Chapter Summary: Economic Decision Making

Economic decision making is a crucial aspect of engineering practice. Engineers

are often involved in projects and designs that have significant economic
implications. Therefore, it's essential for them to understand how to make
sound economic decisions. This chapter typically covers the following key
concepts:
1. The Decision-Making Process: A structured approach to decision making,
often involving steps like:
o Problem definition
o Identifying alternatives
o Evaluating alternatives (using economic criteria)
o Selecting the best alternative
o Implementation and monitoring
2. Types of Engineering Economic Decisions: These can include:
o Investment decisions (e.g., choosing between different equipment)
o Design decisions (e.g., selecting materials or processes)
o Operating decisions (e.g., maintenance strategies)
3. Fundamental Economic Principles: Concepts like:
o Time value of money (the idea that money today is worth more than
the same amount in the future)
o Interest and interest rates
o Cash flow diagrams
4. Methods for Evaluating Alternatives: Techniques used to compare
different options, such as:
o Present worth analysis
o Annual worth analysis
o Future worth analysis
 o Rate of return analysis
o Benefit-cost analysis
5. Uncertainty and Risk Analysis: Recognizing that future events are
uncertain and incorporating this into decision making.
Important Questions and Answers:
Q1. Why is economic decision making important for engineers?
A: Engineers are responsible for designing, building, and operating systems and
projects that have economic consequences. Efficient resource allocation, cost-
effectiveness, and project feasibility are all tied to sound economic decision
making.
Q2. What is the time value of money, and why is it important?
A: The time value of money is the concept that money available at the present
time is worth more than the identical sum in the future due to 1 its potential
earning capacity. This 2 is crucial in engineering economics because projects
often have cash flows occurring over extended periods.
Q3. Explain the difference between present worth and future worth analysis.
A: Both are methods to compare alternatives by bringing all cash flows to a
common point in time. Present worth analysis brings all cash flows to the
present, while future worth analysis brings them to a future point. The decision
criterion is usually to select the alternative with the highest present or future
worth (for benefits) or the lowest (for costs).
Q4. What is rate of return analysis?
A: Rate of return analysis determines the interest rate at which the present
worth of costs equals the present worth of benefits for an investment. This rate
is then compared to a minimum acceptable rate of return (MARR) to decide on
the investment's acceptability.
Q5. How is uncertainty handled in economic decision making?
A: Uncertainty can be addressed through techniques like:
• Sensitivity analysis: Examining how the outcome of a decision changes
when input parameters vary.
 • Scenario analysis: Evaluating outcomes under different possible future
scenarios.
• Probability analysis: Assigning probabilities to different outcomes and
calculating expected values.

