Module 1: Introduction

SI-4151 Ekonomi Teknik

Rani G. K. Pradoto, Ph.D.
Outline Module 1
 What is Economics?
 What is Engineering Economy?
 The Role of Engineering in Shaping the Economic
Environment
 Project Life Cycle
 Some Concepts, Definitions and Terminologies
 Time Value of Money
 Interest and Interest Rate
 Cash Flow

1-2 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.

What is Economics?
 The study of how limited resources are used to
satisfy unlimited human wants.
 The study of how individual and societies choose to
use and utilize scarce resources
 Resources:
 LAND  all gifts of nature that can be applied to the
process (production)
 LABOR  efforts, skills, expertise, knowledge of people
which can be applied to the process
 CAPITAL  human, tools/machineries, financial

1-3 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.

What is Engineering Economy?
 Engineering and the Economy
 Any endeavor, including engineering, will always have
consequences
 Engineering endeavor
 Add value  betterment of effectiveness, efficiency, changing conditions
 Add economic value  the most common comparable measurement
 Example:
 Economic decisions
 A piece of equipment has been used for 10 years as part of important
process. Current condition indicates that service level is slightly decrease,
often breaks down. On the other hand the demand for product is in
constant increase, at least for the next 5 years.
 Alternatives:
 Replaced with a new one or to be repaired
 Current and future technology (?)
 Future demand (?)

1-4 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.

Engineering Economy
 Deals with the concepts and techniques of analysis
useful for evaluating the worth of goods, services,
system in relation to cost
 For engineers, it is used to answer questions such
as:
 Which engineering projects are worthwhile?
 Which engineering projects should have higher priority?
 How should an engineering project be designed?
 The answers based on the concepts of:
 Cash flows (cash in and cash out)
 Interest rate and time value of money
 Equivalent techniques

1-5 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.

The Role of Engineering in Shaping the
Economic Environment
 Engineering Options
 There are many (engineering) alternative solution for any
problem or challenge
 What solution is best to satisfy? For now or anytime in the
future
 How do we compare one to another?
 Engineering Steps
1. Determine objectives
2. Identification of strategic factors
3. Determine means  engineering proposals
4. Evaluation of engineering proposals  cash flow of
alternatives
5. Decision making  economic evaluation

1-6 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.

Project Life Cycle
Concept &
Definition
Phase Next Cycle
Design Phase

Construction Phase

Level of Change Operation & Maintenance Phase

scope cost

Time

1-7 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.

Time Value of Money
 Purchasing or earning power of money
 Funds borrowed for the prospects of gain are commonly
exchanged for goods, services or instruments of
production, that ultimately leads to increase earning
 Time value of money
 What you could buy with Rp. 1 million a year ago will not
be the same with the ones you buy today.
 Rp. 1 million you invested in a bank a year ago will yield
more when you draw today.
 Rp 1 million today is worth more than a year later.
 Concept of equivalence  different sums of money at
different time can be equal in economic value.
Rp. 1 Mill P F Rp. 1 Mill
+ interest

0 1 2 3 n-1 n
1-8 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.
Interest and Interest Rate
 Interest is defined as a rental amount charged by financial
institution of the use of money
 Interest rate (also known as rate of capital growth) is defined
as the rate gain received from an investment  measured in
%
 Interest rate is determined mutual agreement between the
borrower and the lender, or by market forces involving supply
and demand  market value.
 From lender’s point of view:
 Involves risk of default
 Compensate for not taking other alternative (including for own use)
 Cost of investigating borrower and other administrative expenses
 To make up for inflation
 From borrower’s point of view:
 Based in one’s utility, for personal use
 Based on expected return, for financing operation or investment

1-9 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.

Basic Calculation of Interest
Rp. 1 Mill P F Rp. 1 Mill
+ interest

0 1 2 3 n-1 n

 Original investment  present value (P)

 Total accumulated amount  future value (F)
 Interest , I = F – P
 Interest rate, i = (interest accrued per unit time) /
(original amount)

1-10 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.

