Engineering Decision 3

Engineering Economics
Engr.Wajahat Maqbool
What is Engineering Economy?
• Engineering projects
– Use resources: raw materials, labor, money, time
– Can be undertaken in a variety of ways
• Choose one alternative to a problem
– Determine the economically best alternative
• Need to understand the relationship between
time and money
• In many decisions costs and benefits are the
most important factors
The Decision Making Process
• Define problem
• Choose objectives
• Identify alternatives
• Evaluate consequences
• Select the best
• Implement
• Audit results
Uncertainty and sensitivity
analysis
• Whenever people predict the future, errors
occur.
• Engineers estimate
– To control uncertainty, make sure the information
used is accurate
• Sensitivity analysis is to find how sensitive
the results are to the parameters defined in
the problem.
– It is an integral part of EE decisions since data
regarding future activities are always uncertain.
Principles of Engineering
Economics (EE)
• Develop the alternative
• Focus on the differences
• Use a consistent viewpoint
• Use a common unit of measure
• Consider all relevant criteria
• Make uncertainty explicit
• Revisit your decision
Engineering Economics Procedure
• Problem definition
• Development of alternatives
• Development of outcomes
• Selection of a decision criterion
• Analysis and comparison of alternatives
• Selection of the preferred alternative
• Performance monitoring and evaluation of
results
Example: EE procedure
• The management of a small furniture manufacturing
company is under pressure to increase profitability
in order to get a much needed loan from the bank to
purchase a more modern pattern-cutting machine.
One proposed solution is to sell waste wood chips
to a local manufacturer instead of using them to fuel
space heaters for the company’s office and factory
areas
– Define the company’s problem, next reformulate the
problem in a variety of creative ways
– Develop at least one potential alternative for your
reformulated problem
Accounting and EE
• Cost accounting is a subset of accounting
concerned with decision making and
control in a firm.
• Determines the cost of products or
services
– It is the source of some of the cost data that
are needed in EE studies
Summary
• Engineering Economy is defined as considering the time
value of money in the decision making process of
selecting alternative solutions for real projects
• If correctly done, it:
– states the consequences in a common measure
– only consider differences between alternatives
– makes separable decisions separately
– adopt a systems view
– use common planning horizon
• EE uses the proper steps in decision making
A Few Questions First
• Do you know what anything about the following?
• 1. The GNP (Gross National Product)
• 2. Investments
• 3. Macro and micro Economics
• 4. Accounting
• 5. Finance
• 6. Statistics
• 7. What salary you would like to make upon
• graduation
• 8. Why making a profit is important for all of us
• 9. Why is a company in business
The Economic Consequences
• Capital Investments have lives of 3-50 years or more
• Often the choice between alternatives is:
Which one is cheaper?
• Don’t mix technical with economic efficiency
• The concept of time value of money is fundamental
to Engineering Economy
• The main issue usually is the decision between
current value and expected future revenue streams
• Need to balance expenses now with revenues later
Engineering Economy is
Important
• The importance of money to engineering (or more
generally) any business undertaking) has been known
for a long time:
“engineering ... is the art of doing well with one dollar

which any bungler can do with two after a fashion”
- A. M. Wellington (1887)
• They say “cash is king”, so our approach is to deal with

the cash flows of a business as engineering requires it in
the firm.
What is Engineering Economy?
• Engineering projects
– Use resources: raw materials, labor, money, time
– Can be undertaken in a variety of ways
• Choose one alternative to a problem
– Determine the economically best alternative
• Need to understand the relationship between time and money
• In many decisions costs and benefits are the most important
factors
• Cost accounting is a subset of accounting concerned with
decision making and control in a firm.
– Determines the cost of products or services, it is the source
of some of the cost data that are needed in EE studies
Engineering Economy and
Decision Making
• All engineering projects use resources, such as raw
materials, money, labour, and time
• Engineering economy draws upon knowledge of
engineering and economics to address problems of
allocating scarce resources, selecting the preferred
course of action from several technically viable ones
• Quantitative methods to present and evaluate
economics of alternatives
• Primary purpose is to make informed decisions
• But remember that decision making is a multi level
effort with others being part of it - so selling your ideas
is a must in most instances.
Centre for Management of Technology and Course: Maqbool15
Engr.Wajahat
Making Decisions - the Decision
Pyramid
Preferences
Politics People
Facts
Statistics
research
opinion
History
Market
Expert
Costs
Principles for Decision Making
• The following principles will be applied to economic
evaluation of alternatives throughout this course:
1. State consequences in a common measure