Chapter Summary: Engineering Costs & Estimation

This chapter focuses on the crucial aspect of cost management in engineering
projects. It covers the different types of costs encountered in engineering
projects and the various methods used to estimate these costs. Here's a
breakdown of the key concepts:
1. Types of Costs: Understanding the different cost classifications is essential for
effective cost management. Common types include:
• Fixed Costs: Costs that remain constant regardless of the production
volume (e.g., rent, salaries of permanent staff).
• Variable Costs: Costs that vary directly with the production volume (e.g.,
raw materials, direct labor).
• Direct Costs: Costs directly attributable to a specific product or project
(e.g., materials used in construction).
• Indirect Costs: Costs not directly attributable to a specific product or
project but necessary for overall operations (e.g., administrative overhead,
utilities).
• Recurring Costs: Costs that occur repeatedly throughout the life of a
project or product (e.g., maintenance, repairs).
• Non-recurring Costs: One-time costs (e.g., initial investment in equipment,
land acquisition).
• Opportunity Cost: The cost of the next best alternative forgone when
making a decision.
• Sunk Costs: Costs that have already been incurred and cannot be
recovered.
2. Cost Estimation Techniques: Accurate cost estimation is vital for project
planning, budgeting, and decision making. Various methods are used, including:
• Order-of-Magnitude Estimates (Rough Estimates): Used in the early stages
of a project for initial feasibility assessment. Accuracy is typically low (-25%
to +75%).
• Budget Estimates (Preliminary Estimates): Developed during the planning
phase with more detailed information. Accuracy is improved (-10% to
+25%).
• Definitive Estimates (Detailed Estimates): Prepared during the design
phase with complete engineering drawings and specifications. High
accuracy is expected (-5% to +10%).
3. Cost Estimation Models: Different models can be employed for cost
estimation:
• Per-Unit Model: Estimates costs based on a cost per unit of output (e.g.,
cost per square foot of building).
• Segmenting Model: Breaks down a project into smaller components and
estimates the cost of each segment.
• Cost Index Model: Uses historical cost data and cost indices to adjust costs
for inflation or changes in location.
• Power-Sizing Model: Estimates costs based on the capacity or size of
equipment or facilities.
4. Factors Affecting Cost Estimation: Several factors can influence cost
estimates:
• Project scope and complexity
• Availability of resources (labor, materials, equipment)
• Market conditions and inflation
• Technological changes
• Project location and environmental factors
Important Questions and Answers:
Q1. What is the difference between fixed and variable costs? Give examples.
A: Fixed costs remain constant regardless of the production level (e.g., rent,
insurance), while variable costs change in proportion to the production level
(e.g., raw materials, direct labor).
Q2. Explain the different types of cost estimates and their levels of accuracy.
A:
• Order-of-Magnitude: Used in early stages, low accuracy (-25% to +75%).
• Budget: Used in the planning phase, medium accuracy (-10% to +25%).
• Definitive: Used in the design phase, high accuracy (-5% to +10%).
Q3. What are some common cost estimation models used in engineering?
A: Per-unit model, segmenting model, cost index model, and power-sizing
model.
Q4. Why is it important to consider indirect costs in cost estimation?
A: Indirect costs, though not directly tied to a specific product, are necessary for
the overall functioning of the project or organization. Ignoring them can lead to
significant underestimation of total costs.
Q5. How can you account for inflation in cost estimation?
A: Cost indices can be used to adjust historical cost data for inflation. These
indices track changes in prices over time for various goods and services.

Chapter Summary: Cash Flow, Interest, and Equivalence

This chapter lays the foundation for engineering economic analysis by
introducing the concepts of cash flow, interest, and equivalence. These concepts
are essential for evaluating the economic viability of engineering projects.
1. Cash Flow Diagrams: A cash flow diagram is a graphical representation of cash
