MODULE III

ENGINEERING ECONOMY
Decisions Under Certainty
Lesson I: EVALUATION OF MUTUALLY EXCLUSIVE ALTERNATIVES

Basic Concepts for Comparing Alternatives

Principle 1. Emphasized that a choice or decision is among alternatives. Such choices must incorporate
the fundamental purpose of capital investment. In practice, there are usually a limited number of
feasible alternatives to consider for an engineering project. The problem of deciding which mutually
exclusive alternative should be selected is made easier if we adopt different methods.

Principle 2 (focus on the differences). The alternative that requires the minimum investment of capital
and produces satisfactory functional results will be chosen unless the incremental capital associated
with an alternative having a larger investment can be justified with respect to its incremental benefits.

Methods of Comparing Alternatives

1. Present Worth Method

When two or more alternatives are capable of performing the same functions, the economically
superior alternative would be the largest present worth. The present worth method is
restricted to evaluating alternatives that are mutually exclusive and that have the same lives.
This method is suitable for ranking the desirability of alternatives.

In this method, we consider the possible inflows (cash-in) and outflows (cash-out) in an
engineering projects. All inflows and outflows were turned into the present value of money. In
this case, we choose best alternative based on the largest present value. On the other hand,
some cases considers only the cost of the project. From that point since we are pertaining to
cost, the alternative with least present worth cost is the best option.

2. Future Worth Method

The future worth method for economy studies is exactly comparable to the present worth
method except that all cash inflows and outflows are compounded forward to a reference
point in time called the future.

Same with present value, all inflows and outflows should be forwarded to future. The
alternative with highest future value is desirable. On the other hand, if it pertains to cost,
alternative with least value is desirable.

3. Annual Cost Analysis

Alternatives that accomplish the same purpose but that have unequal lives must be compared
by the annual cost method. The annual cost method assumes that each alternative will be
replaced by an identical twin at the end of its useful life (i.e., infinite renewal).

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At this case, we need to get the depreciation cost of an investment using sinking fund method
of depreciation. The alternative with least cost is advisable or desirable.

The calculated annual cost is known as the equivalent uniform annual cost (EUAC) or equivalent
annual cost (EAC). Cost is a positive number when expenses exceed income.

4. Rate of Return

An intuitive definition of the rate of return (ROR) is the effective annual interest rate at which an
investment accrues income. That is, the rate of return of an investment is the interest rate that
would yield identical profits if all money was invested at that rate. Although this definition is
correct, it does not provide a method of determining the rate of return.

In this case, choose the alternative that satisfy the minimum rate of return. For the computation
of the rate of return, use the formula;

Lesson II: EVALUATION INDEPENDENT PROJECTS

Description of Public Projects

• Frequently much larger than private ventures

• They may have multiple, varied purposes that sometimes conflict

• Often very long project lives

• Capital source is ultimately tax payers

• Decisions made are often politically influenced

• Benefits are often nonmonetary and are difficult to measure

• These elements make engineering economy studies more challenging. There can be difficulty
defining benefits, and even in establishing costs.

For any project

• The proper perspective is to consider the net benefits to the owners of the enterprise

For government projects

• the owners are ultimately the taxpayers.

• Benefits are favorable consequences of the project to the public (owners).

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• Costs represent monetary disbursements required of the government, the anticipated
expenditure for construction, maintenance, operation, etc.

• Disbenefits represent negative consequences of a project to the public (owners).

Self-Liquidating Projects

• Projects that are expected to repay their costs.

• These projects generally provide utility services (power, water, toll roads, etc.).

• They earn direct revenue that offset their costs, but they are not expected to earn profits or pay
taxes.

• In some cases, in-lieu payments are made to governments in place of taxes and fees that would
have been paid had it been under private ownership.

Cost allocations in multiple-purpose, public-sector projects tend to be arbitrary

• Production and selling costs of the services provided are also arbitrary.

• Some projects naturally have multiple purposes—e.g., construction of a dam.

• Some of the costs incurred cannot properly be assigned to only one purpose.

