Chapter 1 Foundations Of Engineering Economy

MS291: Engineering Economy

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Contents of the Chapter

What is Economics? Why Economics for Engineers ? What is Engineering Economy ? How to Performing Engineering Economy Study ? Some Basic Concepts Utility & Various cost concepts Time value of money (TVM) Interest rate and Rate of Returns Cash Flow Economic Equivalence Simple and compound interest rates
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Setting the Scene

Lets start with a simple question ? What is Economics ? Anyone ? There are variety of definitions of Economics but let me place the most relevant one for this course A social science that studies how individuals, governments, firms and nations make choices on allocating scarce resources to satisfy their unlimited wants

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Why Engineer Need to know about Economics ?

Individuals, Engineers, Managers all made choice among various alternatives in their every day life ..Any Example ? Mostly these choice is associate with money (more specifically capital or capital funds) but money (or resources) is limited The selection of any choice depends on the expected future return of each alternative Engineers plays a vital role in such decision due to their ability and experience to design, analyze and synthesize
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Why Engineer Need to know about Economics ? (II)

Engineers design and create Designing involves economic decisions Why ? Engineers must be able to incorporate economic analysis into their creative efforts Often engineers must select and implement from multiple alternatives Understanding and applying engineering economy tools ( such as time value of money, economic equivalence, and cost estimation) are vital for engineers A proper economic analysis for selection and execution is a fundamental task of engineering
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What is Engineering Economy ?

Engineering Economy involves
Formulating Estimating, and Evaluating expected economic outcomes of alternatives designed to accomplish a defined purpose
Defined Purpose

Different alternatives with expected economic outcomes

- Formulate - Estimate - Evaluate Expected outcomes of each alternatives

Select the1-6 best alternative

Where Engineering Economy learning is useful ?

It is useful in many different engineering decisions How should the engineering project be designed ? Has civil or mechanical engineer chosen the best thickness for insulation ? Which engineering projects should have a higher priority ? Has the industrial engineer shown which factory improvement projects should be funded with the available resources Which engineering projects are worthwhile ? Has the mining or petroleum engineer shown that mineral or oil deposits is worth developing ?
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Performing Engineering Economy Study

Keeping in mind, what is economics and engineering economy? For doing any engineering study we will need to do many things such as: Problem identifications, its objectives, its various alternatives, information about each alternatives, choosing the best among all alternatives etc.
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Steps in an Engineering Economy Study

Step 1 in Study
Step 2

Problem description Objective statement

Available data Alternatives for solution Cash flows and other estimates Measure of worth criterion (PW, B/C, IRR etc) Engineering Economic Analysis Best alternative Selection Time Passes Implementation and Monitoring New Problem description New engineering economic study begins One or more approaches to meet objectives Expected life Revenues Costs Taxes Project Financing

Step 3

Step 4

Step 5

Tools u will be learning in this course are used here

Step 6

Step 7

Step 1 in Study

Utility
What is Utility ? Anyone ? In economics utility refers to the power of a good or service that satisfy human wants E.g. A glass of water has utility that it satisfy ones thirst Utility is the one of the very basic and important concept of economics Marginal Utility refers to Utility derived from one additional unit of a good

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Law of Diminishing Marginal Utility Total Utility

Total Utility (Utils)
(1) Glass of water (2) Total Utility, Utils (3) Marginal Utility, Utils Utils refers to Unit in which utility can be measured

30 TU 20 10 0 Marginal Utility (Utils)

0 1 2 3 4 5 6 7

0 ] 10 ] 18 ] 24 ] ] 28 ] 30 ] 30 28

10 8 6 4 2 0 -2

Units Consumed Per glass

Marginal Utility 10 8 6 4 2 0 -2 1 2 3 4 5 6 7
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MU
Units Consumed Per glass

Various Type of Costs

There are different type of costs and can be classified by various ways This lecture includes costs classifications mostly use by economists Fixed & Variable Costs, Average Costs & Marginal Costs, Private & Social Costs Opportunity Costs Some other important cost concept you may come across: Sunk Cost and Sinking funds, Operation & Maintenance Cost (O&M Costs), Life-cycle Costs etc.
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Fixed and Variable Costs

Fixed Costs: those costs that do not vary with the quantity of output produced.any example ?
Examples: rent to paid for factory building, interest on invested capital, maintenance, taxes etc

