Bicol University

COLLEGE OF ENGINEERING
Legazpi City

Introduction to Engineering
MODULE 1
Economics
Overview
This module covers a brief introduction to engineering economics, its fundamental concepts
and principles, its importance in the decision-making process, and its applications.

Lesson Objectives
At the end of this lesson, the student should be able to:
1. Define engineering economics and identify areas of application;
2. Understand the principles of engineering economy;

Lesson Outline
1. Introduction
2. Principles of Engineering Economics
3. Engineering Economics and the Design Process

1.1. Introduction
Engineers seek solutions (or alternatives) to various problems as they arise, and the
economic viability of each potential alternative is normally considered along with the

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 Introduction to Engineering Economics [BES 12] Engineering Economics

technical aspects. Considering the economic aspect of an alternative assures the proper
allocation of limited resources.
The Accreditation Board for Engineering and Technology states that engineering is “is
the profession in which a knowledge of the mathematical and natural sciences gained by
study, experience, and practice is applied with judgment to develop ways to utilize,
economically, the materials and forces of nature for the benefit of mankind.*” [emphasis
supplied] In this definition, it is clear that the economic part of engineering practice must is
of great importance. Therefore, engineers must use knowledge, creativity and innovation to
find ways of performing tasks and building things economically.
To simply put, engineering economics is economic decision-making for engineering
systems. Engineering economics is the heart of making decisions. It is all about deciding
among alternatives – which among the alternatives is best for the long-term interests of the
organization. Problems involving money are easier to understand and solve with a concrete
knowledge of the engineering economic decision-making processes.

Engineering economics is a subset of economics concerned with the use of economic principles
to systematically evaluate alternatives in the analysis of engineering decisions. Fundamentally,
it involves formulating, analyzing, synthesizing, and evaluating expected economic outcomes of
alternatives designed to accomplish a defined purpose. It is not a method for determining or
identifying the alternative. On the contrary, engineering economics begins only after the
alternatives have been identified.

Engineering economics deals with economic factors, focusing primarily on three

fundamental factors – costs, revenues and benefits. Everything that engineers design calls
for spending money in the design and building stages, and only after the completion of the
project will revenues or benefits occur.

1.2. Principles of Engineering Economics

We define the foundation of engineering economics to a set of seven fundamental
principles that help provide a comprehensive doctrine for doing engineering economic
analysis.

PRINCIPLE 1 Develop the Alternatives

*
Accreditation Board of Engineering and Technology, Criteria for Accrediting Programs in Engineering in the United States
(New York; Baltimore, MD: ABET, 1998)

2 KIM ARVIN P. LEOCAD IO, REE OLIV ER M. PADUA, CE

Instructor | kapleocadio@bicol-u.edu.ph Instructor | ompadua@bicol-u.edu.ph
[BES 18] Engineering Economics 1.2 Principles of Engineering Economics

Carefully define the problem, and determine feasible alternatives to

address the problem. The alternatives need to be identified and then
defined for subsequent analysis.

The decision is among the alternatives. Carefully defining and understanding the
problem, and developing feasible alternatives for detailed evaluation are of great
importance to the decision-making process because it impacts the quality of the decision.

PRINCIPLE 2 Focus on the Differences

Differences in expected future outcomes among the alternatives are
relevant to their comparison and should be considered in the decision.

Only the differences in the future outcomes of the alternatives are important.
Outcomes that are common to all alternatives can be disregarded in the comparison and
decision. For example, if in a particular equipment purchase, the price is the same, it is
inconsequential to your final choice. Instead, the decision would depend on other factors,
such as durability, performance and efficiency.

PRINCIPLE 3 Use a Consistent Viewpoint

The prospective outcomes of the alternatives, economic and other,
should be valuated from the same defined viewpoint (or perspective).

Alternatives need to be valuated from the same point of view. Costs and benefits
will not be the same for everyone, therefore, in conducting an analysis, the decision
maker’s point of view is commonly used. For example, in a particular building
construction project, the contractor is concerned on minimizing costs and therefore will
opt to purchase materials (not jeopardizing the specifications stated in the contract) of
lower price, while the user of will be primarily concerned with the quality of the building.
It is important to ensure that projects are compared from the same viewpoint.

