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GE 301:

ENGINEERING ECONOMY Engr. Raymond Marquez

Background
EEC President 1987 & IIEE CSC Chairman 1987 BSEE 1988, UST MBA 1999, DLSU REE, Asean Engr. IIEE National President, 2007 ENPAP National President, 2008 EE Consultant to ADB, WB/IFC, BPI, KFW/LBP Director for Operations/Business Devt Cofely Phils.

Methodology
Lecture Applications of Engg Economy Quizzes/Prelims/Finals 20% 40% 40%

References: Engineering Economy, 3rd ed. (Engr. Hipolito Sta. Maria) Engineering Economy, 15th ed. (Sullivan, Wicks, Koelling)

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Tentative Schedule
3EEa Jun 7 Jun 10 Jun 14 Jun 17 Jun 21 Jun 24 Jun 28 Jul 1 Overview Economic Environment Time Value of Money Time Value of Money No classes No classes No classes 3EEb Overview Economic Environment Time Value of Money Time Value of Money No classes No classes No classes Intro to Engg Economy Intro to Engg Economy

Intro to Engineering Economy, S1

Engineering Economy systematic evaluation of the economic merits of proposed solutions to engineering problems.

Intro to Engineering Economy

Principles of Engineering Economy
1. 2. 3. 4. 5. 6. 7. Develop the alternatives Focus on the difference Use of a consistent viewpoint Use of a common unit of measure Consider all relevant criteria Make risk and uncertainty explicit Revisit your decision

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Intro to Engineering Economy

Engineering Economy Analysis Procedure
Problem recognition, definition, and evaluation. Development of the feasible alternatives. Development of the outcomes and cash flows for each alternative. Selection of criteria. Analysis and comparison of the alternative. Selection of the preferred alternative. Performance monitoring and post evaluation of results.

Intro to Engineering Economy

Example 1-1 Defining the Problem and Developing Alternatives The management team of a small furniture mfg. company is under pressure to increase profitability to get a much-needed loan from the bank to purchase a more modern patterncutting machine. One proposed solution is to sell waste wood chips and shavings to a local charcoal manufacturer instead of using them to fuel space heaters for the companys office and factory areas. A. Define the companys problem. Next, reformulate the problem in a variety of creative ways. B. Develop at least one potential alternative for your reformulated problems in A.

Intro to Engineering Economy

Example 1-1 Defining the Problem and Developing Alternatives Solution: A. The companys problem appears to be that revenues are not sufficiently covering costs. 1. The problem is to increase revenues while reducing costs. 2. The problem is to maintain revenues while reducing costs. 3. The problem is an accounting system that provides distorted cost information. 4. The problem is that the new machine is really not needed.

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Intro to Engineering Economy

Example 1-1 Defining the Problem and Developing Alternatives Solution: B. Based on reformulation 1, an alternative is to sell wood chips and shavings as long as increased revenue exceeds extra expenses that may be required to heat the buildings. Another alternative is to discontinue the manufacture of specialty items and concentrate on standardized, high volume products. Yet another alternative is to pool purchasing, accounting, engineering, and other whitecollar support services with other small firms in the area by contracting with a local company involved in proving these services.

Intro to Engineering Economy

Example 1-2 Application of Engineering Economic Analysis Procedure A friend of yours bought a small apartment building for P100,000 in a college town. She spent P10,000 of her own money for the building and obtained a mortgage from a local bank for the remaining P90,000. The annual mortgage payment to the bank is P10,500. Your friend also expects that annual maintenance on the building and grounds will be P15,000. There are 4 apartments in the building that can each be rented for P360/month.

Intro to Engineering Economy

Example 1-2 Application of Engineering Economic Analysis Procedure A. Does your friend have a problem? If so, what is it? B. What are her alternatives? C. Estimate the economic consequences and other required data for the alternatives in B. D. Select a criterion for discriminating among alternatives, and use it to advise your friend on which course of action to pursue. E. Attempt to analyze and compare the alternatives in view of at least one criterion in addition to cost. F. What should your friend do based on the information you and she have generated?

