MODULE 1 – Introduction to Engineering Economy 1

Engr. Caesar Pobre Llapitan

Topics
I. Introduction
II. The Principles of Engineering Economy
III. Engineering Economy and the Design Process
IV. Using Spreadsheets in Engineering Economic Analysis
V. Cost Concepts and Design Economics
VI. Present Economy Studies

Learning Objectives
At the end of this module, the students must be able to
1. define engineering economics and describe its role in decision making.
2. identify the steps in an engineering economy study.
3. describe the different steps and procedures in a decision situation that involves two or
more alternatives.
4. discuss the use of spreadsheets in engineering economic analysis.
5. analyze short-term alternatives when the time value of money is not a factor.
6. explain the present economy studies used for preferred alternative decision making.

This learning material introduces students to the decision-making process that

accompanies “go/no go” evaluations of investments in engineering projects.

I. INTRODUCTION

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.”

A. What is economics?
“Economics is the study of how people and society choose to employ scarce resources that
could have alternative uses in order to produce various commodities and to distribute
them for consumption, now or in the future, …”
– Paul Samuelson and William Nordhaus, Economics, 12th Ed., McGraw-Hill, New York,
1985.

Economics is the study of how individuals and societies choose to use the scarce resources that
nature and previous generations have provided. The key word in this definition is choose.

Economics is a behavioral, or social, science. In large measure, it is the study of how people
make choices. The choices that people make, when added up, translate into societal choices.

Primary resources:
1. Land
All gifts of nature, such as: water, air, minerals, sunshine, plant and tree growth, as well
as the land itself which is applied to the production process.

2. Labor
The efforts, skills, and knowledge of people which are applied to the production
process
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3. Capital
▪ Real Capital (Physical Capital)
– Tools, buildings, machinery -- things which have been produced and which
are used for further production

▪ Financial Capital
– Assets and money which are used in the production process

▪ Human Capital
– Education and training applied to labor in the production process

B. What is engineering economy?

Engineering economy involves the systematic evaluation of the economic merits of proposed
solutions to engineering problems. To be economically acceptable (i.e., affordable), 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.

o Engineering economy is a subset of economy for application to engineering projects.

o Engineers seek solutions to problems, and the economic viability of each potential
alternative or design is normally considered along with the technical aspects
o Engineering economy involves the evaluation of the costs and benefits of proposed
projects

In the simplest of terms, engineering economy is a collection of techniques that simplify

comparisons of alternatives on an economic basis.
▪ The study of how limited resources is used to satisfy unlimited human wants
▪ The study of how individuals and societies choose to use scarce resources that
nature and previous generations have provided.

Note:
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.

Origins of Engineering Economy

The perspective that ultimate economy is a concern to the engineer and the availability of sound
techniques to address this concern differentiates this aspect of modern engineering
practice from that of the past.

▪ Pioneer: Arthur M. Wellington, civil engineer

o latter part of nineteenth century;
o addressed role of economic analysis in engineering projects;
o area of interest: railroad building
▪ Followed by other contributions which emphasized techniques depending on financial
and actuarial mathematics.
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C. Why Engineering Economy is Important?

▪ There are lots of factors that are considered in making Decisions: these factors are
combinations of economic and non-economic ones.
o Engineers play a major role in investment by making decision based on
economic analysis and design considerations
o Thus, decisions often reflect the engineer’s choice of how to best invest funds
by choosing the proper alternative out of a set of alternatives

Role of Engineering Economy in Decision Making

▪ Engineers make decisions, but tools and computers do not.
▪ Tools assist engineers in making decisions.
▪ Decisions affect what will happen in the future and thus the time frame of engineering
economy is the future.
▪ So, engineering economy analysis presents the best estimates of what is expected to
occur.

II. PRINCIPLES OF ENGINEERING ECONOMY

The basic principles of engineering economy are used to develop the methodology of arriving
at the right decision. These are the following:
1. Develop the Alternatives
2. Focus on the Differences
3. Use a Consistent Viewpoint
4. Use a Common Unit of Measure
5. Consider All Relevant Criteria
6. Make Uncertainty Explicit
7. Revisit Your Decisions

Develop the Alternatives

The final choice (decision) is among alternatives. The alternatives need to be identified
and then defined for subsequent analysis.

− An alternative is a stand-alone solution for a given situation.

Example:
selecting the method of transportation, we use to get to work every day deciding between
buying a house or renting one

− The alternatives in engineering considerations usually involve such items as

purchase cost (first cost), anticipated useful life, yearly costs of maintaining assets
(annual maintenance and operating costs), anticipated resale value (salvage value),
and the interest rate.

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.

− The estimated inflows (revenues) and outflows (costs) of money are called cash
flows. These estimates are truly the heart of an engineering economic analysis.
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Use a Consistent Viewpoint

The prospective outcomes of the alternatives, economic and other, should be
consistently developed from a defined viewpoint (perspective).

− Whether we are aware of it or not, we use criteria every day to choose between
alternatives

For example, when you drive to campus, you decide to take the “best” route. But how did
you define best? Was the best route the safest, shortest, fastest, cheapest, most scenic, or
what? Obviously, depending upon which criterion or combination of criteria is used to
identify the best, a different route might be selected each time.

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 alternatives. Thus,
when there are several ways of accomplishing a stated objective, the alternative with the
lowest overall cost or highest overall net income is selected.

− In economic analysis, financial units (dollars or other currency) are generally used
as the tangible basis for evaluation.

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 the outcomes enumerated in the
monetary unit and those expressed in some other unit of measurement or made explicit
in a descriptive manner.

− The decision maker will normally select the alternative that will best serve the
long-term interests of the owners of the organization

Make Uncertainty Explicit

Uncertainty is inherent in projecting (or estimating) the future outcomes of the
alternatives and should be recognized in their analysis and comparison.

− Involves projecting or estimating the future consequences associated with

alternatives decision
o The magnitude and the impact of future outcomes of any course of action
are uncertain

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.

− Organizational discipline is needed to ensure that implemented decisions are

routinely post-evaluated and that the results are used to improve future analyses and
the quality of decision making.
o For example, a common mistake made in the comparison of alternatives is
the failure to examine adequately the impact of uncertainty in the estimates
for selected factors on the decision. Only post-evaluations will highlight this
type of weakness in the engineering economy studies being done in an
organization.
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Example:
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 is 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 $350,000 exists (in the warehouse) that can
be modified for the new drill bit. The in-house technicians have given an estimate of $40,000
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 production requirements at full
capacity. An outside company, McDonald Inc., made the machine seven years ago and can
easily do the same modifications for $60,000. 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 $450,000. McDonald Inc. has promised this machine before the startup date
and is willing to pay any late costs. Your company has $100,000 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.
g. Describe how a post-audit could be performed.

Answer:
(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; startup 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 (i.e., not compromised).

(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.

