engineering economics notes(1)

8/4/2019 Engineering Economics Notes(1)

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Q. Define inflation and deflation. Briefly explain three type of inflation. What are the effectsof inflation and what are the remedies for inflation?

Definition of Inflation & Deflation:

Inflation is process in which the price level is rising at rapid rate and the money is losing itsvalue. Inflation refers to the continual increase in prices. The value or purchasing power of money refers to the amount of goods or services on pound can buy.

Inflation means the value of money is falling because prices keep rising.

Inflationary pressures can come from domestic and external sources and from both the supplyand demand side of the economy.

Deflation occurs when the general level of prices is falling.

Deflation has been rare in the late twentieth century.

Types of Inflation:

Moderate Inflation is characterized by slowly rising prices (single-digit annual inflation rate).

Galloping Inflation is characterized in the double- or triple-digit range.

Hyperinflation occurs when prices rise at a thousands, million or trillion percent annually.Excess printing of paper currency is considered to be one of the principal causes of Hyperinflation. E.g. War situation also result in Hyperinflation e.g. Germany and Hungary caseafter WWW 1, inflation was in billions annually.

Causes of Inflation:

The causes of Inflation are generally grouped under two main heads.

1. Demand Pull Inflation

2. Cost pull Inflation

Demand Pull Inflation :

An Inflation that results from increase in aggregate demand not matches by increase in aggregatesupply is called demand pull inflation. Demand pull inflation occurs when there is too muchmoney chasing too few goods because the demand for current output exceeds supply.

Fasih Ahmed Khan, CU-513A,Final Year Civil Engineering Deptt, Roll # 16 Page 1


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Aggregate Demand > Aggregate Supply

A major source of Infaltionary pressure is the government, which can print money to buy goods.The monetarist view if inflation can be stated in the equation.

MV=PTWhere M = The money supply,

V = The number of times each pound changes hands( the velocity of circulation)

P = The average price of goods

T = The number of goods bought (transaction)

Monetarists belive that the value of V and T are fixed so that any increase in M, the moneysupply must raise P, the level of prices, i.e. be inflationary.

Factors:

The factors that bring about the increase in aggregate demand or rise in the general level of prices are grouped under two separate heads;

1. Factors operation on the demand side

2. Factors operating on the supply side.

Factors operating on the demand side whcih bring continous rise in the general price level:

Increase in money supply

Increase in government expenditure

Increase in private expenditure

Increase in population

Black money

Factors causing decrease in the supply of goods:

Lagging agricultural and industrial production

Inadequate Infrastructure facilities

Long gestation period



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Demand Pull Inflation can be curbed through the adoption of proper deflationary monetary andfiscal policies.

Cost Pull Inflation:The cost push inflation occurs when there is an increase in the costs. Cost Puch inflation occurswhen a firm passes on an increase in production cost to the consumer. When prices increase

because payments to one or more group of resources owners rise faster than productivity, it isthen caught with cost push inflation. The main causes of cost push inflation are:

Increase in money wages rates

Profit push inflation

Material push inflation Higher taxes

Effects of Inflation:

Inflation affects both the economy of a country and its social conditions, as well as the politicaland moral lives of its inhabitants. However, the economic effects of Inflation are stated anddescribed below:

Price inflation has immense effect on the Time Value of Money (TVM). This acts as a principal component of the rates of interest, which forms the basis of all TVM calculations. Thereal or estimated changes occurring in the rates of inflation lead to changes in the rates of interest as well.

Inflation exerts impact on the treasury of a nation as well. In United States of America,Treasury Inflation-protected Securities (TIPS) ensures safety to the American government,assuring the public that they will get back their money. However, the rates of interest charged

by TIPS are less compared to the standard Treasury notes.

The most immediate effect of inflation is the decrease in the purchasing power of dollar and its depreciation. Inflation influences the investments of a country. The Inflation-protected

Securities (IPSs) may act as a guard against the loss in the purchasing power of the fixed-income investments (like fixed allowances and bonds), which may occur during inflation.

Inflation changes the allocation of income. This exerts maximum effect on the lendersthan the borrowers at the time of persisting inflation, because the loans sanctioned previouslyare paid back later in the form of inflated dollars.



