ENGINEERING

ECONOMY
Prof. Dr. Cengiz Kahraman
ITU Industrial Engineering
Department

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 INTRODUCTION TO ENGINEERING ECONOMIC ANALYSIS

DEFINITION
Engineering Economy is a collection of
mathematical techniques that simplify economic
comparisons when making moderate decisions.
Engineering Economy is the art and the
science of selecting the best course of action at
any point in time. Every moment is a decision
point, an opportunity for staying with the status
quo or choosing a different course of action.
Status quo alternative=As-is alternative=Do-
nothing alternative: the current approach is
maintained.
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 INTRODUCTION TO ENGINEERING ECONOMIC ANALYSIS

A Short History of Engineering Economy

The Economic Theory of the Location of Railways, written by Arthur M.
Wellington in 1887, pioneered an engineering interest in economic
evaluations. Wellington, a civil engineer, reasoned that the capitalized cost
method of analysis should utilized in selecting the preferred lenghts of rail
lines or curvatures of the lines.
In the 1920s, C.L. Fish and O.B. Goldman looked at investments in
engineered structures from the perspective of actuarial mathematics. Fish
formulated an investment model related to the bond market. In Financial
Engineering, Goldman proposed a compound-interest procedure for
determining comparative values.
The confines of classical engineering economy were staked out in 1930 by
Eugene L. Grant in Principles of Engineering Economy. Grant discussed
the importance of judgment factors and short-term investment evaluation as
well as conventional comparisons of long-run investments in capital goods
based on compound-interest calculations. His many contributions resulted in
the recognation that Eugene L. Grant can truthfully be called the father of
engineering economy.

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 INTRODUCTION TO ENGINEERING ECONOMIC ANALYSIS

Classifying Investment Alternatives

Dependent and Independent Investments:
Assume there are two investment alternatives: A and B.
The first investment proposal will be said to be
economically independent of the second if the cash flows
expected from the first investment would be the same
regardless of whether the second investment were
accepted or rejected.
If the cash flows associated with the first investment are
affected by the decision to accept or reject the second
investment , the first investment is said to be
economically dependent on the second.

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 INTRODUCTION TO ENGINEERING ECONOMIC ANALYSIS

Classifying Investment Alternatives

Dependent and Independent Investments:
If a decision to undertake the second investment will
increase the benefits expected from the first (or
decrease the costs of undertaking the first without
changing benefits), the second investment is said to
be a complement of the first.
If the decision to undertake the second investment
will decrease the benefits expected from the first (or
increase the costs of undertaking the first without
changing the benefits), the second is said to be a
substitute for the first.

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 INTRODUCTION TO ENGINEERING ECONOMIC ANALYSIS

Classifying Investment Alternatives

Dependent and Independent Investments:
In the extreme case where the potential benefits to be derived
from the first investment will completely disappear if the
second investment is accepted, or where it is technically
impossible to undertake the first when the second has been
accepted, the two investments are said to be mutually
exclusive.
It is also possible to define an extreme case for investments
that are complements. Suppose that the second investment is
impossible (technologically) or would result in no benefits
whatsoever if the first investment were not accepted. Then the
first investment can be said to be a prerequisite of the second.

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 INTRODUCTION TO ENGINEERING ECONOMIC ANALYSIS

Classifying Investment Alternatives

Dependent and Independent Investments:
Graphic Representation for The Possible Relationships Between
Investments

Prerequ. Inde. Inv.s Mu. Exc. Inv.s

Strong Weak Weak Strong

Comp. Comp. .Subs Subs.
.

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 INTRODUCTION TO ENGINEERING ECONOMIC ANALYSIS

Examples: Give your decision about the investment

category for the following alternatives:
To build a toll bridge and operate a ferry across adjacent
points on a river.
The building of a new factory as one investment and the
purchase of an air-conditioning unit for the factory as the
second investment.
The XYZ Company is considering installing a solar
heating system in its manufacturing plant for space and
hot water heating. There are three possible solar system
alternatives in addition to the do-nothing alternative.

