1.

Introduction Engineering economy is the dollars-and-cents side of

The technological and social environments in which the decisions and engineers make or recommend as
we live continue to change at a rapid rate. In recent they work to position a firm to be profitable in highly
decades, advances in science and engineering have
competitive marketplace. Inherent to these decisions
made space travel possible, transformed our
transportation systems, revolutionized the practice of are trade-offs among different types of costs and the
medicine, and miniaturized electronic circuits so that performance (response time, safety, weight,
a computer can be placed on a semiconductor chip. reliability, etc.) provided by the proposed design or
The list of such achievements seems almost endless. problem solution. The mission of engineering
The utilization of scientific and engineering economy is to balance these trade-offs in the most
knowledge for our benefit is achieved through the economical manner.
design of things we use, such as medicines,
structures, products, and services. However, these Engineering economy is the analysis and evaluation
achievements don’t occur without price, monetary or of the factors that will affect the economic success of
otherwise. Therefore, the purpose of this subject is to engineering projects to the end that a
develop and illustrate the principles and recommendation can be made which will insure the
methodology required to answer the basic economic best use of capital.
question of any design: Do its benefits exceed its
1.2. Principles of Engineering Economy
costs?
The development, study, and application of any
The Accreditation Board of Engineering and
discipline must begin with a basic foundation. We
Technology states that engineering “is a profession in define the foundation for engineering economy to be
which a knowledge of the mathematical and natural a set of principles that provide a comprehensive
sciences gained by study, experience, and practice is doctrine for developing the methodology.
applied with judgment to develop ways to utilize, 1. Develop the Alternatives – the choice (decisions)
economically, the materials and forces of nature for is among alternatives. The alternatives need to
the benefit of mankind. be identified and then defined for subsequent
analysis.
1.1. Definition 2. Focus of the Differences – only the differences in
Engineering Economy involves the systematic expected future outcomes among the
evaluation of the economic merits of proposed alternatives are relevant to their comparison and
solutions to engineering problems. To be should be considered in the decision.
economically acceptable (i.e., affordable), solutions to 3. Use a Consistent Viewpoint – the prospective
engineering problems must demonstrate a positive outcomes of the alternatives, economic and
balance of long-term benefits over long-term costs, other, should be consistently developed from a
and they must also defined viewpoint (perspective).
 Promote the well-being and survival of an 4. Use a Common Unit of Measure – using a
organization, common unit of measurement to enumerate as
 Embody creative and innovative technology many of the prospective outcomes as possible
and ideas, commensurable (directly comparable) will
 Permit identification and scrutiny of their simplify the analysis of the alternatives.
estimated outcomes, and 5. Consider all Relevant Criteria – selection of a
 Translate profitability to the “bottom line” preferred alternative (decision making) requires
through a valid and acceptable measure of the use of a criterion (or several criteria). The
merit. decision process should consider both the
outcomes enumerated in the monetary unit and

