An Introduction to

Engineering Economics

Comparing Financial
Characteristics of
Design Options

1 Product Development and Enterpreneurship

Topics to be covered

z What is Engineering Econ?

– Definition & concepts
– Nomenclature
– Return on Capital
z Simple compounding formulas

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 Engineering Econ Example: Comparing
Alternatives

$ Where Should You Build?

Far or Near

$$$

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Example: Comparing Alternatives

Cost Site A Site B

Cost to build @ site $250,000 $500,000

Monthly Costs

Average Hauling Distance 6 5 miles

Hauling Expense $15 $15 /mile
Shipments 250 250 /month
Total Monthly Cost $22,500 $18,750

Monthly Savings $3,750

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 Example: Comparing Alternatives

z Simple payback:
– Site B is preferred after 5 years
($500,000 − $250,000)
≈ 67months
$3,750 / month
z Considering reasonable business assumptions
(15% discount rate)
– Site B is preferred after > 12 years

How do we come up with such a difference? …

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What is Engineering Economy?

z Engineering economy
systematic evaluation of the economic merits of proposed
solutions to engineering problems
z Principles:
– Develop the alternatives
z Alternatives need to be identified and defined.
– Focus on the difference
z Only the differences in expected future outcomes among the alternatives
will effect the decision.
– Use a consistent viewpoint
z Prospective outcomes should be developed from a consistent, defined
viewpoint.
– Consider all relevant criteria
– (try to) Use a common unit of measure
– Make uncertainty explicit
z Uncertainty is inevitable. Identify and explore it in analyses.
– Revisit your decisions

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 Return on Capital

z Why consider return on capital?

– For most engineering projects, capital must be tied up for
some period of time
z Purchase a piece of equipment
z Fund a research project
– Revenues from the use of capital
z Provides incentive to forego using the capital today for
consumption
z Provides incentive to take on risk of losing capital
z Opportunity cost (of capital)
– Profit available from the use of capital in some other
alternative
z Frequent engineering economy question:
Does the return on capital exceed the opportunity cost?
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Engineering Economy –
Problem Solving Approach

z Objective – Evaluation
– How to compare the economic value of alternative
design options?
z Basis – Cash Flow Analysis
– One is indifferent between investments with
equivalent cash flows
z Equivalence occurs when one is indifferent between two
sets of cash flows
z Key issues
– Time value of money
– Cash flows occurring at different times
– “Designs” with different durations
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 Cost Concepts: Nomenclature

z Capital
– Wealth (money or property) that can be used to produce more wealth
z Sunk cost
– Expense which has happened in the past. No relevance to alternatives
being considered.
z Opportunity cost
– Cost / value of the best rejected alternative
z Fixed cost
– Magnitude does NOT vary with changes in level of activity (output) -- over
some range of activity
z Insurance
z Management and administrative salaries
z Licenses
z Variable cost
– Magnitude DOES vary with level of activity (output)
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Engineering Economy

z Objective – Evaluation
– How to compare the economic value of alternative
design options?

vs vs

10
$20k? $25k $350 /month
lease ?
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 Determining Equivalence:
Issue - Value over time

z Money now has a different value than the same amount

at a different date
– Would you prefer $75 today or $80 in one year?
– It depends – Rate of return on investment
z Proper name: Discount Rate, i or r
– Future benefits / costs are reduced (ie, “discounted”) to
compare with present

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Cash Flow Diagram

P F

? ?
Magnitude

Time
…
0
n

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 Notation

z i = effective discount rate per compounding period

z N = number of compounding periods
z P = present sum of money (present value)
equivalent value of cash flows at a reference point in time called
the present
z F = future sum of money (future value)
equivalent value of cash flows at a reference point in the time
called the future
z A = end-of-period cash flows
in a uniform series of payments continuing for a specified time,
starting at the end of the first period and continuing to the end
of the last period

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How does Capital Change

in Value with Time? (Simple Interest)

z Simple interest (infrequently used)

– Total interest earned (charged) is
linearly proportional to
z the initial amount of principal (loan)
z Interest rate
z Number of time periods of commitment

