EE40 Week 1 Principles of Engineering Economy

Principles of Engineering Economics

Different Types of Investments Stocks Bonds Mutual Funds Treasury Notes Certificate of Deposits Rental Property Land

Typical Investment Questions What percentage of annual income should you set aside

for the investment? What is the expected annual return from the investment? How much time is needed to achieve your financial

goals?

Engineering Economic Analysis Use of quantitative and qualitative techniques to analyze

economic differences among engineering design alternatives in selecting the preferred design

Time Value Of Money (TVOM) Php 1,000 today or Php X a year from now

Time Value Of Money (TVOM) Current VS Deferred choice Inflation “Money has time value in the absence of inflation”

Because of the earning power of money Borrowing & Repaying The interest rate you charge is based on TVOM

TVOM Aliases

A.K.A.Opportunity cost of moneyInterest rateDiscount rateHurdle rateMinimum Attractive Rate of Return (MARR)Cost of capital

Cash Flow Approach Cash Flow – when money changes hands from one

individual / organization to another

0 1 2 3YR 0 1 2 3YR

Cash Inflow Cash Outflow

Php 1,000

Php 2,000

Discounted Cash Flows (DCF) Movement of money backward or forward in time Because money has a time value, one should not add or

subtract money unless it occurs at the same point in time

4 DCF Rules

1. Money has a time value2. Money cannot be added or subtracted unless it occurs at

the same point in time3. To move forward one time unit, multiply by (1 + interest

rate)4. To move backward one time unit, divide by (1 + interest

rate)

10 Principles of Engineering Economic Analysis

10 Principles of Engineering Economic Analysis

Principle 1Money has a time value

10 Principles of Engineering Economic Analysis

Principle 2Make investments that are economically justified (that yield positive economic returns)

10 Principles of Engineering Economic Analysis

Principle 3Choose the mutually exclusive investment alternative that maximizes economic worth (consider only monetary aspects of the alternative)

10 Principles of Engineering Economic Analysis

Principle 4Two investment alternatives are equivalent if they have the same economic worth

10 Principles of Engineering Economic Analysis

Principle 5Marginal revenue should exceed marginal cost (added revenue > added cost)

10 Principles of Engineering Economic Analysis

Principle 6Continue to invest as long as each additional increment of investment yields a return that is greater than the investor’s TVOM

10 Principles of Engineering Economic Analysis

Principle 7Consider only differences in cash flows among alternatives

10 Principles of Engineering Economic Analysis

Principle 8Compare investment alternatives over a common period of time (same length of time)

10 Principles of Engineering Economic Analysis

Principle 9Risk and return tend to be positively correlated

10 Principles of Engineering Economic Analysis

Principle 10Past costs (sunk costs) are irrelevant in engineering economic analysis unless they impact future costs

Systemic Economic Analysis Technique (SEAT)

1. What investment alternatives are available?2. What is the length of time over which the decision is to be made?

(planning horizon)3. What TVOM will be used to move monies forward or backward in

time? (interest rate)4. What are the best estimates of the cash flows for each of the

alternatives?5. Which alternative seems best based on the economic criterion

chosen? (PW, FW, AW, ROR, B/C)6. How sensitive is the economic preference to changes in or errors in the

estimates used in the analysis? (What if)7. Which investment is recommended?

Non-Monetary Factors Improved safety Reduced cycle times Improved quality Increased flexibility Increased customer service Improved employee morale Being first to use a particular technology Increased market visibility

Weighted Factor Comparison

Alternative A Alternative B

Factor Weight Rating Score Rating Score

1

2

3

Total 100%

Other Guidelines for Alternatives Obtain support of the users of the recommended system

before presenting it to management Pre-sell the recommendation and eliminate surprises Don’t be enamored with the technical aspects of the

recommended investment Managers tend to have broader perspectives The proposal is only one of many.

ABET’s Engineering Definition Profession in which a knowledge of the mathematical and

natural sciences gained by study, experience and practice is applied with judgment to develop ways to utilize, economically, the materials and forces of nature for the benefit of mankind.

Engineers Work on Projects

Does the project’s benefits exceed its cost?

Engineering Economy Subset of economics applied to engineering projects Engineers seek solution to problems; the economic

viability of each potential solution is normally considered along with the technical aspects

The goal of a solution designer is to seek out the best possible one

Decisions made by engineers, managers, CEOs, and individuals are commonly the result of choosing one alternative over another

Origins of Engineering Economy Arthur Mellen Wellington (1847 – 1895)

was an American civil engineer remembered for his 1887 book The Economic Theory of the Location of Railways.

