well-being and survival of an organization;
 embody creative and innovative technology and ideas;
 permit identification and scrutiny of their estimated outcomes; and
 translate profitability to the “bottom line” through a valid and acceptable
measure of merit.

Therefore, engineering economy is the money side of the decisions that

engineers make as they work to position a firm to be profitable in a highly
competitive marketplace. Inherent to these decisions are tradeoffs among different
types of costs and the performance (response time, safety, weight, reliability, etc.)
provided by the proposed design or problem solution. The mission of engineering
economy is to balance these tradeoffs in the most economical manner. Engineering
economy involves technical analysis, with emphasis on the economic aspects, and
has the objective of assisting decisions. An engineer who is unprepared to excel at
engineering economy is not properly equipped for his or her job.
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PRINCIPLES OF ENGINEERING ECONOMY

The development, study, and application of any discipline must begin with a
basic foundation. We defined the foundation for engineering economy to be a set of
principles, or fundamental concepts, that provide a comprehensive doctrine for
developing the methodology.

PRINCIPLE 1: DEVELOP THE ALTERNATIVES

The choice (decision) is among alternatives. The alternatives need to be

identified and then defined for subsequent analysis.

A decision situation involves making choice among two or more alternatives.

Developing and defining the alternatives for detailed evaluation is important
because of the resulting impact on the quality of the decision. Engineers and
managers should place a high priority on this responsibility. Creativity and
innovation are essential to the process.

One alternative that may be feasible in a decision situation is making no

change to the current operation or set of conditions (doing nothing). If you judge
this option feasible, make sure it is considered in the analysis. However, do not
focus on the status quo to the detriment of innovative or necessary change.

PRINCIPLE 2: FOCUS ON THE DIFFERENCES

Only the differences in expected future outcomes among the alternatives

are relevant to their comparison and should be considered in the decision.

If all prospective outcomes of the feasible alternatives were exactly the same,
there would be no basis or need for comparison. We would be indifferent among
the alternatives and could make a decision using a random selection.

PRINCIPLE 3: USE A CONSISTENT VIEWPOINT

The prospective outcome of the alternatives, economic and other, should

be consistently developed from a defined viewpoint (perspective).

The perspective of the decision maker, which is often that of the owners of
the firm, would normally be used. However, it is important that the viewpoint for
the particular decision be first defined and then used consistently in the
description, analysis, and comparison of the alternatives.

PRINCIPLE 4: USE A COMMON UNIT OF MEASURE

Using a common unit of measurement to enumerate as many of the

prospective outcomes as possible will make easier the analysis and comparison
of the alternatives.
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It is desirable to make as many prospective outcomes as possible

commensurable (directly comparable). For economic consequences, a monetary
unit is the common measure. It is also important to translate other outcomes
(which do not initially appear to be economic) into the monetary unit.
What should you do with the outcomes that are not economic – that is, the
expected consequences that cannot be translated (and estimated) using the
monetary unit? First, if possible, quantify the expected future results using an
appropriate unit of measurement for each outcome. If this is not feasible for one or
more outcomes, describe these consequences explicitly so that the information is
useful to the decision maker in the comparison of the alternatives.

PRINCIPLE 5: CONSIDER ALL RELEVANT CRITERIA

Selection of a preferred alternative (decision making) requires the use of a

criterion (or several criteria). The decision process should consider both the
outcomes enumerated in the monetary unit and those expressed in some other
unit of measurement or made explicit in a descriptive manner.

In engineering economic analysis, the primary criterion relates to the long-

term financial interests of the owners. This is based on the assumption that
available capital will be allocated to provide maximum monetary return to the
owners. Often, though, there are other organizational objectives you would like to
achiever with your decision, and these should be considered and given weight in
the selection of an alternative. These nonmonetary attributes and multiple
objectives become the basis for additional criteria in the decision-making process.

PRINCIPLE 6: MAKE UNCERTAINTY EXPLICIT

Uncertainty is inherent in projecting (or estimating) the future outcomes

of the alternatives and should be recognized in their analysis.

The analysis of the alternatives involves projecting or estimating the future

consequences associated with each of them. The magnitude and the impact of
future outcomes of any course of action are uncertain. Even if the alternative
involves no change from current operations, the probability is high that today’s
estimates of, for example, future cash receipts and expenses will not be what
eventually occur.

