CE 461

Engineering Economy/Entrepreneurship
Lecture 1

Prof. K.B. Nyarko and Dr. Eugene Appiah-Effah

Jan 2021
 Lecture 1
Introduction
Basic Concepts and terms
Learning Objectives
At the end of this lecture student should be able to:
• The concepts of engineering economy
• Time value of money
• Types of engineering cost and cost estimates
• Cash Flow Diagrams

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 Introduction to Eng Economy
• Engineering Economy is about decision making

• Decision making is inevitable

• Simple (figure it out in your head)

• Intermediate (economics as the key criteria)

• Complex (Economic, political, social, humanistic)

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 Introduction to Eng Economy
• Problems that are more amenable to analytical approaches of
engineering economic analysis will be our focus.

• Engineering economy is about determining the economic

factors and economic criteria utilised when one or more
alternatives are considered for selection.

• Engineering economy utilise a collection of mathematically

techniques which simplify economic comparison.

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 Decision Making and Problem Solving
Simple Problems
• Can be analyzed in one’s head without extensive analysis
Should I use taxi, shuttle or buy a bicycle?
How often should I eat out?
Intermediate Problems (Subject of this course!!!)
• They are sufficiently important to justify serious thought and action
• They can’t be worked in one’s head; must be organized
• The economic aspects are significant component in the analysis
leading to a decision

Complex Problems
• Represent a mixture of economic, political, and humanistic
elements:
Selection of a president of a country.
Building a nuclear power plant or Bui Hydropower Plant
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 Question that can be addressed by this
course include:
• Individuals
• What rate of return did I make on this stock investment?
• Should I pay my student loans with borrowed money
immediately after graduation?
• Should I go for a mortgage for my house or build it
gradually?
• Corporations
• Do we build or lease space for our new branch?

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 Engineering Economic Analysis
Key Questions:
• Which engineering projects are worthwhile?
• Phased construction (500mm diameter pipe for 50 yrs vrs 300mm diameter
now +300mm after 25 yrs)
• Bulk water supply vrs independent system from boreholes

• How to make short and long-term financial decisions?

• Short term: One shift Plus overtime vrs 2 shift
• Long term: Make or buy, build or rent an office

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 Rational Decision Making
1. Recognize the problem

2. Define the goal or objective

3. Assemble relevant data

4. Identify feasible alternatives

5. Select the criterion to determine the best alternative

6. Construct a model

7. Predict each alternative’s outcomes or consequences

8. Choose the best alternative

9. Audit the result

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 Rational Decision Making
1. Recognize the problem
• “I need a place to live this semester.”

2. Define the Goal or Objective

• “I’ll find a nice apartment that is not too expensive.”

3. Assemble Relevant Data

• “I need information on rent, utilities, time to faculty, driving time to shopping, the
neighborhood, other amenities provided (swimming, restaurants , table tennis, etc.).”

4. Identify Feasible Alternatives

• “I’ll use information from friends, apartment or room finding services, information from KNUST,
the local newspaper, and my personal experience, to look for apartments/room.”

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 Rational Decision Making
5. Select Criterion to Determine the Best Alternative
• “Most important is rent plus utilities cost. I’m also very concerned about time to faculty, and the kind
of neighborhood the apartment is in.”

6. Construct the model

• “I’ll make a spreadsheet. The rows will be the apartment choices, the columns the evaluation
criteria. Then I’ll try to fill in the interactions between the apartments and the criteria.”
• This includes determining cash flows for engineering economic analysis!!!

7. Predict Outcomes of Each Alternative

• “I’ll fill in the estimated costs for the spreadsheet and rate the amenities, time to faculty, etc.”

8. Choose the Best Alternative

• “Room/Apartment C looks cheapest, but I don`t like the neighborhood. If I pay 50 Ghana cedis
more per month for Apartment B I get a nicer neighborhood, and a 15-minute travel time to faculty.
Maybe I’ll choose Apartment B.”

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 Rational Decision Making
9. Audit the Results

• “Did I make a good choice?”

• “After living in Apartment B for six months, I am very happy with my choice!”

