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System Engineering Economy Analysis

Lecturer Maha Muhaisen

- College of Applied Engineering Urban Planning

System Engineering Economy Analysis

Lecturer Maha Muhaisen

- College of Applied Engineering Urban Planning

Course outline

- Introduction to making economic decision
- Interest and equivalence
- Present worth analysis
- Cash flow analysis
- Rate of return
- Deprecation
- Cost benefit analysis
- Risk, and uncertainly
- Sensitivity analysis

Grading

- Research Projects homework 30
- Midterm Exam. 30
- Final Exam. 40

Resources

- Engineering Economic analysis, by Donald G.

Newnan. , Ted G. Eschenbach, J.P. Lavelle. - Civil and Environmental Systems Engineering,

Charles S. Revelle, Earl Whitlatch , Jeff Wright - Class Notes and Handouts
- Course material will be made available through

the web site

Introduction

Engineering

- Engineers provide answers.
- Ability to solve problems or take advantage of

opportunities through the application of science. - Must meet certain criteria.
- Technical feasibility/efficiency meet or exceed

specifications. - Economic feasibility/efficiency meet budgets and

return.

Engineering Economy

- Every technical solution has financial

consequences. - Engineering economic analysis determines whether

a proposed solution is financially viable. - Will it pay?
- Is this the minimum cost solution?
- Will it generate an acceptable return?

Engineering Economic Decisions

- Profit Enhancing Programs projects designed to

generate revenues. - New product development
- New product acquisition
- Product/service capacity expansion
- Improved customer service

Engineering Economic Decisions

- Cost Control Programs projects designed to

generate savings. - Improving efficiency
- Streamlining operations
- Eliminating waste
- Reducing liabilities

Engineering Economic Decisions

- Public Improvement Programs government entities

also make capital expenditures. - Increased public satisfaction
- Increased public safety
- Improved infrastructure

Investment Categories

- Expansion
- Products, services, capacity can expand
- Often requires choice of technology
- Replacement
- Technology selection
- Outsourcing versus in-house choice
- Abandonment
- Eliminating products, services, or capacity

Investment Decisions

- Invest
- Releases funds to start a project
- Do Not Invest
- Eliminates the project from further consideration
- Wait (Delay)
- Time to gather information about the future can

aid in decision-making

Making an Economic Decision

- Problem or opportunity recognition and definition
- Generation of Solution Alternatives
- Development of Feasible Solution Alternative Cash

Flows and Information Gathering - Evaluation of Solution Alternatives
- Selection and Implementation of Best Alternative
- Post-implementation Analysis and Evaluation

The Role of engineering Economic analysis

- Engineering economic analysis is most suitable

for intermediate problems and economic aspects of

complex problem, they have those qualities - 1) the problem is important enough to justify

our giving it serious thought and effort. - 2) careful analysis requires that we recognize

the problem and all various consequences, and

this is just too much to be done all at once. - 3) the problem has economic aspects important in

reaching a decision.

Engineering Design Decisions

- Problem or opportunity recognition and definition
- Generation of Solution Alternatives
- Assess the Feasibility of Each Approach.
- 4 Selection of Best Alternative According to

Technical and Economic Constraints - 5 Detailed Design, Testing, and Analysis. If

Successful, Implement, Else, Goto 2. - Post-implementation Analysis and Evaluation

Decisions in Design

- The design process is generally embedded in the

second step of the decision-making process. - Designs Solution Alternatives
- Design decisions are generally discipline

specific. - But the economics surrounding design decisions

are for all engineers.

Engineering Economic Decision Analysis Importance

- Companies must invest to grow.
- Companies must invest to improve.
- Investments cost (lots of) money!
- Economic Analysis considers the economic

viability of each and every investment project

such that money is made, not lost.

Engineering Economic Decision Analysis Difficulty

- Investments carry risk.
- Money spent now for expected savings or returns

in the future. - As future is uncertain, so are returns or

savings. - Money spent can be lost. If too often, could

lead to bankruptcy. - While economics are paramount, many other factors

influence decision.

Why YOU, the Engineer?

- Those who generate solutions are most intimate

with the details and best suited to analyze them

financially. - To be heard, engineers must be able to speak

financially - It is generally assumed that the engineering

solution will work -- must justify financially. - Understanding the financials will help you move

up the corporate ladder. - This analysis provides the link to other

departments, such as accounting and finance.

In this course, you will learn

- The fundamentals of engineering economy (time

value of money, interest, economic equivalence) - To perform the economic decision making process
- To financially evaluate engineering projects

under certainty, risk, uncertainty, and multiple

options - Numerous methods in which to determine the best

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

capital investments

- Engineering economic analysis is used to answer

many different questions - Which engineering projects are worthwhile ?
- Which engineering project should give higher

priority? - How should the engineering project be design?
- Engineering economic analysis can also used to

answer questions that are personally important - How to achieve long-term financial goal.
- How to compare different ways to finance

purchases. - How to make short and long term investment

decision.

Decision making process

- Decision making process, include
- - Rational Decision making
- - Decision making for current cost
- - Examples

Decision making process

- It is the choosing from alternatives, but is this

enough for definition?

Rational Decision Making

- Rational decision making is a complex process

that contain nine essential elements. - Although those nine steps are shown sequentially

it is common for decision making to repeat the

steps. - All those steps is required and shown in a

logical order.

(No Transcript)

1- Recognize the problem

- Recognition of the problem is obvious and

immediate - Many firms establish programs for total quality

management (TQM) or continuous improvement that

are designed to identify the problems, so that

they can be solved.

