advanced engineering economy & costing

Advanced Engineering Economy & Costing

D.Prakash

Adminstrative block; Room no: 28

[email protected]

0932120816

mailto:[email protected]

Aim To develop economic and cost analysis models for decisions making.

Course Description

Formulation of economic problems models. Analysis of capital Investments, Decision analysis methods: decision tree analysis, multi-attribute decisions, probabilistic analysis and sensitivity/risk analysis.

Stochastic techniques and risk to evaluate design alternatives, Capital budgeting models: multi-criteria optimization, certainty equivalence. Replacement analysis.

Costing techniques applicable in manufacturing: activity based costing, life cycle costing, theory of constraints, cost of quality.

3

ENGINEERING ECONOMICS INVOLVES:

FORMULATING, ESTIMATING, AND EVALUATING ECONOMIC OUTCOMES

WHEN CHOICES OR ALTERNATIVES ARE AVAILABLE

What Kinds of Questions Can Engineering Economics Answer?

4

How Does It Do This?

BY USING SPECIFIC

MATHEMATICAL RELATIONSHIPS

TO COMPARE THE CASH FLOWS OF THE DIFFERENT ALTERNATIVES

(typically using spreadsheets)

5

Where Does Engineering Economics Fit?

Here is an approach to problem-solving:

• Understand the problem

• Collect all relevant data/information

• Define the feasible alternatives

• Evaluate each alternative

• Select the “best” alternative

• Implement and monitor the decision

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Where Does Engineering Economics Fit?

1. Understand the Problem

2. Collect all relevant data/information (difficult!)

3. Define the feasible alternatives

4. Evaluate each alternative

5. Select the “best” alternative

6. Implement and monitorThis is the major role of engineering economics

Contemporary Engineering Economics, 4th edition, © 2007

7

What Makes the Engineering Economic Decision Difficult? - Predicting the Future

• Estimating a Required investment

• Forecasting a product demand

• Estimating a selling price• Estimating a

manufacturing cost• Estimating a product life


8

Create & Design

• Engineering Projects

Evaluate

• Expected Profitability• Timing of Cash Flows• Degree ofFinancial Risk

Analyze

• Production Methods• Engineering Safety• Environmental Impacts• Market Assessment

Evaluate

• Impact on Financial Statements• Firm’s Market Value• Stock Price

Role of Engineers in Business

The five main types of engineering economic decisions are

(1) service improvement, (2) equipment and process selection,(3) equipment replacement, (4) new product and product expansion, and (5) cost reduction.


10

PresentFuturePast

Engineering EconomyAccounting

Evaluating past performance Evaluating and predicting future events

Accounting Vs. Engineering Economics


11

Fundamental Principles of Engineering Economics

• Principle 1: A nearby dollar is worth more than a distant dollar

• Principle 2: All it counts is the differences among alternatives

• Principle 3: Marginal revenue must exceed marginal cost

• Principle 4: Additional risk is not taken without the expected additional return


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Principle 1: A nearby dollar is worth more than a distant dollar

Today 6-month later


13

Principle 2: All it counts is the differences among alternatives

Option Monthly Fuel Cost

Monthly Maintenance

Cash outlay at signing

Monthly payment

Salvage Value at end of year 3

Buy $960 $550 $6,500 $350 $9,000

Lease $960 $550 $2,400 $550 0

Irrelevant items in decision making


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Principle 3: Marginal revenue must exceed marginal cost

Manufacturing cost

Sales revenueMarginal revenue

Marginal cost

1 unit

1 unit


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Principle 4: Additional risk is not taken without the expected additional return

Investment Class Potential Risk

Expected Return

Savings account (cash)

Low/None 1.5%

Bond (debt) Moderate 4.8%

Stock (equity) High 11.5%

“Simple” Methods

• Simple Payback Period (SPP)- The time required for savings to offset first costs.

• Simple Return on Investment (ROI)- The simple percent return the project pays over its life.

• These methods are “simple” because they do not consider the time value of money.

• Simple methods are OK for investments that are very good and pay off over short time periods.

