Introduction to engineering economics

What is Engineering?
Engineering is the application of science and math to solve problems. While scientists and
inventors come up with innovations, it is engineers who apply these discoveries to the real world.

What is Economics?
Economics is a social science that focuses on the production, distribution, and
consumption of goods and services, and analyzes the choices that individuals, businesses,
governments, and nations make to allocate resources.

• 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 be demonstrate a positive balance of long-term benefits over long-
term costs.
What is engineering economics?
• Fundamentally, engineering economics involves formulating,
estimating, and evaluating the economic outcomes when
alternatives to accomplish a defined purpose are available.
KEY TAKEAWAYS
• Economics is the study of how people allocate scarce resources for production,
distribution, and consumption, both individually and collectively.
• The two branches of economics are microeconomics and macroeconomics.
• Economics focuses on efficiency in production and exchange.
• Gross Domestic Product (GDP) and the Consumer Price Index (CPI) are widely used
economic indicators.
PRINCIPLES OF ENGINEERING ECONOMY
The development, study and application of any discipline must begin
with a basic foundation. Engineering economy involves set of
principles. In engineering economic analysis, experience has shown
that most errors can be traced to some violation or lack of adherence
to the basic principles
PRINCIPLES OF ENGINEERING ECONOMY
PRINCIPLE 1 - DEVELOP THE ALTERNATIVES:
The choice (decision) is among alternatives. The alternatives need to be identified.
A decision involves making a choice among alternatives. Developing and defining
alternatives depends upon engineer’s creativity and innovation.
• Carefully define the problem
• The alternatives need to be identified and then defined for subsequent analysis
• A decision involves making a choice among two or more alternatives
• Developing and Defining the alternatives for detailed evaluation is important
because of the resulting impact on the quality of decision
• Engineers and managers should place a high priority on this responsibility
• Creativity and innovation are essential to the process
PRINCIPLES OF ENGINEERING ECONOMY
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PRINCIPLES OF ENGINEERING ECONOMY
PRINCIPLE 2 - FOUCUS ON THE DIFFERENCE:
Only the differences in expected future outcomes among the alternatives are
relevant to their comparison and should be considered in the decision. If all
prospective outcomes of the feasible alternatives were exactly the same, obviously,
only the differences in the future outcomes of the alternatives are important.
Outcomes that are common to all alternatives can be disregarded in the
comparison and decision. For example, if two apartments were with same purchase
price or rental price, decision on selection of alternatives would depend on other
factors such as location and annual operating and maintenance expenses.
• Only the differences in the future outcomes of the alternatives are important
• Outcomes that are common to all alternatives can be disregarded in the
comparison and decision
PRINCIPLES OF ENGINEERING ECONOMY
EXAMPLE:

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PRINCIPLES OF ENGINEERING ECONOMY
PRINCIPLE 3 - USE A CONSISTENT VIEWPOINT:
The prospective outcomes of the alternatives, economic and other, should
be consistently developed from a defined viewpoint (perspective). Often
perspective of decision maker is owner’s point of view. For the success of the
engineering projects viewpoint may be looked upon from the various
perspective e.g. donor, financer, beneficiary group & stakeholders. However,
viewpoint must be consistent throughout the analysis.
• The prospective outcomes of the alternatives should be consistently
developed from a defined viewpoint
• The perspective of decision maker (which is often that of owner) would
normally be used
• The viewpoint for the particular decision be first defined and then used
consistently in the description, analysis and comparison of alternatives
PRINCIPLES OF ENGINEERING ECONOMY
PRINCIPLE 4 - 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 the alternatives. For economic consequences, a
monetary units such as dollars or rupees is the common measure.
• Using a common unit of measurement to analyze as many of the
prospective outcomes as possible will make easier the analysis and
comparison of alternatives
• Using more than one monetary units for economic analysis will
complicate the project
 PRINCIPLES OF ENGINEERING ECONOMY

