ENGINEERING ECONOMY AND ENTERPREUNERSHIP

FOUNDATIONS OF ENGINEERING ECONOMY

Engineering economy is the application of economic factors and criteria towards
decision making for projects. It involves the computation of economic measures
of fundamental elements of cash flow, time and interest rates.
ENGINEERING
MAKING

ECONOMICS:

DESCRIPTION

AND

ROLE

IN

DECISION

Decision making involves choosing of alternatives. Most decision involves money

or capital fund, which is usually limited in amount. The decision is motivated by
a primary goal of adding value to the the present wealth. Hence, engineering
economy involves formulating, estimating and evaluating the expected
economic outcomes of alternatives to accomplish the highest added
value factors. Other terms that refer to engineering economy are engineering
economic analysis, capital allocation study or economic analysis.
The time frame of engineering economy is the future. The data used reflects the
best estimates of what is expected to occur. It involves four (4) essential
elements namely cash flows, time of occurence of cash flows, interest
rates for the time value of money and measures of economic worth for
selecting an alternative.
The estimates of cash flows are for the future. Therefore, there will be variation
between an amount estimated now and that observed in the future. Sensitivity
analysis is used to determine how a decision might change according to the
varying estimates.
Example:
Year
Average Cost RM/repair

2006
525

2007
430

2008
619

2009
650

2010
625

What range of repair costs should be used to ensure that the analysis is sensitive
to changing warranty costs?
Going over the 5-year period, the average is RM570/repair. Hence the range is
-25% (RM430/repair) to +15 (RM650/repair). However, if the analysis uses the
more recent data; say the last 3 years which shows a more consistent outcome,
the average is RM631/repair giving a range of -1.7% (RM619/repair) to +3%
(RM650/repair).
The criteria used to select an alternative in engineering economy for a specific
set of estimates is called a measure of worth. The measure of worth used are:

Present Worth (PW)

Future Worth (FW)

Rate of Return (ROR) Payback Period

Benefit/Cost (B/C)
Economic Value
1

Added

Annual Worth (AW)

(EVA)
Capitalized Cost (CC) Cost Effectiveness

All of the measures of worth is affected by the time value of money i.e. money
makes more money over time.
Engineering economy is also used for the analysis of past cash flows in order to
determine if a specific criterion or measure of worth was attained.
Example:
You purchase 53 nos. shares for RM4,975 and expect to have 8% appreciation per
year. The share is now worth RM6,744 for a 10.67% return. You have therefore
attained your criterion of only 8% return.
PERFORMING AN ENGINEERING ECONOMY STUDY

The steps in an engineering economy study are as follow:

1. Identify and understand the problem; identify the objective of the project.
2. Collect relevant, available data and define viable solutions alternatives.
3. Make realistic cash flows estimates.
4. Identify an economic measure of worth criterion for decision making.
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5. Evaluate each alternative; consider non-economic factors; use sensitivity

analysis as needed.
6. Select the best alternative.
7. Implement the solution and monitor the results.
Step no. 7 is not part of the economy study, but it is, a step needed to meet the
project objective.
A concise statement of the problem and primary objective(s) is very important
to the formation of an alternative solution. Alternatives are stand-alone
descriptions of viable solutions to problems that can meet the objectives. The
best estimates for parameters are also part of the alternatives example,
equipment first cost, expected life, salvage value, etc. Detailing all viable
alternatives at this stage is crucial.
All cash flows are estimated for each alternative. Since these are future
expenditures and revenues, the estimated cash flows most probably to be
inaccurate when an alternative actually is in place and operating. When cash flow
estimates for specific parameters are expected to vary significantly from a point
estimate made now, risk and sensitivity analyses are needed to improve the
chances of selecting the best alternative.
Engineering economy analysis is the technique and computations that is to be
utilized in making cash flow estimates, time value of money, and a selected
measure of worth. In the end, a selected measure of worth will be used to select
the best alternative. Two factors affecting this analysis are taxes and inflation,
more likely if different projects are impacted differently by them.
Selecting the best alternative is primarily based on the agreed measured of
worth or criterion which in most cases dependence upon economic factors.
However, non-economic or intangible factors must also be considered and that
may alter the decision. Some of these factors are:

Market pressure, such as need for an increased international presence.