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Inflation leads to a handful of the consumers in making extensive speculation, to deriveadvantage of the high price levels. Since some of the purchases are high-risk investments, theyresult in diversion of the expenditures from regular channels, giving birth to a few structuralunemployment



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REMEDIES OF INFLATION The first panacea for a mismanagement nation is inflation of the currency. The second is war.Both bring a permanent ruin.

Cost Pull Inflation

1. Introduce a price and income policy to free price and wage increases

2. Encourage an appreciation

3. Reduce indirect taxation

Demand Pull inflation Remedies:

1. Reduce government spending

2. Increase income tax to reduce consumer spending

3. Reduce people ability to borrow money by increasing interest rates and tightening creditregulations.



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Q. What is Break Even Analysis? Discuss why this technique is used in economics analysis? Draw also break even analysis graph / chart which shows the different costs, revenue loss and profit in it.

Break Even Analysis:

In economics & business, specifically cost accounting , the break-even point (BEP) is the point atwhich cost or expenses and revenue are equal: there is no net loss or gain, and one has "brokeneven". A profit or a loss has not been made, although opportunity costs have been paid, andcapital has received the risk-adjusted, expected return.

Computation:

In the linear Cost-Volume-Profit Analysis model, the break-even point (in terms of Unit Sales(X)) can be directly computed in terms of Total Revenue (TR) and Total Costs (TC) as:

where:

TFC is Total Fixed Costs ,

P is Unit Sale Price, and

V is Unit Variable Cost.

The Break-Even Point can alternatively be computed as the point where Contribution equals Fixed Costs .

http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Businesshttp://en.wikipedia.org/wiki/Cost_accountinghttp://en.wikipedia.org/wiki/Opportunity_costhttp://en.wikipedia.org/wiki/Cost-Volume-Profit_Analysishttp://en.wikipedia.org/wiki/Fixed_Costshttp://en.wikipedia.org/wiki/Fixed_Costshttp://en.wikipedia.org/wiki/Contribution_marginhttp://en.wikipedia.org/wiki/Contribution_marginhttp://en.wikipedia.org/wiki/Contribution_marginhttp://en.wikipedia.org/wiki/Fixed_Costshttp://en.wikipedia.org/wiki/Fixed_Costshttp://en.wikipedia.org/wiki/File:CVP-FC-Contrib-PL-BEP.svghttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Businesshttp://en.wikipedia.org/wiki/Cost_accountinghttp://en.wikipedia.org/wiki/Opportunity_costhttp://en.wikipedia.org/wiki/Cost-Volume-Profit_Analysishttp://en.wikipedia.org/wiki/Fixed_Costshttp://en.wikipedia.org/wiki/Contribution_marginhttp://en.wikipedia.org/wiki/Fixed_Costs


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The quantity is of interest in its own right, and is called the Unit Contribution Margin (C): it is the marginal profit per unit, or alternatively the portion of each sale thatcontributes to Fixed Costs. Thus the break-even point can be more simply computed as the

point where Total Contribution = Total Fixed Cost:

In currency units (sales proceeds) to reach break-even, one can use the above calculation andmultiply by Price, or equivalently use the Contribution Margin Ratio (Unit Contribution Marginover Price) to compute it as:

R=C, Where R is revenue generated, C is cost incurred i.e. Fixed costs + Variable Costs or Q *P(Price per unit) = TFC + Q * VC(Price per unit), Q * P - Q * VC = TFC, Q * (P - VC) = TFC,or, Break Even Analysis Q = TFC/c/s ratio=Break Even

Margin of Safety:

Margin of safety represents the strength of the business. It enables a business to know what theexact amount it has gained or lost is and whether they are over or below the break even point.Margin of safety = (current output - breakeven output)

Margin of safety% = (current output - breakeven output)/current output x 100

When dealing with budgets you would instead replace "Current output" with "Budgeted output".

If P/V ratio is given then profit/ PV ratio= In unit Break Even = FC / (SP VC )

Where FC is Fixed Cost, SP is Selling Price and VC is Variable Cost

Break Even Analysis:

By inserting different prices into the formula, you will obtain a number of break even points, onefor each possible price charged. If the firm changes the selling price for its product, from $2 to$2.30, in the example above, then it would have to sell only (1000/(2.3 - 0.6))= 589 units to

break even, rather than 715.

http://en.wikipedia.org/wiki/Contribution_marginhttp://en.wikipedia.org/wiki/Contribution_marginhttp://en.wikipedia.org/wiki/Contribution_marginhttp://en.wikipedia.org/wiki/Contribution_margin


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To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC inthe diagram) which shows the total cost associated with each possible level of output, the fixed

cost curve (FC) which shows the costs that do not vary with output level, and finally the varioustotal revenue lines (R1, R2, and R3) which show the total amount of revenue received at eachoutput level, given the price you will be charging.