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PRINCIPLES OF ENGINEERING ECONOMY
PRINCIPLE 5 - CONSIDER ALL RELEVANT CRITERIA:
Selection of preferred alternative (decision making) requires the use of a criterion (or
several criteria). The decision process should consider both the outcomes enumerated in
the monetary unit and those expressed in some other unit of measurement or made
explicit in a descriptive manner. Apart from the long term financial interest of owner, needs
of stakeholders should be considered.
• The decision maker will normally select the alternative that will best serve the long term
interests of the owner
• In Engineering economic analysis, the primary criterion relates to long term financial
interests of the owner
• Assumption is that available capital will be allocated to provide maximum monetary
return to the owners
• There are other non financial criteria in an organizational objectives you would like to
achieve with your decision, and these should be considered and given weight in the
selection of an alternative
 PRINCIPLES OF ENGINEERING ECONOMY

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PRINCIPLES OF ENGINEERING ECONOMY
PRINCIPLE 6 - MAKE UNCERTAINTY EXPLICIT:
Uncertainty is inherent in projecting (or estimating) the future outcomes of the
alternatives ad should be recognized in their analysis and comparison. The
magnitude & impact of future impact of any course of action are uncertain or
probability of occurrence changes from the planned one. Thus dealing with
uncertainty is important aspect of engineering economic analysis.
• Risk and uncertainty are inherent in estimating the future outcomes of the
alternatives and should be recognized
• The analysis of the alternatives involves projecting of estimating the future
consequences associated with each of them
• The magnitude and the impact of future outcomes of any course of action are
uncertain
• Dealing with uncertainty is an important aspect of engineering economy analysis
PRINCIPLES OF ENGINEERING ECONOMY
PRINCIPLE 7 - 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. If results
significantly different from the initial estimates, appropriate feedback to the
decision making process should occur.
• A good decision making process can result in a decision that has an
undesirable outcome
• Other decision, even though relatively successful, will have results
significantly different from the initial estimates of the consequences
• Learning from and adapting based on experience are essential and are
indicators of good organization
Engineering Economics and the design
process
• A sound engineering economic analysis procedure incorporates the
basic principles discussed in the previous lectures and involves several
steps
• The seven-step procedure is also used to assist decision making
within the engineering design process
• The general relationship between the activities in the design process
and the steps of the economic analysis procedure is indicated in the
table
 Engineering Economics and the design
process
Engineering Economic Analysis Procedure Engineering Design Process

