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GE 301: ENGINEERING ECONOMY

1.0 INTRODUCTION

1.1 Definitions
1.2 Principles of Engineering Economy
1.3 Engineering Economy and the Design Process
1.4 Cost Concepts for Decision Making
1.5 Present Economy Studies
INTRODUCTION

ENGINEERING ECONOMY is the discipline concerned with the


economic aspects of engineering, and involves the systematic
evaluation of the costs and benefits of proposed technical and
business projects and ventures.
Fundamentally, it involves formulating, estimating, and evaluating the
economic outcomes of alternatives to accomplish a defined purpose.

Some Applications of Engineering Economy:

• Selecting among alternative preliminary designs, or alternative


detailed designs, as part the engineering design process.
• Selecting among proposed projects within the annual capital
budget limits.
• Estimating and analyzing the economic consequences of
alternative automation improvements in a factory operation.
• Choosing between asset lease and purchase options.
Principles of Engineering Economy

The foundation of Engineering Economy is set of principles and


fundamental concepts, that provide a sound basis for the
development of the methodology:

1. Develop the Alternatives. The choice is among alternatives.


Alternatives need to be identified and then defined for
subsequent analysis.
2. Focus on the Differences. Only the differences in expected
future outcomes among the alternatives are relevant to their
comparison and should be considered in the decision.
3. Use a Consistent Viewpoint. The prospective outcomes of the
alternatives, should be consistently developed from a defined
viewpoint.
4. Use a Common Unit of Measure. Using a common unit of
measurement to enumerate as many of the prospective as
possible will make the analysis and comparison of the
alternatives easier.
5. Consider All Relevant Criteria. Selection of a preferred
alternative requires use of a criteria. The decision process
should consider the outcomes enumerated in the monetary unit
and those expressed in some other unit.
6. Make Uncertainty Explicit. Uncertainty is inherent in projecting
the future outcomes of the alternatives and should be recognized
in their analysis and comparison.
7. Revisit Your Decisions. Improved decision making results from
an adaptive process; to the extent practicable, initial project
outcomes of the selected alternative and actual results achieved
should be subsequently compared.

Engineering Economy and the Design Process

An engineering economy study is accomplished using a structured


procedure and mathematical modeling techniques. The economic
results are then used in a decision situation that involves two or more
alternatives and normally includes other engineering knowledge.
Engineering Economic Analysis Procedure:

1. Problem Definition.
2. Search for Alternatives. Includes developing list of alter-natives,
and evaluating or screening them.
3. Development of Prospective Outcomes.
4. Selection of Decision Criteria and Analysis of Alternatives.
5. Selection of Preferred Alternative.
6. Performance Monitoring and Post-evaluation of Results.

Cost Concepts for Decision Making

Fixed, Variable, and Incremental Cost:

FIXED COSTS are those that are unaffected by changes in activity


level over a feasible range of operations for the capacity or capability
available. Examples are: taxes on facilities, general management
and administrative salaries, license fees and interest costs on
borrowed capital.
VARIABLE COSTS are those associated with an operation that will
vary in total with the quantity of output or other measures of activity
level. Examples are the costs of material and labor used in a product
or service since they vary in total with the number of output units.

INCREMENTAL COST or INCREMENTAL REVENUE refers to the


additional cost or revenue, that will result from increasing the output
of a system by one or more units.

Example 1: In paving a new highway, the contractor has a choice of


two sites on which to set up the asphalt mixing plant equipment. The
contractor estimates that it will cost P120.00 per m 3-km to haul the
asphalt paving material from the mixing plant to the job site for both
prospective sites.
The job involves 50,000 m3 of mixed asphalt paving material. It is
estimated that the work will be done from the start of March till the
end of June.
If Site B is selected, there will be an added charge of P600 per day
for a flagman. (a) Which of the two alternatives is a better site in
terms of lower total cost? (b) For the selected site, how many cubic
meters of asphalt does the contractor have to deliver to the job site
before starting to make a profit if paid at P1,000 per cubic meter?

Recurring and Nonrecurring Costs:

RECURRING COSTS are those that are repetitive and occur when
an organization produces similar goods or services on a continuing
basis. Examples are the production costs and monthly rentals.
NONRECURRING COSTS are those that are not repetitive even
though the total expenditure may be cumulative over a relatively short
period of time. Example is the cost for real estate.

