CHAPTER 1

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INTRODUCTION TO
ENGINEERING ECONOMY
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Learning Outcomes
Chapter Outline
 Introduction
 Definitions
 Principles of Engineering
Economy
 Engineering Economy and
the Design Process
 Cost Concepts and
Design Economics
 Present Economy Studies
WHAT IS ECONOMICS ?
The study of how limited
resources is used to
satisfy unlimited human
wants
WHAT IS ECONOMICS ?
The study of how individuals
and societies choose to use
scarce resources that nature
and previous generations
have provided.
Resources

• Land
• Labor
• Capital
 LAND
All gifts of nature, such as: water, air,
minerals, sunshine, plant and tree
growth, as well as the land itself which
is applied to the production process.
 LABOR
The efforts, skills, and knowledge of
people which are applied to the
production process.
 CAPITAL
Real Capital (Physical Capital )
Tools, buildings, machinery -
- things which have been Dollar Bills
produced which are used in
further production
Financial Capital
Assets and money which are
used in the production
process
Human Capital
Education and training
applied to labor
in the production process
ENGINEERING ECONOMY
-is a discipline concerned with the
systematic evaluation of the costs and
benefits of the proposed business projects
and ventures. Its objective is to choose
which among the alternative course of
action will give the maximum benefit at
the least cost.
Solutions to Engineering
Problems Must
Promote the well-being and survival
of an organization
Embody creative and innovative
technology and ideas
Permit identification and scrutiny of
their estimated outcomes
Translate profitability to the “bottom
line” through a valid and acceptable
measure of merit
Origins of Engineering Economy
Pioneer: Arthur M. Wellington, civil engineer
latter part of nineteenth century;
addressed role of economic analysis in
engineering projects; area of interest:
railroad building

Followed by other contributions which

emphasized techniques depending on
financial and actuarial mathematics.
 PRINCIPLES OF
ENGINEERING ECONOMY
1. Develop the Alternatives
2. Focus on the Differences
3. Use a Consistent Viewpoint
4. Use a Common Unit of Measure
5. Consider All Relevant Criteria
6. Make Risk and Uncertainty Explicit
7. Revisit Your Decisions
DEVELOP THE ALTERNATIVES

The final choice (decision) is among

alternatives. The alternatives need to be
identified and then defined for subsequent
analysis.
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.
USE A CONSISTENT VIEWPOINT
The prospective outcomes of the
alternatives, economic and other, should
be consistently developed from a defined
viewpoint (perspective).
 USE A COMMON UNIT
OF MEASURE
Using a common unit of measurement to
enumerate as many of the prospective
outcomes as possible will make easier the
analysis and comparison of alternatives.
 CONSIDER ALL RELEVANT CRITERIA
Selection of a preferred alternative
(decision making) requires the use of a
criterion (or several criteria). The
decision process should consider the
outcomes enumerated in the monetary
unit and those expressed in some
other unit of measurement or made
explicit in a descriptive manner.
MAKE UNCERTAINTY EXPLICIT
Uncertainty is inherent in projecting (or
estimating) the future outcomes of the
alternatives and should be recognized in
their analysis and 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 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 and input.
 ENGINEERING ECONOMIC
ANALYSIS PROCEDURE
1.Problem recognition formulation, 1.Problem /need definition.
and evaluation.

2. Development of the feasible 2. Problem/need formulation and

alternatives. evaluation.
3. Synthesis of possible solutions
(alternatives).
3. Development of the cash flows for
each alternative.
4. Selection of a criterion ( or 4. Analysis, optimization, and
criteria). evaluation.
5. Analysis and comparison of the
alternatives.

6. Selection of the preferred 5. Specification of preferred

alternative. procedure.

