ENGINEERING ECONOMICS

Unit I
Meaning Engineering economics is the application of economic techniques to the evaluation of design and engineering alternatives. The role of engineering economics is to assess the appropriateness of a given project, estimate its value, and justify it from an engineering standpoint. The main area of application of Engineering Economics Elementary economics analysis, Interest formula, Bases for comparing alternative, Replacement analysis, Depreciation, Evaluation of public alternative, Inflation adjusted investment decision, make or buy decision, inventory control, project management, Value engineering and value analysis, linear programming.

ECONOMIC EFFICIENCY Definition Conventional economic efficiency theory states that companies should structure their output to achieve the lowest possible cost per unit produced. Given the combination of fixed and variable costs typical in business, low levels of output are inefficient because fixed costs are shared out across a relatively small number of units. At the other extreme, although above-optimal production can, in theory, generate economies of scale, in practice this apparent benefit is often more than offset by additional costs related to the overstressing of existing systems. In the short term, the point of maximum operational efficiency is achieved at the level of output at which all available economies of scale are taken advantage of, yet short of the level at which the diseconomies of overstraining existing systems come into play. Over the longer term, however, the optimal level of productive efficiency can be raised by increasing the capacity of existing systems. The second element of conventional economic efficiency theory relates to the way existing resources are allocated. The logic is that high levels of competition among producers should prevent them from making excessive profits by raising their selling prices to an unreasonable level above their marginal costs. At the company level, maximum allocative efficiency is achieved when the firm produces the optimal output level of a combination of goods or services to maximize the benefit to the company as a whole. The theory takes account of the fact that company resources are finite and can be used only once, with the result that using a quantity of a material for one purpose involves an opportunity costthat is, it denies the company the chance to use the same material for another purpose. Allocative efficiency is achieved only when no other pattern of utilization of resources can deliver a better overall result in terms of the welfare of all interested parties. This point of maximum allocative efficiency, at which improvements in one aspect of usage can only be achieved at the expense of losses elsewhere, is sometimes referred to as the Pareto optimal allocation of resources.

Advantages The theory provides a basic framework to help understand the various factors that are associated with existing operating costs. An understanding of the main principles of the theory could provide scope for managers to find ways of making some elements of their business work more efficiently. Disadvantages The theory encourages managers to take a static view of their business, with no regard to the possibilities offered by innovation. The rapid pace of technological development over recent years has highlighted this shortcoming in classic economic efficiency theory. The focus on the lowest possible cost can give an overly simplistic representation of the way businesses operate, although the theory retains value in some low-technology, noninnovative manufacturing applications. Action checklist Analyze your companys cost structure, determining which costs are fixed and which are largely variable; in practice most costs tend to be semivariable in nature. Consider the levels of production that are likely to begin to put serious strain on existing infrastructure to the point that diseconomies of scale begin to appear. It may be that lessons can be learned from the way systems performed during past periods of temporary high demand. Study how finite resources are being put to work at present. Excessive downtime of resources, including human resources, should be investigated in an effort to bolster allocative efficiency. Dos and Donts Do Make use of the theory to gain a greater understanding of various cost and resource utilization patterns within companies. However, remember that an excessive focus on miniscule cost improvements could distract management from changing industry trends, potentially allowing competitors to capitalize on exciting new opportunities. Consider whether present resource allocation has more to do with past needs and inhouse politics than present or future requirements. Remember that, as the business environment evolves, company resource allocation decisions should reflect changing demands on the business. Dont Dont use economic efficiency theory in isolation. Remember that taking a static view of your business is unlikely to be the best preparation for change. Dont ignore human factors when seeking greater efficiency. Demoralizing staff in the pursuit of insignificant cost savings could generate unforeseen human resource costs. Dont lose sight of wider opportunities to make a quantum leap in efficiency, rather than the small incremental improvements that are typically achieved using economic efficiency theory. Innovation, particularly related to technology, can deliver substantial efficiency benefits.