• But this certainly isn’t the case every time!!

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 Engineering Economic Analysis
Examples of Non-Monetary Factors:

• Meeting customer expectations consistently

• Maximization of employee satisfaction

• Maintaining flexibility to meet changing demand

• Maintenance of a desired public image

• Improvement of safety in operations

• Reduction of pollutants

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 Different types of cost
Fixed Costs: These are constant and unchanging regardless of the level of the
activity over a feasible range of operations for the capacity or capability
available.
Variable costs: They are operating costs that vary in total with the quantity of
output or other measures of activity level. Eg. chemicals for water treatment.
Direct Costs: It is a cost that can be reasonably measured and allocated to a
specific output or work activity.eg. cost for undertaking a project.
Indirect/Overhead Cost: Cost that it is difficult to attribute or allocate to a specific
output or work activity. eg. Support staff, administrators, secretary,
communicator etc.
Sunk Cost: This is money already spent due to a past decision. As engineering
economists we deal with present and future opportunities. Care must be
taken not to be influenced by the past. Sunk costs are usually disregarded in
engineering economic analysis.

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 Different types of cost
Opportunity Cost: An opportunity cost is the benefit that is foregone by engaging
a business resource in a chosen activity instead of engaging that same
resource in the foregone activity
Recurring and Non-recurring costs: Recurring costs are those expenses that are
known, anticipated, and occur at regular intervals. These costs can be
modelled as cash flows whereas Non-recurring costs are one-of-a-kind and
occur at irregular intervals
Incremental costs: Incremental Cost is the additional cost that results from
increasing the output ofa system by one (or more) units. It is also the cost
incurred for selecting one alternative over another
Life-cycle costs: These are the summation of all costs; recurring and nonrecurring,
related to a product, structure, system, or service during its life span. Like
people, products go through a life cycle or stages namely: Assessment &
Justification Phase; Conceptual or Preliminary Design Phase; Detailed Design
Phase; Production or Construction Phase; Operational Use Phase and Decline
and Retirement Phase

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 Interest Calculation
Manifestation of time value of money is called interest.
Interest = total amount now – original principal

Interest = amount owed now – original principal.

When interest is expressed as a percentage of the original

amount per time unit, the result is called an interest rate.

Interest rate = interest accrued per unit time * 100%

original amount

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 Example 1
An employee at Icy cup borrows GHS10,000 on May 1 and must repay
a total of GHS10,700 exactly 1 year later. Determine the interest
amount and the interest rate paid.

Solution
Interest paid= GHS10,700 - GHS10,000 =700

Interest rate paid for 1 year

=(Interest/Amount borrowed)* 100%
=(700/10,000)* 100%
= 7%

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 Example 2
AMG Company plans to borrow GHS 20,000 from a bank for 1 year at
9% interest for new recording equipment. Compute the interest and
the total amount due after 1 year.

Solution
(i) Interest= Principal x Interest Rate
Interest=GHS 20,000(0.09)=GHS1800
(ii) The total amount due is the sum of principal and interest.
Total due =GHS20,000 + 1800 = GHS21,800

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 Example 3
( a) Calculate the amount deposited 1 year ago to have GHS1000 now at
an interest rate of 5% per year.
(b) Calculate the amount of interest earned during this time period.
Solution
( a) The total amount accrued (GHS 1000) is the sum of the original deposit
and the earned interest. If X is the original deposit,
Total accrued = Deposit + Interest
= Deposit + deposit(interest rate)
1000 = X + X(0.05) = X (1 + 0.05) = 1.05 X
Deposit = X = GHS 952.38
(b) To determine the interest earned.
Interest= Total accrued - Deposit
Interest =1000 - 952.38 = 47.62
Interest =GHS47.62
 Using Equivalence
If we have an appropriate discount rate, we can convert
any arbitrary stream of cash flows to various equivalent
(but more easily understood) cash flows:

P = present value
F = future value at time t
A = annuity of A per period for N periods

To make these conversions, we first need to understand

the "time value of money"

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 Time Value of Money
• "$1 today is worth more than $1 dollar next year
• How much more depends upon the opportunities for using or investing
that $1
• If we invest in a government bond earning i%
per year, then our $1 will be worth $(1+i) at the end of one year and
(1+i)^t at the end of t years
• Likewise, earning $ 1 at the end of year is equivalent to $1/(1+i) today.