7. Performance monitoring and post- 6. Communication.

evaluation results.
 PROBLEM DEFINITION
-This is the first step of engineering
economic procedure. The problem must
be well understood and stated in an
explicit form before the project team
proceeds with the rest of the analysis.
 DEVELOP ALTERNATIVES

The two primary actions of this procedure

are (1) searching for potential alternatives
(2) screening them to select a smaller group
of feasible alternatives for detailed analysis.
 DEVELOP ALTERNATIVES
(1) Searching for Potential Alternatives
In identifying the true problem, several
limitations invariably exist, including lack
of time and money, preconceptions of what
will and what will not work, and lack of
knowledge.
 DEVELOP ALTERNATIVES
(2) Developing Investment Alternatives
Creating value for a firm by turning
innovative and creative ideas into new or
reengineered commercial products and
services.
 DEVELOP ALTERNATIVES
TWO APPROACHES FOR DEVELOPING SOUND
INVESTMENT ALTERNATIVES
(1)Classical Brainstorming
Criticism is ruled out
Freewheeling is welcomed
Quantity is wanted
Combination and improvement are sought
(2) Nominal Group Technique
Individual silent generation ideas
Individual sound-robin feedback and recording of ideas
Group clarification of each idea
Individual voting and ranking to priorities ideas
Discussion of group consensus results
SELECTION OF A DECISION CRITERION
The decision maker will normally select the
alternative that will best serve the long-
term interests of the owners of the
organization.
 ANALYSIS AND COMPARISON
OF ALTERNATIVES
When cash flow and other required
estimates are eventually determined,
alternatives can be compared based on
their differences.
 SELECTION OF THE PREFERRED
ALTERNATIVE
Select the best recommended course of
action after doing technical-economic
modeling and analysis techniques.
 PERFORMANCE MONITORING AND
POSTEVALUATION OF RESULTS
Follow up step to a previous analysis,
comparing actual results achieved with the
previously estimated outcomes.
 ACCOUNTING AND ENGINEERING
ECONOMY STUDIES
Modern cost accounting may satisfy any or all
of the following objectives:
1. To determine the cost of products or services
2. To provide a rational basis for pricing goods
or services
3. To provide a means for controlling
expenditures
4. To provide information on which operating
decisions may be based and the results
evaluated
 COST CONCEPTS
AND
DESIGN ECONOMICS
Cost Terminology
1. Fixed, Variable, and Incremental Costs
2. Direct, Indirect and Standard Costs
3. Cash Cost versus Book Cost
4. Sunk Cost
5. Opportunity Cost
6. Life-Cycle Cost
 Fixed, Variable and Incremental Cost
Examples: insurance,
Fixed Costs taxes on facilities,
costs unaffected by general management,
changes in activity level administrative salaries,
over a feasible range of license fees, interest
operations for the costs on borrowed
capacity available. capital
 Fixed, Variable and Incremental Cost

Variable Costs
costs associated with an
operation that varies in total
with the quantity of output of
other measures of activity
level.
Examples: material
cost, labor cost, energy
or fuel cost, packaging
cost, scrap losses and
spoilage
 Fixed, Variable and Incremental Cost

Incremental Costs
Additional cost (or revenue) that results from increasing
the output of a system by one (or more) units.

Examples: For instance, if a company's total

costs increase from $320,000 to $360,000 as the
result of increasing its machine hours from
8,000 to 10,000, the incremental cost of the
2,000 machine hours is $40,000.
 Direct, Indirect, and Standard Costs

Directs Costs Indirects Costs Standard Costs

costs that can be costs that are difficult to costs per unit of output
reasonably measured attribute or allocate to a that are established in
and allocated to a specific output or work advance of actual
specific output or work activity. These are not production or service
activity. directly accountable to a delivery. These are
cost object (such as a developed from
particular project, anticipated direct labor
facility, function or hours, materials, and
product). overhead categories.