LAW OF SUPPLY AND DEMAND The market price of a good is determined by both the supply and demand for it. In 1890, English economist Alfred Marshall published his work, Principles of Economics, which was one of the earlier writings on how both supply and demand interacted to determine price. Today, the supply-demand model is one of the fundamental concepts of economics. The price level of a good essentially is determined by the point at which quantity supplied equals quantity demanded. To illustrate, consider the following case in which the supply and demand curves are plotted on the same graph. Supply and Demand

On this graph, there is only one price level at which quantity demanded is in balance with the quantity supplied, and that price is the point at which the supply and demand curves cross. The law of supply and demand predicts that the price level will move toward the point that equalizes quantities supplied and demanded. To understand why this must be the equilibrium point, consider the situation in which the price is higher than the price at which the curves cross. In such a case, the quantity supplied would be greater than the quantity demanded and there would be a surplus of the good on the market. Specifically, from the graph we see that if the unit price is $3 (assuming relative pricing in dollars), the quantities supplied and demanded would be: Quantity Supplied = 42 units Quantity Demanded = 26 units Therefore there would be a surplus of 42 - 26 = 16 units. The sellers then would lower their price in order to sell the surplus. Suppose the sellers lowered their prices below the equilibrium point. In this case, the quantity demanded would increase beyond what was supplied, and there would be a shortage. If the price is held at $2, the quantity supplied then would be: Quantity Supplied = 28 units Quantity Demanded = 38 units Therefore, there would be a shortage of 38 - 28 = 10 units. The sellers then would increase their prices to earn more money.

The equilibrium point must be the point at which quantity supplied and quantity demanded are in balance, which is where the supply and demand curves cross. From the graph above, one sees that this is at a price of approximately $2.40 and a quantity of 34 units. To understand how the law of supply and demand functions when there is a shift in demand, consider the case in which there is a shift in demand: Shift in Demand

In this example, the positive shift in demand results in a new supply-demand equilibrium point that in higher in both quantity and price. For each possible shift in the supply or demand curve, a similar graph can be constructed showing the effect on equilibrium price and quantity. The following table summarizes the results that would occur from shifts in supply, demand, and combinations of the two. Result of Shifts in Supply and Demand Demand Supply Equilibrium Price Equilibrium Quantity

+ + + + + +

+ + ? ? + -

+ + + ? ?

