era ate Analysis Peete amo celL (BE) er Pokhara University (PU)i italized Worth Method jerminated Assumption, Capital 2 53 Ae acoaly Exclusive, Contingent and Independent Project in Comin Risk Analysis ; . 6.1 Ongin/Sources of Project Risks. C Mathods of Describing Project Risks; Sensitivity Analysis, Breakeven Analysis scons 2 a Analysis ‘ lation, i Economic Development Se ie Tio and Ecological Limit, “he 72 Concept of sustainable development, 7.3. Ecological Footprint and 2. 7/4 Overcoming Ecological Limits B epreciation and Corporate Income Taxes . * Bi Depreciation and ts causes, Asset Depreciation and Accounting Depreciation, ee x 8.2. Basic Methods of Depreciation: Straight line method, Declining Balance Method Sinkin, Fund Method, Sum of the Year Digit Method, Unit of Production Method. Modified } Accelerated Cost Recovery System (MACRS) ° l 8.3 Introduction to Corporate Income Tax. Taxation Law, Depreciation Rates, Personal Tax, : Corporate Tax, VAT a 8.4 After tax Cash flow Estimate, General Procedure for Making After Tax Economic Analysis. I 9, Enterprise Financing and Capital Investment Pe 9.1 Method of Financing: Equity Financing, Debt Financing and Capital Structure. 9.2 Cost of Capital: Cost of Equity, Cost of Debt and calculating cost of capital. 9.3 Project Funding Mechanism: Government budget, Public Private Partnership and Private‘ Investment. 9.4 FIRR, EIRR and Retum on Equity 10. Basic Accounting Procedure hrs 10.1 Accounting Terminologies; Asset and liabilities: Fundamental equation of accounting, 10.2 Financial statements: The Balance Sheet, Income Statement and Cash flow Statements. 10.3 Using Ratios to make Decisions: Debt Ratio, Current Ratio, Quick Ratio - Acid Test Ratio, Inventory Tumover Ratio, Total Assets Turnover, Profit Margin on Sales, Retum on Total Assets, Price Earnings Ratio and Book Value per Share. Text Book: Chan S. Park. Contemporary Engineering Economics. PHI Learning Private Limited. References: : 1. E, Paul De Garmo, William G. Sullivan and James A, Bontadelli, Engineering Economy, MC Milan Publishing Company. 2. James L. Riggs, David D. Bedworth and Sabah U. Randhawa, Engineering Economics, Tata MacGraw Hill Education Privated Limited. 3. _N.N. Borish and S. Kaplan, Economic Analysis for Engineering and Managerial Decision Making, MCGran Hill Publishing Company. 4. Adhikari, D, Principle's of Engineering Economic Analysis, Global Publication, Nepal 5. SenGupta, Ramprasad, Ecological Limits and Economic Development, Oxford University Press.Engineering Economics (3 — 2-0) Evaluation: Theory Practical Total Sessional 30 = 30 Final 30 = 30 Total 100 = 100 Course Objectives: After completing this course, students will be able to = Understand and describe the basic concept of economics, engineering economics, cost accounting and time value of money. = Assist in the valuation of engineering projects in the public and private sectors in order to take investment decisions. » Analyze the project risk and relate the concept of ecological limit and economic development. » Calculate depreciation, taxation and its application in analysis. Identify different financing options and use, to a limited extent, general accounting procedures. Course Contents: 1 2. 3. 4. Basics of Engineering Economics 3hrs 1.1 Definition of Economics, Demand, Law of Demand, Law of Diminishing Utility, Marginal Utility, Supply, Law of supply. 1.2. Engineering Economics, Principles of Engineering Economy and its application. Cost Concept and Fundamentals of Cost Accounting 3hrs 2.1 Cost Terminology: Manufacturing Cost and Non-Manufacturing Cost i 2.2. Cost for Business Decision: Differential Cost and Revenue; Opportunity Cost, Sunk Cost and Marginal Cost Time Value of Money 4hrs 3.1 Interest, Simple Interest, Compound Interest, Nominal Rate of interest, Effective Rate of Interest 3.2. Economic Equivalence: Present Worth, Future Worth and Annual Worth 3.3. Development of Formulas for Equivalence Calculation. Pe Basic Methods of Engineering Economic Studies ‘Thrs 4.1 Minimum Attractive Rate of Retum = MARR 4.2, Payback Period Method - Simple and Discounted 43. Equivalent Worth Methods; Present Worth Method, Future Worth Method and Annual Worth Method. 4.4. Rate of Retum Methods: Internal Rate of Retum (IRR) Method and External/Modified Rate and Return (ERR/MIRR) Method 4.5. Benefit Cost Ratio Method. Comparative Analysis of Alternatives 6hrs 5.1 Comparing Mutually Exclusive Alternatives having same useful life by Payback Period Method, Equivalent Worth Methad; Rate of Return Methods and Benefit Cost Ratio Method 5.2 ‘Comparing Mutually Exclusive Alternatives having different useful livés by RepeatabilityUnit - Four Basic Methods of Engineering Economics Studies Introduction Minimum Attractive Rate of Return (MARR) Equivalent Worth Method Rate of Return Methods Payback Period Method Cost-Benefit Analysis REVIEW QUESTIONS EXERCISES | Unit - Five Comparative Analysis of Alternatives Mutually Exclusive Investment Alternatives in terms of Combination of Projects Comparison of Alternatives using Capitalized Worth (CW) method Comparing Mutually Exclusive Alternatives Having Same Useful Life Comparing Mutually Exclusive Alternatives Having Different Useful Life REVIEW QUESTIONS EXERCISES Unit - Six Risk Analysis Introduction Origin/Sources of Project Risks Methods of Describing Project Risks Break—Even Analysis Break—Even Analysis for Comparing Two Alternatives Steps to Determine Break—Even Point of Common Variable Sensitivity Analysis Scenario Analysis REVIEW QUESTIONS EXERCISES Unit - Seven Ecological Limits and Economic Development Meaning of Resource and Natural Resource Renewable Resource and Biological Equilibrium Natural Resource and Environment Environment as Input in Economy Concept of Environmental Economics Economic Issues Facing Natural Resources Management _ Doctrine of Increasing Natural Resource Scarcity _ Evidence for natural resource Scarcity/depletionUnit - One f Basics of Engineering Economics Basic Terminologies used in Engineering Economic Analysis Meaning and Definition of Economics Demand and Supply Elasticity of Demand Law of Diminishing Marginal Utility Origin of Engineering Economy Principles of Engineering Economics Cash Flow and Cash Flow Diagram REVIEW QUESTIONS Unit - Two Cost Concept and Fundamentals of Cost Accounting Cost Terminologies Manufacturing & Non-Manufacturing Cost Cost for Business Decision Elements of Cost Life Cycle Cost Comparison between Cost Accounting and General Accounting Method of Cost Accounting REVIEW QUESTIONS Unit - Three Time Value of Money Introduction Interest Calculation Nominal and Effective Interest Rates Relationship between Effective (i) and Nominal (r) Interest Rates Economic Equivalence Derivation of Compound Interest Formulas of Single Cash Flows Interest Formulas Relating a Uniform Series to its Present and Future Sum Continuous Compounding and Formulas Interest Calculation for Uniform Gradient REVIEW QUESTIONS ~ EXERCISES eranFinancial Internal Rate of Return (FIRR) Economic Intemal Rate of Retum (EIRR) Retum on Equity (ROE) Introduction of Business Organization REVIEW QUESTIONS EXERCISES Unit - Ten Basics Accounting Procedure Accounting Terminologies Procedure for Developing an Accounting Equation Financial Statements Trading account Balance Sheet Income statement Cash flow statement Financial Ratio Analysis Types of Ratio Debit and Credit Double Entry Book Keeping The Journal The Ledger REVIEW QUESTIONS Appendix — A OLD AND MODEL QUESTIONS OF PU Appendix ~ B PP ANTEREST FACTORS FOR DISCRETE COMPOUNDING References - 392 442 471act of Human Activities on Natural Resources ternality in Production and Consumption B ronmental Policy Measures for Managing Externalities in EX vine Theory & Ecological Limit Beatin’ of Sustainable Development jogical Footprint eo ming Ecological Limits REVIEW QUESTIONS . = Unit - Eight Depreciation and corporate Income Taxes Introduction Causes of Depreciation ‘Advantages of Providing Depreciation Fund Factors Affecting the Amount of Depreciation ‘Asset Depreciation & Accounting Depreciation Depreciation Methods Recaptured Depreciation Normal Gain Capital Gain / Loss Taxation Law in Nepal What is Tax? The Main Nepalese Taxation Taxation by Provinces and Local Level Structure of Tax Personal Tax Value Added Tax (VAT) Corporate Tax (Tax rate applicable to entity) General Procedure for Making After Tax Cash Flow (ATCF) Economic Analysis REVIEW QUESTIONS EXERCISES Unit - Nine : Enterprise Financing and Capital Investment Methods of Financing Equity Financing Debt financing Capital Structure (Debt to Capital Ratio) Cost of capital Cost of Debt Cost of Equity/ Share/ Stock Project Funding Mechanism 266 266 266 267 267 268 288 289 289 290 290 291 291 291 293 296 298 301 311 312 316 316 317 317 318 318 320 329Unit - One — Basics of Engineering Economics ‘Objectives of this chapter students will be able to learn about; © Basic terminologies used in engineering economic analysis % Meaning and definition of economics % Demand &t law of demand % Supply &t law of supply % Elasticity of demand & Law of diminishing marginal utility % Origin of engineering economy % Why engineer needs concept of economics? % Role of engineers in decision making. % Basic principles of engineering economics. Cash flow and cash flow diagram. ‘After the completion ¢inologies used in Engineering Economic Analysis Basic Te! Annuity *y) occurring at equal periods of time, like: annually : of money) occurring at equal p { equal payments (amount = A series of equal pay ae petiod, then iis known ondinary or deterred annuity, is paid at the end the non oi co ispaid atthe beginning of each period, then itis known annuity due be: 7 2 "t erpetuity. that goes on forever, then it is known perpetuity. = Uf the anni = ifthe annuit = Ifanannu Asset Capital owned by a company. * Aneconomie resource of entity / ng market or exchange value and forming part of the wealth, + land, building, plant, machinery equipments ete sset: eash, s ccurities ete, Break-even point (BEP) A point that indicates graphical representation of the relat shat level of production and sales at which revenue te just ~The percentage of capacity operation of en total revenue and total cost foy er all expe a manufacturing plant at wi hich income will just cove, expenses, © A point where the organization is neither gain nor loss state, Capital 2 Aterm describing wealth which may be Utilized to economic advantage, T Man-made factors that contribute to the Production of goods and se, The non-human ingredients (factors) that may be utilized to economi advantage. It includes cash buildings, plants, equipments, raw Mmatcrials, semi-finished and finished Products, inventories et Capital goods are used for production of other goods, * Eapital goods are produced goods which are used as fact Land Free gift of nature + Permanent factor : Fix ‘Money Kt may be un-invested stock amount [+ that could not give Sy extra | income like interest or pro, income, Wealth Capita * It may be idle Property + Itis mobilized property Which Hot generate extra income, like rent, output. All capital m: Cash-flow The statement showin, =~ Cash inflow; a : MANCIal Ve ssing into the firm, = * Cash outflow; actual rupees pairecovery (CR) Charging periodically to operation amounts that will ultimately equal to the amount of capital expenditure |= tis uniform annual cost of capital investment. Compound interest ‘That type of interest which is periodically added to the amount of principal investment (or loan) so that subsequent interest is based on the cumulative amount. If the interest amount of each period will be added as principal amount for the beginning of next period, then itis called compound interest. w= Itincludes interest on past interest. Simple