Chapter 1 Introduction to

ENGINEERING ECONOMY

In this course, you will learn:

The fundamentals of engineering economy (time value of money, rate of return, economic equivalence) To perform the steps in the economic decision making process

To financially evaluate engineering projects under certainty, risk, uncertainty, and multiple options Numerous methods in which to determine the best choice from a feasible set with multi-attributes

To solve a variety of problems dealing with capital investments

You will appreciate:

The difficulty of making a capital investment decision. The risk associated with capital investments. The level at which most companies invest. The variety of industries affected by engineering. The entire decision-making process.

An engineering economist draws upon the accumulated knowledge of engineering and economics:

Devoted to problem solving / decision making at operational level Identify alternative uses of limited resources Select preferred course of action through evaluations using mathematical model and cost data

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 DECISION MAKING MODEL

When we are making a choice in problem solving activities in organization, we are supposed:

To know all the possible alternatives of action. To foresee the consequences (or the probabilities of the consequences) that will arise from the final choice of each alternative. Have a complete system of preference, enabling us to rank all consequences from the most to the least preferred, thus making an optimal choice.

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Rational Model of Decision Making Consists of a Structured Four-step Sequence:

identifying the problem generating alternative solutions

selecting a solution
implementing and evaluating the solution

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Rational Decision-Making Model

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Example: Charlene selects a Pump

Charlene is a newly hired chemical engineer. She has been asked to select a pump to move 15,000 liters of slurry a day to the pollution treatment centre. What process should she use to select the pump?

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SOLUTION:
1.

Define problem: Slurry characteristics size of particles, corrosiveness Pipe size, flow velocities of input and output Any restrictions on the size, power and location Time horizon, how soon it is needed Cost limits Vendor selection process Choose objectives: Life cycle cost and technical performance Vendor and pump reliability Maintainability, flexibility for changed conditions
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1.

1.

1.

1.

Identify alternatives: Purchased from catalogue or other vendor material Develop alternative specification and request for purchase Evaluate consequences: Charlene must evaluate each alternatives advantages and disadvantages with respect to the objectives. Select Charlene must select a pump based on costs and benefits. Technical performance objectives must be completely satisfied, so that any pump with deficiencies is eliminated from consideration.

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1.

1.

Implement The pump must be ordered, installed, tested and commissioned. Audit This step evaluate the pump and the decision-making process after the pump is in use. The intent is to provide lesson learned to assist future decisions.

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 Every

technical solution has financial consequences. Engineering economic analysis determines whether a proposed solution is financially viable.
Will it pay? Is this the minimum cost solution? Will it generate an acceptable return?

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Engineering project must be: physically realizable economically affordable

Economic factors of a design weigh heavily in the design process.

Engineering economy is an integral part of that process.

Engineering, without economy, makes no sense at all.
(building LRT system in the city of Ipoh . . . physically possible, but is it economically viable?)
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Bi-environmental nature of engineering

Engineers are confronted with two important environment, the physical and the economic environment.

Engineers must operate successfully in both sectors and be able to cope effectively with the bi-environmental nature of engineering application. Efficiency (physical) = output / input
Efficiency (economic) = worth / cost
[benefit/cost]

In final evaluation of most venture, economic efficiencies must take precedence over physical efficiencies.
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Power plant is profitable in economic terms even though its physical efficiency in converting units of energy in coal to electrical energy is relatively low.
Conversion of coal to electrical energy physical efficiency = 36 %

economic efficiency = worth/cost = 36 % x $14.65/$1.80 = 293 %

(OUTPUT Btu: electricity energy has economic worth of $14.65 per million Btu, INPUT Btu: Coal has economic cost of $1.80 per million Btu)

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 WHAT IS ENGINEERING ECONOMY ?

It is the dollars-and-cents side of the decisions that engineers make or recommend as they work to position a firm to be profitable in a highly competitive marketplace. Do its benefits exceed its costs ? Involves systematic evaluation of the economic aspect of the proposal Involves significant technical considerations and technical analysis To demonstrate a positive balance of long-term benefits over long-term costs

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Inherent in these decisions are tradeoffs between costs and performance [such as response time, safety, weight, reliability] provided by the proposed design or solution Engineering Economy balance this tradeoffs so that the solution or design is economically acceptable and affordable to meet the needs Engineering Economy consists of techniques for assessing the worth of prospective projects, investments opportunities, or design choices. The reason for worth assessment is to support decisions.
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 WHAT IS INVESTMENT Two categories:

FINANCIAL INVESTMENT: investors allocate their resources

to some form of financial instrument [stocks or bonds]. A deposit in a savings account at a bank is also an investment.

