INTRODUCTION TO ENGINEERING ECONOMICS

 Decisions are made routinely by:

o individuals in everyday life;
o engineers on the job;
o managers who supervise the activities of others;
o a corporate CEO who operates a business;
o government officials who work for the public good; etc.
 Most decisions involve money, called capital or capital funds, which is usually limited in amount
 Decision of where and how to invest this limited capital is motivated by a primary goal of adding
value as future, anticipated results of the selected alternative are realized.
 Engineers play a vital role in capital investment decisions based upon their ability and experience to
design, analyze, and synthesize.
 Factors upon which a decision is based are commonly a combination of economic and noneconomic
elements. Engineering economy deals with the economic factors.
 By definition,
Engineering Economics 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.
 The analyses take into cognizance the fact that virtually all engineering problems have more than
one way of solving them. The choice of the best alternative using economic analysis is what
engineering economics is all about.
 However, all significant factors of the economy must be accurately taken into consideration and
appropriately handled before a chosen alternative is arrived at.

 The best estimates of what is expected to occur and the decision usually involve four essential
elements:
o Cash flows
o Times of occurrence of cash flows
o Interest rates for time value of money
o Measure of economic worth for selecting an alternative
 Sensitivity analysis is utilized to determine how a decision might change according to varying
estimates, especially those expected to vary widely due to changing circumstances and unplanned
events

Measure of Worth: the criterion used to select an alternative in engineering economy for a specific set
of estimates. These include:
Present worth (PW) Rate of return (ROR) Payback period
Future worth (FW) Benefit/cost (B/C) Cost Effectiveness
Annual worth (AW) Capitalized cost (CC) Economic value added (EVA)

 Time value of money: explains the change in the amount of money over time for funds that are
owned (invested) or owed (borrowed). This is the most important concept in engineering economics.
 Steps in an engineering economy study (Decision-making process) are as follows:
o Definition of the problem: Identify and understand the problem.
o Definition of the goal(s) and objective(s): Identify goals – e.g. increase profit margin,
improving quality, reduce production/service cost, minimize risk, maximize employee
satisfaction. Identify the objective of the project (how to achieve the goals, the process).
o Identify feasible alternatives.
o Collect relevant, available data on feasible alternative solutions.
o Make realistic cash flow estimates.
o Identify an economic measure of worth criterion for decision making (using the same
criterion in order to avoid false decision).
o Evaluate each alternative; consider noneconomic factors; use sensitivity analysis as needed.
o Select the best alternative.
o Implement the solution and monitor the results (a step only needed to meet the project
objective)

 All cash flows are estimated for each alternative

 Before an economic analysis technique is applied to the cash flows, some decisions about what to
include in the analysis must be made. Two important possibilities are taxes and inflation.
 There can always be noneconomic or intangible factors that must be considered and that may alter
the decision. There are many possible noneconomic factors; some typical ones are:
o Market pressures, such as need for an increased international presence
o Availability of certain resources, e.g., skilled labor force, water, power, tax incentives
o Government laws that dictate safety, environmental, legal, or other aspects
o Corporate management’s or the board of director’s interest in a particular alternative
o Goodwill offered by an alternative toward a group: employees, union, county, etc

 At times, only one viable alternative is identified, the do-nothing (DN) alternative, and may be
chosen. The do-nothing alternative maintains the status quo.
 When an engineering economy study is performed, it is important for the engineer performing the
study to consider all ethically related matters to ensure that the cost and revenue estimates reflect
what is likely to happen once the project or system is operating.

