ENGINEERING ECONOMICS (BPK 30902)

Chapter 1 INTRODUCTION TO ENGINEERING EONOMICS

ZUIKARNAIN BIN DAUD

Contents
Introduction of engineering economics Origins of Engineering Economic Principles of Engineering Economic Important concepts in engineering economics Steps in making the best decision Scope of engineering economics Engineering Economic and the Design Process

Learning Outcomes
The scope of engineering economics The importance & concepts in engineering economy Types of business organization The nature and types of engineering economic decisions Format of four financial statements

Introduction To Engineering Economics

Definition
Engineering Economy

Economic Approach

Solving Problem

Engineering Projects Assessment Of Projects Investment

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Definition
Engineering Economy involves the systematic evaluation of the economic merits of proposed solutions to engineering problems. To be economically acceptable or affordable, solutions to engineering problems must demonstrate a positive balance of long-term cost.

Definition
Solutions to engineering problems also must;
o o o o Promote the well-being and survival of an organisation Embody creative & innovative technology & ideas Permit identification & scrutiny of their estimate outcomes Translate profitability to the bottom line through a valid & acceptable measure of merits

Origins of Engineering Economic

Economy
Economy is the study of how limited resources are used optimally to satisfy unlimited human wants Resources are known as factors of production employed to produce goods and services. Four type of resources
Land Labor Capital Entrepreneur

Resources

1.

Land Land is the gifts of nature, such as land, water, air, minerals, sunshine, plant & jungle, which is applied to the production process Labor Labor is the efforts, skills, & knowledge of human resources which are applied to the production process

2.

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Resources .. (continued)
3. Capital Money Capital Money is financial resources which are used in the production process Physical Capital Physical capital is something can be hold like equipment & machineries, tools, buildings, vehicles which are used in production Human Capital Human capital is an education & training applied to labor in the production process
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Resources .. (continued)

4.

Entrepreneur Entrepreneur is individual who takes risk to develop a business by using land, labor & capital effectively, & efficiently

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General Economic Environment

1. Consumer goods Consumer goods & services are those that are directly used by end consumers. 2. Producer goods and services Producer goods/services are those used in the production process of consumer goods and services. For instance inventories, raw materials, factory building, machineries etc. 3. Utility is a measure of the value which consumers place on that product or service
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General Economic Environment continued

4. Demand is total required products/services by the consumer in the particular market 5. Supply is amount of required products/services offered by the firms or sellers 6. Market Competition Level The level of competition in the market are perfect competition (many sellers and product almost the same), monopoly (one or two sellers), oligopoly (few sellers and product has few distinctiveness) , monopolistic (many sellers & product has different features)
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Important Concepts In Engineering Economics

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Concepts in Engineering Economics

1. 2. 3. 4. 5. 6.

Time value of money Interest rate and rate of return Equivalence concept Cash flows Marginal revenue must exceed marginal cost Additional risk is not taken without the expected additional return

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1. Time Value Of Money

Time value of money is a change in money value for certain time of period. The RM1 we receive today is worth more than RM1 in the future because the opportunity cost or interest rate that we could have earned if we have RM1 sooner. Some measures of worth are: 1. Present worth (PW) 2. Future worth (FW) 3. Annual worth (AW) 4. Rate of return (ROR)/ IRR 5. Benefit/ cost ratio (B/C) 6. Payback period
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2. Interest Rate & Rate of Return

Interest is the financial charge for borrowing money A cost to the borrower and an income to a lender Interest is expressed in percentage rate Example, 5% interest rate for a RM20,000 loan Interest payment is RM1,000 (0.05 x RM20,000) The interest earned is known as rate of return (ROR) In Islam, interest element is totally prohibited

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3. Equivalence Concept
The concept in time value of money and interest rate can direct to the creation of economic equivalence concept Economic equivalence means the different sum of money in a different period has the same economic value

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4. Cash Flows
A cash flow is a summation of total cash receipts & total cash disbursements for a given period of time Cash flow are very important in engineering economics because they are the main basis for alternatives evaluation

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Categories Of Cash Flow

Initial cost acquisition cost-to build, to buy & to install. Operations & maintenance (O&M) annual expenditure Salvage value the remaining value of asset at the end of its life usage. Revenues annual receipts due to sale of products & services

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Examples of Cash Inflows & Inflows

Cash Inflows Revenues (incremental value) Operating cost reduction Asset residual value Loan principal receipts Saving or returns

Cash Outflow Initial cost of project Operating cost Periodic maintenance costs Loan interest and principal payments Income taxes