2. Only differences between alternatives need be
considered
3. Separable decisions should be made separately
4. Adopt a systems viewpoint
5. Use a common planning horizon
The Environment for Decision
Making
1. The process involves parallel activities, feedback
loops and repeated steps
2. It is an iterative process and repeats as results are

refined
3. Communications skills are extremely important!
4. Each decision is one of many to be made
5. The organisation emphasises action rather than

analysis
6. Politics are very important!

To Deal with Abstraction: Model
Real
World
Analysis The Model Information

for decision
making
The Decision Making Process
• Real world is a “mess” of conflicting data, objectives,
timing, methods etc.
• A well structured decision making process is:
1. Define/formulate problem (opportunity), boundary
2. Choose objective(s)/set goals
3. Identify alternatives
4. Evaluate consequences
5. Apply criteria for selection
6. Select preferred course of action
7. Specify and implement solution, adjust as required
8. Audit/monitor results, revise as necessary
•
Decision Making
Why is it difficult to make decisions?
– Complexity
– Uncertainty
– Risk
– Conflicting objectives
– Multiple decision makers
– Conflicting data, undefined constraints, incomplete data
• Can decision making be improved??
The Problem Solving
Process
• Economic analyses are typically part of the overall
problem solving process.
• The "problem solver" is involved in performing five
steps, these are:
• 1. Formulation of the problem,

• 2. Analysis of the problem.
• 3. Search for alternative solutions to the problem.
• 4. Selection of the preferred solution.
• 5. Specification of the preferred solution.
• Step 4 is usually based on economic analyses
BUITEMS
Engineering Economics &

Management
Lecturer # 2
Basic Accounting Concepts
• Generally Accepted Accounting Principles
(GAAP)
>guidelines that set out the manner & form
for presenting accounting information
• Accrual Accounting
>the practice of recording economic
activity when recognized rather than
waiting until realized
Basic Accounting Concepts
(continued)
• Depreciation
>reduction in value of a fixed asset over
its expected life intended to reflect the
usage of wearing out of the asset -
doesn’t affect cash
• Accumulated Depreciation
>sum of all previous depreciation
amounts charged to fixed assets
Basic Balance Sheet Terms &
Concepts
• Balance Sheet
>financial statement that provides a
snapshot of a venture’s financial
position as of a specific date
• Balance Sheet Equation:
Total Assets = Total Liabilities +
Owners’ Equity
• Assets
>financial & physical items controlled
or owned by the business Engr.Wajahat Maqbool
Basic Balance Sheet Terms &
Concepts (continued)
• Listing Order of Assets
>assets are listed in declining order of liquidity,
or how quickly the asset can be converted into
cash
• Liabilities >short-
term liabilities are listed first followed by long-
term debts owed by the venture
• Owners’ Equity >equity
capital contributed by the owners of the venture
is shown after listing all liabilities
Types of Balance Sheet Assets
• Current Assets
>cash & other assets that are expected to
be converted into cash in less than one
year
• Fixed Assets
>assets with expected lives of greater
than one year
Types of Current Assets
• Cash
>amount of coin, currency, & checking
account balances
• Receivables
>credit sales made to customers
• Inventories
>raw materials, work-in-process, &
finished products which the venture
hopes to sell
Types of Current Liabilities
• Payables
>short-term liabilities owed to suppliers
for purchases made on credit
• Accrued Wages
>liabilities owned to employees for
previously completed work
• Bank Loan
>interest-bearing loan of one year or
less from a commercial bankEngr.Wajahat Maqbool
Types of Long-Term Liabilities
• Long-Term Debts
>loans that have maturities of longer than
one year
• Capital Leases >long-
term, noncancelable leases whereby the
owner receives payments that cover the
cost of the equipment plus a return on
investment in the equipment
Off-Balance-Sheet Financing:
Operating Leases
• Operating Leases
>provide maintenance in addition to
financing & are also usually cancelable
• Examples
>Computers, copiers, & automobiles are
often financed through operating leases
• Balance Sheet Impact
>for operating leases, no assets or lease
liabilities are recorded on the balance sheet
Basic Income Statement Terms
& Concepts
• Income Statement
>financial statement that reports the
revenues generated & expenses incurred
over an accounting period
• Sales or Revenues
>funds earned from selling a product or
providing a service
• Gross Earnings
>net sales (after deducting returns &
allowances) minus the cost of production
Basic Income Statement Terms
& Concepts (continued)
• Operating Income or Earnings Before Interest &
Taxes (EBIT) >indicates a
firm’s profit after operating expenses, excluding
financing costs, have been deducted from net
sales
• Net Income (or Profit)
>bottom line measure after all operating
expenses, financing costs, & taxes have been
deducted from net sales
Internal Operating Schedules
• Cost of Production Schedule
>important for preparing the income
statement
• Cost of Goods Sold Schedule
>important for preparing the income
statement
• Inventories Schedule
>important for preparing the balance
sheet
Statement of Cash Flows:
Definition and Use
• Statement of Cash Flows
>shows how cash, reflected in accrual
accounting, flowed into & out of a firm
during a specific period of operation
• Can be Used to Determine if a Venture
has been Building or Burning Cash
>”Net Cash Burn” occurs when the sum
of cash flows from “operations” and
“investing” is negative
Operating Breakeven Analysis:
Basic Terms
• Variable Expenses
>costs or expenses that vary directly
with revenues
• Fixed Expenses
>costs that are expected to remain
constant over a range of revenues for a
specific time period
Engineering Economics &
Management
Basics of Accounting
Lecturer # 3
Account Types
• Measures Performance- over a period
– Revenue Accounts - records funds earned
– Expense Accounts – records expenditures
• Measures Accumulation at a point in time

