Engineering Economy

“the art of decision making”

HWRE-5103
Hydraulic and Water Resources Engineering
2024

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 Lecture 1
INTRODUCTION

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 Engineering Economics
Science is a field of study where the basic principles of different physical
systems are formulated and tested. Engineering is the application of
science.

Engineering economics deals with the methods that enable one to take
economic decisions towards minimizing costs and/or maximizing benefits
to business organizations 3
 Basic Principles in Engineering Economics

Quantifying alternatives for easier decision making

 Engineering economy, quite simply, is about determining the
economic factors and the economic criteria utilized when one or
more alternatives are considered for selection.
 Another way to define engineering economy is a collection of
mathematical techniques which simplify economic comparisons.
 The role of engineering economics is to assess the appropriateness of
a given project, estimate its value, and justify it from an engineering
standpoint.

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 Role of Engineering Economy in Decision Making

 There is a popular procedure used to address the development and

selection of alternatives. Typically the steps in the approach are as

follows:

Steps to problem solving

1. Understand the problem and goal
2. Collect relevant information
3. Define the alternative solution
4. Evaluate each alternative
5. Select the best alternative using certain criteria
6. Implement the solution and monitor the result.
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 Project Concept

A project is undertaken for a particular goal or objective to be achieved

within a limited period of time and with limited resources (manpower,
money, etc.).
A project is characterized by:
 A construction period
 An operational period
 (expected) life time
 Specific desired output (benefits)
 Use of scarce and valuable resources and/or undesired outputs
 Sometimes a well defined target.
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 CONT..
Different scholars classify project period into different phases:
 Project identification
 Project formation and preparation
 Project appraisal
 Project implementation
 Project monitoring and evaluation
Projects are classified into:
1. Private owned
2. Public or state owned
This distinction is closely related to the nature of goods and
services in terms of excludability and subtractibility.
Excludability: the degree to which users can be excluded.
Subtractibility: the degree to which consumption by one user
reduces the possibility for consumption by the others. 7
 Element of cost

 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 labor cost, and direct expenses.
 The overhead cost can be classified into factory overhead,
administration overhead, selling overhead, and distribution
overhead.
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 CLASSIFICATION OF COST

Economic analyses may be based on a number of cost classifications:

1. First (or Initial) Cost : Cost to get activity started.
2. Operation and Maintenance Cost : are experienced continually over the useful
life of the activity.
3. Fixed Cost : are relatively constant; they are decoupled from the system
input/output,
4. Variable Cost : are related to the level of operational activity
5. Incremental or Marginal Cost : is the additional expense that will be incurred
from increased output in one or more system units /the cost of producing an
additional unit of that product.

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 Cont…..
Example: Let the cost of producing 20 units of a product be Rs. 10,000, and the
cost of producing 21 units of the same product be Rs. 10,045. Then the marginal
cost of producing the 21st unit is Rs. 45
6. Sunk Cost : It cannot be recovered or altered by future actions. Usually this cost
is not a part of engineering economic analysis/ This is known as the past cost of
an equipment/asset.
Let us assume that an equipment has been purchased for Rs. 1,00,000 about three
years back. If it is considered for replacement, then its present value is not Rs.
1,00,000
7. Life-Cycle Cost : is cost for the entire life-cycle of a product, and includes
feasibility, design, construction, operation and disposal costs.

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Fundamentals of Engineering Economy
• Engineering economy is the process of formulating,
estimating, and evaluating the expected economic
outcomes of alternatives designed to accomplish a defined
purpose
• It follows the following principles;
– Develop the Alternatives
– Focus on the Differences
– Use a Consistent Viewpoint
– Use a Common Unit of Measure
– Consider All Relevant Criteria
– Make Uncertainty Explicit
– Revisit Your Decisions
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Fundamentals of Engineering Economy
• Engineering economy is not a method or
process for determining what the alternatives
are.
• On the contrary, engineering economy begins
only after the alternatives have been identified.
– If the best alternative is actually one that the
engineer has not even recognized as an alternative,
then all of the engineering economic analysis tools
will not result in its selection.

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Fundamentals of Engineering Economy
• Alternatives
– An alternative is a stand-alone solution for a given situation
• May be mutually exclusive or independent
• Cash Flow
– estimated inflows (revenues) and outflows (costs) of money
• High uncertainty in estimating future values
• Alternative Selection
– Every situation has at least two alternatives
– In addition to the one or more formulated alternatives, there is always the
alternative of inaction, called the do-nothing(DN) alternative
• Evaluation Criteria
– Money
• Intangible Factors(none economic factors, market pressure, laws,
personal interests ,availability of certain resources etc)
• Time Value of Money 13
 Interest rates, Rate of Return &MARR
• Interest is the manifestation of the time value of money, and it
essentially represents “rent” paid for use of the money.
– Always two sides to it…..paid and earned

• When interest over a specific time unit is expressed as a

percentage of the original amount (principal), the result is
called the interest rate or rate of return (ROR)

• The time unit of interest rate is interest period

– 1 year is the most common interest period but smaller durations are
also possible
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 Interest rate, rate of Return & MARR
• Example 1
An employee at a company borrows $10,000 on
May 1 and must repay a total of $10,700 exactly 1
year later. Determine the interest amount and the
interest rate paid.
The perspective here is that of the borrower since
$10,700 repays a loan.

