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CE 314 Engineering Economy

Chapter 1

Foundations of Engineering Economy

Why is the study of Engineering Economy


important to Engineers?

Engineers are called upon to analyze and select the


most economical alternative among several design
alternatives.
Engineers often play a major role in investment
decisions based on the analysis and design of new
products or processes.
Decisions made by the engineer during the
engineering phase of a product’s development
determine the majority of the costs of
manufacturing the product.

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What is Engineering Economy?

Two Definitions:
Engineering Economy is a collection of mathematical
techniques that simplify economic comparisons.
Engineering Economy involves formulating, estimating,
and evaluating the economic outcomes when
alternatives to accomplish a defined purpose are
available.

An Engineering Economic Decision


A local Manufacturing Firm produces crankshafts.
They have been using a lathe that was purchased
twelve years ago. As the production engineer in
charge of producing the crankshafts, you expect
demand to continue into the foreseeable future.
Over the past two years the lathe has broken
frequently and has now stopped operating altogether.
You must now decide to repair the lathe or purchase
a new lathe or if a more efficient lathe will be
available in the future you may wait to buy the new
lathe in a couple of years. The economic decision is
whether you should make the considerable
investment in a new lathe now or later. Complicating
the decision is the fact that the demand for
crankshafts has begun to decline.

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What do we need to know to make a decision?
We basically have two alternatives:
1) Repair the existing lathe
2) Purchase a new lathe now or later
For the existing lathe we need to know:
The cost of repairing the lathe.
Frequency or Probability of break down of the lathe.
Time when the lathe becomes obsolete.
Estimate the future demand for the crankshafts.
Estimate the salvage value or cost to remove the old lathe.

For the new lathe we need to know:


The cost of the new lathe including installation.
The cost of educating the operator to use the new lathe.
How often will the lathe require repairs and how much will cost?
The estimated economic and service life of the new lathe.
The estimated salvage value of the new lathe.
Are there any additional operational costs to the new lathe over
the old lathe?
Will the operational costs increase as the new lathe ages?
If so how much will they increase over the years?
Will the new lathe produce more crankshafts to increase income?
What are the tax implications of purchasing the new lathe?
Will the new lathe enhance or lower employee morale?
What are the financing costs of purchasing the new lathe?

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Many of these questions may be difficult to answer!
That is why Engineers make the big bucs! (pun intended)
My suggestion is to purchase an ACME 3000 crystal ball or
to hire a personal Psychic.
Or you can call the McGinnis Psychic hotline at 1-800-
GETREAL. (if no one answers it is just a joke)

Bottom Line: Your analysis is only as good as your


estimated variables!

Good News for you:


At this point in your career you are only learning the
techniques for making economic comparisons. The data will be
given to you for you to learn how to make economic analyses.

Economic Decision-Making Process


1) Collect relevant information regarding the project:
Initial Costs: Design, Manufacturing, Marketing, Testing,
Installation, Construction, Taxes, Down payments,
etc.
Annual Costs: Operating, Maintenance, Finance Payments,
Insurance, Income Taxes, etc.
Periodic Costs: Overhauls, Improvements and Modifications.
Annual Receipts: Income generated and Savings due to increased
Productivity.
Salvage Value: Income generated by sale or cost to remove
obsolete equipment.
Financing Method and Interest Rate.

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Economic Decision-Making Process
2) Recognize and Define Feasible Alternatives:
Consider all possible options including the “DO NOTHING”
alternative.
The generated alternatives may not be economically viable.
Examine each alternative and remove any overlapping options.
If the productivity is the about the same for each alternative,
focus only on the costs.
3) Consider the future consequences of each alternative:
Look at environmental impacts, effects on employee productivity,
marketing potential, public relations, etc.
4) Determine whose viewpoint is to be selected when evaluating
alternatives:
Private vs. Governmental viewpoint. Very important when the
public sector is involved.