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Intro to Engineering Economy

Example 1-2 Application of Engineering Economic Analysis Procedure Solution
A. A quick set of calculations shows that your friend does indeed have a problem. A lot more money is being spent by your friend each year (P10,500+P15,000 = P25,500) than is being received (4 x P360 x 12 = P17,280). The problem could be that the monthly rent is too low. Shes losing P8,220 per year. B. Option 1. Raise the rent. Option 2. Lower maintenance expenses. Option 3. Sell the apartment building. Option 4. Abandon the building.

Intro to Engineering Economy

Example 1-2 Application of Engineering Economic Analysis Procedure C. Option 1. Raise the total monthly rent to P1,440 + P Rent for the 4 apartments to cover monthly expenses of P2,125. Note that the minimum increase in rent would be (P2,125 P1,440)/4 = P171.25 per apartment per month. Option 2. Lower monthly expenses to P2,125 P Cost so that these expenses are covered by the monthly revenue of P1,440/month. Monthly maintenance expenses would have to be reduced to (P1,440 P10,500/12) = P565. Option 3. Try to sell the apartment building for P X, which recovers the original P10,000 investment and recovers the P685/month loss (P8,220/12) on the venture during the time it was owned. Option 4. Walk away from the venture and kiss your investment goodbye. The bank would likely assume possession through foreclosure and may try to collect fees from your friend.

Intro to Engineering Economy

Example 1-2 Application of Engineering Economic Analysis Procedure D. One criterion could be to minimize the expected loss of money. In this case, you might advise your friend to pursue Option 1 or 3. E. Lets use credit worthiness as an additional criterion. Option 4 is immediately ruled out. Option 3 could also harm your friends credit rating. Thus Option 1 & 2 may be her only realistic and acceptable alternatives. F. Your friend should probably do a market analysis of comparable housing in the area to see if the rent could be raised. Maybe a fresh coat of paint and new carpeting would make the apartments more appealing to prospective renters.

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Economic Environment, S2
Consumer goods/services products or services that are directly used by people to satisfy their wants. Producer goods/services used to produce consumer goods and services or other producer goods.

Economic Environment
Necessities products or services that are required to support human life and activities, that will be purchased in somewhat the same quantity even though the price varies considerably. Luxuries products or services that are desired by humans and will be purchased if money is available after the required necessities have been obtained.

Economic Environment
Demand quantity of a certain commodity that is bought at a certain price at a given place and time. Elastic demand occurs when a decrease in selling price result in a greater than proportionate increase in sales. Inelastic demand occurs when a decrease in the selling price produces a less than proportionate increase in sales.

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Economic Environment

Price-Demand Relationship

Price-Supply Relationship

Economic Environment
Perfect competition occurs in a situation where a commodity or service is supplied by a no. of vendors and there is nothing to prevent additional vendors entering the market. Monopoly opposite of perfect competition. Oligopoly exists when there are so few suppliers of a product or service that action by one will almost inevitably result in similar action by the others.

Economic Environment
Law of Supply & Demand under conditions of perfect competition the price at which a given product will be supplied and purchased is the price that will result in the supply and demand being equal. Supply quantity of a certain commodity that is offered for sale at a certain price at a given place and time.

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Economic Environment

Fixed, Variable, & Incremental Costs

Type of Costs
Fixed costs costs which remain constant, whether or not a given change in operations or policy is adopted. Variable costs costs which vary with output or any change in the activities of an enterprise. Incremental costs costs that arise as the result of a change in operations or policy. A very simple example would be a factory making nail where it takes one employee an hour to make a nail. As a simple figure, the incremental cost of a nail would be the wages for the employee for an hour plus the cost of the materials needed to produce a nail. A more accurate figure could include added costs, such as shipping the additional nail to a customer, or the electricity used if the factory has to stay open longer. Marginal cost additional cost of producing one more unit of a product. Marginal cost and average cost can differ greatly. For example, suppose it costs $1000 to produce 100 units and $1020 to produce 101 units. The average cost per unit is $10, but the marginal cost of the 101st unit is $20 Sunk cost represents money which has been spent or capital which has been invested and which cannot be recovered due to certain reasons.