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 Symbols and their meanings
• P = value or amount of money at time denoted as present; cedis,
dollars
• F = value or amount of money at some future time, called future value
or worth; cedis or ..
• A = series of consecutive, equal, end-of- period amount of money
called equivalent value per period or annual worth; cedis per year,
dollars per month
• n=number of interest periods, years, months, days
• i = interest rate per interest period, percent per year, percent per
month
• t = time stated n periods; years, month, days

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 Equivalence factors

• [F/P,i,n] = future value F after n periods given

present value P and discount rate i
• [P/F,i,n] = present value given future value F, i, & N
• [F/A,i,n] = "uniform series compound amount factor"
• [A/F,i,n] = "sinking fund payment“
• eg Annual savings to have a down payment of a house in N years

• [A/P,i,n] = "capital recovery factor“

• eg What will the mortgage payments be?

• [P/A,i,n] = "uniform series present worth factor"

• My business makes $A/year - should I sell for $X?

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 Example 4
Today, Julie borrowed GHS5000 to purchase furniture for her new house. She
can repay the loan in either of the two ways described below. Determine
the engineering economy symbols and their value for each option.
( a) Five equal annual installments with interest based on 5% per year.
(b) One payment 3 years from now with interest based on 7% per year.

Solution
(a) The repayment schedule requires an equivalent annual amount A ,
which is unknown.
P =GHS 5000 i = 5% per year n = 5 years A = ?
(b) Repayment requires a single future amount F, which is unknown.
P = GHS 5000 i = 7% per year n = 3 years F = ?

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 Example 5
Question 5
Last year Jane’s grandmother offered to put enough money into a savings
account to generate GHS5000 in interest this year to help pay Jane’s expenses at
college. ( a ) Identify the symbols, and ( b ) calculate the amount that had to be
deposited exactly 1 year ago to earn GHS5000 in interest now, if the rate of return is
6% per year.
Solution
( a) Symbols
P (last year is 1) and F (this year) are needed.
P= ? i =6% per year n =1 year
F = P + interest = ? + $5000
( b) Let F = total amount now and P = original amount. We know that F – P =
$5000 is accrued interest. Now we can determine P when F = P + Pi
The GHS 5000 interest can be expressed as
Interest = F – P = ( P + Pi ) – P =Pi= GHS 5000 = P (0.06)
P = 5000/0.06 = GHS 83,333.33
Engineering Costs and Cost
Estimating
Costs:
Fixed and Variable
 Direct and Indirect Estimating Benefits
 Marginal and Average
 Sunk and Opportunity Cash Flow Diagrams
 Recurring and Non-
Recurring
 Incremental
Cash and Book
 Life-Cycle
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 Engineering Costs and Cost Estimating
Fixed Costs:
are constant and unchanging regardless of the level of the activity over a feasible range of
operations for the capacity or capability available.

Variable costs:
operating costs that vary in total with the quantity of output or other measures of activity
level.

Direct Costs:
cost that can be reasonably measured and allocated to a specific output or work activity.

Indirect/Overhead Cost:
cost that it is difficult to attribute or allocate to a specific output or work activity.

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 Engineering Costs and Cost Estimating
Example . Albert’s Charter Bus Venture
CESA secretary, Albert plans to charter a bus to
take people for pleasure tour in Akosombo. His
wealthy uncle will reimburse him for his personal
time, so his time cost can be ignored.
Item Cost Item Cost
Bus Rental $80 Ticket $12.50
Gas Expense $75 Refreshments $7.50
Other Fuel Costs $20
Bus Driver $50

Total Costs $225.00 Total Costs $20.00

• Which of the above are fixed and which are variable costs?
• How do we compute Albert’s total cost if he takes n people to
Akosombo?

