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Chapter 1

important to Engineers?

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.

1

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.

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.

2

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.

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?

3

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)

estimated variables!

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.

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.

4

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.

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”.

5

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.

•Money can “make” money if

Invested

•Money made depends on the

interest rate

a given time period is called the time

value of money; by far, the most

important concept in engineering economy

6

Interest Rates

Investment:

Loan:

INTEREST = CURRENT TOTAL OWED - ORIGINAL AMOUNT

Interest Rate

- Interest paid per unit time.

INTEREST RATE =

ORIGINAL AMOUNT

Lending situation

Investing situation

7

Rate of Return (ROR)

- Interest accumulated per unit time.

RATE OF RETURN =

ORIGINAL AMOUNT

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

$16,500 one year from now IF the interest

rate is 10%/year.

8

Economic Equivalence

$16,500

Cash Flow Diagram:

$15,000

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 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.

9

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)

10

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.

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.

future time on the cash flow diagram. F is also

called future worth (FW) and future value (FV) in

dollars.

11

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.

12

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