HU 300

Engineering Economics
 Recap- Seven Principles of Engineering Economy
i. Develop the alternatives
ii. Focus on the differences
iii. Use a consistent viewpoint
iv. Use a common unit of measure
v. Consider all relevant criteria
vi. Make uncertainty explicit
vii. Revisit your decisions

Deciding whether to investment more on R&D when you already

have a patent for a product/process?
 Seven Principles of Engineering Economy (Contd.)
The Tale of two Drugs:
Zantac and Tagamet

In 1977, SmithKline received a patent for its revolutionary anti-ulcer

drug, Tagamet (cimetidine), which gave it the monopoly rights to
sell Tagamet in the United States. It was sold as a prescription
drug…
This forced the (then) rival company Glaxo to design around the
patent leading to the development of anti-ulcer drug Zantac
(ranitidine), which was introduced to the market in July 1983…
soon Zantac became world’s best-selling drug.
Following this there was a full-fledged product competition war
between the two till year 2000, when Glaxo Wellcome merged
with SmithKline Beecham to form the corporation GlaxoSmithKline
(GSK).
 Seven Principles of Engineering Economy (Contd.)
Principle 7: Revisit Your Decisions
Improved decision making results from an adaptive
process…
To the extent practicable, the initial projected outcomes of
the selected alternative should be subsequently
compared with actual results achieved.
Learning from and adapting based on our experience are
essential and are indicators of a good organization.
Too often no feedback to the decision-making process
occurs… which is in fact important for future decision
making on related problems.
 Engineering Economic Process… with Application
Your friend bought an apartment building for $100,000. She spent
$10,000 of her own money, got a mortgage for the remaining
$90,000. Annual mortgage payment to the bank is $10,500.
Expected annual maintenance of the apartment building is
$15,000. She can rent out the 4 apartments (two bedrooms each)
in the building, at $360 per month. [Assume she was working after 12th
standard till last month when she bought an apartment]
Q1. Does your friend have a problem?
Ans:
Apply Step 1 of EE Process: Problem recognition, definition, and
evaluation
• Money Spent by Your Friend annually= $10,500 + $15,000 =
$25,500
• Money Earned by her annually = 4 × 12 × $360 = $17,280
• Net cash flow = $17,280 – $25,500 = –$8,220.
• Seems she is not doing so well… What can she do next?
Engineering Economic Process… with Application(contd.)
Apply Step 2 of EE Process: Development of Alternatives…
Generally, this involves two primary actions:
(1) Searching for Potential Alternatives and
(2) Screening them to select a smaller group of feasible alternatives
for detailed analysis
Superior Alternatives can be searched by applying Principle 1… Use
creativity to Develop Alternatives
Most of the Ideas require investment of money, and only a few of all
feasible ideas can be developed… due to lack of time, knowledge,
or resources….
Use techniques to develop investment alternatives by removing
some of the barriers to creative thinking-
(1) Classical Brainstorming- Based on the principles of Deferment of
judgment and Quantity breeds Quality
Engineering Economic Process… with Application(contd.)
Steps in Brainstorming (A. F. Osborn)
(i) Preparation- Select participants (4-7) and circulate preliminary
problem statement
(ii) Brainstorming- Warm up session with simple unrelated problem
→ the relevant problem with 4 rules presented--- Rules are-
1. Criticism ruled out
2. Freewheeling is welcomed
3. Quantity is wanted
4. Combination and improvement are sought
(iii) Evaluation- Ideas are evaluated relative to the problem

(2) Nominal Group Technique (NGT)- Structured group meeting (5-10

people) to incorporate individual ideas and judgments into group
consensus.
Engineering Economic Process… with Application(contd.)
The Basic Format of Nominal Group Technique (NGT)-
(i) Individual silent generation of ideas
(ii) Individual round-robin feedback and recording of ideas
(iii) Group clarification of each idea
(iv) Individual voting and ranking to prioritize ideas
(v) Discussion of group consensus results

Q2. What are the alternatives available to your friend?

Engineering Economic Process… with Application(contd.)
Q2. What are the alternatives available to your friend?
Ans:
(A) Raise the rent.
(B) Lower the maintenance expenses.
(C) Sell the apartment building.
(D) Abandon the building.
Engineering Economic Process… with Application(contd.)
Apply Step 3 of EE: Develop Prospective Outcomes
Incorporates Principle 2 (Focus on Differences), Principle 3 (Use a
Consistent Viewpoint) and Principle 4 (Common Unit of Measure)
It also uses the Basic Cash-Flow Approach employed in EE…
Represents Economic Effects of an alternative in terms of money
spent and received