interest : Interest is charged only on the basis of initial principal amount for all over the time period. Itis fixed percentage of the principal amount (loan) multiplied by the life of the loan. Discount rate ; The rate used to calculate the present value of the series of future cash flows because of time preference. It is inverse of compounding. Depreciation = Decline in value of capital assets due to wear and tear, passage of time, obsolescence etc. Allocation of the cost of fixed asset over it for economic useful life. Free good = The goods that can be obtained without any payment. x= Free goods are not the result of human effort. =~ Itis free gift of nature like air, water, sunlight etc. Economic good = A .good that is scarce and having economic value. = Anything that is useful, transferable and not abundant. Economic life (Useful life) The length of time of a capital asset that will be economically useful. = The expected period that a property will be used in a trade or business to generate income. Economic efficiency = It is the ratio of the value of output obtained from an economic process to the value of input necessary to produce them. Higher the value of output per rupee’s worth of resource input denotes ‘greater efficiency in the process. Study period = Expected length of time of any project to run and appraisal of the result. Often the anticipated life of the project will be considered but a shorter time will be more appropriate for decision making. Time value of money ™ Cumulative effect of elapsed time on the value of money/invested funds. ™ Expected interest amount due to sacrifice money over time. Relationship between interest and time. Salvage value in eo asset at the end of economic life has to be taken into account, i market or scarp or residual value of a machine. Itis the receipt at project termination, Market price of an investment at the time of its sale, in estimated value of property at the end of its useful life. expected selling price by the owner.Decision making 1c to the final outcome. ce plished policy influenc = A program of action undertaken as a result of esta eS Decision under certainty with the = A simple decision that assumes complete information and no uncertainty 18 connected . analysis of the decisions. ™ Decision under risk . - mA decision for which the analyst elects to consider several possible futures, the probabilities le which can be estimated. o Decision under uncertainty siti - mA decision for which the analyst elects to consider several possible futures, the probabilities of ™ which cannot be estimated. Inflation P % The situation of rise in general price level and fall in value of money. : Deflation I = The situation of falling price level or rising value of money. = Itis opposite of inflation. Utility = Power of satisfaction to a consumer by consuming goods or services. Opportunity cost = It is the cost of best rejected /foregoing opportunity to earn return from the use of resources. » The value of second best opportunity foregone by deciding to do one thing rather than another. Payback period = Required time period (years/months) to recover the initial investment of the project. Labor The capacity of human effort (both mental and muscle) available for the use in producing goods and services. = Use of humane effort in production activity. Demand The various quantities of an item that a buyer is willing to buy at alternative prices, other things being equal. ™ Desire with ability to pay and willingness to pay. | Supply | = The various quantities of an item that a seller is willing to sell at alternative prices, other things | being equal. » Desire to sell with ability to sell and willingness to sell. Tangible factors = Physical factors which can be seen and touched and readily evaluated in quantitative terms as in money such as plant and machinery, land and buildings ete. ™ Material factors (goods) that can be transferred form person to person. Intangible factors = Factors that cannot be touched and readily evaluated in quantits patent right, trademarks, copyright, skill, beauty, intelligence ete, = Non-material factors (goods) that relate to a particular person or organization and cannot be transferred to other. ive terms as in money like goodwill, za Principles of Engineering Economic AnalysisCompetition = The situation when anybody who wants to buy or sell has a choice of possible suppliers or customers, = Amarket in which large number of buyers and sellers trade independently. Monopoly » Amarket situation with only one seller and many buyers. = Condition of single supplier of a product without substitutes and many buyers. Oligopoly = Amarket situation with few sellers but each are anticipating others’ reaction. = Market structure in which more than two but not large number of sellers and firms are aware of the mutual interdependence of sales, production, price, investment and advertising. Price » The amount of money paid for a good or service (per unit). Production = The act of transforming factors of production into the goods and services. = Creation of utility into the goods and services to satisfy human wants. Local market = Geographical sub-divisional market within a country. =. Market behavior having population between the small locality/area according to their needs and local production. ™ Mostly the perishable and low priced goods are available in the local market. National market = Amarket area which covers the demand for national people within the country. Related goods » — Itconsists complementary and substitute nature of goods. = Incomplementary goods, a rise in price of one decreases demand for other like petrol and motorbike where petrol is equally importance to use of bike. In substitute goods, a good can be used instead of another and a rise in price of one increases demand for other like; Coke and Pepsi. Production function Mathematical expression used to describe the technological relationship between inputs and outputs in physical terms. like Q =f (L, K) is a production function. (Where Q = Output or production, f = function, L = Labor, and K = Capital.) Consumer goods » Goods designed for the use of final consumers to satisfy current wants. Many consumer goods are held in inventories by shops and wholesalers. = The goods which directly satisfy want of consumers are called consumer goods like food, cloth, pen, ete. Producer goods ™ The goods which intended for the production purpose are called producer goods. It includes land, labor, capital (building, plant, equipment, machinery, raw materials, fuel etc) and organization. Marginal revenue (MR) ™ The change in total revenue due to one extra unit of quantity sold. * tis the addition made to the total revenue when one more unit of output is sold. * MR=TR,+1—TRy MR = Marginal revenueTR, = Total revenue up ton" unit of ouput sold aa TR, «1 = Total revenue up to (n + 1)" unit of outp 7 ATR _ Change in total revenue MR="AQ Change in quantity sold arginal cost (MC) 2 The change in total cost due to one extra unit of output produced, {tis the addition to the total cost caused by producing one unit of output. MC=TC,,~TC, MC = Marginal cost TC, = Total cost up ton" unit of output TC, +1 = Total cost up to (n + J)" unit of output c= ATC ___Change in total cost AQ“ Chagne in output produced Marginal utility (MU) J The change in total utility due to one more/additional ui {tis a utility detived by single unit in each case, MU=TU,4,-TU, MU = Marginal utiliy Total utility up to nt unit of output consume nea = Total utility up to (n+ D" unit Of output consume TU Ch ange in total utility AQ © Change in quantin 'y consumption nit of consumption. le science of end all i.e, man S lassicay oth (S, : ; he ene ding to him, weaity ng that noises ge OM Definition 2: Alfred Marshal (1842 ~ 1994) ~ Alfred Marshall (Britisimportant side is a part of the study of man." So according to him, economics is concerned with human welfare that means man is primary importance and wealth is only secondary importance i.e. wealth for man. Definition 3: Lionel Robbins (1898 - 1984) Lionel Robbins (British economist) has provided a new definition of economies in 1932. According to him "Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses." Hence, economics is the science of scarcity and choice, and it studies how the scarce resources are allocated among different engines. Karl Marx (1818 - 1883): German Philosopher, published book — Das Capital and Theories of Surplus Value. J. M. Keynes (1883 — 1946): British economist, leader of Modem Macroeconomics. Popular book- The General Theory of Employment, Interest and Money (1936). Propounded Theory of Effective Demand. Keynes was student of Marshall at Cambridge University. Demand and Supply Pe Eee EE [Demans = Desire for anything (goods and services) with ability to pay and willingness to pay. » The various quantities/units of an item that a buyer is willing to buy at alternative/various prices in a market. Law of Demand "Other things being equal demand varies inversely with price." Everybody is known that demand depends upon price. Law of demand states the relationship between the quantity demanded and price of the commodity. Although there are many other factors (income, taste, weather, population size, etc.) to influence on demand, price is the most important determinant of demand in the short-run as well as long-run, Law of demand explains the inverse relationship between price and quantity demanded. It is defined as “all other things remaining the same, the quantity demanded of a commodity increase when its price decrease and vice versa." This law assumes income, fashion, price of related goods, population size, taste and preferences, price expectations etc. are remained constant. The principle of law of demand can be illustrated by a hypothetical demand schedule and graph below. : _ > Price in Rs/Kg _ he Quantity demanded in Kg 5 10 10 8 15 6 20 25 In above demand schedule, as price increases from Rs. 5/kg to Rs. 25/kg, quantity demanded decreases from 10 kg to 2 kg gradually. Demand curve is a graphical presentation of demand schedule. When the data given in the above demand schedule plots in a graphical form, then we can derive a demand curve.D z aa Demand Curve 3g 20 © 15 g 10 c 5 »>\o 246 8 10 Factors influencing to demand (Price of commodity Gi) Income of consumer iii) Price of related goods (iv) Weather () Custom and fashion (i) Size of population (vii) Future €xpectations ete, upp} Law of Supply "Other things being equal, SWPPly varies positively with price.” The relationship between Price and quantit. and positively with price commodity rises its supply i: 'y supplied is known as law Mean be defined as." s« In above tablelexample, graphically as:St Supply Curve Price in Rs. D 4 8 12 1620 . Quantity supplied in kg. Supply curve is @ graphical representation of supply schedule. When the data given in the above example plats ina graphical form, we can derive a supply curve S81, Supply curve always slopes upward to the fightasshown in above figure which represents the meaning of law of supply. Factors influencing to supply () Price of commodity (ji) Price of factors of production (ii) Price of related goods (jv) Production technology (v)_ Change in money income (vi) New inventions (vii) Taxes and subsidies (vii) Development of infrastructures (ix) State of natural resource etc. ene essen ns ee UE TEREIEEEFEEEIEENPvenreemser end Law of demand only states the nature of relationship between change in price and quantity demanded but does not measure of change in quantity demanded in response to certain percentage change in price. So, this question is answered by elasticity of demand. ‘The term ‘elasticity’ denotes the quantity of goods to expand and contract. Hence, the change