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 those expressed in some other unit of alternatives. evaluation.
measurement or made explicit in a descriptive 4. Selection of a
manner. criterion (or
6. Make Uncertainty Explicit – uncertainty is criteria).
5. Analysis and
inherent in projecting (or estimating) the future
comparison of
outcomes of the alternatives and should be the
recognized in their analysis and comparison. alternatives.
7. Revisit your Decisions – improved decision 6. Selection of the 5. Specification of
making results an adaptive process; to be extent preferred preferred
practicable, the initial projected outcomes of the alternatives. alternative.
selected alternative should be subsequently 7. Performance 6. Communication.
compared with actual results achieved. A good monitoring and
decision-making process can result in a decision post evaluation
that has an undesirable outcome. Other of results.
decisions, even though relatively successful, will
have results significantly different from the initial The seven-step engineering economic analysis
estimates of the consequences. Learning from procedure has direct ties to the engineering design
and adapting based on our experience are process. Following this systematic approach will assist
essential and are indicators of a good engineers in designing products and systems and in
organization.
providing technical services that promote the
economic welfare of the company they work for. This
1.3. Engineering Economy and the Design Process
same approach will also help you as an individual
An engineering economy study is accomplished using make sound financial decisions in your personal life.
a structured procedure and mathematical modelling
Middendorf states that “engineering design is an
techniques. The economic results are then used in a
iterative, decision making activity whereby scientific
decision situation that normally includes other
and technological information is used to produce a
engineering knowledge and input.
system, device, or process, which is different, in some
Table 1-1 The General Relationship between the degree, from what the designer knows to have been
Engineering Economic Analysis Procedure and the done before and which is meant to meet human
Engineering Design Process needs.” Also, we want to meet the human need
Engineering Economic Engineering Design economically as emphasized in the definition of
Analysis Procedure Process engineering.
Step Activity
1. Problem 1. Problem/need Example 1-1 Defining the problem and Developing
recognition, definition. Alternatives
definition, and 2. Problem/need
evaluation. formulation and The management team of a small furniture-
evaluation. manufacturing company is under pressure to increase
2. Development of 3. Synthesis of
profitability in order to get a much-needed loan from
the feasible possible solutions
alternatives. (alternatives) the bank to purchase a more modern pattern-cutting
3. Development of machine. One proposed solution is to sell waste wood
the outcomes chips and shavings to a local charcoal manufacturer
and cash flows 4. Analysis, instead of using them to fuel space heaters for the
for each optimization, and company’s office and factory areas.
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 (a) Define the company’s problem. Next, each) in the building that can each rented for $360
reformulate the problem in a variety of per month.
creative ways. Refer to the seven-step procedure in table 1-1 to
(b) Develop at least one potential alternative for answer these questions:
your reformulated problems in part (a). a. Does your friend have a problem? If so, what
is it?
Solution: b. What are her alternatives? (Identify at least
(a) The company’s problem appears to be that
three.)
revenues are not sufficiently covering costs.
c. Estimate the economic consequences and
Several reformulations can be posed:
other required data for the alternatives in
1. The problem is to increase revenues
Part (b).
while reducing costs.
d. Select a criterion for discriminating among
2. The problem is to maintain revenues
alternatives, and use it to advise your friend
while reducing costs.
on which course of action to pursue.
3. The problem is an accounting system that
e. Attempt to analyze and compare the
provides distorted cost information.
alternatives in view of at least one criterion in
4. The problem is that the new machine is
addition to cost.
really not needed (and hence there is no
f. What should your friend do based on the
need for a bank loan).
information you and she have generated?
(b) Based only on reformulation 1, an alternative
is to sell wood chips and shavings as long as Solution:
increased revenue exceeds extra expenses (a) A quick set of calculations shows that your
that may be required to heat the buildings. friend does indeed have a problem. A lot
Another alternative is to discontinue the more money is being spent by your friend
manufacture of specialty items and each year ($10,500 + $15,000 = $25,000) than
concentrate on standardized, high volume is being received (4 x $360 x 12 = $17,280).
products. Yet another alternative is to pool The problem could be that the monthly rent
purchasing, accounting, engineering, and is too low. She’s losing $8,220 per year.
other white-collar support services with (Now, that the problem!)
other small firms in the area by contracting (b) Option (1). Raise the rent. (Will the market
with a local company involved in providing bear an increase?)
these services. Option (2). Lower maintenance expenses (but
not so far as to cause safety problems).
Example 1-2 Application of the Engineering Economic Option (3). Sell the apartment building.
Analysis Procedure (What about a loss?)
A friend of yours bought a small apartment building Option (4). Abandon the building (bad for
for $100,000 in a college town. She spent $10,000 of your friend’s reputation).
her own money for the building and obtained a (c) Option(1). Raise total monthly rent to $1,440
mortgage from a local bank for the remaining + $R for the four apartments to cover
$90,000. The annual mortgage payment to the bank monthly expenses of $2,125 and the interest
is $10,500. Your friend also expects that annual that could be earned on $10,000 if your
maintenance on the building and grounds will be friend had invested it elsewhere. Note that
$15,000. There are four apartments (two bedrooms the minimum increase in rent would be

