EDO STATE UNIVERSITY UZAIRUE

Department of Chemical Engineering

GEE 323 Engineering Economics (3 Units)

Instructor: Engr. Prosper M.O. Ikhazuangbe

Email: [email protected]
Lectures: Mondays, 1pm – 3pm & Thursday 11 – 12noon @ 300L Classroom
Phone: +2348051783465
Office hours: Monday, 8am – 4pm; Office: Engineering block, Chemical Engineering wing
General overview of lecture: This course is intended to give the students a thorough knowledge
of economics principles in engineering

Learning outcomes: At the completion of this course, students are expected to:
i. To demonstrate knowledge of nature and scope of economics, Basic concepts of
engineering economy
ii. To understand Interest formulae, discounted cash flow, present worth, equivalent annual
growth and rate of return comparisons
iii. To have in-depth knowledge of replacement analysis, break down analysis.
iv. Understand benefit-cost analysis, minimum acceptable rate of union, judging
attractiveness of proposed investment.

Continuous Assessment: We expect to have 2 assignments including quiz throughout the course
in addition to a Mid-Term Test, attendance and a Final Exam. Students are expected to attend
70% of the class lectures as a requirement to write the final examination.

Grading: The grading will be assigned as follows: 5% for attendance, 10% for assignments,
15% for the mid-term test and 70% for the final examination.

Textbook: The recommended textbook for this class are as stated:

1. J.J. Biebuma & E.K. Okedu (2007). Principles of Engineering Economics

2. S.M. Chaplain Tyler (1948). Chemical Engineering Economics. 3rd edition

3. Tung AU. & Thomas P. AU. (1992). Engineering economics for capital investment

analysis. 2nd edition

 COURSE OUTLINE

1. The nature and scope of economics. Basic concepts of engineering economy.

2. Interest formulae, discounted cash flow, present worth, equivalent annual growth and rate
of return comparisons.
3. Replacement analysis. Break even analysis.
4. Benefit-cost analysis. Minimum acceptable rate of return. Judging attractiveness of
proposed investment.
Engineering economics

Engineering economics deals with the concepts and techniques of analysis useful in evaluating
the works of systems, products and services in relation to their cost. It is that sub-branch of
economic theory which deals with the methods enabling one to take economic decisions, towards
minimizing costs or maximizing benefits to business organizations. It involves the systemic
evaluation of the cost and benefits of the proposed technical projects. Engineering economics
employs economic theory, mathematical programming and statistical analysis to formulate and
solve problems concerning the evaluation and selection of capital project.

Engineering activities of analysis and design are not an end in themselves but are a means for
satisfying human wants. Thus, engineering has two aspects: one concerns itself with the
materials and forces of nature; the other is concerned with the needs of people. Because we live
in a resource-constrained world, engineering must be closely associated with economics. It is
essential that engineering proposals be evaluated in terms of worth and cost before they are
undertaken.

Engineers can readily extend their inherent ability to analyze to become proficient in the analysis
of the economic aspects of engineering application. Furthermore, the engineer who aspires to a
creative position in engineering will find proficiency in economic analysis helpful. The large
percentage of engineers who will eventually be engaged in managerial activities will find such
proficiency a necessity. Initiative for the use of engineering tests, for the most part, upon those
who will concern themselves with social and economic consequences. To maintain the initiative,
engineers must operate successfully in both the physical and economic sectors of the total
environment. It is the objective of engineering economy to prepare engineers to cope effectively
with the bi-environmental nature of engineering application.

In a chemical business or plant operations, the ultimate focus is to make profit after producing
the desired product. Consequently, the engineer is often confronted with the problem of
estimating profitability and a relative concept of operation design in one form or the other.

As the plant or process passes through various stages of research, we develop, design and
estimate profitability. If it turns out at a stage that the product will not be profitable, we abandon
it and term it “INFEASIBLE”. On the other hand, if the project is feasible but there is poor
equipment, it is discarded due to “technological obsolesce” i.e. decline in value of equipment.

Role of economics in engineering

Engineering economics is concerned with problems encountered in making economic decision

for business firms. The increase in complexity of private and public enterprises in recent years
requires a systematic evaluation of investment alternatives before a decision is made regarding
such problems as the introduction of a new product, the expansion of productive facilities,
charges in the product mix, or the adoption of new technology. Engineering economics seeks to
provide the analytical framework for decision making from an economic viewpoint and to
advance the engineer’s role in the decision making process. The role of economics in
engineering may be summarized as follows:

1. The investment decision. In the long run, growth and profitability of the firm depends on
its ability to increase its productive efficiency and expand its capacity and product lines.
The evaluation and selection of the best investment alternatives. The process involves the
determination of the firm’s cost of capital and the use of certain criteria of profitability.
2. Provision of basic tools. The objective of every rational engineer is to maximize the
profits. In order to achieve this objective, economics equips engineer with the basic tools
of profit maximizing. In fact, profit maximizing is the surplus of revenue over costs.
Economics plays an important role in engineering by providing its basic tools like
demand, costs revenue, firm, industry, market, forecasting, pricing and others.
3. Decision making. The study of economics provides to engineers the techniques for
profitable decision making. A decision situation involves making a choice among two or
more alternatives. An engineering economic analysis recommends a future course of
action based on the difference among feasible alternatives.
4. Common unit of measure. Economics use monetary unit such as dollar, rupee as a
common unit of measurement. Using a common unit of measurement and enumeration of
as many of the prospective outcomes as possible will make easier the analysis and
comparison of the alternatives of an engineering decision. The monetary unit will make
prospective outcome difference comparable. It will enable an engineer to compare
directly the outcome of different alternative projects.
5. Long term interest. A study of economics will enable the decision maker (engineer) to
select the alternatives that will best serve the long term interest of the owners of the
organization. In engineering economic analysis, the primary criterion relates to the long
term financial interests of the firm. This is based on the assumption that available capital
will be allocated to provide maximum monetary return to the firms.
6. Recognition of uncertainty. An important aspect of engineering economic analysis is to
deal with uncertainty. The analysis of the alternatives involves estimating their future
consequences. The impact of the future outcome of any engineering decision is uncertain.
Even if the alternatives involve no change from current operations, the probability is high
that today’s estimate, for example future cash receipts and expenses will not be what
eventually occur. Thus, economics make it clear that uncertainty is inherent in decision
making.
7. Relationship between economic analysis and engineering design process. There are some
aspects of engineering activity that call directly for economic and financial analysis. This
may have to do with the evaluation of development projects. They may be concerned
with the selection of alternative technically feasible means of providing some production
service.
Elements of Costs

Cost can be broadly classified into variable cost and overhead cost. Variable cost varies with the
volume of production while overhead cost is fixed, irrespective of the production volume.

Variable cost can be further classified into direct material cost, direct labour cost, and direct
expenses. The overhead cost can be classified into factory overhead, administration overhead,
selling overhead, and distribution overhead.

Direct material costs are those costs of materials that are used to produce the product. Direct
labour cost is the amount of wages paid to the direct labour involved in the production activities.
Direct expenses are those expenses incurred in relation to the production volume, other than the
direct material costs and direct labour costs.

Overhead cost is the aggregate of indirect material costs, indirect labour costs and indirect
expenses. Administration overhead includes all the costs that are incurred in administering the
business. Selling overhead is the total expense that is incurred in the promotional activities and
the expenses relating to sales force. Distribution overhead is the total cost of shipping the items
from the factory site to the customer sites.

The selling price of a product is derived as shown below:

a. Direct material costs + Direct labour costs + Direct expenses = Prime cost

b. Prime cost + Factory overhead = Factory cost

c. Factory cost + Office and administrative overhead = Costs of production

d. Cost of production + Opening finished stock – Closing finished stock = Cost of goods sold

e. Cost of goods sold + Selling and distribution overhead = Cost of sales

f. Cost of sales + Profit = Sales

g. Sales/Quantity sold = Selling price per unit

In the above calculations, if the opening finished stock is equal to the closing finished stock, then
the cost of production is equal to the cost of goods sold.

IMPORTANT TERMS ASSOCIATED WITH ENGINEERING ECONOMICS

The following are some costs/revenues terms presented below:

• Marginal cost

• Marginal revenue

• Sunk cost
• Opportunity cost

Marginal Cost

Marginal cost of a product is the cost of producing an additional unit of that product. Let the cost
of producing 20 units of a product be ₦10,000, and the cost of producing 21 units of the same
product be ₦10,045. Then the marginal cost of producing the 21st unit is ₦45.

Marginal Revenue

Marginal revenue of a product is the incremental revenue of selling an additional unit of that
product. Let, the revenue of selling 20 units of a product be ₦15,000 and the revenue of selling
21 units of the same product be ₦15,085. Then, the marginal revenue of selling the 21st unit is
₦85.

Sunk Cost

This is known as the past cost of an equipment/asset. Let us assume that equipment has been
purchased for ₦1,000,000 about three years back. If it is considered for replacement, then its
present value is not ₦1,000,000. Instead, its present market value should be taken as the present
value of the equipment for further analysis. So, the purchase value of the equipment in the past is
known as its sunk cost. The sunk cost should not be considered for any analysis done from now
onwards.

Opportunity Cost

In practice, if an alternative (X) is selected from a set of competing alternatives (X, Y), then the
corresponding investment in the selected alternative is not available for any other purpose. If the
same money is invested in some other alternative (Y), it may fetch some return. Since the money
is invested in the selected alternative (X), one has to forego the return from the other alternative
(Y). The amount that is foregone by not investing in the other alternative (Y) is known as the
opportunity cost of the selected alternative (X). So the opportunity cost of an alternative is the
return that will be foregone by not investing the same money in another alternative. Consider that
a person has invested a sum of ₦50,000 in shares. Let the expected annual return by this
alternative be ₦7,500. If the same amount is invested in a fixed deposit, a bank will pay a return
of 18%. Then, the corresponding total return per year for the investment in the bank is ₦9,000.
This return is greater than the return from shares. The foregone excess return of ₦1,500 by way
of not investing in the bank is the opportunity cost of investing in shares.
Cash Flow Approach
Engineering economics uses cash flow approach to find out possible outcomes of a particular
engineering activity. A cash flow occurs when money is transferred from one firm to another.
Thus, a cash flow represents the economic effects of an alternative in terms of money spent
and received. The cash flow for an alternative engineering activity is the difference between
each cash inflows (receipts or saving) or each outflow (cash or expenses) during each time
period.
Sinking Fund
A fund accumulated by periodic deposits and reserved exclusively for a specific purpose,
such as retirement of a debt or replacement of a property. A fund created by making periodic
deposits (usually equal) at compound interest in order to accumulate a given sum at a given
future time for some specific purpose.
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