in quantity demanded due to change in price, income, etc. is called elasticity of demand. It is defined as "elasticity of demand is the measure of relative change quantity demand in response to a relative change in any of its determinants (price of the commodity, income of the consumer, price of related goods etc." Elasticity of demand is technical term used by the economists to describe the degree of responsiveness of the demand for the commodity to change in price and so on. ; Proportionate change in quantity demanded Elasticity of demand (Es) = py gportionate change in any one quantitative determinant of demand Inmodem time, broadly speaking the elasticity of demand is classified into three major types. (a) Price elasticity of demand (0) Income elasticity of demand (c)_ Cross elasticity of demand | (@) Price Elasticity of Demand (Er) Price elasticity of demand is defined as the degree of responsiveness of demand for a commodity to the change in its price. It shows that at what rate the demand changes with change in price. | Proportionate change in quantity demanded of the commodi Proportionate change in the price of the commodity Price elasticity (B;) =4Q Q a9, P40, F Symbolically, Er 2.8. ap aP*Q P Where, Ey = Price elasticity 4Q = Change in quantity demanded Q = Initial quantity demand AP = Change in price P = Initial price This concept can be illustrated by the help of a numerical example. Pricein Rs. | Quantity demanded in unit 25 30 15 50. Here, AQ=50-30=20 AP = 15-2: Q=30 P=25 AQ P20 25_ Erm ap" Q7-10" 307 Ep=-1.66 Here, minus (or ~ve) sign refers inverse relationship between quantity demanded and price of the commodity. The coefficient 1.66 refers 1 percent decrease in price results 1.66 percent increase demand. Types/Degrees of Price Elasticity There are five types of price elasticity of demand which are as follows; (Perfectly elastic demand (Ep = 0) If the quantity demand increases in unlimited quantity with a very small fall in price or it falls to zero with a very small rise in price, then the situation is known as perfectly elastic demand, It is only hypothetical concept i.e. not found in practical life. 4 pi2 Dy | LT oO a @ ~ * Quantity demanded In the figure, price is measured along OY-axis and quantity demanded is measured along OX-axis Horizontal demand curve DD, indicates small rise in price brings quantity demand to zero and small fall in price leads to increase quantity demand infinitely. ! (ii) Relatively elastic demand (Ep > 1) If the percentage change in quantity demanded is greater than the percentage change in price, then it is said to be relatively elastic demand. In case of luxurious and cosmetic goods, such demand can bé realized. Price° Q2 a Quantity demanded Inthe figure, price and quantity demanded is measured along OY and OX-axis respectively. When price decreases from OP, to OP, demand increases from OQ: to OQ. Here, increase in demand is ter than decrease in price which refers relatively elastic price elasticity of demand. (ii) Unitary elastic demand (Ep = 1) If the percentage change in quantity demanded is equal to the percentage change in price, then it is said to be unitary elastic demand, x D. Pa Pit 8 Dy = ° — Quantity demanded In the figure, DD; is unitary elastic demand curve. When price decreases from OP; to OP, demand increases from OQ, to OQ). Here, increase in demand is just equal to the decrease in price. (iv) Relatively inelastic demand (Ep < 1) If the percentage change in quantity demanded is less than percentage change in price, then it is said to be relatively inelastic demand. For example If price falls by 20% and demand increases by 15%, then it can be said such elasticity. In case of daily consumption (normal) goods, such demand can be realized. Quantity demanded In figure, DD, is relatively inelastic demand because change in quality demanded (Q,Qz) is less than change in price (P;P,). In other words, when price decrease from OP, to OP; demand increases from OQ to OQ,, where increase in demand is less than decrease in price.— fi = Peer inelast (v) Perfectly inelastic cena he ve to any change in price, then it is said to be perfectly ine! If there is no response in i sods. demand. It may be applicable very low priced and bare necessary gi xX Quantity demanded In figure, there vertical straight demand curve DD, shows the perfectly inelastic demand. Here, the quantity demanded is remained fixed whatever changes in the price. 'b) Income Elasticity of Demand (Ey) It refers to the chang, change in consumer's income, i = Proportionate change in quantity demanded Income elasticity of demand (E,) = Proportionate change in inpooe 49 : Q 40, ¥ ag y i = ay «= 40,¥ Symbolically, E, AY 'Q “A¥=Ay Q Yi Where, E, = Income elasticity 40 = Change in quantity demanded Q= Initial demand AY: *hange in income Y= Initial income This concept can be illustrated b{er than unity income elasticity (E, > 1) Gr ercetase change in quantity demanded is ' greater than percentage change i e tia to be greater than unity income elastic ai tha ace nnge in income, then itis be writ ity of demand. In the case of luxurious goods, such icity . cust “ Oy £ Y2 3iy,t—seo Oo @& @ ny Quantity demanded Inthe figure, income is measured along OY-axis and quantity demanded is measured along OX~ axis. In above figure, flatter demand curve DD, shows income elasticity is greater than unity. When income increases from OY, to OY2, demand incréase from OQ; to OQ;. Here, increase is demand is x than increase income i.e. QQ: > Y,Y2. i) Equal to unity income elasticity (E, = 1) Ifthe change in income brings the equal change in quantity demanded, then such elasticity is said to. be equal to unity. In another words, it is the situation of change in demand and income by equal tion. propo y D4 gv iy D’ ee Quantity demanded Inthe figure, the demand curve DD; shows unitary income elasticity because when income increases from OY, to OY,, it leads to increase demand from OQ; to OQ: where change in income and change in demand are equal ie. Y;¥2 = QiQ2. (ii) Less than unity income elasticity (Ey <1) Ifthe percentage change in quantity demanded is less than percentage change in income, then it is said to be less than unity income elasticity. In case of normal goods, such elasticity can be realized. Dy O QQ us Quantity demanded Ar 4 leeper i elasticity, Here, the jemand curve DD; shows the less than unity income € ee oe demanded (2109) i less than the change/increase in income (YY). q Hib peaereeeeay ith change in income of the consumer, then it is ema ji ge in inco If demand for the commodity does not change wit mo he cea, to i i js the situation where no any response in q ; Sar cree nae ty caneumer, This happen incase of neta (ore necessary) goods ke any change . salt, matches ete. |___|o x Quantity demanded 7 4 In the figure, vertical straight demand curve DD, indicates zero income elasticity. Here, quantity demand has remained constant whatever changes in the income of the consumer. vi elasticity (E, <0) - 2 As Gaal aes ses St iees‘in income, then it is called negative income elasticity. If goods are giffen or inferior, then the demand varies inversely with income because higher income inspires people to consume superior goods. Xx Quantity demanded In the figure, the negative sloped demand curve DD; demand. In this situation, increase in income leads to decre: 1 indicates negative income elasticity of the ase in quantity demand. (c)_ Cross Elasticity of Demand (Ec) If the change in the price of one commodit it is called cross-elasticity of demand. In elasticity arises. Cross elasticity of demand; _ Proportionate change in quantity demanded of X (Ec) = Proportionate change in price of Y AQx ically, Fe= OX 208, Py _AQe Symbolicaly, Be = Gp Qe Be = +e Py MEW Finches of pigiicerng Beano aE ty brings the change in demand for other commodity, then case of related goods (substitute and complementary) suchwhere, AQx = Change in quantity demanded. | for X commodity ital demand for X commodity AP = Change in price of ¥ commodity Py = Initial price of ¥ commodity Example, Price of coffee in Rs/eup | Demand for tea in cup 10 40 15 60 Let, tea and coffee (substitute goods) are X and ¥ goods respectively. Here, AQx = 60 — 40 = 20 APy = 15-10 =5 Qx=40 Py=10 AC Py 20 10 Here, the coefficient Ec= 1 shows cross elasticity is positive and unitary. Note: The cross elasticity will be negative in case of complementary goods. Types of Cross Elasticity of Demand @ Gi) Cross elasticity is of three types: Positive cross elasticity (Ec = +ve) Ifthe quantity demanded for one commodity (say X) varies positively with the change in price of another commodity (say Y), the cross elasticity will be positive. It is connected with substitute goods like tea and coffee. Y Dy oc 2p = Spt 8 a oO a @* Quantity demanded for X (coffee) In figure, the upward sloping demand curve DD; shows positive cross elasticity of demand, Here, the increase in price of commodity Y (tea) leads to increase in demand for commodity X( coffee). It is because of people substitute tea for coffee due to high price of tea when price of coffee is Temaining constant, Negative cross elasti sity (Ec =—ve) If the quantity demanded for one commodity (say X) varies inversely with the price of another commodity (say Y), the cross elasticity will be negative. It is connected with complementary goods like petrol and motorbike.aD Price of Y(petrol) 2 Quantity Demanded for X(bike) In figure, downward sloping demand curve shows the negative cross elasticity of demand, Here, th increase in price of commodity Y (petrol) leads to reduce the demand for commodity X (motorbike) Itis because of people could not use motorbike due to high price of petrol. Gi) Zero cross elasticity (Ec= 0) If there is no any response in quantity demanded for one commodity (say X) due to the change it Price of another commodity (say Y), the cross elasticity will be zero. It is connected unit perfect non-related goods like watch and sugar, i & fe =P3 ¥ pt 3. ary SP a D Onc es Quantity Demanded for X(sugar) In figure, vertical straight demand curve DD, shows the zero cross elasticity of demand. Here, increase in price of commodity Y (watch) does not any effect to the demand for commodity X (sugar) because these goods are non-related with each other, F Law of Diminishing Marginal Utility This law was first pointed by H. Gossen in 1854 and it was developed and explained by neo-classical economist Marshall. It is central to the cardinal utility analysis of the consumer behavior, Tt states that in the process of fulfilling human wants, when consumer consumes more and more units o a commodity, the utility derived from each successive unit ofthe commodity goes on decreasing. Henct the relationship between quantity consumed and utility derived from each successive unit is called the lat of diminishing marginal utility. According to Marshall, "the additional benefit which a person deriv from an increase of his stock of a thing diminishes with the growth of the stock that he already has." This law is based and explained under certain conditions or assumption, such as; utility is cardinally measurable, consumer's taste and preference must be unchanged, suitable and similar units of commodity rational consumer and continuous consumption etc. It can be explained more systematically with the hel? of'a numerical example and figure. Let us consider the following table: HEL | irc ies or BGG FIOM AeAI SE |Suppose @ consumer is consuming units of apple. Heshe ¥ stars eating apple one after another. The first apple gives him/her great pleasure/satisfaction/utility. Right that-time, he °° starts second one and he compares it with frst. Second apple gives him less satisfaction than first apple and the satisfaction of the third apple will be lesser and so