+ ++ CHAPTER ONE Principles of Engineering Economy and Present Economy Studies 4.1 Def nition of Engineering Economy Engineering economy is that branch of economics that makes use of economic laws, ciples, and concepts to evaluate the value of engineering designs, projects, systems, Prmgucts, and services. It may also be considered as a process of determining the economic ee ‘and principles to be applied to assess the sultabllity of a given venture, estimate its worth, and justify it from an engineering perspective, 4.2 Basic Terminologies rertization! ‘The gradual repayment of a liability through regular installments within a specified period of time. Such installments must be adequate to cover both principal and interest earned, 2 “Authorized Capital , ‘The grand total of assets and operational capability of a corporation. 2 Bank Note (Bill)! Paper currency issued by the central bank that is considered the legal tender of a country. + Board of Directors) “ ‘Are the individuals elected by the stockholders to govern a corporation. 5 [Book Valud ‘The worth of an asset as refiected on a company’s balance sheet, it is the initial cost less the accumulated depreciation, © Break-even (no profit or loss)’ Is a condition where total sales are equal to total cost of production and sales. It is a situation where no profit is generated and no losses are incurred. 7 [Bum Rate} ‘The rate at which an entity spends its money. © (Cartel) An organization of companies, countries or other entities that agree to work together to manipulate market prices by controlling the output and sale of a Particular product. The organization generally prevents the entry of new players to avoid competition. 2 Cash inflow! Any current or expected profit or ‘savings associated with an investment. © [ash outflow) Is the initial cost plus other projected expenses associated with an investment. '\_ [Chief Executive Officer (CEO) Is the highest ranking corporate executive who is responsible for a company's overall operations and performance, normally the President or the Chairman of the Board, 11‘= [Deflation ‘A decrease in the level of national income and output, usually accompanied by a genera deciine in prices. Q ‘A torn that refers to the use and exhaustion of natural resources within a region, It ig Used in reference to activities such as mining, logging, farming, fishing, and oll exploration, Decrease in the value of an asset due to deterioration, obsolescence, or passage of time, ‘A prolonged state of recession where the gross domestic product (GDP) falls by more than 10%. This Is characterized by a decline in investments, high unemployment and low wages, ve Entity, P SYnestip An organizational unit (a proprietorship, partnership, or corporation) for which accounting reports are prepared and financial records are kept. \7 Equity. Is the right, claim, or interest of an entity over the assets of the business. 18 Exchange Rate, ‘The value of one currency in terms of another. Costs incurred for goods and services used in the normal course of business. This excludes goods bought for resale or any item that is capital nature. @ Fixed Assets (Property, Plant, and Equipment). ‘Any business property acquired for use in its operations and which still retains a value at year end. These usually consist of major items like land, buildings, equipment, and vehicles. 21 Franchise A license given to an entity to offer a product or a particular service of the patent holder. 2 [Income (Revenue); Amount or payment received by an entity from its business activities. ©2 (Inflation, Is the general increase in the price level of goods and services - a decrease in the purchasing power of the peso. 24 Insolvent , ‘The state of a company if its funds are insufficient to pay all of its obligations. "Soint Venture, A business agreement under which two or more entities join together to undertake a ‘Common project and agree to share the profits. ‘Landed costs! The total costs involved when it ir rice, shipping, insurance are slved when imparting goods. This includes the purchase price, sho 1-2"A contract that specifies the terms under which a property right of property use to another party. " cameriiacreieciode ® Lessee! ‘The party that is granted the right of property use under the terms of a lease. ‘The owner of property that is rented (leased) by another party. © (Liquidity) The ability of the business to meet current obligations with payments in cash or other assets that can be quickly converted to cash. Expenses that provide no benefit to the business, © VLuuries! Are products or services that are not essential but are desirable and often expensive, they are usually brought about by the conventions and customs of society. ‘The principal debtor who assumes responsibility for the loan payment upon maturity. = ‘Market Value’ The price for a property that a willing buyer would pay and a willing seller would accept, with both acting in their own interests and are under no obligation to buy or sell, ‘The date on which a financial note or other obligation becomes due. 2 Necessities ‘Are products or services that are required to support human life and activities, which will be purchased in almost the same quantities even if the prices vary considerably (e.g. basic food, clothing and shelter). ‘Are the expenses involved in running a business (e.g. rent, insurance, power, wages, etc.). ‘Owner's Equity or Capital! ‘The value of a business to its owner/s. includes the initial investment and retained earnings. =, Parent Company ‘A company that owns or controls other companies, called subsidiaries. Control generally refers to ownership of more than 50% of the stock in the subsidiary. 