PRINCIPLE 7: REVISIT YOUR DECISIONS

Improved decision making results from an adaptive process; to the extent

practicable, the initial projected outcomes of the selected alternative should be
subsequently compared with actual results achieved.

A good decision-making process can result in a decision that has

undesirable outcome. Other decisions, even though relatively successful, will have
results significantly different from the initial estimates of the consequences.
Learning from and adapting based on our experience are essential; whether in the
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private or public sector of our economy, they are indicators of a good organization.
Only post-evaluations will highlight this type of weakness in the engineering
economy studies being done in an organization.

IMPORTANT APPLICATIONS OF ENGINEERING ECONOMY

The most important uses and functions of Engineering Economy are the
following:

SEEKING OF NEW OBJECTIVES

Engineers all over the world are constantly seeking new and wider
applications of their technical knowledge for the benefit of mankind. In this search,
engineering economy provides basic principles and laws. Companies usually
conduct market surveys to learn what people need and want.

DISCOVERY OF FACTORS LIMITING THE SUCCESS OF A VENTURE OR ENTERPRISE

Engineering economy seeks to discover so-called limiting factors, which may
hinder the success of a project. Among the limiting factors, there are some
outstanding ones, called strategic factors, which if altered may be made to ensure
the success of a venture.

ANALYSIS OF POSSIBLE INVESTMENT OF CAPITAL

Engineering economy enables engineers to consider all aspects of the

investment from both the technical and financial viewpoints. It furnishes several
patterns of analysis to determine rate of return, annual costs and payout periods,
which all serve as bases for decisions.

COMPARISON OF ALTERNATIVES AS A BASIS FOR DECISIONS

Most anything that has to be done can be accomplished in many ways with
satisfactory end results, but with varying expenditures. Usually, the alternative
that will accomplish the objective with the least expense is the most desirable. The
principles of engineering economy point out the analysis of such problems on a
quantitative basis and enable decision makers to choose the right decision.
Likewise, qualitative factors involving risk or uncertainty are easier to evaluate
when principles of engineering economy are known and applied.

DETERMINATION OF BASES FOR DECISION

The work of engineers is fundamentally concerned with future actions – on

what to do, not on what has been accomplished. Decisions on future actions are
more valid and their chances for accuracy are improved when principles of
engineering economy are correctly applied. A working knowledge of engineering
5 | Chapter 1 - Introduction to Engineering Economy

economy should improve the ability of an engineer to make correct decisions on all
technical matters involving cost.

ENGINEERING ECONOMY AND THE DESIGN PROCESS

An engineering economy study is accomplished using a structured procedure

and mathematical modeling techniques. The economic results are then used in a
decision situation that involves two or more alternatives and normally includes other
engineering knowledge and input.

A sound engineering economic analysis procedure incorporates the basic

principles of engineering economy add involves several steps. The seven-step
procedure is also used to assist decision-making within the engineering design
process. In this case, activities in the design process contribute information to
related steps in the economic analysis procedure. The general relationship between
the activities in the design process and the steps of the economic analysis
procedure in indicated in Table 1 – 1.

Table 1 – 1
The General Relationship Between the Economic Analysis Procedure and
the Engineering Design Process

Engineering Economic Analysis Engineering Design Process

Procedure
1. Problem recognition, formulation, 1. Problem/need definition.
and evaluation.
2. Problem/need formulation and
evaluation
2. Development of the feasible 3. Synthesis of possible solutions
alternatives (alternatives)
3. Development of the cash flows for
each alternative.
4. Selection of a criterion (or criteria). 4. Analysis, optimization, and
evaluation
5. Analysis and comparison of the
alternatives.
6. Selection of the preferred alternative 5. Specification of preferred alternative
7. Performance monitoring and post- 6. Communication
evaluation of results.

STEP 1: PROBLEM DEFINITION

The term problem is used here generally to include all decision situations for
which an engineering economy analysis is required. Recognition of the problem is
normally stimulated by internal or external organizational needs or requirements.
An operating problem within a company (internal need) or a customer expectation
about a product or service (external requirement) are examples.
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Once the problem is recognized, its formulation should be viewed from

systems perspective. That is, the boundary or extent of the situation needs to be
carefully defined, thus establishing the elements of the problem and what
constitutes its environment.
Evaluation of the problem includes refinement of needs and requirements,
and information form the evaluation phase may change the original formulation of
the problem.

