CHAPTER 3

ECONOMIC ANALYSIS OF ENGINEERING PROBLEMS

3.1 INTRODUCTION
The techniques presented so far illustrate how to convert single amounts of money, and
uniform or gradient series of money, into some equivalent sum at another point in time. These
compound interest computations are an essential part of economic analysis problems.
The typical situation is that there is a number of alternatives and the question is, which
alternative should be selected? The customary method of solution is to resolve each of the
alternatives into some common form and then choose the best alternative.
3.2 TYPES OF ENGINEERING PROBLEMS & ECONOMIC ANALYSIS OBJECTIVE
Engineering problems can be categorized into three main types:
a) Fixed Input
The inputs as the amount of money, labor, materials, equipment or other input resources are
fixed. As an example:
❑ A project engineer has a budget of a million dollar to overhaul a plant.
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 ❑ you have $150 to buy clothes for the start of school.
❑A mechanical contractor has been awarded a fixed price contract to air-condition a building.
❖ The objective of economical analysis for such problems is to maximize the output.
b) Fixed Output
It is required to carry out a fixed task, or other output to be accomplished. For examples:
❑A civil engineering firm has been given the job to build an airport (turn key).
❑You wish to purchase a new car with no optional equipment.
❖ The objective of economical analysis for such problems is to minimize the input.
c) Neither Input nor Output Fixed
This is the general situation where neither the amount of money or other inputs, nor the amount of
benefits or other output are fixed. For example:
❑ An investor might wish to invest in the stock market, but neither the total cost of the investment nor the
benefits are fixed.
❑ Automobile battery is needed. Batteries are available at different prices, and although each will provide
the energy to start the vehicle,
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❑A consulting engineering firm has more work available than it can handle. It is considering paying the
staff for working evenings to increase the amount of design work it can perform.
❖The objective of economical analysis for such problems is to maximize the difference between the
return of the investment and the cost.
3.3 METHODS of ECONOMICAL ANALYSIS of ENGINEERING PROBLEMS
The concept of time-value of money revealed that cash flows can be translated to equivalent
amounts at any point on the time axis in accordance with the selected interest rate.
There are five major methods of comparing alternatives: present worth; future worth; annual cost;
rate of return; and benefit-cost ratio. In this chapter, only three methods will be considered.
❖ Present Worth: Convert the cash flow to a single equivalent amount at zero time (based on i,n )
❖ Annual Cash Flow: Convert the cash flow to an equivalent annual annuity over n, i
❖ Rate of Return: Equate the equivalent value of positive cash flow to the negative cash flow over
the study period (n) and determine the interest rate i.
All three methods are suitable. The choice of which one depends on the type of problem, the personal analyst
or organization preference, and the results that are more understandable to the decision makers involved.
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3.3.1 Present Worth
Present worth analysis is most frequently used to determine the present value of future money
receipts and disbursements. The present worth of an income producing property, like an oil well
can be estimated which may help when the property be bought or sold.
An important restriction in the use of present worth calculations is that there must be a common
analysis period when comparing alternatives. As present worth value is highly affected with the
analysis period.
It would be incorrect, for example, to compare the present worth(PW) of cost of Pump A, expected
to last 6 years, with the PW of cost of Pump B, expected to last 12 years. Improper Present Worth
Comparison
In situations (different service lives of variants) , the solution is either to use some other analysis
technique (generally the Equivalent Uniform Annual Payment method) or to restructure the problem
so there is a common analysis period.
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This approach is easy to use when the different lives of the alternatives have a least common
multiple. Generally, useful service life may be:
Useful Service life

Equal service lives Different service lives Infinite Service Lives

Analysis Period is the Analysis period is the (Least 𝟏+𝒊 𝒏 −𝟏 𝑨

𝒑 = 𝐥𝐢𝐦 𝑨 =
𝒊 𝟏+𝒊 𝒏 𝒊
service life Common Multiple) LCM 𝒏→∞

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In this chapter, the following variables will be defined
PWC (Present Worth Cost)
PW (Present Worth)
PWB (Present Worth Benefit)

EUAC
EUAP(Equivalent Uniform Annual Payment)
EUAB

FWC (Future Worth Cost)

FW (Future Worth)
FWB (Future Worth Benefit)

S (Salvage Value) The value of the equipment by the end of its useful service life
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➢ Service Lives are Equal (Analysis period is the service life)
EXAMPLE 3.1
A firm is considering which of two mechanical devices to install to reduce costs in a particular situation.
Both devices cost $1000 and have useful lives of five years and no salvage value. Device A can be
expected to result in $300 savings annually. Device B will provide cost savings of $400 the first year
but will decline $50 annually, making the second-year savings $350, the third-year savings is $300 and
so forth. With interest at 7% which device should the firm purchase?
SOLUTION
Both devices have the same initial cost and the same useful service lives, so the problem is a fixed
input problem, and the objective of the economic analysis is to maximize the output.
PWB

300 ≡
Device A 0 1 5 0 1 5

𝟏+𝒊 𝒏 −𝟏 𝟏.𝟎𝟕𝟓 −𝟏
𝑷𝑾𝑩 = 𝑬𝑼𝑨𝑩 , PWB = 𝟑𝟎𝟎 =$1230.059
𝒊 𝟏+𝒊 𝒏 𝟎.𝟎𝟕 𝟏.𝟎𝟕 𝟓
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 G=-$50 PWB