Direct, Indirect, and Overhead Costs:

DIRECT COSTS are those that can be reasonably measured and


allocated to a specific output or work activity. Examples are the labor
and material costs directly associated with a product, service, or
construction activity.

INDIRECT COSTS are those that are difficult to attribute or allocate


to a specific output or work activity. Examples are cost of common
tools, general supplies, and equipment maintenance.

OVERHEAD COSTS consist of plant, design or construction costs


that are not direct labor or direct material costs. Examples include
electricity, general repairs, property taxes and supervision.
Standard Costs:

STANDARD COSTS are representative costs per unit of output that


are established in advance of actual production. They are developed
from direct labor hours, materials, and support functions.

Cash Cost and Book Cost:

CASH COSTS involve payment of cash.


BOOK COSTS those that do not involve cash transaction but are
reflected only in the accounting system. The most common example
of book costs is a charge called depreciation for the use of assets
such as plant and equipment.

Sunk Costs:

SUNK COST is one that has occurred in the past and has no
relevance to estimates of future costs and revenues related to an
alternative course of action.
Opportunity Cost:

OPPORTUNITY COST is incurred because of limited resources such


that the opportunity to use those resources to monetary advantage in
an alternative use is foregone.

Life-Cycle Cost:

LIFE-CYCLE COSTS refer to the summation of all the costs, both


recurring and nonrecurring, related to a product, structure, system, or
service during its life span.

General Economic Environment

Consumer and Producer Goods and Services:


• Consumer goods and services are those products or services that
are directly used by people to satisfy their wants.
• Producer goods and services are used to produce consumer goods
and services or other producer goods.
Measures of Economic Worth:
• Goods and services are produced and desired because directly or
indirectly they have utility which is the power to satisfy human wants
and needs.
• Utility, most commonly, is measured in terms of value, expressed
in some medium of exchange as the price that must be paid to obtain
the particular item.

Necessities, Luxuries, and Price Demand:


• Goods and services may be divided into two types, necessities
and luxuries.
• Economic status is an important factor in one’s views regarding
luxuries and necessities.
• For all goods and services, there is a relationship between the price
that must be paid and the quantity that will be demanded or
purchased.
• As the selling price per unit (p) is increased, there will be less
demand (D) for the product, and as the selling price is decreased, the
demand will increase.

Relationship between price p  a  bD


and demand:

Figure: General Price-


Demand Relationship.
• The extent to which price changes influence demand varies
according to the elasticity of the demand.
• The demand for products is said to be elastic when a decrease in
the selling price results in a considerable increase in sales. On the
other hand, if a change in selling price produces little or no effect on
the demand, the demand is said to be inelastic.

Figure: General Price-


Demand Relationship
for Luxuries and
Necessities.
Competition:
• Perfect competition occurs in a situation in which a given product is
supplied by a large number of vendors and there is no restriction on
additional vendors entering the market.
• Perfect monopoly exists when a unique product or service is
available from only a single vendor and that vendor can prevent the
entry of all others into the market.
• Oligopoly exists when there are so few suppliers of a product or
service that action by one will almost inevitably result in similar action
by the others.

Total Revenue Function:


• The total revenue, TR, that will result from a business venture
during a given period is the product of the selling price per unit, p,
and the number of units sold, D.

TR  price x demand  pD
dTR
 incremental or m arg inal revenue
dD

Figure: Total Revenue Function as a Function of Demand


Cost, Volume, and Breakeven Point Relationships:

• Fixed costs remain constant over a wide range of activities while


variable costs vary in total with the volume of output. Thus at any
demand D, the total cost, CT, is:

where,
CT  C F  cv  D  CF = fixed costs
Cv = variable cost per unit

• When the graphs of total revenue and total cost are combined, the
results as a function of demand are depicted in the following Figure.
• At breakeven point, D’1, total revenue is equal to total cost, and
increase in demand will result in a profit for the operation.
• At optimal demand, D*, profit is maximized.
• At breakeven point, D’2, total revenue is again equal to total cost,
but additional volume will result in an operating loss instead of profit.
Figure: Combined
Cost and Revenue
Functions, and
Break-even Points,
as Functions of
Volume and Effect on
Profit.