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 INTRODUCTION TO ENGINEERING ECONOMIC ANALYSIS
CATEGORY ECONOMIC CRITERION

Fixed input: Maximize the benefits or

The amount of money or other outputs
other input resources
are fixed.
Fixed output Minimize the costs or
other inputs

Neither input nor output Maximize (benefits -

fixed costs), or maximize
profit
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 INTRODUCTION TO ENGINEERING ECONOMIC ANALYSIS

Examples: make your decision about the category and the economic
criterion of each situation in the following:
a) A project engineer has a budget of $350,000 to overhaul a portion of a
petrolium refinery.
b) A civil engineering firm has been given the job to survey a tract of land
and prepare a Record of Survey map.
c) You have $100 to buy clothes for the start of school.
d) An outomobile battery is needed. They are available at different prices,
and although each will provide the energy to start the vehicle, their useful
lives are different.
e) You wish to purchase a new car with no optional equipment.
f) A book publisher is about to set the list price (retail price) on a textbook. If
they choose a low list price, they plan on less advertising than if they select
a higher list price. The amount of advertising will affect the number of copies
sold.
g) At an auction of antiques, a bidder for a particular statue would be trying
to.........................

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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

Nature of Problems
Simple Problems
These are defined as decisions that have all important information
readily available and it is easy to understand the information.
Intermediate Problems
This level of decision is defined as not having all important
information readily available and the most important issue is
probably money. Most of the information is findable or could be
calculated as well as finite.
Complex Problems
They represent a mixture of economic, political, and humanistic
elements.The third category of problems is defined as not having
much of the important information or the important information is
intangible or hard to determine. Usually there are many variables
that are very complex and have many and variable potential
impacts.

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 INTRODUCTION TO ENGINEERING ECONOMIC ANALYSIS

Examples: Decide the categories of the following problems:

a) The selection between a manual or a semi-automatic machine.
b) The preparation of the annual budget of Turkey
c) Would it be better to buy an otomobile with a diesel engine or a
gasoline engine?
d) One of the people you might marry has a job that pays very little
money, while another one has a professional job with an excellent
salary. Which one should you marry?
e) Decide on the components of a breakfast.
f) Ahmet backed his car into a tree, damaging the fender. He has
automobile insurancethat will pay for the fender repair. But if he files
a claim for payment, they may change his good driver rating
downward , and charge him more for car insurance in the future.
g) How many people smoke cigarettes although they realize that
smoking may be harmful to health.

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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

Basic Terms
Time Value of Money
Equivalence
Interest
Simple Interest
Compound Interest
Cash Flow
Cash Flow Diagram
Economic Life
Before Tax Cash Flow
Before Tax Rate of Return
Purchase Cost
Salvage Value
Disposal Costs

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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

The Time Value of Money

The change in the value of money over time as
a result of its earning power is called the time
value of money.
Since money has the ability to earn interest, its
value increases with time.
Since money increases in value as we move
from the present to the future, it must decrease
in value as we move from the future to the
present.

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 Time Value of Money
Money has a time value
because it can earn
more money over time
(earning power).
Time value of money is
measured in terms of
interest rate.
Interest is the cost of
moneya cost to the
borrower and an
earning to the lender

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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

Equivalence
Different sums of money at different times are
equal in economic value.
When we are indifferent whether we have a
quantity of money now or the assurance of some
other sum of money in the future , or series of
future sums of money, we say that the present
sum of money is equivalent to the future sum or
series of future sums.

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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

Interest
A fee that is charged for the use of
someone elses money. The size of the fee
will depend upon the total amount of
money borrowed and the length of the
time over which it is borrowed.
Interest is the cost of using capital.
Interest is the rent paid by a borrower to a
lender.
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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

Interest
Example: An engineer wishes to borrow
$20,000 in order to start his own business. A
bank will lend him the money provided he
agrees to pay $920 per month for two years.
How much interest is he being charged?
The total amount of money that will be paid to
the bank is 24x$920=$22,080. Since the original
loan is only $20,000, the amount of interest is
$22,080 - $20,000 = $ 2,080.

