PE-6411 Advanced Engineering

Economy & Costing

Prakash Duraisamy
Adminstrative block; Room no: 28
[email protected]
0936036318
Aim
To develop economic and cost analysis models for decisions
making.
Course Description

Formulation of economic problems models. Analysis of
capital Investments, Decision analysis methods: decision tree
analysis, multi-attribute decisions, probabilistic analysis and
sensitivity/risk analysis.
Stochastic techniques and risk to evaluate design
alternatives, Capital budgeting models: multi-criteria optimization,
certainty equivalence. Replacement analysis.
Costing techniques applicable in manufacturing: activity
based costing, life cycle costing, theory of constraints, cost of
quality.
3
ENGINEERING ECONOMICS INVOLVES:
FORMULATING, ESTIMATING, AND
EVALUATING ECONOMIC OUTCOMES
WHEN CHOICES OR ALTERNATIVES ARE
AVAILABLE
What Kinds of Questions Can
Engineering Economics Answer?
4
How Does It Do This?
BY USING SPECIFIC
MATHEMATICAL RELATIONSHIPS
TO COMPARE THE CASH FLOWS OF THE
DIFFERENT ALTERNATIVES
(typically using spreadsheets)
5
Where Does Engineering
Economics Fit?
1. Understand the Problem
2. Collect all relevant data/information (difficult!)
3. Define the feasible alternatives
4. Evaluate each alternative
5. Select the best alternative
6. Implement and monitor
This is the major role of
engineering economics
Contemporary Engineering Economics, 4th
edition, 2007
6
What Makes the Engineering Economic
Decision Difficult? - Predicting the Future
Estimating a Required
investment
Forecasting a product
demand
Estimating a selling price
Estimating a
manufacturing cost
Estimating a product life
Contemporary Engineering Economics, 4th
edition, 2007
7
Create & Design

Engineering Projects
Evaluate

Expected
Profitability
Timing of
Cash Flows
Degree of
Financial Risk
Analyze

Production Methods
Engineering Safety
Environmental Impacts
Market Assessment

Evaluate

Impact on
Financial Statements
Firms Market Value
Stock Price
Role of Engineers in Business
The five main types of engineering economic decisions are
(1) service improvement,
(2) equipment and process selection,
(3) equipment replacement,
(4) new product and product expansion, and
(5) cost reduction.
Contemporary Engineering Economics, 4th
edition, 2007
9
Present
Future Past
Engineering Economy
Accounting
Evaluating past performance Evaluating and predicting future events
Accounting Vs. Engineering Economics
Contemporary Engineering Economics, 4th
edition, 2007
10
Fundamental Principles of Engineering
Economics
Principle 1: A nearby dollar is worth more
than a distant dollar
Principle 2: All it counts is the differences
among alternatives
Principle 3: Marginal revenue must exceed
marginal cost
Principle 4: Additional risk is not taken
without the expected additional return
Contemporary Engineering Economics, 4th
edition, 2007
11
Principle 1: A nearby dollar is worth more
than a distant dollar

Today 6-month later
Contemporary Engineering Economics, 4th
edition, 2007
12
Principle 2: All it counts is the differences
among alternatives
Option
Monthly
Fuel
Cost
Monthly
Maintena
nce
Cash
outlay at
signing
Monthly
payment
Salvage
Value at
end of
year 3
Buy $960 $550 $6,500 $350 $9,000
Lease $960 $550 $2,400 $550 0
Irrelevant items in decision making
Contemporary Engineering Economics, 4th
edition, 2007
13
Principle 3: Marginal revenue must exceed
marginal cost
Manufacturing cost
Sales revenue
Marginal
revenue
Marginal
cost
1 unit
1 unit
Contemporary Engineering Economics, 4th
edition, 2007
14
Principle 4: Additional risk is not taken
without the expected additional return
Investment Class Potential
Risk
Expected
Return
Savings account
(cash)
Low/None 1.5%
Bond (debt) Moderate 4.8%
Stock (equity) High 11.5%
Simple Methods
Simple Payback Period (SPP)- The time
required for savings to offset first costs.
Simple Return on Investment (ROI)- The
simple percent return the project pays over its
life.
These methods are simple because they do
not consider the time value of money.
Simple methods are OK for investments that
are very good and pay off over short time
periods.
16
Time Value of Money
Money has value
Money can be leased or rented
The payment is called interest
If you put $100 in a bank at 9% interest for one time period
you will receive back your original $100 plus $9
Original amount to be returned = $100
Interest to be returned = $100 x .09 = $9
17
Compound Interest
Interest that is computed on the original
unpaid debt and the unpaid interest
Compound interest is most commonly used
in practice
Total interest earned = I
n
= P (1+i)
n
- P
Where,
P present sum of money
i interest rate
n number of periods (years)
I
2
= $100 x (1+.09)
2
- $100 = $18.81
Present and Future Value
Present Value is the value now of an amount
of money F received n years in the future.
Future Value is value n years in the future of
an amount of money P received now.
If we can earn interest rate i on investments,
the relationship between P and F is:
F = P(1 + i)
n
or P = F/(1 + i)
n

