Module 1: Introduction

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Outline Module 1

What is Economics?
What is Engineering Economy?
The Role of Engineering in Shaping the
Economic Environment
Project Life Cycle
Some Concepts, Definitions and Terminologies
Time Value of Money
Interest and Interest Rate
Cash Flow

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

What is Economics?

The study of how limited resources are used

to satisfy unlimited human wants.
The study of how individual and societies
choose to use and utilize scarce resources
Resources:

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LAND all gifts of nature that can be applied to

the process (production)
LABOR efforts, skills, expertise, knowledge of
people which can be applied to the process
CAPITAL human, tools/machineries, financial

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

What is Engineering Economy?

Engineering and the Economy

Any endeavor, including engineering, will always have

consequences
Engineering endeavor

Add value betterment of effectiveness, efficiency, changing conditions

Add economic value the most common comparable measurement

Example:

Economic decisions

A piece of equipment has been used for 10 years as part of important

process. Current condition indicates that service level is slightly
decreasing, often breaks down. On the other hand the demand for
product is in constant increase, at least for the next 5 years.
Alternatives:

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Replace with a new one or to be repaired

Current and future technology (?)
Future demand (?)

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Engineering Economy

Engineering economy involves formulating,

estimating, and evaluating the expected
economic outcomes of alternatives designed
to accomplish a defined purpose.
Mathematical techniques simplify the
economic evaluation of alternatives.

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Engineering Economy

Deals with the concepts and techniques of analysis

useful for evaluating the worth of goods, services,
system in relation to cost
For engineers, it is used to answer questions such
as:

Which engineering projects are worthwhile?

Which engineering projects should have higher priority?
How should an engineering project be designed?

The answers based on the concepts of:

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Cash flows (cash in and cash out)

Interest rate and time value of money
Equivalent techniques
SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

The Role of Engineering in Shaping the

Economic Environment

Engineering Options

There are many (engineering) alternative solution for

any problem or challenge
What solution is best to satisfy? For now or anytime in
the future
How do we compare one to another?

Engineering Steps
1.
2.
3.
4.
5.
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Determine objectives
Identification of strategic factors
Determine means engineering proposals
Evaluation of engineering proposals cash flow of
alternatives
Decision making economic evaluation
SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

The steps in an engineering economy study are as

follows:
1. Identify and understand the problem; identify the
objective of the project.
2. Collect relevant, available data and defi ne viable
solution alternatives.
3. Make realistic cash fl ow estimates.
4. Identify an economic measure of worth criterion for
decision making.
5. Evaluate each alternative; consider noneconomic
factors; use sensitivity analysis as needed.
6. Select the best alternative.
7. Implement the solution and monitor the results.
8

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

(Engineering) Project Life Cycle

Concept &
Definition
Phase

Next Cycle

Design
Phase
Construction Phase

Operation & Maintenance Phase

Level of Change

scope

cost

Time
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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Time Value of Money

Purchasing or earning power of money

Funds borrowed for the prospects of gain are commonly

exchanged for goods, services or instruments of production,
that ultimately leads to increase earning

Time value of money

What you could buy with Rp. 1 million a year ago will not be
the same with the ones you buy today.
Rp. 1 million you invested in a bank a year ago will yield more
when you draw today.
Rp 1 million today is worth more than a year latter.
Concept of equivalence different sums of money at
different time can be equal in economic value.

Rp. 1 Mill

0
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P
1

n-1
SI-4251 Ekonomi Teknik

Rp. 1 Mill
+
interest

Muhamad Abduh, Ph.D.

Interest and Interest Rate

Interest is defined as a rental amount charged by financial
institution of the use of money
Interest rate (also known as rate of capital growth) is defined
as the rate gain received from an investment measured in %
Interest rate is determined mutual agreement between the
borrower and the lender, or by market forces involving supply
and demand market value.
From lenders point of view:

Involves risk of default

Compensate for not taking other alternative (including for own use)
Cost of investigating borrower and other administrative expenses
To make up for inflation

From borrowers point of view:

Based in ones utility, for personal use

Based on expected return, for financing operation or investment

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Basic Calculation of Interest

Rp. 1 Mill

P
1

n-1

Rp. 1 Mill
+
interest

Original investment present value (P)