Net cash flow

= receipts - disbursements = cash inflows - cash outflows All cash flows are assumed occur at the end of a period and can be illustrated by developing the cash flow diagram/time line
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RM Cash flows from operating activities Receipts from revenues Dividends received Payments for expenses Payments to suppliers Net operating cash flows Cash flows from investing activities Cash proceeds from sale of equipment Loan repaid by other entities Purchase of equipment Loans to other entities Net investing cash flows Cash flows from financing activities Cash proceeds from capital contributions Borrowings Repayments of borrowings Drawings by owner Net financing cash flows Net increase (decrease) in cash Plus: Cash at the beginning of year Cash at the end of year XX XX (XX) (XX) XX XX (XX) (XX) XX XX (XX) (XX)

RM

RM

Cash Flows Statement

XX

XYZ Co. Statement of Cash Flows For Year Ending 31 December 2007

XX

XX XX

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5. Marginal Revenue Must Exceed Marginal Cost

In making a decision, an increase in revenue must greater than an increase in cost. Example: the increase of cost should be included into cost price as to maintain profitable level
Increase of petrol oil Increase of sugar

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6. Additional Risk Is Not Taken Without The Expected Additional Return

Generally, we do not take risk if there is no expected higher return One risk must be compensated with return Example: Additional cost for better packaging for higher sales volume or additional promotion expenses for higher sales forecast

Spent RM200,000 on advertising for higher sales forecast of RM2 mil

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Accounting Financial Statements

Financial statements are prepared to communicate important accounting information to users. Four Types of Accounting Financial Statements Income Statement/ Statement of Financial Performance The income statement shows the net income or loss incurred within a certain period of time. Owners Equity Statement /Statement of Financial Position This statement summarizes the changes in owners equity. Balance Sheet/ Statement of Financial Position A Balance Sheet shows companys financial position of assets, liabilities and owners equity at a point in time. Cash Flows Statement
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Principles of Engineering Economic

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Principles of EE
1. 2. 3. 4. 5. 6. 7. Develope the Alternatives Focus on theDifferences Use a Consistant Viewpoint Use a Common Unit of Measure Consider All Relevent Criteria Make Risk & Uncertainty Explicit Revisit Your Decisions

Principles of EE
1. Develop the Alternatives
The choice (decision) is among alternatives. The alternatives need to be identified & then defined for subsequent analysis

2. Focus on the Differences

Only the differences in expected future outcomes among the alternatives Relevant to their comparison & should be considered in the decision

Principles of EE
3. Use a Consistant Viewpoint
The prospective outcomes of the alternatives, economic & other,should be consistently developed from a defined viewpoint (perspectives)

4. Use a Common Unit of Measure

Using common unit of measurement to enmerate as many of the prospective outcomes as possible willsimplity the analysis of thealternatives

Principles of EE
5. Consider All Relevent 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 in the monetary unit & those expressed in some other unit of measurement or made explicit in a descriptive manner

Principles of EE
6. Make Risk & Uncertainty Explicit Risk & uncertainty are inherent in estimating the future outcomes of the alternatives & should be recognized in their analysis & comparison 7. Revisit Your Decisions Improved decision making results from an adaptive process; to the extent practicable, the initial projected outcomes of the selected alternative should be subsequently compared with actual results achieved

Engineering Economic & The Design Process

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EE and the Design Process

An EE study is accomplished using a structured procedure & mathematical modeling techniques. The economic results are then used in a decision situation that normally includes other engineering knowledge & input

EE and the Design Process

EE Analysis Procedure
Step 1. 2. 3. 4. 5. 6. 7. Problem recognition, definition, & evaluation Development of the outcomes & cash flowsfor each alternative Development of the outcomes andcash flows for eachalternative Selection of a criterion (or criteria) Analysis & comparison of the alternatives Selection of the prefereed alternative Performance monitoring & postevaluation of results 5. 6. Specification of preferred alternative Communication 4. Analysis, optimization, & evaluation
Activity

Engineering Design Process

1. Problem/ need definition

2.
3.

