ENGINEERING ECONOMICS 2020

CHAPTER 1
INTRODUCTION

TOPIC OUTLINE

1. Definitions and Principles of Engineering Economics

2. Engineering Economics and the Design Process
3. Cost Concepts for Decision Making
4. Present Economic Studies

LEARNING OUTCOMES

1. Define various economic terms that are used in the engineering field.
2. Discuss various laws and principles applied in engineering economics.
3. Understand where engineering economics is applied in the design
process
4. Understand Cost concepts for decision making and present economic
studies

IE 111 1|Page
ENGINEERING ECONOMICS 2020

INTRODUCTION

The course is focused on the principles and procedures for making sound
engineering economic decisions. To the first-time student of engineering economics,
anything related to money matters may seem quite strange compared with other
engineering subjects. However, the decision involved in the problem solving is quite
similar to any other engineering economic decision. These principles unite to form the
concepts and techniques presented in the in the succeeding modules, thereby
allowing us to focus on the logic underlying the practice of engineering economics.

TOPIC 1: DEFINITIONS AND PRINCIPLES OF ENGINEERING ECONOMICS

Economics is one of the social sciences which consists of that body of

knowledge dealing with people and their assets or resources. Economics has also
been defined as the sum total of knowledge which treats of the creation and
utilization of goods and services for the satisfaction of human wants.

Engineering economy involves formulating, estimating, and evaluating the

expected economic outcomes of alternatives designed to accomplish a defined
purpose. Mathematical techniques simplify the economic evaluation of alternatives
(Blank and Tarquin, 2005).

Engineering economy is the analysis and evaluation of the factors that will
affect the economic success of engineering projects to the end that a
recommendation can be made which will insure the best use of capital (Sta. Maria,
ND)

The four principles of engineering economics are as follows:

Principle 1: A nearby dollar is worth more than a distant dollar. A fundamental

concept in engineering economics is that money has a time value associated with it.
Because we can earn interest on money received today, it is better to receive money
earlier than later. This concept will be the basic foundation for all engineering project
evaluation.

Principle 2: All that counts is the difference among alternatives. An economic decision
should be based on the differences among alternatives considered. All that is
common is irrelevant to the decision. Certainly, any economic decision is no better
than the alternatives being considered. Therefore, an economic decision should be
based on the objective of making the best use of limited resources. Whenever a
choice is made, something is given up. The opportunity cost of a choice is the value
of the best alternative given up.

Principle 3: Marginal revenue must exceed marginal cost. Any increased economic
activity must be justified based on the following fundamental economic principle:
marginal revenue must exceed marginal cost. Here, the marginal revenue is the
additional revenue made possible by increasing the activity by one unit (or a small
unit). Similarly, marginal cost is the additional cost incurred by the same increase in
activity. Productive resources such as natural resources, human resources, and capital
goods available to make goods and services are limited. Therefore, people cannot

IE 111 2|P age

ENGINEERING ECONOMICS 2020

have all the goods and services they want; as a result. they must choose those things
that produce the most.

Principle 4: Additional risk is not taken without the expected additional return.
For delaying consumption, investors demand a minimum return that must be greater
than the anticipated rate of inflation or any perceived risk. If they didn't receive
enough to compensate for anticipated inflation and perceived investment risk,
investors would purchase whatever goods they desired ahead of time or invest in
assets that would provide a sufficient return to compensate for any loss from inflation
or potential risk.

TOPIC 2: ENGINEERING ECONOMICS AND THE DESIGN PROCESS

Economic decisions differ in a fundamental way from the types of decisions

typically encountered in engineering design. In a design situation, the engineer uses
known physical properties, the principles of chemistry and physics, engineering design
correlations, and engineering judgment to arrive at a workable and optimal design.
If the judgment is sound, the calculations are done correctly, and we ignore
technological advances, the design is time invariant. In other words, if the engineering
design to meet a particular need is done today, next year, or in five years’ time, the
final design will not change significantly.

In considering economic decisions, the measurement of investment

attractiveness, which is the subject of this book, is relatively straightforward. However,
information required in such evaluations always involves predicting or forecasting
product sales, product selling price, and various costs over some future time frame-5
years, 10 years, 25 years, etc.

All such forecasts have two things in common. First, they are never completely
accurate when compared with the actual values realized at future times. Second, a
prediction or forecast made today is likely to be different than one made at some
point in the future. It is this ever-changing view of the future that can make it necessary
to revisit and even change previous economic decisions. Thus, unlike engineering
design outcomes. the conclusions reached through economic evaluation are not
necessarily time invariant. Economic decisions have to be based on the best
information available at the time of the decision and a thorough understanding of
the uncertainties in the forecasted data.

