BASIC ENGINEERING ECONOMY PRINCIPLES

OVERVIEW

This module will be discussing the concepts basic concepts and

principles governing engineering economy such as decision, capital
funds, measure of worth, law of supply and demand, law of diminishing
returns, and types of economic/market situation.

LEARNING OBJECTIVE

At the end of this module, you should be able to:

1. Determine the role of engineering economy in the decision-

making process.
2. Identify what is needed to successfully perform an engineering
economy study.
3. Identify and use engineering economy terminology and symbols.
4. Determine Basic Economic Principles;
5. Differentiate Laws between Supply and Demand;
6. Enumerate some Economic Situation based on the movements of
sellers and buyers; and
7. Familiarize at least one Factor of Production based on
Economical Concept.

LEARNING CONTENT

Introduction

ENGINEERING ECONOMY involves formulating, estimating, and evaluating the

expected economic outcomes of alternatives designed to accomplish a
defined purpose. Mathematical techniques simplify the economic evaluation
of alternatives. Formulas and techniques used in engineering economics are
applicable to all types of money matters

Definitions

Economics is a science which deals with the attainment of the

maximum fulfilment of society’s unlimited demands for goods and
services.

Engineering Economy is the branch of economics which deals with the

application of economics laws and theories involving engineering and
technical projects or equipment.

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 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. On the contrary, engineering economy begins
only after the alternatives have been identified.

Principles of Engineering Economics

1.0 Make a List of Alternates: Plan A, Plan B, etc.

Identify the alternatives and define your final choice, final decision
among the alternatives.

2.0 What Is Different among the Alternates?

Define the differences in the expected future outcomes among the
alternatives, compare and decide on what you should consider.

3.0 Be Clear on What You Want.

Develop a consistent viewpoint among the alternatives including its
economic aspect.

4.0 Develop Common Performance Measures.

Using a common unit of measurement in the list of the different
prospective outcomes will become easier in the analysis and
comparison of the alternatives.

5.0 Meet ALL Relevant Criteria.

The decision making in the selection of a preferred alternative
requires the use of a criterion.

6.0 Weigh the Risk Against the Projected Rewards.

Uncertainty of the alternatives is inherent in projecting future
outcomes. It should be recognized in the analysis and comparison.

7.0 Check the Results of Action Plan and Revise Plan If/When
Improve decision making, alternatives should be practically
compared with the actual results achieved. Revisit decision when
needed.

Engineering Economics and the Design Process

An engineering economy study is accomplished using a structured

procedure and mathematical modelling 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.

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 ENGINEERING ECONOMIC ANALYSIS PROCEDURE

1. Problem recognition, definition, and evaluation

2. Define the goal or objectives
3. Define the feasible alternatives
4. Collect all relevant data/information
5. Evaluate each alternative
6. Select the “best” alternative
7. Implement and monitor the decision

Solutions:

(a) Problem: To find the least expensive method for setting up capacity to
produce drill bits.

(b) Assumptions: The revenue per unit will be the same for either machine;
start-up costs are negligible; breakdowns are not frequent; previous
employee’s data are correct; drill bits are manufactured the same way
regardless of the alternative chosen; in-house technicians can modify
the old machine so its life span will match that of the new machine;
neither machine has any resale value; there is no union to lobby for in-
house work; etc.

(c) Alternatives: (1) Modify the old machine for producing the new drill bit
(using in-house technicians); (2) Buy a new machine for $450,000; (3)
Get McDonald Inc. to modify the machine; (4) Outsource the work to
another company.

(d) Criterion: Least cost in dollars for the anticipated production runs, given
that quality and delivery time are essentially unaffected

(e) Risks: The old machine could be less reliable than a new one; the old
machine could cause environmental hazards; fixing the old machine
in-house could prove to be unsatisfactory; the old machine could be
less safe than a new one; etc.

(f) Non-monetary Considerations: Safety; environmental concerns;

quality/reliability differences; “flexibility” of a new machine; job security
for in-house work; image to outside companies by having a new
technology (machine); etc.

COST CONCEPTS FOR DECISION MAKING

1. Marginal Cost - the total of variable costs, i.e., prime cost plus variable
overheads. It is based on the distinction between fixed and variable costs.

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Fixed costs are ignored and only variable costs are taken into consideration
for determining the cost of products and value of work-in-progress and
finished goods.

2. Out of Pocket Costs - This is that portion of the costs which involves
payment to outsiders, i.e., gives rise to cash expenditure as opposed to such
costs as depreciation, which do not involve any cash expenditure. Such costs
are relevant for price fixation during recession or when make or buy decision
is to be made.

3. Differential Costs - The change in costs due to change in the level of

activity or pattern or technology or process or method of production is known
as differential costs. If any change is proposed in the existing level or in the
existing methods of production, the increase or decrease in total cost as a
result of this decision is known as differential cost.

4. Sunk Costs -A sunk cost is an irrecoverable cost and is caused by complete

abandonment of a plant. It is the written down value of the abandoned
plant less its salvage value. Such costs are historical which are incurred in the
past and are not relevant for decision-making and are not affected by
increase or decrease in volume. Thus, expenditure which has taken place
and is irrecoverable in a situation is treated as sunk cost.

5. Opportunity Cost- It is the maximum possible alternative earning that might

have been earned if the productive capacity or services had been put to
some alternative use. In simple words, it is the advantage, in measurable
terms, which has been foregone due to not using the facility in the manner
originally planned.

6. Imputed Costs - Notional costs or imputed costs are those costs which are
notional in character and do not involve any cash outlay, e.g., notional rent
charged on business premises owned by the proprietor, interest on capital for
which no interest has been paid. When alternative capital investment
projects are being evaluated it is necessary to consider the imputed interest
on capital before a decision is arrived as to which is the most profitable
project.

