Engineering Economic Decisions

Fundamentals of Engineering Economics

Chan S. Park Copyright @ 2013….. THIRD EDITION

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Definition of Engineering Economics
Engineering Economics
• Application of engineering and mathematical analysis to decision making in
economics.
• The knowledge and techniques concerned with evaluating the worth of products
relative to their cost.
• Analysis of the economics of engineering alternatives.
[McGraw-Hill Dictionary of Scientific & Technical Terms, 6th edition, McGraw-
Hill, New York, 2003]

Economics is the study of the production and consumption of goods and the transfer of
wealth to produce and obtain those goods.
(from www.whatiseconomics.org)

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 We, as individuals or businesspersons, constantly make decisions in our
daily lives.
We make most of them automatically, without consciously recognizing that we
are following a logical decision.

Rational decision making can be a complex process that contains decision-

making essential elements. Instead of presenting some rigid rational decision-
making processes, we will provide examples of how two engineering students
approached their financial as well as engineering design problems.

By reviewing some examples, we will be able to identify some essential elements

common to any rational decision-making process.

The first example illustrates how a student named Monica narrowed down her
choice between two competing alternatives when buying an automobile.

The second example illustrates how a typical class-project idea evolves and how
a student named Sonya approached the design problem by following a logical
method of analysis.

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Engineering economics,

previously known as engineering economy, is a subset of

economics concerned with the use and "application of economic
principles" in the analysis of engineering decisions.

that it studies the behaviour of individuals and firms in making

decisions regarding the allocation of limited resources. Thus, it
focuses on the decision making process, its context and environment.

It is pragmatic by nature, integrating economic theory with

engineering practice. such as price determination, competition and
demand/supply.

As a discipline though, it is closely related to others such as

statistics,
mathematics and
cost accounting.

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 It draws upon the logical framework of economics but adds to
that the analytical power of mathematics and statistics.

Engineers seek solutions to problems, and the economic viability

of each potential solution is normally considered along with the
technical aspects.
Fundamentally,
engineering economics involves formulating, estimating,
and evaluating the economic outcomes when alternatives to
accomplish a defined purpose are available.

Considering the time value of money is central to most

engineering economic analyses. Cash flows are discounted using
an interest rate, except in the most basic economic studies.

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For each problem, there are usually many possible alternatives.

The opportunity cost of making one choice over another must also
be considered.

There are also non-economic factors to be considered, like

colour, style, public image, etc.; such factors are termed attributes.

Costs as well as revenues are considered, for each alternative,

for an analysis period that is either a fixed number of years or the
estimated life of the project.
The salvage value is often forgotten, but is important, and is
either the net cost or revenue for decommissioning the project.

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Some other topics that may be addressed in engineering economics are inflation,
uncertainty,
replacements,
depreciation,
resource depletion,
taxes, tax credits,
accounting, cost estimations, or capital financing.
All these topics are primary skills and knowledge areas in the field of cost
engineering.

Since engineering is an important part of the manufacturing sector of the economy,

engineering industrial economics is an important part of industrial or business
economics.

Major topics in engineering industrial economics are: The economics of the

management, operation, and growth and profitability of engineering firms;
Macro-level engineering economic trends and issues;
Engineering product markets and demand influences; and
The development, marketing, and financing of new engineering technologies and
products.

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Why engineering economics essential for engineering
graduates (need or purpose)

✓ In today’s competitive world of business,

it has become essential that engineers should practice financial project
analysis for engineering projects and make rational decisions.
(rational = based on or in accordance with reason or logic.
Ex. I am sure there's perfectly rational explanation)

✓ Engineering economy also includes

the study of accounting practices for manufacturing concerns.
Unique features of accounting for manufacturing concerns are
process costing,
batch costing,
cost allocation.

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◼ Engineering economy deals with justification and selection of projects.
Many engineers work on projects which address a specified activity or
a problem. Any decision regarding the project must be justified.

◼ In business environments, many of them not all, decisions are justified using
monetary criteria such as “profit”. Such decisions are made at the
managerial level and many engineers become managers in manufacturing
environment.