ECONOMIC MODELS
Economic modeling is at the heart of economic theory.
Modeling provides a logical,abstract template to help
organize the analyst's thoughts.
The model helps the economist logically isolate and
sort out complicated chains of cause and effect and
influence between the numerous interacting elements
in an economy.
Through the use of a model, the economist can
experiment, at least logically, producing different
scenarios, attempting to evaluate the effect of
alternative policy options, or weighing the logical
integrity of arguments presented in prose.
Types of Models
visual models,
Mathematical models,
Empirical models,
Simulation models.
1. Visual Models - Visual models are simply pictures of an
abstract economy; graphs with lines and curves that tell an economic story
2. Mathematical Models
The most formal and abstract of the economic models are the purely
mathematical models. These are systems of simultaneous equations with an
equal or greater number of economic variables.
3.Empirical Models
Empirical models are mathematical models
designed to be used with data. The
fundamental
model is mathematical, exactly as described
above. With an empirical model, however,
data is gathered for the variables, and using
accepted statistical techniques, the data are
used to
provide estimates of the model's values.
"What will happen to investment if income
rises one percent?" The purely mathematical
model might only allow the analyst to say,
"Logically, it should rise.
The user of the empirical model, on the other
hand, using actual historical data for
investment, income, and the other variables in
the model, might be able to say,
"By my best estimate, investment should rise by
about two percent."
4.Simulation Models
Simulation models, which must be used with computers,
embody the very best features of mathematical models
without requiring that the user be proficient in mathematics.
The models are fundamentally mathematical (the equations
of the model are programmed in a programming language like
Pascal or C++) but the mathematical complexity is transparent
to the user.
The simulation model usually starts with initial or "default"
values assigned by the program or the user, then certain
variables are changed or initialized, then a computer
simulation is done.
The simulation, of course, is a solution of the model's
equations. The user can usually alter a whole range of
variables at will.
The computerized simulation model can show
the interaction of numerous variables all at
once, including hidden feedback and
secondary effects that are not so apparent in
purely mathematical or visual models.

