Engineering Economics

Engineering Economics

1 CHAPTER ONE BASIC CONCEPTS OF ENGINEERING ECONOMY

(EC-3110) By:- Muliye T.ContentBasic Concepts in Engineering Economy Definition of engineering economyRational Decision-Making ProcessEconomic decisionFundamental principles of engineering economy

What is Engineering Economy?Economic decision making for engineering systems is called engineering economy. This definition may seem restricted to engineering projects and systems only, engineering economy however is also study the industrial economics and the economic and financial factors which influence industry. Engineers are the people who are familiar with all the technicalities of machinery and production therefore they are the best judges of the useful lives of an asset and they also have the technical knowledge to calculate the number of units a proposed plant would produce when operational. In todays competitive world of business it has become essential that engineers should practice financial project analysis for engineering projects and make rational decisions.Engineering economy also includes the study of accounting practices for manufacturing concerns. Unique features of accounting for manufacturing concerns are process costing, batch costing, cost allocation.

3Engineering economy deals with justification and selection of projects. Many engineers work on projects which address a specified activity or a problem. Any decision regarding the project must be justified.In business environments, many if not all, decisions are justified using monetary criteria such as profit. Such decisions are made at the managerial level and many engineers become managers in manufacturing environment. Therefore, all engineers, regardless of their employment, should know methods and tools used in evaluation of projects. The purpose of engineering economy is to expose all engineering students to the methods which are widely used for evaluation of projects.Even though, engineering economy deals mostly with selection of projects in business environment, the tools and methods can be and are used by individuals and non-profit organizations such as government, hospitals, and charitable entities, etc.

4SOME EXAMPLESLet us present few examples in different environments where engineering economy can facilitate the decision making process.Business Environment: A small manufacturing company needs to buy a forklift truck for material handling. Two different brands, say A and B, are being considered. Which truck should be bought? The decision will probably be based on minimization of cost.Non-profit Organizations: A project for widening a two lane highway to four lanes is being considered by the county board. A four lane highway may reduce the traffic accident rate but is expected to lower property values in the immediate neighborhood of the highway. Should the proposed highway be built? The county board must weigh the relative benefit of lower accident rates against the possible loss in value of homes as well as the construction cost.Individuals: A new college graduate needs a new car. Should this new car be bought or leased? Methods from engineering economy can be used for determining the best choice.

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Economic factors are as important as regard for the physical laws and science that determine what can be accomplished with engineering. The following figure shows how engineering is composed of physical and economic components: Physical Environment: Engineers produce products and services depending on physical laws. Physical efficiency takes the form:

System output(s)Physical (efficiency) = ------------------------- System input(s)

Economic Environment: Much less of a quantitative nature is known about economic environments -- this is due to economics being involved with the actions of people, and the structure of organizations.

Satisfaction of the physical and economic environments is linked through production and construction processes. Engineers need to manipulate systems to achieve a balance in attributes in both the physical and economic environments, and within the bounds of limited resources.

7Following are some examples where engineering economy plays a crucial role: Choosing the best design for a high-efficiency gas furnace Selecting the most suitable robot for a welding operation on an automotive assembly line Making a recommendation about whether jet airplanes for an overnight delivery service should be purchased or leased Considering the choice between reusable and disposable bottles for high-demand beverages With items 1 and 2 in particular,Note that coursework in engineering should provide sufficient means to determine a good design for a furnace, or a suitable robot for an assembly line, but it is the economic evaluation that allows the further definition of a best design or the most suitable robot.

8Rational Decision-Making ProcessRecognize a decision problemDefine the goals or objectivesCollect all the relevant informationIdentify a set of feasible decision alternativesSelect the decision criterion to useSelect the best alternative91. Recognize the ProblemThe starting point in rational decision making is recognizing that a problem exists.In typical situations, recognition is obvious and immediate.An auto accident, an overdrawn check, a burned-out motor, an exhausted supply of parts all produce the recognition of a problem.Once we are aware of the problem, we can solve it as best we can. Many firms establish programs for total quality management (TQM) or continuous improvement (CI) that are designed to identify problems, so that they can be solved

102.Define the Goal or ObjectiveThe goal or objective can be a grand, overall goal of a person or a firm. For example, a personal goal could be to lead a pleasant and meaningful life, and a firm's goal is usually to operate profitably.The presence of multiple, conflicting goals is often the foundation of complex problems.But an objective need not be a grand, overall goal of a business or an individual. It may be quite narrow and specific: "I want to payoff the loan on my car by May," or "The plant must produce 300 golf carts in the next 2 weeks," are more limited objectives. Thus, defining the objective is the act of exactly describing the task or goal.11