What role do engineers play within a firm? What specific tasks are assigned to
the engineering staff, and what tools and techniques are available to it to improve a
firm's profits? Engineers are called upon to participate in a variety of decision-making
processes, ranging from manufacturing and marketing to financing decisions. We will
restrict our focus, however, to various economic decisions related to engineering
projects. We refer to these decisions as engineering economic decisions.

IE 111 3|P age

ENGINEERING ECONOMICS 2020

FUNDAMENTAL ECONOMIC CONCEPTS

Consumer and Producer Goods and Services

Consumer goods and services are those products or services that are directly
used by people to satisfy their wants.

Producer goods and services are used to produce consumer goods and
services or other producer goods.

Necessities and Luxuries

Necessities are those products or services that are required to support human
life and activities, that will be purchased in somewhat the same quantity even though
the price varies considerably.

Luxuries are those products or services that are desired by humans and will be
purchased if money is available after the required necessities have been obtained.

Demand

Demand is the quantity of a certain commodity that is bought at a certain price

at a given place and time.

Elastic demand occurs when a decrease in selling price result in a greater than
proportionate increase in sales.

Inelastic demand occurs when a decrease int the selling price produces a less
than proportionate increase in sales.

Unitary elasticity of demand occurs when the mathematical product of volume

and price is constant.

IE 111 4|P age

ENGINEERING ECONOMICS 2020

Competition, Monopoly and Oligopoly

Perfect competition occurs in a situation where a community or service is

supplied by a number of vendors and there is nothing to prevent additional vendors
entering the market.

Monopoly is the opposite of perfect competition. A perfect monopoly exists

when a unique product or service is available from a single vendor and that vendor
can prevent the entry of all others into the market.

Oligopoly exists when there are so few suppliers of a product or service that
action by one will almost inevitably result in a similar action by the others.

The Law of Supply and Demand

Supply is the quantity of a certain commodity that is offered for sale at a

certain price at a given place and time.

The law of supply and demand may be stated as follows:

“Under conditions of perfect competition, the price at which a given product

will be supplied and purchased is the price that will result in the supply and the
demand being equal.”

IE 111 5|P age

ENGINEERING ECONOMICS 2020

The Law of Diminishing Returns

“When the use of one of the factors of production is limited, either in

increasing cost or by absolute quantity, a point will be reached beyond which an
increase in the variable factors will result in a less than proportionate increase in
output”.

TOPIC 3: COST CONCEPTS FOR DECISION MAKING

Many types of cost arise in economy studies of a new or existing enterprise

whenever any change in operations or policy is made. While an engineer may be
cognizant of the various types of cost, it appears that classifying the same and
giving the applications of each will make them clearer.

Classifications of Cost

1. First Cost

First cost includes all the initial expenses for starting any enterprise. In general,
this will be the sum of the promotion and development costs. Thus, prior to actual
operation, the sponsors of a new enterprise must spend for the following:
investigation of the market possibilities, source of raw materials, source of labor
force, negotiations with the owners of the chosen plant site, securing from the
municipal council of a permit or license to locate in the town chosen, legal fees to
draft the corporation papers, securing of a sufficient number of stockholders with
adequate capital, fees to be paid to the technical staff for planning the factory,
construction expenses, initial cost of machinery and other equipment, and other
minor initial expenses.

IE 111 6|P age

ENGINEERING ECONOMICS 2020

First cost is important, because if it is not met, an enterprise may fail to

materialize. The success of an enterprise may be jeopardized right from the
beginning due to lack of capital.

2. Fixed Costs

Fixed costs are those which remain relatively constant regardless of any change
made in operations or policy. Thus, the rental of a property may remain unchanged
even if the output of a factory changes a great deal. The depreciation of a piece of
equipment remains constant regardless of its output. Fixed costs consist of such items
as: rentals on buildings, depreciation, maintenance, taxes, insurance, interest on
borrowed capital, and some administrative expenses.

3. Variable Costs

Variable costs are those which vary with output or any change in the activities of
an enterprise. For example, the cost of materials used depends on the output. In
general, all costs for direct materials, direct labor, and other items which can be
directly allocated to each unit produced, are classified as variable costs.

4. Increment Costs

Increment cost refers to any increase in cost; the word increment meaning
increase. Thus, if to produce 100 units will cost Php 200, and the total cost for
producing 110 units is Php 215, then the increment cost for the additional 10 units is
Php 15 or Php 1.50 per unit. Increment costs are important in problems where it will
be determined whether a change in production will be profitable for the enterprise.

5. Differential Costs

Differential cost has been defined by different authors in different senses. De

Garmo defines differential cost to be those costs “which arise as the result of a
change in operations or policy”, while Thuesen defines the term as “the ratio of a
small increment of cost and a small increment of output”. Thus, in the sense taken by
De Garmo, differential cost may also be considered as synonymous with increment
cost.

