Engineering Economic AnalysisCanadian Edition

Chapter 1:

Making Economic Decisions

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Chapter 1 … Distinguishes between simple and

complex problems. Discusses the role and purpose of

engineering economic analysis. Describes the economic decision-making

process. Relates economic criteria and problems.

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Decision making Decision making is a major aspect of

everyday life.• Individuals, households, and firms face daily

problems Tools for analyzing and solving the economic

problems faced by engineers are needed. Complex problems can be broken down to

produce sensible solutions. Knowledge of the decision making process

and of the tools used to make comparisons between competing alternatives leads to better decisions.

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People are Surrounded by Problems Which career should I pursue? What level of preparation is required for the

career chosen? Where may the preparation be obtained? How will I get ready and go to class?

The problems are often not isolated from each other.

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Organizations Have Opportunities Should we use a

drilling or boring machine?

When must we replace the drilling machine?

Would a mechanized or computerized machine be the better alternative?

Where do we locate machinery in the plant?

Decisions concerning these opportunities may be arrived at with

the help of economic analysis.

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Problems Problems can be classified into simple,

intermediate, and complex. Classifying problems can be difficult due to

their complexity and ‘personality’.• One approach is to classify a problem according to

its degree of difficulty.

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Simple Problems No requirement for sophisticated models or

extensive analysis Limited number of variables and future

consequences• They are manageable.

Time-value mechanics not crucial• Pay with cash or by credit card?• Travel to work by car or by public transit?• Buy a soft- or hardcover novel?

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Intermediate Problems Must be organized and analyzed Are sufficiently important to justify serious

thought and action Have significant economic aspects Are primarily economic Are the principal subject of this course Assume an economic situation in equilibrium Are generally adequately solved with single-

criteria decision making

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Complex Problems Such problems represent a mixture of three

elements: • economic• political• social

Complex problems are beyond the scope of this course, but the economic aspects of complex problems will be discussed.

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The Role of Engineering Economic Analysis Assists in making decisions where:

• the decision is sufficiently important that serious thought and effort are required;

• careful analysis requires that the decision variables be carefully organized and the consequences be understood;

• economic issues are a significant component of the analysis leading to a decision.

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Examples of Engineering Economic Analysis Focus on costs, revenues, and benefits that

occur at different times• All engineering designs call for spending money.

Engineering questions• Which projects are worthwhile?• How should projects be designed?

Questions or issues for engineers as individuals• How to achieve goals?• Making the best investment decisions

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Economics Economics is the social science that studies

how people cope with the problem of scarcity:• choices made by individuals, businesses, govern-

ments, and societies as they cope with scarcity. Scarcity: inability to satisfy all of a society’s

wants or desires at a specific point in time. Scarcity involves making choices.

• A choice is a tradeoff which involves a cost:giving up something to get something else; the highest-valued alternative given up is the opportunity

cost of the activity chosen.

• Whatever we choose to do, we could have done something else instead.

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Engineering and scientific knowledge

Satisfying Needs: The Engineer’s Role

Social

needs

The engineer

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Two Concerns of Engineering Engineers have the dual task of determining:

1. What society wants (what it needs), and

2. How best to combine economic resources, processes, etc. to produce the goods and services desired by society.

Efficiency: physical and economic efficiency must be considered.

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Physical and Economic Efficiency Physical efficiency

• Measure of the success of engineering activity in the physical environment; ratio of outputs to inputs

• Maximum physical efficiency ratio is 1 (or 100%)• Physical units include BTUs, kilowatt-hours, etc.

Economic efficiency• Ratio of value to cost; must exceed 1 or 100%• An engineer must produce outputs that are most

valued (of greatest satisfaction) by society (economic efficiency)

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Evolution of Economic and Physical Efficiency

1970s+

ECONOMIC SPHERE

ENGINEERING SPHERE

Economic Efficiency

Significant overlap

ENGINEERING SPHERE

1950s

ECONOMIC SPHERE

(Economic

efficiency)

Independent decision making

Physical efficiency

(Physical

efficiency)

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The Decision Making Process

1. Recognize the problem.2. Define the goal or objective.3. Assemble relevant data.4. Identify feasible alternatives.5. Select the criterion for determining the best

alternative.6. Construct a model.7. Predict each alternative’s outcomes or

consequences.8. Choose the best alternative.9. Audit the result.

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In the beginning, the problems are given. Later you might have to

analyze the information provided to determine the real problem.

1. Recognize the Problem A problem exists when:

• a standard or expectation is not being met.• a new standard or expectation is established and

needs to be achieved. (An opportunity.)

