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Engineering Economics: BAA3322

2011-2012 Semester I Engr. Dr. Md. Hossain Ali (M. H. Ali)

Introduction
In engineering, and broadly applicable to any field, a technology must offer a high financial rate of return. An investment or intervention is said to be economically efficient when it maximizes the value of output from the resources available. Economic analysis is helpful in identifying opportunities to increase the net values generated with limited resources by various techniques/alternatives, and in designing policies that encourage stakeholders and agency personnel to improve resource management practices in ways that enhance social net benefits. In selecting the best engineering project among alternatives, or to judge a single project for its economic viability, several criteria of economic indices are used, which will be discussed in this subject with a detail analytical procedure and sample examples.

Contents/Coverage of the subject:

Section-1: Concept, need and role of engineering economy Section-2: Fundamentals and concepts of economic theories Section-3: Types and sources of data requirement for economic analysis Section-4: Fundamentals and theories of financial analysis for engg. projects Section-5: Economic indicators and decision rules for selecting project among alternatives Section-6: Risk and uncertainties in engg. projects

Engr. Dr. M. H. Ali

2011-2012, S-I

Section-1: Concept, Need, and Role of Engineering Economics

1.1 Background

In many practical problems, we, the engineers, face multiple alternatives in selecting a development plan or project. In such situation, we have to decide the right thing (the best one) the technology, the structure, project adoption and implementation, etc. among alternatives. Economic merit of a project is judged by comparing projected benefits with projected costs. Under normal condition, an engineering development project should be technically feasible, economically viable, socially acceptable, and environmentally sustainable. So, we have to consider technical performance, durability, financial involvement (input), outcome/output, environmental aspects, etc. Economic analysis of income and services producing from investment is thus essential. In engineering activities, or activities having a major role of engineers, the engineers are best fitted to analyze such thing due to their background in engineering principles.

1.2

Concept of engineering economics

Engineers are involved in planning, designing, implementing, and operating the development work/project. For individuals, public sector (Govt.) projects, or private corporations; either for development works or business farms, our objective is to maximize output (return) from the available (or investable) resource. For that, the manager, engineer, or corporate president has to decide whether the proposed work/project/technology is economically viable and should be materialized, or to choose a project from alternatives. Engineering economics deals with mathematical techniques that justify economic viability of an engineering work/project, or perform economic comparison among alternatives. It involves formulating, analyzing, and comparing economic outcomes of defined engineering work(s)/project(s). The comparison is performed based on a set of criterion. Many examples of engineering activities can be given. Engineering activities/projects are undertaken to solve a problem. For example water supply problem, traffic load problem, housing problem
Engr. Dr. M. H. Ali 2011-2012, S-I

(constructing single-story or multi-story building), etc. As a simple example, lets consider that we want to make a table it may be wooden, steel, wooden top with steel frame, glass/ceramic top with wooden frame, etc. How we can judge the alternatives? To do this, we should know the answer of the following questions: (i) (ii) (iii) (iv) How much each item will cost? Is there any maintenance cost ? What is the effective life for each option ? (initial investment) (maintenance/operating cost) (outcome)

What is the basis for selecting one from the alternatives ? (rule/criteria)

1.3

Steps in decision making process

For the best possible outcome from a project, a systematic and well documented process should be followed. For evaluating multiple options, the same financial analytical procedure should be followed for each case. The steps in decision making process can be summarized as follows: i) ii) iii) iv) v) Realize the problem (problem statement) and define the objective(s) Formulate possible (realistic) solution options Collect relevant data (for each option) Estimate/analyze cost and benefit (in an unified, suitable format) Evaluate the economic outcome (net total benefit) using economic criterion, and decide: (a) Whether the project (in case of single project) is economically viable or not, or (b) Select the best one (in terms of maximum net benefit) from the alternatives (in case of multiple options), and categorize them according to decreasing net benefit vi) Considering other factors along with economic indicators, take final decision on: (a) Acceptance of the project, or rejection (for a single project option) (b) Select the best one from the alternatives (for multiple options) No.(iv) involves a bit mathematics, No.(v) involves some criteria/ decision rule, and analyzing the indicator values.

Engr. Dr. M. H. Ali

2011-2012, S-I

Engineers are appropriate for doing financial analysis and economic decision making process for engineering works/projects, as they know in-and-out of the engineering works; subject to they are well trained in engineering economics.