inflows (receipts) and cash outflows (disbursements) over a period of time. It's a
crucial tool for visualizing and analyzing the timing of cash flows.
 • Conventions: Cash inflows are typically represented by upward arrows,
and cash outflows by downward arrows. The horizontal axis represents
time.
2. Interest and Interest Rates: Interest is the cost of borrowing money or the
return on invested capital. The interest rate is the percentage of the principal
amount charged or earned over a specific period (usually a year).
• Simple Interest: Calculated only on the principal amount.
• Compound Interest: Calculated on the principal amount and any
accumulated interest. This is the most common type of interest used in
engineering economics.
3. Equivalence: The concept of equivalence states that different sums of money
at different points in time can be economically equivalent if they have the same
value when compared at a common point in time. This is achieved through the
use of interest rates.
4. Time Value of Money: The fundamental principle that money available at the
present time is worth more than the same amount in the future due to its
potential earning capacity.
5. Equivalence Calculations: Several methods are used to determine the
equivalence of cash flows:
• Present Worth (P): The equivalent value of a cash flow or series of cash
flows at the present time.
• Future Worth (F): The equivalent value of a cash flow or series of cash
flows at a specified future time.
• Annual Worth (A): The equivalent uniform annual value of a cash flow or
series of cash flows over a specified period.
6. Interest Formulas and Factors: Various formulas and interest factors are used
for equivalence calculations, including:
• Single Payment Compound Amount Factor (F/P, i, n): Finds the future
worth (F) given a present worth (P).
 • Single Payment Present Worth Factor (P/F, i, n): Finds the present worth
(P) given a future worth (F).
• Uniform Series Compound Amount Factor (F/A, i, n): Finds the future
worth (F) given a uniform series of payments (A).
• Uniform Series Present Worth Factor (P/A, i, n): Finds the present worth
(P) given a uniform series of payments (A).
• Capital Recovery Factor (A/P, i, n): Finds the uniform annual payment (A)
equivalent to a present worth (P).
• Sinking Fund Factor (A/F, i, n): Finds the uniform annual payment (A)
required to accumulate a future worth (F).
Important Questions and Answers:
Q1. What is a cash flow diagram, and why is it important?
A: A cash flow diagram is a graphical representation of cash inflows and outflows
over time. It helps visualize the timing and magnitude of cash flows, making it
easier to analyze and compare different investment options.
Q2. Explain the difference between simple and compound interest.
A: Simple interest is calculated only on the principal amount, while compound
interest is calculated on the principal and any accumulated interest. Compound
interest results in faster growth of the investment.
Q3. What is the concept of equivalence in engineering economics?
A: Equivalence means that different sums of money at different times can have
the same economic value if they are compared at a common point in time using
an appropriate interest rate.
Q4. What are present worth, future worth, and annual worth, and how are
they related?
A: These are different ways of expressing the equivalent value of cash flows at
different points in time. Present worth is the value at the present, future worth
is the value at a future time, and annual worth is the equivalent uniform annual
value. They are all related through time value of money calculations.
Q5. When would you use the P/F factor versus the F/P factor?
A: The P/F (Present Worth Factor) is used to find the present value of a single
future cash flow. The F/P (Future Worth Factor) is used to find the future value
of a single present cash flow.
Key Formulas to Remember:
• F = P(1 + i)^n (Future Worth of a Single Payment)
• P = F/(1 + i)^n (Present Worth of a Single Payment)
• F = A[(1 + i)^n - 1]/i (Future Worth of a Uniform Series)
• P = A[(1 + i)^n - 1]/[i(1 + i)^n] (Present Worth of a Uniform Series)
Best Tips for Exam Preparation:
• Practice Drawing Cash Flow Diagrams: This is fundamental to
understanding the problems.
• Master the Interest Formulas and Factors: Know when and how to use
them.