on. In this way, consumer goes on consuming till it drops down to zero. In. 20. there further force on consumption, the satisfaction will be 18. negative which leads to decrease in total utility. According to 16 above table, the utility derived from the first unit of apple is _ 4 10 and it is decreasing on successive units like 8, 6, 4 and so = 12 on. At sixth unit, consumer is getting zero marginal utility and total utility is 30. At this point the satisfaction derived is ° maximum, so it is the point of maximum satisfaction to the 4 consumer. He does not want to consume another ie, seventh 2 ° 2 unit gives him negative utility (-2) instead of positive satisfaction which leads to decrease his total utility by 28. ‘The marginal utility (MU) curve has negative sloped and _— crossed the OX-axis on seventh unit. The total utility (TU) curve is increasing at decreasing rate and it becomes maximum when MU is zero. When MU is negative TU has declined. Consumer's Equilibrium Under This Law A consumer reaches on equilibrium position when he maximizes his total utility with given his money income and price of commodity that he consumes. So, consumer's equilibrium requires answering the question of "how does a consumer allocate his money income among the various units to achieve maximum satisfaction?" Let a consumer has certain money income to spend commodity X and that commodity is available in the market, Both his money income and commodity have utility for the consumer. Therefore, he can either spend his money income on commodity or save it as in the form of wealth. On the process of consuming X, he compares the marginal utility of commodity and marginal utility of money i.e. price. If the marginal utility of commodity X (ie. MUy) is greater than the price of the commodity (i.e. Px), consumer will exchange his money for the commodity to get maximum satisfaction i.e. equilibrium. Hence, according to this law, a consumer reaches on maximum satisfaction i.e. equilibrium when, MUx = Px [Where, MUx = Marginal utility of X and Px = Price of X] 12345 6 (Tastes of enaincering economics HEDBefore 1940, engineers were mainly con th the design, construction and operation of machines, structures and presses, They’ gave less attention to the use of resources (human & physical as well ay capital & financial) that produced the final product, After this, engineers have been more interesting to generate novel technological solutions and to make skillful financial analysis of the effective implementation, Ie means, without these analysis, an entire project can easily become more of burden than a benefit The study of engineering economy draws upon knowledge of engineering and economics to address problems of allocating scarce resources. Its definition suggests that the goal of engineers should transfer resourves (natural) for the economic benefit of human being, The focus on scarce resources welds ‘engineering to economies. ‘The relation of enginecring to economics can be likened to that of engineering to physics. The laws of economic are not as precise as those of physics but their application to the production & utilization of scare resources ensures increasing attention from engineers, For example ~ micro economics is the study ‘of economic behavior of very small segments of the economy with aiming at maximizes profit of a firm ‘or maximizes satisfaction of a houschold consumer. On the other hand, engineering economy focus on economic decision making in an individual univorganization such that engineering economy is closely aligned with microeconomics “The economic theory of the location of Railways” written by A.M, Wellington in 1887 is known as pioneer engineering interest in economic evaluation, Wellington focused that the capitalized cost method of analysis should be utilized in selection the preferred lengths of rail Ii In 1920, C.L. Fish & O.B, Goldinan looked at investment in engineering structures from the perspective of bond market & compound interest procedure for determining comparative economic values An 1930, L. Grant published “Principles of Engineering Economy” and discussed about the importance of judgment factors, short-term investment, long-term investments in capital goods based on compound interest calculations, His many contributions resulted in the recognition that he is called the father of engineering economy, Later on, the modem approaches like; di ete. are being used to reflect today finds on engineering economics. Engineering Economics: What and Why? Engineering economics is the field of those activities wl of the costs and benefits of proposed te: counted cash Mow, capital rationing, risk & sensitivity analysis oncems for resource conservation & effective utilization of public hhich are concerned with the systematic evaluation the nical and business projects design and analysi decision covers a wide variety of areas ranging from choosing airport locations to improving production methods and determining budget requirements. Since all government and corporate decisions are influenced by financial considerations, one of the most effective and important tools available to engineers is economic analysis. Engineering activities of analysis and designs are not end all because they are means for satisfying human wants. Engineering has two concerns: need of the people and resource available, Because of resource constraints, engineering must be closely associated with economics. It is essential that every engineering Proposal be evaluated in terms of cost and worth before they are undertaken and economic feasibility an essential prerequisite of every successful engineering application, Engineering economic analysis which is used interchangeably with engineering ecdnomy, usually ‘feludes significant technical considerations. Conceptually, engineering economic analysis is the same a 3 ca other types of technical analysis, It is mathematical modeling with emphasis on the economic in the primary analytical technique to select between defined feasible altematives. Thus MEE Picpererensnceina economia . Engineeringing sconomy Fequires the application of technical and economic analysis with the goal of deciding best meets technical performance criteria and uses scarce capital in a prudent manner. The domain of such decision-making Activity ranges from the engineer who uses advanced computer technology 10 design new products, structures, systems and services to the chief executive officer considering & major business venture that may transform the organization in the years ahead. Definition 1 “Engineering is the art of doing well with one dollar Which any bungler can do with two after a fashion.” = A.M. Wellington Definition 2 “Engineering sconomics is the application of economic techniques to the evaluation of design and © of engineering economics is to assess the appropriateness of a given justify it from an engineering standpoint.” ~ John M, Watts Important Usages of Engineering Economics The study of Engineering economy draws upon knowledge of engineering and economies to address problens of allocating scarce resourcer, It is consémned with the sysiematjc evaluat of dhe corte ot benefits of proposed technical and business projects. The techniques and models of engineering economy assist people in making decisions. Since decision affects what will be done and the time fame ot engineering economy is primarily the future, Therefore, the use of engineering economic analysis may be best estimates of what is expected to occur. These estimates often involve following three essestiel elements; cash flows, time and interest rate. Engineering economy quantities the benefits and costs associated with engineering projects to determine capital investment. ‘The decisions are made by the engineers to choose one alternative over another and decisions often reflect a person's educated choice of how to best invest capital funds. It is utilized to analyze alternative use of financial resources and in assessing the economic merits of altemative uses of private and public funds, The principles and methodologies of engineering economy have wi and technical as well as general management. Similarly, itis an integral part of daily management and operation of private companies and corporations, government agencies and non-profit organizations, In the operation of capital funds on any project, engineers and managers can use the study of engineering economy to assist decision making situation from the following ground; 1. Selecting between alternatives designs for a component, machine, service during the engineering design process. Estimating and analyzing the economic consequences of improvements ina factory operation, Selecting among proposed projects within the annual capital budget limit, Analyzing whether the equipment in the service should replace or not. . Choosing between asset lease or purchase options to a product, Hence, the use of engineering economics study involves technical and economic analysis with a decision making objective. Role of Engineers in Decision Making An engineering economist draws upon the accumulated knowledge of engineering and economies t0 identify alternative use of limited resources and to select the preferred option in the course of action, It is devoted to problem solving and decision making at all levels, ; A decision is simply the selection of best one from two or more options in course of ation whether it takes place in construction or production, service or manufacturing industries, private or public agencies. ‘de application in engineering design structure, system, produet or yPenject of engineering economy The major decisions have economic overtones that makes the subject of engin any ee miiintie os be bel onan aia expected t0 occur iy i ‘ing economic anal lys " , eee : Te use of ae often involve following three elements; ca cos te — ; ai i Te ing economy quantifies thé benefits & cost associated with eng piesa oscil insets Ts tessa ose by the engineers to choose one pro devin sep esas cheat ion bee use/invest capital funds. Hence, the techniques & methodology of engineering economy can assist engineers in d Process from the following grounds, i, Understand the problem Define objective Collect relevant information/data Develop feasible alternatives ¥. _ Indentify the criteria for decision making Select the best alternative Evaluate each alternative Effective implementation and so on, a. In decision making process, the role of engineers may also be different situations like; i, Equipment & Process selection, Equipment replacement, i. New product & iv. Cost reduction ¥. Capital budget allocation, vi. ice improvement, vii. Project evaluation etc. Hence, engineers generally attack to practical Problems with appropriate solu Process, Principles of Engineering Economics The development, study and application of engineeri foundation for engineering economies basis for developm: production expansion tion in decision making accomplishment of good engineering econonm 1. Develop the alternatives The feasible alternatives need to be identif e ified and then defined for subsequent analysis. A decision involves making a choice among two or more altematives. If there is only one alternative, no choice le alternatives for evatuaty 1 ‘uation is important because of | 0 ping and defining the feasibl quality of the decision, Engineers and managers should place a high "Remember! Quality derives from quantity" 2. Focus on the differences is required. Develo, 203, Use a consistent viewpoint (Economic viewpoint) To delermine prospective (future) outcomes of the feasible alternatives, the viewpoint should be consistently developed and defined, Itis important that the viewpoint for the particular decision is defined and then used consiste