(g) Post Audit: Did either machine (or outsourcing) fail to deliver high quality product on time?
Were maintenance costs of the machines acceptable? Did the total production costs allow an
acceptable profit to be made?
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III. 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.
Engineering economic analysis procedure
1. Problem recognition, formulation, and evaluation.
– A problem must be well understood and stated in an explicit form before the project
team proceeds with the rest of the analysis.
– Recognition of the problem is normally stimulated by internal or external organizational
needs or requirements.

Examples:
operating problem within a company (internal need) or a customer expectation
about a product or service (external requirement)

2. Development of the feasible alternatives.

Two primary actions:

Searching for Superior Alternatives
In searching for superior alternatives or identifying the true problem, several limitations
invariably exist, including (1) lack of time and money, (2) preconceptions of what will
and what will not work, and (3) lack of knowledge.

Developing Investment Alternatives

Two approaches:
a) Classical Brainstorming
– based on the fundamental principles of deferment of judgment and that
quantity breeds quality

Four rules for successful brainstorming:

i. Criticism is ruled out.
ii. Freewheeling is welcomed.
iii. Quantity is wanted.
iv. Combination and improvement are sought.

A. F. Osborn lays out a detailed procedure for successful brainstorming:

i. Preparation. The participants are selected, and a preliminary statement of
the problem is circulated.
ii. Brainstorming. A warm-up session with simple unrelated problems is
conducted, the relevant problem and the four rules of brainstorming are
presented, and ideas are generated and recorded using checklists and other
techniques if necessary.
iii. Evaluation. The ideas are evaluated relative to the problem.

b) Nominal Group Technique

The basic format of an NGT session is as follows:
i. Individual silent generation of ideas
ii. Individual round-robin feedback and recording of ideas
iii. Group clarification of each idea
iv. Individual voting and ranking to prioritize ideas
v. Discussion of group consensus results
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3. Development of the cash flows for each alternative.

– incorporates Principles 2, 3, and 4 and uses the basic cash-flow approach employed in
engineering economy
o 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.
– nonmonetary factors (attributes)
a. Meeting or exceeding customer expectations
b. Safety to employees and to the public
c. Improving employee satisfaction
d. Maintaining production flexibility to meet changing demands
e. Meeting or exceeding all environmental requirements
f. Achieving good public relations or being an exemplary member of the
community

4. Selection of a criterion (or criteria)

– The selection of a decision criterion (Step 4 of the analysis procedure) incorporates
Principle 5 (consider all relevant criteria). The decision maker will normally select the
alternative that will best serve the long-term interests of the owners of the organization.
It is also true that the economic decision criterion should reflect a consistent and proper
viewpoint (Principle 3) to be maintained throughout an engineering economy study.

5. Analysis and comparison of the alternatives.

– based on cash-flow estimates for the feasible alternatives selected for detailed study

6. Selection of the preferred alternative.

– the soundness of the technical-economic modeling and analysis techniques dictates the
quality of the results obtained and the recommended course of action

7. Performance monitoring and post-evaluation results.

Accounting and engineering economy studies

Modern cost accounting may satisfy any or all of the following objectives:
1. To determine the cost of products or services
2. To provide a rational basis for pricing goods or services
3. To provide a means for controlling expenditures
4. To provide information on which operating decisions may be based and the results
evaluated

Example:
You wrecked your car, you need another car immediately. You decided that walking, riding a
bike, and taking a bus are not acceptable.
• An automobile wholesaler offers you $ 2,000 for your car “as is”.
• Your car insurance company estimates that there is $ 2,000 in damages to your car.
• Your insurance company only offers a check for $1,000. The meter reading on your
wrecked car is 58,000 miles.
• You have $7,000 in savings.
• A good used car with 28,000 mileage costs $10,000.
• A part-time mechanic can fix your car for $1,100 but it will take a month. Car rental
for a month costs $400.
• If you repair your car it will be worth $4,500.

WHAT SHOULD YOU DO? Use the seven-step procedure to analyze your situation.
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STEP 1: Define the Problem:

Your basic problem is that you need transportation. Further evaluation leads to the
elimination of walking, riding a bicycle, and taking a bus as feasible alternatives.

STEP 2: Develop Your Alternatives: this is reduced to either replacing or repairing your
car. The alternatives appear to be:
1. Sell the wrecked car for $2,000 to the wholesaler and spend this money, the $1,000
insurance check, and all of your $7,000 savings account on a newer car. The total amount
paid out of your savings account is $7,000, and the car will have 28,000 miles of prior
use.
2. Spend the $1,000 insurance check and $1,000 of savings to fix the car. The total amount
paid out of your savings is $1,000, and the car will have 58,000 miles of prior use.
3. Spend the $1,000 insurance check and $1,000 of your savings to fix the car and then sell
the car for $4,500. Spend the $4,500 plus $5,500 of additional savings to buy the newer
car. The total amount paid out of savings is $6,500, and the car will have 28,000 miles.
4. Give the car to a part-time mechanic, who will repair it for $1,100 ($1,000 insurance and
$100 savings) but will take an extra month of repair time. You need to rent a car for
$400/month (paid out of savings). The total amount paid out of savings is $500, and the
car will have 58,000 mileages.
5. Same as Alternative 4, but you then sell the car for $4,500 and use this money plus $5,500
of additional savings to buy the newer car. The total amount paid out of savings is
$6,000, and the newer car will have 28,000 mileages.

ASSUMPTIONS:
1. The part-time service in Alternatives 4 and 5 will not take longer than one extra month
to repair the car.
2. Each car will perform at a satisfactory operating condition.
3. Interest earned on money remaining in savings is negligible.

STEP 3: Estimate the Cash Flows for Each Alternative

1. Alternative 1 varies from all others because the car is not to be repaired at all but merely
sold. This eliminates the benefit of the $500 increase in the value of the car when it is
repaired and then sold. Also, this alternative leaves no money in your savings account.
There is a cash flow of −$8,000 to gain a newer car valued at $10,000.
2. Alternative 2 varies from Alternative 1 because it allows the old car to be repaired.
Alternative 2 differs from Alternatives 4 and 5 because it utilizes a more expensive ($500
more) and less risky repair facility. It also varies from Alternatives 3 and 5 because the
car will be kept. The cash flow is −$2,000 and the repaired car can be sold for $4,500.
3. Alternative 3 gains an additional $500 by repairing the car and selling it to buy the same
car as in Alternative 1. The cash flow is −$7,500 to gain the newer car valued at $10,000.
4. Alternative 4 uses the same idea as Alternative 2 but involves a less expensive repair
shop. The repair shop is riskier in the quality of its end product, but will only cost $1,100
in repairs and $400 in an additional month’s rental of a car. The cash flow is −$1,500 to
keep the older car valued at $4,500.
5. Alternative 5 is the same as Alternative 4 but gains an additional $500 by selling the
repaired car and purchasing a newer car as in Alternatives 1 and 3. The cash flow is
−$7,000 to obtain the newer car valued at $10,000.