REAL INVESTMENT (capital investment): investment in

physical asset such as new plant, new equipment, expansion of an existing facility.

Two different factors involved: time and risk. Sacrifice takes place in the present and is certain. Reward comes later, if at all, and the magnitude is uncertain. Our primary concern is with real (capital / project) investments.
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 Any

propose investment requires evaluation to ensure or indicate, with reasonable confidence, that the expected benefits exceed costs.
This economic evaluation is variously referred to as economic analysis, or economic decision analysis. The application of this economic analysis techniques in the comparison of engineering design alternatives is referred to as engineering economy.
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 Strategic Engineering Economic Decisions

Project ideas can be classified as:

Discretionary (to generate added profit): New product development, product/service capacity expansion, new equipment and process selection Sustaining investment (preventing loss of profit): Service or quality improvement, cost reduction/control, equipment replacement. Policy or non-economic reasons: such as items required by law, waste treatment facilities, safety to meet regulations or prevent disasters.
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Profit Enhancing Examples

Posco (Korea) said it would invest $12 billion to build an integrated steel plant in India --- capacity of 12 million tons/yr. Matsushita and Toray (Japan) will invest 180 billion yen to build a plasma display panel (PDP) plant, increasing production by 6 million panels/yr. Cargill (USA) announced a $20 million investment to increase capacity of liquid chocolate and a production line for chocolate flakes, drops and chunks in Mouscron, Belgium.

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Cost Control Examples

Union Pacific, North Americas largest railroad, purchased 98 Rail Power hybrid road switcher locomotives (Green Goats). The base price is $750K, but a 20-40% reduction in diesel fuel use and greenhouse gas emissions are expected.
Union Pacific announces plan to reduce pollution, Associated Press Newswires, October 16, 2005. Vaccaro, A., Rail Power Corners Locomotive-Switcher Market, Dow Jones Newswires, June 9, 2005.

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 Public

Improvement Programs: government entities also make capital expenditures.

Increased public satisfaction Increased public safety Improved infrastructure

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 Role of Engineers in Engineering Economic Decisions

In manufacturing, Engineers involved in the production of products, from conceptual design to the shipping. Engineering decisions account for the majority of the product costs. Consider the effective use of capital assets (building, machinery, equipment). Plan for the acquisition of equipment (capital expenditure) to enable the firm to design and produce products economically.

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 Need to estimate the cash flows that the

assets will generate during its service period. Inaccurate estimates of asset needs can have serious consequences to the profitability of the firm.

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 The importance of Engineering Economic Decision Analysis

Companies

must invest to grow. Companies must invest to improve. Investments cost (lots of) money!
Economic Analysis considers the economic viability of each and every investment project such that money is made, not lost.

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The Difficulty of Engineering Economic Decision Analysis

Investments

carry risk. Money spent now for expected savings or returns in the future.
As future is uncertain, so are returns or savings. Money spent can be lost. If too often, could lead to bankruptcy.

While economics are paramount, many other factors influence decision (non-monetary). What are
the other factors?

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 WHY IS ENG ECO IMPORTANT

Some key questions that need to be addressed: For Manufacturing activities Should a manufacturing plant produce a part in its production facility, knowing that major investment will be needed in new equipment and that expensive training procedures will have to be implemented, or should the plant subcontract to an outside vendor? Should automation replace the existing process

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For individuals

The owner of a wholesale distribution centre seeks to improve her delivery service in order to meet competition. To do so, she can buy or rent more trucks, subcontract deliveries, open additional outlets, and/or improve the handling facilities. Capital is limited, and the outlook for increased volume is uncertain. Which alternative should be selected. Doing nothing is always one possible alternative.
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 APPARENT CHARACTERISTICS OF THE QUESTIONS

Two characteristics are apparent in the questions :
1.

Each deals with a choice among alternatives

2. All involves economic considerations

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 PRINCIPLES OF ENGINEERING ECONOMY

Firstly, the problem (opportunity) to be solved has to be recognized and the needs have to be identified. Then the following principles shall be followed: Develop (identify and define) the alternatives Focus on the differences of the expected future outcomes among the alternatives Use consistent viewpoint Use a common unit of measure Consider all relevant criteria Recognize the uncertainty of the future outcomes Revisit your decisions (compare the actual results)
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Explain the reasons for the need to focus only on the differences in the expected future outcomes among the alternatives in the engineering economic analysis.