2- Define the Goal or objective

- The goal can be a grand, overall goal of a person

or a firm. - The presence of multiple goal is often foundation

of complex problem. - But the objective need not to be a grand but the

overall objective may be specific and narrow. I

want to pay a load by may - So defining the objective is the act of exactly

describing the task and goal

3- Assemble of relevant data

- Good decision good

information - Some data are available immediately at little or

no cost, but still other require survey, or

consulting with specific knowledgeable people - Time horizon is part of data as how long

equipment, building will last? - Accounting system is of important source of data
- Financial and cost accounting are designed to

show accounting values and the flow of money

(cost benefit) - What are the cost that related to specific

operation , those indirect (overhead) cost, that

usually allocated to operations, those may be

satisfactory for cost accounting purposes, but

may be unreliable for economic analysis. - To understand the meaningful analysis see the

following example

Example

- The cost accounting records of a large company

show the avg. monthly costs for the three persons

printing dep. The wages of the three dep. members

and benefits such as vacation, sick leave, make

up the first category of the direct labor. The

companys indirect or overhead costs such heat

, electricity, etc must be distributed to its

various departments in some manner , this one

uses floor space as basis for its allocations - Direct labor cost 6000
- Material and supplies consumed 7000
- Allocated overhead costs
- 200m2 of the floor area at 25/m2

5000 - The total 18000
- The printing dep. charges other dep. for its

services to cover 18,000 monthly cost. For

example , the charge to run 1000 copies of an

announcement is - Direct labor 7.6
- Material and supplies 9.8
- Over head 9.05
- Cost to other dep.s 26.45

Cont.

- The shipping dep. checks with a commercial

printer which would print 1000 copies for 22.95

although the shipping dep. needs only about

30,000 copies printed a month, its Forman

decision to stop printing dep. and have work done

by outside printer. The manger has asked to study

situation and recommend what should be done. - Solution

Printing dep. Printing dep. Outside Printer Outside Printer

1000 copies 30,000 copies 1000 copies 30,000 copies

Direct cost 7.6 228.00

Material and supplies 9.8 294.00 22.95 688.5

overhead 9.05 271.5

Total 26.45 793.5 22.95 688.5

Cont.

- The firm will save 294 in material and may or

may not save 228 in direct labor if printing

dep. no longer does the shipping dep. work. - The max. saving will be 294 228 522
- But if the shipping dep. Is permitted to obtain

its printing from outside, the firm will be

688.5 a month. - The saving from not doing the shipping dep. work

in printing de. Would not exceed 522 and it is

probably would be 294 - The result would be a net increase in cost to

firm. For this reason it is not encouraged to

print outside. - Data cost gathering present other difficulty.

One way to look at financial consequences ,

cost-benefit, of various alternative - Market consequences raw material, machinery

cost, ..etc. - Extra market consequences (shadow prices) as

cost of employee injury,ect. - Intangible consequences numerical analysis

probably never fully describe the difference

between alternative. - As how does one evaluate the potential loss of

workers job due to automation ?

4. Identify feasible alternative

- There is no way to ensure the best alternative is

listed among the alternatives considered. - Sometime a group of people considering

alternative in an innovative atmosphere (

brainstorming) can be helpful - Any good listing of alternative will produce

both practical and impractical solutions. - Only feasible alternative are retained for

further analysis.

5. Select the criterion to determine the best

alternative

- To choose the best alternative , we must define

what we mean by best. - Criterion or set of criteria must be judged.
- Worst Bad Fair Good Better Best
- Several possible criteria are
- create the least disturbance to the environment
- Improve the distribution of the wealth among

people. - Minimize the expenditure
- Ensure that benefit greater that losses
- Minimize the time to achieve the goal
- Minimize unemployment
- Maximize profit
- Maximize profit is normally selected in

engineering decision . When it is used all

problems fall into one of the three categories - fixed output , fixed input, or neither input

nor output.

Cont.

- Fixed input the amount of money or other input

resources (like labor, material, or equipment) .

The objective is no effectively utilize them. - Example
- A project engineer has a budget of 350,000 to

renovate a portion of petroleum refinery. - For ecom\nomic efficiency, the appropriate

criterion is to maximize benefits or outputs. - Fixed output there is a fixed task (or other

output objectives / results) to be accomplished - Example
- Civil engineer firm has been given a job of

surveying land and preparing a record of survey

map. - purchasing a car without any optional equipment.

Cont.

- Neither input nor output fixed It is the

general situation, whereas the amount of money or

inputs is not fixed, nor is the amount of

benefits or other output. - Example
- A consulting eng. Firms has a lot of work, and

paying for the staff for evening works to

increase the amount of design work. - In this category, maximize the benefit is the

criterion, since the difference between input and

output is simply the profit.

Cont.

Category Economic Criterion

Fixed input Maximize benefit or other outputs

Fixed output Minimize the costs or other inputs

Neither input nor output Maximize (benefits or, other output minus costs or other input) or stated another way, maximize profit.

6. Constructing the model

- Putting various elements together (objective,

relevant data, feasible alternatives, and

selection criteria) - Relationship between the elements called model

building or constructing model. - To an engineer, the model is a mathematical

equations.

7. Predicting the outcomes for each alternative.

- Each alternative might produce a variety of

outcomes. Studying each alternative and outcomes

for everyone.

8. Choose the best alternative

- The selection of the feasible alternative may be

key item, with the rest of the analysis a

methodical process leading to predictable

decision.

