Engineering Economics

November 3, 2004

Engineering Economy
It deals with the concepts and techniques
of analysis useful in evaluating the worth
of systems, products, and services in
relation to their costs

Engineering Economy
It is used to answer many different
questions
Which engineering projects are worthwhile?
Has the mining or petroleum engineer shown that
the mineral or oil deposits is worth developing?

Which engineering projects should have a

higher priority?
Has the industrial engineer shown which factory
improvement projects should be funded with the
available dollars?

How should the engineering project be

designed?
Has civil or mechanical engineer chosen the best
thickness for insulation?

Basic Concepts
Cash flow
Interest Rate and Time value of money
Equivalence technique

Cash Flow
Engineering projects generally have economic
consequences that occur over an extended
period of time
For example, if an expensive piece of machinery is
installed in a plant were brought on credit, the simple
process of paying for it may take several years
The resulting favorable consequences may last as
long as the equipment performs its useful function

Each project is described as cash receipts or

disbursements (expenses) at different points in
time
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Categories of Cash Flows

The expenses and receipts due to
engineering projects usually fall into one of
the following categories:
First cost: expense to build or to buy and install
Operations and maintenance (O&M): annual
expense, such as electricity, labor, and minor
repairs
Salvage value: receipt at project termination for
sale or transfer of the equipment (can be a
salvage cost)
Revenues: annual receipts due to sale of products
or services
Overhaul: major capital expenditure that occurs
during the assets life
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Cash Flow diagrams

The costs and benefits of engineering
projects over time are summarized on a cash
flow diagram (CFD). Specifically, CFD
illustrates the size, sign, and timing of
individual cash flows, and forms the basis for
engineering economic analysis
A CFD is created by first drawing a
segmented time-based horizontal line,
divided into appropriate time unit. Each time
when there is a cash flow, a vertical arrow is
added pointing down for costs and up for
revenues or benefits. The cost flows are
drawn to relative scale
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Drawing a Cash Flow Diagram

In a cash flow diagram (CFD) the end of period t is the
same as the beginning of period (t+1)
Beginning of period cash flows are: rent, lease, and
insurance payments
End-of-period cash flows are: O&M, salvages, revenues,
overhauls
The choice of time 0 is arbitrary. It can be when a project
is analyzed, when funding is approved, or when
construction begins
One persons cash outflow (represented as a negative
value) is another persons inflow (represented as a
positive value)
It is better to show two or more cash flows occurring in the
same year individually so that there is a clear connection
from the problem statement to each cash flow in the
diagram
8

An Example of Cash Flow Diagram

A man borrowed $1,000 from a bank at 8%
interest. Two end-of-year payments: at the
end of the first year, he will repay half of the
$1000 principal plus the interest that is due.
At the end of the second year, he will repay
the remaining half plus the interest for the
second year.
Cash flow for this problem is:
End of year
0
1
2

Cash flow
+$1000
-$580 (-$500 - $80)
-$540 (-$500 - $40)
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Cash Flow Diagram

$1,000

$580

$540

10

Time Value of Money

Money has value
Money can be leased or rented
The payment is called interest
If you put $100 in a bank at 9% interest for one time
period you will receive back your original $100 plus $9

Original amount to be returned = $100

Interest to be returned = $100 x .09 = $9
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Compound Interest
Interest that is computed on the original
unpaid debt and the unpaid interest
Compound interest is most commonly
used in practice
Total interest earned = In = P (1+i)n - P
Where,
P present sum of money
i interest rate
n number of periods (years)
I2 = $100 x (1+.09)2 - $100 = $18.81
12

Future Value of a Loan With

Compound Interest
Amount of money due at the end of a loan
F = P(1+i)1(1+i)2..(1+i)n or F = P (1 + i)n
Where,
F = future value and P = present value
Referring to slide #10, i = 9%, P = $100 and say n=
2. Determine the value of F.
F = $100 (1 + .09)2 = $118.81

13

Notation for
Calculating a Future Value
Formula:
F=P(1+i)n is the
single payment compound amount factor.

Functional notation:
F=P(F/P,i,n) F=5000(F/P,6%,10)
F =P(F/P) which is dimensionally correct.

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Notation for
Calculating a Present Value
P=F(1/(1+i))n=F(1+i)-n is the
single payment present worth factor.

Functional notation:
P=F(P/F,i,n) P=5000(P/F,6%,10)
Interpretation of (P/F, i, n): a present sum P,
given a future sum, F, n interest periods
hence at an interest rate i per interest
period
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Spreadsheet Function
P = PV(i,N,A,F,Type)
F = FV(i,N,A,P,Type)
i = RATE(N,A,P,F,Type,guess)
Where, i = interest rate, N = number of interest
periods, A = uniform amount, P = present sum
of money, F = future sum of money, Type = 0
means end-of-period cash payments, Type =
1 means beginning-of-period payments,
guess is a guess value of the interest rate
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Equivalence
Relative attractiveness of different
alternatives can be judged by using the
technique of equivalence
We use comparable equivalent values of
alternatives to judge the relative
attractiveness of the given alternatives
Equivalence is dependent on interest rate
Compound Interest formulas can be
used to facilitate equivalence
computations
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Technique of Equivalence
Determine a single equivalent value at
a point in time for plan 1.
Determine a single equivalent value at
a point in time for plan 2.
Both at the same interest rate and at the same time point.