Availability of certain resources e.g. skilled labor force, water, power, tax
incentives.
Government laws that dictate safety, enviromental, legal and other
aspects.
Corporate managements or the board of directorsinterest in a particular
alternative.
Goodwill offered by an alternative toward a group; employees, union, etc.

Once all economic, non-economic, and risk factors have been evaluated, a final
decision of the best alternative is made. When only one viable alternative is
identified, the do-nothing (DN) alternative may be chosen provided the
measure of worth and other factors result in the alternative being a poor choice.
The do-nothing alternative maintains the status quo.

In economic analysis, financial units are generally used as the tangible basis for
evaluation. Thus, when there are several ways of accomplishing a stated
objective, the alternative with the lowest overall cost or highest overall net
income is selected.
PROFESSIONAL ETHICS AND ECONOMIC DECISIONS
Many of the fundamentals of engineering morals and ethics are interwined with
the roles of money and economic-based decisions in the making of professionally
ethical judgement. Morals relate to the underlying tenets that form the
character and conduct of a person in judging right and wrong. Ethical practices
can be evaluated by using a code of morals or code of ethics that forms the
standards to guide decisions and actions of individuals and organizations in a
profession.
There are several different levels and types of morals and ethics:

Universal or common morals fundamental moral beliefs held by

virtually all people. It is however, possible for actions and intentions to
come into conflict concerning a common moral.
Individual or personal morals these are the moral beliefs that a
person has and maintains over time. These usually parallel the common
morals. It is also possible that an individual strongly support the common
morals and has excellent personal morals, but these may conflict when
decisions must be made. Example, common moral accept that cheating is
wrong but when a certain objective need to be met, personal morals on
the same issue can be violated.
Professional or engineering ethics professionals in a specific
discipline are guided in their decision making and performance of work
activities by a formal standard or code. The code states the commonly
accepted standards of honesty and integrity that each individual is
expected to demonstrate in his practice. Conflicts can also easily rise in
the mind of an individual between his personal ethics and that of the
employing corporation.

When an engineering economic study is performed, it is important to consider all

ethically related matters to ensure that the cost and revenue estimates reflect
what is likely to happen once the project or system is operating.
INTEREST RATE AND RATE OF RETURN
Interest is the manifestation of the time value of money. Interest is paid when a
borrower repays a larger amount over time. Interest earned is when an
investor/lender receives a larger amount over time than the deposit made earlier.
Interest paid = Amount owed now Principal
Interest Rate (%) = Interest accrued per time unit (interest period) x 100%
Principal
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Total due = Principal (1 + Interest rate)period

From the perspective of a saver, interest earned is the final amount minus
the initial amount.
Interest earned = Total amount now Principal
Interest earned over a specific period of time is expressed as a percentage of the
original amount and is called Rate of Return (ROR):
Rate of Return (%) = Interest accrued per time unit (interest period) x
100%
Principal
It is important to state whether interest is accrued on simple interest i.e. interest
on principal only or compound interest i.e. interest on interest.
Interest rates reflect two things: a so-called real rate of return plus the expected
inflation rate. The real rate of return allows the investor to purchase more than he
could have purchased before the investment, while inflation raises the real rate
to the market rate that we use on a daily basis. Inflation causes interest rate to
rise.
From the borrow ers perspective, inflation is another interest rate tacked on to
the real interest rate while to the investor, inflation reduces the real rate of return
on the investment. Inflation means that cost and revenue cash flow estimates
increase over time. This increase is due to the changing value of money that is
forced upon a countrys currency by inflation, thus making a unit of currency
worth less relative to its value at a previous time. Inflation contributes to:

A reduction in purchasing power of the currency

An increase in the consumer price index or CPI
An increase in the cost of equipments and its maintenance
An increase in the cost of salaried professionals and hourly employees
A reduction in the real rate of return on personal savings and certain
corporate investments

Inflation can materially contribute to changes in corporate and personal

economic analysis.
TERMINOLOGY AND SYMBOLS
The equations and procedures of engineering economy uses the following terms
and symbols:
P =

value or amount of money at a time designated as present or 0 time.

Also P is referred to as present worth (PW), present value (PV), net
present value (NPV), discounted cash flow (DCF) and capitalized cost (CC)
of monetary units.