STEP 4: Select a Criterion:

It is very important to use a consistent viewpoint and a common unit of measure in
performing this step. The viewpoint in this situation is yours (the owner of the wrecked car).
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The value of the car to the owner is its market value (i.e., $10,000 for the newer car and
$4,500 for the repaired car). Hence, the dollar is used as the consistent value against which
everything is measured. This reduces all decisions to a quantitative level, which can then be
reviewed later with qualitative factors that may carry their own dollar value (e.g., how much is
low mileage or a reliable repair shop worth?).

STEP 5: Analyze and Compare the Alternatives:

(Remember to consider all relevant criteria)
1. Alternative 1 is eliminated, because Alternative 3 gains the same end result and would
also provide the car owner with $500 more cash. This is experienced with no change in
the risk to the owner. (Car value = $10,000, savings = 0, total worth = $10,000.)
2. Alternative 2 is a good alternative to consider, because it spends the least amount of
cash, leaving $6,000 in the bank. Alternative 2 provides the same end result as
Alternative 4, but costs $500 more to repair. Therefore, Alternative 2 is eliminated. (Car
value = $4,500, savings = $6,000, total worth = $10,500.)
3. Alternative 3 is eliminated, because Alternative 5 also repairs the car but at a lower out-
of-savings cost ($500 difference), and both Alternatives 3 and 5 have the same end result
of buying the newer car. (Car value = $10,000, savings = $500, total worth = $10,500.)
4. Alternative 4 is a good alternative, because it saves $500 by using a cheaper repair facility,
provided that the risk of a poor repair job is judged to be small. (Car value = $4,500,
savings = $6,500, total worth = $11,000.)
5. Alternative 5 repairs the car at a lower cost ($500 cheaper) and eliminates the risk of
breakdown by selling the car to someone else at an additional $500 gain. (Car value =
$10,000, savings = $1,000, total worth = $11,000.)

STEP 6: Select the Best Alternative

(Remember to make uncertainty explicit)

The uncertainties that can be found in this problem are:

– If the original car is repaired and kept, there is a possibility that it would have a higher
frequency of breakdowns (based on personal experience).
– If a cheaper repair facility is used, the chance of a later breakdown is even greater (based
on personal experience).

Based on the information in all previous steps, Alternative 5 was actually chosen.

STEP 7: Monitor the Performance of Your Choice

Report the performance of the new car
Record all repairs and maintenance that were needed.

IV. USING SPREADSHEETS IN ENGINEERING ECONOMIC ANALYSIS

Spreadsheets are a useful tool for solving engineering economy problems. Most engineering
economy problems are amenable to spreadsheet solution for the following reasons:
1. They consist of structured, repetitive calculations that can be expressed as formulas that
rely on a few functional relationships.
2. The parameters of the problem are subject to change.
3. The results and the underlying calculations must be documented.
4. Graphical output is often required, as well as control over the format of the graphs.

Exercises 1
1. Explain why the subject of engineering economy is important to the practicing engineer.
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2. Often it makes a lot of sense to spend some money now so you can save more money in the
future. Consider filtered water. A high-tech water filter cost about $60 and can filter 7,200
ounces of water. This will save you purchasing two 20-ounce bottle of filtered water every
day, each costing $1.15. The filter will need replacing every 6 months. How much will this
filter save you in a year’s time?

3. Tyler just wrecked his new Nissan, and the accident was his fault. The owner of the other
vehicle got two estimates for the repairs: one was for $803 and the other was for $852. Tyler
is thinking of keeping the insurance companies out of the incident to keep his driving record
"clean." Tyler's deductible on his comprehensive coverage insurance is $500, and he does
not want his premium to increase because of the accident. In this regard, Tyler estimates
that his semiannual premium will rise by $60 if he files a claim against his insurance
company. In view of the above information, Tyler's initial decision is to write a personal
check for $803 payable to the owner of the other vehicle. Did Tyler make the most
economical decision? What other options should Tyler have explored? In your answer, be
sure to state your assumptions and quantify your thinking.

4. Explain the relationship between engineering economic analysis and engineering design.
How does economic analysis assist decision-making in the design process?

V. COST CONCEPTS AND DESIGN ECONOMICS

A. Cost Terminology
There are a variety of costs to be considered in an engineering economic analysis. They are
categorized as follows.

Fixed, Variable, and Incremental Costs

▪ Fixed cost: unaffected by changes in activity level (ex: insurance, license fees,
administrative salaries, interest on capital)
− Typical fixed costs include insurance and taxes on facilities, general management
and administrative salaries, license fees, and interest costs on borrowed capital.
− When large changes in usage of resources occur, or when plant expansion or
shutdown is involved fixed costs will be affected.

▪ Variable cost: vary in total with the quantity of output or similar measure of activity
− Example of variable costs include: costs of material and labor used in a product
or service, because they vary in total with the number of output units -- even
though costs per unit remain the same

▪ Incremental cost: additional cost resulting from increasing output of a system by one
or more units
− often associated with “go / no go” decisions that involve a limited change in
output or activity level

Example:
the incremental cost of driving an automobile might be $0.27 / mile. This cost
depends on:
• mileage driven;
• mileage expected to drive;
• age of car
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Examples:
1. In connection with surfacing a new highway, a contractor has a choice of two sites on which
to set up the asphalt-mixing plant equipment. The contractor estimates that it will cost $
1.15 per cubic yard mile (yd3-mile) to haul the asphalt-paving material from the mixing plant
to the job location. Factors relating to the two mixing sites are as follows (production costs
at each site are the same):

Cost Factor Site A Site B

Average hauling distance 6 miles 4.3 miles
Monthly rental of site $1,000 $5,000
Cost to set up and remove equipment $15,000 $25,000
Hauling expenses $1.15/yd3-mile $1.15/yd3-mile
Flagperson Not required $96/day

The job requires 50,000 cubic yards of mixed-asphalt-paving material. It is estimated that
four months (17 weeks of five working days per week) will be required for the job. Compare
the two sites in terms of their fixed, variable, and total costs. Assume that the cost of the
return trip is negligible. Which is the better site? For the selected site, how many cubic yards
of paving material does the contractor have to deliver before starting to make a profit if paid
$8.05 per cubic yard delivered to the job location?

Solution:
The fixed and variable costs for this job are indicated in the table shown. Site rental, setup, and
removal costs (and the cost of the flag person at site B) would be constant for the job, but the
hauling cost would vary in total amount with the distance thus with the total output quantity
of yd3-mile (x).

Cost Fixed Variable Site A Site B

Rent  = $4,000 = $20,000
Setup/removal  = $15,000 = $25,000
Flagperson  =0 5(17)($96) = $8,160
Hauling  6(50,000)($1.15) = 345,000 4.3(50,000)($1.15)= 345,000
Total: $364,000 $300,410

Site B, which has the larger fixed costs, has the smaller total cost for the job. Note that the extra
fixed costs of Site B are being “traded off” for reduced variable costs at this site.

The contractor will begin to make a profit at the point where total revenue equals total cost as
a function of the cubic yards of asphalt pavement mix delivered. Based on Site B, we have
4.3($1.15) = $4.945 in variable cost per yd3 delivered

Total cost = Total revenue

$53,160 + $4.945 x = $8.05
x = 17,121 yd3 delivered

Therefore, by using Site B, the contactor will begin to make a profit on the job after delivering
17,121 cubic yards of material.