Pr ofit  total revenue  total cos ts

 
Pr ofit  aD  bD 2   C F  cv D 

Pr ofit  C F   a  cv  D  bD 2
In order for profit to occur, two conditions must be met:
1. (a-cv) > 0; that is, the price per unit that will result in no demand
has to be greater than the variable cost per unit.
2. Total revenue (TR) must exceed total cost (C T) for the period
involved.
• The optimal demand can be obtained by maximizing the profit
which will occur by taking the first derivative with respect to D and
setting it equal to zero.

d  Pr ofit 
 a  cv  2bD  0
dD
• The optimal value of D that maximizes the profit is:

a  cv
D* 
2b
• An economic breakeven point for an operation is reached when
total revenue equals total cost.

Total Re venue  total cos t

aD  bD 2  C F  cv D

 bD 2   a  cv  D  C F  0

• The breakeven points D’1 and D’2 can be obtain by getting the roots
of the quadratic equation.

D 
' 
  a  cv    a  cv   4  b   C F 
2
 0.5

2  b 
Example 2: A company produces an electronic timing switch that is
used in consumer products made by several manufacturing firms.
The fixed cost (CF) is P1,450,000 per month, and the variable cost
(cv) is P1,500 per unit. The selling price per unit (p) is (P3,600 –
0.4D). For this situation, (a) determine the optimal volume for this
product, and confirm that the profit occurs at this demand, and (b)
find the volumes of demand at which breakeven occurs.

• When the price per unit, p, for a product or service can be


represented as constant over a range of demand, and is greater than
the variable cost per unit, cv, a single breakeven point results.
• Then under the assumption that demand is immediately met, total
revenue, TR = p(D).
• If the linear relationship for costs is also used in the model, the
typical situation will be depicted in the following Figure.
Figure: Typical Break-
even Graph with the
Price, p, Constant.

• Market competition creates pressure to lower the breakeven point


of an operation.
• The lower the breakeven point, the less likely that a loss will occur
during market fluctuations.
• If the selling price remains constant, a larger profit will be achieved
at any level of operation above the reduced breakeven point.
Average Unit Cost Function:

• Most engineering projects and business operations are designed to


operate more efficiently at a certain level of capacity utilization.
• Deviations from this level may affect the variable cost of operation
and possibly the fixed cost, and will influence the average unit cost of
the product or service.

C C  c  D  CF where,
CU  T  F v   cv
D D D CU = average unit cost

Present Economy Studies


• When the influence of time on money is not significant
consideration, cost analyses are usually called present economy
studies.
Typical Situations Involving Present Economy Studies:

1. No initial investment of capital; only immediate operating costs


and other factors are involved.
2. There is an initial investment of capital, but after this first cost, the
remaining life cycle cost is estimated to be the same, or directly
proportional to the initial investment.
3. The differences in revenues and costs among the alternatives all
occur within a limited time period, or any future differences are
estimated to remain proportional to those in the first time period.

Present Economy Studies


• When the influence of time on money is not significant
consideration, cost analyses are usually called present economy
studies.
Example 3: The quarrying cost plus delivery cost to the processing
plant of marble and granite blocks are P3,600 per cubic meter for
each. The processing cost of marble into tiles is P300 per square
meter while that of granite into tiles is P800 per square meter.
The marble has a net yield of 40 square meters of tiles per cubic
meter of block and sells at P600 per square meter while granite on
the other hand, gives a net yield of 50 square meters of tiles per
cubic meter of block and sells at P1,200 per square meter. (a)
Determine the profit for each material. (b) Which of the materials is
more profitable and (c) by how much?

Example 4: A call to bid was advertised in the Manila Bulletin for the
construction of a Transmission Line from a Mini-Hydroelectric Power
Plant to the substation which is 5.035 kilometers away. A tanalized
timber electric posts 30 feet long must be placed at intervals of 50
meters. The powerhouse is 15 meters from the first electric post and
the substation is 20 meters from the last electric post. If your
company would join the bidding, determine your minimum bid for the
project using the following data:
The cost of one tanalized timber post 30 ft long delivered to the site
is P4,900 each. Five laborers can dig and erect 3 posts per day.
Each laborer is paid at P250 per day. Four electricians can strung
wires 150 meters per day. Each electrician is paid at P500 per day.
Electric wire costs P20 per meter. Use 5 laborers and 4 electricians
for the project and employ one electrical foreman at P800 per day.
Add 10% contingencies to the direct costs to get the total cost. Your
desired profit is 25% of the total cost.