STEP 2: DEVELOPMENT OF ALTERNATIVES

The two primary actions in this step are (1) searching for potential
alternatives and (2) screening them to select a smaller group of feasible alternatives
for detailed analysis. The term feasible here means that each alternative selected
for further analysis is judged, based on preliminary evaluation, to meet or exceed
the requirements established for the situation.

STEP 3: DEVELOPMENT OF PROSPECTIVE OUTCOMES

This step incorporates Principles 2, 3, and 4 of the Engineering Economy
Principles and uses the basic cash-flow approach. A cash flow occurs when money
is transferred from one organization (or individual) to another. Thus, a cash flow
represents the economic effects of an alternative in terms of money spent and
received.
In addition to the economic aspects of decision making, non-monetary factors
(attributes) often play a significant role in the final recommendation. Examples of
objectives other than profit maximization or cost minimization that can be
important to an organization include the following:
 Meeting or exceeding customer expectations
 Safety to employees and to the public
 Improving employee satisfaction
 Maintaining production flexibility to meet changing demands
 Meeting or exceeding all environmental requirements
 Achieving good public relations or being an exemplary member of the
community.

STEP 4: SELECTION OF A DECISION CRITERION

The decision maker will normally select the alternative that will best serve
the long-term interests of the owners of the organization. This step usually
incorporates Principles 3 and 4 of the Engineering Economy Principles.

STEP 5: ANALYSIS AND COMPARISON OF ALTERNATIVES

Analysis of the economic aspects of an engineering problem is largely based
on cash-flow estimates for the feasible alternatives selected for detailed study. A
substantial effort is normally required to obtain reasonably accurate forecasts of
cash flows and other factors in view, for example, inflationary (deflationary)
pressures, exchange rate movements, and regulatory (legal) mandates that often
occur. Clearly, the consideration of future uncertainties (Principle 6) is an essential
part of and engineering economy study. When cash flows and other required
estimates are eventually determined, alternatives can be compared based on their
7 | Chapter 1 - Introduction to Engineering Economy

differences as called by Principle 2. Usually, these differences will be quantified in

terms of a monetary unit.

STEP 6: SELECTION OF THE PREFERRED ALTERNATIVE

When the first five steps of the engineering economic analysis procedure
have been done properly, the preferred alternative is simply a result of the total
effort. Thus, the soundness of the technical-economic modeling and analysis
techniques dictates the quality of the results obtained and the recommended
course of action.

STEP 7: PERFORMANCE MONITORING AND POST-EVALUATION OF RESULTS

This final step implements Principle 7 and is accomplished during and after
the time that the results achieved from the selected alternative are collected.
Monitoring project performance during its operational phase improves the
achievement of related goals and objectives and reduces the variability in desired
results. This step is also the follow-up step to a previous analysis, comparing
actual results achieved with the previously estimated outcomes. The aim is to learn
how to do better analyses, and the feedback from post-implementation evaluation is
important to the continuing improvement of operations in any organization.
Unfortunately, this final step is often not done consistently or well in engineering
practice; therefore, it needs particular attention to ensure feedback for se in
ongoing and subsequent studies.

Example 1.1 (Application of the Engineering Economic Analysis Procedure)

Your father bought a small apartment building for Php1 million in a college town. He
spent Php100,000 of his own money for the building and obtained a mortgage from a
local bank for the remaining Php900,000. The annual mortgage payment to the bank is
Php105,000. Your father also expects that annual maintenance on the building and
grounds will be Php150,000. There are four apartment units (two bedrooms each) in
the building that can be rented for Php3,600 per month. Refer to the seven-step
procedure to answer these questions:
a. Does your father have a problem? If so, what is it?
b. What are his alternatives (identify at least three)?
c. Estimate the economic consequences and other required data for the alternatives
in part (b).
d. Select a criterion for discriminating among alternatives, and use it to advise your
friend on which course of action to pursue.
e. Attempt to analyze and compare the alternatives in view of at least one criterion
in addition to cost.
f. What should your father do based on the information you and he have
generated?
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 SOLUTION:
a. A quick set of calculations shows that your father does indeed have a problem.
A lot more money is being spent by your father each year than is being
received.
Outflows: Php105,000 + Php150,000 = Php255,000
Inflows: 4 units x Php3,600/unit per month x 12 months = Php172,800
The problem could be that the monthly rent is too low. He’s losing Php82,200
per year. Now, that’s a problem!

b. Option 1: Raise the rent. (Will the market bear an increase?)