PRINCIPLE 4 Use a Common Unit of Measure

Using a common unit of measurement will simplify the analysis of the
alternatives, and consequently simplify the decision-making process.

A common unit of measure ensures that the prospective outcomes are

commensurable (directly comparable). For economic consequences, a monetary unit is

KIM ARV IN P. LEOCADI O, R EE OLIVER M. PAD UA, CE 3

Instructor | kapleocadio@bicol-u.edu.ph Instructor I | ompadua@bicol-u.edu.ph
Introduction to Engineering Economics [BES 12] Engineering Economics

the common preferred measure. It is beneficial to quantify expected future results for
direct comparisons. However, if this is not possible, describe the consequences explicitly
so that the information can be considered in the comparison of alternatives.

PRINCIPLE 5 Consider All Relevant Criteria

Selection of a preferred alternative (decision making) requires the use
of a criterion (or several criteria). The decision process should consider
long-term and short-term consequences to confirm that the project is
feasible.

Considering all relevant criteria is critical to estimating the true cost and projecting
the future outcomes of the project. Alternatives must be selected so as to best serve the
long-term financial interests of the organization. However, there are also other
organizational objectives that needs to be considered and given weight in the selection
of an alternative. These nonmonetary attributes and multiple objectives become the
basis for additional criteria in the decision-making process.

PRINCIPLE 6 Make Risk and Uncertainty Explicit

Risk and uncertainty are inherent in estimating the future outcomes of
the alternatives and should be recognized in their analysis and
comparison. Express where the uncertainties situate and perform
analysis to quantify risk associated with these uncertainties.

Risks and uncertainties are massive parts of the analysis of alternatives. Future
outcomes of any course of action are uncertain, putting in any course of action a
considerable amount of risk. For example, chances are today’s estimates or projections
on future expenses and cash receipts will not eventually occur. Therefore, dealing with
risks and uncertainties is an important aspect of engineering economic analysis.

PRINCIPLE 7 Revisit Decisions

Improved decision-making results from an adaptive process. Make a
comparison of the actual results achieved to the initial projected
outcomes of the selected alternative to improve the process of future
analysis.

4 KIM ARVIN P. LEO CAD IO, R EE OLIV ER M. PADUA, CE

Instructor | kapleocadio@bicol-u.edu.ph Instructor | ompadua@bicol-u.edu.ph
[BES 18] Engineering Economics 1.2 Principles of Engineering Economics

The comparison of actual results to the initial projected outcomes for the selected
alternative may be considered impracticable and not worth the effort, but is of great
importance to ensure that the future analyses and the quality of decision making are
improved.

KIM ARV IN P. LEOCADI O, R EE OLIVER M. PAD UA, CE 5

Instructor | kapleocadio@bicol-u.edu.ph Instructor I | ompadua@bicol-u.edu.ph
 Introduction to Engineering Economics [BES 12] Engineering Economics

1.3. Engineering Economics and the Design Process

An engineering economic study involves the use of a structured procedure and
mathematical modeling techniques, incorporating the basic principles discussed in
Section 1.2. We represent this procedure in terms of the seven steps listed in the left-hand
column of Table 1 below. The seven-step procedure is also used to assist decision making
within the engineering design process, shown in the right-hand column of the table
(illustrated in Figure 1).

TABLE 1 THE GENERAL RELATIONSHIP BETWEEN THE ENGINEERING ECONOMIC ANALYSIS PROCEDURE
AND THE ENGINEERING DESIGN PROCESS

Source: Sullivan, W.G., Wicks, E.M., & Koelling, C.P. Engineering Economy, Sixteenth Edition. p.7

Figure 1. The Engineering Design Process

The procedure will be discussed in the subsections that follow.