Macroeconomic simulation model called
HMCMacroSim
Static and Dynamic Models
Most of the models used in economics are
comparative statics models. Some of the more
sophisticated models in macroeconomics and
business cycle analysis are dynamic models.
The initial equilibrium (point 'a') identifies the price and
level of output that would obtain, given assumptions about
supply and demand and the level of inflationary
expectations.
Then the model is shocked by introducing a higher level of
expectations, demonstrating a new equilibrium at point 'b'.
Obviously this movement in equilibria and the shift in the
model's solution happened over time, but neither the
visual model nor its mathematical counterpart can
demonstrate what happened in the interim. The model
shows only the starting point and the ending point.
The comparative statics approach is roughly analogous to
using snapshots from a camera to record developments
during a dynamic event. With each snapshot a static but
informative picture is presented.
Dynamic Model
Why Comparative Statics Models are
Usually Used?
The answer is simple - comparative statics models
are much easier to solve.
Any student of calculus knows the difficulty of
solving systems of difference or (especially)
differential equations.
The latter, as soon as they achieve any complexity,
are sometimes impossible to solve.
Therefore dynamic models must be kept extremely
simple and are therefore so elementary that more
is lost than gained.
Simple dynamic models, nonetheless, often provide
valuable insights into the complex interactions between
variables over time.
They can capture remarkably subtle feedback effects that
are easily missed by static models.
It should be noted that dynamic models are much easier to
simulate on computers than they are to solve outright.
The user can experiment with an endless variety of values
and assumptions to see whether results obtained are
realistic or insightful. Since computers are now powerful
and cheaper, the importance of dynamic simulation models
should gradually grow in importance.
Expectations-Enhanced Models
Economic models often incorporate economic
expectations, such as inflationary expectations. Such
models are called expectations-enhanced models.
Generally, expectations-enhanced models include one
or more variables based upon economic expectations
about future values.
For example, if consumers, for whatever reason,
expect the inflation rate to be much higher next year
than this year, they are said to have formed
inflationary expectations.
There are many types of expectations found in
economics.
In addition to inflationary expectations,
economists might consider interest rate
expectations, income expectations, and
wealth expectations. This list is hardly
exhaustive.
Adaptive Expectations
The theory of adaptive expectations presumes that
expectations are primarily learned from experience.
For example, the theory of adaptive expectations
would say that if consumers begin to actually see
prices rising, say from three percent to five percent to
seven percent, over a period of, say, two years, they
will begin to form robust expectations of inflationary
expectations perhaps even expectations of double-
digit inflation.
The same theory might claim that consumers will
expect an economic recovery to begin only after ample
evidence that the turning point has been passed.
Rational Expectations
The theory of rational expectations presumes that
expectations are formed when economic agents see new
developments in the economy and they logically deduce
expectations based upon the information they have.
For example, if the Federal Reserve System were to
suddenly increase the money supply, according to the
theory of rational expectations, consumers would
immediately form inflationary expectations, not because
prices are actually rising, but because they deduce that
excessive money supply growth is likely to cause inflation.
The theory of rational expectations emphasizes the effects
of changes in economic policy upon expectations, although
the theory is not restricted to policy decisions alone.
The Limitations of Models
Improper Assumptions
Oversimplification
Mathematical Intractability

The Model as an "Image" of Economic Activity
Two important points are being made here:

1. This model, like most in economies, is not an applied model, where anyone actually uses it to
determine appropriate prices and levels of production. (To be more specific, it is not an
applied management model; corporations don't use these models to make pricing decisions).
Instead, the model represents a type of consistent behavior that economists see in the market
place, and it presents an image of that behavior. It allows an economist to both ask and answer
the question, "What would we expect to happen in a market where prices are too high or too
low? What kind of adjustment would take place, and why?

2. The market reactions of the economic decision-makers are not undertaken by virtue of their
use of this model or any other, but is instead motivated by their necessary response to
market signals that tell them that they must alter their decisions.

The model, therefore, simply captures their responses to a series of market signals.

Analysis of capital investment
Present value method
Future value technique
Annual equivalent cost method
Rate of return method
Present value method

Using the compound interest formulas bring all
benefits and costs to present worth
Select the alternative if its net present worth 0

Net present worth =Present worth of benefits Present worth of costs
44
Present Worth Analysis
A construction enterprise is investigating the
purchase of a new dump truck. Interest rate is 9%.
The cash flow for the dump truck are as follows:
First cost = $50,000, annual operating cost = $2000,
annual income = $9,000, salvage value is $10,000, life
= 10 years. Is this investment worth undertaking?
P = $50,000, A = annual net income = $9,000 - $2,000
= $7,000, S = 10,000, n = 10.
Evaluate net present worth = present worth of
benefits present worth of costs
45
Present Worth Analysis
Present worth of benefits = $9,000(PA,9%,10) =
$9,000(6.418) = $57,762

Present worth of costs = $50,000 +
$2,000(PA,9%,10) - $10,000(PF,9%,10)= $50,000 +
$2,000(6..418) - $10,000(.4224) = $58,612

Net present worth = $57,762 - $58,612 < 0 do not
invest
Future value technique
The future value technique of evaluating
alternatives is almost identical to the present
value method except that all costs and
revenues are stated in terms of future value.

