Engineering Economic

Decisions

Dr. Esam Alhomaidhi

Department of Systems Engineering: Industrial
Engineering

First Semester (231)

ISE 307 Engineering Economics analysis

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 Definition of Engineering
Economy
 Engineering economics is the application of economic approaches in
evaluating engineering alternatives.

 Engineering economy also refers to the study of the economic and

financial factors which influence industry.

 Engineering economy includes the study of accounting practices for

manufacturing concerns, i.e. process costing, batch costing, cost
allocation, etc.
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 Why Economics to
Engineers??

Engineers are the people who are familiar with all the technicalities of
machinery and production. Therefore they are the best judges of the
useful lives of an asset and they also have the technical knowledge to
calculate the number of units a proposed plant would produce.
Engineers can recommend quality control check points and they can
introduce cost effective measures more effectively.
Engineers are able to give the precise break up of all variable and
fixed costs relating to each marginal unit produced.

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 Why Economics to Engineers??

 In order to perform all these functions with the ultimate objective of

making a profit for the organization it is necessary for engineers to
know financial analysis and evaluation methodologies.

 Engineering economics focuses on those economic and financial

aspects which affect the decision-making capacity of the engineer.

 The purpose of teaching economics to engineers is to enable them

assessing the feasibility of projects, estimating its values and
returns, and justifying the accomplishment of a given project
from the viewpoint of engineering.
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Applications
Engineering economy is a useful tool that facilitates the decision making process
in any of these situations;

• Business Environment: A small manufacturing company needs to buy a forklift

truck for material handling. Two different brands, say A and B, are being
considered. Which truck should be bought? The decision will probably be based
on two conflicting objectives; minimization of cost and maximization of
efficiency.

• Non-profit Organizations: A project for widening a two lane highway to four

lanes is being considered by the county board. A four lane highway may reduce
the traffic accident rate but is expected to lower property values in the
immediate neighborhood of the highway. Should the proposed highway be
built? The county board must weigh the relative benefit of lower accident rates
against the possible loss in value of homes as well as the construction cost.

• Individual decisions: A new college graduate needs a new car. Should this new
car be bought or leased? Methods from engineering economy can be used for
determining the best choice.
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 Applications: Real world
example

In December of 2004, Japan Airlines (JAL) announced that it would purchase

30 7E7 aircraft from Boeing Co. to replace aging Boeing 767s and Airbus
A300-600s. The planes, which carry a per-unit list price* of $120 million, are
to be delivered starting in 2008. Six planes are to be delivered at the end of
years 2008 through 2012. If the annual rate of interest is 12.5% and list prices
are paid, what is the present worth of this transaction?

*List price: the price of an article as shown in a list issued

by the manufacturer or by the general body of
manufacturers of the particular class of goods. 7
 Basic terminology (1)
• Interest: It is the cost of having money available for use.
• Time Value of Money: It is a fact that money makes money. This
concept explains the change in the amount of money over time for both
owned and borrowed funds.
• Economic Equivalence: A combination of time value of money and
interest rate that makes different sums of money at different times have
equal economic value.
• Cash Flow: The flow of money into and out of a company, project, or
activity. Revenues are cash inflows and carry a positive (+) sign;
expenses are cash outflows and carry a negative (−) sign. +
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−
 Basic terminology (2)
• End-of-Period Convention: To simplify calculations, cash flows (revenues and
costs) are assumed to occur at the end of a time period.

• Opportunity Cost: A forgone opportunity caused by the inability to pursue a

project. Numerically, it is the largest rate of return of all the projects not funded
due to the lack of capital funds. Stated differently, it is the return of the first
project rejected because of unavailability of funds.

