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ENG 3000 Summer 2018

Module 1: Making Economic Decisions


Reference:
Newnan, D., Jones, J., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Can. ed.). Oxford University Press.

Learning Objectives
• Distinguish between simple and complex problems
• Discuss role and purpose of engineering economic analysis
• Describe nine steps of economic decision-making process
• Select appropriate economic criteria for different problem types
• Solve simple engineering decision-making problems

Problem Complexity
• Can be classified by levels of difficulty:
– Simple (not much effort):
• e.g. If we use a machine three items per week, how many should we buy at a
time?
– Intermediate (primarily economic):
• e.g. Which machine should be purchased? Low-cost, requiring three operators or
high-cost, requiring only two operators?

– Complex (mixture of economic, political and humanistic elements):


• e.g. Annual budget of corporation. All projects evaluated economically but may
also include:
– Non-economic factors such as political or national concerns, individual
concerns, and other corporation-wide impacts.

Role of Engineering Economic Analysis


• Suitable for intermediate problems and economic aspects of complex problems. Problems
should:
– Be important enough to justify serious thought and effort
– Not be easily worked out in one’s head - organization of problem and consequences
required!
– Have economic aspects important in making decision

Decision-Making Problem
1. Recognize the problem
– Starting point in rational decision-making is recognizing problem exists
– Problems can be previously unrecognized or only become apparent directly as result of
new situation
– Some firms establish programs to identify problems, e.g.:
• TQM: Total Quality Management
• CI: Continuous Improvement

2. Define the goal or objective


– Goal or objective can be wide or narrow in scope
• Wide scope:
– e.g. Make business more profitable
• Narrow scope:
– e.g. Determine most economical machines to purchase
– Defining objective describes goal

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Figure 1: Flow Chart of Decision-Making Process (Newnan et al. 2011)

3. Assemble relevant data


– Published information
• Problem’s time horizon part of data assembled
– e.g. how long will building or equipment last?
– Individual’s knowledge and experience
– Accounting data for engineering companies
• Shows costs and benefits
– Need to determine “true” differences between alternatives
• Might require some adjustment of cost accounting data

– Determine financial consequences (costs and benefits) of various alternatives:


• Market consequences
– Items with direct marketplace price
– e.g. Determine raw material prices and machinery costs

• Extra-market consequences
– Items with no direct marketplace price but for which price may be
assigned indirectly
– e.g. Cost of employee injury, value of employee going from five day to
four day week

• Intangible consequences
– Items that cannot be numerically priced
– e.g. potential loss of worker’s jobs due to automation, value of
landscaping around factory

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4. Identify feasible alternatives


– “Do-nothing” alternative sometimes ignored but can be feasible
– Determine and list ALL potential alternatives:
• Conventional and unconventional
• Through “brainstorming”
• Only feasible alternatives are used for analysis

5. Select the criterion to determine the best alternative


– Standards by which to determine best alternative:
• Disturbance to environment
• Monetary expenses
• Benefits gained from decision vs. losses from decision
• Time needed to accomplish goal or objective
• Profit

5. Select the criterion to determine the best alternative


– Standard “profit” normally selected in engineering decision making. If selected, problem
falls into one of three categories
• Fixed input:
– Amount of input resources or money fixed
– Objective is to maximize benefits or outputs
• Fixed output:
– Output objectives or results fixed
– Objective is to minimize costs or other inputs
• Neither fixed:
– Input and output not fixed
– Objective is to maximize difference between benefits (return from
investment) and costs (of investment)

6. Construct a Model
– Various elements of problem brought together to help form solution
• e.g. loan consists of mathematical relationship between:
– Loan amount, Interest rate, duration and payments
– Constructing interrelationship = model building
• e.g. mathematical model of classroom student capacity:

– where l = classroom length, w = classroom width and k = classroom


arrangement factor

7. Predict Each Alternative’s Outcomes or Consequences


– Model and data used to predict outcomes of alternatives
– To choose alternative, they must be evaluated in comparable way
• Usually in terms of money, i.e. costs and benefits
– Most common error for longer-term problems is assumption that current situation will
continue well into future or that “do nothing” alternative implies that nothing else changes

8. Choose the Best Alternative


– Alternative to be chosen is one that best meets chosen criterion/ standard
• After considering numerical + intangible consequences not included in monetary
analysis