Problem/ need formulation & evaluation

Synthesis of possible solutions (alternatives)

Engineering Design Process - Problem Definition

1. Problem Definition Provide basic for analysis Step 1 Problems recognition/ formulation from systems perspective/ evaluation E.g. an operating problem within a company (internal need) or a customer expectation about a product or service (external requirement)

Engineering Design Process Development of Alternatives

2. Development of Alternatives Each alternative selected is judged Steps 2 search potential alternative/ select smaller group a. Searching for Superior Alternative b. Developing Investment alternative

a. Searching for Superior Alternative

The difference between good & great alternatives depends on problem-solving efficiency . Efficiency can be increased in the following ways: Concentrate on redefining one problem at a time Develop many redefinitions for the problems Avoid making judgments as new problems definitions are created Attempt to redefine a problem in terms that different from the problem definition Make sure that the true

b. Developing Investment alternative

Most investment alternatives created by good engineering ideas are drawn from a larger population of equally good problem solutions i. Classical Brainstorming Deferment of judgment & quantity breeds quality ii. Nominal group technique To obtain group thinking (consensus) Reducing dominance of one or more participants & conflicting ideas

Engineering Design Process - Development of Prospective Outcome

3. Development of Prospective Outcome Basic cash flow approach represents economic effects of an alternative in terms of money spend & received Non-monetary factors Meeting /exceeding customer expectations Safety to the employees & to the public Improvement employer satisfaction Maintain feasibility to meet changers demand Achieving good public relation / being member relations

Engineering Design Process 4. Selection of a Decision Criterion Select the alternative that serve the longterms interest Reflect a consistent & proper viewpoint 5. Analysis & Comparison of Alternatives TO obtain accurate forecast of cash flows & other factors

Engineering Design Process

6. Selection of a Preferred Alternative Technical-economic modeling Analysis techniques indicates the quality of the result obtained Recommended course of action 7. Performance Monitoring & Post evaluation of Results Monitoring improves achievement Reduces the variability in desired results Continuing improvement

Steps In Making The Best Decision

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Decision Making Process

1. 2. 3. 4. 5. 6. Recognize & evaluate the problem Collect & analyze the related data Identify the feasible alternatives & make a realistic projection (future cash flow expectation) Identify the required criterion for selecting the alternative Assess & compare the alternatives Choose & implement the alternative

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The Decision Making Process

Economic factors: productions cost, total revenue, financial sources
Non-economic factors: social responsibilities, environment, laws, and politics, the needs of consumer in the marketplace, the affordability of the consumer to purchase the product or services

Combination

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Example

Housing Project
Affordable for customers Safety Cost for the company Decision to purchase a long term asset Machines or equipments The engineers have to consider a long-term benefit for the company

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(1)

I M P O R T A N C E

Pursuing monetary value in the invention to position as profitable firm

(2)
Most economical balance the trade off between cost & performance

(3)
Plays major role in capital investment decisions based on engineers technical knowledge

(4)
Prevent conflict between engineers & financial department

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Scope Of Engineering Economics

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Engineering Economic Project

Most investments made by the engineers will fall into 3 main categories 1. Profit-enhancing programs 2. Cost control programs - to correct errors in system 3. Public improvement programs

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Investments Programs Categories

1. Profit- enhancing Programs New product development New product acquisition Production capacity expansion Service capacity expansion Improved customer service 2. Cost Control Programs - To Correct Errors In System Improving efficiency Streamlining operations Eliminating waste Reducing liabilities 3. Public Improvement Programs Increased public satisfaction Increased public safety Improved infrastructure
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Project Ideas
These programs will lead to the project ideas like: 1. Equipment or process selection 2. Equipment replacement 3. New product or product expansion 4. Cost reduction 5. Improvement in service or quality

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Questions & Problems

1. Explain why the subject of engineering economy is important to the practicing engineer? 2. Briefly discuss what the engineering economic is and give example. 3. What kind of common investment will be made by the engineer? Explain.

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Questions & Problems

4. The management team of ABC Furniture Company is trying to increase profitability in order to require loan from the bank to purchase a new and modern machine. One proposed solution is to sell waste old equipment instead of using them. a) Define the companys problem. Reformulate the problem in other creative ways. b) Develop at least one potential alternative for your reformulated problems in part (a).

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Questions & Problems

5. Sheila bought a small terrace house for RM100,000 in a Cheras town. She spent RM10,000 of her own money for the building and got a bank loan for the remaining RM90,000. The annual loan payment is RM10,000. The annual maintenance of the house is RM12,000. The house can be rented for RM1,500 per month. Refer to the decision making process procedure to answer these questions.
a) b) c) d) e) Does Sheila have a problem? If so, what is it? What are her alternatives (identify at least three) Estimate the economic consequences and other required data for the alternatives in Part (b). Develop a criterion for choosing the alternatives. Analyze and compare the alternatives in view of at least one criterion in addition to cost. What should Sheila do based on the information you and she have generated?

f)

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Thank You

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