The saying that “An engineer can do for a dollar what any fool can do for two” is attributed to him.

Engineering Economy Engineering Economy is applied microeconomics where

the fundamental question is…

Is it in the best interest of the enterprise to invest its limited resources in a proposed technical endeavor, or would the same endeavor produce a higher return elsewhere?

Engineers use knowledge to find ways of doing things economically

Solutions to Eng’g Problems Must

Demonstrate a positive balance of long-term benefits over long-term costs

Promote the well-being and survival of the organization Embody creative and innovative technologies and ideas Permit identification and scrutiny of estimated outcomes

Trade-Offs

Cost vs. PerformanceResponse TimeSafetyWeightReliability

Fundamental Principles in Engineering Economics

Principle 1A peso today is worth more than a peso tomorrow (or at a later time)Principle 2All that counts is the difference among alternativesPrinciple 3Marginal revenue must exceed marginal costPrinciple 4Additional risk is not taken without the expected additional return

Principles in Engineering Economics

1. Develop the alternatives2. Focus on the differences3. Use a consistent viewpoint4. Use a common unit of measure5. Consider all relevant criteria6. Make Uncertainty Explicit7. Revisit your decisions

Principles in Engineering Economics

1. Develop the alternativesThe choice (decision) is among alternatives. The alternative needs to be identified and then defined for subsequent analysis

Principles in Engineering Economics

2. Focus on the differencesOnly the differences in expected future outcomes among the alternatives are relevant to their comparison and should be considered in the decisionGoal should be to recommend a future course of action based on the differences among feasible alternatives

Principles in Engineering Economics

3. Use a consistent viewpointThe prospective outcomes of the alternatives, economic and other, should be consistently developed from a defined viewpoint (perspective).

Principles in Engineering Economics

4. Use a common unit of measureUsing a common unit of measurement to enumerate as many of the prospective outcomes as possible will simplify the analysis of alternatives

Principles in Engineering Economics

5. Consider all relevant criteriaSelection of a preferred alternative (decision making) requires the use of a criterion (or several criteria).The decision process should consider both the outcomes enumerated in the monetary unit and those expressed in some other unit of measurement or made explicit in a descriptive manner

Principles in Engineering Economics

6. Make risk and uncertainty explicitRisk and uncertainty are inherent in estimating the future outcomes of the alternatives and should be recognized in their analysis and comparison.

Principles in Engineering Economics

7. Revisit your decisionsImproved decision making results from an adaptive processTo the extent practicable, the initial projected outcomes of the selected alternatives should be subsequently compared with actual results achieved.

Engineering Economic Analysis Procedure (EEAP)

1. Problem recognition, definition & evaluation2. Development of feasible alternatives (Search & Screen)3. Development of outcomes and cash flows for each

alternative4. Selection of a criterion (or criteria)5. Analysis and comparison of alternatives6. Selection of the preferred alternative7. Performance monitoring and post-evaluation results

Seatwork

Complete the 7 steps of EEAP for the following problem:

Long lines during enrollment

Limitations

1. Lack of time and money2. Preconceptions of what will work and what will not3. Lack of knowledge

2 Approaches to Developing Alternatives

1. Classical Brainstorming2. Nominal Group Technique

2 Approaches to Developing Alternatives

1. Classical BrainstormingDeferment of judgmentQuantity breeds qualityRules1.Criticism is ruled out2.Freewheeling is welcome3.Quantity is wanted4.Combination and improvement are sought

2 Approaches to Developing Alternatives

2. Nominal Group TechniqueAndre P. Delbecq & Andrew H. Van de VenReduces dominance of one or more participantsAvoids suppression of conflicting ideasRules1.Individual silent generation of ideas2.Individual round-robin feedback and recording of ideas3.Group clarification of each idea4.Individual voting and ranking to prioritize ideas5.Discussion of group consensus results

Non-monetary Objectives

1. Meeting and exceeding customer expectations2. Safety to employees and to the public3. Improving employee satisfaction4. Maintaining production flexibility to meet changing

demands5. Meeting or exceeding all environmental requirements6. Achieving good public relations or being an exemplary

member of the community.

Sources• http://en.wikipedia.org/• Sullivan, William G., Elin M. Wicks and James T. Luxhoj, Engineering Economy, 14th Ed., Prentice Hall,

Inc., 2009• White et. al. Principles of Engineering Economic Analysis, 5th Ed. John Wiley & Sons. Inc., 2010