• Purposes may be in conflict.

• Often support for a public project, and its many purposes, is politically sensitive.

Difficulties inherent in engineering economy studies in the public sector.

• Profit standard not used to measure effectiveness

• Monetary effect of many benefits is difficult to quantify

• May be little or no connection between the project and the public (owners).

• Often strong political influence whenever public funds are used, with little consideration to
long-term consequences.

• Public projects are more subject to legal restrictions than private projects

• The ability of governmental bodies to obtain capital is more restricted than that of private
enterprise

• The appropriate interest rate for discounting benefits and costs is often controversially and
politically sensitive.

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Selecting the interest rate to use in public projects is challenging.

• Main considerations are

• the rate on borrowed capital,

• the opportunity cost of capital to the governmental agency, and

• the opportunity cost of capital to the taxpayers.

• If money is borrowed specifically for a project, the interest rate on the borrowed capital is
appropriate to use as the rate.

Applying the benefit-cost ratio method

• The consideration of the time value of money means this is really a ratio of discounted benefits
to discounted costs.

• Recommendations using the B-C ratio method will result in identical recommendations to those
methods previously presented.

• B-C ratio is the ratio of the equivalent worth of benefits to the equivalent worth of
costs.

Two B-C ratios

Conventional B-C ratio with PW

Modified B-C ratio with PW

A project is acceptable when the B-C ratio is greater than or equal to one.

Conventional B-C ratio with AW

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Modified B-C ratio with AW

Added Benefits vs. Reduced Cost

• As with the different types of ratios, the question arises if classifying certain cash flows as either
added benefits or reduced costs.

• As before, while the numerical value of the ratio may change, there is no impact on project
acceptability regardless of how the cash flows are handled.

Selecting projects

• If projects are independent, all projects that have a B-C greater than or equal to one may be
selected.

• For projects that are mutually exclusive, a B-C greater than one is required, but selecting the
project that maximizes the B-C ratio does not guarantee that the best project is selected.

Incremental B-C analysis for mutually exclusive projects.

• Incremental analysis must be used in the case of B-C and mutually exclusive projects.

• Rank alternatives in order of increasing total equivalent worth of costs.

• With “do nothing” as a baseline, begin with the lowest equivalent cost alternative and
determine the incremental B-C ratio (B/C), selecting the alternative with the higher
equivalent cost if the ratio is greater than one.

Comparison of Single Project and the Two or More Alternative

For Single Project:

• B/C > 1 : accept the investment

• B/C = 1 : remain indifferent

• B/C < 1 : reject the investment

For two or more alternative

• Compute B/C on the increment of investment between alternatives

• If B/C > 1 : choose higher cost alternative

• If B/C < 1 : choose lower cost alternative

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Some criticisms of B-C analysis.

• B-C is often used as an “after-the-fact” justification tool.

• Distributional inequities (one group benefits, another pays the cost) may not be accounted for.

• Qualitative information is often ignored.

• Bottom line: these are largely reflective of the inherent difficulties in evaluating public projects
rather than the B-C method itself.

Lesson III: Depreciation and Depletion

Depreciation

Depreciation is an allowable expenses in general accounting purposes and income tax accounting
purposes. But it differ categorically from other conventional expenses because depreciation charge does
not occur any outflow of business fund.

Depreciation allows for the companies to recover cost of an asset when it was purchased. It allows the
companies to cover the total cost of an asset over it’s lifespan. This is important aspect in analyzing cost
because it represents a significant portion of expenses

Methods of depreciation:

1. the cost of the asset;

2. the life of the asset;
3. the expected residual value of the asset;
4. and, by the method of depreciation selected for amortization of the asset which must be
systematic and rational.

Depreciation - the decrease in the value of a physical property with the passage of time.

Types of Depreciation

1. Physical depreciation – this is due to the reduction of the physical ability of an equipment or asset to
produce results.

2. Functional depreciation – this is due to the lessening in the demand for the function which the
property was designed to render.

