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ENGINEERING ECONOMICS

(BPK 30902)

Chapter 1
INTRODUCTION TO
ENGINEERING EONOMICS

ZUIKARNAIN BIN DAUD

Contents

Introduction of engineering economics


Origins of Engineering Economic
Principles of Engineering Economic
Important concepts in engineering economics
Steps in making the best decision
Scope of engineering economics
Engineering Economic and the Design
Process
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Learning Outcomes

The scope of engineering economics


The importance & concepts in engineering
economy
Types of business organization
The nature and types of engineering economic
decisions
Format of four financial statements

Introduction To Engineering
Economics

Definition
Engineering
Economy
Economic
Approach
Solving
Problem
Engineering Projects
Assessment Of Projects
Investment
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Definition

Engineering Economy involves the

systematic evaluation of the economic


merits of proposed solutions to
engineering problems.
To be economically acceptable or
affordable, solutions to engineering
problems must demonstrate a positive
balance of long-term cost.

Definition

Solutions to engineering problems also must;


oPromote the well-being and survival of an

organisation
oEmbody creative & innovative technology & ideas
oPermit identification & scrutiny of their estimate
outcomes
oTranslate profitability to the bottom line through a
valid & acceptable measure of merits

Origins of Engineering
Economic

Economy

Economy is the study of how limited resources


are used optimally to satisfy unlimited human
wants
Resources are known as factors of production
employed to produce goods and services.
Four type of resources

Land
Labor
Capital
Entrepreneur
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Resources
1.

Land
Land is the gifts of nature, such as land, water, air,
minerals, sunshine, plant & jungle, which is applied to
the production process

2.

Labor
Labor is the efforts, skills, & knowledge of human
resources which are applied to the production process

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Resources
.. (continued)
3.

Capital
Money Capital
Money is financial resources which are used in the
production process
Physical Capital
Physical capital is something can be hold like
equipment & machineries, tools, buildings, vehicles
which are used in production
Human Capital
Human capital is an education & training applied to
labor in the production process
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Resources
.. (continued)
4.

Entrepreneur
Entrepreneur is individual who takes risk to develop a
business by using land, labor & capital effectively, &
efficiently

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General Economic Environment


1.

2.

3.

Consumer goods
Consumer goods & services are those that are
directly used by end consumers.
Producer goods and services
Producer goods/services are those used in the
production process of consumer goods and
services. For instance inventories, raw materials,
factory building, machineries etc.
Utility is a measure of the value which consumers
place on that product or service
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General Economic Environment


continued
4.

5.

6.

Demand is total required products/services by the


consumer in the particular market
Supply is amount of required products/services offered by
the firms or sellers
Market Competition Level
The level of competition in the market are perfect
competition (many sellers and product almost the
same), monopoly (one or two sellers), oligopoly (few
sellers and product has few distinctiveness) ,
monopolistic (many sellers & product has different
features)
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Important Concepts In
Engineering Economics

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Concepts in Engineering
Economics
1.
2.
3.
4.
5.

6.

Time value of money


Interest rate and rate of return
Equivalence concept
Cash flows
Marginal revenue must exceed marginal
cost
Additional risk is not taken without the
expected additional return
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1. Time Value Of Money

Time value of money is a change in money value for certain


time of period.
The RM1 we receive today is worth more than RM1 in the
future because the opportunity cost or interest rate that we
could have earned if we have RM1 sooner. Some measures
of worth are:
1. Present worth (PW)
2. Future worth (FW)
3. Annual worth (AW)
4. Rate of return (ROR)/ IRR
5. Benefit/ cost ratio (B/C)
6. Payback period
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2. Interest Rate & Rate of Return

Interest is the financial charge for borrowing money


A cost to the borrower and an income to a lender
Interest is expressed in percentage rate
Example, 5% interest rate for a RM20,000 loan
Interest payment is RM1,000 (0.05 x RM20,000)
The interest earned is known as rate of return (ROR)
In Islam, interest element is totally prohibited