40. Patent} ‘An exclusive right granted by the government for the manufacture, use, and sale of a specific product. 1341 Price Discrimination The practice of providing the same good or service at different prices to different consumers, even if production and sales costs are the same for all transactions. Consumers ‘may be discriminated on the basis of income, gender, age, or geographic location, 42 Price Transparency ‘The process where both seller and the buyer are accorded equal access to pricing information with no mediator involved. The term may also indicate the accessibility of Pricing information to the public. Price War . . ‘A market situation where companies constantly lower prices to weaken the competition or force smaller competitors out of business. Profi Margin (Mar ue) cence between the costs of a product and the pice It s sold ove the cost of the product, expressed as a percentage (e.g. if a product costs P100 and you sell it for P175 then you have a 75% profit margin). 45 ° Pro Rata ‘A term describing an allocation based on proportionate distribution of the full amount. “Rate of Return (ROR). ‘The profit or loss from a financial undertaking, expressed as a percentage of the original investment. 47 Rebate The partial retum of the full amount paid for the purchase of a merchandise or service. 48° Recession ‘A period of economic decline that lasts for a few months, this is usually accompanied by 2 drop in the stock market, a decrease in income and an increase in unemployment. 42° Refund” ‘The amount returned to a customer for the return of previously purchased products. 50 Retained Earnings Are earings reinvested in the business after profit distributions are made to the owners. 5\ Revenues Incorne derived from the selling goods or rendering services. 2 Shareholders (Stockholders) ; I ‘Are the oviners of a company or corporation. : 52 Shares (Stocks) Refers to documents issued by a it 4 ‘company to its owners (the shareholders) indicating how many shares in the company each Company te sharenceuPeny each shareholder has purchased and what percentage ofthe 54 Silent Partner An investor who does ; posi Not actively participate in the mana operati 'eSs but provides capital and shares the liabilities of the ana o epaations ot 145 sinking Fund ‘reserve fund created for the purpose or repaying debt, purchasing new assets or payment of any other anticipated future expense. The fund is generated by periodically depositing a certain amount in an interest-bearing instrument or investment. Flo Subsidiary ‘Acompany owned or controlled by another company, known as the parent company. 5) Subsidy * “Economic benefit or financial assistance granted by the government to business entities or individuals usually in the form of @ cash payment or tax discounts. A subsidy is usually siven to keep prices stable, maintain employment or encourage investment. 58 Sunk Cost Is a cost that has already been incurred and therefore cannot be changed by any current decision or action. 59 Supplies Materials used in the course of business operations that do not generally become part of the sales product. 0 Trading Securities (Marketable Securities) ‘Are financial instruments purchased with the intent of realizing short term income or reselling should the need for cash arise. GI Transaction ‘an economic activity between entities that involve the transfer of funds or resources. 2 ‘Transportation Costs Is the cost of transferring goods into or out of the firm. ©3 Valuation” The process of determining the current worth of a particular property for a specific reason. 1.3 Economic Concepts and Principles 41.31 Demand, Supply, and Price ‘Demand"- is the quantity of goods or services that consumers desire and are able to buy at a specified price at a particular place and time. Supply’— is the total quantity of goods or services that are offered for sale at a Specific price to consumers, cy 65 na Price is the amount of payment or compensation given by one entity to another in exchange for goods or services. 1.32 Law of Demand This law explains the effect price changes have on consumer behavior. The law of demand states that, “if all other factors are held constant, at lower market prices the Gemand for a commodity or service will increase, and demand will decrease at higher market. Prices". To Clarify, price is considered as a restriction from the viewpoint of the consumer, thus, people will buy more at lower prices and buy less at higher prices.41.33 Law of Supply The law of supply describes direct relationship between supply, price and the quantity Supplied. This basic economic principle states that, if all other factors are DS aaeaa the price of a commodity or service increases, then the quantity of the commodity or ser the that suppliers are willing and able to sell also Increases and vice versa”. To ees the Price of a commodity Increases, suppliers will attempt to mayimize profits by in ig the quantity of their products. 