Annual equivalent cost method
The annual equivalent cost method of evaluating alternative
projects states all costs and revenues over the useful life of
the project in terms of an equal annual payment series

1. It requires less effort and fewer calculations.

2. It eliminates the problem of alternatives with incompatible
useful lives.

3. It allows for much more sophistication when considering
inflation, increasing equipment cost, equipment depreciation
schedules, etc.
Rate of Return (ROR)
The rate of return (ROR) method of comparing
alternatives calculates the interest rate for each
alternative and selects the highest ROR.

ROR evaluates INVESTED capital and the costs of
operation and maintenance as opposed to revenues
or benefits received from the project.
Cost-Benefit Analysis
Project is considered acceptable if B C 0 or B/C 1.
Example (FEIM):
The initial cost of a proposed project is $40M, the
capitalized perpetual annual cost is $12M, the
capitalized benefit is $49M, and the residual value is
$0. Should the project be undertaken?

B = $49M, C = $40M + $12M + $0
B C = $49M $52M = $3M < 0

The project should not be undertaken.
50
Rational Decision-Making Process
1. Recognize a decision problem
2. Define the goals or objectives
3. Collect all the relevant
information
4. Identify a set of feasible
decision alternatives
5. Select the decision criterion to
use
6. Select the best alternative
51
Which Car to Lease?
Saturn vs. Honda
1. Recognize a decision problem
2. Define the goals or objectives
3. Collect all the relevant
information
4. Identify a set of feasible
decision alternatives
5. Select the decision criterion
to use
6. Select the best alternative


Need a car

Want mechanical security
Gather technical as well
as financial data
Choose between Saturn
and Honda
Want minimum total cash
outlay
Select Honda
52
Financial Data Required to Make an Economic
Decision
53
Predicting the Future
Estimating a Required
investment
Forecasting a product
demand
Estimating a selling price
Estimating a
manufacturing cost
Estimating a product life
Contemporary Engineering Economics, 4th
edition, 2007
54
Types of Strategic Engineering
Economic Decisions in Manufacturing
Sector

Service Improvement
Equipment and Process Selection
Equipment Replacement
New Product and Product Expansion
Cost Reduction



Contemporary Engineering Economics, 4th
edition, 2007
55
Service Improvement - Healthcare
Delivery
Which plan is more
economically viable?

Traditional Plan: Patients
visit each service provider.

New Plan: Each service
provider visits patients
: patient
: service provider
Contemporary Engineering Economics, 4th
edition, 2007
56
Equipment & Process Selection
How do you choose between the Plastic SMC
and the Steel sheet stock for an auto body
panel?
The choice of material will dictate the
manufacturing process for an automotive
body panel as well as manufacturing costs.
Contemporary Engineering Economics, 4th
edition, 2007
57
Equipment Replacement Problem
Now is the time to
replace the old machine?
If not, when is the right
time to replace the old
equipment?
Contemporary Engineering Economics, 4th
edition, 2007
58
New Product and Product Expansion
Shall we build or acquire
a new facility to meet the
increased demand?
Is it worth spending
money to market a new
product?
Contemporary Engineering Economics, 4th
edition, 2007
59
Types of Strategic Engineering Economic
Decisions in Service Sector

Commercial Transportation
Logistics and Distribution
Healthcare Industry
Electronic Markets and Auctions
Financial Engineering
Retails
Hospitality and Entertainment
Customer Service and Maintenance



Which Material to Choose?
61
New plant design Upgrade old plant
Alternative 1
Description
Cash flows over
some time period
Analysis using an
engineering
economy model
Evaluated
alternative 1
Noneconomic issues-environmental considerations
Alternative2
Description
Cash flows over
some time period
Analysis using an
engineering
economy model
Evaluated
alternative2
Income, cost estimations
Financing strategies
Tax laws

Planning horizon
Interest
Measure of worth
Calculated value of
measure of worth
I select alternative 2
Rate of return (Alt 2)
>Rate of return (Alt 1)

Alternatives
Methods of Economic Selection
62
Compare the following machines on the basis of their equivalent
uniform annual cost. Use an interest rate of 18% per year.

