ECLT 5930/SEEM 5740: Engineering Economics

2016–17 First Term

Master of Science in ECLT & SEEM

Instructor: Dr. Keith Wong

Department of Systems Engineering & Engineering Management
The Chinese University of Hong Kong

September 8, 2016
 Course Personnel

• Instructor: Dr. Keith WONG

– Email: mhwong@se.cuhk.edu.hk

• Teaching Assistants:

Name Office Phone Email

Mr. Shengcheng SHAO ERB 615 3 8335 scshao@se.cuhk.edu.hk
Mr. Gongqiu ZHANG ERB 802 3 4437 gqzhang@se.cuhk.edu.hk
– Office Hours: By appointment

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 Course Particulars
Course Website: in eLearning
(http://www.cuhk.edu.hk/eLearning/ → top right corner)
Textbook: Sullivan, Wicks, and Koelling
Engineering Economy (16th Edition)
Pearson Education Limited 2014

Reference Book: Chan S. Park

Contemporary Engineering Economics (5th Edition)
Pearson Education Limited 2014

Scope: Chapters 1–8, 10–12 + supplementary material

Assessment: Homework assignments (around 4 of them) — 40%

(Assignment Box: C11 in 5/F of ERB)
Final examination — 60%

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 Homework Policy

• Working in groups allowed (even encouraged).

• The writeup must be your own. Copying the solution from your classmates/other
sources is strictly forbidden. (Please read the Department Guideline for
Plagiarism on the course website.)

• Homeworks are due on Thursdays. Late submission will incur a 10% penalty,
unless prior arrangement with the instructor has been made.

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 Rules of the Class

• Important: Please read the Student/Faculty Expectations on Teaching and

Learning, prepared by the Faculty of Engineering, The Chinese University of
Hong Kong.

• Active participation (asking/answering questions, making comments, etc.)

encouraged

• Creative thinking encouraged

• Notes taking encouraged

• Discussions after the lecture encouraged

• Criticisms welcome

• Disruptions, lateness, and absence discouraged

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 What is Engineering Economics?

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 What is Engineering Economics?

From the US Accreditation Board for Engineering and Technology (ABET):

Engineering is the profession in which a knowledge of the
mathematical and natural sciences gained by study, experience,
and practice is applied with judgment to develop ways to utilize,
economically, the materials and forces of nature for the benefit of
mankind.

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• Just being able to build/create things is not enough. One must be able to do it
economically.
– Engineering processes involve decisions and tradeoffs.
– Each has a different cost, i.e., something you give up (usually money).

• Examples
– Building a bridge: Where to build it? What kind of clients does it serve
(pedestrians? heavy trucks? trains?)
– Operating equipment: Buy or rent?
– Designing a cellphone: What features to include? When to launch it?
– Managing a supply chain: When to replenish? Who are the suppliers?
Sustainability issues (so–called “green supply chains”)?

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• The merit of a decision depends on its outcome.
– Being able to predict the outcome, therefore, is important.
– The value of an outcome is often subjective and depends on context.

• Factors affecting the merit of a decision

– Economic indicators: unemployment, debt obligations, interest rates,
exchange rates, inflationary/stagflationary/deflationary pressure, etc.
– Execution complexity
– Beneficiaries: Individual, company, society, nation
– Strategic interactions among the parties involved: Game theory

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 Effect of Uncertainty
Secretary Problem

• You want to hire a secretary from a pool of n applicants.

• Naturally, you only want to hire the best and brightest.

• You cannot tell how good a candidate is until you interview her.

• You must make a decision right after the interview, and the decision
is irrevocable.
What strategy will maximize the probability of hiring the best
candidate?

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 Effect of Strategic Interaction
Prisoners’ Dilemma
Confess Deny
Confess 1,1 4,0
Deny 0,4 3,3

• Two robbers got captured!

• If both confess, then both will get a 1–year sentence.

• If both deny, then both will get a 3–year sentence.

• If one of them denies, then he will be freed, but the other guy will
get a 4–year sentence.
Both of them would deny and end up in a bad situation!

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 Effect of Strategic Interaction
Road Pricing
x

A B

• Travellers can go from A to B using one of two routes.