4.34 Law of Supply and Demand The law of supply and demand describes the effect that the supply of and the “When the demand is high and demand for a particular commodity has on its price. It states, rand the supply goes down the price will increase. In contrast, when the supply is high and the , i there is @ decline in demand decreases, the price will decrease”. Simply explained, when supply, the price goes becuse there is a shortage; on the other hand, when there is an increase in supply the price goes down because there is a surplus. 1.35 Law of Diminishing Returns A law of economics that states, if the input of one factor of production is increased continuously (workers or materials) while holding another factor constant (equipment or workspace), the marginal output of the variable factor will eventually decrease. 1.36 Market and Business Entity A market is an organized structure or system used to exchange commodities (goods, services, or resources) it involves buyers and sellers within a particular area, at a specified period of time, The following are the most common types of market structures: Based on the Supply-Side of the Market: 2. Monopoly ~ A market characterized by a single supplier of a product or service. 4. Oligopoly — A market characterized by a small number of sellers where the action _of one will lead to almost the same action of the others. . Monopolistic Competition or Semi-monopoly — A market characterized by a large ‘number of sellers, each with a degree of control over the price. @. Perfect Competition - A market characterized by a large number of sellers, such that none is able to control or influence the price. Based on the Demand-Side of the Market; a eet, A market characterized by a single buyer of an item for which there : cota rl en eit by a small number of buyers, each with having minimal control over the pace Characterized by a large numberof buyers Ab has omentip nate a senate €conomic unit that is distinguished from its owners. It assifcations of business erie sources and credit arrangements, The following are the 16according to Ownership: a. Sole Proprietorship or Single Ownership — is a business entity owned by a single individual. The owner usually acts as the manager, supplies the required capital and Is responsible for the obligations of the business. Partnership ~ Is a business organization owned by two or more individuals. This is characterized by a legal agreement between partners specifying management responsibilities, capital, and the manner in which earnings or losses shall be distributed. «Corporation ~ Is a business organization of not less than five persons. It is an artificial being created by operation of law, having the rights, powers, attributes and properties expressly authorized by law. It is an entity separate from its owners where ownership is represented by transferable shares of stocks. According to the Nature of the Business: 2. Servicing ~ is a business entity that renders services to its clients or customers (e.g. rental company, laundry services, motor shops, engineers, doctors, and lawyers). .. Merchandising ~ is a trading or retailing business engaged in the selling of goods purchased for the purpose of resale. The success of this type of business depends on its ability to acquire goods at low prices, and sell the same goods at a profit (e.g. groceries, department stores, and appliance centers). Manufacturing ~ is a business entity engaged in the production of the goods that it sells (e.g. textile manufacturing, brewery, and shoe manufacturing) > 1.4 Principles of Engineering Economy The purpose of engineering economy is to assess the suitability of a given engineering project and to evaluate related alternatives from an economic standpoint. For every engineering project, there are usually several potential alternatives. The difficulty of selecting one alternative over others or choosing the do nothing alternative is often encountered. When making a decision evaluation of factors such as costs, revenues, and period of analysis will often lead to a choice, however, attributes like environmental effect, Community development, and public image must at times be considered, In each analysis it will be useful to consider and be guided by the following fundamental principles of engineering economy: PRINCIPLE 1 — IDENTIFY THE ALTERNATIVES Since the selection is among alternatives, the alternatives need to be recognized, Classified and then defined for further evaluation. PRINCIPLE 2 ~ CONSIDER ONLY THE DIFFERENCES Factors that are common to all alternatives are irrelevant thus, only the ‘Ntiating features between the alternatives should be considered in the analysis. differer PRINCIPLE 3 - IGNORE SUNK COSTS This is a corollary to principle 2, note that sunk costs are cash flows that incurred in the past; hence, they are factors common to all the alternatives and are immaterial to an Sconomic choice. Sunk costs are not considered in an economic analysis since investment and other financial I decisions are based on a series of estimates relating to the future. 