1. Problem recognition , definition and evaluation 1. Problem / need definition

2. Development of feasible alternatives 2. Problem / need formulation and evaluation

3. Development of the outcomes and cash flows for each alternative 3. Synthesis of possible solutions (alternatives)

4. Selection of a criterion/criteria 4. Analysis optimization and evaluation

5. Analysis and comparison of the alternatives 5. Specification of preferred alternative

6. Selection of the preferred alternatives 6. Communication

7. Performance monitoring and post evaluation of results

Engineering Economics and the design
process
Problem Definition:
• The first step of the engineering economic analysis procedure (problem
definition) is particularly important, since it provides the basis for the rest
of the analysis
• A problem must be well understood and stated in an explicit from 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
• An operating problem within a company (internal need) or a customer
expectation about a product or service (external requirement) are
examples
Engineering Economics and the design
process
Development of Alternatives:
• The two primary actions is Step 2 of the procedure are:
(1) searching for potential alternatives
(2) screening them to select a smaller group of feasible
alternatives for detailed analysis
Engineering Economics and the design
process
Searching for Superior Alternatives:
• Creativity and resourcefulness were emphasized as being absolutely
essential to development of potential alternatives
• The difference between good alternatives and great alternatives
depends largely on an individual’s or group’s problem –solving
efficiency
Engineering Economics and the design
process
Developing Investment Alternatives:
• “It takes money to make money,” as the old saying goes
• To make money, each firm must invest capital to support its important
human resources
• There are usually hundreds of opportunities for a company to make money
• Engineers are at the very heart of creating value for a firm by turning
innovative and creative ideas into new or re-engineered commercial
products and services
• Most of these ideas require investments of money, and only few of all
feasible ideas can be developed, due to lack of time, knowledge and
resources
Cost concepts for decision making
What is cost concepts for decision making?
• It is based on the distinction between fixed and variable costs. Fixed
costs are ignored and only variable costs are taken into consideration
for determining the cost of products and value of work-in-progress
and finished goods.
Cost concepts for decision making
In order to understand the general concept of costs, it is important to
know the following types of costs:
• Accounting costs and Economic costs
• Outlay costs and Opportunity costs
• Direct/Traceable costs and Indirect/Untraceable costs
• Incremental costs and Sunk costs
• Private costs and Social costs
• Fixed costs and Variable costs
Cost concepts for decision making
Concept of Costs in terms of Treatment
1. Accounting costs
• Accounting costs are those for which the entrepreneur pays direct cash for procuring resources for
production. These include costs of the price paid for raw materials and machines, wages paid to workers,
electricity charges, the cost incurred in hiring or purchasing a building or plot, etc. Accounting costs are
treated as expenses. Chartered accountants record them in financial statements.
2. Economic costs
• There are certain costs that accounting costs disregard. These include money which the entrepreneur
forgoes but would have earned had he invested his time, efforts and investments in other ventures. For
example, the entrepreneur would have earned an income had he sold his services to others instead of
working on his own business
• Similarly, potential returns on the capital he employed in his business instead of giving it to others, the
output generated by his resources which he could have used for others’ benefits, etc. are other examples
of economic costs.
• Economic costs help the entrepreneur calculate supernormal profits, i.e. profits he would earn above the
normal profits by investing in ventures other than his.
Cost concepts for decision making
Concept of Costs in terms of the Nature of Expenses
1. Outlay costs
• The actual expenses incurred by the entrepreneur in employing inputs are
called outlay costs. These include costs on payment of wages, rent,
electricity or fuel charges, raw materials, etc. We have to treat them are
general expenses for the business.
2. Opportunity costs
• Opportunity costs are incomes from the next best alternative that is
foregone when the entrepreneur makes certain choices.
• For example, the entrepreneur could have earned a salary had he worked
for others instead of spending time on his own business. These costs
calculate the missed opportunity and calculate income that we can earn by
following some other policy.
Cost concepts for decision making
Concept of Costs in terms of Traceability
1. Direct costs
• Direct costs are related to a specific process or product. They are also called
traceable costs as we can directly trace them to a particular activity, product or
process.
• They can vary with changes in the activity or product. Examples of direct costs
include manufacturing costs relating to production, customer acquisition costs
pertaining to sales, etc.
2. Indirect costs
• Indirect costs, or untraceable costs, are those which do not directly relate to a
specific activity or component of the business. For example, an increase in
charges of electricity or taxes payable on income. Although we cannot trace
indirect costs, they are important because they affect overall profitability.
Cost concepts for decision making
Concept of Costs in terms of the Purpose
1. Incremental costs
• These costs are incurred when the business makes a policy decision.
For example, change of product line, acquisition of new customers,
upgrade of machinery to increase output are incremental costs.
2. Sunk costs
• Suck costs are costs which the entrepreneur has already incurred and
he cannot recover them again now. These include money spent on
advertising, conducting research, and acquiring machinery.
Cost concepts for decision making
Concept of Costs in terms of Payers
1. Private costs
• These costs are incurred by the business in furtherance of its own
objectives. Entrepreneurs spend them for their own private and business
interests. For example, costs of manufacturing, production, sale,
advertising, etc.
2. Social costs
• As the name suggests, it is the society that bears social costs for private
interests and expenses of the business. These include social resources for
which the firm does not incur expenses, like atmosphere, water resources
and environmental pollution.
Cost concepts for decision making
Concept of Costs in terms of Variability
1. Fixed costs
• Fixed costs are those which do not change with the volume of output. The
business incurs them regardless of their level of production. Examples of
these include payment of rent, taxes, interest on a loan, etc.
2. Variable costs
• These costs will vary depending upon the output that the business
generates. Less production will cost fewer expenses, and vice versa, the
business will pay more when its production is greater. Expenses on the
purchase of raw material and payment of wages are examples of variable
costs.
Present Economic Studies
Selection in Present Economy
• Studies that do not require considerations of time-money
relationships are sometimes called Present-Economy Studies and
generally involve selection between alternative design, materials, or
methods
• Interest is not a factor
Present Economic Studies
The effect of interest do not apply because of the following conditions:
• There is no investment in capital; only out-of-pocket costs are involve
• After any first cost is paid, the long-term costs will be the same for all
alternatives, or will be proportional to the first cost
• The alternatives will have essentially identical results regardless of the
capital investment involved
Present Economic Studies
Two rules shall be followed in conducting present economy studies. These rules, or
criteria, will be used to select the preferred alternative when defect-free output
(yield) is variable or constant among the alternatives being considered

