Engineering Economics

(23EB6309)
Module: 1

Faculty Name: Dr. Jignesh Thaker

Type of Course: Engineering Economics
Teaching Scheme: Lecture (02), Tutorial (00), Practical (00)
Credit: 2
 Economics and Engineering Economy
The English term 'Economics' is derived from the Greek word 'Oikonomia'.
Its meaning is 'household management’.
Economics is the science that deals with the production and consumption
of goods and services, distribution and rendering of these for human
welfare. Economics is defined as the study of allocation of scarce resources
among unlimited ends (or wants).
Engineering economy involves formulating, estimating, and evaluating the
expected economic outcomes of alternatives designed to accomplish a
defined purpose.
An engineering economy study involves many elements: problem
identification, definition of the objective, cash flow estimation, financial
analysis, and decision making.
Implementing a structured procedure is the best approach to select the
best solution to the problem.
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 Origin of Engineering Economy
“The Economic Theory of Railway Location”, 2nd ed. New York: John Wiley
& Sons, 1987 written by Arthur M. Wellington, a civil engineer, pioneered
engineering interest in economic evaluation. His interest was railway in
USA.
A textbook “Principles of Engineering Economy”, New York: The Ronald
Press Company, 1930, was published by Eugene Grant. He is considered
as the father of engineering economy.
Engineering economics deals with the methods that enable one to take
economic decisions towards minimizing costs or maximizing benefits to
business organizations.
Engineering economy involves set of principles: Develop the Alternatives,
Focus on the Difference, Use a Consistent Viewpoint, Use a Common Unit
of Measure, Consider All Relevant Criteria, Make Uncertainty Explicit,
Revisit your decision.
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 Steps in Engineering Economy Study
Economics is a science which studies
human behavior as a relationship
between ends and scarce means
which have alternative uses.
Engineers play a role in effective
utilization of assets.
Scope of Economics:
Development Economics
Microeconomics
Macroeconomics
International Economics
Environmental Economics
Urban and Rural Economics

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 Flow in Economics

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 Flow in Economics

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 Law of Demand and Law of Supply
Demand and supply of a product are independent, and they are
sensitive with respect to the price of that product.

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 Law of Demand and Law of Supply
Law of demand is defined as “Quantity demand of product
decreases if the price of the product increases.”
That is if the price of the product rises then the quantity
demand falls. Because the opportunity cost of consumer
increase which leads consumers to go for any other
alternative or they may not buy it.
Law of demand is defined as “Quantity demand of product
increases if the price of the product decreases.”
Law of supply acts as a bridge between the supply of a
commodity and its price.
Equilibrium means a state of no change. Evidently, at the
equilibrium price, both buyers and sellers are in a state of no
change. Technically, at this price, the quantity demanded by
the buyers is equal to the quantity supplied by the sellers.
Both market forces of demand and supply operate in
harmony at the equilibrium price.

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 Factors Influencing Demand
Price of Product
Taste and Preferences
Consumer’s Income
Availability of Substitutes
Number of Consumers in the Market
Consumer’s Expectations

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 Factors Influencing Supply
Cost of Production
Natural Conditions
Technological Advancements
Transport Conditions
Factor Prices and Their Availability
Government Taxation Policy
Related Good Prices

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 Engineering Economics: Types of Efficiency
Efficiency of a system is generally defined as the ratio of its
output to input. The efficiency can be classified into two
categories: Technical Efficiency and Economic Efficiency.
Technical Efficiency: It is the ability of a firm to produce as
much output as possible with a specified level of inputs, given
the existing technology. In practice, technical efficiency can
never be more than 100%. This is mainly due to frictional/other
losses in the system.

Economic Efficiency: It is the ratio of output (worth) to input

(cost) of a business system. Worth is the annual revenue
generated by way of operating the business and cost is the total
annual expenses incurred in carrying out the business. For
survival and growth of any business, the economic efficiency
should be more than 100%.

