ENGINEERING

ECONOMY
Manufacture in China?

Manufacture in UK?
 Introduction-1
• Individuals, small-business owners, large
corporation presidents, and government agency
heads are routinely faced with the challenge of
making decisions when selecting one alternative
over another.

• These are decisions of how best to invest the funds,

or capital, of the company and its owners.
 Introduction- 2
Engineering economy:
• is the process of determining the economic factors
and the economic criteria utilized when one or more
alternatives are considered for selection.

• A collection of economic/mathematical techniques

are used to evaluate available alternatives.

• The role of engineering economics is to assess the

appropriateness of a given project/product,
estimate its value, and justify it from an engineering
standpoint.
Corporations and Businesses
• Will we make the required return if we install
this new manufacturing technology in the
plant?

• Do we build or lease space for the new

branch in Burkina Faso?

• Is it economically better to make in-house or

buy component parts on a new product line?
Government Units Which Serve the
Public
• How much new tax revenue does the city need to
generate to pay for new public school.

• Is it cost-effective for the city to construct a new

stadium for major sports events?

• Should the university contract part-time lecturers to

teach foundational-level undergraduate courses or
have full-time university faculty teach them?
 Individuals
• What are graduate studies worth financially
over my professional career?

• Exactly what rate of return did we make on

this stock investment?

• Should I buy or lease my next car or keep

the one I have now and continue to pay on
the loan?
 Steps to Problem Solving
1. Understand the problem and goal.

2. Collect relevant information.

3. Define the alternative solutions.

4. Evaluate each alternative.

5. Select the best alternative using some

criteria.

6. Implement the solution and monitor the

results.
Role of Engineering Economy in
Decision Making -1
• Engineering economy has a major role in steps 2, 3, and
5. Steps 2 and 3 set up the alternatives, and engineering
economy helps structure the estimates of each one

• It is the primary technique in step 4 to perform the

economic-based analysis of each alternative.

• Step 4 utilizes one or more engineering economy models

discussed here to complete the economic analysis upon
which a decision is made.
 Example 1
The presidents of two small businesses play racquetball each
week. After several conversations, they have decided that,
due to their frequent commercial- airline travel around the
region, they should evaluate the purchase of a plane jointly
owned by the two companies. What are some of the typical
economic-based questions the two presidents should answer
as they evaluate the alternatives to

• (1) co-own a plane or

• (2) continue as is?

 Solution
Some questions (and what is needed to respond to them) might be:

- How much will it cost each year? (Estimates needed here)

– How do we pay for it? (A financing plan needed here)

– Are there tax advantages? (Tax law information needed here)

– Which alternative is more cost-effective? (Selection criteria

needed here)

– What is the expected rate of return? (Equations needed here)

– What happens if we use different amounts each year than we

estimated? (Sensitivity analysis needed here)
 Step 4 of the Problem
Solving Approach
Step 4: This is the heart of engineering economy. The
technique results in numerical values called measures
of worth, which inherently consider the time value of
money.
Some common measures of worth are:
Present worth (PW) Future worth (FW)
Annual worth (AW) Rate of return (ROR)
Benefit/cost ratio (B/C) Capitalised cost (CC)
 Solution
• Assume that the problem and goal are the same for
each president - available, reliable transportation
which minimizes total cost.

• Engineering economy assists in several ways. Using

the problem-solving approach as a framework.

• Steps 2 and 3: The framework of estimates

necessary for an engineering economy analysis
assists in structuring what data should be estimated
and collected.
 Solution - continued
For example, for alternative 1 (buy the plane):

• They need to make estimates of purchase cost,

financing methods and interest rates, annual
operating costs, possible increase in annual sales
revenue, and income tax deductions.

For alternative 2 (maintain the status quo),

• They need to include information on observed and

estimated commercial transportation costs, annual
sales revenue, and other relevant data.
 Solution - continued
Note: Engineering Economy does not
specifically include the estimation; it helps
determine what estimates and data are
needed for the analysis (step 4) and
decision (step 5).
 Step 5
• For the economic portion of the decision, some criterion
based on one of the measures of worth is used to select only
one of the alternatives.

• There are so many non-economic factors - social,

environmental, legal, political, personal, to name a few - that
the result of the engineering economy analysis may seem, at
times, to use less than the engineer may wish.

• But this is exactly why the decision-maker must have

adequate information for all factors - economic and non-
economic- to make an informed selection.
 Solution - continued
• In our case, the economic analysis may
significantly favor the co-owned plane
(alternative 1).

• But because of non-economic factors, one

or both presidents may decide to remain
with the current situation by selecting
alternative 2.
 The Concept of Time
Value of Money
• The concept of ‘time value of money’ is very
important to engineering economy.

• Money has value which changes with time

• Any future cash flows have less value to us than

current cash flows.
 Interest Calculations

• Interest is the money paid for the use of borrowed money or

the return on invested capital.

• Interest = amount owed now - original principal

• Percent interest rate = interest accrued per unit time x 100%

original amount

The interest period or time unit is typically one year, however, shorter
interest period e.g. one month could also be used. The total number of
interest periods is denoted by n.

Two ways of calculating interests are using: Simple and Compound Interest
techniques
 Simple Interest
• Simple interest: When the repayment amount of
borrowed money is calculated such that interest is
charged each year only on the full amount borrowed
at the beginning.

• Therefore interest = (Principal) (Interest Rate (Time

-number of periods) =P*R*T

•
 Example: Simple Interest
If Jonathan borrows $ 1000 from his older sister for 3 years at 5%
- per-year simple interest, how much money will he repay at the
end of 3 years?
Solution:
Principal =? , Rate of = ?, Number of periods n is ?

