MS291: Engineering Economy

Chapter 1Foundations Of

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 meplace the most relevant one for this course

A social science that studies how individuals,governments, firms and nations make choices onallocating scarce resources to satisfy their unlimitedwants

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Why Engineer Need to know aboutEconomics ?

Individuals, Engineers, Managers all made choice amongvarious alternatives in their every day life ..Any Example ?

Mostly these choice is associate with money (morespecifically capital or capital funds) but money (orresources) is limited

The selection of any choice depends on the expectedfuture return of each alternative

Engineers plays a vital role in “such decision” due to theirability and experience to design, analyze and synthesize

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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, economicequivalence, and cost estimation) are vital for engineers

A proper economic analysis for selection and executionis a fundamental task of engineering

Why Engineer Need to know aboutEconomics ? (II)

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What is EngineeringEconomy ?

Engineering Economy involves– Formulating– Estimating, and– Evaluating

expected economic outcomes ofalternatives designed to accomplish adefined purpose

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DefinedPurpose

Differentalternativeswith expectedeconomicoutcomes

- Formulate- Estimate- EvaluateExpectedoutcomes of eachalternatives

Select the bestalternative

Where Engineering Economylearning 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 ?1-7

Performing EngineeringEconomy Study

Keeping in mind, what is economics andengineering economy?

For doing any engineering study we willneed to do many things such as: Problemidentifications, its objectives, its variousalternatives, information about eachalternatives, choosing the best among allalternatives etc.

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Steps in an Engineering EconomyStudy

Problem descriptionObjective statement

Available dataAlternatives for solution

Cash flows and otherestimates

Engineering EconomicAnalysis

Measure of worth criterion(PW, B/C, IRR etc)

Best alternative Selection

New Problem description

Step 1 inStudy

Step 2

Step 3

Step 5

Step 4

Step 6

Step 7

One or more approaches tomeet objectives

• Expected life• Revenues• Costs• Taxes• Project Financing

Implementation andMonitoring

New engineering economicstudy begins

Step 1 inStudy

Time Passes

Tools u will be learning inthis course are used here

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

one’s thirst• Utility is the one of the very basic and

important concept of economics

• Marginal Utility refers to Utility derived fromone additional unit of a good

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Law of Diminishing MarginalUtility

0

10

20

30

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1 2 3 4 5 6 7

1 2 3 4 5 6 7

Tota

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ity (U

tils)

Marg

inal

Utilit

y (Ut

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(1)Glass

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(2)Total

Utility,Utils

(3)MarginalUtility,Utils

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TU

MU

Total Utility

Marginal Utility

Units Consumed Per glass

Units Consumed Per glass

Utils refers toUnit in which

utility canbe measured

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Various Type of Costs

• There are different type of costs and can beclassified by various ways

• This lecture includes costs classificationsmostly use by economists

• Fixed & Variable Costs, Average Costs & MarginalCosts, 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. 1-12

Fixed and Variable Costs

• Fixed Costs: those costs that do not vary with thequantity of output produced.…any example ?

Examples: rent to paid for factory building, interest oninvested capital, maintenance, taxes etc

• Variable Costs: are those costs that do vary with thequantity of output produced

Examples: consumption of fuel for power generation ….itwill vary as the production of a factor increases or decrease

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Total Costs

• It maybe noted that Fixed Costs (FC) andVariable Costs(VC) may consist of more thanone component and the sum of all respectivecomponents will make up TFC and TVCrespectively

• Total Costs (TC) is equal to sum of Total FixedCosts (TFC) and Total variable costs (TVC):TC = TFC + TVC 1-14

Average Costs

• Average Costs– Average costs can be determined by dividing the

firm’s 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 addingAverage Fixed Costs (AFC) and Average VariableCosts (AVC) …i.e: ATC = AFC + AVC

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Average Costs

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Fixed cost

Quantity

FCAFC

Q

Variable cost

Quantity

VCAVC

Q

Total cost

Quantity

TCATC

Q

Example: a firm produce 100 units of output at cost of$1000, what is the average cost of the firm?

= 1000/100 => $10

Marginal Costs

• Marginal Cost– Marginal cost (MC) measures the increase in

total cost that arises from an extra unit ofproduction

– Marginal cost helps answer the followingquestion:

• How much does it cost to produce an additional unit ofoutput?

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(change in total cost)

(change in quantity)

TCMC

Q

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 1-18

Opportunity Costs

I got a lottery ofworth Rs 10 millions

(1 core)11 22 33

Ranking the Choices

The Next best use is “buying house” that’s Iforgone for paying my Credit card debts so that’s

my Opportunity cost

Opportunity Cost:The Next Best Decision you could make 1-19

Opportunity Costs• Opportunity cost is the cost of second

best use of the available/usedresources in a certain action

• The opportunity cost of you peoplesitting in this class is …the next bestuse of your this time … in work,recreational activities, sports orfacebooking

• My opportunity cost of teaching youthis Course is …… the time & earningopportunity I forgone to teach you

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Sunk Cost

• Sunk Cost: is the costs thatare incurred in the pastand can not be recoveredby any future action

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• Theory states: ignore sunk costs, because they arepaid in either case, and cannot be recovered

• For example: If you lost the movie ticket worth Rs. 800 - youcan't get it back - if you decide not to buy a second ticket and gohome you won't get the first ticket you lost, back

Sinking fund

• A sinking fund is a fund established byan economic entity by setting aside revenueover a period of time to fund a future capitalexpense, or repayment of a long-term debt

• Sinking funds can also be used to set asidemoney for purposes of replacing capitalequipment as it becomes obsolete, or majormaintenance or renewal of elements of a fixedasset, typically a building

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Operation and Maintenance Cost(O&M Costs)

• Operation and Maintenance Cost is the group of costsexperienced continually over the useful life of theactivity… any example ?

