Engineering Economic Decisions

Lecture No. 1
Chapter 1
 Topics of this lesson

Why do Engineers need Business Skills?

What are typical roles of engineers?
How do those roles use Business Skills?
What are the required foundational Concepts?

2
Engineering and Economics
✓ What is this?

✓ Why would a company want to use it?

✓ What are the benefits?

✓ What are the drawbacks?

✓ Why would a company decide to or

✓ not to buy this piece of equipment?

✓ What might be your role in this project?

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 Role of Engineers in Business
Create and Design

• Engineering Projects

Analyze Evaluate Evaluate

• Production Methods • Expected • Impact on

• Engineering Safety Profitability Financial Statements
• Environmental Impacts • Timing of • Firm’s Market Value
• Market Assessment Cash Flows • Stock Price
• Degree of
Financial Risk
Give an example where an
engineer might participate or
lead these activities?
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What Makes Engineering Economic
Decisions Difficult?
• Estimating cost of investment
• Forecasting product demand
• Estimating a manufacturing cost
• Estimating a product life
• Evaluating how this product might need
to change/adapt with future technology

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Accounting Vs. Engineering Economy

Evaluation of Evaluation and

past prediction of
performance future events

Accounting Engineering Economy

Past Future
Present

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 Common Types of Strategic
Engineering Economic Decisions
• Equipment or process selection
• Equipment replacement decisions
• New products and product expansion
• Cost reduction
• Improvement in service or quality
• Design decisions

Contemporary Engineering Economics, 6th ed,

Pearson (c) 2015
7
 Fundamental Principles of
Engineering Economics
• Principle 1: A dollar earned today is worth more than
a dollar earned in the future.

• Principle 2: The only thing that matters is the

difference between alternatives. (Not what it costs
today, only difference)

• Principle 3: Marginal revenue must exceed marginal

cost.

• Principle 4: Additional risk is not taken without the

expected additional return.
Contemporary Engineering Economics, 6th ed,
Pearson (c) 2015
8
Principle 1: A dollar earned today is worth
more than a dollar earned in the future

Interest rate = 10%

$121
$110 – – two-
one- year
$100 - year later
today later
Contemporary Engineering Economics, 6th ed,
Pearson (c) 2015
9
 Principle 1: A dollar earned today is worth
more than a dollar earned in the future
• Why is $100 today worth more than $100 in
2 years?

Purchasing Power

Earning Power
People will pay
Contemporary Engineering Economics,
6th ed, Pearson (c) 2015
Interest to get today
10
 Principle 2: The only thing that matters is the
difference between alternatives

If you are evaluating the cost & benefits of installing solar panels on the roof,
You don’t have to know all the costs of the company, just what it is related to
solar panels. 11
Principle 4: Additional risk is not taken
without the expected additional return

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 Principle 4: Additional risk is not taken
without the expected additional return
Investment Class Potential Expected
Risk Return
o Savings Low/None 1.0%
account (cash)

o Bond (debt) Moderate 4.8%

o Stock (equity) High 9.5%

Risk Proportional to Reward

Contemporary Engineering Economics, 6th ed, Pearson (c)
2015 13
 Interest and Interest Rate
• Interest – the manifestation of the time value of money
• Fee that one pays to use someone else’s money
• Difference between an ending amount of money and a beginning
amount of money

➢ Interest = amount owed now – principal

 Rate of Return

❑ Interest earned over a period of time is expressed as a

percentage of the original amount (principal)

interest accrued per time unit

Rate of return (%) = x 100%
original amount

❖ Borrower’s perspective – interest rate paid

❖ Lender’s or investor’s perspective – rate of return earned
Interest paid Interest earned
Interest paid Interest earned

InterestRate
Interest rate Rate of return
Rate of Return
Impact of Corporations ‘Paying Interest’
• Engineering projects must have a higher Rate
of Return than the Interest Rate the
corporations need to pay.

• This Interest Rate is called Minimally

Attractive Rate of Return (MARR) {Academic
Term}

Contemporary Engineering Economics,

17
6th ed, Pearson (c) 2015
 Minimum Attractive Rate of
Return - MARR
❖ MARR is a reasonable
rate of return (percent)
established for evaluating
and selecting alternatives
❖ An investment is
justified economically if it
is expected to return at
least the MARR
❖ Also termed hurdle rate,
benchmark rate and
cutoff rate
Contemporary Engineering Economics,
18
6th ed, Pearson (c) 2015
 Selecting an MARR in Project Evaluation

premium
• Cost of capital

Risk
o The required return necessary to make
an investment project worthwhile.
o Viewed as the rate of return that a firm
would receive if it invested its money

MARR
someplace else with a similar risk
• Risk premium

Cost of capital
o Each project should have a risk
premium should associated with that
project.

Contemporary Engineering Economics,

19
6th edition, © 2015
 MARR Characteristics
• MARR is established by the financial managers of the firm
• MARR is fundamentally connected to the cost of capital
• All types of capital financing are used to determine the
weighted average cost of capital (WACC) and the MARR
• MARR usually considers the risk inherent to a project

Contemporary Engineering Economics,

20
6th ed, Pearson (c) 2015
Ford Motor Company

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 Summary
• Engineers have to demonstrate value to the
organization of their work
• Engineers have to model future costs and
benefits and shows it is financially viable
• The higher the risk, the greater the return
should be
• Companies look at their cost of capital to
determine the required MARR threshold.
Contemporary Engineering Economics,
22
6th ed, Pearson (c) 2015