Judge the relative attractiveness of the

two alternatives from the comparable
equivalent values.
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Engineering Economic Analysis

Calculation
Generally involves compound interest
formulas (factors)
Compound interest formulas (factors) can
be evaluated by using one of the three
methods
Interest factor tables
Calculator
Spreadsheet

19

Given the choice of these two plans

which would you choose?
Year
0
1
2
3
4
5
Total

Plan 1
$1,000
$1,000
$1,000
$1,000
$1,000
$5,000

Plan 2
$5,000

$5,000

To make a choice the cash flows must be altered

so a comparison may be made.

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Resolving Cash Flows to Equivalent Present

Values
P = $1,000(PA,10%,5)
P = $1,000(3.791) =
$3,791

P = $5,000
Alternative 2 is better
than alternative 1 since
alternative 2 has a
greater present value
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An Example of Future Value

Example: If $500 were deposited in a bank
savings account, how much would be in
the account three years hence if the bank
paid 6% interest compounded annually?
Given P = 500, i = 6%, n = 3, use F =
FV(6%,3,,500,0) = -595.91
Note that the spreadsheet gives a
negative number to find equivalent of P. If
we find P using F = -$595.91, we get P =
500.
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An Example of Present Value

Example 3-5: If you wished to have
$800 in a savings account at the end of
four years, and 5% interest we paid
annually, how much should you put into
the savings account?
n = 4, F = $800, i = 5%, P = ?
P = PV(5%,4,,800,0) = -$658.16
You should use P = $658.16

23

Economic Analysis Methods

Three commonly used economic analysis
methods are
Present Worth Analysis
Annual Worth Analysis
Rate of Return Analysis

24

Present Worth Analysis

Steps to do present worth analysis for a
single alternative (investment)
Select a desired value of the return on
investment (i)
Using the compound interest formulas bring
all benefits and costs to present worth
Select the alternative if its net present worth
(Present worth of benefits Present worth of
costs) 0

25

Present Worth Analysis

Steps to do present worth analysis for
selecting a single alternative (investment)
from among multiple alternatives
Step 1: Select a desired value of the return on
investment (i)
Step 2: Using the compound interest formulas
bring all benefits and costs to present worth
for each alternative
Step 3: Select the alternative with the largest
net present worth (Present worth of benefits
Present worth of costs)
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Present Worth Analysis

A construction enterprise is investigating the
purchase of a new dump truck. Interest rate is
9%. The cash flow for the dump truck are as
follows:
First cost = $50,000, annual operating cost =
$2000, annual income = $9,000, salvage value
is $10,000, life = 10 years. Is this investment
worth undertaking?
P = $50,000, A = annual net income = $9,000 $2,000 = $7,000, S = 10,000, n = 10.
Evaluate net present worth = present worth of
benefits present worth of costs
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Present Worth Analysis

Present worth of benefits = $9,000(PA,9%,10) =
$9,000(6.418) = $57,762
Present worth of costs = $50,000 +
$2,000(PA,9%,10) - $10,000(PF,9%,10)=
$50,000 + $2,000(6..418) - $10,000(.4224) =
$58,612
Net present worth = $57,762 - $58,612 < 0 do
not invest
What should be the minimum annual benefit for
making it a worthy of investment at 9% rate of
return?
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Present Worth Analysis

Present worth of benefits = A(PA,9%,10)
= A(6.418)
Present worth of costs = $50,000 +
$2,000(PA,9%,10) - $10,000(PF,9%,10)=
$50,000 + $2,000(6..418) $10,000(.4224) = $58,612
A(6.418) = $58,612 A = $58,612/6.418
= $9,312.44

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Cost and Benefit Estimates

Present and future benefits (income) and
costs need to be estimated to determine
the attractiveness (worthiness) of a new
product investment alternative

30

Annual costs and Income for a Product

Annual product total cost is the sum of
annual material, labor, and overhead
(salaries, taxes, marketing expenses,
office costs, and related costs), annual
operating costs (power, maintenance,
repairs, space costs, and related
expenses), and annual first cost minus the
annual salvage value.
Annual income generated through the
sales of a product = number of units sold
annuallyxunit price
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Rate of Return Analysis

Single alternative case
In this method all revenues and costs of
the alternative are reduced to a single
percentage number
This percentage number can be compared
to other investment returns and interest
rates inside and outside the organization

32

Rate of Return Analysis

Steps to determine rate of return for a
single stand-alone investment
Step 1: Take the dollar amounts to the same
point in time using the compound interest
formulas
Step 2: Equate the sum of the revenues to the
sum of the costs at that point in time and
solve for i

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Rate of Return Analysis

An initial investment of $500 is being
considered. The revenues from this
investment are $300 at the end of the first
year, $300 at the end of the second, and
$200 at the end of the third. If the desired
return on investment is 15%, is the project
acceptable?
In this example we will take benefits and
costs to the present time and their present
values are then equated
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Rate of Return Analysis

$500 = $300(PF, i, n=1) + 300(PF, i, n=2) +
$200(PF, i, n=3)
Now solve for i using trial and error method
Try 10%: $500 = ? $272 + $247 + $156 = $669
(not equal)
Try 20%: $500 = ? $250 + $208 + $116 = $574
(not equal)
Try 30%: $500 = ? $231 + $178 + $91 = $500
(equal) i = 30%
The desired return on investment is 15%, the
project returns 30%, so it should be
implemented
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