Chapter Summary: Cash Flow & Rate of Return Analysis

This chapter builds upon the concepts of cash flow and equivalence to introduce
methods for evaluating the profitability of investments using rate of return
analysis. It focuses on determining the rate of return an investment is expected
to generate and comparing it to a minimum acceptable rate of return (MARR).
1. Rate of Return (ROR): The rate of return is the interest rate earned on an
investment over its life. It represents the percentage return on each dollar
invested.
2. Methods for Calculating ROR:
• Internal Rate of Return (IRR): The discount rate that makes the net
present value (NPV) of all cash flows from a particular investment equal to
zero. In other words, it's the interest rate at which the present worth of
cash inflows equals the present worth of cash outflows.
 • External Rate of Return (ERR): A modification of the IRR that explicitly
considers the interest rate earned on reinvested cash flows. It addresses
some of the limitations of the IRR method.
3. Minimum Acceptable Rate of Return (MARR): The minimum rate of return an
investor is willing to accept for an investment, given its risk level and other
investment opportunities. It's also known as the hurdle rate or discount rate.
4. Comparing ROR to MARR:
• If ROR ≥ MARR: The investment is considered economically acceptable.
• If ROR < MARR: The investment is not considered economically acceptable.
5. Incremental Analysis: When comparing mutually exclusive alternatives,
incremental analysis is used to determine which alternative is more
economically attractive. This involves calculating the rate of return on the
difference in cash flows between the two alternatives.
6. Cash Flow Analysis for ROR: Accurate cash flow diagrams and tables are
crucial for ROR analysis. They provide a clear picture of the timing and
magnitude of cash inflows and outflows.
7. Reinvestment Rate Assumption: The IRR method implicitly assumes that all
interim cash flows are reinvested at the IRR itself. This can be a limitation if
reinvestment opportunities at that rate are not available. The ERR method
addresses this by explicitly specifying a reinvestment rate.
Important Questions and Answers:
Q1. What is the rate of return, and why is it important in investment analysis?
A: The rate of return is the interest rate earned on an investment. It's important
because it provides a measure of the investment's profitability and allows for
comparison between different investment opportunities.
Q2. Explain the concept of the Internal Rate of Return (IRR).
A: The IRR is the discount rate that makes the net present value (NPV) of an
investment equal to zero. It represents the rate 1 at which the present worth of
cash inflows equals the present worth of cash outflows.
Q3. What is the Minimum Acceptable Rate of Return (MARR), and how is it
used in investment decisions?
A: The MARR is the minimum rate of return an investor is willing to accept. If the
ROR of an investment is greater than or equal to the MARR, the investment is
considered acceptable; otherwise, it's rejected.
Q4. When comparing two mutually exclusive alternatives, how is rate of return
analysis used?
A: Incremental analysis is used. The rate of return on the difference in cash flows
between the two alternatives is calculated. If this incremental ROR is greater
than or equal to the MARR, the higher-investment alternative is preferred.
Q5. What is a limitation of using the IRR method, and how does the ERR
address it?
A: The IRR method assumes that all interim cash flows are reinvested at the IRR
itself. This may not be realistic. The ERR method explicitly specifies a
reinvestment rate, making it a more realistic measure in some cases.
Key Points to Remember:
• IRR Calculation: Often involves iterative calculations or using financial
calculators or software.
• Multiple IRRs: Some cash flow patterns can result in multiple IRR values,
making interpretation difficult.
• Incremental Analysis: Essential for comparing mutually exclusive
alternatives.
• Relationship between NPV and IRR: If NPV > 0 at a discount rate equal to
MARR, then IRR > MARR.
Best Tips for Exam Preparation:
• Practice IRR Calculations: Work through various numerical examples,
including those with different cash flow patterns.
• Understand Incremental Analysis: Be able to apply it to compare mutually
exclusive alternatives.
 • Know the Limitations of IRR: Understand when ERR might be a more
appropriate measure.
• Relate ROR to other evaluation methods: Understand the relationship
between ROR and NPV.

