7 | Chapter 1 - Introduction to Engineering Economy

differences as called by Principle 2. Usually, these differences will be quantified in

terms of a monetary unit.

STEP 6: SELECTION OF THE PREFERRED ALTERNATIVE

When the first five steps of the engineering economic analysis procedure
have been done properly, the preferred alternative is simply a result of the total
effort. Thus, the soundness of the technical-economic modeling and analysis
techniques dictates the quality of the results obtained and the recommended
course of action.

STEP 7: PERFORMANCE MONITORING AND POST-EVALUATION OF RESULTS

This final step implements Principle 7 and is accomplished during and after
the time that the results achieved from the selected alternative are collected.
Monitoring project performance during its operational phase improves the
achievement of related goals and objectives and reduces the variability in desired
results. This step is also the follow-up step to a previous analysis, comparing
actual results achieved with the previously estimated outcomes. The aim is to learn
how to do better analyses, and the feedback from post-implementation evaluation is
important to the continuing improvement of operations in any organization.
Unfortunately, this final step is often not done consistently or well in engineering
practice; therefore, it needs particular attention to ensure feedback for se in
ongoing and subsequent studies.

Example 1.1 (Application of the Engineering Economic Analysis Procedure)

Your father bought a small apartment building for Php1 million in a college town. He
spent Php100,000 of his own money for the building and obtained a mortgage from a
local bank for the remaining Php900,000. The annual mortgage payment to the bank is
Php105,000. Your father also expects that annual maintenance on the building and
grounds will be Php150,000. There are four apartment units (two bedrooms each) in
the building that can be rented for Php3,600 per month. Refer to the seven-step
procedure to answer these questions:
a. Does your father have a problem? If so, what is it?
b. What are his alternatives (identify at least three)?
c. Estimate the economic consequences and other required data for the alternatives
in part (b).
d. Select a criterion for discriminating among alternatives, and use it to advise your
friend on which course of action to pursue.
e. Attempt to analyze and compare the alternatives in view of at least one criterion
in addition to cost.
f. What should your father do based on the information you and he have
generated?
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 SOLUTION:
a. A quick set of calculations shows that your father does indeed have a problem.
A lot more money is being spent by your father each year than is being
received.
Outflows: Php105,000 + Php150,000 = Php255,000
Inflows: 4 units x Php3,600/unit per month x 12 months = Php172,800
The problem could be that the monthly rent is too low. He’s losing Php82,200
per year. Now, that’s a problem!

b. Option 1: Raise the rent. (Will the market bear an increase?)

Option 2: Lower maintenance expense (but not so far as to cause safety
problems).
Option 3: Sell the apartment building. (What about a loss?)
Option 4: Abandon the building. (Bad for your father’s reputation)

c. Option 1: Raise the monthly rent to Php14,400 + Php R for the four
apartments to cover monthly expenses of Php21,250. Note that the minimum
increase in rent would be
(Php21,250 – Php14,400)/4 = Php1,712.50 (almost 50% increase!)
Option 2: Lower monthly expenses to Php21,250 – Php C so that these
expenses are covered by the monthly revenue of Php14,400 per month. This
would have to be accomplished primarily by lowering the maintenance cost.
Monthly maintenance expenses would have to be reduced to
(Php14,400 – Php105,000/12) = Php5,650.
This represents more than a 50% decrease in maintenance expense.
Option 3: Try to sell the apartment building for Php X, which recovers the
original Php100,000 investment and (ideally) recovers the Php6,850 per
month loss (Php82,200/12) on the venture during the time it was owned.
Option 4: Walk away from the venture and kiss your investment goodbye!
The bank would likely assume possession through foreclosure and may try to
collect fees from your father. This option would also be very bad for your
father’s credit rating.
d. One criterion could be to minimize the expected loss of money. In this case,
you might advise your father to pursue Option 1 or 3.
e. For example, let’s use “credit worthiness” as an additional criterion. Option 4
is immediately ruled out. Exercising Option 3 could also harm your father’s
credit rating. Thus, Options 1 and 2 may be his only realistic and acceptable
alternatives.
f. Your father should probably do a market analysis of comparable housing in
the area to see if the rent could be raised (Option 1). Maybe a fresh coat of
paint and new carpeting would make the apartment more appealing to
prospective renters. If so, the rent can probably be raised while keeping
100% occupancy of the four apartments.
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NAME: _______________________________________ SCORE: ________________

COURSE/YEAR: _______________________________ DATE: _________________

EXERCISE 1

Analyze and answer the following.

1. While studying for the engineering economy final exam, you and two friends find
yourselves craving a fresh pizza. You can’t spare the time to pick up the pizza
and must have it delivered. “Pick-Up-Sticks” offers a 1-1/4-inch-thick
(including toppings), 20-inch square pizza with your choice of two toppings for
Php650 plus 15% sales tax and a Php50 delivery charge (no sales tax on delivery
charge). “Fred’s” offers the round, deep-dish Sasquatch, which is 20 inches in
diameter. It is 1-3/4 inches thick, includes two toppings, and costs Php750
plus 5% sales tax and free delivery.
a. What is the problem in this situation? Please state it in an explicit and
precise manner.
b. Systematically apply the seven principles of engineering economy to the
problem you have defined.
c. Assuming that your common unit of measure is pesos (i.e., cost), what is the
better value for getting a pizza based on the criterion of minimizing cost per
unit volume.
d. What other criteria might be used to select which pizza to purchase?

2. During your first month as an employee at Greenfield Industries (a large drill-bit

manufacturer), you are asked to evaluate alternatives for producing a newly
designed drill bit on a turning machine. Your boss’ memorandum to you has
practically no information about what the alternatives are and what criteria
should be used. The same task was posed to a previous employee who could not
finish the analysis, but she has given you the following information: An old
turning machine valued at Php350,000 exists (in the warehouse) that can be
modified for the new drill bit. The in-house technicians have given an estimate
of Php40,000 to modify this machine, and they assure you that they will have
the machine ready before the projected start date (although they have never
done any modifications of this type). It is hoped that the old turning machine
will be able to meet the production requirements at full capacity. An outside
company, McDonald Inc., made the machine seven years ago and can easily do
the same modifications for Php60,000. The cooling system used for this
machine is not environmentally safe and would require some disposal costs.
McDonald Inc. has offered to build a new turning machine with more
environmental safeguards and higher capacity for a price of Php450,000.
McDonald Inc. has promised this machine before the startup date and is willing
to pay any late costs. Your company has Php100,000 set aside for the start-up
of the new product line of drill bits. For this situation,
a. Define the problem.
b. List key assumptions.
c. List alternatives facing Greenfield Industries.
d. Select a criterion for evaluation of alternatives.
e. Introduce risk into this situation.
f. Discuss how nonmonetary considerations may impact the selection.