Engineering Economics

Rajeev Bansal February 1, 2006

Engineering Economics
Why is it important? Value and Interest Cash Flow Diagrams and Patterns Equivalence of Cash Flow Patterns Evaluating Alternatives Break-Even Analysis Income Tax and Depreciation Inflation Conclusion

Why do we care about Engineering Economics?

Engineering designs are intended to produce good results. They are accompanied by undesirables (costs). If outcomes are evaluated in dollars, and good is defined as profit, then decisions will be guided by engineering economics. This process maximizes goodness only if all outcomes are anticipated and can be monetized.

Value and Interest

The value of money depends on the amount and when it is received or spent.
Example: What amount must be paid to settle a current debt of $1000 in two years at an interest rate of 8% ? Solution: $1000 (1 + 0.08) (1 + 0.08) = $1166 $1000 1 2 $1166

Cash Flow Diagrams

P-Pattern F-Pattern A-Pattern G-Pattern
1 2 3 n

present future annual gradient

Equivalence of Cash Flow Patterns

To Find Given Multiply By F P A A P F P G
( F / P )in ( P / F )in ( A / P )in ( A / G )in

Formula
(1 + i) n 1 (1 + i) n i (1 + i ) n (1 + i ) n 1 1 n i (1 + i ) n 1

Example: A new circuit board component insertion tool will save $50,000 in production costs each year and will have a life of seven years. What is the highest price that can be justified for the tool using a 12% interest rate?
50k 50k 50k 50k 50k 50k 50k 5 6 7

Solution:
1 P 2 3 4

(1 + i ) n 1 P = ( P / A)12% A = A 7 n i (1 + i ) (1 + 0.12) 7 1 = $50,000 7 0.12(1 + 0.12) = 4.56 $50,000 = $228k

Evaluating Alternatives
Annual Equivalent Cost Comparisons Present Equivalent Cost Comparisons Incremental Approach Rate of Return Comparisons Benefit/Cost Comparisons

Minimum Attractive Rate of Return (MARR): The lowest rate of return that the organization will accept.

Annual Equivalent Cost Comparison

Incomes are converted to an A-pattern. Costs are converted to an A-pattern. The costs are subtracted from the incomes to determine the ANEV. Mutually Exclusive Alternatives choose the one with highest ANEV Independent Alternatives choose all with positive ANEV
ANEV: Annual Net Equivalent Value

Example: A new circuit board component insertion tool is needed. Which should you buy?
Model JACO Cheepo Price $220k $100k Annual Maintenance Salvage Value Life $20k $35k $30k 0 10 years 5 years

Solution: The ANEV is calculated for each: JACO: ANEV = ( A / P )10% 220k 20k + ( A / F )10% 30k 10 10 = 35.8k 20k + 1.9k = 53.9k Cheepo: ANEV = ( A / P )10% 100k 35k 5 = $61.4k

JACO

Present Equivalent Cost Comparison

Incomes and costs are converted to P-patterns. The costs are subtracted from the incomes to determine the PNEV. Mutually Exclusive Alternatives choose the one with highest PNEV Independent Alternatives choose all with positive PNEV
PNEV: Present Net Equivalent Value, also called life cycle cost, present worth, capital cost, and venture worth.

Incremental Approach
For a set of mutually exclusive alternatives, only the differences in amounts need to be considered.
Model JACO Cheepo Price $220k $100k Annual Maintenance Salvage Value Life $20k $35k $30k 0 10 years 5 years

JACO- Cheepo: PNEV = 120k + ( P / A)10% 15k + ( P / F )10% 100k + ( P / F )10% 30k 10 5 10 = 120k + 92.2k + 62.1k + 11.6k = $45.9k

JACO

Rate of Return Method

ANEV or PNEV is formulated From this, we solve for the interest rate that will give zero ANEV or PNEV This interest rate is the ROR of the alternative For mutually exclusive alternatives, the one with the highest ROR is chosen For independent alternatives, all with a ROR greater than MARR are accepted
ROR: Rate of Return on Investment

Benefit/Cost Comparisons
The benefit/cost ratio is determined from
B uniform net annual benefits = C annual equivalent of initial cost

For mutually exclusive alternatives, the one with the highest B/C is chosen. For independent alternatives, all with B/C > 1 are accepted.
The MARR is used to determine the denominator (cost).

Break-Even Analysis
Break-even point: the value of an independent variable such that two alternatives are equally attractive. For values above the break-even point, one alternative is preferred. For values below the break-even point, the other is preferred. Break-even analysis is useful when dealing with a changing variable (such as MARR).

Income Tax and Depreciation

Businesses pay the IRS a tax:
gross revenue - operating costs TAX = R - interest paid - depreciati on

Depreciation: method of charging the initial cost of an asset against more than one year. An asset is depreciable if :
It is used to produce income, Has a life greater than one year, but Decays, wears out, becomes obsolete, or gets used up.
ACRS: Accelerated Cost Recovery System, used by IRS since 1980.

Inflation
The buying power of money changes with time. Inflation, if anticipated, can be put to good use by fixing costs and allowing income to rise by
Entering long-term contracts for materials or wages Purchasing materials long before they are needed Stockpiling product for sale later.

Conclusion
For-profit enterprises exist to make money. Non-profit entities also make decisions to maximize the goodness of outcomes by assigning dollar values. Your engineering decisions will be shaped by economics.