– Asset Accounts – Wealth
– Liability Accounts – Obligations
– Fund Balance – Net Asset
Accounting Equation
Assets = Liabilities + Net Asset
OR
Assets – Liability = Net Asset

Account Types and Financial
Statements
Operating Statement – Measures period performance
Revenue – Expenses = Surplus or Loss
Balance Sheet (Statement of Net Assets) Measure a point in time

Assets = Liabilities + Net Assets
or
Assets – Liabilities = Net Assets
Financial Statement Flow
Operating Statement
Revenue $10
Expenses 8
Surplus 2
Balance Sheet Balance Sheet

Assets $20 Assets $20
=Liabilities 10 =Liabilities 10
+Net Assets 8 +Net Assets 8
+surplus 2
Revised Accounting Equation
Asset –Liabilities = Net Asset + (Revenue – Expenses)

Accounting Equation and Debit
and Credits
Increase Dr Cr Cr Cr Dr
Accounting Equation and Debit
and Credits
Increase Dr Cr Cr Cr Dr
T- Account
General Journal Cash
Dr Cr Dr Cr
Rent Expense $10 $100
Cash $10 $10
Pay rent from cash
$90
The Accounting Cycle
General Journal Adjusted Trial
Enter Transactions
Balance
Verify Debts = Credits
General Ledger
Post transaction to accounts Operating Statement
Trial Balance Balance Sheet

Verify Debts = Credits
Adjustments Close Books-

Post Year End Adjustments Zero out revenue and
expense accounts
Example: City of Dry Gulch-
Water Department
The City of Dry Gulch has no water. To ensure that they

are able to continue to growth the council has decided to
purchase the facilities of a private water company and set
up a Water Department. The Council appropriates $10
million dollars to accomplish this goal and has hired a
Water Department staff. Following are the accounting
entries for the new water department of the City of Dry
Gulch.
Water Department
1. City gives the water department a startup fund of $10

million.
Dr Cr
Cash ( A ) $10,000,000
Fund Balance (NA ) $10,000,000
Contribution for City

Water Department Ledger
Water Revenue Rent Expense Salaries Expense Cash
$10,000,000
A/R Fixed Asset A/P Fund Balance

