Principles of Engineering Economy

Engineering Economy
- Involves the systematic evaluation of economic
merits of proposed solutions to engineering
problems
- It is the study of the desirability of making an
investment
- Solutions to engineering problems must
demonstrate a positive balance of long-term
benefits over long-term costs, they must also:
o promote the well-being and survival of
an organization,
o embody creative and innovative
technology and ideas,
o permit identification and scrutiny of their
estimated outcomes, and
o translate profitability to the bottom line
through a valid and acceptable measure
of merit.
Principles of Engineering Economy
PRINCIPLE 1: DEVELOP THE ALTERNATIVES
-

The choice (decision) is among alternatives.

The alternatives need to be identified and then
defined for subsequent analysis.

PRINCIPLE 2: FOCUS ON THE DIFFERENCES

-

Only the differences in expected future

outcomes among the alternatives are relevant to
their comparison and should be considered in
the decision.

PRINCIPLE3: USE A CONSISTENT VIEWPOINT

-

The prospective outcomes of the alternatives,

economic and other, should be consistently
developed from a defined viewpoint
(perspective).

PRINCIPLE 4: USE A COMMON UNIT OF MEASURE

-

Using a common unit of measurement to

enumerate as many of the prospective
outcomes as possible will simplify the analysis of
alternatives.

PRINCIPLE 5: CONSIDER ALL RELEVANT CRITERIA

-

Selection 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.

PRINCIPLE 6: MAKE UNCERTAINTY EXPLICIT

-

Risk and uncertainty are inherent in estimating

the future outcomes of the alternatives and
should be recognized in their analysis and
comparison.

PRINCIPLE 7 REVISIT YOUR DECISIONS

-

Improved decision making results from an

adaptive process; to the extent practicable, initial
projected outcomes of the selected alternative
should be subsequently compared with actual
results achieved

ENGINEERING ECONOMIC ANALYSIS PROCEDURE

1. Problem recognition, formulation and

evaluation.
2. Development of the feasible alternatives.
3. Development of the outcomes and cash
flows for each alternative.
4. Selection of a criterion (or criteria).
5. Analysis and comparison of the
alternatives.
6. Selection of the preferred alternative.
7. Performance monitoring and postevaluation of results.
COST CONCEPTS
-

The word cost has meaning that vary in usage.

Since concepts are ideas generalized from
particular instances or situations, the cost
concepts used in an engineering economy study
will depend on the problem or situation and the
decision to be made.

Fixed, Variable, and Incremental Costs

Fixed Costs unaffected by changes in the activity
level over a feasible range of operations for the capacity
or capability available.
Variable Costs are those associated with an operation
that vary in total with the quantity of output or other
measures of activity level.
Incremental Costs or Incremental Revenue refers to
additional cost or revenue that results from increasing
the output of the system by one (or more) units.

Direct, Indirect, and Standard Costs

PRESENT ECONOMY STUDIES

Direct Costs costs that can be reasonably measured

and allocated to a specific output or work activity.

RULE 1:
-

Indirect Costs costs that are difficult to attribute or

allocate to a specific output or work activity (also
overhead or burden).
Standard Costs planned costs per unit of output,
established in advance of production or service delivery.
They are developed from the anticipated direct labor
hours, materials, and overhead categories (with their
established costs per unit).

When revenues and other economic benefits are

present and vary among alternatives, choose
the alternative that maximizes overall profitability
based on the number of defect-free units of a
product or serviced produced.

RULE 2:
-

Cash Cost vs. Book Cost

When revenues and other economic benefits are

not present or are constant among alternatives,
consider only the costs and select the alternative
that minimizes total cost per defect free unit of
product or serviced produced.

Cash cost a cost that involves a payment of cash.

Book cost a cost that does not involve a cash
transaction but is reflected in the accounting system.
Book costs represent the recovery of past expenditures
over a fixed period of time (i.e. depreciation).

Typical Situations involving Present Economy

Studies
-

There is no initial investment of capital; only

immediate operating costs and other factors
involved.

Sunk Costs
Example:
Sunk Costs costs that has incurred in the past and
has no relevance to estimates of future costs and
revenues related to an alternative course of action.
These costs should be ignored in the analysis and
comparison of alternatives that affect the future.
More common cost terminology

Assume that you are employed by Company A and are

making plans for a business trip. You can travel by
commercial aircraft, which will require 3 hours of travel
time and the rental of a car at your destination. The other
alternative is to travel by automobile, which will take 7
hours.

Opportunity cost the monetary advantage foregone

due to limited resources. The cost of the best rejected
opportunity.

Here, the basic considerations are the immediate costs,

the value of your time, and nonmonetary factors. (i.e.,
fatigue)

Life-cycle cost the summation of all costs related to a

product, structure, system, or service during its life span.

Typical Situations involving Present Economy

Studies

PRESENT ECONOMY STUDIES

-

When the influence of time on money is not a

significant consideration, cost analyses are
usually called present economy studies.
When alternatives for accomplishing a specific
task are being compared over one year or less.