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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

Interest

Whenever money is borrowed or invested, one party

acts as the lender and another party as the borrower.
Lender is the owner of the money, and the borrower
pays interest to the lender for the use of the lenders
money.
Example: When money is deposited in a savings
account, the depositor is the lender and the bank is the
borrower. The bank therefore pays interest for the use of
the depositors money.
The bank will then play the role of the lender, by loaning
this money to another borrower , at a higher interest rate.

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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

Interest Rate

If a given amount of money is borrowed for a specified period of

time, a certain percentage of the money is charged as interest. This
percentage is called the interest rate.
Percentage of the original amount per unit of time.
Example:
(a) A student deposits $1,000 in a savings account that pays interest
at the rate of 6% per year. How much money will the student have
after one year? (Answer: $1,060)
(b) An investor makes a loan of $5,000, to be repaid in one lump
sum at the end of one year.. What annual interest rate corresponds
to a lump-sum payment of $5,425? (Answer: 8.5%)

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 INTRODUCTION TO ENGINEERING ECONOMIC ANALYSIS
Interest Period
Time unit used to express rate.
Simple Interest
Simple interest is defined as a fixed percentage of the principal (the
amount of money borrowed), multiplied by the life of the loan.
I = Pni
where
I = total amount of simple interest
n = life of the loan
i = interest rate (expressed as a decimal)
P=principal
It is understood that n and i refer to the same unit of time.
Interest = Principal * Number of Periods * Interest Rate
At the end of the loan period , the total amount (the principal + the
accumulated interest) to be repaid can be expressed as

F P I P 1 ni
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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

Simple Interest
Example: A student borrows $3,000 from his uncle in
order to finish school. His uncle agrees to charge him
simple interest at the rate of 5.5% Per year. Suppose the
student waits two years and then repays th e entire
loan. How much will he have to repay? (Answer: $3,330)
Example: What is the annual rate of simple interest if
$265 is earned in four months on an investment of
$15,000?(Answer:5.3%)
Example: Determine the principal that would have to be
invested to provide $200 of simple interest income at the
end of two years if the annual interest rate is 9%?
(Answer:$1111.119)

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INTRODUCTION TO ENGINEERING ECONOMIC ANALYSIS

Compound Interest
When interest is compounded, the total time
period is subdivided into several interest periods
(e.g., one year, three months, one month).
Interest is credited at the end of each interest
period. and is allowed to accumulate from one
interest period to the next.
For the first interest period, the interest is
determined as
I iP
1
and the total amount accumulated is
F P I P iP P 1 i
1 1
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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

For the second interest period, the interest

is determined as
I iF i 1 i P
2 1

and the total amount accumulated is

F P I I P iP i 1 i P P 1 i 2
2 1 2

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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

For the third interest period,

2
I i 1 i P
3
F P 1 i 3
3
and so on. In general, if there are n interest periods, we
have
Fn P 1 i n

Fn: the total amount of money accumulated, increases

exponentially with n, the time measured in interest
periods.

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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

Compound interest
Example: A student deposits $1,000 in a savings
account that pays interest at the rate of 6% per year,
compounded annually. If all of the money is allowed to
accumulate, how much will the student have after 12
years? Compare this with the amount that would have
accumulated if simple interest had been paid. (Answer:
$2,012.20 and $1,720.00)
Example: Compare the interest earned from an
investment of $1,000 for 15 years at 10% per annum
simple interest, with the amount of interest that could be
arned if these funds were invested for 15 years at 10%
per year, compounded annually. (Answer: $1,500 and
$3,177.25)

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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

Compound interest
Example: Suppose that the interest rate is 10% per year,
compounded annually. What is the minimum amount of
money that would have to be invested for a two-year period in
order to earn $300 in interest? (Answer: $1,428.57)
Example: How long would it take for an investor to double his
money at 10% interest per year, compounded annually?
(Answer: 7.27 years8 years)
Example : Suppose that a man lends $1,000 for four years at
12% per year simple interest. At the end of the four years, he
invests the entire amount which he then has for 10 years at
8% interest per year, compounded annually. How much
money will he have at the end of 14-year period? (Answer:
$3,195.21)