7. Replacement Cost- It is the cost at which there could be purchase of an

asset or material identical to that which is being replaced or revalued. It is the
cost of replacement at current market price.

8. Avoidable Cost and Unavoidable Cost - Avoidable costs are those which
can be eliminated if a particular product or department, with which they are
directly related, is discontinued.

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For example, salary of the clerks employed in a particular department can
be eliminated, if the department is discontinued. Unavoidable cost is that
cost which will not be eliminated with the discontinuation of a product or
department. For example, salary of factory manager or factory rent cannot
be eliminated even if a product is eliminated.

9. Relevant Cost and Irrelevant Cost- A cost that is relevant to a decision is

called relevant cost. Past costs are not generally relevant costs because they
are sunk costs or costs already incurred. Thus, the book value of an asset or
depreciation charged in accounts in respect of an asset is not relevant cost.
On the other hand, the fall in the resale value of an asset as a result of using
it, as also the running expenses incurred to make use of the asset are relevant
costs.

DECISION-MAKING

Decisions are made routinely to choose one alternative over another:

- by engineers on the job
- by managers who supervise the activities of others
- by corporate presidents who operate a business
- by government officials who work for public good

Most decisions involve money called capital or capital funds, which is

usually limited in amount. Engineers play a vital role in capital investment
decisions based upon their ability and experience to design, analyze and
synthesize.

Engineering Economy is the analysis and evaluation of the factors that

will affect the economic success of engineering projects to the end that a
recommendation can be made which will insure the best use of capital.

Engineering Economy involves formulating, estimating, and evaluating

the expected economic outcomes of alternatives designed to accomplish a
defined purpose. Mathematical techniques simplify the economic evaluation
of alternatives.

Since most decisions affect what will be done, the time frame of
engineering economy is primarily the future.

Therefore, the numbers used in engineering economy are best

estimates of what is expected to occur. The estimates and the decision
usually involve four essential elements:
1. Cash flows
2. Times of occurrence of cash flows

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 3. Interest rates for time value of money
4. Measure of worth for selecting an alternative

The criterion used to select an alternative in engineering economy for

a specific set of estimates is called a measure of worth.
1. Present worth (PW)
2. Future worth (FW)
3. Annual worth (AW)
4. Rate of return (ROR)
5. Benefit/ Cost (B/C)
6. Capitalized cost (CC)
7. Payback period
8. Profitability index
9. Economic value added (EVA)

All these measures of worth account for the fact that money makes
money over time. This is the concept of the time value of money.

It is a well-known fact that money makes money.

The time value of money explains the change in the amount of money
overtime for funds that are owned (invested) or owed (borrowed). This is the
most important concept in Engineering Economy.

Engineering Economics is applied in an extremely wide variety of

situations. Samples are:
1. Equipment purchases and leases
2. Chemical processes
3. Cyber security
4. Construction projects
5. Airport design and operations
6. Sales and marketing projects
7. Transportation systems of all types
8. Product design
9. Wireless and remote communication and control
10. Manufacturing processes
11. Safety systems
12. Hospital and healthcare operations
13. Quality assurance
14. Government services for residents and businesses

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CONSUMER AND PRODUCER GOODS AND SERVICES

Consumer goods and services

These are those products or services that are directly used by
people to satisfy their wants.

Producer goods and services

These are used to produce consumer goods and services or
other producer goods.

NECESSITIES AND LUXURIES

Necessities
These are those products or services that are required to support
human life and activities that will be purchased in somewhat the
same quality even though the price varies considerably.

Luxuries
These are those products or services that are desired by humans
and will be purchased if money is available after the required
necessities have obtained.

LAW OF SUPPLY AND DEMAND

“Under conditions of perfect competition, the price at which a given

product will be supplied and purchased is the price that will result in the
supply and the demand being equal. “

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LAW OF DIMINISHING RETURNS

“When the use of one of the factors of production is limited, either

increasing cost or by absolute quantity, a point will be reached beyond
which an increase in the variable factors will result in a less than
proportionate increase in output. “

TYPES OF ECONOMIC/MARKET SITUATION

1. PERFECT COMPETITION
A market situation when a product is traded freely by buyers and
sellers in large numbers without any individual transaction
affecting the price.

2. MONOPOLY
A market situation where there is only a single seller or producer
supplies a commodity or service.

3. OLIGOPOLY
A market situation where there are few suppliers of a particular
product that one supplier’s actions significantly impact prices
and supply

4. MONOPSONY
A market situation where there are many sellers or producers and
has only one buyer.

5. OLIGOPSONY
A market situation where there are many sellers or producers and
have few buyers.

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KEY CONCEPTS/ FOCUS POINTS

Engineering Economy covers the basic steps in the success of an

engineering projects leaning towards the assessment of
economy as a whole.

Correct decision-making is important.

Engineering Economy is present in almost all engineering field.

There are several examples of market situations that follows

certain laws especially laws followed by economists.

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 CROSSWORD PUZZLE

Determine the appropriate term that best corresponds to the definitions as

shown below by filling out the crossword puzzle.

Clue:
1. Products or services that are required to support human life and
activities that will be purchased in somewhat the same quantity even
though the price varies considerably.
2. Economic decision making for engineering systems.
3. Fee that is charged for the use of someone else’s money.
4. Owner of the money.
5. A series of equal payments made at equal intervals of time.
6. Difference between the future worth and its present worth.; d = F – P
7. Interest may be compounded daily, hourly, per minute, etc.; Interest
may be considered to be compounded an infinite number of times per
year.
8. Only a single seller or producer supplies a commodity or service.
9. Those products or services that are desired by humans and will be
purchased if money is available after the required necessities have
obtained.
10. A graphical representation of cash flows drawn on a time scale.
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