Engineering Economy

Lecture 1: Foundations & Introduction

Engineering Economy
Engineering
Definitions (by Webster):
the work of designing and creating large structures
(such as roads and bridges) or new products or
systems by using scientific methods
the application of science and mathematics by
which the properties of matter and the sources of
energy in nature are made useful to people
professional art of applying science to the optimum
conversion of the resources of nature to the uses of
humankind.

Engineering Economy
Economy
Definitions (by Webster):
the process or system by which goods and services
are produced, sold, and bought in a country or
region
careful use of money, resources, etc.
thrifty and efficient use of material resources

Engineering Economy
Why Engineering + Economy?
The need for engineering economy is primarily
motivated by the work that engineers do in
performing analyses, synthesizing, and coming to
a conclusion as they work on projects of all sizes.
In other words, engineering economy is at the
heart of making decisions. These decisions
involve the fundamental elements of cash flows
of money, time, and interest rates.
- Do its benefits exceed its costs?

Engineering Economy
Decision Making
Decisions are made routinely to choose one alternative
over another by:
engineers on the job;
managers who supervise the activities of others;
corporate presidents who operate a business;
government officials who work for the public good.
Most decisions involve money (capital or capital funds):
usually limited in amount.
The decision of where and how to invest this limited
capital is motivated by a primary goal of adding value as
future, anticipated results of the selected alternative are
realized.
Engineering Economy
Decision Making
Engineers play a vital role in capital investment
decisions based upon their ability and
experience to design, analyze, and synthesize.
The factors upon which a decision is based are
commonly a combination of economic and
noneconomic elements.

Engineering Economy
Engineering Economy
“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.”
 Moreover, you can use what you learn in this
course in your everyday life

Engineering Economy
Decisions

Computers, Mathematics,
Concepts, Guidelines

time
People make decisions
The numbers used in engineering economy
are best estimates of what is expected to
occur

Engineering Economy
Decisions & Estimates
Decisions and estimates involve:
Cash flows
Times of occurrence of cash flows
Interest rates for time value of money
Measure of economic worth for selecting an
alternative

Engineering Economy
Sensitivity Analysis
Since the estimates of cash flow amounts and timing
are about the future, they will be somewhat different
than what is actually observed, due to changing
circumstances and unplanned events.
In short, the variation between an amount or time
estimated now and that observed in the future is
caused by the stochastic (random) nature of all
economic events.
Sensitivity analysis is utilized to determine how a
decision might change according to varying estimates,
especially those expected to vary widely.

Engineering Economy
Measure of Worth
The criterion used to select an alternative in
engineering economy for a specific set of
estimates is called a measure of worth. The
measures developed and used in our course are:
Present worth (PW) Benefit/cost (B/C)
Future worth (FW) Capitalized cost (CC)
Annual worth (AW) Payback period
Rate of return (ROR) Economic value added (EVA)
Cost Effectiveness

Engineering Economy
Time Value of Money
It is a well-known fact that money makes money.
The time value of money explains the change in
the amount of money over time for funds that
are owned (invested) or owed (borrowed). This is
the most important concept in engineering
economy.
If we decide to invest capital (money) in a project
today, we expect to have more money in the future
than we invested. If we borrow money today, we
expect to return the original amount plus some
additional amount of money.
Engineering Economy
Engineering Economy Study
The steps in an engineering economy study are as follows:
1. Identify and understand the problem; identify the objective of
the project.
2. Collect relevant, available data and define viable solution
alternatives.
3. Make realistic cash flow estimates.
4. Identify an economic measure of worth criterion for decision
making.
5. Evaluate each alternative; consider noneconomic factors; use
sensitivity analysis as needed.
6. Select the best alternative.
7. Implement the solution and monitor the results.

Engineering Economy
Engineering Economy Study
There may be occasions when the best economic
alternative requires more capital funds than are
available, or significant noneconomic factors preclude
the most economic alternative from being chosen.
Accordingly, steps 5 and 6 may result in selection of
an alternative different from the economically best
one.
Also, sometimes more than one project may be
selected and implemented. This occurs when projects
are independent of one another.

Engineering Economy
Engineering Economy Study

Engineering Economy
Engineering Economy Study
Problem Description and Objective
Statement: A succinct statement of the
problem and primary objective(s) is very
important to the formation of an alternative
solution. As an illustration, assume the
problem is that a coal-fueled power plant
must be shut down by 2015 due to the
production of excessive sulfur dioxide. The
objectives may be to generate the forecasted
electricity needed for 2015 and beyond, plus
to not exceed all the projected emission
allowances in these future years.