F = value or amount of money at some future time. Also F is called future

worth (FW), and future value (FV) of monetary units.
A=

a series of consecutive, equal, end-of-period amounts of money. Also A

is called the annual worth (AW) and equivalent uniform annual worth
(EUAW) of monetary units per time period.

n = number of interest periods; year, months, days

i = interest rate per time period; percent per year, percent per month.
t = time, stated in periods; years, months, days.
P and A represent one-time occurrence: A occurs with the same value in each
interest period for a specified number of periods. The present value P represents
a single sum of money at some time prior to a future value F or prior to the first
occurrence of an equivalent series amoun A.
A always represents a uniform amount i.e. the same amount for each period, that
extends through consecutive interest periods. Both conditions must exist before
the series can be represented by A.
The interest rate i is expressed in percent per interest period. Unless stated
otherwise, assume that the rate applies throughout the enire n years or interest
periods.
All engineering economy problems involve the element of time expressed as n
and interest rate i. In general, every problem will involve at least four of the
symbols P, F, A, n and i with at least three of them estimated or unknown.
Example,
You plan to make a lump-sum deposit of $5,000 now into an investment account
that pays 6% per year, and you plan to withdraw an equal end-of-year amount of
$1,000 for 5 years, starting next year. At the end of the 6th year, you plan to
close your account by withdrawing the remaining money. Define the engineering
economy symbols involve.
All 5 symbols are present, but the future value in year 6 is the unknown.
P = $5,000; A = $1,000 per year for 5 years; F = ? at end of Year 6; i = 6% per
year ;
n = 5 years for the A series and 6 for the F value
CASH FLOWS: ESTIMATION AND DIAGRAMMING
Cash flows are the amounts of money estimated for future projects or observed
for project events that have taken place. Engineering economy bases its
computations on the timing, size and direction of cash flows.
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Cash inflows are the receipts, revenues, incomes and savings generated by
project and business activity. A plus sign indicates a cash inflows. Example,

Revenue: +$150,000 to $75,000 per month in sales for extended battery

life iPhones
Savings: +$24,500 tax savings from the capital loss on equipment salvage

Cash outflows are costs, disbursement, expenses and taxes caused by projects
and business. A negative or minus sign indicates a cash outflows. Example,

Operating costs: -$230,000 per year annual operating costs for software
services
First cost: -$800,000 next year to purchase replacement earthmoving
equipment

Cash flow estimates can be a single value known as point estimates or singlevalue estimates or it can be a range estimate, where range is given instead
of a single value.
Net cash flow (NCF) is the difference between cash inflows and cash outflows or
receipts (R) and disbursement (D).
Net Cash Flow (NCF) = Cash Inflows Cash Outflows
NCF
= R - D
The end-of-period convention means that all cash inflows/outflows are assumed
to take place at the end of the interest period in which they actually occur. When
several inflows and outflows occur within the same period, the net cash flow is
assumed to occur at the end of the period. End of the period means end of
interest period.
Example,
A company is incorporating a GPS data into its latest tracking device. This new
feature will increase the revenue by RM200,000 for each of the next 2 years and
RM300,000 for each of years 3 and 4. The planning horizon is 4 years. The
interest rate is 8% per annum. Determine the total interest and total revenue
after 4 years using a compound interest method.
Yea
r

Revenue
(A)

1
2

200,000
200,000

3.

300,000

Amount received at end-of-period (RM)

Interest
Cum.
Total
(B = Rate x
Interest
(D)
E)
(C)
0
0
200,000
0.08 x
16,000
216,000
200,000 =
16,000
0.08 x
49,280
333,280
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Cum. Total
(E)
200,000
416,000

749,280

4.

300,000

416,000 =
33,280
0.08 x
749,280 =
59,942

109,222

359,942

1,109,222

Note that all receipts are deemed at the end of interest period. Total revenue is
RM1,000,000 and total interest RM109,222
Cash flow diagram represents cash flows drawn on the y-axis with a time scale on
the x-axis. The direction of the arrows on the diagram differentiate income (an
upward pointing arrow) and outgoing (downward pointing arrow).
Example,
A rental company spent RM2,500 on a new air compressor 7 years ago. The
annual rental income from the compressor has been RM750. The RM100 spent on
maintenance the first year has increased each year by RM25. The company plans
to sell the compressor at the end of next year for RM150. Construct the cash flow
diagram from the companys perspective and indicate where the present worth is
located.