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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

Rule of 72
Estimated n = 72 divided by i
Estimated Interest Rate = 72 divided by n
The time required for an initial single
amount to double in size with compound
interest is approximately equal to 72
divided by the rate of return value (in
percent): 72
Estimated n
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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

Rule of 72
The compound rate i in percent required
for money to double in a specified period
of time n can be estimated by dividing 72
by the specified n value:
72
Estimated i
n

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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS
Rule of 72 : to double the amount
Rate of Rule-of-72 Actual
Return, Estimate Years
%per year
1 72 70
2 36 35.3
5 14.4 14.3
10 7.2 7.5
20 3.6 3.9
40 1.8 2.0
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INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS
Symbols - Notation
P = $ at time 0
F = $ at a future time
A = $ at each period
End of period, Uniform series amounts, Equal amounts of money
G = $ at each period
End of period
A uniform gradient is a cash-flow series which either increases or
decreases uniformly. The cash flow, whether income or
disbursements, changes by the same arithmetic amount each
interest period. The amount of the increase or decrease is the
gradient.
n = Number of interest periods
i = Interest rate per period

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INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS
Example: Explain the symbols corresponding to the
numerical values given in the following problems?
If an automobile manufacturer predicts that the cost of
maintaining a robot will increase by $500 per year until
the machine is retired.
A company expects income to decrease by $3,000 per
year for the next 5 years.
How much money should you be willing to pay now for an
investment that is guaranteed to yield $600 per year for 9
years starting next year, at an interest rate of 16% per
year?
How much money must Mehmet deposit every year
starting 1 year from now at 5.5% per year in order to
accumulate $6,000 seven years from now?

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INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS

Cash Flow
A net cash flow is the difference between
total cash receipts (inflows) and total cash
disbursements (outflows) for a given
period of time.

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INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS
Cash Flow Diagrams
The individual cash flows are represented as vertical
arrows along a horizontal time scale.
Positive cash flows are represented by upwardpointing
arrows, and negative cash flows by downward pointing
arrows.
The length of an arrow is proportional to the magnitude
of the corresponding cash flow.
Each cash flow is assumed to occur at the end of the
respective time period.
Arrow direction
Up for inflows of cash
Down for outflows of cash

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 INTRODUCTION TO ENGINEERING ECONOMIC
ANALYSIS
Example: A company plans to invest $500,000 to
manufacture a new product. The sale of this product is
expected to provide a net income of $70,000 a year for
10 years. Draw the cash flow diagram for this proposed
project.
Example: Suppose that you have a savings plan
covering the next ten years, according to which you put
aside $600 today, $500 at the end of every other year for
the next five years, and $400 at the end of each for
remaining five years. As part of this plan , you expect to
withdraw $300 at the end of every year for the first 3
years, and $350 at the end of every other year
thereafter.
Tabulate your cash flows.
Draw your cash flow diagram.
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 Formulas for Single Payment, Uniform Payments, and
Uniform Gradient Payments and Their Functional
Notations

1. Single Payment, Compound-Amount Factor

Single payment formula to calculate the future
worth of a present amount is
F P 1 i n
The ratio n
F P 1 i


is called the single-payment, compound-amount
factor, but it is usually referred to as the
F P factor. In functional notation, the single
payment, compound amount formula is
F P F P , i%, n
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 Formulas for Single Payment, Uniform Payments, and
Uniform Gradient Payments and Their Functional
Notations
Example: A student deposits $1,000 in a
savings account that pays interest at the rate of
6% per year, compounded annually.If all of the
money is allowed to accumulate, how much
money will the student have after 12 years?
Solution: Example: A student deposits $1,000
in a savings account that pays interest at the
rate of 6% per year, compounded annually.If
all of the money is allowed to accumulate,
how much money will the student have after
12 years?
Solution:
F P F P , i%, n $1,000 F P ,6%,12 $1,000 2,0122 $2,012.20
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 Formulas for Single Payment, Uniform Payments, and
Uniform Gradient Payments and Their Functional
Notations

