MIDTERM EXAMINATION

Duration:
ENGINEERING ECONOMY

Head of ISE Department Lecturer: Student ID: Date:

Apr

Name:

INSTRUCTIONS:
1. This is an open book examination. Calculator and dictionary are allowed.
2. Laptop, mobile phone, discussion and materials transfer are strictly prohibited.
Total pages: 3 (including this page)

Question 1

What is engineering economic analysis procedure? Please explain all steps of this procedure with
example for each step.

ANSWER
A sound engineering analysis procedure incorporates the basic principles and involves several steps.
Step:
1. Problem recognition, definition, and evaluation.
2. Development of the feasible alternatives.
3. Development of the outcomes and cash flows for each alternative.
4. Selection of a criterion (or criteria)
5. Analysis and comparison of the alternatives.
6. Selection of the preferred alternative.
7. Performance monitoring and post-evaluation of results.

Explain all steps of this procedure:

1. Problem recognition, definition, and evaluation.
The first step of the engineering economic analysis procedure (problem definition) is particularly
important, since it provides the basis for the rest of the analysis. A problem must be well understood and
stated in an explicit form before the project team proceeds with the rest of the analysis.

The term problem is used here generically. It includes all decision situations for which an engineering
economy analysis is required. Recognition of the problem is normally stimulated by internal or external
organizational needs or requirements. An operating problem within a company (internal need) or a
customer expectation about a productor service (external requirement) are examples.

Once the problem is recognized, its formulation should be viewed from a systems perspective. That is,
the boundary or extent of the situation needs to be carefully defined, thus establishing the elements of
the problem and what constitutes its environment.

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Evaluation of the problem includes refinement of needs and requirements, and information from the
evaluation phase may change the original formulation of the problem. In fact, redefining the problem
until a consensus is reached may be the most important part of the problem- solving process!

2. Development of the feasible alternatives

The two primary actions in Step 2 of the procedure are (1) searching for potential alternatives and (2)
screening them to select a smaller group of feasible alternatives for detailed analysis. The term feasible
here means that each alternative selected for further analysis is judged, based on preliminary evaluation,
to meet or exceed the requirements established for the situation.
2.1. Searching for Superior Alternatives:
In the discussion of Principle 1, creativity and resourcefulness were emphasized as being absolutely
essential to the development of potential alternatives. The difference between good alternatives and
great alternatives depends largely on an individual’s or group’s problem-solving efficiency.

In searching for superior alternatives or identifying the true problem, several limitations invariably exist,
including (1) lack of time and money, (2) preconceptions of what will and what will not work, and (3)
lack of knowledge. Consequently, the engineer or project team will be working with less-than-perfect
problem solutions in the practice of engineering.
2.2. Developing Investment Alternatives
a. Classical Brainstorming: Classical brainstorming is the most well-known and often-used
technique for idea generation. It is based on the fundamental principles of deferment of judgment and
that quantity breeds quality. There are four rules for successful brainstorming:
 Criticism is ruled out.
 Freewheeling is welcomed.
 Quantity is wanted.
 Combination and improvement are sought.
A classical brain storming session has the following basic steps:
 Preparation: The participants are selected, and a preliminary statement of the problem is
circulated.
 Brainstorming: A warm-up session with simple unrelated problems is conducted, the relevant
problem and the four rules of brainstorming are presented, and ideas are generated and recorded
using checklists and other techniques if necessary.
 Evaluation: The ideas are evaluated relative to the problem.
b. Nominal Group Technique:
The technique, when properly applied, draws on the creativity of the individual participants, while
reducing two undesirable effects of most group meetings: (1) the dominance of one or more participants
and (2) the suppression of conflicting ideas. The basic format of an NGT session is as follows:
 Individual silent generation of ideas
 Individual round-robin feedback and recording of ideas
 Group clarification of each idea
 Individual voting and ranking to prioritize ideas
 Discussion of group consensus results

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 3. Development of the outcomes and cash flows for each alternative
Step 3 of the engineering economic analysis procedure incorporates Principles 2, 3, and 4 and uses the
basic cash-flow approach employed in engineering economy. A cash flow occurs when money is
transferred from one organization or individual to another. Thus, a cash flow represents the economic
effects of an alternative in terms of money spent and received.

Consider the concept of an organization having only one “window” to its external environment through
which all monetary transactions occur—receipts of revenues and payments to suppliers, creditors, and
employees. The key to developing the related cash flows for an alternative is estimating what would
happen to the revenues and costs, as seen at this window, if the particular alternative were implemented.
The net cash flow for an alternative is the difference between all cash in flows (receipts or savings) and
cash out flows (costs or expenses) during each time period.