• The delay on the lower route is fixed at one unit.

• The delay on the upper route depends linearly on the amount of traffic.

• Suppose that there is one unit of traffic, representing a large population

of travellers. We would like to minimize delay (naturally).
What is the optimal strategy for an individual? For the collective group?

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 What is Engineering Economics?
Engineering economy involves the systematic evaluation of the
economic merits of proposed solutions to engineering problems.
To be economically acceptable, solutions must
• demonstrate a positive balance of long–term benefits over long–term
costs,

• promote the well–being and survival of an organization,

• embody creative and innovative technology and ideas,

• permit identification and scrutiny of their estimated outcomes, and

• translate profitability to the ”bottom line” through a valid and

acceptable measure of merit.

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• The horizon over which the decisions are made is important — “long–term”
strategies can be very different from “short–term” ones.

• To have a good evaluation of merits, a proper understanding of the situation

is necessary — i.e., need a good model. There is always a tradeoff between
tractability and complexity.

• Technologies tend to improve productivity, but only if they are properly used.

• Solutions should not complicate matter: “Make things as simple as possible,

but not simpler.” — Albert Einstein

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 Principles of Engineering Economy

1. Problem recognition, definition, and evaluation

• What is the need?
• The more concrete the description, the better for further analysis.
• Evaluation of the problem typically includes refinement of needs and
requirements, and information from the evaluation phase may change the
original problem formulation.

2. Develop the alternatives

• What are the possible courses of actions?
• Screening alternatives to select a smaller group for further analysis

3. Focus on the differences

• Only the differences in the alternatives are relevant to their comparison. If all
options are equal, then taking any one of them will do.

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 Principles of Engineering Economy (Cont’d)

4. Use a consistent viewpoint

• Define and evaluate the alternatives and their outcomes from a fixed persective.

5. Use a common unit of measure

• Make sure we are comparing options on an equal basis, i.e., not comparing
oranges with apples.

6. Consider all relevant criteria and develop prospective outcomes

• What is the objective? Single or multiple objectives?
• Typically measured by cash flow — Do I make money?
• Non–monetary factors can also be important (e.g., reputation,
customer/employee satisfaction, long–term sustainability, etc.) However, these
could be tricky to measure.

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 Principles of Engineering Economy (Cont’d)

7. Making risk and uncertainty explicit

• Can be philosophical, e.g., what is risk? Also, what kind of information about
the uncertainty do we know? Scenarios? Probabilities?

8. Revisit your decisions

• Things may not turn out as expected.
• Typically, decisions and outcomes are not in “one–shot”, i.e., they evolve
dynamically over time.
• Factors affecting the outcome may change, and hence the decisions must adapt.
• Monitoring project performance during its operational phase improves the
achievement of related goals and reduces the variability in desired results.

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Engineering Economic Analysis & Engineering Design Process

1. Problem definition

2. Problem formulation and evaluation

3. Synthesis of possible solutions (alternatives)

4. Analysis, optimization, and evaluation

5. Specification of preferred alternative

6. Communication via performance monitoring

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 Application: Buy, Rent or Repair?

• You wreck your car! And you absolutely need one to get around.

• A wholesaler offers $2,000 for the wrecked car, and $4,500 if it is repaired. The
car’s standing mileage is 58,000 miles.

• Your insurance company offers $1,000 to cover the cost of the accident.

• To repair the car costs $2,000.

• A newer second–hand car costs $10,000 with a standing mileage of 28,000 miles.

• A part–time technician can repair the car for $1,100, but it takes a month. In
the meantime, you need to rent a car, which costs $400 per month.

Question: What should you do?

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 Application: Buy, Rent or Repair? (Cont’d)

No panic! Apply the engineering economic analysis procedure.

Step 1: Define the problem

In this case, it is simple — you need a car!

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 Application: Buy, Rent or Repair? (Cont’d)

Step 2: Develop alternatives

You have several options.

(A) Sell the wrecked car and buy the second–hand car. (Of course you would not
just dispose the wrecked car.)

(B) Repair the car and keep it.

(C) Repair the car, sell it, and then buy the second–hand car.

(D) Let the part–time technician repair the car and rent in the meantime. Afterwards,
keep the car.