Chapter Summary: Inflation and Price Change

This chapter addresses the impact of inflation and price changes on engineering
economic analyses. Inflation, the general increase in the price of goods and
services over time, significantly affects project costs, revenues, and profitability.
It's crucial for engineers to understand how to account for inflation in their
economic evaluations.
1. Inflation: A sustained increase in the general price level of goods and services
in an economy over a period of time. It erodes purchasing power, meaning that
a given amount of money buys less over time.
2. Deflation: The opposite of inflation, a sustained decrease in the general price
level.
3. Price Indices: Measures used to track changes in prices over time. Common
examples include:
• Consumer Price Index (CPI): Measures the average change in prices paid
by urban consumers for a basket of consumer goods and services.
• Producer Price Index (PPI): Measures the average change in prices
received by domestic producers for their output.
4. Actual Dollars (Current Dollars or Nominal Dollars): Dollars measured in
terms of their value at the time they are spent or received. They reflect the
actual prices at that time, including the effect of inflation.
5. Real Dollars (Constant Dollars or Inflation-Free Dollars): Dollars adjusted to
reflect a constant purchasing power relative to a base year. They remove the
effect of inflation, allowing for comparisons of economic values over time.
6. Inflation Rate (f): The rate at which the general price level is increasing. It's
usually expressed as a percentage per year.
7. Market Interest Rate (i): The interest rate observed in the market. It includes
both the real interest rate and the effect of inflation.
8. Real Interest Rate (i'): The interest rate adjusted for inflation. It represents
the actual increase in purchasing power.
9. Relationship between Market Interest Rate, Real Interest Rate, and Inflation
Rate:
• (1 + i) = (1 + i')(1 + f)
• i' ≈ i - f (This approximation is valid for small inflation rates)
10. Methods for Handling Inflation in Economic Analysis:
• Working in Actual Dollars: All cash flows are expressed in terms of the
actual dollars expected at the time they occur. The market interest rate is
used for discounting.
• Working in Real Dollars: All cash flows are converted to constant dollars
relative to a base year. The real interest rate is used for discounting.
Important Questions and Answers:
Q1. What is inflation, and how does it affect economic decisions?
A: Inflation is a general increase in the price level. It reduces purchasing power
and needs to be considered in economic analyses to accurately compare costs
and benefits over time.
Q2. Explain the difference between actual dollars and real dollars.
A: Actual dollars (nominal dollars) reflect prices at the time of transaction,
including inflation. Real dollars (constant dollars) are adjusted to remove the
effect of inflation, allowing for comparisons based on constant purchasing
power.
Q3. What are price indices, and how are they used?
A: Price indices (like CPI and PPI) measure changes in prices over time. They are
used to track inflation and to convert actual dollars to real dollars.
Q4. How do you calculate the real interest rate given the market interest rate
and inflation rate?
A: The exact relationship is (1 + i) = (1 + i')(1 + f). An approximation for small
inflation rates is i' ≈ i - f, where 'i' is the market interest rate, 'i'' is the real
interest rate, and 'f' is the inflation rate.
Q5. When is it appropriate to use actual dollars versus real dollars in an
economic analysis?
A: Both methods lead to the same economic decision when applied correctly.
It's often easier to forecast cash flows in actual dollars if future price changes are
known. However, real dollars are preferred when the focus is on changes in
purchasing power or when comparing investments over long time horizons.
Key Points to Remember:
• Use the market interest rate (i) when working with actual dollars.
• Use the real interest rate (i') when working with real dollars.
• Consistency is key: all cash flows and the discount rate must be in the same
type of dollars (actual or real).