9. Audit the results

- It the comparison of what happened against

predication. - Do the results of decision agree with its

predications? - The audit help ensure that projected operating

advantages are ultimately obtained. - On other hand, the economic decision may be

unjustifiably optimistic.

Example

- A concrete aggregate mix is required to contain

at least 31 sand by volume for proper batching.

One source of material, which has 25 sand and

75 coarse aggregate, sells for 3 per cubic

meter (m3). Another source, which has 40 sand

and 60 coarse aggregate, sells for 4.40/m3. - Determine the least cost per cubic meter of

blended aggregates. - Solution
- The least cost of blended aggregates will result

from maximum use of the lower-cost material. The

higher-cost material will be used to increase the

proportion of sand up to the minimum level (3 1)

specified. - Let x Portion of blended aggregates from

3.00/m3 source - 1 - x Portion of blended aggregates from

4.40hi3 source - Sand Balance
- X(0.25) (1 -x)(0.40) 0.31
- 0.25x 0.4-0.4x 0.31
- 0.31 0.4 -0.09 0.6
- 0.25 - .04 -0.15
- Thus the blended aggregates will contain 60

of 3.0m3 material, 40 of 4.40/m3 material - The least cost per cubic meter of blended

aggregates is - 0.6(3.00) 0.4(4.4) 1.81.76 3.56 / m3

Summary

- Classifying to solve. Others problems
- Many problems are simple and thus easy to solve,

others are of intermediate difficulty and need

considerable thought / calculation to properly

evaluate. There intermediate problems tends to

have a substantial economic component, hence, are

good candidates for economic analysis. Complex

problems, on other hand, often contain people

elements along with political and economic

components. - Economic analysis is still very important but the

best alternative must be selected considering all

criteria not just the economic.

Cont.

- The Rational decision making process
- Rational Decision Making Process uses a logical

method to select the best alternative from among

the feasible alternatives. The following nine

steps can be followed sequentially, but decision

makers often repeat some steps undertake some

simultaneously, and skip others altogether. - 1- recognize the problem
- 2- define goal or objective. What is the task?
- 3- assemble relevant data What are the facts?

Are more data needed, and is it worth more than

the cost to obtain it ?4- Define feasible

alternative. - 5- Select the criterion for choosing the best

alternative, possible criteria include political,

economic, environmental, and humanitarian. The

single criterion may be a composite or several

criteria.

Cont.

- 6 - Mathematically model the various

interrelations. - 7- Predict the outcomes for each alternative.
- 8- choose best alternative.
- 9- audit the alternative.
- Engineering DM refers to solving substantial

engineering problems in which economic aspects

dominate and economic efficiency is the criteria

for choosing from among possible alternatives. It

is particular case of general decision making

process, some of unusual aspects of engineering

decision making are as follows - 1- cost accounting systems, while an important

source of cost data, contain allocations of

indirect costs that may be incorporate for use in

economic analysis. - 2- the various consequences costs benefits-

of an alternative may be of three types - Market consequences there are established

market prices. - Extra market consequences there are no direct

market process, but prices can be assigned by

indirect costs. - Intangiable consequences valued by judgment ,

not by monetary prices.

Cont.

- 3- the economic criteria for judging alternatives

can be reduced to three cases - For fixed input maximize the benefits or other

outputs. - For fixed output minimize the costs or other

outputs. - When neither input or output is fixed, maximize

the differences between benefits, and costs or

more simply stated, maximize profit. - The third case states the general rule from which

both first and second cases may derived. - 4- to choose among the alternatives, the market

consequences and extra market consequences are

organized into a cash flow diagram, we will see

in the next chapter, that engineering economic

calculation can be used to compare differing cash

flows.. These outcomes are compared against the

selection criteria. From this comparison plus the

consequences not included in Monterey analysis,

the best alternative is selected. - 5- an essential part of engineering decision

making is post audit of results. This step helps

to ensure that projected benefits are obtained

and to encourage realistic estimates in analysis.

Principles of Engineering Economy

Cash Flows

Cash flow

- Cash flow diagram (CFD) summarized the cost and

benefit of the project occur over time. - CFD is created by first drawing a segmented time

based horizontal line, divided onto appropriate

time units. - At each time at which cash flow will occur a

vertical arrow is added. Pointing down for cost ,

pointing up for revenues or benefit.

Key Concepts

- Cash Flow Diagram the financial description

(visual) of a project - Time Value of Money the value of money changes

with time - Money provides utility (value) when spent
- Value of money grows if invested
- Value of money decreases due to inflation
- Interest used to move money through time for

comparisons

Cash Flow

- Movement of money in (out) of a project
- Inflows revenues or receipts
- Outflows expenses or disbursements
- Net Cash Flow receipts - disbursements

Cash Flows

- Discrete Movement of cash to or from a project

at a specific point in time. - Continuous Rate of cash moving from or to a

project over some period of time.

Cash Flow Diagram

- Financial representation of a project.
- Describes type, magnitude and timing of cash

flows over some horizon.

Cash Flow Diagram

- Describes type, magnitude and timing of cash

flows over some horizon

0

1

2

3

4

5

Time Periods over the Horizon

Cash Flow Diagram

- Describes type, magnitude and timing of cash

flows over some horizon

0

1

2

3

4

5

50

100

500

Discrete Cash Outflow (Disbursement,

Expense) Note the direction of the arrow!