Total Interest = I = P ⋅ N ⋅ i
P=principal amount lent or borrowed
N=number of interest periods
i = interest rate per period

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 How does Capital Change
in Value with Time? (Compound Interest)

z Compound interest
– Interest earned (charged) for a period is based on
z Remaining principal plus
z Accumulated (unpaid) interest at the beginning of the period

In (Interest in Period n) = Pni

Pn = Principal in period n
i = interest rate per period
I = ∑ In
n

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Formulae for N Periods –

Single Payments

Future Amount =
P (1 + i)N =
P (caf) F
P
caf ≡ Compound Amount …
Factor 0 1 2 3 n-1 n

Common notation:
F = P(F/P, i%, N)

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 Formulae for N Periods –
Single Payments

Present Amount =
F F
=
caf (1 + i ) N F
1/caf ≡ Present Worth Factor P
…
0 1 2 3 n-1 n
Common notation:
P = F(P/F, i%, N)

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Single Payment Example

Finding P given F

z An investor can purchase land that will be worth $10k in 6 years

z If the investor’s discount rate is 8%, what is the max they should
pay today?

F
P = F ( P / F , i, N ) =
(1 + i ) N
$10, 000
=
(1 + 0.08)6
= $10, 000 ⋅ 0.6302
= $6,300

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 How Do Specific Parameters Effect the
Result?

Present Value of Single Future Payment ($10k)

$12,000

Discount Rate =
$10,000 2%

$8,000 8%
Present Value

$6,000
20%
$4,000

$2,000

$0
0 1 2 3 4 5 6 7 8 9 10

Year When Payment Received

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Relating a Uniform Series of Payments

to P or F

z Uniform series of payments – often called an Annuity

z By convention:
– P at time 0 P F
– A at end of period
– F at end of period ? A A A A A
?
Therefore:
– 1st A, 1 period after P
Last A, coincident with F
–
…
0 n-1 n

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 Formulas for N Periods
Finite Series of Equal Payments
a) Present Value (P)
N
A
=∑
j (1 + i ) j
P
[(1 + i)N - 1] A A A A A
=A
i (1 + i)N
b) Payment (A) …
[(1 + i ) N ]
= P ×i 0 n-1 n
[(1 + i ) N - 1]
= P (crf)

crf = Capital Recovery Factor

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Review: Cash Flow Equivalence

Type Notation Formula Excel

Compound Amount
F = P(1 + i) N
FV(i,N,,P)
(F/P,i,N)
Single

Present Worth
P = F /(1 + i) N PV(i,N,,P)
(P/F,i,N)
Compound Amount ⎛ (1 + i ) − 1 ⎞
N
F = A⎜ ⎟ FV(i,N,A)
(F/A, i, N) ⎝ i ⎠
Uniform Series

Sinking Fund ⎛
A= F⎜
i ⎞
⎟ PMT(i,N,0,F)
(A/F, i, N) ⎝ (1 + i ) − 1 ⎠
N

Present Worth ⎛ (1 + i ) N − 1 ⎞
P = A⎜ N ⎟ PV(i,N,A)
(P/A, i, N) ⎝ i (1 + i ) ⎠
Capital Recovery ⎛ i (1 + i ) N ⎞
A = P⎜ ⎟ PMT(i,N,P)
(A/P, i, N) ⎝ (1 + i ) − 1 ⎠
N

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 Problem

z Suppose you make 15 equal annual deposits

of $1000 each into a bank account paying 5%
interest per year. The first deposit will be made
one year from today. How much money can be
withdrawn from this bank account immediately
after the 15th deposit?
z What is the present value of this amount?

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Problem – becoming a millionaire

z If you are 20 years of age and save $1 each

day for the rest of your life, do you become a
millionaire?
z Assume that you live to the age of 80 and that
the annual rate of interest is 10%.

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 z That´s all folks !

z Bibliography:
Engineering Economy, 13th Ed.
W. Sullivan, E. Wicks and J. Luxhoj,
Prentice-Hall, 2005, ISBN: 0131486497
Microeconomia, 18ª Ed.
P. Samuelson, W. Nordhaus
McGraw-Hill, 2005, ISBN: 8448147073
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