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3. Equivalence Concept
The concept in time value of money and
interest rate can direct to the creation of
economic equivalence concept
Economic equivalence means the different
sum of money in a different period has the
same economic value

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4. Cash Flows

A cash flow is a summation of total cash receipts &


total cash disbursements for a given period of time
Cash flow are very important in engineering
economics because they are the main basis for
alternatives evaluation

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Categories Of Cash Flow

Initial cost acquisition cost-to build, to buy & to


install.
Operations & maintenance (O&M) annual
expenditure
Salvage value the remaining value of asset at the
end of its life usage.
Revenues annual receipts due to sale of products
& services

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Examples of Cash Inflows &


Inflows

Cash Inflows
Revenues (incremental
value)
Operating cost reduction
Asset residual value
Loan principal receipts
Saving or returns

Cash Outflow
Initial cost of project
Operating cost
Periodic maintenance costs
Loan interest and principal
payments
Income taxes

Net cash flow

=
receipts - disbursements
=
cash inflows - cash outflows
All cash flows are assumed occur at the end of a period and
can be illustrated by developing the cash flow diagram/time
line
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RM
Cash flows from operating
activities
Receipts from revenues
Dividends received
Payments for expenses
Payments to suppliers

Net financing cash flows


Net increase (decrease) in
cash
Plus: Cash at the beginning
of year
Cash at the end of year

Cash Flows
Statement
XX

XYZ Co.
Statement of Cash Flows
For Year Ending
31 December 2007

XX
XX
(XX)
(XX)

Net investing cash flows


Cash flows from financing
activities
Cash proceeds from capital
contributions
Borrowings
Repayments of borrowings
Drawings by owner

RM

XX
XX
(XX)
(XX)

Net operating cash flows


Cash flows from investing
activities
Cash proceeds from sale of
equipment
Loan repaid by other entities
Purchase of equipment
Loans to other entities

RM

XX
XX
XX
(XX)
(XX)

XX
XX

XXX

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5. Marginal Revenue Must Exceed


Marginal Cost

In making a decision, an increase in revenue must


greater than an increase in cost.
Example: the increase of cost should be included
into cost price as to maintain profitable level

Increase of petrol oil


Increase of sugar

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6. Additional Risk Is Not Taken Without


The Expected Additional Return

Generally, we do not take risk if there is no expected


higher return
One risk must be compensated with return
Example: Additional cost for better packaging for higher
sales volume or additional promotion expenses for
higher sales forecast

Spent RM200,000 on advertising for higher sales forecast of


RM2 mil

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Accounting Financial Statements

Financial statements are prepared to communicate important


accounting information to users.
Four Types of Accounting Financial Statements
Income Statement/ Statement of Financial Performance
The income statement shows the net income or loss incurred
within a certain period of time.
Owners Equity Statement /Statement of Financial Position
This statement summarizes the changes in owners equity.
Balance Sheet/ Statement of Financial Position
A Balance Sheet shows companys financial position of
assets, liabilities and owners equity at a point in time.
Cash Flows Statement
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Principles of Engineering
Economic

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Principles of EE
1.
2.
3.
4.
5.
6.
7.

Develope the Alternatives


Focus on theDifferences
Use a Consistant Viewpoint
Use a Common Unit of Measure
Consider All Relevent Criteria
Make Risk & Uncertainty Explicit
Revisit Your Decisions

Principles of EE
Develop the Alternatives

1.

2.

The choice (decision) is among alternatives.


The alternatives need to be identified & then
defined for subsequent analysis

Focus on the Differences

Only the differences in expected future


outcomes among the alternatives
Relevant to their comparison & should be
considered in the decision

Principles of EE
3.

Use a Consistant Viewpoint

4.