Chapter Summary: Present Worth Analysis

Present worth analysis is a powerful technique in engineering economics for
evaluating the economic viability of projects by comparing the present value of
all cash inflows and outflows associated with each project. It brings all future
cash flows back to their equivalent value at the present time, allowing for a
direct comparison of different investment options.
1. Concept of Present Worth (PW or P): The present worth of a cash flow or a
series of cash flows is its equivalent value at the present time (time zero). It
represents the current value of future money, considering the time value of
money.
2. Calculating Present Worth:
• Single Payment: The present worth (P) of a single future cash flow (F)
occurring n periods from now is calculated using the formula:
o P = F / (1 + i)^n
Where: * F = Future cash flow * i = Interest rate (discount rate) per period * n =
Number of periods
• Uniform Series (Annuity): The present worth (P) of a uniform series of
cash flows (A) occurring for n periods is calculated using the formula:
o P = A * [ (1 - (1 + i)^-n) / i ]
This can also be calculated using the Present Worth of a Uniform Series Factor
(P/A, i, n) from interest factor tables:
o P = A * (P/A, i, n)
• Gradient Series: A gradient series is a series of cash flows that increase or
decrease by a constant amount each period. The present worth of a
gradient series can be calculated using specific formulas or by breaking it
down into a uniform series and a gradient component.
• Combined Cash Flows: For projects with a mix of single payments, uniform
series, and gradient series, the present worth of each component is
calculated separately and then summed to find the total present worth of
the project.
3. Decision Criteria for Present Worth Analysis:
• Independent Projects:
o If PW ≥ 0: The project is economically acceptable.
o If PW < 0: The project is not economically acceptable.
• Mutually Exclusive Projects:
o Select the project with the highest present worth.
4. Present Worth of Costs (PWC): When comparing alternatives based on costs
only (e.g., different ways to achieve the same outcome), the alternative with the
lowest present worth of costs is preferred.
5. Capitalized Cost: The present worth of a project that is expected to last
indefinitely (perpetuity). It can be calculated as:
• Capitalized Cost = A / i
Where A is the uniform annual cost.
Important Questions and Answers:
Q1. What is the basic principle behind present worth analysis?
A: Present worth analysis compares the economic value of different alternatives
by converting all future cash flows to their equivalent value at the present time,
taking into account the time value of money.
Q2. How do you calculate the present worth of a single future cash flow?
A: P = F / (1 + i)^n, where F is the future cash flow, i is the interest rate, and n is
the number of periods.
Q3. What is the decision criterion for selecting between mutually exclusive
projects using present worth analysis?
A: Select the project with the highest present worth.
Q4. When is the present worth of costs (PWC) used, and what is the decision
criterion?
A: PWC is used when comparing alternatives based on costs only. The
alternative with the lowest PWC is preferred.
Q5. What is capitalized cost, and how is it calculated?
A: Capitalized cost is the present worth of a project that is expected to last
indefinitely. It's calculated as Capitalized Cost = A / i, where A is the uniform
annual cost and i is the interest rate.
Key Points to Remember:
• Cash Flow Diagrams: Always draw a cash flow diagram to visualize the
timing and magnitude of cash flows.
• Consistent Time Periods: Ensure that the interest rate and the time
periods are consistent (e.g., annual interest rate and annual periods).
• Sign Conventions: Be consistent with sign conventions for cash inflows
(positive) and cash outflows (negative).
 Chapter Summary: Uncertainty in Future Events
This chapter addresses the critical issue of uncertainty in engineering economic
analysis. Real-world projects are subject to various unpredictable factors that
can significantly impact their economic outcomes. This chapter introduces
methods for incorporating uncertainty into decision-making.
1. Sources of Uncertainty: Several factors contribute to uncertainty in future
events, including:
• Market conditions: Fluctuations in demand, prices, and competition.
• Technological advancements: Unexpected innovations that can render
existing technologies obsolete.
• Regulatory changes: New laws and regulations that can affect project costs
and feasibility.
• Natural disasters: Unforeseen events like earthquakes, floods, and storms.
• Political and economic instability: Changes in government policies or
economic downturns.
2. Methods for Handling Uncertainty: Several techniques are used to
incorporate uncertainty into economic analysis:
• Sensitivity Analysis: Examines how the outcome of a decision changes
when one or more input parameters are varied. It helps identify the most
sensitive variables and their impact on the project's profitability.
• Scenario Analysis: Evaluates the project's performance under different
possible future scenarios (e.g., best-case, base-case, worst-case). It
provides a range of potential outcomes and helps assess the project's
robustness.
• Probability Analysis: Assigns probabilities to different possible outcomes
and calculates the expected value of the project's economic measures
(e.g., expected present worth, expected rate of return).
• Decision Trees: A graphical representation of decision alternatives and
their possible outcomes, along with associated probabilities. They are
useful for analyzing sequential decisions under uncertainty.
 • Monte Carlo Simulation: A computational technique that uses random
sampling to simulate a large number of possible outcomes and generate a
probability distribution of the project's economic measures.
3. Expected Value: The weighted average of the possible outcomes, where the
weights are the probabilities of each outcome. It represents the average
outcome that would be expected if the uncertain event were to occur many
times.
Expected Value (EV) = Σ (Outcome * Probability)
4. Risk and Risk Aversion: Risk refers to the variability of possible outcomes. Risk
aversion is the tendency of decision-makers to prefer less risky options, even if
they have slightly lower expected returns.
Important Questions and Answers:
Q1. What are some common sources of uncertainty in engineering projects?
A: Market conditions, technological advancements, regulatory changes, natural
disasters, and political and economic instability are common sources of
uncertainty.
Q2. Explain how sensitivity analysis is used to handle uncertainty.
A: Sensitivity analysis examines how the project's outcome changes when input
parameters are varied. It helps identify the most sensitive variables and their
impact on the project's profitability.
Q3. What is the purpose of scenario analysis?
A: Scenario analysis evaluates the project's performance under different
possible future scenarios (e.g., best-case, base-case, worst-case). It provides a
range of potential outcomes and helps assess the project's robustness.
Q4. How is probability analysis used to incorporate uncertainty?
A: Probability analysis assigns probabilities to different possible outcomes and
calculates the expected value of the project's economic measures.
Q5. What is the expected value, and how is it calculated?
A: The expected value is the weighted average of possible outcomes. It is
calculated as EV = Σ (Outcome * Probability).
Key Points to Remember:
• Sensitivity Analysis: Focuses on the impact of changing individual
variables.
• Scenario Analysis: Considers multiple variables changing simultaneously
under different scenarios.
• Probability Analysis: Requires assigning probabilities to different
outcomes, which can be subjective.
• Decision Trees: Useful for analyzing sequential decisions with multiple
stages of uncertainty.
• Monte Carlo Simulation: A powerful technique for complex projects with
many uncertain variables.