Rule 1:
When revenues and other economic benefits are present and vary among
alternatives, choose the alternative that maximizes overall profitability based on
the number of defect-free units of a product or service produced

Rule 2:
When revenues and other economic benefits are NOT present or are constant
among all alternatives, consider only the costs and select the alternative that
minimizes total cost per defect-free unit of product or service output
Present Economic Studies
Situation where Present Economy Studies are involved:
Material Selection - Involves selection among materials available that will
result in the most economical
product and give the best results.
Selection of Method - Two or more different methods may give the same
satisfactory results.
- Involves selection on the most
economical way to accomplish operations.
Selection of Design - The design to be selected must be best suited for the
work to be done with particular
care being given to the one which will do the work with the utmost economy.
Site Selection - Costs relevant to selecting sites must be carefully
considered (land cost, construction
cost, cost of available labor, cost of transporting equipment and materials).
Proficiency of Workers - Keep in mind that workers have varying efficiency and
proficiency. Worker proficiency can
be translated into monetary values.
Economy of Tools and Equipment Maintenance - Consider the costs of acquiring tools and equipment and the costs of maintaining
them
Economy in the Utilization of Personnel - Only a certain number of personnel will lead to the highest productivity; increasing
this number will not cause a
proportional increase in productivity.
Present Economic Studies
SAMPLE PROBLEM:
A contractor has a job which should be completed in 100 days. At present, he
has 80 men on the job and it estimated that they will finish the work in 130
days. If of the 80 men, 50 are paid Php 190 a day, 25 at Php 220 a day, and 5
at Php 300 a day and if for each day beyond the original 100 days, the
contractor has to pay Php 2,000 liquidated damages.
a. How many more men should the contractor add so he can complete the
work on time?
b. If the additional men of 5 are paid Php 220 a day and the rest at Php 190 a
day, would the contractor save money by employing more men and not
paying the fee?
 Present Economic Studies

Answer @ 80 men + 24 men = 104 men

Given:
(50 men + 19 men) * Php190/day * 100 days = Php 1,311,000
Contract Duration – 100 days
(25 men + 5 men) * Php 220/day * 100 days = Php 660,000
a. (80 men)(130days) = (80 men + x) (100 days) 5 men * Php 300/day * 100 days = Php 150,000
x = 24 men Penalty : none
b. @ 80 men
TOTAL = PHP 2,121,000
50 men * Php190/day * 130 days = Php 1,235,000
25 men * Php 220/day * 130 days = Php 715,000
5 men * Php 300/day * 130 days = Php 195,000 2,205,000 – 2,121,000 = Php 84,000
Penalty : (130 – 100) * 2000 = Php 60,000
TOTAL = PHP 2,205,000
Conclusion: Yes, the contractor can save cost if they will add labor to finish
the contract instead of pay the penalty.