2. A group of enterprising engineering students has developed a process for extracting

combustible methane gas from cow manure (don’t worry, the exhaust is odorless). With a
specially adapted internal combustion engine, the students claim that an automobile can be
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propelled 15 miles per day from the “cow gas” produced by a single cow. Their experimental
car can travel 60 miles per day for an estimated cost of $5 (this is the allocated cost of the
methane process equipment—the cow manure is essentially free).
a. How many cows would it take to fuel 1,000,000 miles of annual driving by a fleet of
cars? What is the annual cost?
b. How does your answer to Part (a) compare to a gasoline-fueled car averaging 30 miles
per gallon when the cost of gasoline is $3.00 per gallon?

Solution:
1,000,000 miles/year
a. number of cows = = 182.6 or 183 cows
(365 days/year)(15 miles/day)

Annual cost = (1,000,000 miles/year) ($5/60 miles) = $83,333 per year

1,000,000 miles/year
b. Annual cost of gasoline = ( $3 / gallon ) = $100,000 per year
30 miles/gallon

It would cost $16,667 more per year to fuel the fleet of cars with gasoline

Direct, Indirect, and Standard Costs

These frequently encountered cost terms involve most of the cost elements that also fit into
the previous overlapping categories of fixed and variable costs.

▪ Direct
− can be measured and allocated to a specific work activity (labor and material
directly allocated with a product, service or construction activity like ingredients
to make a certain product)

▪ Indirect
− difficult to attribute or allocate to a specific output or work activity; also called
overhead or burden (costs of common tools, utility bills, equipment
maintenance)

▪ Standard cost
− cost per unit of output, established in advance of production or service delivery

Uses of standard costs:

o Estimating future manufacturing or service delivery costs;
o Measuring operating performance by comparing actual cost per unit with
the standard unit cost;
o Preparing bids on products or services requested by customers;

Standard Cost Element Sources of Data

Direct Labor Process routing sheets, standard times, standard labor rates
+
Direct Material Material quantities per unit, standard unit materials cost
+
Factory Overhead Costs Total factory overhead costs allocated based on prime costs

▪ Establishing the value of work-in-process and finished inventories

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More ways to categorize costs

▪ Recurring Costs
− those that are repetitive and occur when an organization produces similar goods
or services on a continuing basis. Variable costs are also recurring costs, because
they repeat with each unit of output. Fixed costs could also be recurring (rent is
an example).

Variable costs are recurring costs because they repeat with each unit of output.
A fixed cost that is paid on a repeatable basis is also a recurring cost:
• Office space rental
• Purchasing food

▪ Nonrecurring Costs
− those that are not repetitive or occurred over a relatively short period of time.
Example: purchase cost for real estate upon which a plant will be built, and the
construction costs of the plant itself; Emergency maintenance expenses

Sometimes we attempt to plan for large non-recurring costs by buying insurance.

Paying the periodic insurance premium turns this expense into a recurring cost

▪ Overhead
− consists of plant operating costs that are not direct labor or material costs
– indirect costs, overhead and burden are the same

▪ Prime Cost
− a common method of allocating overhead costs among products, services and
activities in proportion the sum of direct labor and materials cost

Some useful cost terminology

▪ Cash cost
− a cost that involves a payment of cash (buying supplies) and results in cash flows
− movement of money from one owner to another - also known as a cash flow.
Example: Payment this month on an auto loan

▪ Book cost
− a cost that does not involve a cash transaction but is reflected in the accounting
system (ex: depreciation).
o Depreciation is the most common example of book cost; depreciation is
what is charged for the use of assets, such as plant and equipment;
depreciation is not a cash flow
− book costs represent the recovery of past expenditures over a fixed period of time
− cost of a past transaction that is recorded in an accounting book
o Down payment recorded in your checkbook from last year’s automobile
purchase

▪ Sunk cost
− a cost that has occurred in the past and has no relevance to estimates of future
costs and revenues related to an alternative course of action (down payment on
a bike then you changed your mind)
 MODULE 1 – Introduction to Engineering Economy 14
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More useful cost terminology

▪ Opportunity cost
− the monetary advantage foregone due to limited resources. The cost of the best
rejected opportunity.

Example:
employee leaves his $20,000/year job for a year to study and pays $5000
for his studies. The opportunity cost of going to university is $25000).

The best alternative that we give up, or forgo, when we make a choice or decision.

Examples:
1. You have been invited by friends to fly to Germany for Octoberfest next year. For
international travel, you apply for a passport that costs $97 and is valid for 10 years. After
you receive your passport, your travel companions decide to cancel the trip because of
“insufficient funds.” You decide to also cancel your travel plans because traveling alone is
no fun. Is your passport expense a sunk cost or an opportunity cost? Explain your answer.

Answer:
o The $97 you spent on a passport is a sunk cost because you cannot get your money back.
If you decide to take a trip out of the U.S. at a later date, the passport’s cost becomes
part of the fixed cost of making the trip (just as the cost of new luggage would be).

2. A friend of yours has been thinking about quitting her regular day job and going into
business for herself. She currently makes $60,000 per year as an employee of the Ajax
Company, and she anticipates no raise for at least another year. She believes she can make
$200,000 as an independent consultant in six-sigma “black belt” training for large
corporations. Her start-up expenses are expected to be $120,000 over the next year. If she
decides to keep her current job, what is the expected opportunity cost of this decision?
Attempt to balance the pros and cons of the option that your friend is turning away from.

Answer:
o The certainty of making $200,000 - $120,000 = $80,000 net income is not particularly
good. If your friend keeps her present job, she is turning away from a risky $80,000 gain.
This “opportunity cost” of $80,000 balanced in favor of a sure $60,000 would indicate
your friend is risk averse and does not want to work hard as an independent consultant
to make an extra $20,000 next year.

Phases of the Life Cycle & Their Relative Costs

Purpose of the life-cycle concept is to make explicit the interrelated effects of costs over
the total life span for a product. An objective of the design process is to minimize the
life-cycle cost − while meeting other performance requirements − by making the right
trade-offs between prospective costs during the acquisition phase and those during the
operation phase.

The life cycle may be divided into two general time periods: the acquisition phase and
the operation phase. As shown in the Figure, each of these phases is further subdivided
into interrelated but different activity periods.

▪ Life-cycle cost
− the summation of all costs related to a product, structure, system, or service
during its life span.
 MODULE 1 – Introduction to Engineering Economy 15
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− Life cycle begins with the identification of the economic need or want (the
requirement) and ends with the retirement and disposal activities

▪ Life-cycle - all the time from the initial conception of an idea to the death of a product
(process).

