engeco chap 01 - introduction to engineering economy

Chapter 1Chapter 1

Introduction to Introduction to

ENGINEERING ENGINEERING ECONOMYECONOMY

In this course, you will learn:In this course, you will learn:

The fundamentals of engineering economy (time The fundamentals of engineering economy (time value of money, interest, economic equivalence)value of money, interest, economic equivalence)

To perform the steps in the economic decision To perform the steps in the economic decision making processmaking process– To financially evaluate engineering projects under To financially evaluate engineering projects under

certainty, risk, uncertainty, and multiple optionscertainty, risk, uncertainty, and multiple options– Numerous methods in which to determine the best Numerous methods in which to determine the best

choice from a feasible set with multi-attributeschoice from a feasible set with multi-attributes To solve a variety of problems dealing with To solve a variety of problems dealing with

capital investmentscapital investments

Decision-makingCost-benefit analysis

You will appreciate:You will appreciate:

The difficulty of making a capital investment The difficulty of making a capital investment decision.decision.

The risk associated with capital investments.The risk associated with capital investments. The level at which most companies invest.The level at which most companies invest. The variety of industries affected by engineering.The variety of industries affected by engineering. The entire decision-making process.The entire decision-making process.

SEMESTER JULY 2010 4

An engineering economist draws upon the An engineering economist draws upon the accumulated knowledge of engineering and accumulated knowledge of engineering and economics:economics:

11 Devoted to problem solving / Devoted to problem solving / decision makingdecision making at at operational leveloperational level

22 Identify alternative uses of limited resourcesIdentify alternative uses of limited resources33 Select preferred course of action through evaluations Select preferred course of action through evaluations

using mathematical model and cost datausing mathematical model and cost data


√ √ DECISION MAKING MODELDECISION MAKING MODEL

When we are making a choice in problem solving When we are making a choice in problem solving activities in organization, we are supposed:activities in organization, we are supposed:

To know all the possible alternatives of action.To know all the possible alternatives of action. To foresee the consequences (or the probabilities of the To foresee the consequences (or the probabilities of the

consequences) that will arise from the final choice of each consequences) that will arise from the final choice of each alternative.alternative.

Have a complete system of preference, enabling us to rank Have a complete system of preference, enabling us to rank all consequences from the most to the least preferred, thus all consequences from the most to the least preferred, thus making an optimal choice.making an optimal choice.


Rational Model of Decision Making Consists of a Structured Four-step Sequence:

identifying the problem

generating alternative solutions

selecting a solution

implementing and evaluating the solution


Rational Decision-Making Model


Example: Charlene selects a PumpExample: Charlene selects a Pump

Charlene is a newly hired chemical engineer. Charlene is a newly hired chemical engineer. She has been asked to select a pump to move She has been asked to select a pump to move 15,000 liters of slurry a day to the pollution 15,000 liters of slurry a day to the pollution treatment centre.treatment centre.

What process should she use to select the What process should she use to select the pump?pump?


SOLUTION:SOLUTION:

1.1. Define problem:Define problem: Slurry characteristics – size of particles, corrosivenessSlurry characteristics – size of particles, corrosiveness Pipe size, flow velocities of input and outputPipe size, flow velocities of input and output Any restrictions on the size, power and locationAny restrictions on the size, power and location Time horizon, how soon it is neededTime horizon, how soon it is needed Cost limitsCost limits Vendor selection processVendor selection process

2.2. Choose objectives:Choose objectives: Life cycle cost and technical performanceLife cycle cost and technical performance Vendor and pump reliabilityVendor and pump reliability Maintainability, flexibility for changed conditionsMaintainability, flexibility for changed conditions


3.3. Identify alternatives:Identify alternatives: Purchased from catalogue or other vendor materialPurchased from catalogue or other vendor material Develop alternative specification and request for Develop alternative specification and request for

purchasepurchase4.4. Evaluate consequences:Evaluate consequences: Charlene must evaluate each alternative’s advantages Charlene must evaluate each alternative’s advantages

and disadvantages with respect to the objectives.and disadvantages with respect to the objectives.5.5. SelectSelect Charlene must select a pump based on costs and Charlene must select a pump based on costs and

benefits. Technical performance objectives must be benefits. Technical performance objectives must be completely satisfied, so that any pump with deficiencies is completely satisfied, so that any pump with deficiencies is eliminated from consideration.eliminated from consideration.