• This includes costs like, labour costs for operating &maintenance personal, fuel and power costs, spareand repair part costs, costs for taxes etc.

• These costs can be substantial and can exceed the initialcosts

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Life-cycle Costs

• Life-cycle - all the time from the initialconception of an idea to the death of aproduct (process)

• Life-cycle costs - sum total of all the costsincurred during the life cycle

• Life-cycle costing - designing a product withan understanding of all the costs associatedwith a product during it’s life-cycle

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Product Life-cycle

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Begin EndTime

Needsassessment

andjustification

Conceptual orpreliminary

design phase

Conceptual orpreliminary

design phase

Detaileddesignphase

Production orConstruction

Phase

OperationalPhase

Decline andretirement

phase

Requirements

OverallFeasibility

ConceptualDesignPlanning

Impact Analysis

Proof ofconcept

PrototypeDevelopmentand testing

Detailed designplanning

Allocation ofresources

Detailedspecification

Componentand supplierselection

Production orconstructionphase

Product,goods andservicebuilt

Allsupportingfacilitiesbuilt

Operational useplanning

Operational Use

Use by ultimatecustomer

Maintenance andsupport

Process,materials andmethods use

Declined andretirementplanning

DecalingUse

Phase out

Retirement

Responsibledisposal

Cumulative Life-cycle CostsCommitted and Dollars Spent

Definition andconceptual design

Detaileddesign Production Operational use Decline/

Retirement

Life-cycle costs committed

Life-cycle costs spent

Project Phase

Tota

l life

-cyc

le co

st %

100%

80%

60%

40%

20%

0%

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Time Value of Money (TVM)

• A Rupee (or dollar) received today is worthmore 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 theinvestment

• Time value of money quantifies the value ofa dollar through time

The time value of money is the most important concept inengineering economy 1-27

Interest

• What is Interest ?– It is the manifestation (or display) of the time value of

money– Fee that one pays to use someone else’s money– Computationally, interest is the difference between an

ending amount of money and a beginning amount ofmoney

• There are two perspectives for interest:1-Borrower’s perspective – Interest paid

Interest Paid= amount owed now – principal2- Lender’s or investor’s perspective – Interest Earned

Interest Earned= Total amount now – principal1-28

Interest Rate &Rate of Return (ROR)

• Interest rate – Interest paid over a time period expressedas a percentage of principal

• ROR refers to Interest earned over a period of timeexpressed as a percentage of the original amount(principal)

interest accrued per time unitRate of return (%) = x 100%

original amount1-29

Interest paid Interest earned

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Interest rate (i) Rate of Return(ROR)

Cash Flows (CFs): Basics

• CFs are amount of money estimated for futureprojects or observed for project events that havetaken place

• CFs are during specific time period

• CF is difficult to estimate as its predicting future

• There are three important concepts related toCash flows: Cash Inflows, Cash Outflows, NetCash flows

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Cash Flows: Terms• Cash Inflows – Revenues (R), receipts,

incomes, savings generated by projects andactivities that flow in. Plus sign used

• Cash Outflows – Disbursements (D), costs,expenses, taxes caused by projects andactivities 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 alternativeCash inflow: Income = $150,000 per month

Range estimate – Min and max values thatestimate 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 makedecisions 1-33

Cash Flow: DiagramsWhat a typical cash flow diagram might look like

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Draw a time line

One timeperiod

Show the cash flows (to approximate scale)

Always assume end-of-period cash flows

Time

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

0 1 2 n-1 n--- --- --- --- ---

0 1 2 n-1 n--- --- --- --- ---

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

- (down) for outflow

Cash Flow Diagram: Example

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

$-2500

$650 $625 $600 $575 $550 $525 $500

$600

Years-7 -6 -5 -4 -2 0 1-1-3

Economic Equivalence

Different sums of money at different times maybe equal in economic value at a given rate

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01

$100 now

$110

Rate of return = 10% per year

$100 now is economically equivalent to $110 one year fromnow, if the $100 is invested at a rate of 10% per year

Year

Economic Equivalence: Combination of interest rate (rate ofreturn) and time value of money to determine different amounts ofmoney at different points in time that are economically equivalent

Commonly used Symbols

t = time, usually in periods such as years or monthsP = value or amount of money at a time t

designated as present or time 0F = value or amount of money at some future

time, such as at t = n periods in the futureA = series of consecutive, equal, end-of-period

amounts of moneyn = number of interest periods; years, monthsi = interest rate or rate of return per time period;

percent per year or month

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Simple and Compound Interest

Simple InterestInterest is calculated using principal onlyInterest = (principal) (number of periods) (interest rate)

I = P x n x i

Example: $100,000 lent for 3 years at simple i = 10%per year. What is repayment after 3 years?

Here P=$100,000n= 3i= 10%

Interest = 100,000(3)(0.10) = $30,000Total due = 100,000 + 30,000 = $130,000

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Simple and Compound Interest

Compound InterestInterest is based on principal plus all accrued interestThat 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 repaymentafter 3 years?Interest, year 1: I1 = 100,000(0.10) = $10,000

Total due, year 1: F1 = 100,000 + 10,000 = $110,000

Interest, year 2: I2 = 110,000(0.10) = $11,000Total due, year 2: F2 = 110,000 + 11,000 = $121,000

Interest, year 3: I3 = 121,000(0.10) = $12,100Total due, year 3: F3 = 121,000 + 12,100 = $133,100

Compounded: $133,100 Simple: $130,0001-40

THANK YOU

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