▪ Life-cycle costing - designing a product with an understanding of all the costs

associated with a product during its life-cycle

The cumulative committed life-cycle cost curve increases rapidly during the acquisition
phase. In general, approximately 80% of life-cycle costs are “locked in” at the end of this
phase by the decisions made during requirements analysis and preliminary and detailed
design. In contrast, as reflected by the cumulative life-cycle cost curve, only about 20% of
actual costs occur during the acquisition phase, with about 80% being incurred during the
operation phase.

Typical life-cycle for products, goods and services

Need assessment Conceptual or Detailed design Production or Operational Decline and
and justification preliminary phase construction use phase retirement
phase design phase phase phase
1. Requirements 1. Impact analysis 1. Allocation of 1. Product, 1. Operational 1. Declining
2. Overall feasibility 2. Proof of concept resources goods and use use
3. Conceptual 3. Prototype/ 2. Detailed services built 2. Use by 2. Phase out
design planning breadboarding specification 2. All supporting ultimate 3. Retirement
4. Development 3. Component facilities built customer 4. Responsible
and testing and supplier 3. Operational 3. Maintenance disposal
selection use planning and support
 MODULE 1 – Introduction to Engineering Economy 16
Engr. Caesar Pobre Llapitan

5. Detailed design 4. Production or 4. Processes,

planning construction materials and
phase methods
used
5. Decline and
retirement
planning

Several basic life-cycle cost

▪ Investment Cost or capital investment is the capital (money) required for most activities
of the acquisition phase
− In simple cases, such as acquiring specific equipment, an investment cost may
be incurred as a single expenditure

▪ Working Capital refers to the funds required for current assets needed for start-up and
subsequent support of operation activities

▪ Operation and Maintenance Cost includes many of the recurring annual expense items
associated with the operation phase of the life cycle
− The direct and indirect costs of operation associated with the five primary
resource areas—people, machines, materials, energy, and information—are a
major part of the costs in this category.

▪ Disposal Cost includes those nonrecurring costs of shutting down the operation and the
retirement and disposal of assets at the end of the life cycle

B. The General Economic Environment

Basic economic concepts – factors for consideration in engineering studies and managerial
decisions

Consumer and Producer Goods and Services

▪ Consumer goods and services are those products or services that are directly used by
people to satisfy their wants.

Examples:
Food, clothing, homes, cars, television sets, haircuts, opera, and medical services

The providers of consumer goods and services must be aware of, and are subject to, the
changing wants of the people to whom their products are sold.

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

Examples:
Machine tools, factory buildings, buses, and farm machinery

Goods and services are produced and desired because they have utility - the power to
satisfy human wants and needs. Thus, they may be used or consumed · directly, or they
may be used to produce other goods or services. Utility is most commonly measured in
terms of value, expressed in some medium of exchange as the price that must be paid to
obtain the particular item.
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The General Price-Demand Relationship

Goods and services may be divided into two types: necessities and luxuries.
− These terms are relative, because, for most goods and services, what one person
considers a necessity may be considered a luxury by another
− For all goods and services, there is a relationship between the price that must be paid
and the quantity that will be demanded or purchased.

The demand for a product or service is directly related to its price according to p = a - bD where
p is price, D is demand, and a and b are constants that depend on the particular product or
service.

Price p = a – bD

Units of Demand

– a is the intercept on the price axis and −b is the slope.

– Thus, b is the amount by which demand increases for each unit decrease in p. Both a
and b are constants.

Because economic laws are general statements regarding the interaction of people and wealth,
they are affected by the economic environment in which people and wealth exist. Most general
economic principles are stated for situations in which perfect competition exists.

▪ Perfect competition
o Perfect competition occurs in a situation in which any given product is
supplied by a large number of vendors and there is no restriction on additional
suppliers entering the market.
o Under such conditions, there is assurance of complete freedom on the part of
both buyer and seller.

▪ Monopoly
o Monopoly is at the opposite pole from perfect competition.
o A perfect monopoly exists when a unique product or service is only available
from a single supplier and that vendor can prevent the entry of all others into
the market.
o Under such conditions, the buyer is at the complete mercy of the supplier in
terms of the availability and price of the product.

Perfect monopolies rarely occur in practice, because

1) few products are so unique that substitutes cannot be used satisfactorily and
2) governmental regulations prohibit monopolies if they are unduly restrictive.

The Total Revenue Function

Total revenue depends on price and demand.
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Total Revenue (TR) is the product of the selling price per unit, p, and the number of units sold,
D.

TR = price × demand = p · D
a
TR = pD = ( a - bD ) = aD - bD2 for 0  D  and a  0, b  0
b

Calculus can help determine the demand that maximizes revenue.

dTR
= a − 2bD = 0
dD

a
Solving, the optimal demand is D =
2b

Cost, Volume, and Breakeven Point Relationships

Fixed costs remain constant over a wide range of activities, but variable costs vary in total with
the volume of output Thus, at any demand D, total cost is

Total Cost = Fixed Costs + Variable Costs

CT = CF + c v (1)

At any Demand D:

CV = cV. D Linear relationship (2)

Scenario 1
– Combined Cost and Revenue Functions, and Breakeven Points, as Functions of Volume,
and Their Effect on Typical Profit
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– At breakeven point D′1, total revenue is equal to total cost, and an increase in demand
will result in a profit for the operation.
– Then at optimal demand, D∗, profit is maximized [Equation (4)].
– At breakeven point D′2, total revenue and total cost are again equal, but additional
volume will result in an operating loss instead of a profit.
– The conditions for which breakeven and maximum profit occur are of primary interest.

Profit is revenue minus cost

Profit (Loss) = (aD − bD2) − (CF + cvD)

Profit = - bD2 + ( a - cv ) D - CF (3)

a
for 0  D  and a  0, b  0
b

Differentiating, we can find the value of D that maximizes profit:

a - cv
D* = → second derivative of profit must be negative (-2b) (4)
2b

In order for a profit to occur, based on Equation (3), and to achieve the typical results depicted
in Figure above, two conditions must be met:
1. (a − cv) > 0; that is, the price per unit that will result in no demand has to be greater
than the variable cost per unit. (This avoids negative demand.)
2. Total revenue (TR) must exceed total cost (CT) for the period involved.

If these conditions are met, we can find the optimal demand at which maximum profit will occur
by taking the first derivative of Equation (1) with respect to D and setting it equal to zero:

d ( profit )
= a − cv − 2bD = 0
dD

The optimal value of D that maximizes profit is

 MODULE 1 – Introduction to Engineering Economy 20
Engr. Caesar Pobre Llapitan

a - cv
D* = (5)
2b

To ensure that we have maximized profit (rather than minimized it), the sign of the second
derivative must be negative.

d 2 ( profit )
= −2b
dD2

An economic breakeven point for an operation occurs when total revenue equals total cost.

Total revenue = Total cost

aD − bD2 = CF + cvD

−bD2 + (a − cv)D − CF = 0 Quadratic equation in D (6)

Solving, we find the demand at which this occurs.