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2. Define the Goal or Objective A goal or objective is the standard or

expectation we wish to meet.• A goal is a general statement about what we

expect. Pay all our bills on time.

• An objective is narrow and specific.Schedule a payment to be made on the auto loan on

Tuesday via internet banking.

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3. Assemble Relevant Data Information may be published or come from

individual knowledge. Deciding which data is relevant may be a

complex process. Two important sources of data are the

organization’s accounting and purchasing departments.

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Economic analysis - Inside vs outside supplier

For:Comparison: Inside vs. outside printing of copies for shipping.Requestor: Shipping departmentUnit affected: Printing departmentSupplier: Outside printerRequirements 30,000 copies

Cost per Cost per Absolute/ Possible/Copies 1000 30,000 30,000 30,000

Direct labor 7.60$ 228.00$ Maybe -$ 228.00$ Materials and supplies 9.80$ 294.00$ Yes 294.00$ 294.00$ Overhead costs 9.05$ 271.50$ No -$ -$ Total 26.45$ 793.50$ 294.00$ 522.00$

111.00$ (388.50)$ (160.50)$ Large company savings

Large company

Apparent costPrinting department

Shipping department savings

Printing departmentSavings

Cost saved

Example 1-1

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4. Identify Feasible Alternatives The best alternative should be implemented.

Sometimes, the best alternative is to maintain the current situation, the ‘status quo’.

When alternatives are considered, they should include both conventional and innovative approaches.

Only feasible alternatives should be retained for further analysis.

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5. Select the Criterion to Determine the Best Alternative

A criterion (or a set of criteria) is a standard or a measure of merit that is used to evaluate the alternatives to determine which is best.• The ‘best’ alternative is relative, not absolute.

Selecting criteria to use is not easy because different groups often support different criteria.• The criterion most often used in economic

decision-making is to ‘use money in the most efficient manner’.

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Panoply of Standards The following standards should always be

considered:• Minimize negative environmental consequences.• Improve the distribution of income or wealth.• Minimize costs.• Ensure the gains of winners exceed the losses of

losers.• Maximize profit or sales.• Minimize project completion time.• Minimize the creation of inefficiencies, like

unemployment.

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Three Categories of Economic Decision Making Problems

1. For fixed input situations, maximize the benefits or other outputs.

2. For fixed output situations, minimize the costs or other inputs.

3. Where inputs and outputs vary, maximize (Benefits – Costs).

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6. Construct the Model Model construction requires merging the

various elements: • objective and relevant data,• feasible alternatives, and• selection criteria.

In economic decision making, the models are usually mathematical.

A model is a representation of reality. • A model must represent the important parts of the

system at hand.• A model must be adequate to solve the problem.

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7. Predicting the Outcomes for Each Alternative

To avoid complications, we assume that a decision is based on a single criterion. If necessary, multiple criteria can be combined into a single criterion.

Usually, the consequences or alternatives are stated in the form of money, i.e. costs and benefits.

Costs and benefits may occur over a short or long time period.

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8. Choosing the Best Alternative When choosing the best alternative, both

economic and non-economic criteria must be considered.

During the prior steps in the decision making process, only dominant alternatives may be included based on either economic or non-economic criteria.

The elimination of feasible alternatives may predetermine the outcome of the decision making process.

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9. Audit the Results Compare the results of changes to the

predictions to assure that the chosen alternative was implemented as planned and the results are as expected.• Fix deviations from planned changes.• Make sure prediction errors are not repeated.• Identify added opportunities.

Audits promote realistic economic analysis and implementation.

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Examples Some short time period economic decisions

are illustrated in these three examples.

Examples 1-2, 1-3 and 1-4

Source A B C Mix Mix (min)% sand 25% 40% 28.00% 31%% aggregate 0.00% 0%% course aggregate 75% 60% 72.00% 0%

Cost 3.00$ 4.40$ 3.28$ % of source in mix 80% 20% 0% 100%

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The Engineering Process Key steps by the engineering community

must be taken to ensure that their activities will satisfy social needs/wants.• economic efficiency

Engineering activities that are not valued by society will waste scarce resources.• Increase the gap between social wants and the

capacity to satisfy them.

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Why ‘Engineering Economics’? The engineer has a dual role in both a

consumer and a business decision making. Engineering

• Consider problems in which economic aspects dominate.

Economics• Time-value mechanics• Economic efficiency

Scarcity of resourcesUnlimited social needs

Choices must be made. Not all wants can be satisfied.

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Suggested Problems 1-3, 1-9, 1-14, 1-18, 1-23, 1-31, 1-32, 1-35, 1-

37, 1-38, 1-40, 1-41, 1-42.