6.6. ImplementImplement The pump must be ordered, installed, tested and The pump must be ordered, installed, tested and

commissioned.commissioned.7.7. AuditAudit This step evaluate the pump and the decision-making This step evaluate the pump and the decision-making

process after the pump is in use. The intent is to provide process after the pump is in use. The intent is to provide “lesson learned” to assist future decisions.“lesson learned” to assist future decisions.


Every technical solution has financial Every technical solution has financial consequences.consequences.

Engineering economic analysis Engineering economic analysis determines whether a proposed determines whether a proposed solution is financially viable.solution is financially viable.– Will it pay?Will it pay?– Is this the minimum cost solution?Is this the minimum cost solution?– Will it generate an acceptable return?Will it generate an acceptable return?


Engineering project must be:Engineering project must be:physically realizablephysically realizableeconomically affordableeconomically affordable

Economic factors of a design weigh heavily in the design Economic factors of a design weigh heavily in the design process.process.

Engineering economy is an integral part of that process.Engineering economy is an integral part of that process.

Engineering, without economy, makes no sense at all.Engineering, without economy, makes no sense at all.

(building LRT system in the city of Ipoh . . . physically possible, but is it (building LRT system in the city of Ipoh . . . physically possible, but is it economically viable?)economically viable?)


Bi-environmental nature of engineeringBi-environmental nature of engineeringEngineers are confronted with two important environment, Engineers are confronted with two important environment, the physical and the economic environment.the physical and the economic environment.

Engineers must operate successfully in both sectors and be Engineers must operate successfully in both sectors and be able to cope effectively with the bi-environmental nature of able to cope effectively with the bi-environmental nature of engineering application.engineering application.

Efficiency (physical) = output / inputEfficiency (physical) = output / input

Efficiency (economic) = worth / cost Efficiency (economic) = worth / cost [benefit/cost][benefit/cost]

In final evaluation of most venture, economic efficiencies In final evaluation of most venture, economic efficiencies must take precedence over physical efficiencies.must take precedence over physical efficiencies.


Power plant is profitable in economic terms even Power plant is profitable in economic terms even though its though its physical efficiency in converting units of energy in coal to physical efficiency in converting units of energy in coal to electrical energy is relatively low.electrical energy is relatively low.

Conversion of coal to electrical energyConversion of coal to electrical energy

physical efficiency = 36 %physical efficiency = 36 %

economic efficiency = worth/costeconomic efficiency = worth/cost = 36 % x $14.65/$1.80= 36 % x $14.65/$1.80 = 293 %= 293 %

(OUTPUT Btu: electricity energy has economic worth of $14.65 per (OUTPUT Btu: electricity energy has economic worth of $14.65 per million Btu, INPUT Btu: Coal has economic cost of $1.80 per million Btu)million Btu, INPUT Btu: Coal has economic cost of $1.80 per million Btu)

http://images.google.com.my/imgres?imgurl=http://www.cbc.ca/gfx/pix/nanticoke_power_plant.jpg&imgrefurl=http://www.cbc.ca/story/canada/national/2005/06/15/plant050615.html&h=255&w=220&sz=13&hl=en&start=17&tbnid=8UBfB2jy7tYrYM:&tbnh=111&tbnw=96&prev=/images%3Fq%3Dcoal%2Bpower%2Bplant%26svnum%3D10%26hl%3Den%26lr%3D%26sa%3DG


√ WHAT IS ENGINEERING ECONOMY ?

It is the dollars-and-cents side of the decisions that engineers make or recommend as they work to position a firm to be profitable in a highly competitive marketplace.