Direct, Indirect and Standard Costs

Direct Cost costs that can be reasonably measured and allocated to a specific output or work activity, e.g. labor, materials Indirect Cost costs that are difficult to attribute or allocate to a specific output or work activity, e.g. cost of tools, general supplies, electricity (overhead) Standard Cost planned costs per unit of output that are established in advance of actual production or service delivery.

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Opportunity Cost & Life-Cycle Cost

Opportunity Cost incurred because of use of limited resources. Example: A firm is considering the replacement of an existing piece of equipment that originally cost $50,000, is presently shown on the company records with a value of $20,000, but has a present market value of only $5,000. For purposes of an engineering economic analysis of whether to replace the equipment, the present investment in that equipment should be considered as $5,000, because, by keeping the equipment, the firm is giving up the opportunity to obtain $5,000 from its disposal. Thus, the $5,000 immediate selling price is really the investment cost of not replacing the equipment and is based on the opportunity cost concept.

Life Cycle Cost Analysis

Life Cycle Cost (LCC) analysis is a management tool that can help companies minimize waste and maximize energy efficiency for many types of systems. The LCC of any piece of equipment is the total lifetime cost to purchase, install, operate, maintain, and dispose of that equipment.

Life Cycle Cost Analysis

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Life Cycle Cost Analysis Components

Initial costs Installation and commissioning costs Energy costs Operation costs Repair and maintenance costs Down time costs Environmental costs Decommissioning and disposal costs

LCCA for IB & CFL

120% 100% 80% 60% 40% 20% 0% IB 50W CFL 9W PV Energy PV Replacement First Cost

LCCA for Hot Water

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LCCA for STACU & Solar Assisted Cooling

120% 100% 80% PV Energy 60% 40% 20% 0% STACU 1TR Solar Cooling 1TR PV Maintenance First Cost

Sample, S2
An electrical contractor has a job which should be completed in 100 days. At present, he has 80 men on the job and it is estimated that they will finish the work in 130 days. If of the 80 men, 50 are paid P190 a day, 25 at P220 a day, and 5 at P300 a day and if for each day beyond the original 100 days, the contractor has to pay P2000 liquidated damages. (a) How many more men should the contractor add so he can complete the work on time? (b) If the additional men of 5 are paid P220 a day and the rest at P 190 a day, would the contractor save money by employing more men and not paying the fine?

Solution: (a) Let x = no. of men to be added to complete the job on time (x+80)(100) = (80)(130) x = 24 men (b) 80 men on the job Wages: 50xP190x130 = P1,235,000 25xP220x130 = P 715,000 5xP300x130 = P 195,000 Damages P2000x30 = P 60,000 104 men on the job Wages: (50+19)(190)(100) = P1,311,000 (25+5)(190)(100) = P 660,000 5xP300x100 = P 150,000 Savings = P2,205,000 P2,121,000 = P84,000

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Time Value of Money, S3

A dollar today is worth more than a dollar one or more years from now (for several reasons). Interest and profit are payments for the risk the investor takes in letting another use his or her capital. Any project or venture must provide a sufficient return to be financially attractive to the suppliers of money or property.

Time Value of Money

Simple Interest - when the total interest earned 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.
P = principal amount lent or borrowed N = number of interest periods (e.g., years) i = interest rate per interest period The total amount repaid at the end of N interest periods is P + I.

Time Value of Money

If P5,000 were loaned for five years at a simple interest rate of 7% per year, the interest earned would be I = P5,000 x 5 x 0.07 = P1,750 So, the total amount repaid at the end of five years would be the original amount (P5,000) plus the interest (P1,750), or P6,750.

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Time Value of Money

Compound interest reflects both the remaining principal and any accumulated interest. For P1,000 at 10%
(1) (2)=(1)x10% Amount owed Interest at beginning of amount for period period P1,000 P100 P1,100 P1,210 P110 P121 (3)=(1)+(2) Amount owed at end of period P1,100 P1,210 P1,331

Period 1 2 3

Compound interest is commonly used in personal and professional financial transactions.

