Engineering Economy

Chapter one
Introduction

People make decisions using computers, mathematics, ideas,

and guidelines in their decision-making process. Since most
decisions affect what will be done, the time frame of
engineering economy is primarily the future. Therefore, the
numbers used in engineering economy are best estimates of
what is expected to occur. The estimates and the decision
usually involve four essential elements:
Engineering economy involves formulating, estimating, and evaluating
the expected economic outcomes of alternatives designed to accomplish
a defined purpose.

Mathematical techniques simplify the economic evaluation of

alternatives.

 Cash flows
 Times of occurrence of cash flows
 Interest rates for time value of money
 Measure of economic worth for selecting an alternative
• Sensitivity analysis is utilized to determine how a decision might
change according to varying estimates, especially those expected to
vary widely.
Example:
• An engineer is performing an analysis of warranty costs for drive train repairs
within the first year of ownership of luxury cars purchased in the United States. He
found the average cost (to the nearest dollar) to be $570 per repair from data taken
over a 5-year period.
• What range of repair costs should the engineer use to ensure that the analysis is
sensitive to changing warranty costs?
Year 2006 2007 2008 2009 2010
Average cost / repair 525 430 619 650 625

sum of the 5 years = 525+430+619+650+625

= 2849
Average = 2849/5
= 569.8 ~ 570
First glance the range should be approximately –25% to +15% of the $570 average
cost to include the low of $430 and high of $650.
However, the last 3 years of costs are higher and more consistent with an average of
$631 (619+650+625)/3. The observed values are approximately ±3% of this more
recent average.
If the analysis is to use the most recent data and trends, a range of, say, ±5% of $630
is recommended. If, however, the analysis is to be more inclusive of historical data
and trends, a range of, say, ±20% or ±25% of $570 is recommended.
• The principle used to select an alternative in engineering economy for a
specific set of estimates is called a measure of worth.

Present worth (PW) Future worth (FW) Annual worth (AW)

Rate of return (ROR) Benefit/cost (B/C) Capitalized cost (CC)

Payback period Economic value added (EVA) Cost Effectiveness

The concept of the time value of money is that money makes money over time.
• The utilization of scientific and engineering knowledge for our benefit
is achieved through the design of things we use, such as machines,
structures, products, and services.
• The purpose of studying engineering economy is to develop and
illustrate the principles and methodology required to answer the
basic economic question of any design: Do its benefit exceed its
costs?
• Engineering economy involves the systematic evaluation of the
economic qualities of proposed solution to engineering problems.
• To be economically acceptable (i.e., affordable), solutions to
engineering problems must demonstrate a positive balance of long
term benefit over long term costs.
• Promote the well being and survival of an organization.
• Embody creative and innovative technology and ideas.
• Permit identification and analysis of their estimate outcomes.
• Translate profitability to the “bottom line” through a valid and
acceptable measure of quality.
Principles of engineering economy
1. Develop the alternatives
The choice (decision) is among alternatives. The alternatives
need to be identified and then defined for subsequent
analysis.
2. Focus on the differences
Only the differences in expected future outcome 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, economic
and other, should be consistently developed from a defined
viewpoint (prospective).
4. Use a common unit of measure
Using a common unit of measurement to specify as many of the
prospective outcomes as possible will simplify the analysis of the
alternatives.
5. Consider all relevant criteria
Selection of a preferred alternative (decision making) requires the use
of a several criteria. The decision process should consider both the
outcomes enumerated in the monetary unit and those expressed in some
other unit of measurement or made explicit in a descriptive manner.
6. 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.
7. Revisit your decision
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.
What is Economics?
• Economics is the study of choices made by people who are faced with
scarcity, that is, when there are limits to what they can get.
• Scarcity is a situation in which resources (the things we use to produce
goods and services) are limited in quantity and can be used in different
ways.
• Because of scarcity, people must make choices. Decisions are made at
every level in society.
• The choices made by individual, firms, and governments answers three basic
questions:
1. What goods and services do we produce?
2. How do we produce these goods and services?
3. Who consumes the goods and services that are produced?
 Economic Transaction and Markets

• The amount of goods and services a person can purchase depends on

income earned through these transactions, which in turn depends on
the productive resources owned, the willingness to sell the services of
those resources to others, and the prices at which they can be sold.
The Purpose and function of Market
• A Market is a meeting of buyers and sellers for the purpose of trading
goods or services. Markets constitute means through which buyers and
sellers can communicate and trade at mutually agreeable terms.
Competition and interaction in markets establish the prices on which
many choices are based.
• Markets function
• distribute information concerning what sellers are willing to sell and what buyers want to buy.
• provide a means for communication of new information and thereby allow prices to change as
buyers and sellers react accordingly