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 ($2,125 - $1,440)/4 = $171.25 per apartment (f) Your friend should probably do a market
per month (almost a 50% increase!). And this analysis of comparable housing in the area to
figure doesn’t include the interest she could see if the rent could be raised (option 1).
have been earning on the $10,000. Maybe a fresh coat of paint and new
Option (2). Lower monthly expenses to carpeting would make the apartments more
$2,125 - $C so that these expenses and the appealing to prospective renters. If so, the
interest earning ability of $10,000 is covered rent probably be raised while keeping 100%
by the monthly revenue of $1,440 per month. occupancy of the four apartments.
This would have to be accomplished primarily
Activity No. 1 (Short size bond paper, hand written).
by lowering the maintenance cost. (There’s
1) Explain why the subject of engineering
not much to be done about the annual
economy is important to the practicing
mortgage cost unless a favourable
engineer.
refinancing opportunity presents itself.) If she
2) Will the increased use of automation increase
could have earned just 0.25% per month on
the importance of engineering economy
the $10,000 (which comes to $25 per month
studies? Why or why not?
in interest), monthly maintenance expenses
3) Explain the meaning of the statement’ “The
would have to be reduced to ($1,440 - $25 -
choice (decision) is among alternatives.”
$10,500/12) = $540. This represents more
4) Define uncertainty. What are some of the
than a 50% decrease in maintenance
basic causes of uncertainty in engineering
expenses.
economy studies?
Option (3). Try to sell the apartment building
5) Explain the relationship between engineering
for $X, which recovers the original $10,000
economic analysis and engineering design.
investment and (ideally) recovers the $685
How does economic analysis assist decision
per month loss ($8,220 / 12) on the venture
making in the design process?
during the time it was owned. It would also
be wonderful to recover the lost interest that
could have been earned on the $10,000. 1.4. Cost Concepts for Decision Making
Option (4). Walk away from the venture and Designing to meet economic needs and achieving
kiss your investment good-bye. The bank competitive operations in private-and public-sector
would likely assume possession through organizations depends on prudently balancing what is
foreclosure and may try to collect fees from technically feasible and what is economically
your friend. This option would be very bad acceptable. Unfortunately, there is no shortcut
for your friend’s credit rating. method available to reach this balance between
(d) One criterion could be to minimize the technical and economical feasibility. Thus, methods
expected loos of money. In this case, you of engineering economic analysis should be used to
might advise your friend to pursue option (10 provide results that will help to attain an acceptable
or (3). balance.
(e) For example, let’s use “credit worthiness” as
an additional criterion. Option (4) is The word cost (or expenses) has meaning that varies
immediately ruled out. Exercising option (3) in usage. The concepts and other economic principles
could also harm your friend’s credit rating. used in an engineering economy study depend on the
Thus, options (1) and (2) may her only problem situation and on the decision to be made.
realistic and acceptable alternatives.
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 Cost Terminology
Nonrecurring Costs are those which are not
Fixed costs – those unaffected by changes in activity repetitive, even though the total expenditure may be
level over a feasible range of operations for the cumulative over a relatively short period of time. It
capacity or capability available. Typical fixed costs involves developing or establishing a capability or
include insurance and taxes on facilities, general capacity to operate. For example, the purchase cost
management and administrative salaries, license for real estate upon which a plant will be built is a
fees, and interest costs on borrowed capital. nonrecurring cost, as is the cost of constructing the
plant itself.
Variable costs – those associated with an operation
that vary in total with the quantity of output or other Direct costs are costs that can be reasonably
measures of activity level. For example, the costs of measured and allocated to a specific output or work
material and labor used in a product or service are activity. The labor and material costs directly
variable costs, because they vary in total with the associated with a product, service, or construction
number of output units, even though the costs per activity are direct costs. For example, the materials
unit stay the same. needed to make a pair of scissors would be a direct
cost.
Incremental cost (or incremental revenue) is the
additional cost (or revenue) that results from Indirect costs are costs that are difficult to attribute
increasing the output of a system by one (or more) or allocate to allocate to a specific output or work
units. Incremental cost is often associated with “go- activity. The term normally refers to types of costs
no go” decisions that involve a limited change in that would involve too much effort to allocate
output or activity level. For instance, the incremental directly to a specific output. For example, the costs of
cost per mile for driving an automobile may e $0.27, common tools, general supplies, and equipment
but this cost depends on considerations such as total maintenance in a plant are treated as indirect costs.
mileage driven during the year (normal operating
range), mileage expected for the next major trip, and Overhead consists of plant operating costs that are
the age of the automobile. Also, it is common to read not direct labor or direct material costs. The terms
of the “incremental cost of producing a barrel of oil” indirect costs, overhead, and burden are used
and “incremental cost to the state for educating a interchangeably. Examples of overhead include
student.” As these examples indicate, the electricity, general repairs, property taxes, and
incremental cost (or revenues) is often quite difficult supervision.
to determine in practice.
Standard costs are representative costs per unit of
Recurring costs – are those that are repetitive and output that are established in advance of actual
occur when an organization produces similar goods production or service delivery. They are developed
or services on a continuing basis. Variable costs are from anticipated direct labor hours, materials, and
also recurring costs, because they repeat with each overhead categories (with their established costs per
unit of output. But recurring costs are not limited to unit). Because total overhead costs are associated
variable costs. A fixed cost that is paid on a with a certain level of production, this is an important
repeatable basis is a recurring cost. For example, in condition that should be remembered when dealing
an organization providing architectural and with standard cost data. It plays an important role in
engineering services, office space rental, which is a cost control and other management functions. Some
fixed cost, is also a recurring cost. typical uses are the following:
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1. Estimating future manufacturing costs. Life-Cycle Cost refers to a summation of all costs,
2. Measuring operating performance by comparing both recurring and recurring, related to a product,
actual cost per unit with the standard unit cost. structure, system, or service during its life span. The
3. Preparing bids on products or services requested life cycle begins with identification of the economic
by customers. need or want (the requirement) and ends with
4. Establishing the value of work in process and retirement and disposal activities. It is a time horizon
finished inventories. that must be defined in the context of the specific
situation. It may be divided into two general time
Cash cost versus Book cost periods: the acquisition phase and the operation
A cost that involves payment of cash is called a cash phase.
cost (and results in a cash flow) to distinguish it from
one that does not involve a cash transaction and is Investment cost is the capital required for most of the
reflected in the accounting system as a noncash cost. activities in the acquisition phase. In simple cases,
This noncash cost is often referred to as a book cost. such as acquiring specific equipment, an investment
Cash cost are estimated from the perspective cost may be incurred as a single expenditure. On a
established for the analysis and are the future large, complex construction project, however, a
expenses incurred for the alternatives being series of expenditures over an extended period could
analyzed. Book cost are cost that do not involve cash be incurred. This cost is also called a capital
payment, but rather represent the recovery of past investment.
expenditures over a fixed period of time. The most
common example of book cost is the depreciation The working capital refers to the funds required for
charged for the use of assets such as plant and current assets (i.e., other than fixed assets such as
equipment. Depreciation, for example, is not a cash equipment, facilities, etc.) that are needed for the
flow and is important in analysis only because it startup and support of operational activities. For
affects income taxes, which are cash flows. examples, products cannot be made or services
delivered without having materials available in
Sunk Cost is one that has occurred in the past and has inventory.
no relevance to estimates of future costs and
revenues related to an alternative course of action. Operation and maintenance cost includes many of
Thus, a sunk cost is common to all alternatives, is not the recurring and expense items associated with the
part of the future (prospective) cash flows, and can operation phase of the life cycle. The direct and
be disregarded in an engineering economic analysis. indirect costs of operation associated with the fove
For instance, sunk costs are non-refundable cash primary resource areas – people, machines,
outlays, such as earnest money on a house or money materials, energy, and information – are a major part
spent on a passport. of the cots in this category.