Chapter Summary: Depreciation

Depreciation is the systematic allocation of the cost of an asset over its useful
life. It's a crucial concept in engineering economics because it affects a
company's taxable income and, therefore, its cash flows. Understanding
depreciation methods is essential for accurate economic analysis of projects
involving capital assets.
1. Basic Concepts:
• Depreciable Asset: A tangible property used in a business or held for the
production of income, with a useful life of more than one year.
• Cost Basis: The original cost of the asset, including expenses for
acquisition, transportation, and installation.
• Useful Life: The estimated period during which the asset is expected to be
used in the business.
• Salvage Value (or Residual Value): The estimated value of the asset at the
end of its useful life.
• Depreciation Expense: The portion of the asset's cost that is allocated as
an expense in a given period.
 • Book Value: The asset's original cost minus the accumulated depreciation.
2. Depreciation Methods: Several methods are commonly used to calculate
depreciation:
• Straight-Line Depreciation: The simplest method, where the same amount
of depreciation is taken each year.
o Depreciation Expense = (Cost Basis - Salvage Value) / Useful Life
• Declining Balance Depreciation: An accelerated method where a fixed
percentage of the asset's book value is depreciated each year. The most
common form is the Double Declining Balance (DDB) method, where the
depreciation rate is twice the straight-line rate.
o Depreciation Rate (DDB) = 2 / Useful Life
o Depreciation Expense = Book Value * Depreciation Rate
• Sum-of-the-Years' Digits (SYD) Depreciation: Another accelerated method
where the depreciation expense is higher in the early years of the asset's
life.
o Depreciation Expense = (Remaining Useful Life / Sum of the Years'
Digits) * (Cost Basis - Salvage Value)
o Sum of the Years' Digits = n(n+1)/2, where n is the useful life
• Modified Accelerated Cost Recovery System (MACRS): The depreciation
system currently used for tax purposes in the United States. It specifies
recovery periods (useful lives) and depreciation methods for different
classes of assets. MACRS is not typically covered in basic Engineering
Economics courses outside the US, but it's important to be aware of it.
3. Effects of Depreciation on Taxes: Depreciation is a non-cash expense that
reduces a company's taxable income. This results in lower tax payments, which
increases the company's cash flow.
4. Book Depreciation vs. Tax Depreciation: Companies may use different
depreciation methods for financial reporting (book depreciation) and tax
purposes (tax depreciation).
Important Questions and Answers:
Q1. What is depreciation, and why is it important?
A: Depreciation is the systematic allocation of the cost of an asset over its useful
life. It's important because it affects a company's taxable income, cash flow, and
financial statements.
Q2. Explain the straight-line depreciation method.
A: Straight-line depreciation allocates the same amount of depreciation expense
each year over the asset's useful life. The formula is: Depreciation Expense =
(Cost Basis - Salvage Value) / Useful Life.
Q3. What is an accelerated depreciation method, and give an example?
A: An accelerated depreciation method allows for higher depreciation expenses
in the early years of an asset's life. An example is the Double Declining Balance
(DDB) method.
Q4. How does depreciation affect a company's taxes?
A: Depreciation reduces a company's taxable income, which leads to lower tax
payments and increases cash flow.
Q5. What is the difference between book value and market value?
A: Book value is the asset's original cost minus accumulated depreciation.
Market value is the price the asset could be sold for in the current market. They
are often different.
Key Points to Remember:
• Understand the formulas for each depreciation method.
• Be able to calculate the depreciation expense and book value for each year
of an asset's life.
• Understand the differences between the various depreciation methods
and when each might be used.
 Chapter Summary: Replacement Analysis
Replacement analysis deals with the economic evaluation of replacing existing
assets with new ones. It's a crucial aspect of engineering economics, as
businesses constantly face decisions about whether to continue using existing
equipment or invest in newer, more efficient technologies.
1. Basic Concepts:
• Defender: The existing asset currently in use.
• Challenger: The proposed replacement asset.
• Economic Life: The period over which an asset provides the most
economic service. It's not necessarily the same as the physical life.
• Remaining Life: The number of years the defender is expected to continue
providing service.
• Market Value (or Salvage Value): The current resale value of the defender.
• Trade-in Value: The value offered for the defender when purchasing a new
asset.
• First Cost: The initial cost of the challenger.
• Operating Costs: The annual costs associated with operating and
maintaining an asset.
2. Reasons for Replacement:
• Physical Impairment: Deterioration, wear and tear, or damage to the
defender.
• Obsolescence: The defender becoming outdated due to technological
advancements.
• Increased Operating Costs: Rising maintenance, repair, or energy costs
associated with the defender.
• Improved Performance: The challenger offering superior efficiency,
productivity, or quality.
3. Replacement Analysis Methods:
 • Present Worth Analysis: Comparing the present worth of costs of
continuing with the defender versus replacing it with the challenger.
• Annual Worth Analysis: Comparing the annual worth of costs of the
defender and the challenger.
• Equivalent Uniform Annual Cost (EUAC): A special case of annual worth
analysis often used in replacement studies.
4. Economic Life of the Challenger: When evaluating a challenger, it's essential
to determine its economic life, which minimizes its EUAC. This involves
calculating the EUAC for different possible service lives and selecting the life that
results in the lowest EUAC.
5. Defender's Remaining Life: The remaining life of the defender is a crucial
factor in the analysis. If the defender has a very short remaining life,
replacement is often more economical.
6. Sunk Costs: Past costs associated with the defender are considered sunk costs
and should not be included in the replacement analysis. Only future costs and
revenues are relevant.
Important Questions and Answers:
Q1. What is the difference between the defender and the challenger in
replacement analysis?
A: The defender is the existing asset currently in use, while the challenger is the
proposed replacement asset.
Q2. What are some common reasons for replacing an existing asset?
A: Physical impairment, obsolescence, increased operating costs, and improved
performance of the challenger are common reasons.
Q3. Why are sunk costs not considered in replacement analysis?
A: Sunk costs are past costs that cannot be recovered. Only future costs and
revenues are relevant to the replacement decision.
Q4. How is the economic life of the challenger determined?
A: The economic life of the challenger is the service life that minimizes its
Equivalent Uniform Annual Cost (EUAC).
Q5. What are the common methods used for replacement analysis?
A: Present Worth Analysis, Annual Worth Analysis, and Equivalent Uniform
Annual Cost (EUAC) analysis are commonly used.
Key Points to Remember:
• Focus on future costs and revenues.
• Determine the economic life of the challenger.
• Consider the defender's remaining life.
• Use appropriate analysis methods (PW, AW, EUAC).