Economic Decision-Making Process


5) The consequences of each alternative must be expressed in
monetary units for us “dollars”:
You must consider the “time value of money”. It is sometimes very
difficult to put a monetary value on a consequence.
6) When comparing alternatives, focus on the differences between
the alternatives:
The past is common to all alternatives: look towards the future
when comparing alternatives. There can be no consequences
before the moment of decision.
7) Develop several criteria to be used in evaluating the alternatives:
Primary criterion: Economic analysis of alternatives based on a
Minimum Attractive Rate of Return (MARR) value.
Secondary criterion: Look at “intangibles” and “side-effects”.

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Economic Decision-Making Process
8) Evaluate each alternative, using a sensitivity analysis to enhance
the evaluation:
Evaluation methods include: Present Worth (PW), Annual Worth
(AW), Future Worth (FW), Rate of Return (ROR), Capitalized Cost
(CC), Benefit/Cost Ratio (B/C) and Payback Period Analysis using a
Minimum Attractive Rate of Return (MARR).
9) Select the best alternative based on the economic analysis while
remembering the secondary criterion.

•Time Value of Money Concept:


•Money can “make” money if
Invested
•Money made depends on the
interest rate

The change in the amount of money over


a given time period is called the time
value of money; by far, the most
important concept in engineering economy

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Interest Rates

Interest: Money paid for the use of money

Investment:

INTEREST = CURRENT VALUE - ORIGINAL AMOUNT

Loan:
INTEREST = CURRENT TOTAL OWED - ORIGINAL AMOUNT

The original amount of the loan is called the “Principal”.

Interest Rate
- Interest paid per unit time.

INTEREST PAID PER TIME UNIT


INTEREST RATE =
ORIGINAL AMOUNT

The interest rate is expressed as a percentage.

Remember: Interest can be viewed from two perspectives:


Lending situation
Investing situation

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Rate of Return (ROR)
- Interest accumulated per unit time.

INTEREST ACCRUED PER TIME UNIT


RATE OF RETURN =
ORIGINAL AMOUNT

The rate of return is expressed as a percentage.

Economic Equivalence
Two sums of money at two different points in
time can be made economically equivalent if:
• We consider an interest rate and,
• The number of time periods between the two sums

Equality in terms of Economic Value

$15,000 now is economically equivalent to


$16,500 one year from now IF the interest
rate is 10%/year.

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Economic Equivalence
$16,500
Cash Flow Diagram:

10% Per Year 1 Year

$15,000

Interest Paid = Principal (Interest Rate)


Interest Paid = $15,000 (0.10) = $1,500
Amount After one Year = Principal + Interest
Amount After one Year = $15,000 + $1,500 = $16,500

Simple and Compound Interest

Two “types” of interest calculations


Simple Interest
Compound Interest
Compound Interest is more common worldwide and
applies to most analysis situations. Although some
institutions do pay simple interest on savings
accounts and most bonds pay simple interest.

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Simple Interest
Calculated on the principal amount only
Easy to calculate
The formula for Simple Interest is:
I = (Principal)(Number of Time Periods)(Interest Rate)

I = (P)(n)(i)

Compound Interest
Calculated on the principal amount plus the total
amount of interest accumulated in previous
periods.
Compound Interest can be computed using the
formula for Simple Interest:
Interest = (Principal + All Accrued Interest)(Interest Rate)

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Example:
An individual borrows $18,000 at an interest rate
of 7% per year to be paid back in a lump sum
payment at the end of 4 years. Compute the total
amount of interest charged over the 4-year period
using the simple interest and compound interest
formulas. Compute the total amount owed after 4
years using simple and compound interest.

Terminology and Symbols:

P represents the value or amount of money at a


time designated as the present or time t=0 on the
cash flow diagram. P is also referred to as present
worth (PW), present value (PV), net present value
(NPV), discounted cash flow (DCF), and capitalized
cost (CC) in dollars.

F represents the value or amount of money at some


future time on the cash flow diagram. F is also
called future worth (FW) and future value (FV) in
dollars.

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Terminology and Symbols:
A represents a series of consecutive, equal, end-
of-time-period amounts of money. A is also called
the annual worth (AW) and equivalent uniform
annual worth (EUAW) in dollars per year, dollars
per month, etc.
n represents the number of interest periods in
years, months, days, etc.
i represents the interest rate or rate of return
per time period in percent per year, percent per
month, etc.
t represents time stated in years, months, days,
etc.

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