In the Case of Your Friend-

(A) Raise the rent…. How much??
To cover the monthly expense of $25,500/12 = $2,125, the rent has
to be $2,125/4 = $531.25 (for each of the 4 apartments)
i.e. an Increase of $(531.25 – 360) = $171.25 which is
171.25/360 * 100 = 47.6% increase!
Engineering Economic Process… with Application(contd.)
Apply Step 3 of EE: Develop Prospective Outcomes (contd.)
(B) Lower the maintenance expenses… How much??
Lower the monthly expenses such that the expenses are covered by
the monthly revenue of $1,440
Present monthly expenditure = $25,500/12 = $2,125
Since annual mortgage payment ($10,500) cannot be reduced…
hence only option is to bring down the monthly maintenance cost
of building to a value $C such that
($10,500/12) + $C = $1,440
i.e. the monthly maintenance cost should be at ($1,440 –
$10,500/12) = $565 rather than the present $1500/12 = $1250
This amounts to (565-1250)/1250*100 = 54.8% drop in maintenance
cost.
Engineering Economic Process… with Application(contd.)
Apply Step 3 of EE: Develop Prospective Outcomes (contd.)
(C) Sell the Apartment Building… Approximate selling price??
The apartment building should be sold at a selling price which
recovers the original $10,000 investment + the amount that she is
losing every month on this venture during the time it is owned…
i.e. $8220/12 = $685 per month
(D) Abandon the Building… Can this option be bad for your friend??
If your friend walks away from the venture, the bank will most
probably take possession through foreclosure and also try to
collect some penalty from her…. Her credit rating would also fall….
i.e. A Very Bad Option!!!
Engineering Economic Process… with Application(contd.)
Apply Step 4 of EE: Select a Decision Criteria
For this step one should incorporate Principle 3 (Use a Consistent
Viewpoint) and Principle 5 (consider all relevant criteria)
For your friend the criterion to discriminate among the alternatives
could be “minimize the expected loss of money”
Another criterion could be “credit worthiness”

Apply Step 5 of EE: Analysis and Comparison of Alternatives

For this step Principle 2 (Focus on differences) and Principle 6 (Make
Risk and Uncertainties Explicit) are important
If your friend considers both “minimization of cost” and “credit
worthiness” then Option D (Abandon the building) is immediately
ruled out.
Engineering Economic Process… with Application(contd.)
Apply Step 5 of EE: Analysis and Comparison of Alternatives (Contd.)
Option C (Sell the Apartment Building) may also affect your friend’s
credit rating. Further, there is uncertainty regarding complete
recovery of investments (or costs)… people may not be willing to
pay higher price than what she had bought it for…
Thus, options A (Increase Rent) and B (Reduce Maintenance Costs)
may be the only alternatives worth pursuing..
What if a new Directive is expected in near future from the local
government that each apartment building should compulsorily
have an appropriate security system installed and maintained by
the owner?
This unexpected directive (i.e. future uncertainty) → your friend
cannot reduce maintenance costs much… → Only Option A
(Increase rent) may become relevant then.
Engineering Economic Process… with Application(contd.)
Apply Step 6 of EE: Selection of Preferred Alternative
If the above directive from local government is impending then the
preferred alternative for your friend would be Option A (Increase
Rent)…
Your friend may try to do market research of comparable housing in
the area… or
Maybe a fresh coat of paint and new carpeting would make the
apartments more appealing to prospective renters...

Then rent can probably be raised to cover all the cost and with 100%
occupancy of the four apartments.
Engineering Economic Process… with Application(contd.)
Apply Step 7 of EE: Performance Monitoring and Post evaluation of
Results
For this step Principle 7 (Revisit your Decisions) is relevant.
Your friend decides to offer the apartment at higher rent… Three
apartments are occupied by families… However she is not getting
tenant for fourth one… she has to search for solution for this….
Maybe she can rent the 4th apartment to two students on price-
sharing basis that can cover the remaining costs.

Thus, the 7 steps of the Engineering Economic Process has been

applied to solve a general problem.
 An important concept in Economics- Efficiency
Objective of Engineering is to get the greatest end result per unit of
resource expenditure…. Essentially a physical process in which the
objective is the maximization of physical efficiency (or
Engineering Efficiency) i.e.

If interpreted broadly enough, physical efficiency is the measure of

the success of engineering activity in the physical environment
with respect to a particular input
Eg. Efficiency of an engine = The amount of usable energy produced
by the engine/ Amount of energy in the fuel burned by engine
The loss may be due to friction, heat loss, other unavoidable waste…
Steam engine is 40% efficient → 40% of energy in the fuel that is
burned in the boiler is converted into work that is done by the
engine, while the other 60 percent is lost.
When such physical units are involved, efficiency will always be less
than unity, or less than 100%
 Concepts of Efficiency (contd.)
Technical Efficiency
It is related to the physical amount of all factors used in the process
of producing some product.
A particular method of producing a given level of o/p is technically
efficient if there are no other ways of producing the o/p that use
less of at least one i/p while not using more of any others. Eg.
Suppose a firm is using technology (T1) to produce current level of
o/p using 100 units of labour and 50 units of capital…
However, there exists a technology (T2) where same amount of o/p
can be produced using only 90 units of labour and 50 units of
capital ➔ Currently firm is technically inefficient … wasting 10
labour units
Thus technical efficiency is about getting most o/p from any given set
of i/ps OR equivalently,
Producing given o/p level using the least amount of physical i/ps.