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– Intangibles may influence decision such that most economical


(monetarily) may not be chosen
– Need to consider way in which decision-making process is carried out
• e.g. When is decision made and who makes it?
• May drastically affect final decision

9. Audit the Results


– Comparison of what happened against predictions
– Benefits:
• Provides feedback into decision-making process
• Helps keep project on track
• Helps future estimates and assumptions
• Provides incentive to give accurate estimates

Ethics
• Need to distinguish between right and wrong in decision making
– Usually clear but there are ethical dilemmas
– Ethical dilemmas may arise in many situations including economic analysis

• Ethical codes of conduct exist for professional engineers


– Canadian Council of Professional Engineers (CCPE) Code of Ethics

Table 1: Examples of Ethical Lapses in Decision-Making Process (Newnan et al. 2011)

• Sales tactics can mix business and pleasure activities


– Some activities can be considered business opportunities (networking) but can bring up
ethical questions
– Are tactics providing ‘favour’?
• Need to separate “favours” from “appropriate evaluation”

• Most common conflicts in conceptual design phase involves trade-offs between:


– Cost
– Quality
– Functionality
• How to treat this?

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• Environment:
– Large-scale projects typically involve some environmental impact
• How to account for these impacts?
• How to balance stakeholders with opposing viewpoints?
• How to set minimum standards?

• Most difficult trade-offs between:


– Safety
– Cost
• Is it safe enough?
• Can anything be “too safe”?
• How much more cost versus relative safety?

Decision-Making for Current Costs


• If decision is one where results are known in short time period:
– Can be made by adding up costs and benefits between alternatives
– Example: (Tile for plant floor—fixed output)
• 1000 m2
• Tile A costs:
– Purchase: $52/m2, Installation: $37,000
• Tile B costs:
– Purchase: $63/m2, Installation: $28,000
• Select Tile A to minimize cost for fixed output

Example 1
Problem
Assume a company with the following average monthly costs for its three-person printing department.

The printing department charges the other departments for its services to recover its $18,000 monthly
cost. The charge to run 1,000 copies of an announcement is:

Another commercial printer prints the same 1,000 copies for $22.95. If the shipping department needs
about 30,000 copies printed a month, which printer should the department use?

Solution

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The allocation of indirect costs may be misleading for decision-making. As shown on above table,
shipping department would reduce cost from $793.50 to $688.50. What about printing department’s
costs?

 Direct labour: if the printing department works overtime, then overtime would be reduced or
eliminated. But assuming no overtime, it’s unlikely that a printer will be fired! Although there might
be a $228 saving, it’s more likely there will be no reduction in direct cost.

 Materials and supplies: There would be a $294 saving.

 Allocated Overhead Costs: There will be no reduction as there will be no reduction in department
floor space (actually, there might be small reduction in company’s power costs).

The company will save $294 in materials and supplies and may or may not save $228 in direct labour if
the job is done by the outside printer. The maximum saving would be $522 and it would most probably be
$294. If the shipping department obtains printing from outside printer, the company will pay $668.50 a
month.

The shipping department should therefore use the printing department and not the outside printer.

Example 2
Problem
A concrete aggregate mix must contain at least 31% sand by volume for proper batching. Source A has
25% sand and 75% coarse aggregate and sells for $3 per cubic metre (m 3). Source B has 40% sand and
60% coarse aggregate and sells for $4.40/ m 3. Determine which source or blend of sources (in
percentage) will be used and its cost per cubic metre.

Solution

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Therefore, the blended aggregates will contain: 60% of source A and 40% of source B. The cost per cubic
meter of this blend is $3.56/m 3.

Example 3
Problem
A machine part is manufactured at a unit cost of 40¢ for material and 15¢ for direct labour. An investment
of $500,000 in tooling is required for this method.

A new method of manufacture is being investigated. This new method reduces unit costs to 34¢ for
material and 10¢ for direct labour. An investment of $600,000 in tooling would be required.

Both methods incur other costs that are 2.5 times the direct labour costs.

Assume an order call for 1.5 million pieces. Which of these two methods should be used?

Solution
Old method cost:

New method cost:

The newest method has the lowest cost. Therefore, it should be used.

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