Engineering Economy
Engineering Economy Study

Alternatives: These are stand-alone

descriptions of viable solutions to problems
that can meet the objectives. The best
estimates for parameters are also part of the
alternative. Some parameters include
equipment first cost, expected life, salvage
value (estimated trade-in, resale, or market
value), and annual operating cost (AOC),
which can also be termed maintenance and
operating (M&O) cost, and subcontract cost
for specific services. If changes in income
(revenue) may occur, this parameter must be
estimated.

Engineering Economy
Engineering Economy Study

Cash Flows All cash flows are estimated for

each alternative. Since these are future
expenditures and revenues, the results of step
3 usually prove to be inaccurate when an
alternative is actually in place and operating.
When cash flow estimates for specific
parameters are expected to vary significantly
from a point estimate made now, risk and
sensitivity analyses (step 5) are needed to
improve the chances of selecting the best
alternative. Sizable variation is usually expected
in estimates of revenues, AOC, salvage values,
and subcontractor costs.

Engineering Economy
Engineering Economy Study

Engineering Economy
Engineering Economy Study

Engineering Economy Analysis: The techniques and

computations utilize the cash flow estimates, time
value of money, and a selected measure of worth.
The result of the analysis will be one or more
numerical values; this can be in one of several
terms, such as money, an interest rate, number of
years, or a probability. In the end, a selected
measure of worth will be used to select the best
alternative. Before an economic analysis technique
is applied to the cash flows, some decisions about
what to include in the analysis must be made. Two
important possibilities are taxes and inflation.

Engineering Economy
Engineering Economy Study

Selection of the Best Alternative: The measure of

worth is a primary basis for selecting the best
economic alternative. For example, if alternative A
has a rate of return (ROR) of 15.2% per year and
alternative B will result in an ROR of 16.9% per year,
B is better economically. However, there can always
be noneconomic or intangible factors that must be
considered and that may alter the decision. There
are many possible noneconomic factors.
At times, only one viable alternative is identified. In
this case, the do-nothing (DN) alternative may be
chosen provided the measure of worth and other
factors result in the alternative being a poor choice.
The do-nothing alternative maintains the status quo.

Engineering Economy
Everyday Decisions
Whether we are aware of it or not, we use criteria every
day to choose between alternatives:
For example, when you drive to campus, you decide to take
the “best” route. But how did you define best? Was the best
route the safest, shortest, fastest, cheapest, most scenic, or
what? Obviously, depending upon which criterion or
combination of criteria is used to identify the best, a
different route might be selected each time.
In economic analysis, financial units (TL, €, $ or other currency)
are generally used as the tangible basis for evaluation. Thus, when
there are several ways of accomplishing a stated objective, the
alternative with the lowest overall cost or highest overall net
income is selected.

Engineering Economy
Ethics
Morals usually relate to the underlying tenets
that form the character and conduct of a
person in judging right and wrong.
Ethical practices can be evaluated by using a
code of morals or code of ethics that forms the
standards to guide decisions and actions of
individuals and organizations in a profession,
for example, electrical, chemical, mechanical,
industrial, or civil engineering.

Engineering Economy
Ethics
Universal or common morals These are fundamental moral beliefs
held by virtually all people. Most people agree that to steal,
murder, lie, or physically harm someone is wrong.
Individual or personal morals These are the moral beliefs that a
person has and maintains over time. These usually parallel the
common morals in that stealing, lying, murdering, etc. are
immoral acts.
Professional or engineering ethics: Professionals in a specific
discipline are guided in their decision making and performance of
work activities by a formal standard or code. The code states the
commonly accepted standards of honesty and integrity that each
individual is expected to demonstrate in her or his practice. There
are codes of ethics for medical doctors, attorneys, and, of course,
engineers.

Engineering Economy
Ethics
Although each engineering profession has its own code of
ethics, the Code of Ethics for Engineers published by the
National Society of Professional Engineers (NSPE) is very
commonly used and quoted:
“Engineers, in the fulfillment of their duties, shall hold paramount
the safety, health, and welfare of the public.”
“Engineers shall not accept financial or other considerations,
including free engineering designs, from material or equipment
suppliers for specifying their product.”
“Engineers using designs supplied by a client recognize that the
designs remain the property of the client and may not be
duplicated by the engineer for others without express
permission.”
Engineering Economy
Ethics & Economy
Safety factors are compromised to ensure that a price
bid comes in as low as possible.
Family or personal connections with individuals in a
company offer unfair or insider information that
allows costs to be cut in strategic areas of a project.
A potential vendor offers specifications for company-
specific equipment, and the design engineer does not
have sufficient time to determine if this equipment
will meet the needs of the project being designed and
costed.