$10,000,000
Water Department
2. Water Department makes first of two annual payments

of $5 million for purchase of water company.
Dr Cr
Fixed Assets (A) $10,000,000
Cash (A) $5,000,000
N/P (L) 5,000,000
Purchase water lines and pumping station

$10,000,000
$5,000,000
A/R Fixed Asset N/P Fund Balance

$10,000,000
$10,000,000
$5,000,000
Water Department
3. Water Department pays for office rent in the amount of

$500,000 .
Dr Cr
Rent Expense (E) $500,000
Cash (A) $500,000
Pay Office Rent for 2 years

$500,000 $10,000,000
$5,000,000
$500,000

$10,000,000
$10,000,000
$5,000,000
Water Department
4. Water Department pays employees salaries from cash

in the amount of $500,000 .
Dr Cr
Salaries Expense (E) $500,000
Cash (A) $500,000
Pay Salaries
$500,000 $10,000,000
$500,000
$5,000,000
$500,000
$500,000

$10,000,000
$10,000,000
$5,000,000
Water Department
5. Water Department sends out bills to customers in the

amount of $3,000,000.
Dr Cr
A/R (A) $3,000,000
Water Sales ( R ) $3,000,000
Customer billing
$3,000,000 $500,000 $10,000,000
$500,000
$5,000,000
$500,000
$500,000

$3,000,000 $10,000,000
$10,000,000
$5,000,000
Water Department
6. Water Department receives cash in partial payment of

bills mailed out. Total receipts are $2,000,000.
Dr Cr
Cash (A) $2,000,000
A/R (R) $2,000,000
Customer billing receipts

$3,000,000 $500,000 $10,000,000
$500,000
$5,000,000
$500,000
$2,000,000 $500,000
$3,000,000 $500,000 $500,000 $6,000,000

$3,000,000 $2,000,000 $10,000,000
$10,000,000
$5,000,000
$1,000,000 $10,000,000
$5,000,000 $10,000,000
Closing Worksheet
F in an cial S tate me n t W o rksh e e t
T rial B alan ce Ad ju stme n ts Ad j. T rial B al O p e ratin g S tate me n t B a lan ce S h e e t
Acco u n t Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr
W ater Revenue 3 ,0 0 0,0 00
Rent E xpense 5 00,000
S alary E xpense 5 00,000
C ash 6 ,0 0 0,0 00
A /R 1 ,0 0 0,0 00
F ixed A ssets 1 0 ,0 0 0,000
N/P 5 ,0 0 0,0 00
F und B alanc e 1 0 ,0 0 0,0 00
P repaid E xpense
T o tal 1 8 ,0 0 0,000 1 8 ,0 0 0,0 00

N et
Closing Worksheet
W ater Revenue 3 ,0 0 0,0 00
Rent E xpense 5 00,000 2 5 0,000
S alary E xpense 5 00,000
C ash 6 ,0 0 0,0 00
A /R 1 ,0 0 0,0 00
F ixed A ssets 1 0 ,0 0 0,000
N/P 5 ,0 0 0,0 00
F und B alanc e 1 0 ,0 0 0,0 00
P repaid E xpense 250 ,00 0
T o tal 1 8 ,0 0 0,000 1 8 ,0 0 0,0 00 250 ,00 0 2 5 0,000

N et
7. Adjustment Entry:
Prepaid Rent 250,000
Rent Expense 250,000
Adjust rent for a single years expense
$3,000,000 $500,000 $10,000,000
$500,000
$5,000,000
$250,000
$500,000
$2,000,000 $500,000
$3,000,000 $500,000 $250,000 $6,000,000

$3,000,000 $2,000,000 $10,000,000
$10,000,000
$5,000,000
$1,000,000 $10,000,000
$5,000,000 $10,000,000
Prepaid Rent
$250,000
$250,000
Closing Worksheet
W ater Revenue 3 ,0 0 0,0 00 3,0 00 ,00 0
Rent E xpense 5 00,000 2 5 0,000 25 0 ,0 0 0
S alary E xpense 5 00,000 50 0 ,0 0 0
C ash 6 ,0 0 0,0 00 6 ,00 0,0 00
A /R 1 ,0 0 0,0 00 1 ,00 0,0 00
F ixed A ssets 1 0 ,0 0 0,000 10,00 0 ,0 0 0
N/P 5 ,0 0 0,0 00 5,0 00 ,00 0
F und B alanc e 1 0 ,0 0 0,0 00 1 0,000 ,000
P repaid E xpense 250 ,00 0 25 0 ,0 0 0
T o tal 1 8 ,0 0 0,000 1 8 ,0 0 0,0 00 250 ,00 0 2 5 0,000 18,00 0 ,0 0 0 1 8,000 ,000