Total accumulated amount future value
(F)
Interest , I = F P
Interest rate, i = (interest accrued per unit
time) / (original amount)

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Simple Interest

Simple interest = (principal)(number of periods)(interest rate), I = P.n.i

Accumulated amount, F = P + I = P(1+ni)

i=12%
End of
Period
(A)

Amount Owed
at Beginning of
Period
(B)

Interest
Charged
(C) = (B) x i

Amount Owed
at End of
Period
(D) = (B) + (C)

Amount
Paid at End
of Period

Rp. 1.000.000,-

Rp.
120.000,-

Rp.
1.120.000,-

Rp. 0

Rp. 1.120. 000,-

Rp.
120.000,-

Rp.
1.240.000,-

Rp. 0

Rp. 1.240.000,-

Rp.
120.000,-

Rp.
1.360.000,-

Rp. 1.360.000,1-14

Rp. 0
EXCEL
Rp.
Rp.
Rp.
SI-4251 Ekonomi
Teknik Muhamad1.480.000,Abduh, Ph.D.
120.000,1.480.000,-

Compound Interest

Compound interest interest will be charged for all unpaid amount

Accumulated amount, F = P(1+i)n

End of
Period
(A)

Amount Owed at
Beginning of
Period
(B) = (C)n-1

Interest
Charged
(C) = (B) x i

Amount Owed at
End of Period
(D) = (B) + (C)

Amount Paid
at End of
Period
(E)

Rp. 1.000.000,-

Rp. 120.000,-

Rp. 1.120.000,-

Rp. 0,-

Rp. 1.120. 000,-

Rp. 134.400,-

Rp. 1.254.400,-

Rp. 0,-

Rp. 1.254.400,-

Rp. 150.528,-

Rp. 1.404,928-

Rp. 0,-

Rp. 1.404.928,-

Rp. 168.592,-

Rp. 1.573.519,-

End of
Period

Amount Owed at
Beginning of
Period

Interest
Charged

Rp.
Amount Owed at End1.573.519,of
Period

Pi

P + Pi

= P (1+i)1

P(1+i)

P(1+i) i

P(1+i) 1 + P(1+i)i

= P (1+i) 2

P(1+i) 2

P(1+i) 2i

P(1+i) 2 + P(1+i) 2.i

= P (1+i) 3

P(1+i) n-1

P(1+i) n-1i

P(1+i) n-1 + P(1+I) n1

i

= P(1+i) n

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SI-4251 Ekonomi Teknik

EXCEL

Muhamad Abduh, Ph.D.

Exercise for Concept of Equivalence

Loan: $ 5,000, i = 8%, n = 5

Repayment plans:

Plan 1: Simple interest, pay all at end.

Plan 2: Compound interest, pay all at end.
Plan 3: Simple interest paid annually, principal
repaid at end.
Plan 4: Compound interest and portion of principal
repaid annually.
Plan 5: Equal payments of compound interest and
principal made annually.

EXCEL

16

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Cash Flows

Any undertaking and/or business endeavor

(including engineering projects) generally have
economic consequences that occur over an
extended period of time.
Each project is described as cash received (inflow
cash in) or disbursement or expenses (outflow
cash out) at different point in time.
Cash Flow Diagram (CFD) summarizes the costs
and benefits of engineering project over time.
CFD illustrates the size, sign and timing of
individual cash flows and form as the basis for
engineering economic analysis
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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Cash Flows Diagram

In a CFD the end of period t is the same as
the beginning of next period t+1
The choice of time 0 is arbitrary. It can be
when the project is analyzed, when funding
is approved or when the construction
begins

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Homework #1
1.What will be the accumulated amount of Rp 1.750.000,compounded annually for three years at the rate of 15% p.a?

2.How much do you have to save now if youd like to have

Rp. 12.500.000,- to start a new company 3 years
from now at the interest rate of 12% per year?

3.What is the rate of return of an initial investment worth Rp.

30 millions that yield Rp. 45.000.000,- after 3 years?

4.An initial investment of Rp. 50 millions is being considered.

The revenues from this investment are Rp 20
millions at the end of first year, Rp 25 millions and Rp 15
millions at the end of second and third years. If the
alternative will give a revenue of Rp 57,5 millions at the end
of the third year, which investment would you recommend?
The interest rate is set at 10% annually.
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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.