◼ Therefore,
all engineers, regardless of their employment,
should know methods and tools used in evaluation of projects.

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❖ The purpose of engineering economy is to
expose all engineering students to the methods
which are widely used for evaluation of projects.

❖ Even though, engineering economy deals mostly with

selection of projects in business environment,
the tools and methods can be and
are used by individuals
and

non-profit organizations such as government, hospitals, and

charitable entities, etc.

Hint: Profit or financial gain…

a financial gain, especially the difference between the amount earned and the amount spent in
buying, operating or producing something.

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 SOME EXAMPLES
✓ Let us present few examples in different environments where engineering
economy can facilitate the decision-making process.

✓ Business Environment(Profit organization):

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
minimization of cost.
✓ 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.

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✓ Individuals:
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.

✓ Economic factors are as important as regard for

the physical laws and science that determine
what can be accomplished with engineering.

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❑ Physical Environment:
Engineers produce products and services depending on physical laws.
Physical efficiency takes the form:
System output(s)
Physical (efficiency) = -------------------------
System input(s)

❑ Economic Environment:
Much less of a quantitative nature is known about economic
environments -- this is due to economics being involved with the
actions of people, and the structure of organizations. Economic environment
means cost, investment, production planning, taxes, interest rate, etc.

❑ Satisfaction of the physical and economic environments is linked through

production and construction processes.
Engineers need to manipulate systems to achieve a balance in attributes in both the
physical and economic environments, and within the bounds of limited resources.

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◼ Following are some examples where engineering economy plays a
crucial role:

1. Choosing the best design for a high-efficiency gas furnace

2. Selecting the most suitable robot for a welding operation on an
automotive assembly line
3. Making a recommendation about whether jet airplanes for an overnight
delivery service should be purchased or leased
4. Considering the choice between reusable and disposable bottles for
high-demand beverages

◼ With items 1 and 2 in particular, note that coursework in engineering should

provide sufficient means to determine a good design for a furnace, or a
suitable robot for an assembly line, but it is the economic evaluation that
allows the further definition of a best design or the most suitable robot.

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 Engineering Economics
Overview
• Rational Decision-Making Process
• Economic Decisions
• Predicting Future
• Role of Engineers in Business
• Large-scale engineering projects
• Types of strategic engineering economic
decisions

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Rational Decision-making process:

◼ Rational decision making is often a complex process that includes several essential
elements
◼ Some essential elements common to any rational decision-making process
◼ 1. Whether we are going to purchase a new car or leased,
◼ 2. How typical class project idea evolves and how a student approached the design
problems by a logical method of analysis.
◼ Rational means a set of reasons or logical basis for a course of action

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✓ 1. Recognize a decision in problem: How do we make typical personal decisions?
✓ For Jane William, a senior at the university of Arizona, the future holds a new car.
✓ Her 2002 Saturn has clocked almost 150,000 miles, and she wants to replace it soon.
✓ But how to do it should she buy or lease?
✓ In either case, “car payments would be difficult”, said a manager, who works as a part time
cashier at local market.
✓ I have never leased before, but I am learning toward it this time to save on the down payment.
✓ I also don’t want to worry about major repair.
✓ Also, for Jane William, leasing would provide the warranty protection, she wants along with a
new car every three years.
✓ On the other hand, she would be limited to driving only, a specified number of miles, about
12,000 per year, after would have to 20 cents or more per mile.
✓ Jane understands that choosing the right vehicle and the best possible financing is an
important decision.
✓ Yet at this point, jane is unsure of the implication of buying versus leasing.

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✓ 2.Establishing the goal or objectives: Define the goal or objectives
✓ Jane decided to research the local paper, and she try to get special incentive packages.
✓ Which one is within the budget 2024 Ford Focus or 2024 Honda civic
✓ But both are appeared to be equally attractive in terms of style, price and option.