(E) Let the part–time technician repair the car and rent in the meantime. Afterwards,
sell the car and buy the second–hand car.

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 Application: Buy, Rent or Repair? (Cont’d)

Step 3: Develop prospective outcomes via cash flows

(A) Sell the wrecked car and buy the second–hand car. $2,000 + $1,000 – $10,000
= –$7,000

(B) Repair the car and keep it. $1,000 – $2,000 = –$1,000

(C) Repair the car, sell it, and then buy the second–hand car. $1,000 – $2,000 +
$4,500 – $10,000 = –$6,500

(D) Let the part–time technician repair the car and rent in the meantime. Afterwards,
keep the car. $1,000 – $1,100 – $400 = –$500

(E) Let the part–time technician repair the car and rent in the meantime. Afterwards,
sell the car and buy the second–hand car. $1,000 – $1,100 – $400 + $4,500 –
$10,000 = –$6,000

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 Application: Buy, Rent or Repair? (Cont’d)
Step 4: Use a consistent criterion
Let us just focus on your asset value immediately after the decision is made. (We
are ignoring other things, such as higher future insurance costs, resell value of the
second–hand car, etc.)
Step 5: Compare the alternatives

(A) Sell the wrecked car and buy the second–hand car. $10,000 – $7,000 = $3,000

(B) Repair the car and keep it. $4,500 – $1,000 = $3,500

(C) Repair the car, sell it, and then buy the second–hand car. $10,000 – $6,500 =
$3,500

(D) Let the part–time technician repair the car and rent in the meantime. Afterwards,
keep the car. $4,500 – $500 = $4,000

(E) Let the part–time technician repair the car and rent in the meantime. Afterwards,
sell the car and buy the second–hand car. $10,000 – $6,000 = $4,000

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 Application: Buy, Rent or Repair? (Cont’d)

Step 6: Choose a preferred alternative after considering risk and uncertainties

From the asset value point–of–view, (D) and (E) are equally good. To differentiate
them, we need other criteria. Say, if the repaired car has a higher risk of failing,
then we would prefer (E).

Step 7: Revisit the decision

Road test the newer car and confirm your decision.

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 Another Application: Apartment Financing

• Your friend bought an apartment building for $100,000.

• She spent $10,000 of her own money, got a mortgage for the remaining $90,000.

• Annual mortgage payment to the bank is $10,500.

• Expected annual maintenance of the apartment building at $15,000.

• She can rent out the 4 apartments in the building, at $360 per month.

Question: Is your friend in a good position? If not, what can be done?

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 Another Application: Apartment Financing (Cont’d)

As before, we can apply the engineering economic analysis procedure to solve this
problem.

Step 1: Define the problem

Her annual net cash flow is –$10,500 – $15,000 + 4 × 12 × $360 = –$8,220.

Seems she is not doing so well. The problem then is whether it is possible for her
to achieve a better position.

Step 2: Develop alternatives

What are her alternatives?

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 Another Application: Apartment Financing (Cont’d)

Some alternatives include:

(A) Raise the rent.

(B) Lower the maintenance expenses.

(C) Sell the apartment building.

(D) Abandon the building.

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 Another Application: Apartment Financing (Cont’d)
Step 3: Develop prospective outcomes

(A) Raise the rent.

To cover the monthly expense of $25,500/12 = $2,125, the rent has to be
increased to $2,125/4 = $531.25, which is a 47.6% increase!

(B) Lower the maintenance expenses.

To break even with the current rent level, the monthly cost has to be decreased
to $1,440. This means that the monthly maintenance cost should be at $1,440
– $10,500/12 = $565. This amounts to a 54.8% drop in maintenance cost.

(C) Sell the apartment building.

Ideally, the selling price should cover the original investment of $10,000 plus the
$8,220/12 = $685 per month loss.

(D) Abandon the building.

A very bad idea!

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 Another Application: Apartment Financing (Cont’d)

Step 4: Use a consistent criterion

It could be that of minimizing the expected loss of money.

What other criteria can we use?

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 What’s Next?

• Assignment: Read Chapter 1 of the course textbook.

• Next: Cost concepts and design economics (Chapter 2 of the course textbook)

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