Do its benefits exceed its costs ? Involves systematic evaluation of the economic

aspect of the proposal Involves significant technical considerations and

technical analysis To demonstrate a positive balance of long-term

benefits over long-term costs


√ Inherent in these decisions are tradeoffs between costs and performance [such as response time, safety, weight, reliability] provided by the proposed design or solution

Engineering Economy balance this tradeoffs so that the solution or design is economically acceptable and affordable to meet the needs

Engineering Economy consists of techniques for assessing the worth of prospective projects, investments opportunities, or design choices. The reason for worth assessment is to support decisions.


√ √ WHAT IS INVESTMENTWHAT IS INVESTMENT

Two categories:Two categories: FINANCIAL INVESTMENTFINANCIAL INVESTMENT: : investors allocate their resources investors allocate their resources

to some form of financial instrument [stocks or bonds]. A deposit to some form of financial instrument [stocks or bonds]. A deposit in a savings account at a bank is also an investment.in a savings account at a bank is also an investment.

REAL INVESTMENT REAL INVESTMENT (capital investment)(capital investment): : investment in investment in physical asset such as new plant, new equipment, expansion of physical asset such as new plant, new equipment, expansion of an existing facility.an existing facility.

Two different factors involved: Two different factors involved: time and risk.time and risk.SacrificeSacrifice takes place in the takes place in the present present and is and is certaincertain..RewardReward comes comes laterlater, if at all, and the magnitude is , if at all, and the magnitude is uncertainuncertain..

Our primary concern is with Our primary concern is with real (capital / project) investmentsreal (capital / project) investments..


√ √ Any propose investment requires evaluation Any propose investment requires evaluation to ensure or indicate, with reasonable to ensure or indicate, with reasonable confidence, that the expected benefits exceed confidence, that the expected benefits exceed costs.costs.

This economic evaluation is variously referred This economic evaluation is variously referred to as to as economic analysiseconomic analysis, or , or economic decision economic decision analysisanalysis..The application of this economic analysis The application of this economic analysis techniques in the comparison of engineering techniques in the comparison of engineering design alternatives is referred to as design alternatives is referred to as engineering economyengineering economy..


√ √ Strategic Engineering Economic Strategic Engineering Economic DecisionsDecisions

PProject ideas can be classified as:roject ideas can be classified as:

Discretionary (to generate added profit): New product Discretionary (to generate added profit): New product development, product/service capacity expansion, new development, product/service capacity expansion, new equipment and process selectionequipment and process selection

Sustaining investment (preventing loss of profit): Sustaining investment (preventing loss of profit): Service or quality improvement, cost reduction/control, Service or quality improvement, cost reduction/control, equipment replacement.equipment replacement.

Policy or non-economic reasons: such as items Policy or non-economic reasons: such as items required by law, waste treatment facilities, safety to required by law, waste treatment facilities, safety to meet regulations or prevent disasters.meet regulations or prevent disasters.


Profit EnhancingProfit Enhancing Examples Examples

Posco (Korea) said it would invest $12 billion to build an Posco (Korea) said it would invest $12 billion to build an integrated steel plant in India --- capacity of 12 million tons/yr.integrated steel plant in India --- capacity of 12 million tons/yr.

Matsushita and Toray (Japan) will invest 180 billion yen to build a Matsushita and Toray (Japan) will invest 180 billion yen to build a plasma display panel (PDP) plant, increasing production by 6 plasma display panel (PDP) plant, increasing production by 6 million panels/yr.million panels/yr.

Cargill (USA) announced a $20 million investment to increase Cargill (USA) announced a $20 million investment to increase capacity of liquid chocolate and a production line for chocolate capacity of liquid chocolate and a production line for chocolate flakes, drops and chunks in Mouscron, Belgium.flakes, drops and chunks in Mouscron, Belgium.


Cost ControlCost Control Examples Examples

Union Pacific, North America’s largest railroad, Union Pacific, North America’s largest railroad, purchased 98 Rail Power hybrid road switcher purchased 98 Rail Power hybrid road switcher locomotives (Green Goats). The base price is locomotives (Green Goats). The base price is $750K, but a 20-40% reduction in diesel fuel $750K, but a 20-40% reduction in diesel fuel use and greenhouse gas emissions are use and greenhouse gas emissions are expected.expected.