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Time Value of Money

• Money has value– Money can be leased or rented– The payment is called interest– If you put $100 in a bank at 10% interest for one time

period you will receive back your original $100 plus $10

Original amount to be returned = $100Interest to be returned = $100 x .10 = $10

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Compound Interest• Interest that is computed on the original

unpaid debt and the unpaid interest• Compound interest is most commonly used

in practice• Total interest earned = In = P (1+i)n - P

– Where,• P – present sum of money• i – interest rate• n – number of periods (years)

I2 = $100 x (1+.09)2 - $100 = $18.81

Present and Future Value

• Present Value is the value now of an amount of money F received n years in the future.

• Future Value is value n years in the future of an amount of money P received now.

• If we can earn interest rate i on investments, the relationship between P and F is:

F = P(1 + i)n or P = F/(1 + i)n

ECONOMIC MODELS

• Economic modeling is at the heart of economic theory. • Modeling provides a logical,abstract template to help

organize the analyst's thoughts. • The model helps the economist logically isolate and sort out

complicated chains of cause and effect and influence between the numerous interacting elements in an economy.

• Through the use of a model, the economist can experiment, at least logically, producing different scenarios, attempting to evaluate the effect of alternative policy options, or weighing the logical integrity of arguments presented in prose.

Types of Models

• visual models, • Mathematical models, • Empirical models, • Simulation models.

1. Visual Models - Visual models are simply pictures of an abstract economy; graphs with lines and curves that tell an economic story

2. Mathematical Models The most formal and abstract of the economic models are the purely mathematical models. These are systems

of simultaneous equations with an equal or greater number of economic variables.

3.Empirical Models

• Empirical models are mathematical models designed to be used with data. The fundamental

• model is mathematical, exactly as described above. With an empirical model, however,

• data is gathered for the variables, and using accepted statistical techniques, the data are used to

• provide estimates of the model's values.

• "What will happen to investment if income rises one percent?" The purely mathematical model might only allow the analyst to say, "Logically, it should rise.“

• The user of the empirical model, on the other hand, using actual historical data for investment, income, and the other variables in the model, might be able to say,

"By my best estimate, investment should rise by about two percent."

4.Simulation Models• Simulation models, which must be used with computers,

embody the very best features of mathematical models without requiring that the user be proficient in mathematics.

• The models are fundamentally mathematical (the equations of the model are programmed in a programming language like Pascal or C++) but the mathematical complexity is transparent to the user.

• The simulation model usually starts with initial or "default" values assigned by the program or the user, then certain variables are changed or initialized, then a computer simulation is done.

• The simulation, of course, is a solution of the model's equations. The user can usually alter a whole range of variables at will.

• The computerized simulation model can show the interaction of numerous variables all at once, including hidden feedback and secondary effects that are not so apparent in purely mathematical or visual models.

• Macroeconomic simulation model called HMCMacroSim

Static and Dynamic Models

• Most of the models used in economics are comparative statics models. Some of the more sophisticated models in macroeconomics and business cycle analysis are dynamic models.

• The initial equilibrium (point 'a') identifies the price and level of output that would obtain, given assumptions about supply and demand and the level of inflationary expectations.

• Then the model is shocked by introducing a higher level of expectations, demonstrating a new equilibrium at point 'b'.

• Obviously this movement in equilibria and the shift in the model's solution happened over time, but neither the visual model nor its mathematical counterpart can demonstrate what happened in the interim. The model shows only the starting point and the ending point.

• The comparative statics approach is roughly analogous to using snapshots from a camera to record developments during a dynamic event. With each snapshot a static but informative picture is presented.

Dynamic Model

Why Comparative Statics Models are Usually Used?

• The answer is simple - comparative statics models are much easier to solve.

• Any student of calculus knows the difficulty of solving systems of difference or (especially) differential equations.

• The latter, as soon as they achieve any complexity, are sometimes impossible to solve.

• Therefore dynamic models must be kept extremely simple and are therefore so elementary that more is lost than gained.