6. Marginal Cost

Marginal cost is the additional cost of producing one more unit of a product.
Thus, marginal cost may also be considered as increment cost for an additional unit.

Sunk Cost

Sunk cost represents money which has been spent or capital which has been
invested and which cannot be recovered due to certain reasons. Sunk cost may
also be defined as the unrecovered balance remaining if the net income received is
less than the amount of capital invested. Sunk cost arise when the expected result

IE 111 7|P age

ENGINEERING ECONOMICS 2020

from an investment does not materialize. Thus, sunk costs represent losses due to
errors in past decisions. For instance, if a company purchases a machine for Php 10,
000.00, but finds out later that it is not the proper type of machine that it needs, and
then disposes the same for Php 8, 000.00, then the unrecovered capital of Php 2, 000
represents sunk cost. Good business practice dictates that the loss be considered as
such, as soon as it is recognized, for usually further delay in taking the loss will result in
more losses.

ILLUSTRATIVE PROBLEMS

1. The total cost of manufacturing 10, 000 pieces and 12, 000 pieces of a certain
plastic product are Php 2, 000 and Php 2, 280, respectively. Determine the
following:
a. the average production cost per unit for the first 10, 000 pieces;
b. the variable cost per unit;
c. the total fixed cost;
d. the average fixed cost per unit for the first 10, 000 pieces; and
e. the profit or loss if 1, 000 units in excess of the first 10, 000 pieces can be
sold for Php 0.18 each.
Solution:

a. the average production cost per unit for the first 10, 000 pieces

𝑃ℎ𝑝 2, 000
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡 = = 𝑷𝒉𝒑 𝟎. 𝟐𝟎 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕
10, 000

b. the variable cost per unit

c. the total fixed cost

𝐿𝑒𝑡 𝐹 = 𝑡𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 𝑟𝑒𝑔𝑎𝑟𝑑𝑙𝑒𝑠𝑠 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡

𝐿𝑒𝑡 𝑣 = 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑝𝑖𝑒𝑐𝑒

𝐹𝑜𝑟 10, 000 𝑝𝑖𝑒𝑐𝑒𝑠, 𝐹 + 10, 000𝑣 = 𝑃ℎ𝑝 2, 000 → 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛 1

𝐹𝑜𝑟 12, 000 𝑝𝑖𝑒𝑐𝑒𝑠, 𝐹 + 12, 000𝑣 = 𝑃ℎ𝑝 2, 280 → 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛 2

Solve the 2 equations simultaneously,

𝒗 = 𝑷𝒉𝒑 𝟎. 𝟏𝟒 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕

𝑭 = 𝑷𝒉𝒑 𝟔𝟎𝟎

d. the average fixed cost per unit for the first 10, 000 pieces

𝐿𝑒𝑡 𝐹 , = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑓𝑖𝑟𝑠𝑡 10, 000 𝑝𝑖𝑒𝑐𝑒s

𝑃ℎ𝑝 600
𝐹 , = = 𝑷𝒉𝒑 𝟎. 𝟎𝟔 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕
10, 000

IE 111 8|P age

ENGINEERING ECONOMICS 2020

e. the profit or loss if 1, 000 units in excess of the first 10, 000 pieces can be sold
for Php 0.18 each.

The fixed cost will be charged to the first 10, 000 units. A profit will result
because the selling price of Php 0.18 exceeds the variable cost of Php
0.14 per unit.

𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑜𝑟 1000 𝑢𝑛𝑖𝑡𝑠 𝑖𝑛 𝑒𝑥𝑐𝑒𝑠𝑠 𝑜𝑓 10, 000 𝑢𝑛𝑖𝑡𝑠 = 1, 000(𝑃ℎ𝑝 0.04)

𝑷𝒓𝒐𝒇𝒊𝒕 𝒇𝒐𝒓 𝟏𝟎𝟎𝟎 𝒖𝒏𝒊𝒕𝒔 𝒊𝒏 𝒆𝒙𝒄𝒆𝒔𝒔 𝒐𝒇 𝟏𝟎, 𝟎𝟎𝟎 𝒖𝒏𝒊𝒕𝒔 = 𝑷𝒉𝒑 𝟒𝟎. 𝟎𝟎

2. A car owner estimates from available data that it costs him an average of
Php 3, 700 per month for car insurance, taxes, and depreciation, and a
variable cost of Php 1.75 per kilometer travelled. On the average, he travels
about 2, 000 kilometers each month. Determine the increment cost if he
travels 2, 300 kilometers during a certain month.

