 Topics to be covered

 Introduction

 Types of Cost/Benefit

 Cash flow Diagram

 Time Value of money

 Interest Formulas and Applications

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Introduction to Engineering Economics
 From the organization’s point of view, efficient and effective functioning of the
organization would certainly help it to provide goods/services at a lower cost which in
turn will enable it to fix a lower price for its goods or services.

 Engineering Economics is the application of economic principles to engineering

problems, for example in comparing the comparative costs of two alternative capital
projects or the systematic formulation, estimation & evaluation of the economic merits of
proposed solutions to engineering problems.

 Engineering economics deals with the methods that enable one to take economic
decisions towards minimizing costs and/or maximizing benefits to business
organizations.
 It deals with the concepts and techniques of analysis useful in evaluating the
worth of systems, products, and services in relation to their costs.

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Introduction to Engineering Economics
 The estimates and the decisions in engineering economy
usually
involve four essential elements:
1. Cash flows
2. Times of occurrence of cash flows
3. Interest rates for time value of money
4. Measure of economic worth(e.g PW) for selecting an alternative
 The decision is based on analyzing and evaluating the
activities
involved in producing the outcome of the project.
 These activities have either a cost or a benefit.

 Financial analysis gives us the tools to perform this evaluation.

 Often the decision to make is to proceed or not to proceed with

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The steps in an engineering economy study

The steps are as follows:

1.Identify and understand the problem; identify the objective of the
project.
2.Collect relevant, available data and define viable solution
alternatives.
3. Make realistic cash flow estimates.
4.Identify an economic measure of worth criterion for decision making.
5.Evaluate each alternative; consider noneconomic factors; use
sensitivity analysis as needed.
6. Select the best alternative.
7. Implement the solution and monitor the results.
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Role of Engineering Economics in the Industry
 Why do engineers care about engineering economics?

 Engineering designs are intended to produce good results with

value addition.

 They are accompanied by undesirables (costs).

 If outcomes are evaluated in dollars, and “good” is

defined as
profit, then decisions will be guided by engineering economics.

 This process maximizes goodness only if all outcomes

are
anticipated and can be monetized.
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Role of Engineering Economics in the Industry
 It is used to answer many different questions:

 Which engineering projects are worthwhile?

 Has the mining or petroleum engineer shown that the mineral

or oil deposits is worth developing?

 Which engineering projects should have a higher priority?

 Has the industrial engineer shown which factory improvement

projects should be funded with the available dollars?

 How should the engineering project be designed?

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 Role of Engineers in the Industry
 Role of Engineers: Profit
Manufacturing
 Estimating a required
investment.
Planning
 Forecasting a product
demand.
 Estimating a selling
price.
 Estimating a
manufacturing cost.
 Estimating a product life.
Investment Marketing

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Accounting Vs. Engineering Economy
Evaluating past performance Evaluating and predicting future events

Accounting Engineering Economy

Past Present Future

 Types of Strategic Engineering Economic Decisions in

Manufacturing Sector:
 Service Improvement.
 Equipment and Process Selection.
 Equipment Replacement.
 New Product and Product Expansion.
 Cost Reduction.
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Types of Costs

 There are usually two types of costs/Benefits associated with an engineering

project, one-time costs, which include first costs and salvage costs, and annual
costs (or benefits) that occur every year or several years of the project.

 One time costs:

 First Costs or Initial Costs are the costs necessary to implement a project, including:

 Costs of new equipment, Costs of shipping and installation, Costs of

renovations, Cost of engineering, Cost of permits, licenses, etc.

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Types of Costs

 Salvage value is the money that can be obtained at the end of the project by selling
equipment. Salvage value is a benefit rather than a cost.

 Annual Costs/Benefits:

 Direct operating costs such as supervision, supplies,

labor, maintenance, material, electricity, fuel, etc.

 Indirect operating costs sometimes included, such as a portion of building

rent, a portion of secretarial expenses, etc.