Comparison point
New Machine Used Machine
Capital cost 44000 m.u. 23000 m.u.
Annual operating
cost
7000 m.u. 9000 m.u.
Annual repair cost

210 m.u. 350 m.u.
Overhauling 2500 m.u. every 5 years 1900 m.u. every 2 years
Salvage value 4000 m.u. after 15 years 3000 m.u. after 8 years
Example 7.2
Cash flows of the two machines.
63
0 1 2 3 4 5 6 7 8 9 10 11 12 15 13 14
i=18%
m.u.2500 m.u.2500
m.u.7210/year
m.u.44000-2500
New machine
m.u.4000
m.u.2500
EUAC
new
= 7,210 + (44000 2500) (A/P, 18%, 15) + 2500 (A/P, 18%, 5) 4000 (A/F, 18%, 15)
= 7210 + 41500 (0.18 (1.18
15
) / (1.18
15
1)) + 2500 (0.18 (1.18
5
) / (1.18
5
1))
4000 (0.18/ (1.18
15
-1))
EUACnew = 16094.55 m.u. per year.
64
EUAC
used
= 9350 + (23000 1900) (A/P, 18%, 8) + 1900 (A/P, 18%, 2) 3000 (A/F, 18%, 8)
= 21100 (0.18 (1.18)
8
/ (1.18
8
1)) + 9350 + 1900 (0.18 (1.18)
2
/ (1.18
2
1))
3000 (0.18 / (1.18
8
1))
= 15542.4 m.u. per year.
1 2 3 4
0
5
i= 18 %
6 7
8
m.u.23000
m.u.9350/year
m.u.1900 m.u.1900 m.u.1900
Used machine
m.u.3000
65
Since we have found that: EUACused <EUACnew

Then it would be more economical to purchase the used
machine instead of the new one.

Providing that both have same productivity and quality.
NB: The overhauling cost is not taken into consideration at
the end of the equipment life.

66
Spreadsheet Solution for example 7.2
Analysis
The acceptance or rejection of a project based on the IRR criterion
is made by comparing the calculated rate with the required rate of return,
or cutoff rate established by the firm. If the IRR exceeds the required rate
the project should be accepted; if not, it should be rejected.


If the required rate of return is the return investors expect the
organization to earn on new projects, then accepting a project with an IRR
greater than the required rate should result in an increase of the firms
value.


Analysis

There are several reasons for the widespread popularity of the IRR as an
evaluation criterion:

Perhaps the primary advantage offered by the technique is that
it provides a single figure which can be used as a measure of
project value.

Furthermore, IRR is expressed as a percentage value. Most
managers and engineers prefer to think of economic decisions
in terms of percentages as compared with absolute values
provided by present, future, and annual value calculations.
Analysis
Another advantage offered by the IRR method is related to the
calculation procedure itself:

As its name suggests, the IRR is determined internally for
each project and is a function of the magnitude and timing of the
cash flows.

Some evaluators find this superior to selecting a rate
prior to calculation of the criterion, such as in the profitability index
and the present, future, and annual value determinations. In other
words, the IRR eliminates the need to have an external interest
rate supplied for calculation purposes.


Sensitivity and Breakeven Analysis:
These techniques are used to see how
sensitive a decision is to estimates for the
various parameters.
BREAKEVEN ANALYSIS is done to locate
conditions under which various alternatives
are equally desirable. Examples include single
vs. multi-stage construction ,hours of
equipment utilization, production volume
required, and equipment replacement analysis
Break-Even Analysis
Excel using a Goal Seek function


