Lecture - 7
“Engineering Economics”
Assistant Professor
Ahmed Khan
Learning Objectives
After studying this lecture, the students should be
able to :
• Understand the need for Engineering Economy in
the field of engineering.
• Understand the basic Engineering Economy.
• Determine the role of Engineering Economy in
decision making.
Lecture Contents
Chapter 1 Engineering Economic Decisions by Fundamentals of
Engineering Economics Chan S. Park 2012
People are Surrounded
by Problems
• Which career to pursue?
• What level of preparation is required for the
career chosen?
• Where may the preparation be obtained?
• How to get up and get to class?
The problems are often not
isolated from each other.
3
Organizations Have Problems
• Do we make part A or B • Would a mechanized or
today? computerized drilling
• Should we use a drilling or machine be the preferred
boring machine? alternative?
• Should we purchase a • Where do we locate
boring machine? machinery in the plant?
• When must we replace the
drilling machine?
Decisions concerning these opportunities may be
arrived at with the help of economic analysis.
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Why Engineering Economy
• Utilization of scientific and engineering
knowledge
– Achieved through the design we use
• Achievements do not occur without a price
• Purpose of this course
– Develop and illustrate the principles required to answer
the basic economic question
• “Do its benefits exceed its costs?”
5
Engineering Economy Definition
• Involves systematic evaluation of economic
merits of proposed solutions to engineering
problems
• Solutions to engineering problems
– Must demonstrate a positive balance of long-term
benefits over long-term costs
– Must promote the well-being and survival of an
organization
• Involves technical analysis with emphasis on
economic aspects 6
Which Car to Lease?
1. Recognize a decision • Need a car
problem
2. Define the goals or
objectives • Want mechanical
3. Collect all the relevant security
information • Gather technical as well
as financial data
4. Identify a set of feasible
decision alternatives • Choose between Saturn
and Honda
5. Select the Criterion to
• Want minimum total
Determine the Best one cash outlay
6. Select the best alternative • Select Honda
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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.)
In the beginning the problems are a given.
Later you might have to analyze the information
provided to determine the real problem.
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2. Define the Goals or Objectives
• 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.
• Pay the auto loan on Tuesday morning at the bank.
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3. Collect all the relevant information
– Information may be published or individual
knowledge.
– Deciding which data is relevant may be a
complex process.
– In engineering decision making two important
sources of data are the organization’s
accounting and purchasing departments.
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4. Identify Feasible Alternatives
– The best alternative should be implemented.
Occasionally this is to maintain the existing
situation.
– Alternatives considered 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 used to
evaluate the alternatives to determine which is
best.
– The “best” alternative is relative.
– 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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Economic Decision-Making
Problems Fall Into Three Categories
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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Construct the Model
• Requires merging the various elements:
objective, 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.
– Be adequate to solve the problem.
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Predicting the Outcomes for Each
Alternative
• To avoid complications, we assume that a
decision is based on a single criterion. If
necessary, multiple criteria are combined into a
single criterion.
• Usually the consequences or alternatives are
stated in the form of money, i.e., costs/benefits.
• Costs and benefits may occur over a short or
long time period.
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6. Select 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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Engineering Economic Decisions
Manufacturing Profit
Planning Investment
Marketing
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Predicting the Future
• Required investment
• Forecasting product
demand
• Estimating selling
price
• Estimating
manufacturing cost
• Estimating product life
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Role of Engineers in Business
• Participate in a variety of
decision-making
processes, ranging from
manufacturing, through
marketing, to financing
decisions
• Plan for the acquisition of
equipment
• Design products from the
concept to shipping
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A Large-Scale Engineering
Project
• Requires a large sum
of investment
• Takes a long time to
see the financial
outcomes
• Difficult to predict the
revenue and cost
streams
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Types of Strategic Engineering
Economic Decisions
• Equipment and Process Selection
• Equipment Replacement
• New Product and Product Expansion
• Cost Reduction
• Service Improvement
• Public Works
• Cost Effectiveness
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Equipment Replacement
• Now is the time to
replace the old
machine?
• If not, when is the
right time to replace
the old equipment?
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New Product and Product
Expansion
• Shall we build or
Gillette’s MACH3
acquire a new facility
Project
to meet the increased
demand?
• Is it worth spending
money to market a
new product?
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Cost Reduction
• Should a company buy
equipment to perform
an operation now done
manually?
• Should spend money
now in order to save
more money later?
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Service Improvement
• How many more jeans would Levi need to sell to justify
the cost of additional robotic tailors?
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Equipment & Process Selection
• How do you choose between Plastic SMC
and Steel sheet stock for the auto body
panel?
• The choice of material will dictate the
manufacturing process for the body panel as
well as manufacturing costs.
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Which Material to Choose?
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The Four Fundamental Principles
of Engineering Economics
• 1: An instant dollar is worth more than a distant dollar…
• 2: Only the relative (pair-wise) difference among the considered
alternatives counts…
• 3: 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
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Principle 1
An instant dollar is worth more
than a distant dollar…
Today 6 months later
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Principle 2
Only the cost (resource) difference
among alternatives counts
Option Monthly Monthly Cash paid Monthly Salvage
Fuel Cost Maintenance at signing payment Value at
(cash end of year
outlay ) 3
Buy $960 $550 $6,500 $350 $9,000
Lease $960 $550 $2,400 $550 0
The data shown in the green fields are irrelevant items for decision 30
making, since their financial impact is identical in both cases
Principle 3
Marginal (unit) revenue has to
exceed marginal cost, in order to
increase production
Marginal
cost
Manufacturing cost 1 unit
Marginal
revenue
Sales revenue 1 unit
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Principle 4
Additional risk is not taken without a
suitable expected additional return
Investment Class Potential Expected
Risk Return
Savings account Lowest 1.5%
(cash)
Bond (debt) Moderate 4.8%
Stock (equity) Highest 11.5%
A simple illustrative example. Note that all investments imply
some risk: portfolio management is a key issue in finance
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Summary
• The term engineering economic decision refers to
all investment decisions relating to engineering
projects.
• The five main types of engineering economic
decisions are (1) equipment and process selection,
(2) equipment replacement, (3) new product and
product expansion, (4) cost reduction, and (5)
service improvement.
• The factors of time and uncertainty are the
defining aspects of any investment project.
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