 Depreciation of equipment.

 Savings or profits from the project and tax.

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Cash Flow Diagram

 The graphic presentation of the costs and benefits over the time is called the cash
flow diagram.

 It is a presentation of what costs have to be incurred and what benefits are received

at all points in time. CFD illustrates the size, sign, and timing of individual cash

flows, and forms the basis for engineering economic analysis.

 A CFD is created by first drawing a segmented time-based horizontal line, divided

into appropriate time unit. Each time when there is a cash flow, a vertical arrow is

added, pointing down for costs and up for revenues or benefits.

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Cash Flow Diagram
 Different cost flows are drawn to relative scale.

 Horizontal axis = time; vertical axis = costs and benefits.

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Drawing Cash Flow Diagram

 In a cash flow diagram (CFD) the end of period t is the same as

the beginning of period (t+1).

 Beginning of period cash flows are: rent, lease, and

insurance payments.

 End-of-period cash flows are: salvages, revenues, overhauls.

 The choice of time 0 is arbitrary. It can be when a project

is analyzed, when funding is approved, or when construction begins.

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Drawing Cash Flow Diagram
 Example 1: A car leasing (renting) company buys a car from
a
wholesaler for $24,000 and leases it to a customer for four years at
$5,000 per year. Since the maintenance is not included in the lease, the leasing
company has to spend $400 per year in servicing the car. At the end of the four
years, the leasing company takes back the car and sells it to a secondhand car
dealer for $15,000. For the moment, in constructing the cash flow diagram, we
will not consider tax, inflation, and depreciation.

 Solution:

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Time Value of Money
 The time value of money is the idea that money available at the present time is worth more than the
same amount in the future due to its potential earning capacity.
Money has value. It is the change in
the amount of money over time
 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 amount
Original $9. to be returned = $100
Interest to be returned = $100 x .09 = $9

 The “value” of money depends on the amount and when it is

received or spent.
 Example: What amount must be paid to settle a current debt
of $1000 in two years at an interest rate of 8% ?
 Solution: $1000 (1 + 0.08) (1 + 0.08) = $1166

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Interest Formulas and Application
 The notations which are used in various interest formulae are as
follows:

P = principal amount (Initial amount of money

invested or borrowed).

 n = No. of interest periods.

i = interest rate (It may be compounded monthly,

quarterly, semiannually or annually).

 F= future amount at the end of year n.

 A = equal amount deposited at the end of every interest period.

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Interest Formulas and Their Applications
 Interest rate: is the rental value of money. It represents the growth of capital
per unit period. The period may be a month, a quarter, semiannual or a year.

 Interest formulas:

 Simple interest: the interest is calculated, based on the initial deposit for every interest period.
In this case, calculation of interest on interest is not applicable.

 Note :Simple interest is commonly used with bonds.

 Compound interest: the interest for the current period is computed based on the amount
(principal plus interest up to the end of the previous period(at the beginning of the current
period).

Note: Engineering economic analysis uses the compounded- interest

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Interest Formulas and Application
 1. Single-Payment Compound Amount: Here, the objective is to find the single
future sum (F) of the initial payment (P) made at time 0 after n periods at an
interest rate i compounded every period.
 The formula to obtain the single-payment compound amount is:
 F= P(1 + i)n = P(F| P, i, n)
 Where (F|P, i, n) is called as single-payment compound amount factor.

 Example: A person deposits a sum of $ 20,000 at the interest rate of 18%

compounded annually for 10 years. Find the maturity value after 10 years.
 Solution: P= $ 20,000, i = 18% compounded annually, n= 10 years
 F= P(1 + i)n = P(F|P, i, n)
= 20,000 (F|P, 18%, 10)
= 20,000 * 5.234 = $ 104,680

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2.Compounding other than annually
The formula for compound interest, including principal
sum, is:
F = P (1 + i/m) (𝑚𝑛)
M is the number of times that interest is compounded per unit n.