Solution:

The fixed monthly expense of Php 3, 700 is independent of the distance the car is
used, and it will not affect the increment cost regardless of car usage. Thus,

𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡 = (2300 − 2000)(𝑃ℎ𝑝 1.75)

𝑰𝒏𝒄𝒓𝒆𝒎𝒆𝒏𝒕 𝒄𝒐𝒔𝒕 = 𝑷𝒉𝒑 𝟓𝟐𝟓. 𝟎𝟎

3. The cost of electric energy in a certain city is based on the following

consumption: first 25 kw-hr per month at Php 6.00; next 25 kw-hr at Php 4.50;
next 50 kw-hr at Php 4.00; and the additional kw-hr in excess of 100 kw-hr at
Php 3.00. The present consumption of a family is 80 kw-hr a month. If it is
contemplated to install an electric range which will use about 110 kw-hr per
month, determine the monthly cost of energy for the range.

Solution:

For the present consumption of 80 kw-hr a month,

𝑃ℎ𝑝 6.00 𝑃ℎ𝑝 4.50 𝑃ℎ𝑝 4.00

𝐶𝑜𝑠𝑡 = 25 𝑘𝑤 − ℎ𝑟 + 25 𝑘𝑤 − ℎ𝑟 + 30 𝑘𝑤 − ℎ𝑟
𝑘𝑤 − ℎ𝑟 𝑘𝑤 − ℎ𝑟 𝑘𝑤 − ℎ𝑟

𝐶𝑜𝑠𝑡 = 𝑃ℎ𝑝 382.5

If the range is installed, the power consumption will be 80 kw-hr + 110 kw-hr = 190 kw-
hr

For this consumption,

IE 111 9|P age

ENGINEERING ECONOMICS 2020

𝑃ℎ𝑝 6.00 𝑃ℎ𝑝 4.50 𝑃ℎ𝑝 4.00

𝐶𝑜𝑠𝑡 = 25 𝑘𝑤 − ℎ𝑟 + 25 𝑘𝑤 − ℎ𝑟 + 50 𝑘𝑤 − ℎ𝑟
𝑘𝑤 − ℎ𝑟 𝑘𝑤 − ℎ𝑟 𝑘𝑤 − ℎ𝑟
𝑃ℎ𝑝 3.00
+ 90 𝑘𝑤 − ℎ𝑟
𝑘𝑤 − ℎ𝑟

𝐶𝑜𝑠𝑡 = 𝑃ℎ𝑝 732.5

Thus, for the electric range, the cost of energy will be

𝐶𝑜𝑠𝑡 = 𝑃ℎ𝑝 732.5 − 𝑃ℎ𝑝 382.5

𝑪𝒐𝒔𝒕𝒓𝒂𝒏𝒈𝒆 = 𝑷𝒉𝒑 𝟑𝟓𝟎. 𝟎𝟎

TOPIC 4: PRESENT ECONOMIC STUDIES

Present economic studies are engineering economic analyses where

alternatives for accomplishing a specific task are being compared over one year or
less and the influence of time on money can be ignored.

Two rules shall be followed in conducting present economy studies. These

rules, or criteria, will be used to select the preferred alternative when defect-free
output (yield) is variable or constant among the alternatives being considered.

Rule 1

When revenues and other economic benefits are present and vary among
alternatives, choose the alternative that maximizes overall profitability based on the
number of defect-free units of a product or service produced.

Rule 2

When revenues and other economic benefits are NOT present or are
constant among all alternatives, consider only the costs and select the alternative
that minimizes total costs per defect-free unit of product or service output.

Situations Where Present Economic Studies are Involved

Material Selection
Involves selection among materials available that result in the most
economical product and give the best results.

Selection of Method
Two or more different methods may give the same satisfactory results. Select
the most economical way to accomplish operations.

Selection of Design

IE 111 10 | P a g e
ENGINEERING ECONOMICS 2020

The design to be selected must be best suited for the work to be done with
particular care being given to the one which will do the work with utmost economy.

Site Selection
Costs relevant to selecting sites must be carefully considered (land cost,
construction cost, cost of available labor, cost of transporting equipment and
materials)

Proficiency of Workers
Bear in mind that workers have varying efficiency and proficiency. Worker
proficiency can be translated into monetary values.

Economy of Tool and Equipment Maintenance

Consider the costs of acquiring tools and equipment and the costs of
maintaining them.

Economy in the Utilization of Personnel

Only a certain number of personnel will lead to the highest productivity;
increasing this number will not cause a proportional increase in productivity.

IE 111 11 | P a g e
ENGINEERING ECONOMICS 2020

EXERCISES 01

ESSAY: Explain the importance or role of engineering economy in the practice of

civil engineering.

IE 111 12 | P a g e