Cash Flow Diagram

- Describes type, magnitude and timing of cash

flows over some horizon

500

200

200

200

0

1

2

3

4

5

Discrete Cash Inflow (Revenue)

Cash Flow Diagram

- Describes type, magnitude and timing of cash

flows over some horizon

500

200

200

200

0

1

2

3

4

5

50

100

500

Cash Flow Diagram

- Net cash flows add expenses and disbursements at

same point in time.

500K

200K

200K

200K

0

1

2

3

4

5

50K

100K

Can write as net cash flow

500K

Cash Flow Diagram

- Net cash flows add expenses and disbursements at

same point in time.

500

200

200

100

0

1

2

3

4

5

50

500

Cash Flow Diagram

- Continuous cash flows define a rate of movement

of cash over time.

500

200

200

0

1

2

3

4

5

Continuous Cash Inflow (Revenue) 200 Rate of

Flow per unit time

500

Cash Flow Diagram

- Continuous cash flows define a rate of movement

of cash over time. - While good for analysis, not used often.

500

200

200

0

1

2

3

4

5

Continuous Cash Inflow (Revenue) 200 Rate of

Flow per unit time

500

Cash Flow Diagram

- Can describe any investment opportunity.
- Typical investment

Cash Flow Diagram

- Can describe any investment opportunity.
- Typical investment

0

P

Make an initial investment (purchase)

Cash Flow Diagram

- Can describe any investment opportunity.
- Typical investment

0

1

2

N

3

P

Receive revenues over time.

Cash Flow Diagram

- Can describe any investment opportunity.
- Typical investment

0

1

2

N

3

P

Pay expenses over time.

Cash Flow Diagram

- Can describe any investment opportunity.
- Typical investment

Receive salvage value at time N.

F

0

1

2

N

3

P

Cash Flow Diagram

- Can describe any investment opportunity.
- Typical investment

AN

A3

A2

0

1

2

N

3

A1

P

Write as a NET cash flow in each period.

Example (Nothing to Sneeze At!)

- Tissue paper company Svenska Cellulosa announced

an investment of 490 million for a new tissue

machine at its Valls, Spain plant to expand

capacity by 60,000 tons/year. Most product is

for retail private labels. - Assume Investment in 2006 with operations

beginning in 2007. The machine has a service

life of 10 years and a salvage value of 25M.

Fixed OM costs are 10 million in year 1,

increase 8 per year. Revenues are 6,400/ton

against costs of 4,600/ton. - Draw the cash flow diagram.

Cash Flow Diagram

- Timeline

0

1

2

10

3

Cash Flow Diagram

- Individual cash flows Investment Cost

0

1

2

10

3

490M

Cash Flow Diagram

- Individual cash flows Per Unit Revenues

384M

384M

384M

384M

0

1

2

10

3

490M

Cash Flow Diagram

- Individual cash flows Per Unit Costs

384M

384M

384M

384M

0

1

2

10

3

276M

276M

276M

276M

490M

Cash Flow Diagram

- Individual cash flows Fixed Costs

384M

384M

384M

384M

0

1

2

10

3

276M

276M

276M

276M

10M

10.8M

11.7M

20M

490M

Cash Flow Diagram

- Individual cash flows Salvage Value

25M

384M

384M

384M

384M

0

1

2

10

3

276M

276M

276M

276M

10M

10.8M

11.7M

20M

490M

Cash Flow Diagram

- Net Cash Flow Diagram

113M

98.0M

97.2M

96.4M

89.5M

0

1

2

10

3

9

490M

Cash Flow Diagram

- Net Cash Flow Diagram

113M

98.0M

97.2M

96.4M

89.5M

0

1

2

10

3

9

This is a typical investment. (Invest at zero,

returns later.)

490M

Cash Flow Diagram

- Net Cash Flow Diagram

113M

98.0M

97.2M

96.4M

89.5M

0

1

2

10

3

9

This is a typical investment. (Invest at zero,

returns later.) Can also use a spreadsheet!

490M

Spreadsheet Basics

- Sheet defined by rows and columns of cells.

Spreadsheet Basics

- Can enter the following into a cell
- Data Input that is fixed.
- Variables Input that can change.
- Accomplished by references.
- Absolute references are fixed when copied.
- Relative references change when copied.
- Functions Accept input (arguments) and return

pre-defined output. - Combinations Data, Variables, and Functions.
- Labels Formatting that makes it easy to read!

Good Spreadsheet Form

- Give your spreadsheet a title.
- Put data in a data center and reference it (so

you can change it easily). - Label units, scales, time, etc.
- Use formatting to make it easy to read.

Good Spreadsheet Form

- Give your spreadsheet a title.
- Put data in a data center and reference it (so

you can change it easily). - Label units, scales, time, etc.
- Use formatting to make it easy to read.
- If you dont, you will just end up doing it

again!

Return to our Example

Return to our Example

Data Center with Data

Return to our Example

Relative Reference A13 Copies relative distance

between cell and copied cell to the new

cell. Absolute Reference G4 Copies the cell

reference exactly (fixed).

Return to our Example

Function Call SUM(argument1, argument2,)

argument1argument2

Return to our Example

Engineering Costs and Cost Estimating

- Costs
- Fixed and Variable
- Direct and Indirect
- Marginal and Average
- Sunk and Opportunity
- Recurring and Non-Recurring
- Incremental
- Cash and Book
- Life-Cycle

Cost Indices Estimating Benefits Cash Flow

Diagrams

Engineering Costs and Cost Estimating

- Fixed Costs
- are constant and unchanging regardless of the

level of the activity over a feasible range of

operations for the capacity or capability

available. - Variable costs
- operating costs that vary in total with the

quantity of output or other measures of activity

level. - Direct Costs
- cost that can be reasonably measured and

allocated to a specific output or work activity. - Indirect/Overhead Cost
- cost that it is difficult to attribute or

allocate to a specific output or work activity.