− ( a − cv )  ( a − cv )2 − 4 ( −b )( −C F )
D'=
2 ( −b )

There are two roots of the equation; so, there are two breakeven points (D'1 and D'2)

Scenario 2 If Price is Constant (independent of demand)

Single Breakeven Point

– When the price per unit (p) for a product or service can be represented more simply as
being independent of demand [versus being a linear function of demand, as assumed
and is greater than the variable cost per unit (cv).
– Then, under the assumption that demand is immediately met, total revenue (TR) = p·D.
If the linear relationship for costs in Equations (1) and (2) is also used in the model, the
typical situation is depicted in Figure.
 MODULE 1 – Introduction to Engineering Economy 21
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Examples
1. A company produces an electronic timing switch that is used in consumer and commercial
products. The fixed cost (CF) is $73,000 per month, and the variable cost (cv) is $83 per unit.
The selling price per unit is p = $180 – 0.02D. For this situation,
a. determine the optimal volume for this product and confirm that a profit occurs (instead
of a loss) at this demand.
b. find the volumes at which breakeven occurs; that is, what is the range of profitable
demand?

Solution:
a − cv $180 − $83
a. D* = = = 2,425 units per month
2b 2 ( 0.02 )

Is (a – cv) > 0?
($180 - $83) = $97 which is greater than 0

And is (total revenue – total cost) > 0 for D* = 2,425 units per month?
[$180(2,425) – 0.02(2,425)2] – [$73,000 + $83(2,425)] = $44,612

A demand of D* = 2,425 units per month results in a maximum profit of $44,612 per
month. Notice that the second derivative is negative (-0.04).

b. Total revenue = total cost (breakeven point)

−bD2 + (a – cv)D – CF = 0
−0.02D2 + ($180 - $83) D − $73,000 = 0
−0.02 D2 + 97 D – 73,000 = 0

And
0.5
−97  ( 97 ) − 4 ( −0.02 )( −73,000 ) 
2

D'=  
2 ( −0.02 )
−97 + 59.74
D' = = 932 units per month
−0.04
−97 − 59.74
D'= = 3,918 units per month
−0.04

Thus, the range of profitable demand is 932 – 3,918 units per month.

2. A plant operation has fixed costs of $2,000,000 per year, and its output capacity is 100,000
electrical appliances per year. The variable cost is $40 per unit, and the product sells for $90
per unit.
a. Construct the economic breakeven chart.
b. Compare annual profit when the plant is operating at 90% of capacity with the plant
operation at 100% capacity. Assume that the first 90% of capacity output is sold at $90
per unit and that the remaining 10% of production is sold at $70 per unit.

Solution:
CF $2,000,000
a. D' = = = 40,000 units per year
p − cv ( $90 − $40 ) / unit
 MODULE 1 – Introduction to Engineering Economy 22
Engr. Caesar Pobre Llapitan

b. Profit (Loss) = Total Revenue – Total Cost

(90% Capacity) = 90,000 ($90) – [$2,000,000 + 90,000 ($40)] = $2,500,000 per year
(100% Capacity) = [90,000 ($90) + 10,000 ($70)] – [$2,000,000 + 100,000 ($40)]
= $2,800,00 per year

C. Cost-Driven Design Optimization

Engineers must maintain a life-cycle (i.e., "cradle to grave") viewpoint as they design products,
processes, and services. Such a complete perspective ensures that engineers consider initial
investment costs, operation and maintenance expenses and other annual expenses in later years,
and environmental and social consequences over the life of their designs.

Thus, engineering design is an economically driven art.

In general, the cost models developed in these problems consist of three types of costs:
1. fixed cost(s)
2. cost(s) that vary directly with the design variable
3. cost(s) that vary indirectly with the design variable

A simplified format of a cost model with one design variable is

b
Cos t = aX + +k (7)
X

where a is a parameter that represents the directly varying cost(s),

b is a parameter that represents the indirectly varying cost(s),
k is a parameter that represents the fixed cost(s), and
X represents the design variable in question (e.g., weight or velocity)

A more general model is the following:

1 2
Cost = k + ax + b1 x e + b2 x e + (8)

where e1 = −1 reflects costs that vary inversely with X, e2 = 2 indicates costs that vary as the square
of X, and so forth.
 MODULE 1 – Introduction to Engineering Economy 23
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In a particular problem, the parameters a, b, and k may actually represent the sum of a group of
costs in that category, and the design variable may be raised to some power for either directly
or indirectly varying costs.

The following steps outline a general approach for optimizing a design with respect to cost:
1. Identify the design variable that is the primary cost driver (e.g., pipe diameter or
insulation thickness).
2. Write an expression for the cost model in terms of the design variable.
3. Set the first derivative of the cost model with respect to the continuous design variable
equal to zero. For discrete design variables, compute the value of the cost model for each
discrete value over a selected range of potential values.
4. Solve the equation found in Step 3 for the optimum value of the continuous design
variable. For discrete design variables, the optimum value has the minimum cost value
found in Step 3. This method is analogous to taking the first derivative for a continuous
design variable and setting it equal to zero to determine an optimal value.
5. For continuous design variables, use the second derivative of the cost model with respect
to the design variable to determine whether the optimum value found in Step 4
corresponds to a global maximum or minimum.

Note:
If multiple optima (stationary points) are found in Step 4, finding the global optimum
value of the design variable will require a little more effort. One approach is to
systematically use each root in the second derivative equation and assign each point as a
maximum or a minimum based on the sign of the second derivative. A second approach
would be to use each root in the objective function and see which point best satisfies the
cost function.

Examples:
1. The cost of operating a large ship (CO) varies as the square of its velocity (v); specifically, CO
= knv2, where n is the trip length in miles and k is a constant of proportionality. It is known
that at 12 miles/hour the average cost of operation is $100 per mile. The owner of the ship
wants to minimize the cost of operation, but it must be balanced against the cost of the
perishable cargo (CC), which the customer has set at $1,500 per hour. At what velocity should
the trip be planned to minimize the total cost (CT), which is the sum of the cost of operating
the ship and the cost of perishable cargo?

Solution:
$1,500 n
CT = C0 + CC = knv 2 +
v
dCT 1,500
= 0 = 2kv − 2 = kv 3 − 750
dv v
750
v=
k

To find k, we know that

C0
= $100/mile at v = 12 miles/hr
n
C0
= kv 2 = k ( 12 ) = 100
2

And
 MODULE 1 – Introduction to Engineering Economy 24
Engr. Caesar Pobre Llapitan

k = 100 / 144 = 0.6944

So
750
v= = 10.25 miles/hr
0.6944

The ship should be operated at an average velocity of 10.25 mph to minimize the total cost
of operation and perishable cargo

Note: The second derivative of the cost model with respect to velocity is

d 2CT n
2
= 1.388 n + 3, 000 3
dv v

The value of the second derivative will be greater than 0 for n > 0 and v > 0. Thus, we have
found a minimum cost velocity.

2. The fixed cost for a steam line per meter of pipe is $450X + $50 per year. The cost for loss of
heat from the pipe per meter is $4.8/X112 per year. Here X represents the thickness of
insulation in meters, and X is a continuous design variable.
a. What is the optimum thickness of the insulation?
b. How do you know that your answer in Part (a) minimizes total cost per year?
c. What is the basic trade-off being made in this problem?