• Simple dynamic models, nonetheless, often provide valuable insights into the complex interactions between variables over time.

• They can capture remarkably subtle feedback effects that are easily missed by static models.

• It should be noted that dynamic models are much easier to simulate on computers than they are to solve outright.

• The user can experiment with an endless variety of values and assumptions to see whether results obtained are realistic or insightful. Since computers are now powerful and cheaper, the importance of dynamic simulation models should gradually grow in importance.

Expectations-Enhanced Models

• Economic models often incorporate economic expectations, such as inflationary expectations. Such models are called expectations-enhanced models.

• Generally, expectations-enhanced models include one or more variables based upon economic expectations about future values.

• For example, if consumers, for whatever reason, expect the inflation rate to be much higher next year than this year, they are said to have formed inflationary expectations.

• There are many types of expectations found in economics.

• In addition to inflationary expectations, economists might consider interest rate expectations, income expectations, and wealth expectations. This list is hardly exhaustive.

Adaptive Expectations

• The theory of adaptive expectations presumes that expectations are primarily learned from experience.

• For example, the theory of adaptive expectations would say that if consumers begin to actually see prices rising, say from three percent to five percent to seven percent, over a period of, say, two years, they will begin to form robust expectations of inflationary expectations perhaps even expectations of double-digit inflation.

• The same theory might claim that consumers will expect an economic recovery to begin only after ample evidence that the turning point has been passed.

Rational Expectations• The theory of rational expectations presumes that expectations are

formed when economic agents see new developments in the economy and they logically deduce expectations based upon the information they have.

• For example, if the Federal Reserve System were to suddenly increase the money supply, according to the theory of rational expectations, consumers would immediately form inflationary expectations, not because prices are actually rising, but because they deduce that excessive money supply growth is likely to cause inflation.

• The theory of rational expectations emphasizes the effects of changes in economic policy upon expectations, although the theory is not restricted to policy decisions alone.

The Limitations of Models

• Improper Assumptions• Oversimplification• Mathematical Intractability

The Model as an "Image" of Economic Activity

Two important points are being made here:

1. This model, like most in economies, is not an applied model, where anyone actually uses it to determine appropriate prices and levels of production. (To be more specific, it is not an applied management model; corporations don't use these models to make pricing decisions).

Instead, the model represents a type of consistent behavior that economists see in the marketplace, and it presents an image of that behavior. It allows an economist to both ask and answerthe question, "What would we expect to happen in a market where prices are too high or too

low? What kind of adjustment would take place, and why?“

2. The market reactions of the economic decision-makers are not undertaken by virtue of their use of this model or any other, but is instead motivated by their necessary response to market signals that tell them that they must alter their decisions.

The model, therefore, simply captures their responses to a series of market signals.

Analysis of capital investment

• Present value method• Future value technique• Annual equivalent cost method• Rate of return method

Present value method

– Using the compound interest formulas bring all benefits and costs to present worth

– Select the alternative if its net present worth ≥ 0

• Net present worth =Present worth of benefits – Present worth of costs

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Present Worth Analysis• A construction enterprise is investigating the

purchase of a new dump truck. Interest rate is 9%. The cash flow for the dump truck are as follows:

• First cost = $50,000, annual operating cost = $2000, annual income = $9,000, salvage value is $10,000, life = 10 years. Is this investment worth undertaking?

• P = $50,000, A = annual net income = $9,000 - $2,000 = $7,000, S = 10,000, n = 10.

• Evaluate net present worth = present worth of benefits – present worth of costs

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Present Worth Analysis

• Present worth of benefits = $9,000(PA,9%,10) = $9,000(6.418) = $57,762

• Present worth of costs = $50,000 + $2,000(PA,9%,10) - $10,000(PF,9%,10)= $50,000 + $2,000(6..418) - $10,000(.4224) = $58,612

• Net present worth = $57,762 - $58,612 < 0 do not invest

Future value technique

• The future value technique of evaluating alternatives is almost identical to the present value method except that all costs and revenues are stated in terms of future value.