Opportunity Cost is incurred because of the use of Consumer and Producer Goods and Services
limited resources, such that the opportunity to use Consumer goods and services are those products or
those resources to monetary advantage in an services that are directly used by people to satisfy
alternative use is foregone. Thus, it is the cost of the their wants. The providers of consumer goods and
best rejected (i.e., foregone) opportunity and is often services must be aware of, and are subject to, the
hidden or implied. changing wants of the people to whom their products
are sold.

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Producer goods and services are used to produce alternative that minimizes total cost per defect-free
consumer goods and services or other producer unit of product or service output.
goods. Machine tools, factory buildings, buses, and 2. Money-Time Relationships and Equivalence
farm machinery are examples. In the long run,
producer goods serves to satisfy human wants, but The term capital refers to wealth in the form of
only as a means to that end. Thus, the amount of money or property that can be used to produce more
producer goods needed is determined indirectly by wealth. The majority of engineering economy studies
the amount of consumer goods or services that are involves commitment of capital for extended periods
demanded by people. Goods and services are divided of time, so the effect of time must be considered. In
into two types: necessities and luxuries. this regard, it is recognized that a dollar/peso today is
worth more than a dollar/peso one or more years
Measures of Economic Growth from now because of the interest (or profit) it can
Goods and services are produced and desired earn. Therefore, money has a time value.
because directly or indirectly they have utility – the
power to satisfy human wants and needs. Thus, they Why Consider Return to Capital?
may be used or consumed directly, or they may be
Capital in the form of money for the people,
used to produce other goods or services that may, in
machines, materials, energy, and other things needed
turn, be used directly. Utility is most commonly
in the operation of an organization may be classified
measured in terms of value, expressed in some
into two basic categories. Equity capital is that owned
medium of exchange as the price that must be paid
by individuals who have invested their money or
to obtain the particular item.
property in a business project or venture in the hope
of receiving a profit. Debt capital, often borrowed
1.5. Present Economy Studies
capital, is obtained from lenders (e.g., through the
When alternatives for accomplishing a specific task
sale bonds) for investment. In return, the lenders
are being compared over one year or less and the
receive interest from the borrowers.
influence of time on money can be ignored,
engineering economic analyses are referred to as There are fundamental a reason why return to capital
present economy studies. Several situations involving in the form of interest and profit is an essential
present economy studies are illustrated. The rules, or ingredient of engineering studies. First, interest and
criteria will be used to select the preferred profit pay the providers of capital for forgoing its use
alternative when defect-free output (yield) is variable during the time the capital is being used. The fact
or constant among the alternative being considered. that the supplier can realize a return on capital acts
In addition, other criteria of acceptability (e.g., as an incentive to accumulate capital by savings, thus
compliance with environmental regulations) must postponing immediate consumption in favour of
also be satisfied. creating wealth in the future. Second, interest and
Rule 1 – When revenues and other economic benefits profit are payments for the risk the investor takes in
are present and vary among alternatives, choose the permitting another person, or an organization, to use
alternatives, choose the alternative that maximizes his or her capital.
overall profitability based on the number of defect-
free units of a product or service produced. In typical situation, investors must decide whether
Rule 2 – When revenues and other economic benefits the expected return on their capital is sufficient to
are not present or are constant among all justify buying into a proposed project or venture. If
alternatives, consider only the cots and select the capital is invested in a project, investors would