Engineering Economy
Ethics & Economy
Delayed or below-standard maintenance can be
performed to save money when cost overruns exist in
other segments of a project.
Opportunities to purchase cheaper repair parts can
save money for a subcontractor working on a fixed-
price contract.
Safety margins are compromised because of cost,
personal inconvenience to workers, tight time
schedules, etc.

Engineering Economy
Interest Rate & Rate of Return
Interest is the manifestation of the time value of money.
Computationally, interest is the difference between an
ending amount of money and the beginning amount. If
the difference is zero or negative, there is no interest.
There are always two perspectives to an amount of
interest—interest paid and interest earned.

Engineering Economy
Interest Rate & Rate of Return
Interest paid on borrowed funds (a loan) is
determined using the original amount, also called
the principal:
Interest = amount owed now - principal
When interest paid over a specific time unit is
expressed as a percentage of the principal, the
result is called the interest rate.

Engineering Economy
Interest Rate & Rate of Return
The time unit of the rate is called the interest
period. By far the most common interest
period used to state an interest rate is 1 year.
Shorter time periods can be used, such as 1%
per month.
Thus, the interest period of the interest rate
should always be included. If only the rate is
stated, for example, 8.5%, a 1-year interest
period is assumed.

Engineering Economy
Interest Rate & Rate of Return
Comp X, plans to borrow $20,000 from a bank for
1 year at 9% interest for new recording
equipment. ( a ) Compute the interest and the
total amount due after 1 year. ( b ) Construct a
column graph that shows the original loan
amount and total amount due after 1 year used
to compute the loan interest rate of 9% per year.

Engineering Economy
Interest Rate & Rate of Return

Engineering Economy
Interest Rate & Rate of Return
From the perspective of a saver, a lender, or an
investor, interest earned is the final amount minus
the initial amount, or principal.
Interest earned over a specific period of time is
expressed as a percentage of the original amount and
is called rate of return (ROR).
The term return on investment (ROI) is used
equivalently with ROR in different industries and
settings, especially where large capital funds are
committed to engineering-oriented programs.

Engineering Economy
Interest Rate & Rate of Return
Example: Calculate the amount deposited 1
year ago to have $1000 now at an interest rate
of 5% per year. What is the amount of interest
earned during this time period?

Engineering Economy
Interest Rate & Rate of Return
Inflation can significantly increase an interest rate. By
definition, inflation represents a decrease in the value of a
given currency. That is, 100 TL now will not purchase the
same amount of gasoline for your car as 100TL did 2 years
ago. The changing value of the currency affects market
interest rates.
In simple terms, interest rates reflect two things: a so-
called real rate of return plus the expected inflation rate.
The real rate of return allows the investor to purchase
more than he or she could have purchased before the
investment, while inflation raises the real rate to the
market rate that we use on a daily basis.
Engineering Economy
Interest Rate & Rate of Return
From the borrower’s perspective, the rate of
inflation is another interest rate tacked on to
the real interest rate .
And from the vantage point of the saver or
investor in a fixed-interest account, inflation
reduces the real rate of return on the
investment.

Engineering Economy
Interest Rate & Rate of Return
Inflation means that cost and revenue cash flow
estimates increase over time. This increase is due to the
changing value of money that is forced upon a country’s
currency by inflation, thus making a unit of currency
worth less relative to its value at a previous time:
A reduction in purchasing power of the currency
An increase in the CPI (consumer price index)
An increase in the cost of equipment and its maintenance
An increase in the cost of salaried professionals and hourly
employees
A reduction in the real rate of return on personal savings and
certain corporate investments.
Engineering Economy
Interest Rate & Rate of Return

Engineering Economy
Cash Flows
Engineering economy bases its computations
on the timing, size, and direction of cash flows:
Cash inflows are the receipts, revenues, incomes, and
savings generated by project and business activity. A plus
sign indicates a cash inflow.
Cash outflows are costs, disbursements, expenses, and
taxes caused by projects and business Cash flow activity. A
negative or minus sign indicates a cash outflow. When a
project involves only costs, the minus sign may be omitted
for some techniques, such as benefit/cost analysis.