1.3.1. Problem Definition

6 KIM ARVIN P. LEOCAD IO, REE OLIV ER M. PADUA, CE

Instructor | kapleocadio@bicol-u.edu.ph Instructor | ompadua@bicol-u.edu.ph
[BES 18] Engineering Economics 1.4 Engineering Economics and the Design Process

The first step in the engineering economic analysis is problem definition. Carefully
defining the problem is greatly important since it serves as the basis for the analysis. The
problem must be well understood and stated in explicit before proceeding with the rest
of the analysis.
Recognition of the problem is normally stimulated by internal or external
organizational needs or requirements. An operating problem within a company (internal
need) or a customer expectation about a product or service (external requirement) are
examples.
Once the problem is recognized, it must be clearly defined and viewed from a
systems perspective – the boundary or extent of the problem, its elements and its
environment must be carefully defined.

1.3.2. Development of Alternatives

After clearly defining and understanding what the problem is, we then need to
develop feasible alternatives. By feasible, we mean that each alternative, based on
preliminary evaluation, meets or exceeds the requirements to respond to the problem.
Thus, the development of alternatives involves two actions – (1) searching for potential
alternatives and (2) screening these potential alternatives to select feasible alternatives
for detailed analysis.

1.3.3. Development of Prospective Outcomes

This step in the economic engineering analysis incorporates Principles 2, 3 and 4 in
Section 1.2, and uses the basic cash-flow approach.
Cash flow, to simply define, is cash (or cash equivalents) entering or leaving an
organization or individual. A cash flow occurs when cash (or cash equivalents) is
transferred from one organization or individual to another. The net cash flow for an
alternative is the difference between all cash inflows (cash entering, i.e. income) and cash
outflows (cash leaving, i.e. expense).

1.3.4. Selection of a Decision Criterion

The fourth step of the engineering economic analysis is the selection of a decision
criterion. This incorporates Principle 5 (defined in Section 1.2). The decision must be
selected so as to best serve the long-term interests.

KIM ARVIN P. L EOCAD IO, R EE OLIV ER M. PADUA, CE 7

Instructor | kapleocadio@bicol-u.edu.ph Instructor I | ompadua@bicol-u.edu.ph
Introduction to Engineering Economics [BES 12] Engineering Economics

1.3.5. Analysis and Comparison of Alternatives

Analysis and comparison of alternatives, the fifth step in the engineering economic
analysis, is based primarily on cash-flow estimates for the feasible alternatives selected
for detailed study. A substantial effort is required to obtain reasonably accurate forecasts
of cash flows and other factors. Consideration of future uncertainties (Principle 6) will
be an integral part of the study. When cashflow and the other required estimates are
determined, comparison of alternatives based on their differences (as called for by
Principle 2) may be performed. Usually, these differences will be quantified in terms of
monetary value.

1.3.6. Selection of the Preferred Alternative

After accomplishing the first five steps of the engineering economic analysis, the
selection of the preferred alternative is done based upon the results obtained. The course
of action is determined and recommended for implementation.

1.3.7. Performance Monitoring and Post-evaluation of Results

This final step in the engineering economic analysis implements Principle 7, and is
accomplished during and after the collection of results from the selected alternative.
Monitoring project performance during its operational phase improves the achievement
of related goals and objectives, and reduces the variability of the desired results. This
final step is also a follow-up step to a previous analysis, comparing actual results
achieved with previously estimated outcomes. Understanding how everything turns out,
the results achieved, relative to the projected outcomes will help with future decision-
making processes.
EXAMPLE 1 The Engineering Economic Analysis Procedure

Engr. Lunas bought a small apartment building as an investment for Php 6,000,000 near
Bicol University College of Engineering. He spent Php 1,000,000 of his own money for the
purchase of the building and obtained a mortgage from a local bank for the remaining
Php 5,000,000. The annual mortgage payment to the bank is Php 600,000.
Engr. Lunas also expects the annual maintenance of the building and grounds to be Php
750,000. There are four apartment units (two bedrooms each) in the building that can
each be rented for Php 20,000 per month.
a. Does your Engr. Lunas have a problem with his investment? If so, what is it?