ntly in the description, analysis and comparison of the alternatives. Suppose all the feasible alternatives have the same future cost to the public company. In this situation, the Perspective of the employces and their satisfaction may be important decision criterion. The viewpoint of this anat ysis, comparison and decision should be that of the employees of the company as a group and the feasible altemative should be defined from their perspective, "What is your viewpoint? Be consistent” 4, Use a common unit of measure "Remember! Standard unit oj 5. Consider all relevant criteria (Social Selection of a preferred alternative requires the use of all relevant criteria, In engineering economic analysis, the primary criterion rel i ary return to the owners. But other objectives like Social, cultural, envi criteria in the decision-making pr "Try to 6. Make uncertainty explicit Uncertainty is inherent in project rocess, underpin your decision from all perspectives" should be Tecognized in their analysis and comparison. Thus, dealing with "uncertainty is an important aspect of engineering economic analysis. "Expose yourself; there may uncertainty everywhere" 7. Revisit your decision (Self evaluation) Improve decision results from an adaptive process, ue to this the projected outcomes of the selected altemative and actual results achieved should be subsequently compared. Organizational discipline "Practice makes a man perfect” Engineering Economy Methodology and Its Application Methodology part of the engineering economy consists techni content of the discipline, Techniques incorporate principles above) and tools used in engineering practice which are the topic for the remaining chapters of this book. The application of engineering economy are diverse and found in Most areas of an organization. It is primarily concerned with the evaluation of alternatives uses of capital, Engineering economic analysis is used to assist decision making in many different situations, They are typically classified as: (i) Equipment and process selection ii) Equipment replacement Gil) New product and production expansion (iv) ‘Cost reduction (¥) Capital budget allocation BSc i es ques and procedures from the technical (seven principles which have explained(Wi) Service improvement (vil) New project evaluation ete. any is ter The analysis of economic events and transactions that affects on oe cash Lee oe i a a ‘ane as cash flow. A cash flow statement is a statement of company's ed to ger ivitic h it i i \d their need of cash. : tivities such as operating, investing and financing an : ne Tis the satement which shows the inflows and outflows of cash and cash equivalents during ifferen, = . caine , t abil The cash flow statement of an enterprise is useful in providing information to the os jeboat a sy « the enterprise to generate cash and cash equivalents and the need of the enterprise to flows. Cash flows are important in engineering economy because it is the basis for evaluating differen: alternatives, Cash flow means the actual ru Cash flow diagram A typical cash flow time scale for N years. pees coming into or goes out during different time. F interest rate per period | 9 ~ | Tee noi | Time in years 8 Ina cash flow diagram The horizontal line is a labels are applied to in period. The arrows signify cash flows ie, represent cash inflow Exampk time scale with progression of time moving from left to Tight. The period (year) tervals of time i.e. the end of 1* Period is coinciding with the beginning of * | downward arrows represent cash outflows/ex ‘incomes/ receipts of th ‘penses and upward arrows \e given project. 1 life of the project. Solution: ¢ cash inflows, | End of year Cash outflow (Rs.) Cash inflows (Rs) 0 10000 = T 3000 S310 2 2 3000 S310 2310 3 3000 5310 2310 4 3000 5310 2Cash flow diagram Presentation of above cash flow into diagram for $ years, 2,000 5,310 6,310 5,310 6,310 5,310 3,000 3,000 3,000 3,000 3,000 Yoars ring e . What are the important uses of engineering economies? Explain, 2. State and explain principles of engineering economics, 3. Define engineering economics. Write down the principles of Engineering Eeonomie Analysis. 4 What do you mean by utility and marginal utility? Describe the aw of diminishing marginal utility with an example. 5. Define law of demand and law of supply. Explain the factors influencing to demand and supply. Why engineering economics is considered as important aspect for making decision for engineers? Explain. "Knowledge of engineering economies hel of engineering economics. 8. Explain why the subject of engineering economies is important to Civil Engineer. Explain the roles of engineers in making economic decision with appropriate examples. 10. Scarcity is an emerging issue in engineering field. How does the study of economies help to engineers in decision making process? Discuss. ps in decision making process". Justify it by the principles 11. Why do engineers need knowledge of economics during engineering decision making. process? Mention any five types of engineering economic decisions. What is Demand? What are the factors affecting demand of a commodity? Describe the law of diminishing utility with neat sketches. (PU-2018 Fall) "Hydropower is known as demandable project to the Nepal, What are the factors affecting the demand? (PU-2017 Spring) 14. What do you mean by engineering economics? Explain the importance of engineering economics in 12. 13. business projects. (PU-2017 Fall) 15, Define demand, supply and utility. Explain about elasticity of demand. (PU-2016 Fall) 16. What are the principles of Engineering Economics? Explain why studying Engineering Economics is useful to engineering student. | : inering Gee Fall) 17, i by Engineering Economies? Describe its importance in engineering field. What is meant by Engin: 1B are) 18. What is meant by cross elasticity of demand? Describe all types of cross elasticity of demand with a (PU-2015 Spring) suitable figures. A Ber is engineerii ics? Why do you think studying this course is important for engineering 19. Wt 2 a economics? Why do y yi pe ane lent? Justify. LLL ase or eraineetna rcononics TM20, What are the principles of engineering economics? Explain the importance of entry economics in business projects. vee | - (PU-2017 Spri, 21, What do you mean by utility, marginal utility and diminishing law of marginal utility? (PU-2017 Spring Define engineering economics, Explain its principles. (PU-2016 Sp What do you understand by engineering economics? Explain its seven principles and importanee” business or engineering projects. 22, 23. (PU-2019 Sp 24. What do you understand by engineering economics? Explain its seven principles and importance business or engineering projects, (PU-2019 25. What do you mean by demand, clasticity of demand and types of elasticity of demand? Spring (PU-2019-Fyy oon aCost Concept and Fundamentals of Cost Accounting ‘Student Learning Objectives % terminologies % Manufacturing cost and non-manufacturing cost % Cost for business decision % Element of cost % Life cycle cost Cimparison berween cost accounting and general accounting % Method of cost accounting= A measure of what must De BF «The value of the inputs needed a oe ee ee snc called cost or cost the amount of expenditure incurred gy “The amount of money paid for a thing 15 a given thing. Total cost ; = The sum of fixed costs and variable costs. = Itis also called sum cost. a alte past (previous) costs which cannot be recovered when a firm leaves from an industry. isi ing in future. > have no relevance to decision making in : - a region design, wages, registration, license, decoration, depreciation etc. are the ‘examples of sunk cost. Opportunity cost ; = The cost of best rejected opportunity to ear return. : % Itis hidden or expected cost but important for decision making process. : = Opportunity cost is appeared due to possibility of alternative use of scarce resources 1-c. factor fer to obtain something. Poe any goods or service, that has to be measured in some inputs. Fixed cost Those costs which are associated with fixed factors of production like land, plant, building, equipment ete. ™ — Itremains constant in the production process for certain level of output capacity. Variable cost = — Those cost which are associated with variable factors of production and vary with change in level of output like labour, raw materials, fuel etc. The difference between fixed cost and variable cost may be found in only short-run production process. Incremental cost (Marginal cost) ~The change in total cost due to change in one unit of extra output. Iti the incremental (additional) cost required to increase in the quantity of output by one unit. It is also referred to as marginal cost (MC). (TC, = Total Cost up to last (n") unit of output] (Where, TC = Total cost, Q = Output quantity & A = Change) Average cost = Itis per unit cost of any output level. = AC Recurring cost = All the costs which are occurring over the production process on a continuing basis = All the variable as well as fixed costs which is paid as a repeatable basis is recurring cost. ™ Rent, wages, salaries, price of raw materials, fuel cost etc. _— aNon-recurring cost = Those costs which are not occurring/repeating over a production process. = Itinvolves the cost of devetoping capacity to operate = Purchase cost of land, plant, equipment, technology etc. Direct cost = itis i costs which can be reasonably measured and allocated with specific output or work activity. are direct costs, = Itisalso known as prime cost. Indirect and Overhead cost = It consist all costs other than direct material and direct labour. te the sum ere material Cost, indirect labour cost and all other indirect expenses. ferm overhead cost is used to mean all expenditures that are not direct costs. Indirect costs are those that cannot be reasonably measured and allocated to a specific output or work activity. Overhead cost may be four and Distribution overhead. Direct Cost Items ; Direct Material Direct Labour Direct Expenses vue types- Production overhead, Administrative overhead, Selling overhead "Examples Milk for curd, Cloth in a shirt, Paper in book, Wood in a chair etc. Salary of manager, Salary of driver and other staffS etc. Cost of design and drawing, Registration fee, Hire of Special tools, tax, depreciation, insurance etc. Indirect Cost Items ‘Examples % A Indirect Material Fuel, lubricants, small tools, glue ion a book, thread in a shirt ete. Indirect Labour Overtime pay, holiday pay, maintenance charge etc. Indirect Expenses | Stationary, electric, water, training, medicine etc. Standard cost ™ Standard cost is representative or planned cost per unit of output that is established in advance of actual production or service delivery. They are developed from anticipated direct labour hours, materials needed and overhead categories for the production or delivery process. = Standard costs play an important role in cost control and other management functions like comparison between actual with standard cost. tis also known as estimating cost. Cash cost versus Book cost ™ — A cost that involves payment of cash form is called a cash cost. On the other, a cost that does not involve a cash transaction but is reflected in the accounting system is called non-cash cost. Such non-cash cost is often referred to as a book cost in accounting. ™ Cash costs are estimated from the economic perspective to analyze alternatives. * Book costs are not involved in cash payments but rather represent the recovery of past expenditures over a fixed period of time.The most common example of book cost is the depreciation charged for the most c¢ plant and equipment. the defined perspective forthe analysis need to be considered. = Depreciation is not a cash flow and is