The break even points (A,B,C) are the points of intersection between the total cost curve (TC)and a total revenue curve (R1, R2, or R3). The break even quantity at each selling price can beread off the horizontal axis and the break even price at each selling price can be read off thevertical axis. The total cost, total revenue, and fixed cost curves can each be constructed withsimple formulae. For example, the total revenue curve is simply the product of selling price

times quantity for each output quantity. The data used in these formulae come either fromaccounting records or from various estimation techniques such as regression analysis .

Limitations:

Break-even analysis is only a supply side ( i.e. costs only) analysis, as it tells you nothingabout what sales are actually likely to be for the product at these various prices.

It assumes that fixed costs (FC) are constant. Although, this is true in the short run, an

increase in the scale of production is likely to cause fixed costs to rise.It assumes average variable costs are constant per unit of output, at least in the range of

likely quantities of sales. ( i.e. linearity)

It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e.,there is no change in the quantity of goods held in inventory at the beginning of the periodand the quantity of goods held in inventory at the end of the period).

http://en.wikipedia.org/wiki/Regression_analysishttp://en.wikipedia.org/wiki/File:Breakeven_small.pnghttp://en.wikipedia.org/wiki/Regression_analysis


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In multi-product companies, it assumes that the relative proportions of each product soldand produced are constant ( i.e. , the sales mix is constant).

Application

The break-even point is one of the simplest yet least used analytical tools in management. Ithelps to provide a dynamic view of the relationships between sales, costs and profits. A better understanding of break-even, for example, is expressing break-even sales as a percentage of actual salescan give managers a chance to understand when to expect to break even (bylinking the percent to when in the week/month this percent of sales might occur).

The break-even point is a special case of Target Income Sales , where Target Income is 0(breaking even). This is very important for financial analysis.

http://en.wikipedia.org/wiki/Target_Income_Saleshttp://en.wikipedia.org/wiki/Target_Income_Sales


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Q. Define Depreciation. Explain the criteria of Depreciation. Depreciable property can beeither tangible or intangible. What does it mean? What cannot be depreciated?

Depreciation:

The word depreciate means to decrease or diminish in value. Equipment, machinery, & other

assets will depreciate because of:

Normal wear-and-tear (deterioration due to use);

Obsolescence (no longer needed; or replaced by more efficient options).

Depreciation can be defined in several ways:

A decrease in market value (accepted value of property at any given time; i.e., its value to potential buyers.);

A decrease in value from the owners perspective; Systematic allocation of an assets initial cost over its depreciable life

An accounting concept and it can be understood as capital recovery

It reduces tax burden on the Depreciable property as it is inversely proportional to tax.

It is allowed under federal and municiple income tax laws and regulation.

Depreciation is the loss in value of asset over time

Criteria of Depreciation:

You can depreciate property only if it meets the following requirements:

It is used in business or held for the production of income.

It must be expected to last for more than one year. In other words, it must have auseful life that extends substantially beyond the year it was placed in service.

It is property that wears out, decays, gets used up, becomes obsolete, or loosesvalue from natural causes.

Depreciable property can be either tangible or intangible

Types of Assets or Property:



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Government tax codes/rules for depreciation are linked to the type of property under consideration:

1. Tangible property (material goods that can be seen & touched) a. Real property (land, crops, buildings, or anything attached

to the land) b. Personal property (equipment, vehicles, furnishings, etc.,

which are tangible and not classified as real property)2. Intangible property has value to the owner but is not material goods (patents,

copyrights, trade names, franchises, endorsements)

Tangible Depreciable Property:

Purchased property you can see or touch

Livestock (purchased) Machinery

Buildings and improvements, fences

Dams, ponds, or terraces

Irrigation systems and water wells

Partial business use

You can claim depreciation on the part of a vehicle used in the business.

Intangible Depreciable Property

Purchased property that has value that you cannot readily see or touch

Computer Software

Copyrights, patents, etc


engineering economics notes(1)

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