8 KIM ARVIN P. LEOCAD IO, REE OLIV ER M. PADUA, CE

Instructor | kapleocadio@bicol-u.edu.ph Instructor | ompadua@bicol-u.edu.ph
 [BES 18] Engineering Economics 1.4 Engineering Economics and the Design Process

b. What are his alternatives? (Identify at least three.)

c. Estimate the economic consequences and other required data for the
alternatives in Part (b).
d. Select a criterion for discriminating among alternatives, and use it to advise
Engr. Lunas on which course of action to pursue.
e. Attempt to analyze and compare the alternatives in view of at least one
criterion in addition to cost.
f. What should Engr. Lunas do based on the information you and he have
generated?

SOLUTION:

a. Doing a quick calculation on the given data:

INCOME:
4 × Php 20,000 × 12 = Php 960,000
EXPENSE:
Php 600,000 (mortgage) + 750,000 (maintenance) = Php 1,350,000
NET INCOME = Php 960,000 – 1,350,000 = (Php 390,000)*

The calculations show that Engr. Lunas loses Php 390,000 every year. The
problem could possibly be that the monthly rent is low!
b. Solution 1. Raise the rent. (Will the market bear an increase?)
Solution 2. Lower the maintenance expenses. (but not so far as to cause
safety issues)
Solution 3. Sell the apartment building.
Solution 4. Abandon the building. (bad for reputation!)

c. Solution 1. To breakeven, the monthly revenue should cover the monthly

expenses, that is, Php 1,350,000 / 12 months = Php 112,500/month for the
four apartment units or Php 112,500 / 4.units = Php 28,125/month per unit.
Therefore, there must be at least a Php 28,125 – 20,000
= Php 8,125/month per unit increase in rent (about a 40% increase in rent!).
Solution 2. Another option to breakeven is to lower the monthly expense, that
is, in this case, can be primarily accomplished by lowering the monthly
maintenance costs (because unless there’s a favorable refinancing

* Parentheses denote profit loss.

KIM ARVIN P. L EOCAD IO, R EE OLIV ER M. PADUA, CE 9

Instructor | kapleocadio@bicol-u.edu.ph Instructor I | ompadua@bicol-u.edu.ph
Introduction to Engineering Economics [BES 12] Engineering Economics

opportunity, we can do nothing to lower the annual mortgage cost). The

annual maintenance costs must be reduced to Php 960,000 – 600,000 = Php
360,000 (that’s a 60% reduction in the maintenance costs!).
Solution 3. Try to sell the apartment to breakeven on the venture. That is, the
Php 1,000,000 capital plus the losses incurred, equal to Php 390,000/12 =
Php 32,500 per month, during the time the investment was owned and
operated.
Solution 4. A “not so good for reputation” option is to abandon the building
(walking away from the investment). Surely, opting to consider this option
will probably prevent more losses to be incurred but also mean that previous
losses will be unrecovered. The bank would likely foreclose the property,
and even might try to collect fees and/or penalties.

d. One criterion could be to minimize the expected loss of money. In this case, Engr.
Lunas may opt to either raise the rent (Solution 1) or try to sell the property
(Solution 3). Solution 2, lowering the maintenance costs, will surely be not an
option because it might jeopardize the safety of his tenants (that means, possible
lawsuits!). Solution 4, on the other hand, to simply put, is bad for business as it
will surely harm Engr. Lunas’ credit rating.

e. If we consider “credit worthiness” as an additional criterion to costs, then aside

from Solution 4, Solution 3 can now be ruled out as it can harm Engr. Lunas’
credit rating. Therefore, only Solution 1 would probably be an acceptable
alternative.

f. Engr. Lunas can do a market survey, of comparable housing, on the average

amounts of rent in the area to see if the rent could feasibly be raised. Probably,
minor renovations can be done to the building to make it more appealing to
prospective renters, keeping 100% occupancy on the four apartment units
despite an increase in rent.

10 KIM ARVIN P. LEOCAD IO, REE OLIV ER M. PADUA, CE

Instructor | kapleocadio@bicol-u.edu.ph Instructor | ompadua@bicol-u.edu.ph