Solution:
a. Total Annual Cost (TAC) = Fixed Cost + Cost of Heat Loss = 450X + 50 + 4.80/X1/2

d (TAC ) 2.40
= 0 = 450 −
dX X 3/2
2.40
X 3/2 = = 0.00533
450
X = 0.0305 meters

d 2 (TAC ) 3.6
b. 2
= > 0 for X > 0
dX X 5/2

Since the second derivative is positive, X = 0.0305 meters is minimum cost thickness.

c. The cost of extra insulation (a directly varying cost) is being traded-off against the value
of reduction in lost heat (an indirectly varying cost)

Economic Balance in Evaporation

1. What is the most economical number of effects to use in the recovery of black liquor in a
paper plant if the ff. cost data are available? The annual fixed costs increase essentially
linearly with each effect (except for condensing, feeding, and other equipment costs for
multiple units which may be considered to balance each other). If a fixed amount of
evaporation is to be obtained and each unit is to have 1000 ft2 of heating surface with a
service life of 5 years, the annual fixed costs CF would be
0.6
 1000   25000 
CF =     N $/yr
 5000   5 
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Engr. Caesar Pobre Llapitan

where N is the number of effects:

Because of steam economy in multiple – effect operation, the direct costs for steam will
decrease and the total of all annual costs, CD, has been established for this type of
operation as
C D = 65000 N −0.95 $

Solution:
CT = C D + C F
= 1900 N + 65000 N-0.95

dCT
= 0 = 1900 + ( −0.95 )( 65000 ) N −1.95
dN
N = 5.95  5 effects or 6 effects

2. A multiple effect evaporator is to be used for evaporating 400,000 lb of water per day from
a salt solution. The total initial cost for the first effect is $18,000 and each additional effect
costs $15000. The life period is estimated to be 10yrs. and the salvage value or scrap value at
the end of the life period may be assumed to be zero. The straight – line depreciation method
is used. Fixed charges minus depreciation are 15% yearly based on the first cost of
equipment. Steam costs $ 0.50 per 100lb. Annual maintenance charges are 5 percent of the
initial equipment cost. All other costs are independent of the number of effects. The unit
will produce 300 days/yr. If the pound of water evaporated per pound of steam equals 0.88
x number of effects, determine the optimum number of effects for minimum annual cost.

Solution:
E = 400000 lbH2O / day
C1 = $ 18000
CN = $ 18000 + (N – 1) 15000
L = n = 10 yrs.
CL = 0
d=0

Annual FC = 15% C0 (minus depreciation)

Maintenance = 5% C0
Csteam = $ 0.50/1000 lb
Operation = 300 days/yr
Economy = 0.85 lb H2O/lb steam

CT = C F + C V
CF = K F C0

Annual fixed charges expressed as % of initial cost

= Depreciation + FC + MC
= (1/10 + 0.05 + 0.15) C0

CF = 0.30 C0

But C0 = C1 + CN+1
C0 = 18000 + (N – 1) 15000
 MODULE 1 – Introduction to Engineering Economy 26
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Therefore,
CF = 0.3 [18000 + (N – 1)15000]
CF = 900 + 4500 N

CV = cost of steam
$0.50 lb steam 400,000 lb H2O 300 day
=   
1000 lb steam 0.85 N lb H2O day year
70,588.24
=
N

Therefore,
CT = 900 + 4500 N + 70588.24/N

dCT 70588.24
= 0 = 4500 −
dN N2

N = 4 effects

Exercises 2
1. An engineering consulting firm measures its output in a standard service hour unit, which
is a function of the personnel grade levels in the professional staff. The variable cost (cv) is
$62 per standard service hour. The charge-out rate [i.e., selling price (p)] is $85.56 per hour.
The maximum output of the firm is 160,000 hours per year, and its fixed cost (CF) is
$2,024,000 per year. For this firm,
a) what is the breakeven point in standard service hours and in percentage of total
capacity?
b) what is the percentage reduction in the breakeven point (sensitivity) if fixed costs are
reduced 10%; if variable cost per hour is reduced 10%; and if the selling price per unit is
increased by 10%?
2. A large, profitable commercial airline company flies 737-type aircraft, each with a maximum
seating capacity of 132 passengers. Company literature states that the economic breakeven
point with these aircraft is 62 passengers.
a. Draw a conceptual graph to show total revenue and total costs that this company is
experiencing.
b. Identify three types of fixed costs that the airline should carefully examine to lower its
breakeven point. Explain your reasoning.
c. Identify three types of variable costs that can possibly be reduced to lower the
breakeven point. Why did you select these cost items?
3. A plant has a capacity of 4,100 hydraulic pumps per month. The fixed cost is $504,000 per
month. The variable cost is $166 per pump, and the sales price is $328 per pump. (Assume
that sales equal output volume.) What is the breakeven point in number of pumps per
month? What percentage reduction will occur in the breakeven point if fixed costs are
reduced by 18% and unit variable costs by 6%?
4. The annual fixed costs for insulating a certain steam pipe installation can be expressed as
CF = 30S + 40 dollar per year

where S is thickness of insulation in inches, and the annual cost of energy lost (annual direct
costs) from the installation may be expressed in terms of the insulation thickness as CP =
100/S $ per year. Determine the optimum annual insulation thickness cost.
5. A plant produces refrigerators at the rate of P units per day. The variable costs per
refrigerator have been found to be $47.73 + 0.1 P1.2. The total daily fixed charges are $1750,
 MODULE 1 – Introduction to Engineering Economy 27
Engr. Caesar Pobre Llapitan

and all other expenses are constant at $ 7325 per day. If the selling price per refrigerator is
$173, determine:
a) the daily profit at a production schedule giving the minimum cost per refrigerator.
b) the daily profit at a production schedule giving the maximum daily profit.
c) The production schedule at the break – even point.
6. An organic chemical is produced by a batch process. In this process, chemical X and Y react
to form chemical 2. since the reaction rate is very high, the total time required per batch has
been found to be independent of the amounts of the materials, and each batch requires 2h,
including time for charging, heating & dumping. The ff. equation shows the relation
between the pounds of Z produced (lbz) and the pounds of X (lbx) and Y (lby) supplied:
lbz = 1.5 (1.1 lbx lbz + 1.3 lby lbz – lbxlby)0.5

Chemical X costs $0.09 per pound. Chemical Y costs $0.04 per pound. Chemical Z sell for
$0.80 per pound. If one – half of the selling price for chemical Z is due to costs other that for
raw materials, what is the maximum profit obtainable per pound of chemical Z?
7. A farmer estimates that if he harvests his soybean crop now, he will obtain 1,000 bushels,
which he can sell at $3.00 per bushel. However, he estimates that this crop will increase by
an additional 1,200 bushels of soybeans for each week he delays harvesting, but the price
will drop at a rate of 50 cents per bushel per week; in addition, it is likely that he will
experience spoilage of approximately 200 bushels per week for each week he delays
harvesting. When should he harvest his crop to obtain the largest net cash return, and how
much will be received for his crop at that time?