Variable Costs: are those costs that do vary with the quantity of output produced
Examples: consumption of fuel for power generation .it will vary as the production of a factor increases or decrease
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Total Costs
It maybe noted that Fixed Costs (FC) and Variable Costs(VC) may consist of more than one component and the sum of all respective components will make up TFC and TVC respectively

Total Costs (TC) is equal to sum of Total Fixed Costs (TFC) and Total variable costs (TVC):
TC = TFC + TVC
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Average Costs
Average Costs
Average costs can be determined by dividing the firms costs by the quantity of output it produces The average cost is the cost of each typical unit of product

Average Costs can also be obtained by adding

Average Fixed Costs (AFC) and Average Variable Costs (AVC) i.e: ATC = AFC + AVC
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Average Costs
Example: a firm produce 100 units of output at cost of $1000, what is the average cost of the firm?
AFC Fixed cost FC Quantity Q

Variable cost VC AVC Quantity Q ATC Total cost TC Quantity Q

= 1000/100 => $10

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Marginal Costs
Marginal Cost
Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production Marginal cost helps answer the following question:
How much does it cost to produce an additional unit of output?

(change in total cost) TC MC (change in quantity) Q

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Private / Social Cost

Private costs (benefits) of an action
accruing to the actor only

Social costs (benefits)

total costs of activity including those that accrue to people other than the actor

Example: driving a car

Private costs: fuel, maintenance Social costs include pollution, road wear
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Opportunity Costs
I got a lottery of worth Rs 10 millions (1 core)

Ranking the Choices

The Next best use is buying house thats I forgone for paying my Credit card debts so thats my Opportunity cost

Opportunity Cost: The Next Best Decision you could make

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Opportunity Costs
Opportunity cost is the cost of second best use of the available/used resources in a certain action The opportunity cost of you people sitting in this class is the next best use of your this time in work, recreational activities, sports or facebooking My opportunity cost of teaching you this Course is the time & earning opportunity I forgone to teach you
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Sunk Cost
Sunk Cost: is the costs that are incurred in the past and can not be recovered by any future action Theory states: ignore sunk costs, because they are
paid in either case, and cannot be recovered
For example: If you lost the movie ticket worth Rs. 800 - you cant get it back - if you decide not to buy a second ticket and go home you wont get the first ticket you lost, back 1-21

Sinking fund
A sinking fund is a fund established by an economic entity by setting aside revenue over a period of time to fund a future capital expense, or repayment of a long-term debt Sinking funds can also be used to set aside money for purposes of replacing capital equipment as it becomes obsolete, or major maintenance or renewal of elements of a fixed asset, typically a building
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Operation and Maintenance Cost (O&M Costs)

Operation and Maintenance Cost is the group of costs experienced continually over the useful life of the activity any example ? This includes costs like, labour costs for operating & maintenance personal, fuel and power costs, spare and repair part costs, costs for taxes etc. These costs can be substantial and can exceed the initial costs
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Life-cycle Costs
Life-cycle - all the time from the initial conception of an idea to the death of a product (process) Life-cycle costs - sum total of all the costs incurred during the life cycle Life-cycle costing - designing a product with an understanding of all the costs associated with a product during its life-cycle

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Product Life-cycle
Begin
Needs assessment and justification

Time

End

Conceptual or preliminary design phase

Detailed design phase

Production or Construction Phase Product, goods and service built All supporting facilities built Operation al use planning

Operational Phase

Decline and retirement phase

Impact Analysis Requirements Overall Feasibility Conceptual Design Planning Proof of concept Prototype Development and testing Detailed design planning

Allocation of resources Detailed specification Component and supplier selection Production or construction phase

Operational Use Use by ultimate customer Maintenance and support Process, materials and methods use Declined and retirement planning

Decaling Use Phase out Retirement Responsible disposal

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Cumulative Life-cycle Costs Committed and Dollars Spent

100% 80% 60% 40% 20% 0%
Definition and conceptual design Detailed design Production Operational use Decline/ Retirement

Life-cycle costs committed

Total life-cycle cost %

Life-cycle costs spent

Project Phase
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Time Value of Money (TVM)

A Rupee (or dollar) received today is worth more than a rupee received tomorrow
because a dollar received today can be invested to earn interest The amount of interest earned depends on the rate of return that can be earned on the investment

Time value of money quantifies the value of a dollar through time

The time value of money is the most important concept in engineering economy
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Interest
What is Interest ?