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 Ways to Improve Economic Efficiency
Increased out for the same input
Decreased input for the same output
By a proportionate increase in the output which is more than
the proportionate increase in the input
By a proportionate decrease in the input which is more than
the proportionate decrease in the output
Through simultaneous increase in the output with decrease
in the input.

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 Elements of Costs
Variable Cost: It varies with the volume of production. It can be
further classified into direct material cost, direct labour cost and
direct expenses.
Direct material cost is the cost of materials which are used
to produce the product. Direct labour cost is the amount of
wages paid to the direct labour involved in administering the
business.
Overhead Cost: It is fixed, irrespective of the production volume.
It is the aggregate of indirect material costs, indirect labour costs
and indirect expenses. It can be classified into factory overhead,
administration overhead, selling overhead, and distribution
overhead.
Administration overhead includes all the costs those are
incurred in administering the business. Selling overhead is
the total expense that is incurred in the promotional
activities and expenses relating to sales force. Distribution
overhead is the total cost of shipping the items from the
factory site to the customer sites.
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 Elements of Costs
Marginal Cost: The benefit of mass production can be seen in
marginal cost.
When a product is manufactured in a company, the cost
of producing that product for a given volume of V1 units is
X1 and that for producing the same product for v1+1 units
is X2. The difference between X2 and X1 is the cost of
production of the additional unit with reference to the
production volume. This is known as Marginal Cost of
production.
Marginal revenue of the product is the additional revenue
generated by that product for an additional unit of sales
with reference to a given volume of sales.

Average Cost: The average cost is the average obtained by

dividing the total cost of producing a given volume of a
product by the volume of production of that product.

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 Elements of Costs
Sunk Cost: Sunk cost is the past cost of an equipment/asset.
Example: equipment has been purchased for Rs. 100000
about three years back. If it is decided to replace it, then
its present value is not same amount. Instead, its present
market value should be taken as the present value of the
equipment for further analysis. The purchase value of the
equipment in the past is known as its Sunk Cost.

Opportunity Cost: The amount that is foregone by not

investing in the other alternative is known as the opportunity
cost of selected alternative. The opportunity cost of an
alternative is the return that will be foregone by not investing
the same money in another alternative.

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 Elements of Costs
Recurring Cost: Recurring costs are those costs which are
incurred for goods and services used in a business during a
financial year. The occurrence of this type of cost will be
repeated periodically. Few examples of recurring cost are as
follows:
Monthly salary of employees in an organization.
Rent paid for the building/house/office.
Electricity bill of company/house/building.
Travelling expenses of executives.
Annual maintenance cost of machinery/houses/buildings.
Loan and insurance premium payments.
Recurring cost will be fixed in nature in the short run, but it
varies in the long run (example: rent for building,
maintenance cost of machinery, etc.)

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 Elements of Costs
Non-Recurring Cost: Non-Recurring costs are those costs
which are incurred one time in a business. Few examples of
recurring cost are as follows:
Initially outlay of a company, which is the total cost
involved to set up a factory/any business.
Costs involved in the expansion of a business at a point in
time.
Cost of modernization of plant.
Cost on employee welfare measures on some special
occasion of the organization, such as silver jubilee or
golden jubilee celebration.
Capital expenditures, unusual charges, design,
development and investment costs, various kinds of losses,
legal costs, and moving expenses.

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 Elements of Costs
Incremental Cost: Incremental cost is the cost of increasing
the production volume by one unit.
The total cost consists of fixed cost and variable cost. The
cost of producing one unit extra will be equal to the
average cost per unit.
The incremental cost includes all variable costs. This
means that added costs would be absent if an additional
unit is not produced.
This cost is useful for economic analysis such as the
determination of production volume of a product, beyond
which the production will bot be efficient or economical.