N et
Closing Worksheet
W ater Revenue 3 ,0 0 0,0 00 3,0 00 ,00 0 3,0 00 ,00 0
Rent E xpense 5 00,000 2 5 0,000 25 0 ,0 0 0 25 0 ,0 0 0
S alary E xpense 5 00,000 50 0 ,0 0 0 50 0 ,0 0 0
C ash 6 ,0 0 0,0 00 6 ,00 0,0 00
A /R 1 ,0 0 0,0 00 1 ,00 0,0 00
F ixed A ssets 1 0 ,0 0 0,000 10,00 0 ,0 0 0
N/P 5 ,0 0 0,0 00 5,0 00 ,00 0
F und B alanc e 1 0 ,0 0 0,0 00 1 0,000 ,000
P repaid E xpense 250 ,00 0 25 0 ,0 0 0
T o tal 1 8 ,0 0 0,000 1 8 ,0 0 0,0 00 250 ,00 0 2 5 0,000 18,00 0 ,0 0 0 1 8,000 ,000 75 0 ,0 0 0 3,0 00 ,00 0
N et 2,2 50 ,00 0
Operating Statement
Revenues:
Water Sales $3,000,000
Total Revenues $3,000,000
Expenses
Rent Expense (250,000)
Salary Expense (500,000)
Total Expense (750,000)
Surplus/Loss $2,250,000
Closing Worksheet
F in a n cial S tate me n t W o rksh e e t
T rial B alan ce Ad ju stme n ts Ad j. T rial B al O p e r atin g S tate me n t B alan ce S h e e t
W ater Revenue 3 ,0 00 ,00 0 3,000 ,00 0 3,000 ,000
Rent E xpense 50 0,0 00 2 50,0 00 25 0 ,0 00 2 5 0 ,0 0 0
S alary E xpense 50 0,0 00 50 0 ,0 00 5 0 0 ,0 0 0
C ash 6 ,0 0 0,000 6 ,000 ,00 0 6 ,0 0 0,0 00
A /R 1 ,0 0 0,000 1 ,000 ,00 0 1 ,0 0 0,0 00
F ixed A ssets 1 0,0 00,0 00 10 ,00 0 ,0 00 1 0 ,0 0 0,0 00
N/P 5 ,0 00 ,00 0 5,000 ,00 0 5,0 00,00 0
F und B alanc e 1 0 ,0 00 ,00 0 10,0 00,00 0 1 0,0 00,00 0
P repaid E xpense 25 0 ,0 0 0 25 0 ,0 00 2 5 0,0 00
T o tal 1 8,0 00,0 00 1 8 ,0 00 ,00 0 25 0 ,0 0 0 2 50,0 00 18 ,00 0 ,0 00 18,0 00,00 0 7 5 0 ,0 0 0 3,000 ,000 1 7 ,2 5 0,0 00 1 5,0 00,00 0
N et 2,250 ,000 2,2 50,00 0
1 7 ,2 5 0,0 00 1 7,2 50,00 0
Balance Sheet
Assets:
Cash $6,000,000
A/R 1,000,000
Fixed Asset 10,000,000
Total Assets 17,000,000
Liabilities:
N/P 5,000,000
Total 5,000,000
Net Assets 12,000,000

Water Department
8. Close Revenue and Expense Accounts to Income

Summary.
Dr Cr
Water Revenue $3,000,000
Income Summary $3,000,000
Income Summary 750,000
Rent Expense 250,000
Salary Expense 500,000
Close Revenue & Expense Accounts

$3,000,000 $500,000 $10,000,000
$500,000
$500,000 $5,000,000
$250,000
$3,000,000 $250,000 $500,000
$2,000,000 $500,000
$0 $0 $0 $6,000,000