Chapter Summary: Accounting

This chapter introduces the fundamental concepts of accounting, which are
essential for engineers to understand the financial implications of their projects
and decisions. Accounting provides a framework for recording, summarizing,
and analyzing financial transactions.
1. Basic Accounting Concepts:
• Accounting Equation: Assets = Liabilities + Owner's Equity. This equation
forms the basis of double-entry bookkeeping.
• Assets: Resources owned by a business that are expected to provide future
economic benefits (e.g., cash, accounts receivable, inventory, equipment).
• Liabilities: Obligations of a business to others (e.g., accounts payable,
loans payable).
• Owner's Equity (or Stockholders' Equity): The residual interest in the
assets of the entity after deducting liabilities. It represents the owner's
investment in the business.
• Revenue: Inflows of economic benefits arising from the ordinary activities
of an entity (e.g., sales revenue, service revenue).
• Expenses: Outflows of economic benefits arising from the ordinary
activities of an entity (e.g., cost of goods sold, salaries, rent).
2. Accounting Principles:
• Generally Accepted Accounting Principles (GAAP): A set of accounting
standards, rules, and procedures that govern the preparation of financial
statements.
• Matching Principle: Expenses should be recognized in the same period as
the revenues they helped generate.
• Accrual Accounting: Revenues are recognized when earned, and expenses
are recognized when incurred, regardless of when cash is received or
paid.
• Going Concern Principle: Assumes that a business will continue to operate
indefinitely.
• Cost Principle: Assets are recorded at their original cost.
3. Financial Statements:
• Income Statement (or Profit and Loss Statement): Reports a company's
revenues, expenses, and net income (or net loss) over a specific period.
• Balance Sheet: Reports a company's assets, liabilities, and owner's equity
at a specific point in time.
• Statement of Cash Flows: Reports a company's cash inflows and outflows
during a specific period, categorized into operating, investing, and
financing activities.
4. Key Accounting Terms and Ratios:
• Net Income: Revenue - Expenses.
• Gross Profit: Revenue - Cost of Goods Sold.
• Current Assets: Assets expected to be converted to cash or used up within
one year.
• Current Liabilities: Obligations due within one year.
• Working Capital: Current Assets - Current Liabilities.
• Profit Margin: Net Income / Revenue.
 • Return on Assets (ROA): Net Income / Total Assets.
• Debt-to-Equity Ratio: Total Liabilities / Owner's Equity.
Important Questions and Answers:
Q1. What is the basic accounting equation?
A: Assets = Liabilities + Owner's Equity.
Q2. Explain the difference between assets and liabilities.
A: Assets are resources owned by a business that are expected to provide future
economic benefits. Liabilities are obligations of a business to others.
Q3. What are the three primary financial statements?
A: The income statement, balance sheet, and statement of cash flows.
Q4. What is the matching principle in accounting?
A: The matching principle states that expenses should be recognized in the same
period as the revenues they helped generate.
Q5. What is the difference between accrual accounting and cash accounting?
A: Accrual accounting recognizes revenues when earned and expenses when
incurred, regardless of when cash is received or paid. Cash accounting
recognizes revenues when cash is received and expenses when cash is paid.
Key Points to Remember:
• Understand the accounting equation and how transactions affect it.
• Know the basic accounting principles.
• Be able to interpret basic financial statements.
• Understand the key accounting terms and ratios.