3. Collect all the relevant informationTo make a good decision, one must first collect information. In addition to all the published information, there is a vast quantity of information that is not written down anywhere but is stored as individuals' knowledge and experience. There is also information that remains un gathered. A question like "How many people in your town would be interested in buying a pair of left-handed scissors?" cannot be answered by examining published data or by asking anyone person. Market research or other data gathering would be required to obtain the desired information124.Identify Feasible AlternativesOne must keep in mind that unless the best alternative is considered, the result will always be suboptimal.Two types of alternatives are sometimes ignored. First, in many situations a do-nothing alternative is feasible.This may be the "Let's keep doing what we are now doing," or the "Let's not spend any money on that problem" alternative. Second, there are often feasible (but unglamorous) alternatives, such as "Patch it up and keep it running for another year before replacing it."There is no way to ensure that the best alternative is among the alternatives being considered. One should try to be certain that all conventional alternatives have been listed and then make a serious effort to suggest innovative solutions. 135.Select the decision criterion to use

The central task of decision making is choosing from among alternatives.How is the choice made? Logically, to choose the best alternative, we must define what we mean by best.There must be a criterion, or set of criteria, to judge which alternative is best. Since we are dealing in relative terms, rather than absolute values, the selection will be the alternative that is relatively the most desirable.14

6.Select the best alternativeEarlier we indicated that choosing the best alternative may be simply a matter of determining which alternative best meets the selection criterion. But the solutions to most problems in economics have market consequences, and intangible consequences.Since the intangible consequences of possible alternatives are left out of the numerical calculations, they should be introduced into the decision-making process at this point. The alternative to be chosen is the one that best meets the choice criterion after considering both the numerical consequences and the consequences not included in the monetary analysis.15Engineering Economic Decisions

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PlanningInvestmentMarketingProfitManufacturingPredicting the FutureEstimating a Required investmentForecasting a product demandEstimating a selling priceEstimating a manufacturing costEstimating a product life17Role of Engineers in Business18Create & Design

Engineering ProjectsEvaluate

Expected Profitability Timing of Cash Flows Degree ofFinancial RiskAnalyze

Production Methods Engineering Safety Environmental Impacts Market Assessment

Evaluate

Impact on Financial Statements Firms Market Value Stock PriceTypes of Strategic Engineering Economic Decisions Service Improvement Equipment and Process SelectionEquipment ReplacementNew Product and Product ExpansionCost Reduction

19Service improvement20

Equipment & Process SelectionHow 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.21Equipment Replacement ProblemNow is the time to replace the old machine?If not, when is the right time to replace the old equipment?

22New Product and Product expansionShall we build or acquire a new facility to meet the increased demand?Is it worth spending money to market a new product?

23Cost ReductionShould a company buy equipment to perform an operation now done manually?Should spend money now in order to save more money later?2425Types 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

26Example - Healthcare DeliveryWhich plan is more economically viable?

Traditional Plan: Patients visit each service provider.

New Plan: Each service provider visits patients : patient: service providerFundamental Principles of Engineering EconomicsPrinciple 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 27Principle 1: A nearby dollar is worth more than a distant dollar

28A fundamental concept in engineering economics is that money has a time value associated with it. Because we can earn interest on money received today, it is better to receive money earlier than later. This concept will be the basic foundation for all engineering project evaluation.Principle 2: All it counts is the differences among alternativesOptionMonthly Fuel CostMonthly MaintenanceCash outlay at signingMonthly paymentSalvage Value at end of year 3Buy$960$550$6,500$350$9,000Lease$960$550$2,400$550029Irrelevant items in decision makingPrinciple 3: Marginal revenue must exceed marginal cost30Manufacturing costSales revenueMarginal revenueMarginal cost1 unit1 unit31 marginal revenue must exceed marginal cost Marginal revenue is the additional revenue made possible by increasing the activity by one unit (or a small unit).Similarly, marginal cost is the additional cost incurred by the same increase in activity. Productive resources such as natural resources, human resources, and capital goods available to make goods and services are limited. Therefore, people cannot have all the goods and services they want; as a result. they must choose those things that produce the most.Principle 4: Additional risk is not taken without the expected additional returnInvestment ClassPotential RiskExpected ReturnSavings account (cash)Low/None1.5%Bond (debt)Moderate4.8%Stock (equity)High11.5%32