Option 2: Lower maintenance expense (but not so far as to cause safety
problems).
Option 3: Sell the apartment building. (What about a loss?)
Option 4: Abandon the building. (Bad for your father’s reputation)

c. Option 1: Raise the monthly rent to Php14,400 + Php R for the four
apartments to cover monthly expenses of Php21,250. Note that the minimum
increase in rent would be
(Php21,250 – Php14,400)/4 = Php1,712.50 (almost 50% increase!)
Option 2: Lower monthly expenses to Php21,250 – Php C so that these
expenses are covered by the monthly revenue of Php14,400 per month. This
would have to be accomplished primarily by lowering the maintenance cost.
Monthly maintenance expenses would have to be reduced to
(Php14,400 – Php105,000/12) = Php5,650.
This represents more than a 50% decrease in maintenance expense.
Option 3: Try to sell the apartment building for Php X, which recovers the
original Php100,000 investment and (ideally) recovers the Php6,850 per
month loss (Php82,200/12) on the venture during the time it was owned.
Option 4: Walk away from the venture and kiss your investment goodbye!
The bank would likely assume possession through foreclosure and may try to
collect fees from your father. This option would also be very bad for your
father’s credit rating.
d. One criterion could be to minimize the expected loss of money. In this case,
you might advise your father to pursue Option 1 or 3.
e. For example, let’s use “credit worthiness” as an additional criterion. Option 4
is immediately ruled out. Exercising Option 3 could also harm your father’s
credit rating. Thus, Options 1 and 2 may be his only realistic and acceptable
alternatives.
f. Your father should probably do a market analysis of comparable housing in
the area to see if the rent could be raised (Option 1). Maybe a fresh coat of
paint and new carpeting would make the apartment more appealing to
prospective renters. If so, the rent can probably be raised while keeping
100% occupancy of the four apartments.
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NAME: _______________________________________ SCORE: ________________

COURSE/YEAR: _______________________________ DATE: _________________

EXERCISE 1

Analyze and answer the following.

1. While studying for the engineering economy final exam, you and two friends find
yourselves craving a fresh pizza. You can’t spare the time to pick up the pizza
and must have it delivered. “Pick-Up-Sticks” offers a 1-1/4-inch-thick
(including toppings), 20-inch square pizza with your choice of two toppings for
Php650 plus 15% sales tax and a Php50 delivery charge (no sales tax on delivery
charge). “Fred’s” offers the round, deep-dish Sasquatch, which is 20 inches in
diameter. It is 1-3/4 inches thick, includes two toppings, and costs Php750
plus 5% sales tax and free delivery.
a. What is the problem in this situation? Please state it in an explicit and
precise manner.
b. Systematically apply the seven principles of engineering economy to the
problem you have defined.
c. Assuming that your common unit of measure is pesos (i.e., cost), what is the
better value for getting a pizza based on the criterion of minimizing cost per
unit volume.
d. What other criteria might be used to select which pizza to purchase?

2. During your first month as an employee at Greenfield Industries (a large drill-bit

manufacturer), you are asked to evaluate alternatives for producing a newly
designed drill bit on a turning machine. Your boss’ memorandum to you has
practically no information about what the alternatives are and what criteria
should be used. The same task was posed to a previous employee who could not
finish the analysis, but she has given you the following information: An old
turning machine valued at Php350,000 exists (in the warehouse) that can be
modified for the new drill bit. The in-house technicians have given an estimate
of Php40,000 to modify this machine, and they assure you that they will have
the machine ready before the projected start date (although they have never
done any modifications of this type). It is hoped that the old turning machine
will be able to meet the production requirements at full capacity. An outside
company, McDonald Inc., made the machine seven years ago and can easily do
the same modifications for Php60,000. The cooling system used for this
machine is not environmentally safe and would require some disposal costs.
McDonald Inc. has offered to build a new turning machine with more
environmental safeguards and higher capacity for a price of Php450,000.
McDonald Inc. has promised this machine before the startup date and is willing
to pay any late costs. Your company has Php100,000 set aside for the start-up
of the new product line of drill bits. For this situation,
a. Define the problem.
b. List key assumptions.
c. List alternatives facing Greenfield Industries.
d. Select a criterion for evaluation of alternatives.
e. Introduce risk into this situation.
f. Discuss how nonmonetary considerations may impact the selection.