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 Albert’s Charter Bus Venture (example)

• Question: How do we compute Albert’s total cost if he

takes n people to Akosombo?
• Answer: Total Cost = $225 + $20 n.
Graph of Total Cost Equation:
Total cost

$250

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 Albert’s Charter Bus Venture (example)
marginal cost (marginal tax)

-The cost to take one more person

average cost
- Average cost: the cost per person
Marginal and Average Costs

$300.00

Avg. Cost = TC/n $250.00

Avg. Cost = ($225+$20n)/n $200.00

Average

Cost
$150.00 Marginal
Trip Ticket

• For n = 30, TC = $885 $100.00

Avg. Cost = $885/30 = $29.50

$50.00

$0.00
1 3 5 7 9 11 13 15 17 19 21 23
Number of People

Total cost cannot be calculated

from an average cost value

For n =35, TC ≠ 35*($29.50) = $ 1,032.50

Suppose Albert’s ticket cost drops to $10 per person if he brings 20 or more people. What is the total cost equation? What is the total cost if number of people exceeds capacity of 1 bus
28 (bus capacity= 40)? What is the marginal cost in this case?
 Albert’s Charter Bus Venture (example)
Question: Do we have enough information yet to decide how much money Albert will make on his venture?
What else must we know?
• Albert needs to know his total revenue
• Albert knows that similar ventures in the past have charged $35 per person, so that is what he decides to charge
• Total Revenue = 35n (for n people)

Total profit =
Total Revenue – Total Cost: Albert's Charter Bus Venture

35n – (225 + 20n) = 15n – 225 $1,000.00

$800.00

Question: $600.00
How many people does

Total Cost
$400.00 Cost
Albert need to break even? Revenue
(not lose money on his venture) $200.00 Profit

$0.00
Solve 15 n – 225 = 0 => n=15 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23
($200.00)
more than 15, he makes money
($400.00)
Number of People
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 Albert’s Charter Bus Venture (example)
Where is the Loss Region?
Where is the Profit Region?
Where is the Breakeven point?
Can you make this chart in Excel? Albert's Charter Bus Venture

$1,000.00

$800.00

$600.00

Total Cost
$400.00 Cost
Revenue
$200.00 Profit

$0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23
($200.00)

($400.00)
Number of People

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 Sunk Costs

A sunk cost is money already spent due to a past decision.

• As engineering economists we deal with present and future opportunities
• We must be careful not to be influenced by the past
• Disregard sunk costs in engineering economic analysis

Example:
Suppose that three years ago your parents bought you a laptop PC for $2000.
• How likely is it that you can sell it today for what it cost?
• Suppose you can sell the laptop today for $400. Does the $2000 purchase cost have
any effect on the selling price today?

The $2000 is a sunk cost. It has no influence on the present opportunity to sell the laptop
for $400. ( stock costs now $20 you bought for $80)

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 Opportunity Cost
• An opportunity cost is the benefit that is foregone by engaging a business
resource in a chosen activity instead of engaging that same resource in
the foregone activity.

• Example: Suppose your wealthy uncle gives you $75,000 when you
graduate from high school. It is enough to put you through college
(5 years at $15,000 per year). It is also enough for you to open a business
making web pages for small companies instead of going to college. You
estimate you would make $20,000 per year with this business.

• If you decide to go to college you give up the opportunity to make $20,000 per year
• Your opportunity cost is $20,000
• Your total cost per year is $35,000

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 Sunk and Opportunity Cost
Example A distributor has a case of electric pumps. The
pumps are unused, but are three years old. They are
becoming obsolete. Some pricing information is available
as follows.

Item Amount Type of Costs

Price for case 3 years ago $7,000 Sunk cost

Storage costs to date $1,000 Sunk cost

List price today for a case of Can be used to help
new and up to date pumps $12,000 determine what the lot is
worth today.
Amount buyer offered for case
2 years ago $5,000 A foregone opportunity

Case can currently be sold for $3,000 Actual market value today

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 Recurring and Non-Recurring Costs

• Recurring costs are those expenses that are known, anticipated, and
occur at regular intervals. These costs can be modeled as cash flows.