The prospective outcomes of the alternatives,


economic & other,should be consistently
developed from a defined viewpoint
(perspectives)

Use a Common Unit of Measure

Using common unit of measurement to


enmerate as many of the prospective outcomes
as possible willsimplity the analysis of
thealternatives

Principles of EE
5.

Consider All Relevent Criteria


Selection of a preferred alternative
(decision making) requires the use of a
criterion (or several criteria).
The decision process should consider both
the outcomes in the monetary unit & those
expressed in some other unit of
measurement or made explicit in a
descriptive manner

Principles of EE
6.

7.

Make Risk & Uncertainty Explicit


Risk & uncertainty are inherent in estimating the
future outcomes of the alternatives & should be
recognized in their analysis & comparison
Revisit Your Decisions
Improved decision making results from an adaptive
process; to the extent practicable, the initial
projected outcomes of the selected alternative
should be subsequently compared with actual
results achieved

Engineering Economic & The


Design Process

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EE and the Design Process


An

EE study is accomplished using a


structured procedure & mathematical
modeling techniques.
The economic results are then used in a
decision situation that normally includes
other engineering knowledge & input

EE and the Design Process


EE Analysis Procedure
Step

Engineering Design Process


Activity

1.

Problem/ need definition

2.

Problem/ need formulation &


evaluation

3.

Synthesis of possible solutions


(alternatives)

4.

Analysis, optimization, & evaluation

1.

Problem recognition, definition, &


evaluation

2.

Development alternative

3.

Development of the outcomes and


cash flows for each alternative

4.

Selection of a criterion (or criteria)

5.

Analysis & comparison of the


alternatives

6.

Selection of the prefereed


alternative

5.

Specification of preferred alternative

7.

Performance monitoring & postevaluation of results

6.

Communication

Engineering Design Process Problem Definition


1.

Pro blem Defi ni ti on

2.

Prov ide basic f or analy sis


Step 1 Problem s recognit ion/ f ormulation f rom sy st ems perspe ctiv e/ ev aluat ion
E.g. an operat ing problem wit hin a company (inte rnal need) or a cust omer exp ectat ion about a product or s erv ice (external requirement )

Engineering Design Process Development of Alternatives


2.

Devel opment o f Al te rn ati ves

Each alt ernat iv e select ed is judged


Steps 2 search pote ntial alt ernat iv e/
a. Searc hing f or Superior Alt ernativ e
b. Dev eloping Inv est m ent alt ernat iv e

3.

select sm aller group

a. Searching for Superior Alternative

2.

The diff erence between good & great alternat ives depends on problem-solving efficiency .
Ef ficiency can be increased in t he f ollowing ways:

C o nc e ntr ate o n re de fin in g o n e pr ob lem a t a time


D e ve lo p ma ny r ed e fin itio ns fo r the p ro ble ms
Avo id ma kin g jud g men ts as n ew p ro bl ems d efi nition s ar e cr ea ted
Atte mpt to re de fin e a pr ob lem i n ter ms th a t d iffe re n t fr om th e p ro ble m de fi nition
Ma ke s ur e tha t th e tr ue

b. Developing Investment alternative

i.
ii.

Most investment alternat ives creat ed by good engineering ideas are drawn f rom a larger populat ion of equally good problem solutions
Classical Brainstorming

Deferment of judgment & quantity breeds quality


Nominal group technique
T o obt ain group thinking (consensus)
Reducing dominance of one or more participants & conflicting ideas

2.

Engineering Design Process Development of Prospective Outcome


3.

3.

Development of Prospective Outcome


Basic cash f low approach represents economic ef fect s of an alternative in terms of money spend & received
Non-monet ary factors
Meeting / exceeding customer expect at ions
Safety t o the employees & to t he public

Improvement employer satisf action


Maintain f easibility t o meet changers demand
Achieving good public relation / being member relations

Engineering Design Process


4.

Sel ecti on of a Deci sion Cr iter i on


Sel ect the al ter native that ser ve the l ong - ter ms inter est

5.