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 Rational Decision-Making
Process (Value)

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

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 Which Car to Lease?
Saturn vs. Honda

1. Recognize a decision problem • Need a car

2. Define the goals or objectives
• Want mechanical
3. Collect all the relevant security/ minimum cost,
information etc..
4. Identify a set of feasible • Gather technical as well
decision alternatives as financial data
5. Select the decision criterion • Choose between Saturn
to use and Honda
6. Select the best alternative • Want minimum total cash
outlay (cost)
• ?
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Data Required to Make an
Economic Decision – an example
of auto leasing

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 Which Car to Lease?
Saturn vs. Honda

1. Recognize a decision problem • Need a car

2. Define the goals or objectives
• Want mechanical
3. Collect all the relevant security/ minimum cost,
information etc..
4. Identify a set of feasible • Gather technical as well
decision alternatives as financial data
5. Select the decision criterion • Choose between Saturn
to use and Honda
6. Select the best alternative • Want minimum total cash
outlay (cost)
• Select Honda
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 Difference between
economic decisions and
other design decisions

 Design decisions are basically based on physical properties, principles

of chemistry and physics, engineering design correlations while
economic decisions are based on forecasting future product sales,
selling prices, and various cost over a time period.

 Design decisions are time invariant while economic decisions are

not necessarily time invariant, due to the errors in forecasting.

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 Predicting the Future

• Estimating a required investment

• Forecasting a product demand

• Estimating a selling price

• Estimating a manufacturing cost

• Estimating a product/equipment life

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 Two Factors in
Engineering Economic
Decisions

The factors of time and uncertainty

are the defining aspects of any
engineering economic decisions.

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 Engineering Economic
Decisions
Making capital budgeting decisions is a primary function of an engineer

Design Manufacturing Profit

Planning Investment
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Marketing
 Types of engineering
economic decisions

 The term engineering economic decision refers to all investment

decisions relating to engineering projects.

 The five main types of engineering economic decisions are;

(1) new product and product expansion

(2) equipment and process selection
(3) cost reduction
(4) equipment replacement
(5) service improvement

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 1- New Products/Product Expansion

Two types of expansion decisions

1- Decisions about expenditures to increase the output of an existing
facility. Is it better to build or acquire a new facility/factory?

2- Decisions about expenditures to produce a new product/derivative or

to expand into a new geographic area.

Example:
Investment in iPad A4 chip is estimated to be $1 billion. The cost for Apple
to build the $500 base model is $229.35.
Will there be enough demand (return on investment)?
Will it repeat iPhone history (successful product)?
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 2- Equipment, labors and Process
Selection

 What material will be used for manufacturing a given product?

 What kind of labors skills is required for a given manufacturing

process or a service?

 Which of several items of proposed equipment/technology shall

we purchase for a given purpose?

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3- Cost Reduction

• Deciding whether to produce in-house or to buy from a

supplier in order to reduce the total production cost. (make-or-
buy analysis/decision)

• The expected future cash inflows from cost reduction decisions

are savings from lower operating costs.

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Make or Buy Example

B & S Company manufactures several lines of pressure washers. One

unique part, an axial cam, requires specialized tools that need to be
replaced. Management has decided that the only alternative to
replacing these tools is to acquire the axial cam from an outside
source. B & S’s average usage of the axial cam is 120,000 units
each year over the next five years. Make or Buy ?

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Axial cam
4- Equipment replacement

• This decision involves considering the cash outflows

necessary to replace obsolete equipment.

• Due to market competitions and changes in

technology, company’s may decide to retire an existing
equipment before it worn out.

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5- Service or Quality Improvement

• Investments in this category includes any activities

that improve the productivity, quality, or customer
satisfaction in service sector, such as banking,
healthcare, insurance, security, etc…

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 Four Fundamental
Principles in Engineering
Economics
• An earlier dollar is worth more than a later dollar
 A fundamental concept in engineering economics is that
money has a time value associated with it.
 Because we can earn interest on money received today, it is
better to receive money earlier than later.

• All that counts is the differences among alternatives

 To avoid regret about the opportunity costs.

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 Four Fundamental
Principles in Engineering
Economics
• Marginal revenue must exceed marginal cost
 Any increased economic activity must be justified based on
the fundamental economic principle.
 The marginal revenue is the additional revenue made
possible by increasing the activity by one unit

• Additional risk is not taken without expected

additional return.
The purpose of teaching economics to engineers is to enable them assessing
the feasibility of projects (decisions), estimating its values, costs, and
returns, and justifying the accomplishment of a given project from the
viewpoint of engineering.
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