Time Value of Money

Notation used in formulas for compound interest calculations.
i = effective interest rate per interest period N = number of compounding (interest) periods P = present sum of money; equivalent value of one or more cash flows at a reference point in time; the present F = future sum of money; equivalent value of one or more cash flows at a reference point in time; the future A = end-of-period cash flows in a uniform series continuing for a certain number of periods, starting at the end of the first period and continuing through the last

Time Value of Money

A cash flow diagram is an indispensable tool for clarifying and visualizing a series of cash flows.
Start of Period 1 End of Period 1 F = ? (inflow or receipt)

2 End of Period

4=N i = ?% per period

P = ? (outflow or disbursement)

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Time Value of Money

2,000

5,310

4=N 3,000

End of Year 10,000

Time Value of Money

Cash flow tables are essential to modeling engineering economy problems in a spreadsheet

Time Value of Money

Using the standard notation, we find that a present amount, P, can grow into a future amount, F, in N time periods at interest rate i according to the formula below. In a similar way we can find P given F by

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Time Value of Money

It is common to use standard notation for interest factors.
This is also known as the single payment compound amount factor. The term on the right is read F given P at i% interest per period for N interest periods. is called the single payment present worth factor.

Time Value of Money

P2,500 at time zero is equivalent to how much after six years if the interest rate is 8% per year?
F = P2,500 (F/P, 8%, 6) = P2,500 (1.5869) = P3,967

P3,000 at the end of year seven is equivalent to how much today (time zero) if the interest rate is 6% per year?
P = P3,000 (P/F, 6%, 7) = P3,000(0.6651) = P1,995

Sample on Compound Interest

A P2000 loan was originally made at 8% simple interest for 4 years. At the end of this period the loan was extended for 3 years, without the interest being paid, but the new interest rate was made 10% compounded semiannually. How much should the borrower pay at the end of 7 years?

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F4

F7

2 Simple interest

Compound interest

P2000

Solution: F4 = P (1+ni) = P2000 (1+ (4)(0.08)) = P2,640 F7 = F4 (1+i)^n = P2,640 (1+0.05)^6 = P3,537.86

Time Value of Money

There are interest factors for a series of end-of-period cash flows.

How much will you have in 40 years if you save $3,000 each year and your account earns 8% interest each year?

Time Value of Money

Finding the present amount from a series of end-of-period cash flows.

How much would is needed today to provide an annual amount of $50,000 each year for 20 years, at 9% interest each year?

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Time Value of Money

Finding A when given F.

How much would you need to set aside each year for 25 years, at 10% interest, to have accumulated $1,000,000 at the end of the 25 years?

Time Value of Money

Finding A when given P.

If you had $500,000 today in an account earning 10% each year, how much could you withdraw each year for 25 years?

Time Value of Money Pause and solve

Acme Steamer purchased a new pump for $75,000. They borrowed the money for the pump from their bank at an interest rate of 0.5% per month and will make a total of 24 equal, monthly payments. How much will Acmes monthly payments be?

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Time Value of Money, S4 Finding N

Acme borrowed $100,000 from a local bank, which charges them an interest rate of 7% per year. If Acme pays the bank $8,000 per year, now many years will it take to pay off the loan? So,

Time Value of Money Finding i

Jill invested $1,000 each year for five years in a local company and sold her interest after five years for $8,000. What annual rate of return did Jill earn? So,

Sample on Annuity
A businessman needs P50,000 for his operations. One financial institution is willing to lend him the money for one year at 12.5% interest per annum (discounted). Another lender is charging 14%, with the principal and interest payable at the end of one year. A third financier is willing to lend him P50,000 payable in 12 equal monthly installments of P4,600. Which offer is best for him?

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Compare the effective rate of each offer and select the one with the lowest effective rate.
P X = P50,000 (1-0.125) = P43,750 P50,000 P50,000

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P50,000

P50,000 (1.14)

P4,600

P4,600

Second Offer: First Offer: 14%/yr (eff rate) Rate of interest = (P50,000 P43,750) /P43,750 = 14.29%/yr (eff rate)

Third Offer: P/A,i%,12= P/A (1-(1+i)^-12)/i)=10.87

Try i=1% & 2%: i = 1.57%/mo.

Eff rate = (1+0.0157)^12 1 = 20.26%/yr

Sample on Annuity
Today, you invest P100,000 into a fund that pays 25% interest compounded annually. Three years later, you borrow P50,000 from a bank at 20% annual interest and invest in the fund. Two years later, you withdraw enough money from the fund to repay the bank loan and all interest due on it. Three years from this withdrawal you start taking P20,000 per year out of the fund. After five withdrawals, you withdraw the balance in the fund. How much was withdrawn?