$3,000,000 $2,000,000 $10,000,000
$10,000,000
$5,000,000
$1,000,000 $10,000,000
$5,000,000 $10,000,000
Prepaid Rent Income Summary

$250,000 $3,000,000
$500,000
$250,000
$250,000 $2,250,000
Water Department
9. Close Income Summary Account
Dr Cr
Fund Balance $2,500,000
Income Summary $2,500,000
Close Income Summary to Fund Balance

$10,000,000
$5,000,000
500,000
2,000,000 500,000
$6,000,000

$3,000,000 $2,000,000 $10,000,000
$10,000,000
$5,000,000
2,250,000
$1,000,000 $10,000,000
$5,000,000 $12,250,000
Prepaid Rent Income Summary

$250,000 $3,000,000
$500,000
250,000
2,250,000
$250,000 $0
Cost Concepts
Cost Estimating
• The most difficult, time-consuming part of an EE
study is the estimation of costs and other data.
• Cost estimating is to forecast the present and
future cost consequences of engineering design
– Most projects are unique
– It requires active participation of not only engineering
designers but also personnel from marketing, finance,
manufacturing and top management.
Cost Estimating – Cont.
• The results are used for a variety of purposes
– Providing information in setting a selling price
– Determining whether a proposed product can be
made at a profit
• There are two approaches to cost estimating
– Top-down: uses historical data for similar projects
– Bottom-up: a more detailed method which breaks
down the project into manageable units
Example: Estimating the cost of
getting a Bachelor of Science
Top-down approach
Year Tuition, Fees, Other Total

Room expenses estimated
cost
1 $15,750*1.06 $5,000 $21,000
=$16,695
2 $16,695*1.06 $5,000 $22,697
=$17,697
3 $17,697*1.06 $5,000 $23,759
=$18,759
4 $18,759*1.06 $5,000 $24,885
=$19,885
Total = $93,036
Example: Estimating the cost of
getting a Bachelor of Science
Bottom-up approach
Sum over 4 years to

obtain Total Cost
2003, 2004, 2005, 2006
Tuition Books and Living Transportation

and Fees Supplies Expenses
fuel
tuition books food
insurance
Activity fees supplies rent
maintenance
Medical software clothing
insurance
Fixed and Variable Costs
• Fixed costs
– Remain constant over a specific range of
operating conditions
– Example: general management and
administrative salaries
• Variable costs
– Vary in total with the quantity of output
– Example: material and labor costs
Direct and Indirect Costs
• Direct costs
• Related to a particular output
• Example: the cost of piece of wood used to make a
baseball bat
• Indirect costs
• Difficult to relate to a specific output
• Example: the cost of lighting in the factory where
the bat was made
Sunk Cost
• Has occurred in the past
• Has no relevance to the future costs and
benefits
• Example: A firm is considering the replacement of
a piece of equipment. It originally cost $50,000, is
presently shown on the company records with a
value of $20,000 and can be sold for an estimated
$5,000. For purpose of replacement, $50,000 is a
sunk cost.
Price and Demand
• As the selling price (p) increases, there
will be less demand (D)
General price-demand relationship
p
a: the intersection of
p = a - bD price axis
-b: slope
D
Break-Even Point
• Break-even point: Total Revenue = Total Cost
Total Revenue
TR = TC
Profit
pD = Cf +Cv
Break-even point
pD = Cf + cvD Total Cost
Cf
D=
p −C v
Loss Fixed Cost
neve R dna t s o C
Example 1
• The variable cost of producing a wooden dining
table is $62. The selling price is $85,56 per unit.
The maximum output of the firm is 1600 per year
and its fixed cost is $20,240 per year.
• For this firm, what is the break-even point in units and in
percentage of total capacity?
• Sensitivity analysis: What is the percentage reduction in the
break-even point if fixed cost is reduced 10%, if variable cost
is reduced 10%, if both costs are reduced 10%, and if the
selling price per unit is increased by 10%?
• To which of these changes is the break-even point more
sensitive?
Present Economy Studies
• When alternatives are being compared over one
year or less and the influence of time on money
can be ignored, engineering economic analysis
is referred to as present economy studies.
– Rule 1: when revenue and other benefits are present
and vary among alternatives, choose the one that
maximizes overall profitability.
– Rule 2: when revenues and other benefits are not
present or are constant among alternatives, select the
alternative that minimizes the total cost.
Example 2
Machine A Machine B
• The production of a part can
be done with Machine A or Production 100 parts/hr 130 parts/hr
rate
Machine B. The important
Hours 7 hr/day 6 hr/day
differences between the available for
machines are their production production
capacity (production
rate*available production Percent 3% 10%
parts
hours) and their reject rates (% rejected
of parts produced that cannot Material cost $6 /part $6 /part
be sold).
Selling price $12 /part $12 /part
Operator $15 /hr $15 /hr