✓ 3. Collect the relevant information's

✓ Jane decided to visit the deals
✓ And see how both models looked and take them for test drive
✓ Both can give her very satisfactory driving experience
✓ Jane thoroughly examine the many technical and safety features of both vehicles.
✓ After her examination both models were virtually identical in terms of reliability, safety
features and quality.

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✓ 4. identify a set of feasible decision alternatives.
✓ 2024 Saturn could be traded on for around $2,200 (only that amount is enough for down
payment

✓ 5. Knowing other opportunities.

✓ By leasing, she would never experience the joy of the final payment, but she would
have a new car every three year.

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Rational Decision-Making Process

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 ◼ Need a car
problem
2. Define the goals or ◼ Want mechanical
objectives security
3. Collect all the relevant ◼ Gather technical as well
information as financial data
4. Identify a set of feasible ◼ Choose between
decision alternatives Saturn and Honda
5. Select the decision ◼ Want minimum total
criterion to use cash outlay
6. Select the best alternative ◼ Select Honda

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Financial Data Required to Make an Economic Decision

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Engineering Economic Decisions

Manufacturing Profit

Planning Investment

Marketing
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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 life

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Role of Engineers in Business

Create & Design

• Engineering Projects

Analyze Evaluate Evaluate

• Production Methods • Expected • Impact on

• Engineering Safety Profitability Financial Statements
• Environmental Impacts • Timing of • Firm’s Market Value
• Market Assessment Cash Flows • Stock Price
• Degree of
Financial Risk

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✓ What makes economic decision different from other design decisions:
✓ In a design situations, the engineers uses known physical properties, the principles of
chemistry, physics, engineering design, and engineering judgement to arrive at a
workable and optimal design.
✓ If the judgement is sound, the calculation are done correctly.
✓ In other words, engineering design to meet a particular need today, next year or in five
years’ time the financial design will not need to change significantly.

✓ In considering economic decision:

✓ The measurement of investment attractiveness, always involves predicting or
forecasting's, product sales, product selling price, various costs over some future time
frame.
✓ Economic decisions need to be based on the best information available at the time of
the decision and a through understanding the uncertainties in the forecasted data.

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✓ The decision-making role in business:

✓ What shall be role?

✓ What are the specific tasks?
✓ What are tools and techniques?
✓ Engineers are called upon to participate in variety of decision-making process, ranging
from manufacturing, and marketing to finances.

✓ Making capital expenditure decision:

✓ Engineering decision account for the majority of product costs. Engineers must
consider the effective use of fixed capital assets such as building and machinery.
✓ One of the primary task is to plan for the acquisition (purchase) of equipment.
✓ With purchase of any fixed asset – equipment or prediction about the future.

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✓ Large scale engineering economic decision:

✓ Let us consider the real-world engineering decision problem on a much larger scale.
(try to avoid the dependency from others. In USA, the move away from its dependency
on foreign oil, they commercialize cellulosic ethanol is apparent)

✓ Impact of engineering projects on financial statements:

✓ Financial statement provides the basis for future investment analysis
✓ In practice, we seldom make investment decision based solely on an estimate of
projects profitability, because we must also consider the projects overall impact on the
financial strength and position of the company.

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✓ Types of strategic engineering economic decision:
✓ 1. new product or product expansion
✓ 2. equipment and process selection
✓ 3. cost reduction,
✓ 4. equipment replacement
✓ 5. service or quality improvement.
✓ Can existing plant be used to achieve the new production level?
✓ Does the firm have the capital to undertake this new investment?
✓ Does the new proposal warrant the recruitment of new technical personnel?
✓ 1. New product or product expansion:
✓ Investment in this category are those that increase the revenue of a company if output
is increased.
✓ “shall we build or otherwise acquire a new facility?
✓ - expenditure necessary to produce a new product or to expand into a new geographic
area. (these needs large sums of money over long period)

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✓ 2.Equipment and process selection:
✓ Selecting the best course of action, when there are several ways to meet the project
requirements. Which of several proposed items of equipment shall we purchase for a
given purpose?

✓ 3.Cost reduction:
✓ We need to consider whether a company should buy equipment to perform an
operation now done manually or in some other way spend money now to save more
money later.