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 Interest rate, rate of Return & MARR
• Example 2
– A record company plans to borrow $20,000 from a
bank for 1 year at 9% interest for new recording
equipment.
• Compute the interest and the total amount due after 1
year.
Compute the total interest accrued

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 Interest rates, Rate of Return &MARR
• A reasonable rate must be established so that the
accept/reject decision on engineering projects can be
made.
• The reasonable rate, called the minimum attractive rate of
return(MARR) must be
– higher than the cost of money used to finance the alternative,
– higher than the rate that would be expected from a bank or safe
(minimal risk) investment

• Note that the MARR is not a rate calculated like the ROR;
MARR is established by financial managers and is used as a
criterion for accept/reject decisions 17
 Simple and Compound Interest
• Simple interest, interest calculated using the principal
only, ignoring any interest accrued in preceding
interest periods.
– The total simple interest over several periods is computed as

• Compound interest, the interest accrued for each

interest period is calculated on the principal plus the
total amount of interest accumulated in all previous
periods.
– Now the interest for one period is calculated as

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 Simple and Compound Interest
• Example 3
– A bank lent an engineering company $100,000 to
retrofit an environmentally unfriendly building.
The loan is for 3 years at 10% per year simple
interest. How much money will the firm repay at
the end of 3 years?

For Compound interest, Total due = 100,000(1+0.1)3=133,100

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 Nominal and Effective Interest Rates
• If the interest rate is compounded more than once
in the payment period, it is referred to as nominal
interest rate, r
r= interest rate per period x number of periods
• Frequencies such as semiannually, quarterly,
monthly, weekly, daily or even continuously are all
possible
• In such a case the nominal value need to be
changed to an effective interest rate for use in
computations
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 Nominal and Effective Interest Rates
• The equation for converting a nominal interest
rate into an effective interest rate is

Where
i is the effective interest rate for a
certain period,
r, is the nominal interest rate for
that period
m, is the number of times interest
is compounded in that same period 21
 Nominal and Effective Interest Rates
• If we allow compounding to occur more and more frequently,
the compounding period becomes shorter and shorter.
• Then m, the number of compounding periods per payment
period, increases.
• As m approaches infinity, the effective interest rate reduces to

Effective continuous interest rate

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 Nominal and Effective Interest Rates
• Interest statements and interpretations

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 Nominal and Effective Interest Rates

• Example 4
– A Visa credit card issued through Commercial bank carries
an interest rate of 1% per month on the unpaid balance.
1. Calculate the effective rate per semiannual period.
2. If the card’s interest rate is stated as 3.5% per quarter, find the
effective semiannual and annual rates.

The nominal rate r=1%*6=6%

Number of compounding periods,
m=6 and using the equation

i=6.15%
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 Some TerminologyOne&timeSymbols
occurrences
• The equations and procedures of engineering economy
utilize the following terms and symbols. Sample units
The same amount each
are indicated. period and extends
– P, amount of money at a time designatedthrough
as theconsecutive
present, t=0
interest periods
– F, value or amount of money at some future time, t
– A, a series of equal consecutive end-of-period amount of
money
– n, number of interest periods; years, months or days
– i, interest rate, rate of return per time period
– t, time stated in periods Compound
interest assumed
unless specified
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 Some Terminology & Symbols
• Example 5
– You plan to make a lump-sum deposit of $5000 now into an
investment account that pays 6% per year, and you plan to
withdraw an equal end-of-year amount of $1000 for 5 years,
starting next year. At the end of the sixth year, you plan to
close your account by withdrawing the remaining money.
Define the engineering economy symbols involved.

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 Cash Flows
• Cash flows are inflows(revenue and income) and outflows
(cash disbursements—expenses, and costs) of money.
– These cash flows may be estimates or observed values
• The direction of the arrows on the cash flow diagram is
important.
– A vertical arrow pointing up indicates a positive cash flow.
– Conversely, an arrow pointing down indicates a negative cash
flow

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 Cash Flows
• The end-of-period convention means that
– all cash flows are assumed to occur at the end of
an interest period
• i.e. When several receipts and disbursements occur
within a given interest period, the net cash flow is
assumed to occur at the end of the interest period

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 Cash Flows
• Example 6
– Plot the cash flow for Example 5
P=$5000 I = 6%

1 2 3 4 5 F

A=$1000

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 Gradient Cash Flows
• Sometimes the cash flows that occur in consecutive
interest periods are not the same amount (not an A
value), but they do change in a predictable way.
• These cash flows are known as gradients, and there are
two general types:
• Arithmetic Gradient, G
– An arithmetic gradient is one wherein the cash flow changes
(increases or decreases) by the same amount in each period.
• Geometric Gradient, g
– A geometric gradient series is a cash flow series that either
increases or decreases by a constant percentage each period.
The uniform change is called the rate of change
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 Shifted Cash Flows
• When a uniform series begins at a time other
than at the end of period 1, it is called a
shifted series

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 Economic Equivalence
• In engineering economy, the time value of money
and the interest rate help develop the concept of
economic equivalence,
– Which means that different sums of money at
different times would be equal in economic value
• For example, if the interest rate is 6% per year, $100 today
(present time) is equivalent to $106 one year from today.
• We can apply the same logic to determine equivalence for
previous years
• A total of $100 now is equivalent to $100/1.06 = $94.34
one year ago at an interest rate of 6% per year

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