It is the manifestation (or display) of the time value of money Fee that one pays to use someone elses money Computationally, interest is the difference between an ending amount of money and a beginning amount of money

There are two perspectives for interest: 1- Borrowers perspective Interest paid
Interest Paid= amount owed now principal
2- Lenders or investors perspective Interest Earned Interest Earned= Total amount now principal

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Interest Rate & Rate of Return (ROR)

Interest rate Interest paid over a time period expressed as a percentage of principal

ROR refers to Interest earned over a period of time expressed as a percentage of the original amount (principal)
interest accrued per time unit Rate of return (%) = x 100% original amount
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Interest paid

Interest earned

Interest rate (i)

Rate of Return (ROR)

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Cash Flows (CFs): Basics

CFs are amount of money estimated for future projects or observed for project events that have taken place CFs are during specific time period CF is difficult to estimate as its predicting future There are three important concepts related to Cash flows: Cash Inflows, Cash Outflows, Net Cash flows

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Cash Flows: Terms

Cash Inflows Revenues (R), receipts, incomes, savings generated by projects and activities that flow in. Plus sign used Cash Outflows Disbursements (D), costs, expenses, taxes caused by projects and activities that flow out. Minus sign used Net Cash Flow (NCF) for each time period: NCF = cash inflows cash outflows = R D End-of-period assumption:
Funds flow at the end of a given interest period
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Cash Flows: Estimating

There are two ways for estimating Cash flows: Point estimate A single-value estimate of a cash flow element of an alternative
Cash inflow: Income = $150,000 per month

Range estimate Min and max values that estimate the cash flow
Cash outflow: Cost is between $2.5 M and $3.2 M
- Point estimates are commonly used;
- however, range estimates with probabilities attached provide a better understanding of variability of economic parameters used to make decisions

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Cash Flow: Diagrams

What a typical cash flow diagram might look like Draw a time line
0 1 2 One time period ----Always assume end-of-period cash flows

Time
--- --- --n-1 n

Show the cash flows (to approximate scale)

---

---

--- --- ---

n-1
- (down) for outflow

Cash flows are shown as directed arrows: + (up) for inflow

Remember: One and only one of the perspectives is selected to develop CF diagrams

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Cash Flow Diagram: Example

Plot observed cash flows over last 8 years and estimated sale next year for $150. Draw a Net Cash flow diagram

$650

$625

$600

$600 $575 $550 $525 $500

-7 -6

-5

-4

-3

-2

-1

Years
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$-2500

Economic Equivalence
Different sums of money at different times may be equal in economic value at a given rate
$110
Year

0 1 $100 now

Rate of return = 10% per year

$100 now is economically equivalent to $110 one year from now, if the $100 is invested at a rate of 10% per year Economic Equivalence: Combination of interest rate (rate of return) and time value of money to determine different amounts of money at different points in time that are economically equivalent
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Commonly used Symbols

t = time, usually in periods such as years or months P = value or amount of money at a time t designated as present or time 0 F = value or amount of money at some future time, such as at t = n periods in the future A = series of consecutive, equal, end-of-period amounts of money n = number of interest periods; years, months i = interest rate or rate of return per time period; percent per year or month
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Simple and Compound Interest

Simple Interest
Interest is calculated using principal only Interest = (principal) (number of periods) (interest rate) I=Pxnxi

Example: $100,000 lent for 3 years at simple i = 10% per year. What is repayment after 3 years?
Here P=$100,000 n= 3 i= 10% Interest = 100,000(3)(0.10) = $30,000 Total due = 100,000 + 30,000 = $130,000
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Simple and Compound Interest

Compound Interest
Interest is based on principal plus all accrued interest That is, interest compounds over time
Interest = (principal + all accrued interest) (interest rate)

Interest for time period t is

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Compound Interest Example

Example: $100,000 lent for 3 years at i = 10% per year compounded. What is repayment after 3 years?
Interest, year 1: Total due, year 1: Interest, year 2: Total due, year 2: Interest, year 3: Total due, year 3: I1 = 100,000(0.10) = $10,000 F1 = 100,000 + 10,000 = $110,000 I2 = 110,000(0.10) = $11,000 F2 = 110,000 + 11,000 = $121,000 I3 = 121,000(0.10) = $12,100 F3 = 121,000 + 12,100 = $133,100
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Compounded: $133,100 Simple: $130,000

THANK YOU

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