Engineering Economic

Chapter 1
Chan S. Park, Contemporary Engineering Economics

Hamad Manzoor

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 Chapter 1
Engineering Economic Decisions
• Rational Decision- making Process
• The Engineer’s Role in Business
• Types of Strategic Engineering Economic Decisions
• Fundamental Principles in Engineering Economics
Opening Story: Google

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A Little Google History
• 1995
• Developed in dorm room by Larry Page and Sergey Brin,
graduate students at Stanford University
• Nicknamed BackRub (reflecting great taste… ☺)
• 1998
• Raised $25 million to set up Google, Inc.
• Ran 100,000 queries a day out of a garage in Menlo Park
• 2005
• Over 4,000 employees worldwide
• Over 8 billion pages indexed
• Estimated market value over $100 billion
• As of today, the value of Google is likely to be in the
hundreds of billions range
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Rational Decision-Making Process
▪ Recognize the decision
problem
▪ Collect all needed (relevant)
information
▪ Identify the set of feasible
decision alternatives
▪ Define the key objectives
and constraints
▪ Select the best possible and
implementable decision
alternative
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A Simple Illustrative Example: Car to
Lease – Saturn or Honda?
▪ Recognize the decision • Need to lease a car
problem
• Gather technical and
▪ Collect all needed (relevant) financial data
information
• Select cars to consider
▪ Identify the set of feasible
decision alternatives • Wanted: small cash outlay,
▪ Define the key objectives and
safety, good performance,
constraints aesthetics,…
▪ Select the best possible and • Choice between Saturn and
implementable decision Honda (or others)
alternative • Select Honda

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Engineering Economic Decisions
Needed e.g. in the following (connected) areas:
Profit! Then continue
at the next stage…
Manufacturing
Design

Financial Investment
planning and loan Marketing

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What Makes Engineering Economic Decisions
Difficult? Predicting the Future
• Estimating the required
investments
• Estimating product
manufacturing costs
• Forecasting the demand for a
brand new product
• Estimating a “good” selling
price
• Estimating product life and
the profitability of continuing
production

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The Role of Engineers in Business
Create & Design

• Engineering Projects

Analyze Evaluate Evaluate

• Production Methods • Expected • Impact on Financial

• Engineering Safety Profitability Statements
• Environmental Impacts • Timing of • Firm’s Market Value
• Market Assessment Cash Flows • Stock Price
• Degree of
Financial Risk

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Accounting vs. Engineering Economy

Evaluating past performance Evaluating and predicting future events

Accounting Engineering Economy

Past Future
Present

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Key Factors in Selecting Good Engineering
Economic Decisions

Objectives, available resources, time and uncertainty are the key

defining aspects of all engineering economic decisions

Two Factors in Engineering Economic Decisions

The factors of time and uncertainty are the defining aspects of any
engineering economic decisions

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Large-Scale Engineering Projects
These typically
• require a large sum of investment
• can be very risky
• take a long time to see the financial outcomes
• lead to revenue and cost streams that are difficult to predict

• All the above aspects (and some others not listed here) point towards the
importance of EEA

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Types of Strategic Engineering Economic Decisions
in the Manufacturing Sector
❑ Service Improvement
❑ Equipment and Process Selection
❑ Equipment Replacement
❑ New Product and Product Expansion
❑ Cost reduction or profit maximization

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 Service Improvement
• How many more jeans would Levi need to sell to justify the cost of
additional robotic tailors?
Healthcare Service Improvement
■ 1 Traditional Plan: Patients visit the
service providers
■ 2 New Strategy: Service providers
visit the patients
Which one of the two plans 1
is more economical? The
answer typically depends on
the type of patients and the
services offered. Examples?

service providers patients 2

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Equipment & Process Selection
• How do you choose between Plastic SMC and Steel sheet stock for the
auto body panel?
• The choice of material will dictate the manufacturing process for the
body panel as well as manufacturing costs.
Which Material to Choose?
Equipment Replacement Problem
• Key question:
When is the right time to replace an old
machine or equipment?
• If not, when is the right time to
replace the old equipment?

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New Product and Product Expansion
• Shall we build or acquire a new
facility to meet the increased
(increasing forecasted) demand?
• Is it worth spending money to
market a new product?

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Cost Reduction
• Should a company buy new
equipment to perform an operation
that is now done manually?
• Should we spend money now, in
order to save more money later?
• The answer obviously depends on a
number of factors; can you name
some of these?

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Types of Strategic Engineering Economic
Decisions in the Service Sector
❑ Commercial Transportation
❑ Logistics and Distribution
❑ Healthcare Industry
❑ Electronic Markets and Auctions
❑ Financial Engineering and Banking
❑ Retail
❑ Hospitality and Entertainment
❑ Customer Service and Maintenance

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 U.S. Gross Domestic Product (GDP)
Distribution by Sector
Manufacturing 14%
Healthcare 14%
Agriculture 2%

Total 30%

Service sector 70%

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Four Fundamental Principles of Engineering Economics

• Principle 1: An instant dollar is worth more than a distant dollar…

• Principle 2: Only the relative (pair-wise) difference among the
considered alternatives counts…
• Principle 3: Marginal revenue must exceed marginal cost, in order to
carry out a profitable increase of operations
• Principle 4: Additional risk is not taken without an expected additional
return of suitable magnitude

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Principle 1
An instant dollar is worth more than a distant dollar…

Today 6 months later

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Principle 2
Only the cost (resource) difference among
alternatives counts

Option Monthly Fuel Monthly Cash paid at Monthly Salvage

Cost Maintenance signing payment Value at end
(cash outlay of year 3
)

Buy $960 $550 $6,500 $350 $9,000

Lease $960 $550 $2,400 $550 0

The data shown in the green fields are irrelevant items for decision
making, since their financial impact is identical in both cases
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Principle 3
Marginal (unit) revenue has to exceed marginal
cost, in order to increase production

Marginal
cost
Manufacturing cost 1 unit

Marginal
revenue
Sales revenue 1 unit

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Principle 4
Additional risk is not taken without a suitable expected
additional return

Investment Class Potential Expected

Risk Return

Savings account Lowest 1.5%

(cash)
Bond (debt) Moderate 4.8%
Stock (equity) Highest 11.5%

A simple illustrative example. Note that all investments imply

some risk: portfolio management is a key issue in finances
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Summary
• The term engineering economic decision refers to any investment
or other decision related to an engineering project
• The five main types of engineering economic decisions are:
• (1) service improvement, (2) equipment and process selection, (3)
equipment replacement, (4) new product and product expansion,
and (5) cost reduction
• The factors of time, resource limitations and uncertainty are key
defining aspects of any investment project
• all listed decision types can be seen and modeled as a constrained
decision (optimization) problem

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