1-7RINCIPLE 4 — ESTABLISH A PERSPECTIVE aa potential worth ofthe altematives, economic and otherwise, must be evauaty from the point of view of the decision maker, which may be that of the owners oft business, the employees or the customers. PRINCIPLE 5 ~ USE A COMMON UNIT OF MEASURE Practica ff the alternatives a common and To simplify assessment and comparison o unit of measurement must be applied. This is usually achieved by expressing the prospect. outcomes in monetary terms or in percentage of the rate of return. PRINCIPLE 6 ~ REFLECT ON ALL RELEVANT CRITERIA — : The appropriate evaluation all alternative requires the use of a criteria or several decisive factors. The decision process should consider not only the expected rease specified in monetary terms but also those explicitly conveyed as the Supplementary adjectives of the project. Non-monetary considerations such as customer satisfacton ervironmental benefits, employee welfare, community improvement, etc,, may also be wy ‘compelling importance. PRINCIPLE 7 - CONSIDER THE UNCERTAINTIES OF THE FUTURE Because estimates are only predictions, uncertainty is inherent in estimating the future outcomes of alternative choices. However, the type and degree of uncertainty ics be considered in the assessment and comparison of altematives to ensure the quaity a reliability of the analysis. PRINCIPLE 8 — RE-EXAMINE YOUR DECISIONS When a decision is made and the proposal is implemented it is critically important to follow- up on the project. Actual results should be consistently monitored and subsequently compared with the projected outcomes of the selected alternative. Evaluation Teports should be stored in an organized manner and the information generated used to improve future analyses of alternative selection. 1.5 Engineering Economy and the Design Process Engineering economy studies consists of data gathering and data assessment between two or more alternatives. This is accomplished by integrating the principles of reasonable and which alternative should be given highest priority. As a general rule, an Engineering economy study is a decision-assisting process that involves the following steps: ‘STEP 1 ~ PROBLEM DEFINITION ing conditions fail to meet our expectations and requirements, it is but n existit usual to look for its cause or seek improvement. Once the problem is rec it must be ‘ognized, it mus assessed and defined explicitly for easy understanding. STEP 2 ~ IDENTIFY ALTERNATIVES a ies sep requires searching for possible alternatives and screening them to establish evaluation stage, "Pl alternatives (principle 1), This is usually referred to as the pre- 1-8grep 3 - EVALUATE ALTERNATIVES aaa ‘After preliminary evaluation, the selected set of alternatives is assessed comprehensibly using time value of money concepts (refer to chapter 2) and related models of capital allocation. This step of the economic analysis also integrates principles 2, 3, 4, and 5 of section 1.4. TEP 4 - DECIDE ON A DECISION CRITERION ‘The selection process for the best alternative requires the use of a specific criterion or several criteria. This step involves the incorporation of principle 6 of section 1.4. The economic decision criterion should reflect a constant and appropriate perspective (principle 4) and this must be maintained for the duration of the engineering economy study. TEP 5 - EXAMINE AND COMPARE ALTERNATIVES The examination and comparison phase of the study should consider all relevant criteria when weighing the altematives. The comparative study of the alternatives is essentially based on a cash flow estimates (principle 5), thus a considerable amount of effort is required to obtain an accurate forecast of projected cash flows. Obviously, uncertainty is inherent in projecting future outcomes (principle 7); hence, consideration of other factors such as exchange rate movement, inflation, taxes, and depreciation should be included in the analysis and comparison of alternatives. STEP 6 - SELECTION, MONITORING AND FOLLOW-UP After careful study of the analytical results of step 5 is made the selection or implementation of the preferred alternative follows. With implementation comes project monitoring and follow-up, the effects of our choice on the problem or the opportunity it generates should be evaluated based on estimated outcomes. An appropriate recording system must be established for better analysis and to improve on future engineering economy studies (principle 8). 1.6 Cost Concepts for Decision Making Evaluation of cost estimates is one of the most tedious and time-consuming part of an engineering economic study. Alternative selection studies in engineering projects must consider both the explicit (clear and expressed) costs and the implicit (present but non- apparent) costs. To develop a better understanding of cost estimates the basic cost Concepts encountered in engineering economic analysis are defined and explained in this section, = Costs are costs that are independent of production or sales output. These costs remain constant and must be paid even if the Production output is zero. Typical fixed costs i include rental payments, interest payment on loans, management and administrative Salaries, license fees, and insurance payments. ce Varlable costs are expenses that change in direct proportion with the volume of Production or are dependent on the number of units sold. Variable costs include expenses for luction materials, power, direct labor, and shipping. 