Role of Engineering Managers in Decision Making

 Today’s business environment is becoming more technical.
 An engineer must combine technical and economic knowledge to enable him act as a consultant to
management in taking some decisions.
 Engineer’s scientific and mathematical background enables him to recognize the practical limitations
of any techniques that would be applied in implementing a project.
 BREAK-EVEN ANALYSIS

 A firm’s profits or losses are determined by the relationship between the total revenue (sales) and
total costs at a certain volume of production.
 Break-even analysis: A management decision-making tool designed to relate the factors of total
sales (revenue) and total costs (expenses) at a certain volume of production
 An effective managerial tool if the data used in the analysis result from an intensive study of price
and cost behaviour with due considerations for all factors that influence selling prices and costs
 It reveals whether, and where, the plant utilization operations show profit or loss.
 Break-even point: volume or level of production at which the total revenue and total cost are
exactly equal
 Any volume above break-even point shows a profit; any volume below shows a loss

Areas of Application
 Product planning: what new product to add, which to be dropped for increased profit margin
 Product pricing: to fix prices for enhanced profitability, taking advantage of elasticity of demand
 Profit planning: To assist in budget-planning process for increased profit
 Make-or-buy decision: for optimal allocation of capital resources in order to determine which
product to buy or to internally manufacture
 Equipment selection and replacement: to decide whether to keep an old equipment or replace it with
a new one with the aim of minimizing production cost and, hence, increase profit

Classification of Costs
 Break-even analysis is traditionally based on two types of costs: Fixed and Variable costs
 Fixed Costs: cost components that don’t change with production rate or volume for the given
proposal and a given time span. E.g., depreciation charges, insurance, local taxes, selling, rental and
general administrative expenses
 Variable Costs: those costs that will change with volume of production or operation. E.g., direct
labour cost, direct material cost, commissions on sales.
 Semi-variable Costs: Costs that may not easily be separated into fixed and variable components. E.g.
o Those costs that have a fixed element that can easily be segregated plus variable component,
e.g. Electricity supply charge (demand + energy charge)
o Costs that cannot be precisely fitted to level of activity attained e.g., clerical salaries and
supervisory costs
o Those costs that bear no measurable relationship to activity and, therefore, do not vary in
proportion to volume but rather as management think they should.
 Scatter diagram may be used to separate semi-variable costs into fixed and variable costs for
break-even analysis.
Basic Assumptions
1. Cost function is linear.
2. Revenue function is linear.
3. All products are sold (at the same price per unit???).
4. Fixed costs are independent of production.
5. There is no income other than from the operations.

Notations
x = volume of production or sales
v = unit variable cost (Naira per unit)
V = v.x = total variable cost (Naira)
F = total fixed cost
p = unit sales price
R = p.x = total revenue or income from sales (Naira)
Zg = gross profit = R – C (i.e. total revenue – total cost)

Graphical Solution
Cost
(Naira) R
C=F+V
B
C0=R0

V
B(x0, C0) = break-even point
F

x0 x (units)

Algebraic Solution
 Total fixed cost, C = F + v.x
 Total revenue, R = p.x
 Gross profit, Zg = R – C = p.x – (F+v.x)
 Break-even point is when Zg = 0. That is, at
F
x 0=
p−v

 And total cost at break-even point is

p. F
C 0=R0 =
p−v
Examples…

Production Above Normal Capacity

 Assume normal production capacity with C = F + v.x
 Let x ' =excess units above normal capacity
 Let y ' =unit variable cost above normal capacity
 Total cost = F + v.x + v’.x’
 Total revenue, R = p.x + p.x’
 Therefore, Gross profit, Zg = R – C = p.x + p.x’ – (F + v.x + v’.x’)
= p(x + x’) – F – V.x – v’.x’)

Cost/Revenue Revenue
(Naira)
Cost

C0=R0

x (units)

Examples…

Dumping
 Occurs on occasions when a constant unit price can be realized for the sale of a product over a
specific range of production. Thus, only added units in excess of a specific production level must
be sold at a reduced price
 Let p = unit price of the first x units produced
 p’’ = (reduced) unit price of extra x’’ units (above x units)
 Thus, total revenue is R = p.x + p’’.x’’
 Total cost is C = F + v.x + v.x’’
since the cost of producing the extra x’’ units is the same as for the first x units
Gross profit, Zg = R – C = p.x + p’’.x’’ – (F + v.x + v.x’’)
 Cost/Revenue
(Naira) Revenue
Cost
C0=R0

x (units)

Example…
TIME-VALUE OF MONEY