Examples: labor cost, Examples: cost of

material cost, expenses common tools, general
related to the production suupplies, equipment
of a product maintenance,
adminitration, personnel
and security costs
 Cash Cost versus Book Cost
Cash Costs
costs that involves payment
of cash. Cash costs are costs
that businesses pay for
when using cash, or a
check, but not credit.
Book Costs
costs that does not involve
cash transaction and is
reflected in the accounting
system as a noncash cost.
These costs represent the
recovery of past
expenditures over a fixed
period of time.
Example: depreciation for
the use of assets such as
plant and equipment.
 Sunk Cost

Sunk Cost
cost that has occurred in the past and has no relevance to estimates of
future costs and revenues related to an alternative course of action.
Example:
Suppose Joe finds a motorcycle he likes and pays $40 as a down payment,
which will be applied to the $1,300 purchase price, but which must be
forfeited if he decides not to take the cycle. Over the weekend, Joe finds
another motorcycle he considers equally desirable for a purchase price of
$1,230. For the purpose of deciding which cycle to purchase, the $40 is a
sunk cost and thus would not enter into the decision, except that it lowers
the remaining cost of the first cycle.

Alternative 1: $1,260 ($1,300-$40)

Alternative 2: $1,230
 Opportunity Cost

Opportunity Cost
cost incurred because of the use of limited resources, such that the
opportunity to use those resources to monetary advantage in an
alternative use if foregone.

Example:
A student could earn $20,000 for working during a year, but chooses
instead to go to school for a year and spend $5,000 to do so. The
opportunity cost of going to school for that year is $25,000: $5,000 cash
outlay and $20,000 for income foregone.
 Life-Cycle Cost

Life-Cycle Cost
summation of all the costs related to a product, structure, system or
service during its life span.

Investment Cost-capital required for most of the activities in the

acquisition phase.

Capital Investment-series of expenditures over an extended period.

Working Capital-funds required for the current assets that are needed for
the start-up and support of operational activities.

Operation and maintenance cost-many of the recurring annual expense

items associated with the operation phase of the life cycle.

Disposal cost-nonrecurring costs of shutting down the operation and the

retirement and disposal of assets at the end of the life cycle.
 Life-Cycle Cost

Phases of the Life-Cycle and Their Relative Cost

Consumer and Producer Goods and Services

Consumer goods and services

Products or services that are directly used by people to satisfy their
wants. Examples: food, clothing, home, cars, etc.

Producer goods and services

Used to produce consumer goods and services or other producer goods.
Examples: machine tools, factory buildings, buses, farm machinery,
etc.
 Competition

Perfect competition occurs in a situation in which any given

product is supplied by a large number of vendors and there is no
restriction on additional suppliers entering the market.

Monopoly opposite from perfect competition where a unique

product or service is only available from a single supplier and
that vendor can prevent the entry of all others into the market.
 Necessities, Luxuries, and Price Demand

Goods and services may be divided into two types:

necessities and luxuries.

Necessities
needs of human beings that are without them human beings cannot be
survived like food, shelter, clothing and family.

Luxuries
needs by which human beings can live but these are wanted to make
life easy and luxurious like car, motorbike, mobile, etc.
 LAW OF SUPPLY

The supply of the commodity varies

directly as the price of the commodity,
though not proportionately

p
r
i
c
e

Supply
 LAW OF DEMAND

The demand for a commodity varies

inversely as the price of the commodity,
though not proportionately

p
r
i
c
e

Demand
 LAW OF DEMAND & SUPPLY
Under conditions of perfect competition, the price at
which any given product will be supplied and
purchased is the price that will result in the supply
and the demand being equal.

p
r
i
c
e
Quantity
The relationship between price and
demand can be expressed as a line
p
r p = a - bD
i
c
e

Demand (D)

Where a is the intercept on the price

(p)axis and –b is the slope.
TOTAL REVENUE – VOLUME
RELATIONSHIP

R Peak point – represents the

Maximum revenue
T e
O v
T e
A n Demand that maximizes
L u Total Revenue
e
D'
Volume (D)
COST - VOLUME RELATIONSHIP

Total Cost
C
o Variable Cost
s
t Fixed Cost

Volume (D)
COMBINATION OF COST - VOLUME &
REVENUE VOLUME RELATIONSHIP

R Represents the
C e Maximum Profit

o v Total Cost
o
s e
r
t n
Demand that maximizes
u Total Profit
e
D*

Volume (D)