import which are cash flows. Manufacturing & Non-Manufacturing Cost :d in various ways because cost is clas: In engineering economics, the term cost is use Of assets such gy In engineering econot lysis, only those costs that are cash flows or potential cost flows fr; gineering economic anal ant in an analysis only because it affects income tag, fied according tot needs of management. So, each different use of cost data makes different classification & definition Abou st. Be Preparation of financial report needs the record of historical cost data ; Decision making process may require current and future/estimated cost data. The common activities of manufacturing companies are; (Acquiring raw materials Gi) Producing finish goods ii) Marketing & (iv) Administrating To understand the cost in a manufacturing company we must have bet manufacturing and non-manufacturing cost (A) Manufacturing cost (factory or production cost) tter_ knowledge abou. In the process of converting raw materials into finished goods a manufacturer needs various nature of costs that refer manufacturing cost. Most into prime and overhead followed by each cost elements, a~ Prime cost (Direct cost) Prime costs are those cost related to a given cost object and that can Product, Prime cost is the aggregate of the following cost elements, i, Direct material costs Direct labour costs iii. Direct expenses i Conveniently traced to a unit of fin, cloth in shirt, paper book, etc, The total cost having on such materials refers direct material cost, ii) Direct labour cost ili) Direct expenses are called direct expenses. Special designs and di manufacturing job and their maintenance are Some examples, of direct e: be traced into specific unit of tools and equipment for xpenses,b- Overhead costs (Indirect costs) Overhead costs are related to the Particular cost object that cannot be traced to specific units of product. Overhead cost is the aggregate of following three elements. i- Indirect material cost The costs of materials, that could not directly traceable and those extremely small in monetary value are called indirect material Cost. Like cost of glue used to bind a book, screws in a famine factory, dishwasher (Weterjent:in a:tar-foon Testaurant etc are some examples of indirect material costs, ii- Indirect labour cost The labour cost that are not directly traceable for Specific output are called indirect labour cost. Cost associated with security Suard, overtime pay, meeting allowance, part time staff ect. are some examples of indirect labour cost. ii Indirect expenses (B) Non-manufacturing costs: ing additional costs may incurred in supporting for manufacturing operation. i. Marketing or selling costs/expenses : and supply of finish product into commission, sales travel, sales salaries Administrative costs/expenses - relations, secretarial support assoc: Distribution It includes all cost neces hands of the customer, ete, includes executive compensation, ted with general management of sary to secure customer order advertising, shipping, sales general accounting, public an organization, Historical cost data may not be suitable for planning and future decision on business, Hence, Gost data that management needs in making future business decision (choive between alt different from historical cost data. Differential Cost ex Revenue In business decisions, each alternative (project) has certain costs and revenue that must be compared with other available alternatives (projects). : A difference in cost between any two alternatives is known incremental cost. Technically, alternative to another. Similarly, a difference in revenue between any two alternatives is known as differential revenue. ‘An investor must comp: are cost & revenue within a project and also between Many projects and make the type of lemnative) are as a differential cost it is also called an incremental cost should refer only to an increase in cost from one decision accordingly. IfRevenue > Cost => Select project. TfRevenue < Cost Reject project. (east concept and randamenta of cos Aecouing EMDifferential (incremental) cost is the difference in total cost that results from selecting one alternative (project instated of another. If several alternatives are possible, we select the one which has the minirmum cost and maximum savings from the base (existing method). Problems of this type are often called trade. off problems, because cost of one project is traded off cost for another project. It is the best ecu opportunity to earn retum by using available resources. In another words, it is the best opportunity to generate income that is forgone by not using the limited resources. It is more useful in business decision. If the asseUresource has been abandoned, then the opportunity cost will be zero. Sunk cost: All the costs that already has been incurred in past actions which cannot be recovered refers such cost. Sunk costs are not relevant to decision making process because they cannot be changed regardless of what decision is made now or in the future. Marginal cost; ‘The change in total cost due to increase in output by single unit. ‘The net cost involved in producing one more unit of product is called margi Marginal cost (MC) = TC, ~ TC, 1 are OR, MC = = s used in production activity, c -d into following thr (i) Material cost Gi) Labour cost (iii) Overhead expenses @ Material cost ‘The substance which is used for the production of an 'y things is known as material. Hence, the cost of raw materials, Spare parts, consumable materials (fueVelectrie, water), packing materials (carton, wrapping paper, cardboard boxes) ete. are called material cost, Gi) Labour cost Human effort is indispensable for the conversion of materi ials into final goods and such effort is known as labour. Hence, all the costs of skilled and unskilled lab our employed in construction or production process are called labour cost. (iii) Overhead expenses Overhead expenses include all the cost which have xp pot covered by material cost and labour cost. Therefore, it includes the cost of special design, n drawings or layouts, cost of purchase or hiring of tools and equipment for a particular job and maintenance costs o| ols : f such tools and equipment. Similarly, royalty fee, training expenses, rent, insurance, depreciation, tax, stationary ec, are fall under this category. In another words, overhead expense is the indirect cost that can't be reasonably measured and allocated to a specific output or work activity. Hence, overhead expenses are the sum of indirect material cost, indirect labour cost and all indirect expenses. The elements of cost mentioned above constitute the total cost, Hence, Total cost = Material cost + Labour coust + Overhead expenses:ith retirement and disposable activities. It may also be ication of the economic need and ends wit sdoffsed asthe summation of acquisition, operation, Papeyele cost consists following three components: (i) Fisteost i ci Operating and Maintenance costs i) Disposal costs (First cost (Initial investment, capital cost) The first cost is the total initial investment required to get the item (project) ready for service and such costs are non-recurring nature over the life of the item. The first cost may consist of the following major elements: (a) Land cost (6) Engineering design and development cost (©) Building cost (@) Basic machine and installation cost (¢) Training and special tooling cost (9 Cost of supporting equipmenv/computer and transportation (g) Manufacturing and fabrication costs ete, Operating and Maintenance cost Operating and maintenance costs are recurring costs that are necessary to operate and maintain an item/project during its useful life. Operating costs usually consists ofthe following elements: (@) Labour cost (wages and salaries) (b) Material (raw materials) (©) Consumable materials (fuel, electric power, water, packing material) (@) Overhead items (tax, insurance premium, inventory charges, administrative and management expenses, stationary, small tools, overtime and meeting expenses etc.) (ce) Transportation cost etc. Operating cost will be recurring nature and possible to estimate annual basis but maintenance costs may not be such nature. (iii) Disposal cost When the life cycle of an item/project has ended, disposal costs usually result. Disposal costs may include following elements: (a) Labour cost for removal of the item. (b) Material cost (tools, fuel/electric, packing material etc.) (©) Transportation cost etc. Although disposal costs may be incurred at the end of the life cycle, most items have some monetary value at the time of their disposal. This value is the true or market value (actual selling price of the item/project). After deducting the cost of disposal from the market value, the net worth of the item/project is obtained. Such net worth at the time of disposal is called salvage/scarp value of the item/project. maintenance and disposable costs. iPrime and overhead cost on Production cost = Prime cost is the sum of direct cost that can be reasonably measured and allocated to a specif ie output. Hence, itis the aggregate of direct material cost, direct labour cost and direct expenses, Production cost refers to the summation of all costs for the specific output or work activity, His the s incurred to the output, sum total of direct as well as indirect cos Direct Material ale is Prime Direct Labour Cost Production | Direct Expenses Cost Indirect Material i Overhead Indirect Labour Cost Indirect Expenses | Comparison between Cost Accounting and General Accounting s the and General Accounting (Financial Accounting) General accounting is primarily concerned with systematic record keepin; preparation of Profit & Loss Account and Balance Sheet, It provides information regarding the pro loss that the business enterprise is making and e, Balance Sheet. Cost Accounting Cost accounting is mainly concerned with the classifying, record expenditure. It also concern to the determination of cost of products and services, and presenta ‘and services produced by the firm that helps to the control of cost and fication, and directed towar also financial position on a particular date and appropriate allocation of n of cost data. It deals with the cost of goods provides guideline to the management. Hence, cost ac presentation and interpretation of costs and its accounting, a Comparison between cost account ig (Financial Accounting) ounting relates to the collection, clas J control to the various elements of cost. and general accounting Cost accounting Points of | General account! nto ss in all provides informat management for proper — plana ion, control and decision making] Tt provides information about busin about the profit & loss and cd] op regarding cost, ‘Recounts are kept voluntarily to meet the requirements of the management, Purpose general way. It tells financial position of the business to owners outsiders. are kept in such a way as to meet the Form of | Accounts ‘ax requirements of Company Act and Income T Act. Recording It classifies transactions in according to nature of, accounts Trrecords the expenditure in an objective ccording to purpose fo analyses the ie.