6.

Reflect a consi stent & pr oper viewpoint

Analysis & Compar ison of Alternatives


TO obtai n accur ate for ecast of cash fl ows & other factor s

Engineering Design Process


6.

Selection of a Pr efer red Al ternati ve

7.

8.

Technical -economic modeli ng


Anal ysis techniq ues i ndi cates the q ual ity of the result obtained
Recommended cour se of acti on

Perfor mance Monitoring & Post evaluation of Results


M onitor ing i mproves achievement

Reduces the vari abil ity in desir ed results


Continuing i mprovement

Steps In Making The Best


Decision

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Decision Making Process


1.
2.
3.

4.

5.
6.

Recognize & evaluate the problem


Collect & analyze the related data
Identify the feasible alternatives & make a realistic
projection (future cash flow expectation)
Identify the required criterion for selecting the
alternative
Assess & compare the alternatives
Choose & implement the alternative

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The Decision Making Process

Economic
factors:
productions cost,
total revenue,
financial sources

Combination

Non-economic
factors:
social responsibilities,
environment, laws,
and politics, the
needs of consumer in
the marketplace, the
affordability of the
consumer to purchase
the product or
services

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Example

Housing Project
Affordable for customers
Safety
Cost for the company
Decision to purchase a long term asset
Machines or equipments
The engineers have to consider a longterm benefit for the company

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(1)
Pursuing
monetar
y value
in the
invention
to
position
as
profitabl
(3)
e firm
Plays
major
role in
capital
investm
ent
decision
s based
on
enginee
rs

I
M
P
O
R
T
A
N
C
E

(2)
Most
economical
balance the
trade off
between
cost &
performanc
e

(4)
Prevent
conflict
between
engineer
s&
financial
departme
nt
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Scope Of Engineering
Economics

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Engineering Economic Project

Most investments made by the engineers will fall


into 3 main categories
1. Profit-enhancing programs
2. Cost control programs - to correct errors in
system
3. Public improvement programs

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Investments Programs Categories


1. Profit- enhancing Programs
New product development
New product acquisition
Production capacity
expansion
Service capacity expansion
Improved customer service

2. Cost Control Programs - To


Correct Errors In System
Improving efficiency
Streamlining operations
Eliminating waste
Reducing liabilities
3. Public Improvement
Programs
Increased public satisfaction
Increased public safety
Improved infrastructure
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Project Ideas
These programs will lead to the project ideas like:
1.
Equipment or process selection
2.
Equipment replacement
3.
New product or product expansion
4.
Cost reduction
5.
Improvement in service or quality

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Questions & Problems

1.
2.
3.

Explain why the subject of engineering economy


is important to the practicing engineer?
Briefly discuss what the engineering economic
is and give example.
What kind of common investment will be made
by the engineer? Explain.

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Questions & Problems

4.

The management team of ABC Furniture


Company is trying to increase profitability in
order to require loan from the bank to purchase
a new and modern machine. One proposed
solution is to sell waste old equipment instead
of using them.
a) Define the companys problem. Reformulate
the problem in other creative ways.
b) Develop at least one potential alternative for
your reformulated problems in part (a).
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Questions & Problems


5. Sheila bought a small terrace house for RM100,000 in a

Cheras town. She spent RM10,000 of her own money for


the building and got a bank loan for the remaining
RM90,000. The annual loan payment is RM10,000. The
annual maintenance of the house is RM12,000. The
house can be rented for RM1,500 per month. Refer to the
decision making process procedure to answer these
questions.

a)
b)
c)
d)
e)
f)

Does Sheila have a problem? If so, what is it?


What are her alternatives (identify at least three)
Estimate the economic consequences and other required
data for the alternatives in Part (b).
Develop a criterion for choosing the alternatives.
Analyze and compare the alternatives in view of at least one
criterion in addition to cost.
What should Sheila do based on the information you and
she have generated?
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Thank You

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