INTRODUCTION & BASIC PRINCIPLES OF

ECONOMY

Determining the optimal staffing plan for

a computer help desk.

Engineering Economy
Engineering
Economics
Engineering Economy
Engineering economy involves the
systematic evaluation of the economic
merits of proposed solutions to
engineering problems.
Solutions to engineering economy 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
Engineering economic analysis can play a role
in many types of situations.
Choosing the best design for a highefficiency gas furnace.
Selecting the most suitable robot for a
welding operation on an automotive
assembly line.
Making a recommendation about
whether jet airplanes for an overnight
delivery service should be purchased or
leased.

Principles of Engineering Economy

Develop the alternatives
Focus on the differences
Use a consistent viewpoint
Use a common unit of measure
Consider all relevant criteria
Make risk and uncertainty explicit
Revisit your decisions
Engineering Economic Analysis Procedure
1. Problem definition
2. Development of alternatives
3. Development of prospective outcomes
4. Selection of a decision criterion
5. Analysis and comparison of alternatives
6. Selection of the preferred alternative
7. Performance monitoring and postevaluation of results
COST CONCEPTS & DESIGN ECONOMICS
Cost Terminology
Fixed costs are those unaffected by
changes in activity level over a feasible
range of operations for the capacity or
capability available.

Variable costs are those associated with

an operation that varies in total with the
quantity of output or other measures of
activity level.
Incremental cost (or incremental
revenue) is the additional cost (or
revenue) that results from increasing the
output of a system by one (or more)
units.
Direct costs are costs that can be
reasonably measured and allocated to a
specific output or work activity.
Indirect costs are costs that are difficult
to attribute or allocate to a specific
output or work activity.
Standard costs are planned costs per
unit of output that are established in
advance of actual production or service
delivery.
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 is incurred because of
the use of limited resources, such that
the opportunity to use those resources
to monetary advantage in an alternative
use is foregone.
Life-cycle cost refers to a summation of
all the costs related to a product,
structure, system, or service during its
life span.
Life-cycle cost
Acquisition phase (investment cost and
working capital)

Needs assessment, definition of

requirements
Conceptual design, advanced
development, prototype testing
Detailed design, production or
construction planning, facility and
resource acquisition

Operation phase (operation and

maintenance cost and disposal cost)

Production or construction

Operation or consumer use

Maintenance and support

Retirement and disposal

General Economic Environment

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.
Necessities are those products or
services that are required to support
human life and activities.
Luxuries are those products or services
that are desired by humans and will be
purchased if money is available after the
required necessities have been obtained.
Demand is the quantity of a certain
commodity that is bought at a certain
price at a given place and time.

Inelastic demand

Supply is the quantity of a certain

commodity that is offered for sale at a
certain price at a given place and time.

A cash-flow diagram is a graphical

representation of cash flows drawn on a
time scale.

Receipt (positive cash flow or cash

inflow)

Disbursement (negative cash flow

or cash outflow)

Perfect competition
Monopoly
Oligopoly
THE TIME VALUE OF MONEY
Simple Interest
Capital refers to wealth in the form of
money or property that can be used to
produce more wealth.
When the total interest earned or
charged is linearly proportional to the
initial amount of the loan (principal), the
interest rate, and the number of interest
periods for which the principal is
committed, the interest and interest rate
are said to be simple.
Ordinary Simple Interest

computed on the basis of one

bankers year, which is:

= 12 months, each consisting of 30 days

= 360 days
Exact Simple Interest

computed on the basis of the

exact number of days, 365 for an
ordinary year and 366 days for a
leap year

Elastic demand
Cash-Flow Diagrams

Compound Interest
Whenever the interest charge for any
interest period is based on the remaining
principal amount plus any accumulated
interest charges up to the beginning of
that period, the interest is said to be
compound.
The quantity

( 1+i )n is the single

payment compound amount factor and

is designated by F/P, i%, n.
The quantity

( 1+i )n

is the single

payment present worth factor and is

designated by P/F, i%, n.
Nominal Rate of Interest
The nominal rate of interest specifies the
rate of interest and a number of interest
periods in one year.
Effective Rate of Interest
Effective rate of interest is the actual or
exact rate of interest on the principal
during one year.
Equation of Value
An equation of value is obtained by
setting the sum of the values on a

certain comparison or focal date of one

set of obligations equal to the sum of the
values on the same date of another set
of obligations.
Continuous Compounding
In discrete compounding, the interest is
compounded at the end of each finitelength period.
In continuous compounding, it is
assumed that cash payments occur once
per year, but the compounding is
continuous throughout the year.
Discount
Interest deducted in advance
Difference on what is worth in the future
and its present worth
Discount = Future Worth Present Worth
Inflation
Inflation is the increase in the prices of
goods and services from one year to
another, thus decreasing the purchasing
power of money.
CAPITAL FINANCING
Equity capital or ownership funds those
supplied and used by the owners of an
enterprise in the expectation that a
profit will be earned.
Borrowed funds or capital are those
supplied by others on which a fixed rate
of interest must be paid and the debt
must be repaid at a specified time.
Types of Business Organizations