cost
Variable cost $5 /hr $5 /hr
Example 2 – Cont.
• Assume that the daily demand for this part
is large enough that all defect-free parts
can be sold. Which machine should be
selected?
• What would the percentage of parts
rejected have to be for Machine B to be as
profitable as Machine A?
Time Value of Money
Interest and interest rate
• Engineering decisions involve comparing the
costs and benefits that occur in different time
periods
– Invest in a project today and get the benefits in the
future
• Interest
– The cost of using capital
– Having money today is preferable than having the
same amount one year later
• Interest rate
– Is the percentage that borrowed money will cost
Reasons of Interest
• In our economy, capital is the basic resource.
– Can be converted to goods or services
– From a lender’s point of view: can be spent on goods
to produce profit
– From a borrower’s point of view: an opportunity
– To take advantage of this opportunity the borrower
agrees to pay a certain amount in addition to the
money borrowed
Present and Future Worth
P= amount of money today
F= future amount
i= interest rate
F=P+I
F=P+Pi
F=P(1+i)
I
1 Period
F
P P
Interest rate i
Example
• You buy a one-year GIC for a $5,000 from
a bank. The bank is paying 8% interest on
one-year GICs. How much do you get
after one year?
Interest Periods
• Semi-annual
• Quarterly
• Monthly
• Weekly
• Daily
• Continuous
Compound Vs. Simple Interest
• Loans are often for several periods
• To calculate the future amount of the
amount P after N periods
F=P(1+i)N
• Simple interest is not usually used in
practice
F=P(1+Ni)
Compound Interest Computation
Beginning of Amount Lent Interest Amount Owed
Period Amount at Period End
1 P Pi P(1+i)
2 P(1+i) P(1+i)i P(1+i)2
3 P(1+i)2 [P(1+i)2]i P(1+i)3
… … … …
N P(1+i)N-1 [P(1+i)N-1 ]i P(1+i)N
Example
• If you borrow $100 for 3 years at 10% per
year compound interest, how much
interest would you pay at the end of the
three years?
I = 100(1+0.1)3-100
I = $33.10
How much would you pay if it were simple
interest?
I =PiN = 100*0.1*3 = $30
Graphically
800
Interest is 10% per annum
700
600
500 Compound interest
400
Total $ at Year
300
200
end
Simple interest
100
0
5 10 15 20
Years
Nominal and Effective Interest
Rates
• The difference between these two terms is the
frequency of compounding in a time period
• Given a 10% per year interest, compounded monthly,
but paid yearly. What is the effective interest rate?
In effect, we have 10/12% per month compounded
• The formula is: i=(1+r/m)m - 1 Where: i = effective
interest rate, r = nominal, m = number of compound-ding
period in a year and I = number of years
• Simple interest = 10%, Effective interest for our example
= 10.47% or [(1+0.1/12)12-1=0.1047]
Example
• What is the effective interest year of 5%
interest per month, compounded monthly?
is=0.05
m=12
ie=(1+0.05)12-1=0.7959≈79.6%
Cash Flow Diagram
• A graphical representation of cash flows
– Magnitude and time
Cash
Flow
Positive cash flow
Time Period
0 1 2 3 4
Negative cash flow