Engineering Economy
Cash Flows

Point
Estimates

Engineering Economy
Cash Flows

Range
Estimates

Engineering Economy
Cash Flows

The end-of-period convention means that all cash

inflows and all cash outflows are assumed to take
place at the end of the interest period in which they
actually occur. When several inflows and outflows
occur within the same period, the net cash flow is
assumed to occur at the end of the period.

Engineering Economy
Cash Flows

Engineering Economy
Cash Flows

Engineering Economy
Cash Flows

Engineering Economy
Cash Flows

Engineering Economy
Cash Flows

Engineering Economy
Economic Equivalence
Economic equivalence is a fundamental concept
upon which engineering economy computations
are based.
Economic equivalence is a combination of interest
rate and time value of money to determine the
different amounts of money at different points in
time that are equal in economic value.
if the interest rate is 6% per year, $100 today (present
time) is equivalent to $106 one year from today.

Engineering Economy
Simple & Compound Interest
Simple interest is calculated using the principal
only, ignoring any interest accrued in preceding
interest periods. The total simple interest over
several periods is computed as:

Engineering Economy
Simple & Compound Interest
For compound interest, the interest accrued for each
interest period is calculated on the principal plus the
total amount of interest accumulated in all previous
periods. Thus, compound interest means interest on
top of interest.
In mathematical terms, the interest It for time period t
may be calculated using the relation.

Engineering Economy
Simple & Compound Interest

Engineering Economy
Example
$5.000 loan to be repayed with 4 different
plans in 5 years at a 8% compound interest.

Engineering Economy
Example – Plan 1

Engineering Economy
Example – Plan 2

Engineering Economy
Example – Plan 3

Engineering Economy
Example – Plan 4

Engineering Economy
Minimum Attractive Rate of Return
For any investment to be profitable, the investor
(corporate or individual) expects to receive more
money than the amount of capital invested. In other
words, a fair rate of return, or return on investment,
must be realizable. The definition of ROR is used in
this discussion, that is, amount earned divided by the
principal.
Engineering alternatives are evaluated upon the
prognosis that a reasonable ROR can be expected.
Therefore, some reasonable rate must be established
for the selection criteria of the engineering economy
study.
Engineering Economy
Minimum Attractive Rate of Return
The Minimum Attractive Rate of Return
(MARR) is a reasonable rate of return
established for the evaluation and selection of
alternatives. A project is not economically
viable unless it is expected to return at least
the MARR. MARR is also referred to as the
hurdle rate, cutoff rate, benchmark rate, and
minimum acceptable rate of return.

Engineering Economy
Minimum Attractive Rate of Return
In the United States, the current U.S. Treasury Bill
return is sometimes used as the benchmark safe
rate. The MARR will always be higher than this, or
a similar, safe rate. The MARR is not a rate that is
calculated as a ROR. The MARR is established by
(financial) managers and is used as a criterion
against which an alternative’s ROR is measured,
when making the accept/reject investment
decision.

Engineering Economy
Minimum Attractive Rate of Return
Although the MARR is used as a criterion to
decide on investing in a project, the size of
MARR is fundamentally connected to how
much it costs to obtain the needed capital
funds.

Engineering Economy
Financing
In general, capital is developed in two ways—
equity financing and debt financing. A
combination of these two is very common for
most projects.
Equity financing: The corporation uses its own funds from
cash on hand, stock sales, or retained earnings. Individuals
can use their own cash, savings, or investments.
Debt financing: The corporation borrows from outside
sources and repays the principal and interest according to
some schedule. Sources of debt capital may be bonds, loans,
mortgages, venture capital pools, and many others.

Engineering Economy
Financing
Combinations of debt-equity financing mean that a
weighted average cost of capital (WACC) results.
For a corporation, the established MARR used as a
criterion to accept or reject an investment alternative
will usually be equal to or higher than the WACC that
the corporation must bear to obtain the necessary
capital funds. So the below inequality must be correct
for an accepted project:

Engineering Economy
Opportunity Cost
New projects that are undertaken usually have an expected
return at least as great as the return on another alternative
that is not funded. The expected rate of return on the
unfunded project is called the opportunity cost.
The opportunity cost is the rate of return of a forgone
opportunity caused by the inability to pursue a project.
Numerically, it is the largest rate of return of all the projects
not accepted (forgone) due to the lack of capital funds or
other resources. When no specific MARR is established, the
de facto MARR is the opportunity cost, i.e., the ROR of the
first project not undertaken due to unavailability of capital
funds.

Engineering Economy