Annual equivalent cost method• The annual equivalent cost method of evaluating alternative

projects states all costs and revenues over the useful life of the project in terms of an equal annual payment series

1. It requires less effort and fewer calculations.

2. It eliminates the problem of alternatives with incompatible useful lives.

3. It allows for much more sophistication when considering inflation, increasing equipment cost, equipment depreciation schedules, etc.

Rate of Return (ROR)

• The rate of return (ROR) method of comparing alternatives calculates the interest rate for each alternative and selects the highest ROR.

• ROR evaluates INVESTED capital and the costs of operation and maintenance as opposed to revenues or benefits received from the project.

Cost-Benefit AnalysisProject is considered acceptable if B – C ≥ 0 or B/C ≥ 1.• Example (FEIM): The initial cost of a proposed project is $40M, the

capitalized perpetual annual cost is $12M, the capitalized benefit is $49M, and the residual value is $0. Should the project be undertaken?

• B = $49M, C = $40M + $12M + $0• B – C = $49M – $52M = –$3M < 0

• The project should not be undertaken.

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Rational Decision-Making Process

1. Recognize a decision problem2. Define the goals or objectives3. Collect all the relevant

information4. Identify a set of feasible

decision alternatives5. Select the decision criterion to

use6. Select the best alternative

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Which Car to Lease?Saturn vs. Honda

1. Recognize a decision problem2. Define the goals or objectives3. Collect all the relevant

information4. Identify a set of feasible

decision alternatives5. Select the decision criterion

to use6. Select the best alternative

• Need a car

• Want mechanical security • Gather technical as well

as financial data• Choose between Saturn

and Honda• Want minimum total cash

outlay• Select Honda

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Financial Data Required to Make an Economic Decision

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Predicting the Future

• Estimating a Required investment

• Forecasting a product demand

• Estimating a selling price• Estimating a

manufacturing cost• Estimating a product life


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Types of Strategic Engineering Economic Decisions in Manufacturing Sector

Service Improvement Equipment and Process SelectionEquipment ReplacementNew Product and Product ExpansionCost Reduction


56

Service Improvement - Healthcare Delivery Which plan is more

economically viable?

Traditional Plan: Patients visit each service provider.

New Plan: Each service provider visits patients

: patient

: service provider


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Equipment & Process Selection

• How do you choose between the Plastic SMC and the Steel sheet stock for an auto body panel?

• The choice of material will dictate the manufacturing process for an automotive body panel as well as manufacturing costs.


58

Equipment Replacement Problem

• Now is the time to replace the old machine?

• If not, when is the right time to replace the old equipment?


59

New Product and Product Expansion

• Shall we build or acquire a new facility to meet the increased demand?

• Is it worth spending money to market a new product?


60

Types of Strategic Engineering Economic Decisions in Service Sector

Commercial Transportation Logistics and Distribution Healthcare Industry Electronic Markets and Auctions Financial Engineering Retails Hospitality and Entertainment Customer Service and Maintenance

Which Material to Choose?

62

New plant design Upgrade old plant

Alternative 1

Description

Cash flows over some time period

Analysis using an engineering

economy model

Evaluated alternative 1

Noneconomic issues-environmental considerations

Alternative2

Description

Cash flows over some time period

Analysis using an engineering

economy model

Evaluated alternative2

•Income, cost estimations•Financing strategies•Tax laws

•Planning horizon•Interest•Measure of worth

• Calculated value of measure of worth

I select alternative 2

Rate of return (Alt 2) >Rate of return (Alt 1)

Alternatives

Methods of Economic Selection

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Compare the following machines on the basis of their equivalent

uniform annual cost. Use an interest rate of 18% per year.

Comparison pointNew Machine Used Machine

Capital cost 44000 m.u. 23000 m.u.

Annual operating cost

7000 m.u. 9000 m.u.

Annual repair cost210 m.u. 350 m.u.

Overhauling 2500 m.u. every 5 years 1900 m.u. every 2 years

Salvage value 4000 m.u. after 15 years 3000 m.u. after 8 years

Example 7.2

Cash flows of the two machines.