Simple Interest
 Simple interest = (principal)(number of periods)(interest rate), I = P.n.i
 Accumulated amount, F = P + I = P(1+ni)

i=12%
End of Amount Owed at Interest Amount Owed at Amount Paid
Period Beginning of Charged End of Period at End of
(A) Period (C) = (B) x i (D) = (B) + (C) Period
(B)
1 Rp. 1.000.000,- Rp. 120.000,- Rp. 1.120.000,- Rp. 0
2 Rp. 1.120. 000,- Rp. 120.000,- Rp. 1.240.000,- Rp. 0
3 Rp. 1.240.000,- Rp. 120.000,- Rp. 1.360.000,- Rp. 0
4 Rp. 1.360.000,- Rp. 120.000,- Rp. 1.480.000,- Rp.
1.480.000,-
EXCEL

1-11 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.

 Compound Interest
 Compound interest  interest will be charged for all unpaid amount
 Accumulated amount, F = P(1+i)n
End of Amount Owed at Interest Charged Amount Owed at Amount Paid at
Period Beginning of Period (C) = (B) x i End of Period End of Period
(A) (B) = (C)n-1 (D) = (B) + (C) (E)
1 Rp. 1.000.000,- Rp. 120.000,- Rp. 1.120.000,- Rp. 0,-
2 Rp. 1.120. 000,- Rp. 134.400,- Rp. 1.254.400,- Rp. 0,-
3 Rp. 1.254.400,- Rp. 150.528,- Rp. 1.404,928- Rp. 0,-
4 Rp. 1.404.928,- Rp. 168.592,- Rp. 1.573.519,- Rp. 1.573.519,-

End of Amount Owed at Interest Amount Owed at End of Period

Period Beginning of Period Charged
1 P Pi P + Pi = P (1+i)1
2 P(1+i) P(1+i) i P(1+i) 1 + P(1+i)i = P (1+i) 2
3 P(1+i) 2 P(1+i) 2i P(1+i) 2 + P(1+i) 2.i = P (1+i) 3
n P(1+i) n-1 P(1+i) n-1i P(1+i) n-1 + P(1+I) n-1i = P(1+i) n EXCEL

1-12 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.

Exercise for Concept of Equivalence
 Loan: $ 5,000, i = 8%, n = 5
 Repayment plans:
 Plan 1: Simple interest, pay all at end.
 Plan 2: Compound interest, pay all at end.
 Plan 3: Simple interest paid annually, principal repaid at
end.
 Plan 4: Compound interest and portion of principal repaid
annually.
 Plan 5: Equal payments of compound interest and
principal made annually.
EXCEL

13 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.

Cash Flows
 Any undertaking and/or business endeavor (including
engineering projects) generally have economic
consequences that occur over an extended period of
time.
 Each project is described as cash received (inflow – cash
in) or disbursement or expenses (outflow – cash out) at
different point in time.
 Cash Flow Diagram (CFD) summarizes the costs and
benefits of engineering project over time. CFD illustrates
the size, sign and timing of individual cash flows and form
as the basis for engineering economic analysis

1-14 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.

Cash Flows Diagram
 In a CFD the end of period t is the same as the
beginning of next period t+1
 The choice of time 0 is arbitrary. It can be when
the project is analyzed, when funding is
approved or when the construction begins

1-15 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.

Homework #1
1. What will be the accumulated amount of Rp 1.750.000,-
compounded annually for three years at the rate of 15% p.a?
2. How much do you have to save now if you’d like to have
Rp. 12.500.000,- to start a new company 3 years from now at
the interest rate of 12% per year?
3. What is the rate of return of an initial investment worth Rp. 30
millions that yield Rp. 45.000.000,- after 3 years?
4. An initial investment of Rp. 50 millions is being considered.
The revenues from this investment are Rp 20 millions at the
end of first year, Rp 25 millions and Rp 15 millions at the end
of second and third years. If the alternative will give a
revenue of Rp 57,5 millions at the end of the third year, which
investment would you recommend? The interest rate is set at
10% annually.

1-16 SI-4151 Ekonomi Teknik Rani G. K. Pradoto Ph.D.