VI. PRESENT ECONOMY STUDIES

“Present economy studies” can ignore the time value of money.

• Alternatives are being compared over one year or less.

Rules for Selecting Preferred Alternative

Rule 1: When revenues and other economic benefits vary among alternatives, choose the
alternative that maximizes overall profitability of defect-free output.

Rule 2: When revenues and other economic benefits are not present or are constant among
alternatives, choose the alternative that minimizes total cost per defect-free unit.

Total Cost in Material Selection

− In many cases, selection of among materials cannot be based solely on costs of materials.
Frequently, change in materials affect design, processing, and shipping costs

Alternative Machine Speeds

− Machines can frequently be operated at different speeds, resulting in different rates of
product output. However, this usually results in different frequencies of machine
downtime. Such situations lead to present economy studies to determine preferred
operating speed

Make Versus Purchase (Outsourcing) Studies

A company may choose to produce an item in house, rather than purchase from a supplier
at a price lower than production costs if:
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Engr. Caesar Pobre Llapitan

1. direct, indirect or overhead costs are incurred regardless of whether the item is
purchased from an outside supplier, and
2. The incremental cost of producing the item in the short run is less than the supplier’s
price

The relevant short-run costs of the make versus purchase decisions are the incremental costs
incurred and the opportunity costs of resources

• Opportunity costs may become significant when in-house manufacture of an item causes
other production opportunities to be foregone (E.G., insufficient capacity)
• In the long run, capital investments in additional manufacturing plant and capacity are
often feasible alternatives to outsourcing.

Example 4:
Two currently owned machines are being considered for the production of a part. The capital
investment associated with the machines is about the same and can be ignored for purposes of
this example. The important differences between the machines are their production capabilities
(production rate  available production hours) and their reject rates (percentage of parts
produced that cannot be sold).

Consider the following table:

Machine A Machine B
Production rate 100 parts/hour 130 parts/hour
Hours available for production 7 hours/day 6 hours/day
Percent parts rejected 3% 10%

The material cost is $6.00 per part, and all defect-free parts produced can be sold for $12 each.
(Rejected parts have negligible scrap value). For either machine, the operator cost is $15.00 per
hour and the variable overhead rate for traceable costs is $5.00 per hour.
a) Assume that the daily demand for this part is large enough that all defect-free parts can be
sold. Which machine should be selected?
b) What would the percent of parts rejected have to be for Machine B to be as profitable as
Machine A?

Solution:
a) Rule 1 applies in this situation because total daily revenues (selling price per part times the
number of parts sold per day) and total daily costs will vary depending on the machine
chosen. Therefore, we should select the machine that will maximize the profit per day:

Profit per day = Revenue per day – Cost per day

= (Production rate) (Production hours) ($12/part)  [1 – (% rejected/100)]
− (Production rate) (Production hours) ($6/part)
− (Production hours) ($15/hour + $5/hour)

Machine A
 100 parts   7 hours  $12   100 parts   7 hours  $6 
Profit per day =      ( 1-0.03 ) -    
 hour   day  part   hour   day  part 
 7 hours   $15 $5 
-  + 
 day   hour hour 
=$3,808 per day
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Engr. Caesar Pobre Llapitan

Machine B
 130 parts   6 hours  $12   130 parts   6 hours  $6 
Profit per day =      ( 1-0.10 ) -    
 hour   day  part   hour   day  part 
 6 hours   $15 $5 
-  + 
 day   hour hour 
=$3,624 per day

Therefore, select Machine A to maximize profit per day.

b) To find the breakeven percent of parts rejected, X, for Machine B, set the profit per day of
Machine A equal to the profit per day of Machine B, and solve for X:

 130 parts   6 hours  $12   130 parts 

$3,808 / day =     (1 − X ) −  
 hour   day   part   hour 
 6 hours   $6   6 hours   $15 $5 
   −  + 
 day   part   day   hour hour 

Thus, X = 0.08, so the percent of parts rejected for Machine B can be no higher than 8%
for it to be as profitable as Machine A.

Exercises 3
1. A producer of synthetic motor oil for automobiles and light trucks has made the following
statement: “One quart of Dynolube added to your next oil change will increase fuel mileage
by one percent. This one-time additive will improve your fuel mileage over 50,000 miles of
driving.”
a. Assume the company’s claim is correct. How much money will be saved by adding one
quart of Dynolube if gasoline costs $4.00 per gallon and your car averages 20 miles per
gallon without the Dynolube?
b. If a quart of Dynolube sells for $19.95, would you use this product in your automobile?
2. Two alternative designs are under consideration for a tapered fastening pin. The fastening
pins are sold for $0.70 each. Either design will serve equally well and will involve the same
material and manufacturing cost except for the lathe and drill operations. Design A will
require 12 hours of lathe time and 5 hours of drill time per 1,000 units. Design B will require
7 hours of lathe time and 8 hours of drill time per 1,000 units. The variable operating cost of
the lathe, including labor, is $18.60 per hour. The variable operating cost of the drill,
including labor, is $16.90 per hour. Finally, there is a sunk cost of $5,000 for Design A and
$9,000 for Design B due to obsolete tooling.
a. Which design should be adopted if 125,000 units are sold each year?
b. What is the annual saving over the other design?

3. A company is analyzing a make-versus-purchase situation for a component used in several

products, and the engineering department has developed these data:

Option A:
Purchase 10,000 items per year at a fixed price of $8.50 per item. The cost of placing
the order is negligible according to the present cost accounting procedure.

Option B:
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Engr. Caesar Pobre Llapitan

Manufacture 10,000 items per year, using available capacity in the factory. Cost estimates
are direct materials = $5.00 per item and direct labor = $1.50 per item. Manufacturing
overhead is allocated at 200% of direct labor (= $3.00 per item).

Based on these data, should the item be purchased or manufactured?

4. Ocean water contains 0.9 ounces of gold per ton. Method A costs $550 per ton of water
processed and will recover 90% of the metal. Method B costs $400 per ton of water processed
and will recover 60% of the metal. The two methods require the same capital investment
and are capable of producing the same amount of gold each day. If the extracted gold can
be sold for $1,750 per ounce, which method should be recommended? The supply of ocean
water is essentially unlimited. Hint: Work this problem on the basis of profit per ounce of
gold extracted.

REFERENCES
1. Blank, L., Tarquin, A. (2012). Engineering Economy (7th Edition). McGraw-Hill, Inc.
2. Peters, Max S, Klaus D. Timmerhaus and Ronald E. WesT (2004). Plant Design and
Economics for Chemical Engineers (5th Edition) McGraw-Hill Science
3. Sullivan, William G., et al. (2015). Engineering Economy (16th Edition) Pearson Higher
Education, South Asia, PTE Ltd
4. Thane Brown (2006) Engineering Economics and Economic Design for Process
Engineers Taylor & Francis Group, LLC