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0 1 2 3 4 5 6 7 8 9 10 11 12 1513 14

i= 18%

m.u.2500 m.u.2500

m.u.7210/year

m.u.44000-2500

New machine

m.u.4000

m.u.2500

EUACnew = 7,210 + (44000 – 2500) (A/P, 18%, 15) + 2500 (A/P, 18%, 5) – 4000 (A/F, 18%, 15)

= 7210 + 41500 (0.18 (1.1815) / (1.1815 – 1)) + 2500 (0.18 (1.185) / (1.185 – 1))

– 4000 (0.18/ (1.1815-1))

EUACnew = 16094.55 m.u. per year.

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EUACused = 9350 + (23000 – 1900) (A/P, 18%, 8) + 1900 (A/P, 18%, 2) – 3000 (A/F, 18%, 8)

= 21100 (0.18 (1.18)8 / (1.188 – 1)) + 9350 + 1900 (0.18 (1.18)2 / (1.182 – 1))

– 3000 (0.18 / (1.188 – 1))

= 15542.4 m.u. per year.

1 2 3 4

0

5

i= 18 %

6 7 8

m.u.23000

m.u.9350/year

m.u.1900 m.u.1900 m.u.1900

Used machine

m.u.3000

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Since we have found that: EUACused <EUACnew

Then it would be more economical to purchase the used

machine instead of the new one.

Providing that both have same productivity and quality.

NB: The overhauling cost is not taken into consideration at the end of the equipment life.

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Spreadsheet Solution for example 7.2

Analysis

The acceptance or rejection of a project based on the IRR criterion is made by comparing the calculated rate with the required rate of return, or cutoff rate established by the firm. If the IRR exceeds the required rate the project should be accepted; if not, it should be rejected.

If the required rate of return is the return investors expect the organization to earn on new projects, then accepting a project with an IRR greater than the required rate should result in an increase of the firms value.

Analysis

There are several reasons for the widespread popularity of the IRR as an evaluation criterion:

– Perhaps the primary advantage offered by the technique is that it provides a single figure which can be used as a measure of project value.

– Furthermore, IRR is expressed as a percentage value. Most managers and engineers prefer to think of economic decisions in terms of percentages as compared with absolute values provided by present, future, and annual value calculations.

AnalysisAnother advantage offered by the IRR method is related to the calculation procedure itself:

As its name suggests, the IRR is determined internally for each project and is a function of the magnitude and timing of the cash flows.

Some evaluators find this superior to selecting a rate prior to calculation of the criterion, such as in the profitability index and the present, future, and annual value determinations. In other words, the IRR eliminates the need to have an external interest

rate supplied for calculation purposes.

Sensitivity and Breakeven Analysis:

• These techniques are used to see how sensitive a decision is to estimates for the various parameters.

• BREAKEVEN ANALYSIS is done to locate conditions under which various alternatives are equally desirable. Examples include single vs. multi-stage construction ,hours of equipment utilization, production volume required, and equipment replacement analysis

Break-Even Analysis

Excel using a Goal Seek function

Analytical Approach

Excel Using a Goal Seek Function

Goal Seek

Set cell:

To value:

By changing cell:

Ok Cancel

? X

$F$5

0

$B$6

NPW

Breakeven Value

Demand

1234567891011121314151617181920212223242526272829303132333435363738394041

A B C D E F G

Example 10.3 Break-Even Analysis

Input Data (Base): Output Analysis:

Unit Price ($) 50$ Output (NPW) $0Demand 1429.39Var. cost ($/unit) 15$ Fixed cost ($) 10,000$ Salvage ($) 40,000$ Tax rate (%) 40%MARR (%) 15%

0 1 2 3 4 5Income Statement Revenues: Unit Price 50$ 50$ 50$ 50$ 50$ Demand (units) 1429.39 1429.39 1429.39 1429.39 1429.39 Sales Revenue 71,470$ 71,470$ 71,470$ 71,470$ 71,470$ Expenses: Unit Variable Cost 15$ 15$ 15$ 15$ 15$ Variable Cost 21,441 21,441 21,441 21,441 21,441 Fixed Cost 10,000 10,000 10,000 10,000 10,000 Depreciation 17,863 30,613 21,863 15,613 5,581