“Union Pacific announces plan to reduce pollution,” Associated Press Newswires, October 16, 2005.Vaccaro, A., “Rail Power Corners Locomotive-Switcher Market,” Dow Jones Newswires, June 9, 2005.


Public Improvement Programs: Public Improvement Programs: government entities also make capital government entities also make capital expenditures.expenditures.

– Increased public satisfactionIncreased public satisfaction– Increased public safetyIncreased public safety– Improved infrastructureImproved infrastructure


√ √ Role of Engineers in Engineering Economic Role of Engineers in Engineering Economic DecisionsDecisions

In manufacturing, Engineers involved in the production of In manufacturing, Engineers involved in the production of products, from conceptual design to the shipping. products, from conceptual design to the shipping. Engineering decisions account for the majority of the Engineering decisions account for the majority of the product costs.product costs.

Consider the Consider the effective use of capital assetseffective use of capital assets (building, (building, machinery, equipment). machinery, equipment).

PlanPlan for the for the acquisition of equipment acquisition of equipment (capital expenditure) (capital expenditure) to enable the firm to design and produce products to enable the firm to design and produce products economically.economically.


√ √ Need to Need to estimate the cash flowsestimate the cash flows that the that the assets will generate during its service period.assets will generate during its service period.InaccurateInaccurate estimates of asset needs can estimates of asset needs can have serious consequences to the profitability have serious consequences to the profitability of the firm.of the firm.


√ √ The The importance importance of Engineering Economic of Engineering Economic Decision Analysis Decision Analysis

Companies must invest to grow.Companies must invest to grow. Companies must invest to improve.Companies must invest to improve. Investments cost (lots of) Investments cost (lots of) money!money!

– Economic Analysis considers the economic Economic Analysis considers the economic viability of each and every investment project viability of each and every investment project such that money is made, not lost.such that money is made, not lost.


√ √ TheThe Difficulty Difficulty of Engineering Economic of Engineering Economic Decision AnalysisDecision Analysis

Investments carry Investments carry riskrisk.. Money spent now for expected savings or Money spent now for expected savings or

returns in the returns in the futurefuture..– As future is uncertain, so are returns or savings.As future is uncertain, so are returns or savings.

Money spent can be lost. If too often, could lead to Money spent can be lost. If too often, could lead to bankruptcy.bankruptcy.

While economics are paramount, many other While economics are paramount, many other factors influence decision factors influence decision (non-monetary)(non-monetary). . What are What are the other factors?the other factors?


√ WHY IS ENG ECO IMPORTANT

Some key questions that need to be addressed:

For Manufacturing activities Should a manufacturing plant produce a part in its

production facility, knowing that major investment will be needed in new equipment and that expensive training procedures will have to be implemented, or should the plant subcontract to an outside vendor?

Should automation replace the existing process


For individuals

The owner of a wholesale distribution centre seeks to improve her delivery service in order to meet competition.

To do so, she can buy or rent more trucks, subcontract deliveries, open additional outlets, and/or improve the handling facilities.

Capital is limited, and the outlook for increased volume is uncertain. Which alternative should be selected. Doing nothing is always one possible alternative.


√ √ APPARENT CHARACTERISTICS OF APPARENT CHARACTERISTICS OF THE QUESTIONSTHE QUESTIONS

Two characteristics are apparent in the questions :Two characteristics are apparent in the questions :

1.1. Each deals with a Each deals with a choice among alternativeschoice among alternatives

2.2. All involves All involves economic considerationseconomic considerations


√ PRINCIPLES OF ENGINEERING ECONOMY

Firstly, the problem (opportunity) to be solved has to be recognized and the needs have to be identified.Then the following principles shall be followed: Develop (identify and define) the alternatives Focus on the differences of the expected future outcomes

among the alternatives Use consistent viewpoint Use a common unit of measure Consider all relevant criteria Recognize the uncertainty of the future outcomes Revisit your decisions (compare the actual results)


Explain the reasons for the need to focus only on the Explain the reasons for the need to focus only on the differences in the expected future outcomes among the differences in the expected future outcomes among the alternatives in the engineering economic analysis.alternatives in the engineering economic analysis.