There is an initial investment of capital, but after

this first cost the remaining life-cycle cost is
estimated to be the same, or directly
proportional to the initial investment. Thus the
alternative with the lowest first cost will be the
most economical.
The differences in the revenues and costs
among the alternatives all incur within a limited
time period (1 year or less is a general
guideline), or any future differences are
estimated to remain proportional to those in the
first time period. This is often the case when the
decision is between alternative materials in
manufacturing.

FIXED, VARIABLE, AND INCREMENTAL COSTS

In connection with surfacing a new highway, a contractor
has a choice of two sites on which to set up the asphaltmixing plant equipment. The contractor estimates that it
will cost $1.15 per cubic yard per mile (yd3/mile) to haul
the asphalt-paving material from the mixing plant to the
job location. Factors relating to the missing sites are as
follows (production costs at each site are the same):

The job requires 50,000 cubic yards of mixed that four

months (17 weeks of five working days per week) will be
required for the job. Compare the two sites in terms of
their fixed, variable, and total costs. Assume that the
cost of the return trip is negligible. Which is the better
site? For the selected site, how many cubic yards of
paving material does the contractor have to deliver
before starting to make a profit if paid $8.05 per cubic
yard to the job location?
TOTAL COST IN MATERIAL SELECTION
The part of a product was produced in considerable
quantities on a high-speed turret lathe, using 1112 screw
machine steel costing $0.30 per pound. A study was
conducted to determine whether it might be cheaper to
use brass screw stock, costing $1.40 per pound. Since
the weight of steel required per piece was 0.0353 pound
that of brass was 0.0384 pound, the material cost per
piece was $0.0106 for steel and $0.0538 for brass.
However, when the manufacturing and standards
departments were consulted, it was found that, although
57.1 defect-free parts per hour were being produced
using steel, the output would be 102.9 defect-free parts
per hour if brass were used. Annual demand for the part
is 100,000 units. The machine operator was paid $15.00
per hour and the overhead cost for the turret lathe was
$10.00 per hour. Which material should be used for this
part?
SOLUTION

Since 100,000 parts were made each year,

revenues are constant across alternatives.
RULE 2 would select brass. This will produce a
savings of $151.60 per thousand a total of
$15,160 per year.

It is also clear that costs other than the cost of

material were of basic importance in the
economy study.

TOTAL COST IN MATERIAL SELECTION

Two currently owned machines are being considered for
the production of a part. The capital investment
associated with the machines is about the same and can
be ignored for purposes of this example. The important
differences between the machines are their production
capacities (production rate x available production hours)
and their reject rates (percentage of parts produced that
cannot be sold). Consider the following table:

The material cost is $6.00 per part, and all defect-free

parts produced can be sold for $12 each. (Rejected
parts have negligible scrap value). For either machine,
the operator cost is $15.00 per hour and the variable
overhead rate for traceable costs is $5.00 per hour.
a) Assume that the daily demand for this part is
large enough that all defect-free parts can be
sold. Which machine should be selected?
b) What would be the percent of parts rejected
have to be for Machine B to be as profitable as
Machine A?
ALTERNATIVE MACHINE SPEEDS
Lumber put through the planer increases in value by
$0.10 per board foot. When the planer was operated at a
cutting speed of 5,000 feet per minute, the blades have
to be sharpened after 2 hours of operation, and lumber
could be planed at the rate of 1,000 board feet per hour.
When the machine was operated at 6,000 feet per
minute, the blades had to be sharpened after 1 1/2 hours
of operation, and the rate of planing was 1,200 board
feet per hour. Each time the blades were changed, the
machine had to be shut down for 15 minutes. The
blades, unsharpened, cost $50 per set and could be
sharpened 10 times before having to be discarded.
Sharpening costs $10 per occurrence. The crew that
operated the planer changed and reset the blades. At
what speed should the planer be operated?

MAKE VERSUS PURCHASE (OUTSOURCE) STUDIES

A company is analyzing a make or buy situation for a
component used in several products and the engineering
department has developed these data:
Option A: Purchase 10,000 items per year at a fixed
price of $8.50 per item. The cost of placing the order is
negligible.
Option B: manufacture 10,000 items per year using the
available capacity in the factory. Cost estimates are
direct materials = $ 5.00 per item and direct labor =
$1.50 per item. Overhead is allocated at 200% of direct
labor.
Should the item be manufactured or bought?
TRADE-OFFS IN ENERGY EFFICIENCY STUDIES
Two pumps capable of delivering 100hp to an
agricultural application are being evaluated in a present
economy study. The selected pump will only be utilized
for one year, and it will have no market value at the end
of the year. Pertinent data are summarized as follows:

If the electric power costs $0.10 per kWh and the pump
will be operated 4,000 hours per year, which pump
should be chosen? Recall that 1hp = 0.746 kW.