2. Single-Payment, Present-Worth
Factor
Single payment formula to calculate the
present worth of a future amount is
P F 1 i n
The single-payment, present-worth factor
is the reciprocal of the single-payment,
compound amount factor:
1
P F F P 1 i n
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 Formulas for Single Payment, Uniform Payments, and
Uniform Gradient Payments and Their Functional
Notations
The functional notation for this quantity is

P F , i%, n
And the single payment, present worth formula in
functional notation is

P F P F ,i%,n


Example: A certain sum of money will be deposited in a
savings account that pays interest at the rate of 6% per
year, compounded annually. If all of the money is allowed
to accumulate, how much must be deposited initially so
that $5,000 will have accumulated after 10 years?

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 Formulas for Single Payment, Uniform Payments, and
Uniform Gradient Payments and Their Functional
Notations

Solution:

P F P F,i%,n $5,000





P F,%6,10

$5,000(0.5
584) $2,792.00

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 Formulas for Single Payment, Uniform Payments, and
Uniform Gradient Payments and Their Functional
Notations

3. Uniform-Series, Compound-Amount
Factor
Let equal amounts of money, A, be
deposited in a savings account at the end
of each year over a period of n years. If
the money earns interest at a rate i,
compounded annually, how much money
will have accumulated after n years?

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 3. Uniform-Series, Compound-Amount
Factor
The first years deposit will have increased
in value to
F A1 i n 1
1
Similarly, the second years deposit will
have increased in value to
F A1 i n 2
2
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 3. Uniform-Series, Compound-Amount
Factor
and so on. The total amount accumulated
will thus be the sum of geometric
progression:
F F F ... Fn
1 2
n1 n2
F A 1 i

A 1 i

... A

A 1 i n 1 1 i n 2 ... 1

1 i n 1
A
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 3. Uniform-Series, Compound-Amount Factor

The ratio
n
1 i 1

F A
i
is called the uniform-series, compound-
amount factor.
In functional notation, the uniform-series,
compound-amount factor is
F A F A, i%, n
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 3. Uniform-Series, Compound-Amount Factor

and the uniform-series, compount amount

formula is

F A F A,i%,n


Example: A student plans to deposit $600 each
year in a savings account, over a period of 10
years. If the bank pays 6% per year,
compounded annually, how much money will
have accumulated at the end of the 10-year
period?
F A F A, i%, n $600 F A,6%,10 $60013.1808 $7,908.48
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 4. Uniform-Series, Sinking-Fund Factor

The uniform-series, sinking-fund factor is

the reciprocal of the uniform-series,
compound-amount factor:

1
A F F A
i
1 i n 1

The functional notation of the uniform-

series, sinking-fund factor is A F , i%, n .
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 4. Uniform-Series, Sinking-Fund Factor

The uniform-series, sinking fund formula in functional

notation is

A F A F , i%, n

Example: Suppose that a fixed sum of money, A, will be

deposited in a savings account at the end of each year
for 20 years. If the bank pays 6% Per year, compounded
annually, find A such that a total of $50,000 will be
accumulated at the end of the 20-year period.
Solution:
A F A F , i%, n $50,000 A F ,6%,20 $50,000 0.02718 $1,359
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 5. Uniform-Series, Capital-
Recovery Factor
Suppose that a given sum of money , P, is
deposited in a savings account where it
earns interest at a rate i per year,
compounded annually. At the end of each
year a fixed amount, A, is withdrawn. How
large should A be so that the bank
account will just be depleted at the end of
n years?