|manner i which the costs incurred. records and ‘a subjective manner ‘expenses. ‘Economic Analysiswithout attachin, position at the end of year, It is the account of wh discloses the net profit or lo: a whole. It lays emphasis on the Tecording aspect 8 any importance to control [It teporis operating results apd-peoccar 8 Tesults and financial tole “business and SS of the business as Tt provides a detailed system control for material, labour and overhead cost. Tt gives cost reports to management when desired. Itis only a part of general account and Aiscloses profit and loss of each product Gob or service). The costs are reported in a general accounts. igeregate way on| Costs are breakdown on a unit basis in business i.e. manufacturin; and distribution, It relate to commercial transactions of the 8, office, selling| cost accounts. It relates to manufacture of goods and| service. {information Monetary information is only used. Method of Cost Accounting ‘Non-monetary information like units is| also used. Basically there are two methods of cost accounting: (a) Specific order (Job) costing (b) Operation (Process) costing (a) Specific order (Job) costing Itis the category of basic costing method and applicable where the work consists on separate job, batch or contract, and each of which is authorized by a specific order or contract. Order costing is used to find out the cost of special jobs made to consumer's specification. This method is used when products are manufactured in clearly distinguishable lots according to individual specifications and itis practical to keep a separate record of each lot from beginning to job completion. It is done commonly for building construetion, printing, repairing, decoration, furnishing etc. () Operation (Process) costing Itis the category of basic costing method applicable where standardized goods ot services result fiom a sequence of repetitive continuous operation or process. It refers to costing of one or more Process involved while converting a raw material into finished output, Process costing is done on Paper, textile mills, chemical plants, food, oil refining, diary product ete. This method is employed where itis not possible to trace the items of prime cost to a particular order. In oil refining factory, wwe can not trace the prime cost of a specific order for say 200 liters of refined oil where thousands ofliters of oil are being produced at the same time. Tob Costing ~ Production is made by specific order. 1. other, complete, ' No transfer of cost from one job to another, - Different jobs may be independent to each | 2. : Cost is computed when the job is | 3. Comparison between Job and Process Costing Process Costing Production is in continuous flow. Being manufactured in a continuous flow, productions are similar identity. Costs are calculated at the end of each cost period/process. Cost are transferred from one process to another until the goods are completely manufactured.5. More managerial attention is needed due to | 5. Duc to standard production, the control of process difference in jobs. activities will be comparatively casier. Method of Overhead Distribution ‘There are many methods of allocating overhead cost among the products of service produced, The most commonly used methods involve allocation in proportion to direct labour cost, direct laobur hours, direct material cost, sum of direct labour and direct material cost or machine hours. In these methods, it is necessary to estimate what the total overhead cost will be? Accordingly, total overhead costs are customarily associated with a certain level of production, which is an important conditions that should always be remembered when dealing with unit-cost data. To illustrate one method of allocation of overhead cost, consider the method that assumes overhead is incurred in direct proportion to the cost of direct labour used. According to this, the overhead cost per unit would be, Overhead rate = “Tyirect labour in dollars for period Overhead cost/unit = Overhead rate « Direct labour costunit Example: 2. Following are the costs for the production of 100 badminton racquets; Labor rate; Rs. 40/hr Leather; 50 meter @ Rs. 200/meter Gut; 300 meter @ Rs. 50/meter Graphite; 100 kg @ Rs. 200/kg. Total Labor hours needed; 200 hours Total annual factory overhead; Rs. 50,00,000 Total annual direct labor hours; 2,50,000 hours. Break down the costs into components of prime costs and overhead costs and find out the manufacturing cost of each racquet. Solution: Direct labor cost = Rs. 40 x 200 hours = Rs. 8000 Direct leather cost = Rs. 200 x 50 meter =Rs. 10,000 Gut cost ‘s. 50 x 300 meter Rs. 15,000 (PU-2015 Fal) Total prime cost Rs 53,000 For the overhead cost: Total factory annual overhead cost Total annual direct labor hours Rs 50000000 250000 hours = Rs, 20/hr. ‘actory overhead per hour cost Total labor hours needed Rs, 20 x 200 hours = Rs. 4,000 ‘Total prime cost + Total overhead cost =Rs. 53,000 + Rs, 4,000 = Rs. 57,000 Factory overhead per hour cost = ‘Total overhead cost Total cost =Total cost Total production units _ Rs. $7000 100 = Rs $70/racquet Manufacturing cost of cach racquet Example: 2.2 —————— that for a future period the overhead Seppos fot the cost is expected to be total $1,00,000 and total direct ais Bie to be $50,000. Similarly, for a unit of product the direct labour cost is a coe culate overhead rate per dollar of direct labour cost and overhead cost per Solution: Given, Total overhead cost = $1,00,000 Total direct labour cost = $50,000 Direct labour cosvunit $60 Hence, overhead rate =~ Total overhead cost Total direct labour cost _ $1.00,000 $50,000 $2/direct labour cost Similarly, overhead cosVunit = Overhead rate x Direct labour cost/unit = $2 = $60 = $120 1. Define direct and indirect cost with example. Explain about the life cycle of cost including their components. 2. Explain the concept of manufacturing and non-manufacturing cost with suitable example. 4. Define cost accounting and general accounting. How do you compare between these concepts? 7. Define Prime cost, Overhead cost, Fixed cost, Variable cost, Opportunity cost, Sunk cost, Marginal cost and differential cost. (PU-2018 Fall) 8. Define funding and financing with example. What is the difference between the general accounting and cost accounting? (PU-2017 Spring) 9. Explain opportunity cost, marginal cost and sunk cost with example, (PU-2017 Fall) 10. Whats life cycle cost? What are the differences between financial accounting and cost accounting? (PU-2016 Fall) manufacturing, sunk and opportunity costs with suitable example. (PU- 2018 Spring) cost, non-manufacturing cost and differential cost and differential revenues with suitable (PU-2017 Spring) example. ; i 13. Explain manufacturing, non-manufacturing cost and, opportunity cost. (PU-2016 Spring) 11. Explain manufacturing, non— 12. Define manufacturing 14. Explain marginal, differential, sunk and opportunity cost with suitable examples. aes Batted 7 , dif it jinal cost with suit 15. Explain manufacturing cost, non-manufacturing cost, opportunity cost and marginal ons a examples. 16. Following are the costs for the production of 100 badminton racquets; Labor rate; Rs. 40/hr (Sauer Teas nce ane minal ofc acd EMLeather; 50 meter @ Rs. 200'meter Gaz: 300 meter @ Rs. 50'meter Graphite; 100 ke @ Rs. 200/Kg. Total Labor hours needed: 200 hours Total annual factory overhead: Rs. 30,00,000 Total annual direct labor hours; 2,50,000 hours. Break down the costs into components of prime costs and overhead costs and find out the manufacturing cost of each racquet. (PU ~ 2015 Fal)_ Time Value of Money Student Learning Objectives % [After the completion of this chapter students will be able to lean about: % Interest: simple interest & compound interest % Nominal & effective rate of interest % Economic equivalence: present worth, % Development of formulas for equivalence cal future worth and annual worth culation including gradientne value of money is a fundamental concept in comparison of the economic performance between projects i.¢, alternatives. Money has a time values, the value of a given sum of money depends on when the money is received. Time value of money is defined as the time dependent value of money because of changes in purchasing power (inflation or deflation) and real earning capacity of money over time. Since money has the ability to earn interest, its value increases with the time. Hence, it is the relationship between interest and time. Interest Calculation Interest is the price of money ser ces or it is the fee that is charged for the use of money. Interest depends upon the total amount of money and the length of time over which it is borrowed. Normally, it is calculated as an annual rate and interest payments are made by borrowers to lenders. There are two methods on interest calculation. (i) Simple interest (ii) Compound interest Simple Interest When the total amount of interest eamed is directly proportional to the initial principal amount, then the interest is said to be simple. Simple interest is not used in commercial practice at this modern time. For a deposit (P) at simple interest rate (x) for periods (N), the total earned interest amount (I) would be, PeNXR or, 1=P*xT*R (T= time in years) ‘The total amount available at the end of N periods i.e. total future amount (F) would be, F=P41 Compound Interest Whenever the interest charge for any interest period (year) is based on the principal loan amount plus any accumulated interest charges up to the beginning of that period, the interest is said to be compound. It is mostly used in practic Following notation is u ized for compounding interest calculations: i= Effective interest rate per interest period N= Number of compounding periods Present sum of money Future sum of money ‘A= End of period cash flows in a uniform series ‘According to this, future amount (F) would be : F = P(1+i) Nominal and Effective Interest Rates Nominal Interest Rate : Ifa financial institution uses a unit of time less than one year in length such asa month, a quarter etc., institution usually quotes the interest rate on the annual basis. In this situation, the basic annual rate of interest is known as the nominal interest rate and it is represented by . oe en camped ms be stated for any time less than one year such as, 6 months (semi annual), “ ee aay eed For example, if the interest rate is 12% per year and compound semiannua yer eee per interest period and the interest period is six month), in this situation, not ae 12%). But the actual rate of interest would be greater than 12% because of the compoundingEffective Interest Rate ‘The actual rate of interest earned during one year is known as effective rate and it is also expressed ‘on the annual basis, unless specifically stated otherwise. Effective interest rate is represented by‘. Relationship between Effective (i) and Nominal (r) Interest Rates Let us suppose that, the interest rate is compounded semiannually, | aati en 1 pyear We know, F=P(+i)% Let, i = Effective interest rate per year Nominal interest rate per year m= No. of compounding periods in year Then, the interest rate per single compounding period would be r m We can also write, (1 + zy =P(1 +i)! or, i=(1+2) -1 Hence t= (142) —1 Note: When m=I; =r m>li>r . lim ry = moor ig= 9 [ (1 +2) -1| — 1 (Where, e = 2.71828) From the above example, the effective interest rate for 12% compounded semiannually can be computed as, = (122) —1=1230% HoW to find inoaniy When igris given ? We know, ie=(14+5) -1 or, (+3) = (1+ ies) os, (1+) =a +i! (Note: In this case, r = 12% and m = 2) or, y= (1 ieg)™=1 inonnty = (1 + ie)" —1 Similarly, ige= (1 + ipa)! 