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expect, as a minimum, to receive a return at least established by John Calvin, and it refuted the notion
equal to the amount they have sacrificed by not using that interest was unlawful. Consequently, interest
it in some other available opportunity of comparable taking again became viewed as an essential and legal
risk. This interest or profit available from an part of doing business. Eventually, published interest
alternative investment is the opportunity cost or tables became available to the public.
equity capital is involved, there is a cost for the
capital employed in the sense that the project and Simple Interest.
venture must provide a sufficient return to be When the total earned or charged is linearly
financially attractive to suppliers of money or proportional to the initial amount of the loan
property. In summary, whenever capital is required in (principal), the interest rate, and the number of
engineering and other business projects and interest periods for which the principal is committed,
ventures, it is essential that proper consideration be the interest and interest rate are said to be simple.
given to its cost (i.e., time value). Simple interest is not used frequently in modern
commercial practice.
2.1. Interest and the Time Value of Money

The Origins of Interest When simple interest is applicable, the total interest,
I earned or paid may be computed in the formula; I =
Like taxes, interest has existed from earliest recorded (P)(N)(i), where P = principal amount lent or
human history. Records reveal its existence in borrowed; N = number of interest periods (e.g,
Babylon in 2000 BC. In the earliest instances, interest years); I = interest rate per interest period.
was paid in money for the use of grain or other
commodities that were borrowed; it was also paid in Compound Interest
the form of grain or other goods. Many existing Whenever the interest charge for any interest period
interest practices stem from early customs in the (a year, for example) is based on the remaining
borrowing and repayment of grain and other crops. principal amount plus any accumulated interest
charges up to the beginning of that period, the
History also reveals that the idea of interest became
so well established that a firm of international interest is said to be compound. The effect of
bankers existed in 575 B.C., with home offices in compounding of interest can be seen in the following
Babylon. The firm’s income was derived from the table for $1,000 loaned for three periods at an
high interest rates it charged for the use of its money interest rate of 10% compounded each period:
for financing international trade. (refer picture.. page 131)
Throughout early recorded history, typical annual
rates of interest on loans of money were in the
neighbourhood of 6 to 25%, although legally
sanctioned rates as high as 40% were permitted in
some instances. The charging of exorbitant interest
rates on loans was termed usury, and prohibition of
usury is found in the Bible (Exodus 22:21-27).

During the Middle Ages, interest taking on loans of

money was generally outlawed on scriptural grounds.
In 1536, the Protestant theory of usury was
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2.2. The Concept of Equivalence

Alternatives should be compared when they produce

similar results, serve the same purpose, or
accomplish the same function. This is not always
possible in some types of economy studies, but now
our attention is directed at answering the question:
How can alternatives for providing the same service
or accomplishing the same function be compared
when interest is involved over extended periods of
time? Thus, we should consider the comparison of
alternative options, or proposals, by reducing them to
an equivalent basis that is dependent on (1) the
interest rate, (2) the amounts of money involved, (3)
the timing of the monetary receipts or expenses, and
(4) the manner in which the interest, or profit, on
invested capital is paid and the initial capital
recovered.

To better understand the mechanics of interest and

to explain the concept of equivalence, suppose you
have a $17,00 balance on your credit card. “This has
got to stop!” you say to yourself. So you decide to
repay the $17,000 debt in four months. An unpaid
credit card balance at the beginning of a month will
be charged interest at the rate of 1% by your credit
card company. For this situation, we have selected
three plans to repay the $17,000 principal plus
interest owned.

(insert table 4-1..page 133)

2.3. Cash Flows

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