Individual Ownership
Individual ownership or sole
proprietorship is the simplest form of
business organization, wherein a person
uses his or her own capital to establish a
business and is the sole owner.
Partnership
A partnership is an association of two or
more persons for the purpose of
engaging in a business for profit.
Corporation
A corporation is a distinct legal entity,
separate from the individuals who own
it, and which can engage in almost any
type of business transaction in which a
real person could occupy himself or
herself.
Capitalization of a Corporation
The capital of a corporation is acquired through
the sale of stock.
Two principal types of capital stock:
Common stock
Preferred stock
Bonds
A bond is a certificate of indebtedness of
a corporation usually for a period not
less than ten years and guaranteed by a
mortgage on certain assets of the
corporation or its subsidiaries.
Classification of Bonds
According to the method of paying interest:
Registered bonds

Coupon bonds
Classification of Bonds
According to the security behind the bonds:
Mortgage bonds
Collateral trust bonds
Equipment obligation bonds
Classification of Bonds
According to the security behind the bonds:
Debenture bonds
Joint bonds
Methods of Bond Retirement
The corporation may issue another set of
bonds equal to the amount of bonds due
for redemption.
The corporation may set up a sinking
fund into which periodic deposits of
equal amount are made. The
accumulated amount in the sinking fund
is equal to the amount needed to retire
the bonds at the time they are due.
Value of a Bond
The value of a bond is defined to be the
present worth of all the amounts the
bondholder will receive through his
possession of the bond.
The bondholder will receive two types of
payments:
A single payment which the owner will
receive at the date of maturity of the
bond, which is usually equal to the par
value of the bond; and

 The periodic payments for interest on

the bond until it is redeemed by the
issuing corporation.
SELECTIONS IN PRESENT ECONOMY
Present Economy
Present economy involves the analysis of
problems for manufacturing a product or
rendering a service based on present or
immediate costs.
Present Economy
Selection of Materials
Selection of Method
Selection of Design
Site Selection
Present Economy
Comparison of Proficiency of Workers
Economy of Tool and Equipment
Maintenance
Economy in the Utilization of Personnel
BASIC METHODS FOR MAKING ECONOMY
STUDIES

Interest on the original investment

(minimum required profit) is included as
a cost.

always be used unless there are definite

reasons why an alternative requiring a
larger investment should be adopted.

If the excess of annual cash inflows over

annual cash outflows is not less than
zero, the proposed investment is
justified (valid).

Methods or Patterns in Comparing Alternatives

Present Worth (PW) Method

If the present worth of the net cash flows
is equal to or greater than zero, the
project is justified economically.
Future Worth (FW) Method
All cash inflows and outflows are
compounded forward to a reference
point in time called future.
If the future worth of the net cash flows
is equal to or greater than zero, the
project is justified economically.
Payback (Payout) Period Method
The payback period is defined as the
length of time required to recover the
first cost of an investment from the net
cash flow produced by that investment
for an interest rate of zero.

Annual Cost (AC) Method

The annual cost of the alternatives
including interest on investment is
determined.
The alternative with the least annual
cost is chosen.
Equivalent Uniform Annual Cost (EUAC) Method
All cash flows (irregular and uniform)
must be converted to an equivalent
uniform annual cost, that is, a year end
amount which is the same each year.
The alternative with the least equivalent
uniform annual cost is preferred.

Determine the present worth of the net

cash outflows for each alternative for the
same period of time.

Rate of return is a measure of the

effectiveness of an investment of capital.

Annual Worth (AW) Method

If the rate of return on the additional

investment exceeds the current rate of
return on the capital, the more
expensive alternative should be chosen.

Present Worth Cost (PWC) Method

Rate of Return (ROR) Method

A rate of return equivalent from 20% to

25% of the investment is adequate to
justify the investment.

Rate of Return on Additional Investment

Method

COMPARISON OF ALTERNATIVES
Fundamental Principle:
The alternative that requires the
minimum investment of capital and will
produce satisfactory functional result will

The alternative with the least present

worth of cost is selected.

Capitalized Method

 Determine the capitalized cost of all the

alternatives and choose that one with
the least capitalized cost.
Usually used when life is 20 or more
years

Payback (Payout) Period Method

The alternative with the shortest
payback period is adopted.
This method is seldom used.