Sample answer:Sample answer:If the prospective outcomes of the feasible alternatives If the prospective outcomes of the feasible alternatives were exactly the same, there would be no basis or need were exactly the same, there would be no basis or need for comparison. In this case decision can be made by for comparison. In this case decision can be made by random selection.random selection.For example, two feasible housing alternatives are two For example, two feasible housing alternatives are two residences with same purchase price of RM150,000. In residences with same purchase price of RM150,000. In this case, price would be inconsequential to the final this case, price would be inconsequential to the final choice. Instead, decision would depend on other factors choice. Instead, decision would depend on other factors such as location, design of the house, etc.such as location, design of the house, etc.


√ SEVEN-STEP ECONOMIC ANALYSIS PROCEDURE

Problem (opportunity) recognition, definition, and evaluation

Development of the feasible alternatives Development of prospective outcomes (use the basic

cash flow approach employed in Engineering Economy)

Selection of a Decision Criterion Analysis and comparison of alternatives Selection of the preferred alternative Performance monitoring and post-evaluation of

results

Engineering Economic Analysis Procedure Rational Decision-making Process

Step1. Problem recognition, definition, and evaluation

Activity 1. Problem identificationActivity 2. Identification of objectives with respect to problem

Step 2. Development of the feasible alternative Activity 3. Comprehensive search for alternative course of action

Step 3. Development of the outcomes and cash flows for each alternative

Activity 4. Objective evaluation of alternatives

Step 4. Selection of a criterion (or criteria)

Step 5. Analysis and comparison of the alternatives Activity 5. Selection of alternative most likely to achieve objectives

Step 6. Selection of the preferred alternative Activity 6. Implementation of chosen course of action

Step 7. Performance monitoring and post-evaluation of results

Activity 7. Monitoring consequences with respect to objectivesActivity 8. If unsatisfactory, repeat process as necessary


The General Relationship between the Engineering Economy Analysis Procedure and the Rational Decision-making Process

Decision Step Decision Step Engineering Field of StudyEngineering Field of Study 1. Problem recognition 1. Problem recognition Engineering designEngineering design and definition. and definition. 2. Generation of solution 2. Generation of solution Organizational behaviorOrganizational behavior alternatives. alternatives. Human factors Human factors

Engineering design Engineering design 3. Cost and cash-flow 3. Cost and cash-flow Work measurement systemsWork measurement systems estimation. estimation. Statistics (regression, forecasting) Statistics (regression, forecasting)

Accounting Accounting 4. Economic evaluation. 4. Economic evaluation. Engineering economy Engineering economy

Operations research Operations research 5. Selection and 5. Selection and Engineering economyEngineering economy implementation. implementation. Statistics and probability Statistics and probability

Operations research Operations research Simulation Simulation 6. Post-implementation 6. Post-implementation Information systems (data-base)Information systems (data-base) evaluationevaluation



√ Examples of decisions supported by Engineering Economy calculation

1.1. A chemical engineer determines the appropriate A chemical engineer determines the appropriate diameter of a pipeline, knowing that a greater diameter of a pipeline, knowing that a greater diameter will decrease pumping costs throughout diameter will decrease pumping costs throughout the life of the line but will increase purchase and the life of the line but will increase purchase and installation costs.installation costs.

2.2. A warehouse manager reviews stock levels of A warehouse manager reviews stock levels of various stocked items, wanting to minimize the various stocked items, wanting to minimize the sum of holding costs and stock out costs.sum of holding costs and stock out costs.

3.3. A mechanical engineer determines the appropriate A mechanical engineer determines the appropriate balance between adding insulation to a building balance between adding insulation to a building and increasing the capacity of its cooling plant.and increasing the capacity of its cooling plant.