P50,000 (1.20)^2 (F/P, 25%, 7) P50,000 (1.20)^2 P20,000 (F/A, 25%, 5) P20,000 each

3 4 P50,000

10

11

12

P50,000 (F/P, 25%, 9) P100,000 P100,000 (F/P, 25%, 12)

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Solution: Let Q = amt. withdrawn after 12 yrs Using 12 yrs as Focal date: equation of value is Q + P20,000 (F/A, 25%, 5) + P50,000 (1.20)^2 (F/P, 25%, 7)= P100,000 (F/P, 25%, 12) + P50,000 (F/P, 25%, 9) Q+P20,000(8.2070)+P50,000(1.20)^2(4.7684) = P100,000(14.5519) + P50,000 (7.4506) Q = P1,320,255

Sample on Annuity
A certain property is being sold and the owner received two bids. The first bidder offered to pay P400,000 each year for 5 years, each payment is to be made at the beginning of each year. The second bidder offered to pay P240,000 first year, P360,000 the second year and P540,000 each year for the next 3 years, all payments will be made at the beginning of each year. If money is worth 20% compounded annually, which bid should the owner of the property accept?

First Bid P1

P400,000 Yr (0 4)

Solution: Let P1 = present worth of the 1st bid P1 = A (1 + P/A, 20%, 4) = P400,000 (1+2.5887) = P1,435,480

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Second Bid P2

0 P240,000

P360,000 P540,000 Yr (2 4)

Solution: Let P2 = present worth of the 2nd bid P2 = P240,000 + P360,000 (P/F,20%,1)+P540,000(P/A,20%,3)(P/F,20%,1) = P1,487,875 (Choose 2nd bid)

Time Value of Money We need to be able to handle cash flows that do not occur until some time in the future.
Deferred annuities are uniform series that do not begin until some time in the future. If the annuity is deferred J periods then the first payment (cash flow) begins at the end of period J+1.

Time Value of Money Finding the value at time 0 of a deferred annuity is a two-step process.
1. Use (P/A, i%, N-J) find the value of the deferred annuity at the end of period J (where there are N-J cash flows in the annuity). 2. Use (P/F, i%, J) to find the value of the deferred annuity at time zero.

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Sample on Deferred Annuity

A debt of P40,000, whose interest rate is 15% compounded semiannually, is to be discharged by a series of 10 semiannual payments, the first payment to be made 6 months after consummation of the loan. The first 6 payments will be P6,000 each, while the remaining 4 payments will be equal and of such amount that the final payment will liquidate the debt. What is the amount of the last 4 payments?

P40,000

10

P6,000 Yr (1 6) P6,000 (P/A, 7.5%, 6) A (P/A, 7.5%, 4)(P/F, 7.5%, 6)

A Yr (7-10)

A (P/A, 7.5%, 4)

Solution: Using today as focal date, the equation of value is P40,000 = P6,000 (P/A, 7.5%, 6) + A(P/A,7.5%, 4)(P/F,7.5%,6) P40,000 = P6,000(4.6938)+A(3.3493)(0.6480) A = P5,454

Sample on Amortization
A debt of P10,000 with interest at the rate of 20% compounded semiannually is to be amortized by 5 equal payments at the end of each 6 months, the first payment is to be made after 3 years. Find the semiannual payment and construct an amortization schedule.

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P10,000

10

A Yr (6-10)

Solution: P = A(P/A,10%,5)(P/F,10%,5) A = P10,000 (0.2638)(1.6105) A = P4,248.50

Amortization Schedule
Period Outstanding Principal at beginning of period 10,000.00 11,000.00 12,100.00 13,310.00 14,641.00 16,105.10 13,467.11 10,565.32 7,373.35 3,862.19 Interest due at end of period Payment Principal repaid at end of period

1 2 3 4 5 6 7 8 9 10

1,000.00 1,100.00 1,210.00 1,331.00 1,464.10 1,610.51 1,346.71 1,056.53 737.34 386.22 P11,242.41 4,248.50 4,248.50 4,248.50 4,248.50 4,248.50 P21,242.50 2,637.99 2,901.79 3,191.97 3,511.16 3,862.28 P16,105.19

Time Value of Money Pause and solve

Irene just purchased a new sports car and wants to also set aside cash for future maintenance expenses. The car has a bumper-to-bumper warranty for the first five years. Irene estimates that she will need approximately $2,000 per year in maintenance expenses for years 6-10, at which time she will sell the vehicle. How much money should Irene deposit into an account today, at 8% per year, so that she will have sufficient funds in that account to cover her projected maintenance expenses?