1.4

Significance of economic analysis of engineering works/projects

Significance of economic analysis of engineering works is hidden within the definition of engineering itself. In a generous word, engineering is the art of utilizing natural resources for the benefit of mankind. The word benefit demands for maximizing the benefit; which could be obtained by comparing economic outcome (net financial benefit) among possible alternative uses of the materials/resources. Some examples of engineering works are:
Problem (1) Water crisis (have to satisfy the demand by increasing supply) Solution options - surface water storage Engineering work/options Construction of dam: - earthen - concrete/RCC - rubber dam Construction of artificial channel/river: - earthen - concrete Installation of tube-well / Establishment of well-field Set up of water purification plant Performing works (steps) for cloud seeding/artificial rain Construction of pipe line Construction of dam and set up of hydro-electric power plant Set up of thermal power plant: - From coal - From diesel/patrol - From gas Set up of nuclear power plant Set up of renewable energy farm: - Wind - Solar - Wave - Geo-thermal

diversion artificial river

channel/

(2) Electricity crisis (have to satisfy the demand by increasing generation) -

groundwater abstraction purification of polluted/ contaminated water artificial rain import of freshwater from nearby country Hydro-electric power plant Thermal power plant

Nuclear power plant Renewable energy (solar, wind, wave, geo-thermal) use

Engr. Dr. M. H. Ali

2011-2012, S-I

(3) Residence crisis in the town (to meet the residential demand)

Single-story building

Construction building

of

single-story

High-rise building

(multi-story)

Construction of high-rise building (along with other facility playground, shop, mosque, etc.)

(4) Transport / traffic load problem (to decrease the traffic jam)

Fly-over Diversion network Tram /road rail Underground rail

Construction of the same.

As the resources are becoming scarce and have alternate use, evaluation of different alternates is prerequisite to achieve economic efficiency. Economic efficiency is achieved when limited resources are used in a manner that generates the greatest net value. Economic analysis can be helpful in indentifying inefficient allocation of resources, and in determining strategies for moving towards an efficient allocation. Economic analysis is an essential part of decision making process. The role of economic analysis can be viewed in money cycle (Fig.1.1).

Financial analysis of project/alternatives Economic indicators and decisive rules

New project

Profit

Project acceptance and implementation

Project operation, improvement (both technical & financial)

Fig.1.1. Typical Money cycle

Engr. Dr. M. H. Ali

2011-2012, S-I

1.5

Role of economic analysis in decision making process

Typical criteria of a technology

1.5.1

In engineering works, and broadly applicable to any field, a technology should have the following criteria: i. The technology must offer a high financial rate of return. A possible increase of ten to twenty percent in yield will not stimulate rapid uptake. This requires a return of 40 100 percent or more. ii. The technology must offer a quick payoff. For crops this should be in terms of half-year or less. Forestry projects require longer but the recommendation is if you want to get trees planted, go for quick-growing species not slow-growing one.

iii.

A new technology must involve low risk, preferably reducing the existing risk.

iv.

The technology must have low inputs. For the farmer, the technology should require low cash and low inputs of labour. For the government, the technology should avoid recurrent costs, it should have a low import content and maximum use of locally available materials. It should avoid maintenance which requires imported spares or high levels of skill.

v.

The technology should be easy to teach and demonstrate For widespread adoption there must be the multiplier effect of farmers teaching other farmers. A project which requires large inputs of engineers or of imported machinery, will inevitably be restricted to small project areas. A technology which requires a saturation level of extension agents, will be restricted to a short period of time, or a limited area.

vi.

The technology should be socially acceptable

Engr. Dr. M. H. Ali 2011-2012, S-I

Success of a technology depends on the positive and quick response of the users, willingness to accept it. vii. The technology should be environment-friendly The technology should not dispose of hazardous materials that are harmful to environment.

1.5.2

Factors affecting decision making process

The factors affecting decision making process of a project involves: (1) Total net financial return (2) Rate of financial return (3) Financial involvement / Initial capital investment (4) Operating cost (5) Maintenance cost (6) Involvement of foreign currency / input / expertise (7) National/State/Province priority (8) Employment generation (9) Nature of technology involvement (high/medium/low) or labour (intensive/non-intensive) (10) Risk / uncertainty (11) Future well-being / Future development prospect (12) Environmental aspects / environmental sustainability (13) Social acceptance

1.5.3

Role of economic criteria in decision making process

The economic criterion is not the only decisive criteria in decision making process. Although the objective of most projects is to maximize the net financial return, it is not the unique criteria. Other

Engr. Dr. M. H. Ali

2011-2012, S-I

factors (described earlier) should also be considered. The importance/weight of other factors depends on the impact of the project on the particular factor and national priority. Then, applying judgement, the optimum one (project) should be selected which minimizes adverse/bad effects and maximizes overall social benefits.

1.5.4

Impact of economic decision in engineering projects on social, national, and global context

Engineering works/projects are designed to meet societys/regional/national need. If for a society, a certain amount of budget is allocated for development work, and the planner fails to choose the best project which maximizes net return, the society will be deprived from financial benefit. Similarly, for regional and national level projects, the society and the nation will be deprived from the benefit. In global context, project should be undertaken where it is more economically viable. For example, if it is planned to produce rice in Saudi Arabia or Iraq where water is scarce, it will not be a wise decision; rather more rice can be produced in Asian countries (with some measures) where rainfall or water is abundant. Similarly, it will be wise to produce electricity from solar energy at Sahara and Australia where the sunshine is abundant, than the Asian countries. Thus, the people at global scale will be more benefited. Of course, this calls for strengthening of global trade.

Engr. Dr. M. H. Ali

2011-2012, S-I