Engineering Costs and Cost Estimating

- Average cost dividing the total cost for all

units by the total number of units. DM use cost

to attain an overall cost picture of the

investment on a per unit analysis. - Marginalized cost is used to decide whether the

additional unit should be made, purchase, or

enrolled in - (for full time student, marginal cost of another

credit is 0 or 120 depend in how many credits

has already signed up.

Engineering Costs and Cost Estimating

- Key Question Where do the numbers come from that

we use in engineering economic analysis? - Cost estimating is necessary in an economic

analysis - When working in industry, you may need to

consult with professional accountants to obtain

such information

Engineering Costs and Cost Estimating

- Example 2-1.
- an industrialist DK was considering the money

making potential plans to charter a bus to take

people to see a wrestling match show in

Jacksonville. His wealthy uncle will reimburse

him for his personal time, so his time cost can

be ignored.

- Item Cost Item Cost
- Bus Rental 80 Ticket 12.50
- Gas Expense 75 Refreshments

7.50 - Other Fuel Costs 20
- Bus Driver 50
- Total Costs 225.00 Total Costs

20.00 - Which of the above are fixed and which are

variable costs? - How do we compute total cost if he takes n people

to Jacksonville?

DKs Charter Bus Venture (example)

- Answer Total Cost 225 20 per person.
- Graph of Total Cost Equation

Total cost

n

DKs Charter Bus Venture (example)

- marginal cost -The cost to take one more person
- average cost
- - Average cost the cost per person
- Avg. Cost TC/n
- Avg. Cost (22520n)/n
- For n 30, TC 885
- Avg. Cost 885/30 29.50
- Total cost cannot be calculated
- from an average cost value
- For n 35, TC ? 35(29.50) 1,032.50

DK Charter Bus Venture (example)

- Question Do we have enough information yet to

decide how much money he will make on his

venture? What else must we know? - he needs to know his total revenue
- he knows that similar ventures in the past have

charged 35 per person, so that is what he

decides to charge - Total Revenue 35n (for n people)
- Total profit
- Total Revenue Total Cost
- 35n (225 20n) 15n 225
- Question
- How many people does
- DK need to break even?
- (not lose money on his venture)
- Solve 15 n 225 0 gt n15

- Break-even point the level of business activity

at which the total costs provide the product,

good, or services are equal to revenue (or

saving) generated by providing services. This is

he level at which one just break even) - Profit region the output level of the variable

x (or n) greater than the breakeven point, where

the total revenue is greater than the total cost. - Loss region the output level of variable x (n)

less than the breakeven point, where total cost

are greater than the total revenue.

DKs Charter Bus Venture (example)

- Where is the Loss Region?
- Where is the Profit Region?
- Where is the Breakeven point?
- Can you make this chart in Excel?

Sunk Costs

- A sunk cost is money already spent due to a past

decision. - As engineering economists we deal with present

and future opportunities - We must be careful not to be influenced by the

past - Disregard sunk costs in engineering economic

analysis - Example
- Suppose that three years ago your parents bought

you a laptop PC for 2000. - How likely is it that you can sell it today for

what it cost? - Suppose you can sell the laptop today for 400.

Does the 2000 purchase cost have any effect on

the selling price today? - The 2000 is a sunk cost. It has no influence on

the present opportunity to sell the laptop for

400

Opportunity Cost

- An opportunity cost is the benefit that is

foregone by engaging a business resource in a

chosen activity instead of engaging that same

resource in the foregone activity. - Example Suppose your wealthy uncle gives you

75,000 when you graduate from high school. It

is enough to put you through college - (5 years at 15,000 per year). It is also

enough for you to open a business making web

pages for small companies instead of going to

college. You estimate you would make 20,000 per

year with this business. - If you decide to go to college you give up the

opportunity to make 20,000 per year - Your opportunity cost is 20,000
- Your total cost per year is 35,000

Sunk and Opportunity Cost

- Example 2-3. A distributor has a case of

electric pumps. The pumps are unused, but are

three years old. They are becoming obsolete.

Some pricing information is available as follows. - Item Amount Type of Costs

Price for case 3 years ago 7,000

Sunk cost

Sunk cost

Storage costs to date 1,000

List price today for a case of new and up to

date pumps 12,000

Can be used to help determine what the lot is

worth today.

Amount buyer offered for case 2 years ago

5,000

A foregone opportunity

Case can currently be sold for 3,000

Actual market value today

Recurring and Non-Recurring Costs

- Recurring costs are those expenses that are

known, anticipated, and occur at regular

intervals. These costs can be modeled as cash

flows. - Non-recurring costs are one-of-a-kind and occur

at irregular intervals. They are difficult to

plan for or anticipate. - Example. You decide to landscape a lot of ground

and then care for it. Which are recurring and

which are non-recurring costs you incur? - Remove existing trees, vegetation
- Have land graded with bulldozer
- Have yard planted with grass
- Plant vegetation, trees
- trim grass
- Fertilize grass, shrubs
- Water grass, shrubs

Incremental Cost

- Incremental Cost is the additional cost that

results from - Increasing the output of a system by one (or

more) units - Selecting one alternative over another
- Example 2-4. Philip can choose between model A

or model B. The following information is

available. - Cost Items Model A Model B Incremental

Cost of

B

Purchase price 10,000 17,500

7,500

Installation cost 3,500 5,000

1,500

Annual maintenance cost 2,500 750

-1,750/yr

800/yr

Annual utility expense

1,200 2,000

-200

Disposal cost after useful life 700 500

- Can we conclude that model B is more expensive

than model A?