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 Process Planning/ Process Modification
Process planning, also known as operations planning, is the
systematic determination of the engineering processes and
systems to manufacture a product competitively and
economically.
Planning processes can result in increased output, higher
precision, and faster turnaround for vital business tasks.
A process is described as a set of steps that result in a
specific outcome. It converts input into output.
While planning for a new component, a feasible sequence of
operations with the least cost of processing is to be
considered.
The process sequence of a component which has been
planned in the past is not static. It is always subject to
modification with a view to minimize the cost of
manufacturing the component.
The objective of process planning is to identify the most
economical sequence of operations to produce a component.
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 Process Planning/ Process Modification
The steps in process planning are as follows:
Analyze the part drawing to get an overall picture of what
is required.
Make recommendations or consult with product engineers
on product design changes.
List the basic operations required to produce the part to
the drawings or specifications.
Determine the most practical and economical
manufacturing method.
Devise the best way to combine the operations and put
them in sequence.
Specify the gauging required for the process.

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 Process Planning/ Process Modification

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 Numerical Problems
Problem Statement 1: The process planning engineer of a firm listed the
sequences of operations as shown in below table to produce a component.
Sequence Process Sequence
1 Turning-Milling-Shaping-Drilling
2 Turning-Milling-Drilling
3 All operations are performed with CNC machine
The details of processing times of the component for various operations and
their machine hour rates are summarized in below table.
Process Sequence (min)
Operation Machine hour rate (INR)
1 2 3
Turning 200 5 5 --
Milling 400 8 14 --
Shaping 350 10 -- --
Drilling 300 3 3 --
CNC Operations 1000 -- -- 8
Find the most economical sequence of operations to manufacture the
component.

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 Numerical Problems
Solution: Cost of component using process sequence 1. The process
sequence 1 of the component is as follows:

Turning-Milling-Shaping-Drilling

The calculation for the cost of the above process sequence are summarized in
following table:

Operation Time
Operation Machine hour rate Cost
No. Min Hour
1 Turning 5 0.083 200 16.60
2 Milling 8 0.133 400 53.20
3 Shaping 10 0.167 350 58.45
4 Drilling 3 0.050 300 15
Total 143.25

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 Numerical Problems
Solution: Cost of component using process sequence 2. The process
sequence 2 of the component is as follows:

Turning-Milling-Drilling

The calculation for the cost of the above process sequence are summarized in
following table:

Operation Time
Operation Machine hour rate Cost
No. Min Hour
1 Turning 5 0.083 200 16.60
2 Milling 14 0.233 400 93.20
3 Drilling 3 0.050 300 15
Total 124.80

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 Numerical Problems
Solution: Cost of component using process sequence 3. The process
sequence 3 of the component is as follows:

Only CNC Operations

The calculation for the cost of the above process sequence are summarized in
following table:

Operation Time
Operation Machine hour rate Cost
No. Min Hour
CNC
1 8 0.133 1000 133
Operations
Total 133

The process sequence 2 has the least cost. Therefore, it should be selected for
manufacturing the component.

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 Numerical Problems
Problem Statement 2: Ramesh decided to leave his job and start a
grocery. There was a spare room in his house which was adjoining the
road where a previous tenant was running a garment boutique and was
paying him a rent of Rs. 10,000 per month. After running the grocery for a
year, Ramesh sat down to audit his earning and expenses. He found the
following information.
Sales revenue for the year = Rs. 30,00,000.
Cost of goods sold = Rs. 22,00,000
Cost of Maintenance, Electricity and Phone etc. = Rs. 50,000
His Salary in the job = Rs. 40,000 per month
Calculate his Accounting and Economic Profits.
Ans: Opportunity Cost is implicit value of a resource in its best alternative
use. It is the highest value alternative forgone when a choice is made.