• Non-recurring costs are one-of-a-kind and occur at irregular intervals.

They are difficult to plan for or anticipate.

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 Incremental Cost
• Incremental Cost is the additional cost that results from:
• Increasing the output of a system by one (or more) units
• Selecting one alternative over another

Example Philip can choose between model A or model B. The

following information is available.

Cost Items Model A Model B Incremental

Cost of B
Purchase price $10,000 $17,500 $7,500
Installation cost $3,500 $5,000 $1,500
Annual maintenance cost $2,500 $750 $-1,750/yr

Annual utility expense $1,200 $2,000 $800/yr

Disposal cost after useful life $700 $500 $-200

• Can we conclude that model B is more expensive than model A?

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 Cash Costs vs. Book Costs
Cash costs
require the cash transaction of dollars from “one pocket to
another”.

Book costs
are cost effects from past decisions that are recorded in the
books (accounting books) of a firm
• Do not represent cash flows
• Not included in engineering economic analysis
• One exception is for asset depreciation (used for tax
purposes).

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 Life-Cycle Costs
Life-cycle costs are the summation of all costs, both recurring and
nonrecurring, related to a product, structure, system, or service during its
life span

Products go through a life cycle, just like people

• Assessment & Justification Phase
• Conceptual or Preliminary Design Phase
• Detailed Design Phase
• Production or Construction Phase
• Operational Use Phase
• Decline and Retirement Phase

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 Example of service life cycle unit cost of small towns water service
delivery in Ghana
9
Annual Cost per capita in Ghc Rehabilitated Water Systems
8
Support
7
CapManEx
6
5 OpEx

4 CapEx

3
2
1
0

Water Systems
 Cash Flows: Estimation and Diagramming
Cash flows are the amounts of money estimated for future projects or
observed for project events that have taken place

Engineering economy bases its computations on the timing, size, and

direction of cash flows

Cash inflows are the receipts, revenues, incomes, and savings

generated by project and business activity. A plus (+) sign indicates a
cash inflow.

Cash outflows are costs, disbursements, expenses, and taxes caused

by projects and business activity. A negative or minus (-) sign indicates
a cash outflow. When a project involves only costs, the minus sign may
be omitted for some techniques, such as benefit/cost analysis.
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 Example
Cash Inflow Estimates
• Income: +GHS150,000 per year from sales of solar-powered watches
• Savings: +GHS24,500 tax savings from capital loss on equipment salvage
• Receipt: +GHS750,000 received on large business loan plus accrued interest
• Savings: +GHS150,000 per year saved by installing more efficient air conditioning
• Revenue: +GHS50,000 to +GHS75,000 per month in sales for extended battery life
iPhones
Cash Outflow Estimates
• Operating costs: -GHS230,000 per year annual operating costs for software services
• First cost: -GHS800,000 next year to purchase replacement earthmoving equipment
• Expense: -GHS20,000 per year for loan interest payment to bank
• Initial cost: -GHS1 to -GHS1.2 million in capital expenditures for a water recycling unit
Net cash flow (NCF) = cash inflows (R) - cash outflows (D)
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 Cashflow R

0 1 2 3 4 n

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 Cash Flow Diagrams Example:
• Cash flow diagrams (CFD) Time Period Size of Cash Flow
summarize the costs and benefits
of projects 0 (today) Receive $100 (positive CF)
1 Pay $100 (negative CF)
• A CFD illustrates the size, sign, 2 Positive CF of $100
3 Negative CF of $150
and timing of individual cash flows 4 Negative CF of $150
5 Positive CF of $50
• Periods may be months, quarters,
years, etc.
Tomorrow
COMMENTS:
• The end of one period is the 100 100
beginning of the next one
50
• Arrows point up for revenues or
benefits, down for costs
• One person’s payment (cash 0 1 2 3 4 5
outflow w. neg. sign) is another
person’s receipt (cash inflow w.
pos. sign)
100
It is essential to use only one Today
perspective in any CFD 150 150
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 Thank You

For any concerns, please contact

[email protected]
[email protected]
0322 191132
Jan 2021