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Time Value of Money Uniform Arithmetic Gradient

Economic analysis problems involve receipts or disbursements that increase or decrease by a uniform amount each period. For example, Repairs & Maintenance expenses on specific equipment or property may increase by a relatively constant amount each period.

Time Value of Money It is easy to find the present value of a uniform gradient series.
Similar to the other types of cash flows, there is a formula (albeit quite complicated) we can use to find the present value, and a set of factors developed for interest tables.

Time Value of Money We can also find A or F equivalent to a uniform gradient series.

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Time Value of Money

The annual equivalent of this series of cash flows can be found by considering an annuity portion of the cash flows and a gradient portion.

End of Year 1 2 3 4

Cash Flows ($) 2,000 3,000 4,000 5,000

End of Year 1 2 3 4

Annuity ($) 2,000 2,000 2,000 2,000

Gradient ($) 0 1,000 2,000 3,000

Sample on Uniform Arith. Gradient

A loan was to be amortized by a group of four end of year payments forming an ascending arithmetic progression. The initial payment was to be P5,000 and the difference between successive payments was to be P400. But the loan was renegotiated to provide for the payment of equal rather than uniformly varying sums. If the interest rate of the loan was 15%, what was the annual payment?

P6,200 P5,800 P5,400 P5,000

P5,000 Yr (1 4)

0 P

0 Pa

P1,200 P800 P400

A Yr (1 4)

= 0 Pg 1 2 3 4 0 P 1 2 3 4

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Solution: Let A = annual payment; A=P5,000; G=P400, n=4; i = 15% P/A,15%,4 = (1-(1.15)^-4)/0.15 = 2.8550 P/G,15%,4 = (1/0.15)[(((1.15)^4-1)/0.15)4][1/((1.15)^4)] = 3.7865 P = A(P/A,15%,4) + G (P/G,15%,4) = (P5,000)(2.8550) + (P400)(3.7865) = P15,789.60 A(P/A,15%,4) = P15,789.60 A = P5,530.51

Time Value of Money Nominal and effective interest rates.

More often than not, the time between successive compounding, or the interest period, is less than one year (e.g., daily, monthly, quarterly). The annual rate is known as a nominal rate. A nominal rate of 12%, compounded monthly, means an interest of 1% (12%/12) would accrue each month, and the annual rate would be effectively somewhat greater than 12%. The more frequent the compounding the greater the effective interest.

Time Value of Money The effect of more frequent compounding can be easily determined.
Let r be the nominal, annual interest rate and M the number of compounding periods per year. We can find, i, the effective interest by using the formula below.

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Time Value of Money Finding effective interest rates.

For an 18% nominal rate, compounded quarterly, the effective interest is.

For a 7% nominal rate, compounded monthly, the effective interest is.

Time Value of Money Continuous compounding interest factors.

The other factors can be found from these.

Sample on Interest
Compare the accumulated amounts after 5 years of P1,000 invested at the rate of 10% per year compounded (a) annually, (b) semi annually, (c) quarterly, (d) monthly, (e) daily, and (f) continuously.

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Solution: Using the formula, F = P (1+i)^n (a) F = P1000 (1+0.10)^5 = P1,610.51 (b) F = P1000 (1+0.10/2)^10 = P1,628.89 (c) F = P1000 (1+0.10/4)^20 = P1,638.62 (d) F = P1000 (1+0.10/12)^60 = P1,645.31 (e) F = P1000 (1+0.10/365)^1825 = P1,648.61 (f) F = Pe^rn = P1000 (e)^(0.10x5) = P1,648.72

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