1-9Recurring Costs Recurring costs are costs that are incurred regularly and repeatedly as a busines entity generates the same services or products on a continuing basis. Rentals, Salaries ang variable costs are considered as recurring costs. Non-recurring Costs "i Non-recuing costs are non-repetitive and are considered as one-time costs jg engineering projects. These include the costs for research and design of a project, the cost of testing a new product, and the cost of real estate property. Oe ret costs are expenses directly attributed in the production of goods oF the performance of a service. In the case of manufacturing products this is also referred ty product cost. For the furniture industry the cost of all the materials and wages of worke-. required in the production of tables and chairs is an example of direct costs. Indirect costs are costs that are not directly related to the manufacture of @ product but are required by the business. These include the expenses for advertising, marketing, security, maintenance, office supplies and salaries of administrative staff. Marginal cost is defined as the difference in the cost of one more or one less unit manufactured above or below existing level of production. In this connection, a unit may represent a single item, a dozen, a pack, a box or any other measure of products. For example, if a manufacturing firm produces X units at a total cost of P50 000.00 and if by increasing the output by one unit the cost goes up to P50 800.00, the cost of the additiona| unit will be P800.00 which is marginal cost. Standard cost is a predetermined cost estimated from administrative standards of efficient operations. These are used as reference for cost control, cost reduction, and budget preparation. ‘Sunk Cost ‘Sunk cost or embedded cost is an expenditure that was incurred in the past and can no longer be recovered or retrieved. Hence, it plays no Part in estimating any future revenue or expense in a project. Sunk costs are irrelevant and are usually disregarded in engineering economic analysis. As an example, assume that you purchase a ticket for the advance Screening of a blockbuster movie, on the date of the showing you are required to work overtime to finish a job project. Knowing the importance of Meeting the deadline you are also aware that you will not be able to make it to the movie showing. So you call some cee 2 ca be al your ee find out they already have tickets or are not interested. re non-refundable and it is obvi i then, the cost of the ticket is considered as a Sunk cost Mat Youjcannok see yn or ‘Opportunity Costs ' Opportunity cost is the benefit that could have bee: i "n gained had an alternative action been considered. For example an opportunity arises for hai to invest your money in 2 corporate stock but you decide to deposit your Money in a bank that guarantees 3% interest 1-10r year. If at the end of the year the stock pays dividends of 10% then, the opportunity Peres 736 (109-39). ‘cyde Cost’ \Lfe OV fe cycle cost is the overall or total cost incurred for a project, structure, equipment or throughout its full life span, This includes cost of acquisition, operation, Craintenance, repairs, conversion and disposal. 1.7 Present Economy Studies Present economy studies involve economic analysis that neglects the influence of time on the value of money. Investment decisions and alternative selection for such studies require cost analysis for a period of one (1) year or less, thus, the effects of interest, infation and depreciation are considered insignificant. To recognize such problems, E. Paul Degarmo one of the pioneer authors on the subject of engineering economy considered the following situations as distinctive to present economy studies: 1. There is no need for initial capital investment and only operating or out-of-pocket costs are required. 2. There is 2 need for initial capital investment; however, the life-time expenses shall be constant or directly proportional to the first cost. 3. The disparity of differences in expenses and income generated for alternatives all ‘occur within a one (1) year period, with any future differences considered as directly proportional to the first period. With this, it is evident that making decisions based on present economy studies reque only the WaSiKTOWedOe GUAIGEBF and where the rule is fo maximize profit and to minimize cost. Hime value of money -value of varies as tim Passes ly References: > DeGarmo, E. P./ Sullivan, W. G./ Bontadelli, J. A./ Wicks, E. M. Engineering Economy, 10” Edition, Prentice- Hall International Inc., pp. 21-62. McConnell, C. R./ Brue, S. L./ Flynn, S. M. Economics, 8” Edition, McGraw-Hill Companies, pp. 45-62. Newnan D, G./ Lavelle J. P./ Eschenbach T. G. Engineering Economic Analysis, 9” Edition, Oxford University Press, pp. 4-18. > Sullivan, W. G./ Wicks, E. M./ Luxhoj, J. T. Engineering Economy, 12" Edition, MetMillan Publishing Co., pp. 2-40, pp. 52-60. » Park, C. S. Contemporary Engineering Economics, 5* Edition, Pearson Education, Inc., pp. 29-42. > White, J. A./ Case, K. E./ Pratt, D. B./ Agee, M. H. Principles of Engineering Economic Analysis, 4" Edition, John Wiley & Sons, Inc., pp. 7-29. > http://www.businessdictionary.com/definition > http://www.investorwords.com > http://www.investopedia.com/terms v v