✓ 4.Equipment replacement:
✓ Considering the expenditure necessary to replace worn out or obsolete equipment.

✓ 5.Service or quality improvement:

✓ Economy dominates both gross domestic product and total employment. Its also the
fastest growing part of the economy and the one offering the most fertile opportunities
for productivity improvement.

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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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Summary

◼ The term engineering economic decision refers to all investment

decisions relating to engineering projects.
◼ The five main types of engineering economic decisions are:
(1) service improvement,
(2) equipment and process selection,
(3) equipment replacement,
(4) new product and product expansion, and
(5) cost reduction.
◼ The factors of time and uncertainty are the defining aspects of any
investment project.

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Fundamental principles(4):

Principle 1 : An earlier dollar is worth more than a later dollar

Principle 2: All that count is the differences among alternatives

Principle 3: Marginal revenue must exceed marginal cost

Principle 4: Additional risk is not taken without expected additional return

Principle 1 : An earlier dollar is worth more than a later dollar

Basic 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.
This concept will be the foundation for all engineering project evaluation.
(the most powerful force in the universe is compound interest)

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Principle 2: All that count is the differences among alternatives
An economic decision should be based on the differences among the alternatives . All that is common is irrelevant to the
decision. Therefore, an economic decision should be based on the objective of making the best use of limited resources.
The opportunity cost of a choice is the value of the best alternative given up.

Principle 3: Marginal revenue must exceed marginal cost

Any increased economic activity must be justified based on the above (marginal revenue must exceed marginal cost)
fundamental economic principle.
here, the marginal revenue is the additional revenue made possible by increasing the activity by one unit or a small unit.
Similarly marginal cost is the additional cost incurred by the same increase in activity.
Productive resources, such as natural resources, human resources, and capital goods available to make goods and services
are limited.

Principle 4: Additional risk is not taken without expected additional return

Investors demand a minimum return that must be greater than the anticipated rate of inflation or than any perceived risk

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1. What is Engineering economics?
Engineering economy (more focus on selection of alternatives) is a subset of engineering economics
concerned with the use and "application of economic principles" in the analysis of engineering decisions. Engineering
economics focuses on the decision making process, its context and environment.

2. What are the economic theory integrating with engineering practice?

Such as price determination, competition and demand/supply.

3. What are the discipline, closely related to engineering economics?

statistics, mathematics and cost accounting.

4. Time value of money?

that receiving $13.5 million today is likely to prove a better deal than taking
4,853,333 a year for 29 years. (or) should you buy something today or buy it later.

5.What is meant by alternatives or optimum?

opportunity or cost of making one choice over another must also be considered.

Optimum solution: for any kind of problem, i.e., decision making, having N type of solution are available. From the
among N solution, we choose any one of, according to our situation or sources.

What are topics that may addressed in engineering economics?

Inflation, uncertainty, replacement, depreciation, resource depletion, taxes, tax credits (incentive or refund),
accounting, cost estimation.

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Why engineering economics essential for engineering graduates?
Engineers should practice financial project analysis for engineering projects and make a
rational decision(accordance with reason or logic).
Engineering economics deals with justification and selection of projects.

Which is the main criteria in the business environment? (for taking decision making)
Profit is the main criteria to take decision in the business environment.

What are the non-profit organization?

Government, Government hospitals, charitable entities etc.,

Definition of profit?
It is financial gain, especially, difference between the amount earned and in the amount
spent in buying, operating or producing some thing.

What are the steps in engineering economics decision?

In personal decision:(How do we make)
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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What are major topics in engineering industrial economics?
The economics of the management, operation, growth and profitability of engineering firms.

How do we predict the future? (in engineering economics)

Estimating a required investment.
Forecasting a product demand.
Estimating a selling price.
Estimating a manufacturing cost.
Estimating a product life.

Role of engineers in business?

Create a design,
perform Analysis,
Evaluate

What are the five main types of strategic engineering economic decision are
Service improvement,
Equipment and process selection
Equipment replacement
new product and product expansion
Cost reduction.

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