Taxable Income 22,166$ 9,416$ 18,166$ 24,416$ 34,448$ Income Taxes (40%) 8,866 3,766 7,266 9,766 13,779

Net Income 13,299$ 5,649$ 10,899$ 14,649$ 20,669$

Cash Flow StatementOperating Activities: Net Income 13,299 5,649 10,899 14,649 20,669 Depreciation 17,863 30,613 21,863 15,613 5,581 Investment Activities: Investment (125,000) Salvage 40,000 Gains Tax (2,613)

Net Cash Flow (125,000)$ 31,162$ 36,262$ 32,762$ 30,262$ 63,636$

Goal SeekFunctionParameters

Analytical Approach Unknown Sales Units (X)

0 1 2 3 4 5

Cash Inflows:

Net salvage 37,389 X(1-0.4)($50) 30X 30X 30X 30X 30X 0.4 (dep) 7,145 12,245 8,745 6,245 2,230

Cash outflows:

Investment -125,000 -X(1-0.4)($15) -9X -9X -9X -9X -9X -(0.6)($10,000) -6,000 -6,000 -6,000 -6,000 -6,000

Net Cash Flow -125,000 21X + 1,145

21X + 6,245

21X +2,745

21X +245

21X +33,617

PW of cash inflowsPW(15%)Inflow= (PW of after-tax net revenue)

+ (PW of net salvage value) + (PW of tax savings from depreciation

= 30X(P/A, 15%, 5) + $37,389(P/F, 15%, 5) + $7,145(P/F, 15%,1) + $12,245(P/F, 15%, 2)

+ $8,745(P/F, 15%, 3) + $6,245(P/F, 15%, 4) + $2,230(P/F, 15%,5)

= 30X(P/A, 15%, 5) + $44,490

= 100.5650X + $44,490

PW of cash outflows:PW(15%)Outflow = (PW of capital expenditure_

+ (PW) of after-tax expenses= $125,000 + (9X+$6,000)(P/A, 15%, 5)= 30.1694X + $145,113

The NPW:PW (15%) = 100.5650X + $44,490

- (30.1694X + $145,113)=70.3956X - $100,623.

Breakeven volume:

PW (15%) = 70.3956X - $100,623 = 0Xb =1,430 units.

DemandPW of inflow

PW of Outflow NPW

X 100.5650X- $44,490

30.1694X + $145,113

70.3956X-$100,623

0 $44,490 $145,113 100,623

500 94,773 160,198 65,425

1000 145,055 175,282 30,227

1429 188,197 188,225 28

1430 188,298 188,255 43

1500 195,338 190,367 4,970

2000 245,620 205,452 40,168

2500 295,903 220,537 75,366

Outflow

Break-Even Analysis Chart

0 300 600 900 1200 1500 1800 2100 2400

$350,000

300,000

250,000

200,000

150,000

100,000

50,000

0

-50,000

-100,000

Profit

Loss

Break-even Volume

Xb =

1430

Annual Sales Units (X)

PW

(15

%)

Inflow

Scenario AnalysisVariable

ConsideredWorst-Case

Scenario

Most-Likely-Case

Scenario

Best-CaseScenario

Unit demand 1,600 2,000 2,400

Unit price ($) 48 50 53

Variable cost ($) 17 15 12

Fixed Cost ($) 11,000 10,000 8,000

Salvage value ($) 30,000 40,000 50,000

PW (15%) -$5,856 $40,169 $104,295

The decision making processs

• Identifying objectives• Identifying options for achieving the objectives• Identifying the criteria to be used to compare the options• Analysis of the options• Making choices, and• Feedback.

advanced engineering economy & costing

Documents

economics fit

economics answer

cost analysis models

replacement analysis

decision analysis methods

probabilistic analysis

sensitivityrisk analysis

alternatives principle