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 5. Uniform-Series, Capital-
Recovery Factor

A A
0
n

Previously defined factors to solve this

problem can be used, since

A P F P A F
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 5. Uniform-Series, Capital-
Recovery Factor
n
i 1 i
A P 1 i n i
n P n
1 i 1 1 i 1

The ratio is

1 i in
AP n
1 i 1
The uniform-series, capital-recovery
formula in functional notation is

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A P A P , i%, n 50
 5. Uniform-Series, Capital-
Recovery Factor
Example: An engineer who is about to
retire has accumulated $50,000 in a
savings account that pays 6% Per year,
compounded annually. Suppose that the
engineer wishes to withdraw a fixed sum
of money at the end of each year for 10
years. What is the maximum amount that
can be withdrawn?

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 5. Uniform-Series, Capital-
Recovery Factor
Solution:

A P A P , i%, n $50,000 A P ,6%,10 $50,000 0,1359 $6,795

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 6. Uniform-Series, Present
Worth Factor
The uniform-series, present-worth factor is
the reciprocal of the uniform-series,
capital-recovery factor:
n 1
P A A P 1
1 i
1 i n i
The functional notation for the uniform-
series, present-worth factor is
P A P A, i%, n
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 6. Uniform-Series, Present
Worth Factor
The uniform-series, present-worth formula in functional
notation is
P A P A, i%, n
Example:
An engineer who is planning his retirement has decided
that he will have to withdraw $10,000 from his savings
account at the end of each year. How much money must
the engineer havein the bank at the start of his
retirement, if his money earns 6% Per year, compounded
annually, and he is planning a 12- year retirement (i.e. 12
annual withdrawals)?
Solution:
P A P A , i%, n $10,000 P A,6%,12 $10,000 8.3839 $83,839
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 7. Gradient Series Factor
A+(n-1)G

A+2G
A+G
A
Time

Cash flows of this form may be resolved

into two components:

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 7. Gradient Series Factor

(n-1)G
A A A A A 2G
G

PP P
1 2

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 7. Gradient Series Factor

1 i n 1
P A n A P A, i%, n
1 1 i i

G 1 i n 1 1
P n n G P G , i%, n
2 i
i 1 i

The gradient series factor is :

1 n
AG n A G , i%, n
i 1 i 1
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 7. Gradient Series Factor
Uniform Gradient
Increases or decreases by a uniform
amount each interest period.
Increase or decrease is the gradient
amount.
Year one is the Uniform Series Amount.
Not a part of the gradient.
G = Gradient amount

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 7. Gradient Series Factor
Example:
An engineer is planning for a 15-year retirement.
In order to supplement his pension and offset
the anticipated effects of inflation, he intends to
withdraw $5,000 at the end of the first year, and
to increase the withdrawal by $1,000 at the end
each successive year. How much money must
the engineer have in his savings account at the
start of his retirement, if money earns 6% per
year, compounded annually?
P $106,116 .59
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 7. Gradient Series Factor
Example:
How much money must initially be
deposited in a savings account paying 5%
Per year, compounded annually, to
provide for ten annual withdrawals that
start at $6,000 and decrease by $500
each year? (Answer: $30,504.19)

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 8. Geometric Series Factor
Oftentimes, cash flows change by a
constant percentage in consecutive
payment periods. This type of cash flow,
called a geometric series, is shown in
general form in the following figure where
g represents the geometric growth rate in
decimal form.

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 8. Geometric Series Factor

C1(1+g)n-1

C1 C1(1+g)

n
1 2

F
P
1 1 i n 1 g n nC nC
P C ig P 1 1 ig
1 ig 1 g 1 i

1 i n 1 g n
F C ig F nC 1 i n1 nC 1 g n 1 ig
1 06:49 PMi g
02/25/17 1 1 62

 8. Geometric Series Factor
Example:
Someone plans to deposit $2,000 in a money
market account starting 1 year from now and
wants to increase annual deposits by 20% each
year for the following 6 years. Assuming that
deposits earn 9% annually, determine what
equal-payment annuity would accumulate the
same amount over the 7-year period.
(A=$3,458.53)

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 Standard Notations

SPPWF = (P/F,i%,n)
SPCAF = (F/P,i%,n)
USPWF = (P/A,i%,n)
CRF = (A/P,i%,n)
SFF = (A/F,i%,n)
USCAF = (F/A,i%,n)

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