*Engineering Economic DecisionsLecture 1Presentation based on the book Chan S. Park, Contemporary Engineering Economics Chapter 1, Pearson Education International Edition

Contemporary Engineering Economics, 4th edition, 2007

*Introduction and Motivation

Discussion TopicsRational decision-making processThe role of engineers in businessWhat makes engineering economics decisions difficult?Strategic decisionsThe fundamental principles in engineering economics

*Opening Story: Google

*A Little Google History1995Developed in dorm room by Larry Page and Sergey Brin, graduate students at Stanford UniversityNicknamed BackRub (reflecting great taste )1998Raised $25 million to set up Google, Inc.Ran 100,000 queries a day out of a garage in Menlo Park2005Over 4,000 employees worldwideOver 8 billion pages indexedEstimated market value over $100 billionAs of today, the value of Google is likely to be in the hundreds of billions range

*Rational Decision-Making ProcessRecognize the decision problemCollect all needed (relevant) information Identify the set of feasible decision alternativesDefine the key objectivesand constraintsSelect the best possible and implementable decision alternative

*A Simple Illustrative Example: Car to Lease Saturn or Honda?Recognize the decision problemCollect all needed (relevant) information Identify the set of feasible decision alternativesDefine the key objectivesand constraintsSelect the best possible and implementable decision alternativeNeed to lease a car

Gather technical andfinancial dataSelect cars to considerWanted: small cash outlay, safety, good performance, aesthetics, Choice between Saturn and Honda (or others)Select a car (i.e., Honda, Saturn or another brand)

*Engineering Economic DecisionsFinancialplanningInvestmentand loanMarketingProfit! Then continueat the next stageManufacturingNeeded e.g. in the following (connected) areas:Design

*What Makes Engineering Economic Decisions Difficult? Predicting the FutureEstimating the required investmentsEstimating product manufacturing costsForecasting the demand for a brand new productEstimating a good selling priceEstimating product life and the profitability of continuing production

*Create & 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 PriceThe Role of Engineers in Business

*PresentFuturePastEngineering EconomyAccountingEvaluating past performanceEvaluating and predicting future eventsAccounting vs. Engineering Economy

*Key Factors in Selecting Good Engineering Economic DecisionsObjectives, available resources, time and uncertaintyare the key defining aspects of all engineering economic decisions

*Large-Scale Engineering ProjectsThese typicallyrequire a large sum of investmentcan be very riskytake a long time to see the financial outcomeslead to revenue and cost streams that are difficult to predict

All the above aspects (and some others not listed here) point towards the importance of EEA

*Types of Strategic Engineering Economic Decisions in the Manufacturing SectorService Improvement Equipment and Process SelectionEquipment ReplacementNew Product and Product Expansion

Cost reduction or profit maximization can be seen as generic (common, eventual) objectivesIn the most general sense, we have to make decisions under resource constraints, and in presence of uncertainty not only in the EEA context

*Example 1: Healthcare Service Improvement1 Traditional Plan: Patients visit the service providers2 New Strategy: Service providers visit the patientsWhich one of the two plans is more economical? Theanswer typically depends onthe type of patients and theservices offered. Examples?patientsservice providers12

*Example 2: Equipment and Process SelectionHow do you choose between using alternative materials for an auto body panel?The choice of material will dictate the manufacturing process and the associated manufacturing costs

*Example 3: Equipment Replacement ProblemKey question: When is the right time to replace an old machine or equipment?

*Example 4: New Product and Product ExpansionShall we build or acquire a new facility to meet the increased (increasing forecasted) demand?Is it worth spending money to market a new product?

*Example 5: MACH 3 ProjectR&D investment: $750 million(!)Product promotion through advertising: $300 million(!)Priced to sell at 35% higher than the preceding Sensor Excel model (i.e., about $1.50 extra per razor)Question 1: Would consumers pay $1.50 extra for a shave with greater smoothness and less irritation?Question 2: What happens if the blade consumption drops more than 10% due to the longer blade life of the new razor?...

*Example 6: Cost ReductionShould a company buy new equipment to perform an operation that is now done manually?Should we spend money now, in order to save more money later?The answer obviously depends on a number of factors.

*Further Areas of Strategic Engineering Economic Decisions in the Service SectorCommercial Transportation Logistics and Distribution Healthcare Industry Electronic Markets and Auctions Financial Engineering and Banking Retail Hospitality and Entertainment Customer Service and Maintenance

*U.S. Gross Domestic Product (GDP)Distribution by Sector Manufacturing 14%Service sector 70%Healthcare 14%Agriculture 2%

Total 30%

*The Four Fundamental Principles of Engineering Economics1: An instant dollar is worth more than a distant dollar 2: Only the relative (pair-wise) difference among the considered alternatives counts3: Marginal revenue must exceed marginal cost, in order to carry out a profitable increase of operations 4: Additional risk is not taken without an expected additional return of suitable magnitude

*Principle 1 An instant dollar is worth more than a distant dollar

Today6 months later

*Principle 2 Only the cost (resource) difference among alternatives countsThe data shown in the green fields are irrelevant items for decision making, since their financial impact is identical in both cases

OptionMonthly Fuel CostMonthly MaintenanceCash paid at signing(cash outlay )Monthly paymentSalvage Value at end of year 3Buy$960$550$6,500$350$9,000Lease$960$550$2,400$5500

*Principle 3 Marginal (unit) revenue has to exceed marginal cost, in order to increase productionManufacturing costSales revenueMarginal revenueMarginal cost1 unit1 unit

*Principle 4 Additional risk is not taken without a suitable expected additional returnA simple illustrative example. Note that all investments implysome risk: portfolio management is a key issue in finance

Investment ClassPotential RiskExpected ReturnSavings account (cash)Lowest1.5%Bond (debt)Moderate4.8%Stock (equity)Highest11.5%

*SummaryThe term engineering economic decision refers to any investment or other decision related to an engineering projectThe 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 reductionThe factors of time, resource limitations and uncertainty are key defining aspects of any investment projectNotice that all listed decision types can be seen and modeled as a constrained decision (optimization) problem