In addition to the economic aspects of decision making, nonmonetary factors (attributes) often play a
significant role in the final recommendation. Examples of objectives other than profit maximization or
cost minimization that can be important to an organization include the following:
 Meeting or exceeding customer expectations
 Safety to employees and to the public
 Improving employee satisfaction
 Maintaining production flexibility to meet changing demands
 Meeting or exceeding all environmental requirements
 Achieving good public relations or being an exemplary member of the community

4. Selection of a Decision Criterion

The selection of a decision criterion incorporates Principle 5 (consider all relevant criteria). The decision
maker will normally select the alternative that will best serve the long-term interests of the owners of the
organization. It is also true that the economic decision criterion should reflect a consistent and proper
viewpoint (Principle 3) to be maintained throughout an engineering economy study.

5. Analysis and Comparison of Alternatives

Analysis of the economic aspects of an engineering problem is largely based on cash-flow estimates for
the feasible alternatives selected for detailed study. A substantial effort is normally required to obtain
reasonably accurate forecasts of cash flows and other factors in view of, for example, inflationary (or
deflationary) pressures, exchange rate movements, and regulatory (legal) mandates that often occur.
Clearly, the consideration of future uncertainties (Principle 6) is an essential part of an engineering
economy study. When cash flow and other required estimates are eventually determined, alternatives can
be compared based on their differences as called for by Principle 2. Usually, these differences will be
quantified in terms of a monetary unit such as dollars.

6. Selection of the Preferred Alternative

When the first five steps of the engineering economic analysis procedure have been done properly, the
preferred alternative is simply a result of the total effort. Thus, the soundness of the technical-economic

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modeling and analysis techniques dictates the quality of the result s obtained and the recommended
course of action.

7. Performance Monitoring and Post evaluation of Results

This final step implements Principle 7 and is accomplished during and after the time that the results
achieved from the selected alternative are collected. Monitoring project performance during its
operational phase improves the achievement of related goals and objectives and reduces the variability
in desired results

Example all steps of this procedure:

A friend of yours bought a small apartment building for $100,000 in a college town. She spent $10,000
of her own money for the building and obtained a mortgage from a local bank for the remaining
$90,000. The annual mortgage payment to the bank is $10,500. Your friend also expects that annual
maintenance on the and grounds will be $15,000. There are four apartments (two bedroom each) in the
building that can each be rented for $360 per month.

Step 1. Problem recognition, definition and evaluation

A lot more money is being spent by your friend each year than is being received.

 Expense > Revenue

 $ 10,500 + $ 15,000 = $ 25,500 > 4 x $360 x 12 month = $ 17,280
 $ 25,500 > $ 17,280 (variance $ 8,220)
The problem could be that the monthly rent is too low. She is losing $ 8,220 per year

Step 2. Development of the feasible alternatives

 Option (1). Raise the rent (Will the market bear an increase?)
 Option (2). Lower maintenance expenses (But not so far as to cause safety problems)
 Option (3). Sell the apartment building. (What about a loss?)
 Option (4). Abandon the building (Bad for your friend’s reputation)
Step 3. Development of the outcomes for each alternative.
Option (1). Raise total monthly rent to $ 1,440 + $ R for the four apartments to cover monthly expenses
of $ 2,125.

Note that the minimum increase in rent would be ($ 2,125 – $ 1,440) / 4 = $ 171,25 per apartment per
month (Almost a 50% increase!).

Option (2). Lower monthly expenses to $2,125 – $C so that these expenses are covered by the monthly
revenue of $1,440 per month.  This would have to be accomplished primarily by lowering the
maintenance cost.

There’s not much to be done about the annual mortgage costs unless a favorable refinancing opportunity
presents itself.

Monthly maintenance expenses would have to be reduced to ($ 1,440 – $ 10,500) / 12 = $ 565. (This
represent more than a 50% decrease in maintenance expenses!)

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Option (3). Try to sell the apartment building for $ X, which recovers the original $ 10,000 investment
and (ideally) recovers the $ 685 per month loss ($ 8,220 / 12) on the venture during the time it was
owned.

Option (4). Walk away from the venture and kiss your investment good-bye. The bank would likely
assume possession through foreclosure and may try  to collect fees from your friend. This option would
also very bad for your friend’s credit rating.

Step 4. Selection of a criterion

Criterion that your friend concern is to minimize the expected loss of money and credit worthiness

Step 5. Analysis and comparison of the alternatives

 Minimize the expected loss of money. In this case you might advise your friend to pursue Option
(1) or (3)
 Credit worthiness. Option (4) is immediately ruled out and Option (3) could also harm your
friend’s credit rating.
Options (1) and Option (2) may be her only realistic and acceptable alternatives.

 Step 6. Selection of the preferred alternative

Your friend should probably do a market analysis of comparable housing in the area to see if the rent
could be raised (Option 1). Maybe a fresh coat of paint and new carpeting would make the apartments
more appealing to prospective renters.

If so, the rent can probably be raised while keeping 100% occupancy of the four apartments.

Step 7. Performance monitoring and post-evaluation of results

In the long run your friend needs to see alternatives for lowering maintenance expenses. If there is
opportunity in market selling the apartment building is also good option if capital gain is bigger than
investment cost.  All those 4 alternatives should be monitored according changes in market.

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