1 Hemant = (1 + ouaney)* — 1 en ee iguantesly = (1 + deer) Hi So amevs inwny = (1 + gute) ie = (1 + inontiy) ® Example: 3.1 Mf nominal rate of interest per year is 12% that compounds quarterly, find effective interest rate. Solution: Given, r= 12% and m= 4 We know, ig = (0 ) 4 ( + 92) ~1 = 0.1255 or 12.55% OR, - Interest pre quanrter= a =3% or 0.03 We know, ign'= (I-Figusts) 1 = (140.03)'-1 = 0.1255 or 12.55% Example: 3.2 A bank is starting its nominal interest rate of 9% paa, and compounding quarterly. Calculate The effective interest rate (i) a year (ii) a quarter (iii) a month (iv) half year. Solution: Given, r= 9% ot, 0.09 compounding quarterly Wetnomig=(1+2) -1 + 09/4)‘ 09/4 0,093 i.c.9.3% a year 0225 ic. 2.25% 0.00743 i.e. 0.743% 1=(1 + 0.0225) — femi-anmuat = (1 + igg)!? Example: 3.3 a of interest per year = 0.1956 = 19.56%, Alternatively r ; + 7p = (1.1956)! Nominal interest per year (¢) r or, 1 +55 = (1.01499) = monthly interest x months in a year or, 7 = 0.01499 0 1.5 x 12 = 18% T= 18% ME eso ricci conic mata mee 1799 = 18 = 13%zconomic Equivalence fas time value and due to this it leads to important que Morey thing as receiving Rs. 1,000 at any future time. Hence, how do we measure and compare A os cash payments / received at different points of time? How do we kote whether we dela prefrto have Rs 20,000 today and Rs. 50,000 ten years from now or Rs.8,000 cach year for the next ten years? Beonomic equivalence describes the basic techniques for solving such questions, Economic equivalence refers to a cash flow whether a single payment or a series of payment that can be converted to an equivalent cash flow at any point of time (PW, FW, AW). For example we could find the equivalent future worth (FW) of a present amount (P) at interest rate (i for period (N) or we could determine the equivalent present worth (PW) of an equal payment (A) with given rate of interest (i). Economic equivalence is used commonly in engineering field to compare alternatives (projects). In engineering economy, we could compare the value of two proposals by finding the equivalent value of each at any common point of time, ions; receiving Rs. 1,000 today is not Economic equivalence is a combination of interest rate and time value of money to determine the different amounts of money at different points in time that are equal in economic value. As an illustration, if the interest rate is 6% per year, $100 today (present time) is equivalent to $106 one year from today. Amount accrued = 100 + 100(0.06) = 100(1 + 0.06) = $106 Five Types of Cash Flows Whenever we identify the pattem of business cash flow transaction, we able to classify such cash flow transactions into five different categories. 1. Single Cash Flow; it only deals two amounts i.e. present amount P and its future worth F, 2. Uniform (Equal) Payment Series; it is a series of equal cash flow at regular intervals like payment of loan in equal periodic installments (A) and deals with equivalence relationship between P, Fand A. Linear Gradient Series; it is a series of cash flow that vary with constant amount (increase or decrease) from any time period. For example, a series of annual payment that increases by Rs. 500 each year. Geometric Gradient Series; itis a series of cash flow that vary with constant rate (increase or decrease) from any time period. For example, a series of annual payment that increases by 10% each successive year. 5. Derivation of Compound Interest Formulas of Single Cash Flows ree ee Sas POWs) [Finding F when given P| Ifan amount of P dollars is deposited now to earn an interest i% per period (year), then the amount will grow as follows: Irregular Payment Series; it is a series of un-equal cash flow at regular intervals, At the end of year 1, the amount = P + Pi = P(1 +i) At the end of year 2, the amount = P(I +i) +P( + i)i At the end of year 3, the amount = P(1 + i)? + P(I +i)? Similarly, At the end of year N, the amount = P(1 + i) The accumulated amount after N periods is the future sum and itis denoted by Hence, F = p(1 +i)Here, the factor term of the bracket i.e. (1 + i)' is called single payment compound amount factoy Functionally, it is denoted by (F/P, i%, N) and it is read as ‘finding F given P at i% interest for y periods." The process of determining future sum of a single payment cash flow is known as compounding Process. Example: 3.4 Calculate future sum at the end of 7% interest per year. Solution: Monthly deposit (A) = 6,000 for 3 years i.e, 3x12 = 36 months. i=7% per year; (1 +0.07)'"7 We KNOW, inontiy = (1+ gg)! = Future sum at the end of 5" year Future sum at the end of 3" year (F3) = A (FIA, iipontny 36) | cae | Welnow, y= PAP =H) 9 3.799 Future sum at the end of 5" year ; Fs Fs From the above equation, we know that ) = F=P(+i)® Solving it for P, P=F(+iy% Here, the term (1 + iis called the single payment by (PAF, i% Example: 3.5 Suppose you borrow Rs. 8,000 from a bank, that charges Interest aa Va 0% compounded ; te of 10% annually. How much would you owe at the end of year 4? a Solution: Given, P = Rs. 8,000 F=Rs. 8,000(1 + 0.1)* 2 F=Rs. 11,7128 Example: 3.6 Suppose you have invested Rs. 1,000 at present. How long does it take Tor your invesunear™ double if interest rate is 8% compounded annually? Solution: Let the investment P will become 2P after N years. 2,38,790 (1 +i)? 2,38,790 (1 +0.07)" Hence, Fs=2,73,390 N) and itis read as ‘finding P given F ati, The process of determining present worth of a future si year when monthly deposit is R }00 for 3 years that cams ).00565, F3 (FP, i%, 2) resent worth factor. Functionally, it is denoted % interest for N periods." sum is known as discounting process. Componding E=2 P=8,000 0 i ae ee |Then, F = 2P ’ Alternatively we aaa an 1000 (1 +i = 2000 on 2P=P(I +i) or, 1000 (1.08) = 2000 3p . or, (1.08)%=2 or, Fa (1 + 0.08) Taking log on both sides, or, 1.08% =2 Nlogl.08 = log? ‘Taking log on both sides, Of; oN = 789 years N logl.08 = log? N a log? =9 years ot, N=Togi.og 9 years N=9 years Example TE aT a ree A man wants to have Rs. 10,00,000 for his daughter's education after 5 years. How much should he deposit now at saving account to invest for that purpose, if interest rate is 9% compounded annually? Solution: Given, F = 10,00,000 i=9% N=5 years Po? 7 We know, P=F(+iy% P= 10,00,000(1 + 0.09) * P=Rs. 6,49,931 Example: 3.8 F = 10,00,000 Discounting “Ram deposits Rs. 5,000 now in a bank which gives 10% interest per year. He draws Rs. 2,000 at the end of 3" year. What will be the remaining amount at the end of 5" year? Solution: At the end of 3 year, the accumulated amount will be, F =PU+i)* 5,000 FH? = 5,000(1 +0.1)° = Rs, 6,655 After drawing Rs. 2,000 the remaining deposit amount at the end of 3 year will be, 12345 Rs. 6,655 — Rs. 2,000 = Rs. 4,655 2,000 At the end of 5" year, the total accumulated amount will be, F=4,655(1 + 0.1)? = Rs. 5,632.5 Alternatively, F = {5,000(1.1)° — 2000}(1.1)? = Rs. 5,632.5 Example: 3.9 Find effective interest rate when the nominal rate of interest is 18% per year and compounding is; (i) Monthly, (ii) Daily, (iii) Hourly and (iv) Continuously Solution: If nominal rate of interest is 18%, the effective interest rate for different time period can be calculated as:(i) Monthly 2 ie(t +8) -1=19.561% (ii) Daily xs i= (+98 9.716% (ii) Hourly Be) 17 19-7215% (iv) Continuously i=e'—1=e™_1=19.7217% A person deposits Rs. 4,000 at a nominal interest rate of 20% for 5 yea deposit when the interest is compounding quarterly. Solution: Given, P = Rs. 4,000 N=5 years 10% compounding quarterly Fa? According to question, Interest period in a year = 4 (i.e. compounded quarterly). Total interest period for 5 years = 4 x 5=20 20% m4 75% Find the maturity of the F = P(F/P,5%, 20)= 4,000(1 + 0.05)" = Rs. 10,613 Alternatively, ie=(1422) i= (1 47 N=5 years ©. F= 4,000 (F/P, 21.55%, 5)= 4,000(140.2155)° = Rs, 10,613 Interest Formulas Relating a Uniform Series to its Present and By using single payment compound amount factor formula, 1.55% per year Future Sum Ul Iniform series (equal payment) Uniform series shows equal cash low amount (payments or reccips) occuring atthe end of each eq periods. Such uniform series is often called an annuity and it is denoted by 'A'. Commercial ingullnests rental payments, insurance payments ctc. are the better examples of uniform series, A cash flow diagram for uniform series Fe? Ap Ag Ag -1 AFindin fa amount ‘A’ occurs at the end of each period for N periods at i% interest rate per period, the future sum (worth) at the end of N* period ean be written as, coal +i Tea tihte ++i) +1) ‘The bracketed terms comprise a geometrical sequence having common ratio (1 + i)". So, the sum of the y= bay =b ue (Sx) of a geometric sequence is $= 1—bax where, a= first term of the sequence mi = last term of the sequence b=common ratio (14a 5) aie 1 (+i) — ory 5 hc CU UT hati 7 = 1 +i) -! a Here, the factor term of the bracket is called uniform series compound amount factor. Symbolically it is denoted by (F/A, 1%, N) Alternatively, Future sum of uniform series can be written as, F=A(1+i)8-'+ AC + ih? + +A +i) +A This equation can be written as, =At+A(1+i) +A +i + Multiplying both sides by (1 + i) FU +i) = AC +i) + AC Fi FAC FY + ae HAL FIN Subtracting equation (i) from equation (ii), we get F(l+i)-F=A(1+i)%— or, Fxi=A{(1+i)%—1} rote ACL +i)%~ [Note: if annuity starts at the beginning, F = A(FIA, i%, N) * (I + i) is needed If annuity starts at the beginning, P = A(P/A, i%, N) * (1 + i) is needed] Example: 3.11 account at the end of 10 years? When i= 7% compounded annually. Solution: Given, A=Rs. 6,000, N= 10 years, i= 7% per year and F =? By using uniform series compound amount factor,+0.07)"°—1 F= AGIA, 7%, 10) = 6,000 wean) Hence, F = Rs. 82,898.68 Example: 3.12 If you deposit Rs. 2,000 per month for two years, what will be the amount at the end of five years bank interest rate is 3% in every six month? Solution: Given, A = 2,000 per month for 2 years i =3% (0.03) every six month (semi-annual) Fs=? We know, inonhty = (1 + igemi)!® — 1 = (1 + 0.03)" — 1= 0.0049 ie = (1 + incmi)® — 1 = (1 + 0.03)? — 1= 0.0609 Future amount at the end of 2" year; We know, F2 = A (FIA, imons 24) N OnF. -(e | Substituting values we get, F; = 50,805 Similarly, Fs =F, (FIP, ics, 3) Fs = 50,805 (1 + 0.0609) = 60,664 Example: 3.13 If you make equal monthly deposits of Rs. 5,000 into the bank for 10 years, saving accounts that Pays interest rate of 6% compounded monthly, what would be the amount at the end of 15 years? Solution: Given, A= 5,000 per month for 10 years N= 10x 12= 120 months = 6% compounded monthly We know, i= (1+) —1 = 6.168% eerlehe 05% Similarly, Fyo (F/A, 0.5%, 120)=8, i930 Similarly, Fis = Fio (F/A, 6.168%, 5) = 8,19,397 (1.06168)* = 11,05,255 Hence, amount at the end of 15 years (Fys) = 11,05,255 Finding P when given Al We know, F = P(1 +i) Substituting for F, oy {ers =Pasi’ Itgives, a+’ =] ia +i) Here, the factor term of bracket is called uniform series present worth denoted by (P/A, i%, N) Example: 3.14 How much money should you deposit now in your bank account so that you may have five end! | year withdrawals of Rs. 500 each? Ifi= 12% compounded annually. wa factor. Symbolically, it ®solution: Given, . A=Rs. 500; N=5 years; i= 12% and P=? Using uniform series present worth factor, 1+ 0.12) P=A(P/A, 12%, 5) = 501 cara] = Rs, 1,802.38 Finding Awhen given F (Sinking fund Solving for A, i ang ara] Here, the factor term ofthe bracket is called sinking fund factor. Symbolically, iis denoted by (AF, i%, N). Note: If a fixed amount is deposited fund recover is called sinking fund. Example: 3.15 “A women desires to have Rs, 1,00,000 in her Toiiromear saving plan after working 20 years, She will accomplish it by deposing money end of each year that earns 7% per year. How rmuch must she deposit each year? Solution: Given, F=Rs. 1,00,000; N = 20 years; i= 7% and A=? By using sinking fund factor, A=F(A/F, i%, N) = Rs. 100,000 7 + Example: 3.16 Evaluate the project by using AW formulation of the project at = 12% _ Jor each period on interest bearing account with the purpose of = Rs. 2,439.3 EOY 0 1 2 3 4 5 Cash flow 3000 800 1000 1100 1210 1464 Solution: AW = [3,000 + 800 (1.12) 7 + 1,000 (1.12) * + 1,100 (1.12) 3+ 1,210 (1.12) * + 1,464 (1.12) AW =248 Example: 3.17 Your father wants to have Rs. 20,00,000 for the study of your sister ater the period of S years How much money does he has to deposit each year in saving account that earns 8% interest annually? Solution: Given, F=Rs. 20,00,000; N= 5; i= 8%; A=? F= 20,00,000