Sample answer: If the prospective outcomes of the feasible alternatives were exactly the same, there would be no basis or need for comparison. In this case decision can be made by random selection. For example, two feasible housing alternatives are two residences with same purchase price of RM150,000. In this case, price would be inconsequential to the final choice. Instead, decision would depend on other factors such as location, design of the house, etc.

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 SEVEN-STEP ECONOMIC ANALYSIS PROCEDURE

Problem (opportunity) recognition, definition, and evaluation Development of the feasible alternatives Development of prospective outcomes (use the basic cash flow approach employed in Engineering Economy) Selection of a Decision Criterion Analysis and comparison of alternatives Selection of the preferred alternative Performance monitoring and post-evaluation of results
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The General Relationship between the Engineering Economy Analysis Procedure and the Rational Decision-making Process
Engineering Economic Analysis Procedure Step1. Problem recognition, definition, and evaluation Step 2. Development of the feasible alternative Rational Decision-making Process Activity 1. Problem identification Activity 2. Identification of objectives with respect to problem Activity 3. Comprehensive search for alternative course of action alternatives

Step 3. Development of the outcomes and cash flows Activity 4. Objective evaluation of for each alternative Step 4. Selection of a criterion (or criteria) Step 5. Analysis and comparison of the alternatives Step 6. Selection of the preferred alternative Step 7. Performance monitoring and post-evaluation of results

Activity 5. Selection of alternative most likely to achieve objectives Activity 6. Implementation of chosen course of action Activity 7. Monitoring consequences with respect to objectives Activity 8. If unsatisfactory, repeat process as necessary
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Decision Step
1. Problem recognition and definition. 2. Generation of solution alternatives. 3. Cost and cash-flow estimation. 4. Economic evaluation. 5. Selection and implementation.

Engineering Field of Study

Engineering design Organizational behavior Human factors Engineering design Work measurement systems Statistics (regression, forecasting) Accounting Engineering economy Operations research Engineering economy Statistics and probability Operations research Simulation Information systems (data-base)

6. Post-implementation evaluation

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 Examples of decisions supported by Engineering

Economy calculation
1.

2.

3.

A chemical engineer determines the appropriate diameter of a pipeline, knowing that a greater diameter will decrease pumping costs throughout the life of the line but will increase purchase and installation costs. A warehouse manager reviews stock levels of various stocked items, wanting to minimize the sum of holding costs and stock out costs. A mechanical engineer determines the appropriate balance between adding insulation to a building and increasing the capacity of its cooling plant.
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1.

A corrosion engineer estimates whether it is better to use stainless steel and replace a tank every five years or use carbon steel and replace it every three years.

5. An electrical engineer estimates the costs of installing capacitor bank to alleviate the phase lag that lowers power factor and leads to high electricity bill.

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Discussion
1.

2.

3.

4.

Why is the study of engineering economy by engineers and technologists more important today than in the past? Explain the role of economic considerations in product competitiveness. Why should the economic interpretation of engineering proposals be made by engineers? Discuss some of the moral (non-monetary) issues or obligation that should be considered by engineers in the analysis of engineering proposals.

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Discussion Q1:
1.

Why is the study of engineering economy by engineers and technologists more important today than in the past?

Prerequisite of successful engineering application is economic feasibility Intense economic competition Sustainable competitive advantage in the marketplace

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Discussion Q2:
1.

Explain the role of economic considerations in product competitiveness.

View in the context of product life cycle.

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Discussion Q3:
1.

Why should the economic interpretation of engineering proposals be made by engineers? View and elaborate from the engineering process involved in analyzing an engineering proposal: Determination of objective Identification of strategic factors Determination of means Evaluation of engineering proposal Assistance in decision making

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Discussion Q4:
1.

Discuss some of the moral (non-monetary) issues or obligation that should be considered by engineers in the analysis of engineering proposals.
Your views may include the following points: Political stability Welfare of employees: morale, quality of life, stability, etc Prestige Safety and Environmental considerations Sustainable development Product specification minimal compliance / exceeding specifications Future considerations Taking personal responsibility Engineering decisions engineers take professional responsibility

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 Group Assignment #1
Size of group: max 4 students) Review the contents of the business section of Malaysian newspaper namely the Star, New Straits Times, Edge (Malaysia) for the past weeks. Select (in the form of paper cutting) three (3) business investment decisions (for each type of strategic engineering economic decisions discussed in Chapter 1) that appeared in the news. Justify your answer.
(Submit this assignment not later than 2nd June 2011)
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