- Notice that the cost for the cost categories

given, the incremental costs of B are both ()

and (-). Positive incremental costs mean that B

costs more than A and negative incremental costs

indicate that there would be a saving (reduction

of the cost) if B were chosen. - Because B has more features, a decision would

also have to reflect consideration the

incremental benefits offered by model.

Cash Costs vs. Book Costs

- Cash costs
- require the cash transaction of dollars from

one pocket to another. - Book costs
- are cost effects from past decisions that are

recorded in the books (accounting books) of a

firm - Do not represent cash flows
- Not included in engineering economic analysis
- One exception is for asset depreciation (used for

tax purposes). - Example You might use Edmonds Used Car Guide to

conclude the book value of your car is 6,000.

The book value can be thought of as the book

cost. If you actually sell the car to a friend

for 5,500, then the cash cost to your friend is

5,500.

Life-Cycle Costs

- Life-cycle costs are the summation of all costs,

both recurring and nonrecurring, related to a

product, structure, system, or service during its

life span - Products go through a life cycle, just like

people - Assessment Justification Phase
- Conceptual or Preliminary Design Phase
- Detailed Design Phase
- Production or Construction Phase
- Operational Use Phase
- Decline and Retirement Phase

Life-Cycle Costs

Life-Cycle Costs

- Comments
- The later design changes are made in the

life-cycle, the higher the costs. - Decisions made early in the life-cycle tend to

lock in costs incurred later in the life cycle - Nearly 70 to 90 of all costs are set during

the design phases, while only 10 to 30 of the

cumulative life-cycle costs have been spent. - Bottom Line. Engineers should consider all

life-cycle costs when designing products and the

systems that produce them.

Estimating Benefits

- For the most part, we can use exactly the same

approach to estimate benefits as to estimate

costs - Fixed and variable benefits
- Recurring and non-recurring benefits
- Incremental benefits
- Life-cycle benefits
- Rough, semi-detailed, and detailed benefit

estimates - Difficulties in estimation
- Segmentation and index models
- Major differences between benefit and cost

estimation - Costs are more likely to be underestimated
- Benefits are most likely to be overestimated
- Benefits tend to occur further in the future than

costs

System Engineering Economy Analysis

Lecturer Maha Muhaisen

- College of Applied Engineering Urban Planning

Discussion

- Chapter (1)

Q-27

- A farmer must decide what combination of seed,

water, fertilizer, and pest control will be most

profitable, for the coming year. The local

agricultural college did a study of this

farmer's situation and - prepared the following table.
- Plan Cost/acre income/acre
- A 600 800
- B 1500 1900
- C 1800 2250
- D 2100 2509
- the last page of the college's study was torn

off, and hence the farmer is not sure which plan

the agricultural college recommends. Which plan

should the farmer adopt? Explain.

Solution

- Plan Cost/acre income/acre Profit
- A 600 800 200
- B 1500 1900 400
- C 1800 2250 450
- D 2100 2509 400
- To maximize profit, choose alternative C.

Q-33

- Marie., a college student, is getting ready for

three final examination at the end of the school

year. Between now and the start of exams, she has

15 hours of study time available. She would like

to get as high a grade average as possible in her

math, physics, and engineering economy classes. - She feels she must study at least 2 hours for

each course and if necessary, will settle for low

grade that limited study would yield. - How much time should Maria devote to each class

if she estimate her grade in each subject as

follows

Solution

- The question here is how to apportion the

available 15 hrs of study among the courses. One

might begin for example, assuming 5hrs of study

for each course. The combined total score would

be 190. - Further study would show that the best use of

time is - Math 4hrs 44
- Physics 7 hrs 77
- Eng. Economy 4 hrs 71
- Total 192 hrs

Q-31

- On her first engineering job, Joy Hayes was given

the responsibility of determining the production

rate for a new product. She has assembled data as

indicated - (a) Select an appropriate economic criterion and

estimate-the production rate based upon it - Joy's boss told Joy "I want you to maximize

output with minimum input, Joy wonders if it is

possible to achieve her boss's criterion. - She asks your advice. What would you tell her?

(No Transcript)

solution

- The suitable criterion is to maximize net profit
- The date from graphs may be tabulated as follows
- The best production rate is 150 unit/hr
- B. minimum input is zero max. output is 250

units/hr. since one can not achieve max. output

at minimum input, the statement makes no sense.

Q. 40

- a firm is planning t manufacture a new product.

The sales dep. estimates that the quantity that

can be sold deponds on the selling price. As the

selling price is increased, the quantity that can

be sold decreases, numerically they estimate - P 35 0.02 Q
- Where P selling price per unit.
- Q quantity sold per year.
- On the other hand, the management estimates that

the average cost of manufacturing and selling the

product will decrease as the quantity sold

increases. They estimate - C 4Q - 8000, where C cost to product and

sell Q per year.