400 ≡
Device B 0 1 5 0 1 5
𝟏+𝒊 𝒏 −𝟏 𝟏+𝒊 𝒏 −𝒊𝒏−𝟏
𝑷𝑾𝑩 = 𝒑ƴ + 𝒑" = 𝑬𝑼𝑨𝑩 +𝑮
𝒊 𝟏+𝒊 𝒏 𝒊𝟐 𝟏+𝒊 𝒏
𝟏.𝟎𝟕𝟓 −𝟏 𝟏.𝟎𝟕𝟓 −𝟓×𝟎.𝟎𝟕−𝟏
= 𝟒𝟎𝟎 𝟓 − 𝟓𝟎
𝟎.𝟎𝟕 𝟏.𝟎𝟕 𝟎.𝟎𝟕𝟐 ×𝟏.𝟎𝟕𝟓
=1640.078 – 382.333= $1257.745
The firm should purchase device B
NOTE : Both devices save $1500 during the 5 years period, but due to the concept of the time value
of money, the analysis shows that device B is preferable.
EXAMPLE 3.2
A city plans to build an aqueduct. It can be built at a reduced size now for $300m and be enlarged after
25 years for an additional $350m. An alternative is to construct the full-sized aqueduct now for $400m.
Both alternatives would provide the needed capacity for the 50-year analysis period . Maintenance
costs are small and may be ignored. At 6% interest which alternative should be selected ?
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SOLUTION
Both Alternatives will provide the city with water for a 50-year period, i.e. fixed output problem, then the objective of the
analysis is to minimize the cost.
Alternative I 0 25 50 ≡ 0 50

$300m $350m PWC

350
𝑃𝑊𝐶 = 300 + = $381.5495𝑚
1.0625
Alternative II

$400 m
The cash flow diagram of alternative II is in the required form
The city should select the first alternative.
The interpretation of this answer is that if the city has $381.5495m now, they will use $300m to construct the reduced size
aqueduct and put $81.5495m in a bank with interest 6% for 25 years at which time they will be $350m
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EXAMPLE 3.3
A purchasing agent is considering the purchase of some new equipment for the mail room. Two
different manufacturers have provided quotations. An analysis of the quotations indicates the
following: Manufacturer Cost ($) Useful Life (Year) Salvage Value ($)
Speedy 1500 5 200
Allied 1600 5 325

The performance of the equipment of the two manufacturers is expected to be at the desired level.
Assume 7% interest and equal maintenance cost, which equipment should be selected?
SOLUTION
This is a fixed output problem, so, the objective of the analysis is to minimize the input. The service
lives of the two equipment are equal 5 years, then, the analysis period is 5 years.
Speedy $ 200

0 $1500 5 ≡ 0 5

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 200
𝑃𝑊𝐶 ȁ𝑆𝑝𝑒𝑒𝑑𝑦 = 1500 − 5
= $ 1357
1.07
Allied $ 325

0 $1600 5 ≡ 0 5

PWC
325
𝑃𝑊𝐶 ȁ𝐴𝑙𝑙𝑖𝑒𝑑 = 1600 − = $ 1368 Select Speedy Equipment
1.075
EXAMPLE 3.4
A firm is trying to decide which of two alternate weighing scales should be installed to check a
package filling operation in the plant. The scales would allow better control of the filling operation
and result in less overfilling. If both scales have equal service lives of six years. Which one should
be selected ? Assume interest rate to be 8%.
Alternatives Cost ($) Uniform Annual benefit ($) Salvage value ($)
Atlas 2000 450 100
Tom Thumb 3000 600 700
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SOLUTION $450 $100 PWB

Atlas 0 1 6 ≡ 0 6
$2000

100 1.086 −1
PWBȁAtlas = −2000 + + 450 = $143
1.086 0.08×1.086
Tom Thumb $700 PWB

$600

0 1 6 ≡ 0 6

$3000

700 1.086 − 1
PWBȁTom Thumb = −3000 + 6
+ 600 6
= $215
1.08 0.08 × 1.08
Choose Tom Thumb
EXAMPLE 3.5
Two alternatives have the following cash flows, which one should be selected? ( interest rate is 5%
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Alternative I $800 PWB Year Alternative I ($) Alternative II ($)
0 1 3 0 3 0 -2000 -2800
$2000 1 800 1100
2 800 1100
1.053 − 1
𝑃𝑊𝐵 = 800 3
− 2000 = $178.4 3 800 1100
0.05 × 1.05

Alternative II $1100 ≡ PWB

$2800

1.053 − 1
PWB = 1100 3
− 2800 = $195.3
0.05 × 1.05
Choose alternative II

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➢ Service Lives are Different (Analysis period is the LCM of service lives)
The Least Common Multiple (LCM) - for a set of numbers- is the number which is divisible by
these numers and it can be obtained by expressing these numbers as a multiples of prime
numbers, then form the LCM as a multiple of the common and different factors.
Example find the LCM for the following numbers (4,6,8)
4 = 2×2
6=2 ×3
8 = 2 ×2 × 2
LCM=2 × 2 × 3 × 2 = 24
So, the analysis period is 24 years and for the alternative which has 4 years service life, it should be
replaced with identical item 6 times. The alternative that has 6 years should be replaced with
identical item 4 times, while the alternative that has 8 years service life should be replaced with
identical item 3 times.
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