Purpose of Depreciation

1. To enable the cost of depreciation to be included as a cost in the production of goods and
services.

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2. Annual costs of depreciation are being put up in a fund called depreciation reserve for
replacement of the property.
3. To recover capital invested in the property.
4. Provide as an additional capital termed as depreciation reserve.

Properties Depreciable Assets

1. It must have a determinable life and the life must be greater than 1 year.
2. It must be something used in business or held to produce income.
3. It must be something that gets used up, wears out decays, become obsolete, or loses its value
due to natural causes.
4. It must not be an inventory stock in trade or investment property.

Depreciation Terminology

Initial Investment/First Cost (FC) – the cost of acquiring an asset, including transportation expenses and
other normal costs of making the asset serviceable for its intended use.

Book Value (BV)– worth of property or an asset as shown on the accounting records of the company. It
is the original cost of the property less all allowable depreciation deductions.

Salvage Value (SV)- the amount that will be paid by a willing buyer to a willing seller for a property after
depreciation is competed.

Useful life (L)– the expected period that a property will be used in trade or business to produce income.

Physical life – the length of time during which the property is capable of performing the function

Economic life – length of time during which the property may be operated at a profit.

Recovery period (n)– the number of years over which the basis of property is recovered through the
accounting process.

Recovery rate (i)- a percentage for each year of the recovery period that utilized to compute an annual
depreciation deduction.

Notation use for Depreciation:

d = annual cost of depreciation

L = useful life

n = any year during the life of the property

dn = depreciation cost during year n

Dn = total cost of depreciation after n years

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FC = initial investment, original cost, first cost

SV = salvage value/scrap value

BV = book value at the end of n years

Methods of Depreciation

1. Straight Line Method (SLM) –The simplest depreciation method. this method assumes that the
loss in the value is directly proportional to the age of the equipment or asset.
a. Annual cost of depreciation

b. Total depreciation after n years

c. Book value at the end of n years

2. Sinking Fund Method (SFM) - This method assumes that a sinking fund is established in which
funds will accumulate for replacement. The total depreciation that has taken place up to any
given times is assumed to be equal to the accumulated amount in the sinking fund at that time.
a. Annual cost of depreciation

( )
b. Total depreciation after n years

( )

c. Book value at the end of n years

3. Declining Balance Method. In this method, sometimes called the constant percentage method
or the Matheson Formula, it is assumed that the annual cost of depreciation is a fixed
percentage of the salvage value at the beginning of the year. The ratio of the depreciation in any
year to the book value at the beginning of that year is constant throughout the life of the
property and is designated by k, the rate of depreciation.

√ √

a. Annual depreciation d

b. Salvage Value

c. Total depreciation Dn

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d. Book value at the end of n years

4. Double Declining Balance Method (DDBM) - This method is very similar to the DBM except that
the rate of depreciation k is replaced by 2/L
a. Annual depreciation d

( )( )
b. Salvage Value

( )
c. Total depreciation Dn

( ( ) )

d. Book value at the end of n years

5. Sum of the year digit method (SOYDM) - It is a method of evaluating depreciation where the
depreciation changes from year to year.

a. Annual depreciation d

( )

b. Total depreciation Dn

( )

c. Book value at the end of n years

6. Service-Output Method (SOM) - This method assumes that the total depreciation that has taken
place is directly proportional to the quantity of output of the property up to that time. This
method has the advantage of making the unit cost of depreciation constant and giving low
depreciation expense during periods of low production.
6.1 Service Method (Number of hours used)
Let H= total units of hours used and within the useful life
Hn = total number of hours used at nth year.

( )

( )
6.2 Output Method (Number of units produced)
Let T= total number of units produced w/in the useful life.
Tn = number of units produced at the nth year

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( )

( )

Depletion

This method is generally applied in case of wasting assets e,g, mines, quarries and natural resources.
Here the rate of production is measured by the rate of exhaustion of the asset. Under this method the
total reserve of asset is measured by an expert valuer. After that the cost per unit of reserve asset is
ascertained by dividing the cost of acquisition of the asset by the total reserve of that asset. Periodic
depreciation is calculated by multiplying the reserve of assets exhausted during the period by the cost
per unit of reserve asset. The asset reduced to zero at ends of the total exhaustion, so the method is
known as depletion method.