• Prices act as signals to buyers and sellers by conveying information on

the scarcity of goods and services and productive resources.
Economists have identified five factors of production:
 Natural resources are created by Alaah. Natural
resources such as arable land, mineral deposit, oil and
gas deposits, and water are used to produce goods and
services. Some economists refer to all types of natural
resources as land.
 Labour is the human effort (both physical and
mental)used to produce goods and services.
 Physical capital is made by human beings such as
machines, building, equipment, computers...
 Human capital is the knowledge and skills a worker
acquires through education and experience.
 Entrepreneurship is the effort used to coordinate the
production and sale of goods and services.
 Scarcity and production
possibilities

• What goods and services do we produce?

• How do we produce these goods and services?
• Who consumes the goods and services that are
produced?
Scarcity and production possibilities

• What goods and services do we produce?

Shifts in the Production Possibilities
Curve
How do we produce these goods and services?

• Factor or input market. The owners of the factors

of production - natural resources, labour,
physical capital (machines, building, and
equipment), and human capital (the knowledge
and skills acquired by worker) sell these inputs
to organizations that will transform them into
goods and services.
• Product or output market. The organizations sell
their goods and services to consumers.

How do we produce these
goods and services?
a. In labour markets, firms hire workers for
wages in exchange for the output produced by
the workers. (About 75% of income earned by
households)
• Households as Sellers (of factors) and
Buyers (of final products).
b. In capital markets, households use
their savings (money in bank
accounts, mutual funds, and stock
investments) to provide funds that
firms use to purchase physical capital
such as buildings and machines.
Households receive interest or a
share of the firm’s profits in return.
(About 20% of income earned by
households)
c. In natural resource markets,
households own natural resources
(land, minerals, or oil) or own the firm
that control the natural resources.
These natural resources are sold to
firms to use as inputs in the
production process.
d. Households are involved in
output markets when they purchase
goods and services from firms.
 • Firms as Sellers (of final products)
How do we produce these and Buyers (of factors).
goods and services?
a. Note that inputs flow from
households into factor markets
where they are purchased by firms
and then transformed into outputs.
The outputs then flow from firms to
the product market where
households purchase them.
b. The money that firms pay to
households flows into the product
market where households use it to
pay for outputs. Thus, the money
returns to the firms and can be used
to purchase further inputs.
Who consumes the goods and services that
are produced?

Economic systems
• Market-based economy.
A world where all the economic decisions (what products to produce,
how to produce them and who gets the products) would be made in
unregulated markets. Laissez-faire policies (translated from French
roughly as “let it happen”.
• Mixed economies.
A market-based economy system under which government plays an
important role, including the regulation of markets, where most
economic decision are made, provision of public goods and services
(such as highways and national defence), income redistribution
programs (such as cash assistance and subsidizes for medical care),
and taxation.
Government Regulation of Markets

1. Establishes a legal system to enforce property rights and contracts.

2. Regulates economic activity.
a. Regulates purchase and sale of stocks
b. Promotes competition through merger policy
c. Promotes product safety
d. Protects the environment
e. Regulates banking, transportation, land use, and some professions
• Centrally-planned economy.
a. Economic system under which production and consumption
decisions are made by central government, not by individual
producers and consumers in markets.
b. There is no private property; every thing is owned by the
government.
c. Prices are defined by governments.
 Transition to a market system.

• Many nations that relied on centrally planned economies have

recently shifted to mixed economic systems. Two challenges are
associated with the transition: the establishment of property rights and
privatization of state-run firms.
a. Establishment of property rights and rule of law.
b. Privatization of state-owned firms
Protective Policies

• public policies to restrict international trade, usually to protect

domestic firms.
1. Quota. Is an absolute limit on the volume of a particular good
that can be imported into a country?
2. Voluntary export restraint (VER). One country agrees to limit
the volume of exports to another country.
3. Tariff. A tax on imported goods.
4. Nontariff trade barriers. Some ways that a country limits imports
without an official trade barriers.
• The General Agreement on Tariffs and Trade (GATT) was
initiated in 1947 by the United States and 23 other countries, and now
has over 100 members.
• World Trade Organization (WTO) was found in 1995, it is formed
to oversee GATT and other international trade agreements.