Beginning and ending of periods
Time 0
Time period
-1 1 2
Period 1 Period 2
Perspectives for cash flow
diagrams
Loan, $
Borrower’s
+ 1 2 3
viewpoint Time
0
-
Payments, $
(expenditures)
Payments, $
(receipts)
Lender’s +
viewpoint Time
-
Loan, $
Example
• Monthly income: $2200 (received at the end of each
month)
• Rent include utility: $700 (at the end of each month)
• Weekly food and entertainment: $120
• Telephone bill: $40 (at the end of the first week of each
month)
• Credit card purchases: $300 (at the end of the second
week of each month)
• Show the cash flow diagram.
Example – Cont.
$2200
0 1 2 3 4
$120
$40
$300
$700
Example – Cont.
$1380
0 1 2 3 4
$160 $120
$420
Time-Value Equivalence
• Two things are equivalent when they
produce the same effect
• A value of a cost in a time is equivalent to
the value of the related benefit received at
a different time.
F=P(1+i)N
Mathematical Equivalence
Example
• $1000 deposited at 10% interest
compounded annually,
$1000(1+0.10)2=$1210
has the value of $1210 after 2 years.

Therefore, $1000 today is equivalent to
$1210 in 2 years.
Summary
• Interest is an amount charged for the use of
money by those who have saved.
• The relationship between interest and time leads

to the concept of the time value of money.
• Investment of money into producer goods which

increase productivity leads to the concept of the
earning power of money.

Engineering Decision 3

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Engineering Decision 3

Uploaded by

Copyright:

Available Formats

Engineering Economics

“engineering ... is the art of doing well with one dollar

• They say “cash is king”, so our approach is to deal with

1. State consequences in a common measure

2. It is an iterative process and repeats as results are

3. Communications skills are extremely important!

4. Each decision is one of many to be made

5. The organisation emphasises action rather than

6. Politics are very important!

Analysis The Model Information

• Can decision making be improved??

• 1. Formulation of the problem,

• Step 4 is usually based on economic analyses

Engineering Economics &

• Measures Accumulation at a point in time

Assets = Liabilities + Net Asset

Assets – Liability = Net Asset

Balance Sheet (Statement of Net Assets) Measure a point in time

Balance Sheet Balance Sheet

Asset –Liabilities = Net Asset + (Revenue – Expenses)

Asset –Liabilities = Net Asset + (Revenue – Expenses)

Trial Balance Balance Sheet

Adjustments Close Books-

The City of Dry Gulch has no water. To ensure that they

1. City gives the water department a startup fund of $10

Contribution for City

A/R Fixed Asset A/P Fund Balance

2. Water Department makes first of two annual payments

Purchase water lines and pumping station

A/R Fixed Asset N/P Fund Balance

3. Water Department pays for office rent in the amount of

Pay Office Rent for 2 years

A/R Fixed Asset N/P Fund Balance

4. Water Department pays employees salaries from cash

A/R Fixed Asset N/P Fund Balance

5. Water Department sends out bills to customers in the

A/R Fixed Asset N/P Fund Balance

6. Water Department receives cash in partial payment of

Customer billing receipts

$3,000,000 $500,000 $500,000 $6,000,000

A/R Fixed Asset N/P Fund Balance

T o tal 1 8 ,0 0 0,000 1 8 ,0 0 0,0 00

T o tal 1 8 ,0 0 0,000 1 8 ,0 0 0,0 00 250 ,00 0 2 5 0,000

$3,000,000 $500,000 $250,000 $6,000,000

A/R Fixed Asset N/P Fund Balance

T o tal 1 8 ,0 0 0,000 1 8 ,0 0 0,0 00 250 ,00 0 2 5 0,000 18,00 0 ,0 0 0 1 8,000 ,000

Net Assets 12,000,000

8. Close Revenue and Expense Accounts to Income

Close Revenue & Expense Accounts

A/R Fixed Asset N/P Fund Balance

Prepaid Rent Income Summary

9. Close Income Summary Account

Close Income Summary to Fund Balance

A/R Fixed Asset N/P Fund Balance

Prepaid Rent Income Summary

Year Tuition, Fees, Other Total

Sum over 4 years to

2003, 2004, 2005, 2006

Tuition Books and Living Transportation

Operator $15 /hr $15 /hr

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

3 P(1+i)2 [P(1+i)2]i P(1+i)3

500 Compound interest