ECONOMIC EQUIVALENCE
Economic equivalence is a combination of interest rate and time value of money
to determine the different amounts of money at different points in time that are
equal in economic value. Example, at 6% per year, RM100 at time 0 is RM94.34
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at time - 0 i.e. RM100/1.06 and RM106 in time 1 i.e. RM100(1.06). The interest
rate to be RM94.34 at time -1 and RM106 at time 1 must be 6%. These amount
are equivalent following the time value of money.
Comparison of alternative cash flow series requires the use of equivalence to
determine when the series are economically equal or if one is economically
preferable to another. The keys to the analysis are the interest rate and the
timing of the cash flows.
SIMPLE AND COMPOUND INTEREST
Simple interest is calculated using the principal only, ignoring any interest
accrued in the preceding interest periods.
Simple Interest (I) = Principal x Number of periods x Interest rate = Pni
For compound interest, the interest accrued for each interest period is calculated
on the principal plus the total amount of interest accumulated in all previous
periods.
Compound interest = (Principal + All accrued interest)(Interest rate)
Total due afte n years = Principal (1 + interest rate) n years = P(1 + i)n
MINIMUM ATTRACTIVE RATE OF RETURN (MARR)
For investment to be profitable, a fair rate of return (ROR) or return on
investment (ROI) must be realized.
The Minimum Attractive Rate of Return (MARR) is a reasonable rate of return
established for the evaluation and selection of alternatives. A project is not
economically viable unless it is expected to return at least the MARR. MARR is
also referred to as the hurdle rate, cutoff rate, benchmark rate and minimum
acceptable rate of return.

In Malaysia, the Malaysian Government Securities/Treasury Bill return is the

return with no risk. The MARR is always higher than this.
Although the MARR is used as criterion to decide on investing in a project, the
size of MARR is fundamentally connected to the cost of capital i.e. the cost of
money in the form of interest to raise capital.
Capital is developed in two ways i.e. equity financing and debt financing. Equity
financing is when corporations uses its own funds from cash on hand, stock
sales or retained earnings. Debt financing is when corporation borrows from
outside sources and repays the principal and interest. Sources of debt capital
may be bonds, loans, mortgages, venture capital pools.
Combinations of debt-equity financing results in Weighted Average Cost of
Capital (WACC). The established MARR used as a criterion to accept or reject an
investment alternative will usually equal to or higher than the WACC that the
corporation must bear to obtain the needed capital fund.
ROR > MARR > WACC
There are many alternatives that are expected to yield a ROR that exceeds the
MARR but they maybe insufficient capital available or the project is of high risk.
As an alternative, the comparison on the viability of a project is made against
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unfunded project. The expected rate of return on the unfunded project is called
the opportunity cost.
The opportunity cost is the rate of return of a forgone opportunity caused by the
inability to pursue a project. Numerically, it is the largest rate of return of all the
projects not accepted (forgone) due to the lack of capital funds or other
resources. When no specific MARR is established, the de facto MARR is the
opportunity cost, i.e. the ROR of the first project not undertaken due to
unavailability of capital funds.
Example,
Assume a project is targeted to have an MARR of 12%. A proposal A, for similar
project but not funded is expected to have a ROR of 13%. Another proposal B, is
funded and has a ROR of 14.5%. Since proposal A is not funded due to lack of
capital, its estimated ROR of 13% is the opportunity cost; that is, the opportunity
to make an additional 13% return is forgone.
INTRODUCTION TO SPREADSHEET USE
The functions on a computer spreadsheet can greatly reduced the amount of
hand work for equivalency computations involving compound interest and the
terms P, F, A, i and n. A total of seven Excel functions can perform most of the
fundamental enginering economy functions.

To find the present value P

: = PV(i%, n, A, F)
To find the future value F
: = FV(i%, n, A, P)
To find equal, periodic value A
: = PMT(i%, n, P, F)
To find the nos. Of periods n
: = NPER(i%, A, P, F)
To find the compound interest rate i : = RATE(n, A, P, F)
To find the compound interest rate i : = IRR(first_cell:last_cell)
To find the present value P of any series :
= NPV(i%,
second_cell:last_cell) + first_cell

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