Interest = Principal * Rate * Time

=
= $ 150
The amount to pay at the end of the period = principal + interest
=?
 Compound Interest
Compound interest arises when interest is added to the
principal, so that, from that moment on, the interest that
has been added also earns interest.
•This addition of interest to the principal is called
compounding.

Interest = (principal + all accrued interest) (interest rate).

Example :Compound Interest
If Jonathan borrows $ 1000 from his older sister for 3 years at 5% - per-year
compound interest (instead of simple interest), how much money will he repay
at the end of 3 years?
Solution:
Year 1 interest = Principal * rate
= $ 1000 * 0.05 = $50  Principal is now 1000 + 50 = $1050
Year 2 interest = $ (1000 + 50) * 0.05 = $ 52.50  $ 1050 +52.50 =
$1102.50

Year 3 interest =$ (1050 + 52.5) * 0.05 = $ 55.13

After 3 years, Jonathan will pay his sister = 1102.50 + 55.13 = $ 1157.63
 THE CONCEPT OF
EQUIVALENCE
The concept of time value of money and interest rates
help us develop the concept of equivalence.

• EQUIVALENCE: means that different sums of money considered

at different times are equal in economic value.

• For example, if the interest rate were 6% per year, GH¢100

today (present time) would be equivalent to GH¢106 one year
from today.

Amount accrued = 100 + 100(0.06) = 100(1 + 0.06) = GH¢106

 MINIMUM ATTRACTIVE
RATE OF RETURN
• For any investment to be profitable, the
investor (corporate or individual) must
expect to receive more money than the
amount invested.

• In other words, a fair rate of return, or

return on investment must be realizable.
 MINIMUM ATTRACTIVE RATE
OF RETURN
• Over a stated period of time, the rate of return (ROR) is
calculated as

• ROR = Current amount - original investment x100%

original investment
• The numerator may be called profit, net income, ... The
term rate of return is commonly used when estimating
the profitability of a proposed alternative or when
evaluating the results of a completed project or
investment. Rate of return and interest rates are both
represented by the symbol i.
 MINIMUM ATTRACTIVE RATE
OF RETURN
• Some reasonable rate must, therefore, be
stated and utilized in the selection criteria
phase of the engineering economy study
approach.
• The reasonable rate is called the Minimum
Attractive Rate of Return (MARR) and is
higher than the rate expected from a bank or
some safe investment, which involves
minimal investment risk.
 SYMBOLS AND THEIR
MEANING -1
• P = value or amount of money at a time
denoted as the present, called the present
worth or present value; currency, dollars ($),
Ghana cedis (GH¢), pound sterling (£), etc.

• F = value or amount of money at some future

time, called future worth or future value;
dollars ($), Ghana cedis (GH¢), pound sterling
(£), etc
 SYMBOLS AND THEIR
MEANING - 2
• A = series of consecutive, equal,
end-of-period amounts of money, called
the equivalent value per period or annual
worth, dollars per year ($/yr.), Ghana
cedis per year (GH¢/yr.), pound sterling
per year (£/yr.)

• n = number of interest periods; years,

months, days
 SYMBOLS AND THEIR
MEANING - 3
• i = interest rate per interest period;
percent per year, percent per month

• t = time stated in periods; years,

months, days
 CASH FLOWS: THEIR ESTIMATION AND
DIAGRAMMING - 1
Cash flow is a fundamental concepts of Engineering
Economy.
A cash flow diagram is a graphical representation of
cash flows drawn on a time scale.
• Every organization has cash flows: cash inflows
(revenue receipts and income) and cash outflows
(expenses and costs)
• Cash flows occur during specified periods of time
such one month or 1 year.

– Assumption: all cash flows are received at the

end of the interest period (also known as end of
period convention).

Net cash flow = Receipts – disbursement

= Cash inflows – cash outflows
 CASH FLOWS: THEIR ESTIMATION
AND DIAGRAMMING -2

• Make a neat diagram to approximate

scale for both time and cash-flow
magnitude.

• The direction of the arrows on the cash-flow

diagram is important. Throughout this text,
a vertical arrow pointing up will indicate a
positive cash flow. Conversely, an arrow
pointing down will indicate a negative cash
flow.
A typical cash-flow time
scale for 5 years.
Example of positive and
negative cash flows.
 SAMPLE CASH INFLOWS
• Asset salvage value.

• Receipt of loan principal.

• Income-tax savings.

• Receipts from stock and bond sales.

• Construction and facility cost savings.

• Savings or return of corporate capital

funds.
 SAMPLE CASH OUTFLOWS
• First cost of assets.
• Operating costs (annual and incremental).
•Periodic maintenance and rebuild costs.
•Loan interest and principal payments.
•Major, expected upgrade costs.
•Income taxes.
•Bond dividends and bond payment.
•Expenditure of corporate capital funds.
 RULE OF 72: ESTIMATING
DOUBLING TIME AND INTEREST
RATE
• Sometimes it is important to
estimate the number of years n, or
the rate of return i, that is required
for a single cash-flow amount to
double in size.

• The rule of 72 for compound-interest

rates can be used to estimate i or n,
given the other value.
 ESTIMATIING n GIVEN i

• The estimation is simple; the time

required for an initial single amount
to double in size with compound
interest is approximately equal to 72
divided by the rate of return value
(in percent).
• Estimated n = 72
i
 Estimation i given n
• Alternatively, the compound rate i in
percent required for money to double
in a specified period of time n can be
estimated by dividing 72 by the
specified n value.

Estimated i = 72
n