Analytical Approach
Excel Using a Goal Seek Function
Goal Seek
Set cell:
To value:
By changing cell:
Ok Cancel
? X
$F$5
0
$B$6
NPW
Breakeven Value
Demand
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
A B C D E F G
Example 10.3 Break-Even Analysis
Input Data (Base): Output Analysis:
Unit Price ($) 50 $ Output (NPW) $0
Demand 1429.39
Var. cost ($/unit) 15 $
Fixed cost ($) 10,000 $
Salvage ($) 40,000 $
Tax rate (%) 40%
MARR (%) 15%
0 1 2 3 4 5
Income Statement
Revenues:
Unit Price 50 $ 50 $ 50 $ 50 $ 50 $
Demand (units) 1429.39 1429.39 1429.39 1429.39 1429.39
Sales Revenue 71,470 $ 71,470 $ 71,470 $ 71,470 $ 71,470 $
Expenses:
Unit Variable Cost 15 $ 15 $ 15 $ 15 $ 15 $
Variable Cost 21,441 21,441 21,441 21,441 21,441
Fixed Cost 10,000 10,000 10,000 10,000 10,000
Depreciation 17,863 30,613 21,863 15,613 5,581
Taxable Income 22,166 $ 9,416 $ 18,166 $ 24,416 $ 34,448 $
Income Taxes (40%) 8,866 3,766 7,266 9,766 13,779
Net Income 13,299 $ 5,649 $ 10,899 $ 14,649 $ 20,669 $
Cash Flow Statement
Operating Activities:
Net Income 13,299 5,649 10,899 14,649 20,669
Depreciation 17,863 30,613 21,863 15,613 5,581
Investment Activities:
Investment (125,000)
Salvage 40,000
Gains Tax (2,613)
Net Cash Flow (125,000) $ 31,162 $ 36,262 $ 32,762 $ 30,262 $ 63,636 $
Goal Seek
Function
Parameters
Analytical Approach
Unknown Sales Units (X)
0 1 2 3 4 5
Cash Inflows:
Net salvage
37,389
X(1-0.4)($50)
30X 30X 30X 30X 30X
0.4 (dep)
7,145 12,245 8,745 6,245 2,230
Cash outflows:
Investment
-125,000
-X(1-0.4)($15)
-9X -9X -9X -9X -9X
-(0.6)($10,000)
-6,000 -6,000 -6,000 -6,000 -6,000
Net Cash Flow
-125,000 21X +
1,145
21X +
6,245
21X +
2,745
21X +
245
21X +
33,617
PW of cash inflows
PW(15%)
Inflow
= (PW of after-tax net revenue)
+ (PW of net salvage value)
+ (PW of tax savings from depreciation

= 30X(P/A, 15%, 5) + $37,389(P/F, 15%, 5)
+ $7,145(P/F, 15%,1) + $12,245(P/F, 15%, 2)
+ $8,745(P/F, 15%, 3) + $6,245(P/F, 15%, 4)
+ $2,230(P/F, 15%,5)

= 30X(P/A, 15%, 5) + $44,490

= 100.5650X + $44,490

PW of cash outflows:
PW(15%)
Outflow
= (PW of capital expenditure_
+ (PW) of after-tax expenses
= $125,000 + (9X+$6,000)(P/A, 15%, 5)
= 30.1694X + $145,113
The NPW:
PW (15%) = 100.5650X + $44,490
- (30.1694X + $145,113)
=70.3956X - $100,623.
Breakeven volume:

PW (15%) = 70.3956X - $100,623 = 0
X
b
=1,430 units.

Demand
PW of
inflow
PW of
Outflow

NPW
X 100.5650X
- $44,490
30.1694X
+ $145,113
70.3956X
-$100,623
0 $44,490 $145,113 100,623
500 94,773 160,198 65,425
1000 145,055 175,282 30,227
1429 188,197 188,225 28
1430 188,298 188,255 43
1500 195,338 190,367 4,970
2000 245,620 205,452 40,168
2500 295,903 220,537 75,366
Outflow
Break-Even Analysis Chart
0 300 600 900 1200 1500 1800 2100 2400
$350,000
300,000
250,000
200,000
150,000
100,000
50,000
0
-50,000
-100,000
Profit
Loss
Break-even Volume
X
b

=

1
4
3
0

Annual Sales Units (X)
P
W

(
1
5
%
)

Scenario Analysis
Variable
Considered
Worst-
Case
Scenario
Most-Likely-
Case
Scenario
Best-Case
Scenario
Unit demand 1,600 2,000 2,400
Unit price ($) 48 50 53
Variable cost ($) 17 15 12
Fixed Cost ($) 11,000 10,000 8,000
Salvage value ($) 30,000 40,000 50,000
PW (15%) -$5,856 $40,169 $104,295
The decision making processs
Identifying objectives
Identifying options for achieving the objectives
Identifying the criteria to be used to compare the options
Analysis of the options
Making choices, and
Feedback.