Opportunity Cost =
Salary for One Year (4,80,000) + Rent received for a year (1,20,000)
= Rs. 6,00,000

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 Numerical Problems
Accounting profits is total revenue minus the explicit or accounting cost of
production.
Accounting Profit = 30,00,000 - (22,00,000+50,000) = Rs. 7,50,000

Economic profit is total revenue minus the explicit and implicit costs of
production.
Explicit cost involves outflow of cash due to use of one or more factors of
production (Land, Labour, Capital).
Explicit Cost = 22,00,000 + 50,000 = Rs. 22,50,000

Economic Profit = Sales revenue – (Explicit + Implicit (Opportunity) cost)

= 30,00,000 – (22,50,000 + 6,00,000)
= Rs. 1,50,000

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 Numerical Problems
Problem Statement 3: Ramesh decided to leave his job and start a
grocery. There was a spare room in his house which was adjoining the
road where a previous tenant was running a garment boutique and was
paying him a rent of Rs. 9000 per month. After running the grocery for a
year, Ramesh sat down to audit his earning and expenses. He found the
following information.
Sales revenue for the year = Rs. 25,00,000.
Cost of goods sold = Rs. 18,00,000
Cost of Maintenance, Electricity and Phone etc. = Rs. 50,000
His Salary in the job = Rs. 30,000 per month
Calculate his Accounting and Economic Profits.
Ans:
Opportunity Cost: 3,60,000+1,08,000 = Rs. 4,68,000
Accounting profits = 25,00,000 - (18,00,000+50,000) = Rs. 6,50,000
Economic profiles = Sales – (Explicit + Implicit (Opportunity) cost)
= Rs. 1,82,000

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 Numerical Problems
Problem Statement 4: Dr. Manisha is employed at Kailash Hospital as a
consultant on a salary of Rs. 100,000 per month. She is planning to leave
her job and devote herself full time to her own private practice. The place
she has chosen for her clinic would cost her Rs. 20,000 per month as rent.
Other miscellaneous expenditure (electricity, telephone, stationery etc.)
would total Rs. 15000 per month. She would need an office attendant at a
salary of Rs. 10000 per month. Her consultation fee is Rs. 500 per patient
and she expects to see 15 paying patients on a day. Assume there are 25
working days in a month. Calculate the accounting and the economic
profits.

Ans.
Accounting Profit = Total Revenue – Explicit Costs
Total Revenue (per month) = (Consultation fee/patient) x (Patients/day) x
(Working days/month)
= 500*15*25 = Rs.187500
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 Numerical Problems
Ans.
Explicit Costs = Rent + Wage+ Miscellaneous Expenses
= 20000+10000+15000 = Rs. 45000
Accounting Profit = 187500 – 45000 = Rs. 142500

Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)

Implicit Cost = Opportunity Costs = Rs. 100,000
Economic Profit = 187500 – (45000+100000) = Rs.42500

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 Numerical Problems
Problem Statement 5: Lease Rental = Rs 100,000 per month; Cost of
Electricity = Rs. 10000 per month; Cost of manpower = Rs. 40000 per
month; Cost of petrol = Rs. 100 per liter. Find the fixed, variable and total
costs if the pump is selling 10000 litres of petrol per month.
Ans.
Fixed Costs: These are costs that do not vary with the level of output or
production. They remain constant regardless of the quantity produced.
Total Fixed Cost = Lease Rental = Rs. 100,000 per month
Variable Costs: These are costs that change with the level of output or
production. In this case, the variable costs include the cost of electricity,
manpower, and petrol.
Cost of Electricity = Rs. 10,000 per month
Cost of Manpower = Rs. 40,000 per month
Cost of Petrol = Rs. 100 per liter * 10,000 liters = Rs. 1,000,000
Total Variable Cost = 10000 + 40000 + 1000000 = Rs.1050000
Total Costs: This is the sum of fixed and variable costs.
Total Costs = Total Fixed Costs + Total Variable Costs
= Rs. 100,000 + Rs. 1,050,000
= Rs. 1,150,000 per month

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 Numerical Problems
Problem Statement 6: The total fixed cost of a firm is Rs. 40 per month.
The average variable costs relative to output are given below. Fill the
remaining cells of the table.
Output Average Variable Total Variable Total Fixed Total Marginal
(units) Cost (Rs) Cost (Rs) Cost (Rs) Cost (Rs) Cost (Rs)
1 30 30 40 70 70
2 20 40 40 80 10
3 25 75 40 115 35

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