Example: If an amount of $5,000 is deposited into a savings account at an annual

interest rate of 5%, compounded monthly, the value of the investment after 10 years
can be calculated as follows:
P = 5000
i= 5/100 = 0.05
m = 12
n = 10

F= = 5000 (1 + 0.05 / 12) (12 * 10) =

8,235.05.
So, the investment balance after 10 years is $8,235.05.
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Interest Formulas and Application
 3. Single-Payment Present Worth Amount: Here, the objective is to find
the present worth amount (P) of a single future sum (F) which will be received
after n periods at an interest rate of i compounded at the end of every interest
period.

 Example: A person wishes to have a future sum of $100,000 for his son’s
education after 10 years from now. What is the single- payment that he should
deposit now so that he gets the desired amount after 10 years?
The bank gives compounded annually.
 Ans:100,000(0.2472)
 Ans: $24,720
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Interest Formulas and Application
 4. Equal-Payment Series Future Worth Amount: In this type of investment
mode, the objective is to find the future worth of n equal payments which are
made at the end of every interest period till the end of the n-th interest period at
an interest rate of i compounded at the end of each interest period.

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Interest Formulas and Application

 Example: A person who is now 35 years old is planning for his retired life. He
plans to invest an equal sum of $10,000 at the end of every year for the next 25
years starting from the end of the 35th year. The bank gives 20% interest rate,
compounded annually. Find the maturity value of his account when he is 60 years
old.
 Ans: F=10,000(F/A, 20%, 25)=10,000 X 471.981=$ 4,719,810 22
Interest Formulas and Application
 5. Equal-Payment Series Sinking Fund: In this type of investment
mode, the objective is to find the equivalent amount (A) that should
be deposited at the end of every interest period for n interest periods
to realize a future sum (F) at the end of the nth interest period at an
interest rate of i.

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Interest Formulas and Application
 …Equal-Payment Series Sinking Fund:

 Example: A company has to replace a present facility after 15 years at an outlay of

$500,000. It plans to deposit an equal amount at the end of every year for the next 15
years at an interest rate of 18% compounded annually. Find the equivalent amount that
must be deposited at the end of every year for the next 15 years.
 Ans: = 500,000 (A/F, 18%, 15)=500,000 X 0.0164= $ 8,200.

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Interest Formulas and Application
 6. Equal-Payment Series Present Worth Amount : The objective of this mode
of investment is to find the present worth of an equal payment made at the end
of every interest period for n interest periods at an interest rate of i compounded
at the end of every interest period.

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Interest Formulas and Application
 …Equal-Payment Series Present Worth Amount :

 Example: A company wants to set up a reserve which will help the company to have an
annual equivalent amount of $1,000,000 for the next 20 years towards its employees
welfare measures. The reserve is assumed to grow at the rate of 15% annually. Find the
single-payment that must be made now as the reserve amount.
 Ans: P =10, 00,000 X (P/A, 15%, 20)=1000,000 X 6.2593=$ 6,259,300
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Interest Formulas and Application
 7. Equal-Payment Series Capital Recovery Amount: The objective of this
mode of investment is to find the annual equivalent amount (A) which is to be
recovered at the end of every interest period for n interest periods for a loan (P)
which is sanctioned now at an interest rate of i compounded at the end of every
interest period.

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Interest Formulas and Application
 …Equal-Payment Series Capital Recovery Amount:

 Example: bank gives a loan to a company to purchase an

equipment
A worth $ 1,000,000 at an interest rate of 18% compounded annually. This
amount should be repaid in 15 yearly equal installments. Find the installment amount
that the company has to pay to the bank.
 Ans:A= 1000,000 X (A/P, 18%, 15)=10, 00,000 X (0.1964)=$196,400.
 The annual equivalent installment to be paid by the company to the bank is
$196,400
.
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The End !!
Thank You!