- The firms management wishes to produce and sell

the product at rate that will be a maximum. - What quantity should the decision makers plan to

produce and sell each year? - Solution
- Profit income cost PQ C , where,
- PQ 35Q 0.02Q2
- C 4Q 8000
- Profit 35Q 0.02Q2-4Q-8000
- 31Q 0.02Q2 8000
- D (profit) / dq 31 0.04Q solve for Q
- Q 775 units /year

- Solution
- Profit income cost PQ C , where,
- PQ 35Q 0.02Q2
- C 4Q 8000
- Profit 35Q 0.02Q2-4Q-8000
- 31Q 0.02Q2 8000
- D (profit) / dq 31 0.04Q solve for Q
- Q 775 units /year

Interest and Equivalence

- Time Value of Money
- Simple and Compound Interest

Cash Flow Diagrams

- Cash flow diagrams (CFD) summarize the costs and

benefits of projects - A CFD illustrates the size, sign,
- and timing of individual cash flows
- Periods may be months, quarters, years, etc.

Example Time Period Size of Cash Flow 0

(today) Receive 100 (positive CF) 1 Pay 100

(negative CF) 2 Positive CF of 100

3 Negative CF of 150 4 Negative CF of 150

5 Positive CF of 50

- COMMENTS
- The end of one period is the beginning of the

next one - Arrows point up for revenues or benefits, down

for costs - One persons payment (cash outflow w. neg. sign)

is another persons receipt (cash inflow w. pos.

sign) - It is essential to use only one perspective in

any CFD

Cash Flow Analysis

- Given that any investment opportunity can be

drawn by a cash flow diagram, how can we select

the best? - Transform all cash flow diagrams into something

similar for comparison. - Use a Common Interest Rate
- Use Time Value of Money Calculations

Time Value of Money

- Money has value because it gives us utility.
- Generally, money is preferred now, as opposed to

later (same amount) - One can spend it now and get utility
- One can invest it and watch it grow with interest

for greater future utility - One can put it under the mattress and watch it

lose purchasing power

Time Value of Money

- To describe the same amount of money at different

periods of time requires the use of an interest

rate. With a positive rate - Money grows (compounds) into larger future sums

in the future. - Money is smaller (discounted ) in the past.

Time Value of Money

- Question Would you prefer 100 today or 100

after 1 year? - There is a time value of money. Money is a

valuable asset, and people would pay to have

money available for use. The charge for its use

is called interest rate. - Question Why is the interest rate positive?
- Argument 1 Money is a valuable resource, which

can be rented, similar to an apartment.

Interest is a compensation for using money. - Argument 2 Interest is compensation for

uncertainties related to the future value of the

money.

Interest

- Cost of Money
- Rental amount charged by lender for use of money
- In any transaction, someone earns and someone

pays interest - Savings Account bank pays you

1.5 fee to depositor - Home/Auto Loan borrower pays bank

7.5 fee to bank

Interest

- Interest Rate comprised of many factors
- Example Home Mortgage 7.5
- Prime Rate (Banks borrow money at this rate

from the Federal Reserve banks when needed) 5 - Risk Factor 1
- Administration Fees 0.5
- Profit 1
- May raise more for higher risk client.

Definitions

- Principal (capital) P
- Amount invested or loaned
- Interest Rate i
- Rental charge for money defined as a percentage

of principal per time period - Compounding Period
- Defines how often interest is calculated (may not

be paid, however) - Length of loan/investment N periods

Simple Interest

- Interest earned/paid is directly proportional to

capital involved.

Simple Interest

- Interest earned/paid is directly proportional to

capital involved. - (Principal)(Interest Rate)(Periods)

Simple Interest

- Simple interest is interest that is computed on

the original sum. - If you loan an amount P for n years at a rate of

i a year, then after - n years you will have
- P n ? (i P) P n ? i ? P P (1 i n).
- Note Interest is usually compound interest, not

simple interest. - Example You loan your friend 5000 for five

years at a simple interest rate of 8 per year. - At the end of each year your friend pays you 0.08

? 5000 400 in interest. - At the end of five years your friend also repays

the 5000. - After five years your friend has paid you
- 5000 5 ? 400 5000 5 ? 0.08 ? 5000.
- Note The borrower has used the 400 for 4 years

without paying interest on it.

Example

- Keystone Cement Co. announced a 165 million

expansion of its Lehigh Valley PA plant. The

state Machinery and Equipment Loan Fund is

supplying a 4.5 million loan to be paid at a

rate of 3.25 percent over 10 years and the

states Development Authority is providing a 2

million loan at 4.25 percent over 15 years. - Consider the machinery loan. What is owed after

10 years assuming simple annual interest?

4.5M (4.5M)(.0325)(10) 5.96M

Compound Interest

- Interest is paid on both the capital and accrued

interest. - Must compute interest owed periodically.

Revisit the Example

- Repeat example assuming 3.25 compounded

annually. How much is owed after two years if no

payments are made?

Compound Interest

- Compounded interest is interest that is charged

on the original sum and un-paid interest. - You put 500 in a bank for 3 years at 6 compound

interest per year. - At the end of year 1 you have (1.06) ? 500

530. - At the end of year 2 you have (1.06) ? 530

561.80. - At the end of year 3 you have (1.06) ? 561.80

595.51. - Note
- 595.51 (1.06) ? 561.80
- (1.06) (1.06) 530
- (1.06) (1.06) (1.06) 500 500

(1.06)3

Revisit the Example

- Assuming 3.25 compounded annually
- After the first year
- Balance Interest
- 4.50M (.0325)(4.5M) 146,250
- After the second year
- Balance Interest
- 4.65M (.0325)(4.65M) 151,003
- 4,797,253 owed after two years.