In the above table, "+" represents an increase, "-" represents a decrease, a blank represents no change, and a question mark indicates that the net change cannot be determined without knowing the magnitude of the shift in supply and demand. If these results are not immediately obvious, drawing a graph for each will facilitate the analysis. MARGINAL COST The marginal cost of production is the increase in total cost as a result of producing one extra unit. The concept of marginal cost in economics is similar to the accounting concept of variable cost. It is the variable costs associated with the production of one more units. Marginal costs are not constant. For example a factory may be operating at the highest capacity it can with all workers working normal full time hours, so increasing production by one more unit would mean paying overtime, so the marginal cost would be higher than the current variable cost per unit. MARGINAL REVENUE The revenue associated with one additional unit of production. Whether this is higher, lower or the same as the revenue from the previous unit of production depends on the demand for the producer's product. In the case of a producer who supplies a very small percentage of the market, an extra unit of production is unlikely to have an effect on market prices. In this case, increased production will not affect marginal revenue. On the other hand, if the producers supplies most or all of the market (such as in a monopoly or near-monopoly), then increased production is likely to reduce marginal revenue. SUNK COST Sunk costs are costs that have been incurred and cannot be reversed, for example, spending on ADVERTISING or researching a product idea. They can be a barrier to entry. If potential entrants would have to incur similar costs, which would not be recoverable if the entry failed, they may be scared off. A common mistake made by investors is reluctance to sell securities at a loss. It does not matter what you paid for shares, if the market price has fallen you have already made that loss. It is a sunk cost and should be forgotten about. What matters is whether the shares are worth holding or not at the current market price. A key question is whether the shares would still be worth buying at current prices. If not, they are probably not worth holding. OPPORTUNITY COST The true cost of something is what you give up to get it. This includes not only the money spent in buying (or doing) the something, but also the economic benefits (UTILITY) that you did without because you bought (or did) that particular something and thus can no longer buy (or do) something else. For example, the opportunity cost of choosing to train as a lawyer is not merely the tuition fees, PRICE of books, and so on, but also the fact that you are no longer able to spend your time holding down a salaried job or developing your skills as a footballer. These lost opportunities may represent a significant loss of utility. Going for a walk may appear to cost nothing, until you consider the opportunity forgone to use that time earning money. Everything you do has an opportunity cost (see SHADOW PRICE). ECONOMICS is primarily about the efficient use of scarce resources, and the notion of opportunity cost plays a crucial part in ensuring that resources are indeed being used efficiently.
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BREAK-EVEN ANALYSIS Introduction Break-even analysis is a technique widely used by production management and management accountants. It is based on categorizing production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production). Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point"). The Break-Even Chart In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made. Fixed Costs Fixed costs are those business costs that are not directly related to the level of production or output. In other words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of
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investment in production capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business. Examples of fixed costs: - Rent and rates - Depreciation - Research and development - Marketing costs (non- revenue related) - Administration costs Variable Costs Variable costs are those costs which vary directly with the level of output. They represent payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs such as commission. A distinction is often made between "Direct" variable costs and "Indirect" variable costs. Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those working on the production line are good examples. Indirect variable costs cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output - e.g. machine hours), maintenance and certain labour costs. Semi-Variable Costs Whilst the distinction between fixed and variable costs is a convenient way of categorising business costs, in reality there are some costs which are fixed in nature but which increase when output reaches certain levels. These are largely related to the overall "scale" and/or complexity of the business. For example, when a business has relatively low levels of output or sales, it may not require costs associated with functions such as human resource management or a fully-resourced finance department. However, as the scale of the business grows (e.g. output, number people employed, number and complexity of transactions) then more resources are required. If production rises suddenly then some short-term increase in warehousing and/or transport may be required. In these circumstances, we say that part of the cost is variable and part fixed. PV RATIO P/V Ratio is the relationship between the profit & sales.In formula it is expressed as P/V Ratio= Contribution/sales*100. The higher the P/V Ratio better is for company prospects. P/V ratio= Contribution/sales. P/V ratio= Sales-Variable Cost/Sales P/V ratio= Fixed Cost+ Profit/ Sales.
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PROCESS PLANNING Process planning is a key element in project management that focuses on selecting resources for use in the execution and completion of a project. In a manufacturing setting, this aspect of planning also includes establishing the general sequence of steps that begin with the acquisition of materials and end with the creation of a finished product. Process planning is often closely associated with project planning, although the specific functions of each tool are used differently in the overall strategic planning. While both process planning and project planning are necessary to give form and focus to any project, each procedure fulfills specific needs. Process planning helps to create the general process necessary to reach an ultimate goal, such as the creation of a product or the development of a marketing campaign. Project planning looks at each of the steps or processes identified in process planning and defines the specific actions that must take place in order for each of the processes to be completed successfully. In a sense, a process plan provides the framework for a procedure while a project plan provides the specifics of how to complete each step or process necessary to achieve the desired outcome. Process planning is not a new concept. The strategy has been utilized in business circles for centuries. Private and non-profit organizations often use this same type of planning when structuring a new project or directive. While the amount of detail involved will depend greatly on the scope of the project and the culture of the business or entity conducting the project, the planning works in just about any setting where a group of people wish to determine how to reach a specific goal. In a manufacturing setting, process planning may also address concerns that are related to the steps identified as necessary to create a product. For example, the plan may also address issues such as designing the packaging or labeling for the final product, as well as the creation of user instructions that accompany each unit that is sold. ELEMENTS OF COSTS VARIABLE COST A cost of labor, material or overhead that changes according to the change in the volume of production units. Combined with fixed costs, variable costs make up the total cost of production. While the total variable cost changes with increased production, the total fixed costs stays the same. Direct material cost Part of raw material cost that can be specifically and consistently associated with or assigned to the manufacture of a product, a particular work order, or provision of a service. Direct labour cost Part of wage-bill or payroll that can be specifically and consistently assigned to or associated with the manufacture of a product, a particular work order, or provision of a service.

Direct expenses Direct expenses are those expenses that are levied during the production of goods. For ex. wages.
Fixed Cost

A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity. Unlike variable costs, fixed costs are not affected by changes in activity. Consequently, as the activity level rises and falls, the fixed costs remain constant in total amount unless influenced by some outside forces, such as price changes. Rent is a good example of fixed cost. Fixed cost can create confusion if they are expressed on per unit basis. This is because average fixed cost per unit increases and decreases inversely with changes in activity. Examples of fixed cost include straight line depreciation, insurance property taxes, rent, supervisory salary etc.
Overhead Cost

In business, overhead, overhead cost or overhead expense refers to an ongoing expense of operating a business (also known as Operating Expenses - rent, gas/electricity, wages etc). The term overhead is usually used to group expenses that are necessary to the continued functioning of the business, but cannot be immediately associated with the products/services being offered

Indirect material cost

The cost of raw materials and components cost that cannot easily and economically be identified either with an individual unit of production or with a responsibility centre. Indirect expenses Indirect expenses are those expenses which are incurred after the manufacturing of goods. Selling price of a product is derivecd as shown below: a) b) c) d) e) f) g) Prime costs = Direct material costs + direct labour costs + direct expenses Factory Cost = Prime cost + factory overhead Cost of Production = factory cost + office and administrative overhead Cost of goods sold = cost of production + opening finished stock closing finished stock Cost of sales = Cost of goods sold + selling and distribution overhead Sales = Cost of sales + Profit Selling per unit = Sales / quantity sold