4.4. A corrosion engineer estimates whether it is A corrosion engineer estimates whether it is better to use stainless steel and replace a better to use stainless steel and replace a tank every five years or use carbon steel tank every five years or use carbon steel and replace it every three years.and replace it every three years.

5.5. An electrical engineer estimates the costs of An electrical engineer estimates the costs of installing capacitor bank to alleviate the installing capacitor bank to alleviate the phase lag that lowers power factor and phase lag that lowers power factor and leads to high electricity bill.leads to high electricity bill.


DiscussionDiscussion 1.1. Why is the study of engineering economy by Why is the study of engineering economy by

engineers and technologists more important today engineers and technologists more important today than in the past?than in the past?

2.2. Explain the role of economic considerations in Explain the role of economic considerations in product competitiveness.product competitiveness.

3.3. Why should the economic interpretation of Why should the economic interpretation of engineering proposals be made by engineers?engineering proposals be made by engineers?

4.4. Discuss some of the moral (non-monetary) issues or Discuss some of the moral (non-monetary) issues or obligation that should be considered by engineers in obligation that should be considered by engineers in the analysis of engineering proposals.the analysis of engineering proposals.


Discussion Q1:Discussion Q1:

1.1. Why is the study of engineering economy by engineers and Why is the study of engineering economy by engineers and technologists more important today than in the past?technologists more important today than in the past?

Prerequisite of successful engineering application is Prerequisite of successful engineering application is economic feasibilityeconomic feasibility

Intense economic competitionIntense economic competition Sustainable competitive advantage in the marketplaceSustainable competitive advantage in the marketplace



2.2. Explain the role of economic considerations in product Explain the role of economic considerations in product competitivenesscompetitiveness..

View in the context of product life cycle.View in the context of product life cycle.



3.3. Why should the economic interpretation of engineering Why should the economic interpretation of engineering proposals be made by engineers?proposals be made by engineers?

View and elaborate from the engineering process involved View and elaborate from the engineering process involved in analyzing an engineering proposal:in analyzing an engineering proposal:

Determination of objectiveDetermination of objective Identification of strategic factorsIdentification of strategic factors Determination of meansDetermination of means Evaluation of engineering proposalEvaluation of engineering proposal Assistance in decision makingAssistance in decision making


Discussion Q4:Discussion Q4:4.4. Discuss some of the moral (non-monetary) issues or obligation Discuss some of the moral (non-monetary) issues or obligation

that should be considered by engineers in the analysis of that should be considered by engineers in the analysis of engineering proposals.engineering proposals.Your views may include the following points:Your views may include the following points:

Political stabilityPolitical stability Welfare of employees: morale, quality of life, stability, etcWelfare of employees: morale, quality of life, stability, etc PrestigePrestige Safety and Environmental considerationsSafety and Environmental considerations Sustainable developmentSustainable development Product specification – minimal compliance / exceeding specificationsProduct specification – minimal compliance / exceeding specifications Future considerationsFuture considerations Taking personal responsibilityTaking personal responsibility Engineering decisions – engineers take professional responsibilityEngineering decisions – engineers take professional responsibility


√ √ Group Assignment #1Group Assignment #1Size of group: max 4 students)Size of group: max 4 students)

Review the contents of the business section of Malaysian Review the contents of the business section of Malaysian newspaper namely the Star, New Straits Times, Edge newspaper namely the Star, New Straits Times, Edge (Malaysia) for the past weeks.(Malaysia) for the past weeks.

Select three (3) business investment decisions (for each Select three (3) business investment decisions (for each type of strategic engineering economic decisions type of strategic engineering economic decisions discussed in Chapter 1) that appeared in the news. Justify discussed in Chapter 1) that appeared in the news. Justify your answer.your answer.

(Submit this assignment not later than 6(Submit this assignment not later than 6thth August 2010) August 2010)

engeco chap 01 - introduction to engineering economy

Documents

expected future

economic considerations

prospective

rational decision

capital investments

economic interpretation

engineering

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