Cost Depletion

The capitalized costs that generally go into the cost depletion basis for petroleum and mining projects
are for mineral rights acquisition and/or lease bonuses or their equivalent ascertained costs:

Where:

There are three steps involved in computation of depreciation under depletion method.

Step 1: Determination of the depletion base: The depletion base comprises of cost incurred to acquire
or lease the asset, exploration cost, development cost and any cost incurred to restore the property to
its original condition after the assets or resources have been fully depleted.

Step 2: Computation of depletion rate per unit: The depletion rate per unit of a natural resource or asset
depends upon the total number of units expected to be extracted. This is calculated by dividing the
depletion base less salvage value (if any) by the number of units expected to be extracted. Depletion
rate = (Depletion base – Salvage value)/Total units expected to be extracted

Step 3: Computation of depletion/depreciation charge: Finally, the units extracted during the period are
multiplied by the depletion rate per unit to compute the depletion or depreciation charge for the
period.

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The above three steps can be combined together to make the following formula for computing
depletion or depreciation charge for a particular period.

Lesson IV: Replacement Analysis

Replacement analysis

Replacement analysis plays an important role in the economic running of any concern for years or
decades. As a business firm, they have to face different types of replacement decisions such as, the
replacement of capital equipment as it wear out or becomes obsolete, the capital equipment required
for expansion and the displacement of old technology by the new one.

The Four Major Reasons for Replacement

1. Physical Impairment
The existing asset is completely or partially worn out and will no longer function satisfactorily
without extensive repairs.
2. Inadequacy
The existing asset does not have sufficient capacity to meet the present demands that are
placed on it.
3. Obsolescence
This may be caused either by a lessening in the demand for the service rendered by the asset or
the availability of more efficient assets which will operate with lower out-of-pocket costs.
4. Rental or lease possibilities
It is possible to rent identical or comparable asset or property, thus freeing capital for other and
more profitable use.

Sunk Cost Due to Unamortized Value

Unamortized value of an equipment or property is the difference between its book value and its resale
value when replaced. Unamortizedva should be considered a sunk cost or a loss.

Basic Patterns for Replacement Studies

Replacement economy studies may be made by any of the basic procedures or patterns which have
been discussed previously. However, in most cases either the rate of return method or the annual cost
method is used.

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Lesson V: Break-Even Analysis

Break-even analysis

-is a method of determining when value of one alternative becomes equal to the value of another. It is
commonly used to determine when costs exactly equal revenue. If the manufactured quantity is less
than the break-even quantity, a loss is incurred. If the manufactured quantity is greater than the
breakeven quantity, a profit is made.

-A critical tool for determining the capacity or facility must have to achieve profitability. It is a means of
finding the point, in dollars and units, at which cost equals revenues.

- is one of the most important business tools. It is used to determine the level of profitability of a certain
company. It provides the companies with targets to cover costs and make a profit. It helps the business
determine the cost structures and the number of units that need to be sold in order to cover the cost
and start making a profit.

-is usually done as part of a business plan to see how practical the business idea is, and whether or not it
is worth pursuing.

Break-even point can be determined by calculating the points at which revenue received equals the
total costs associated with the production of goods or services.

Break-even chart

A graphical representation of break even analysis. The break-even point is the quantity of production at
which the income is equal to total cost. It is the intersection of the income line and the total cost line on
the break-even chart. When two alternatives are to be compared, the break-even point is the
intersection of the total cost line for each alternative on the break-even chart.

References: A. Sta. Maria, Hipolito B., Engineering Economy, 3rd Edition, Philippines, 2000. B. Sullivan,
et. Al., Engineering Economy, 12th Edition, Singapore: Prentice Hall International, Inc., 1997.

-End of Module III

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