Quarterly Compounded Interest Rates

- Example. You put 500 in a bank for 3 years at

6 compound interest per year. Interest is

compounded quarterly. - The bank pays you i 0.06/4 0.015 every 3

months - 1.5 for 12 periods (4 periods per year ? 3

years). - At the end of three years you have
- F P (1i)n 500 (1.015)12 500 (1.19562) ?

597.81 - (598 in

text due to rounding) - Note. Usually the stated interest is for a

1-year period. If it is compounded quarterly

then an interest period is 3 months long. If the

interest is i per year, each quarter the interest

paid is i/4 since there are four 3-month periods

a year.

Example

- Example. In 3 years, you need 400 to pay a

debt. In two more years, you need 600 more to

pay a second debt. How much should you put in

the bank today to meet these two needs if the

bank pays 12 per year?

- Interest is compounded yearly
- P 400(P/F,12,3) 600(P/F,12,5)
- 400 (0.7118) 600 (0.5674)
- 284.72 340.44 625.16

- Interest is compounded monthly
- P 400(P/F,12/12,312) 600(P/F,12/12,512)
- 400(P/F,1,36) 600(P/F,1,60)
- 400 (0.6989) 600 (0.5504)
- 279.56 330.24 609.80

Example Points of view

- Borrower point of viewYou borrow money from the

bank to start a business. - Investors point of viewYou invest your money in

a bank and buy a bond.

Concluding Remarks

- The Blue Pages in the text book tabulate
- Compound Amount Factor
- (F/P,i,n) (1i)n
- Present Worth Factor
- (P/F,i,n) (1i)-n
- These terms are in columns 2 and 3, identified as

- Compound Amount Factor Find F Given P F/P
- Present Worth Factor Find P Given F P/F

- Present value
- Economic Equivalence

Present Value (PV)

- Example You borrowed 5,000 from a bank at 8

interest rate and you have to pay it back in 5

years. There are many ways the debt can be repaid.

- Plan A At end of each year pay 1,000 principal

plus interest due. - Plan B Pay interest due at end of each year and

principal at end of five years. - Plan C Pay in five end-of-year payments.
- Plan D Pay principal and interest in one payment

at end of five years.

Example

- You borrowed 5,000 from a bank at 8 interest

rate and you have to pay it back in 5 years. - Plan A At end of each year pay 1,000 principal

plus interest due.

a b c d e f

Year Amnt. Owed Int. Owed Total Owed Princip. Payment Total Payment

Year Amnt. Owed intb bc Princip. Payment Total Payment

1 5,000 400 5,400 1,000 1,400

2 4,000 320 4,320 1,000 1,320

3 3,000 240 3,240 1,000 1,240

4 2,000 160 2,160 1,000 1,160

5 1,000 80 1,080 1,000 1,080

SUM 15,000 1,200 16,200 5,000 6,200

Example (cont'd)

- You borrowed 5,000 from a bank at 8 interest

rate and you have to pay it back in 5 years. - Plan B Pay interest due at end of each year and

principal at end of five years.

a b c d e f

Year Amnt. Owed Int. Owed Total Owed Princip. Payment Total Payment

Year Amnt. Owed intb bc Princip. Payment Total Payment

1 5,000 400 5,400 0 400

2 5,000 400 5,400 0 400

3 5,000 400 5,400 0 400

4 5,000 400 5,400 0 400

5 5,000 400 5,400 5,000 5,400

SUM 25,000 2,000 27,000 5,000 7,000

Example (cont'd)

- You borrowed 5,000 from a bank at 8 interest

rate and you have to pay it back in 5 years. - Plan C Pay in five end-of-year payments.

a b c d e f

Year Amnt. Owed Int. Owed Total Owed Princip. Payment Total Payment

Year Amnt. Owed intb bc Princip. Payment Total Payment

1 5,000 400 5,400 852 1,252

2 4,148 332 4,480 920 1,252

3 3,227 258 3,485 994 1,252

4 2,233 179 2,412 1,074 1,252

5 1,160 93 1,252 1,160 1,252

SUM 15,768 1,261 17,029 5,000 6,261

Example (cont'd)

- You borrowed 5,000 from a bank at 8 interest

rate and you have to pay it back in 5 years. - Plan D Pay principal and interest in one payment

at end of five years.

a b c d e f

Year Amnt. Owed Int. Owed Total Owed Princip. Payment Total Payment

Year Amnt. Owed intb bc Princip. Payment Total Payment

1 5,000 400 5,400 0 0

2 5,400 432 5,832 0 0

3 5,832 467 6,299 0 0

4 6,299 504 6,802 0 0

5 6,802 544 7,347 5,000 7,347

SUM 29,333 2,347 31,680 5,000 7,347

?

COMPOUND INTEREST

Example (cont'd)

147

Example (cont'd)

148

Example (cont'd)

149

Example (cont'd)

150

Economic Equivalence

- What do we mean by economic equivalence?
- Why do we need to establish an economic

equivalence? - How do we establish an economic equivalence?

Economic Equivalence

- Economic equivalence exists between cash flows

that have the same economic effect and could

therefore be traded for one another. - Even though the amounts and timing of the cash

flows may differ, the appropriate interest rate

makes them equal.

Equivalence from Personal Financing Point of View

- If you deposit P dollars today for N periods at

i, you will have F dollars at the end of period N.

Alternate Way of Defining Equivalence

P

- F dollars at the end of period N is equal to a

single sum P dollars now, if your earning power

is measured in terms of interest rate i.

N

0

F

N

0

Example

At an 8 interest, what is the equivalent worth

of 2,042 now in 5 years?

If you deposit 2,042 today in a savings account

that pays an 8 interest annuall