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Chapter 1INTRODUCTION TO ENGINEERING EONOMICS

ENGINEERING ECONOMICS(BPK 30902)

ZUIKARNAIN BIN DAUD

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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

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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

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Introduction To Engineering Economics

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Definition

Economic Approach

Solving Problem

Engineering Economy

Engineering Projects – Assessment Of Project’s Investment

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 Promote the well-being and survival of an organisationo Embody creative & innovative technology & ideaso Permit identification & scrutiny of their estimate outcomeso Translate profitability to “the bottom line” through a valid

& acceptable measure of merits

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Origins of Engineering Economic

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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. LandLand is the gifts of nature, such as land, water, air, minerals, sunshine, plant & jungle, which is applied to the production process

2. Labor

Labor is the efforts, skills, & knowledge of human resources which are applied to the production process

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Resources….. (continued)

3. CapitalMoney 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 process11

Resources….. (continued)

4. EntrepreneurEntrepreneur 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

Concepts in Engineering Economics

1. Time value of money2. Interest rate and rate of return3. Equivalence concept4. Cash flows5. Marginal revenue must exceed marginal cost6. 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)/ IRR5. 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 loanInterest 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

Examples of Cash Inflows & InflowsCash 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

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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 RM RM

Cash flows from operating activitiesReceipts from revenues Dividends receivedPayments for expensesPayments to suppliers

XXXX

(XX)(XX)

Net operating cash flows XX

Cash flows from investing activitiesCash proceeds from sale of equipmentLoan repaid by other entities Purchase of equipmentLoans to other entities

XXXX

(XX)(XX)

Net investing cash flows XX

Cash flows from financing activitiesCash proceeds from capital contributionsBorrowingsRepayments of borrowingsDrawings by owner

XXXX

(XX)(XX)

Net financing cash flows XX

Net increase (decrease) in cashPlus: Cash at the beginning of year

XX

Cash at the end of year XXX

Cash Flows Statement

XYZ Co. Statement of Cash Flows

For Year Ending31 December 2007

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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.

– Owner’s Equity Statement /Statement of Financial Position• This statement summarizes the changes in owner’s equity.

– Balance Sheet/ Statement of Financial Position• A Balance Sheet shows company’s financial position of assets,

liabilities and owner’s equity at a point in time. – Cash Flows Statement

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Principles of Engineering Economic

Principles of EE

1. Develope the Alternatives2. Focus on theDifferences3. Use a Consistant Viewpoint4. Use a Common Unit of Measure5. Consider All Relevent Criteria6. Make Risk & Uncertainty Explicit7. 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

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Engineering Economic & The Design Process

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 ProcessEE Analysis Procedure Engineering Design Process

Step Activity

1. Problem recognition, definition, & evaluation

1. Problem/ need definition

2. Problem/ need formulation & evaluation

2. Development of the outcomes & cash flowsfor each alternative

3. Synthesis of possible solutions (alternatives)

3. Development of the outcomes andcash flows for eachalternative

4. Analysis, optimization, & evaluation4. Selection of a criterion (or criteria)

5. Analysis & comparison of the alternatives

6. Selection of the prefereed alternative 5. Specification of preferred alternative

7. Performance monitoring & post-evaluation of results

6. Communication

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)

2. /

Engineering Design Process - Development of Alternatives

2. Development of Alternatives– Each alternative selected is judged– Steps 2 search potential alternative/ select smaller groupa. Searching for Superior Alternativeb. Developing Investment alternative

3. /

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

2. /

b. Developing Investment alternative

• Most investment alternatives created by good engineering ideas are drawn from a larger population of equally good problem solutionsi. Classical Brainstorming

– Deferment of judgment & quantity breeds qualityii. Nominal group technique

– To obtain group thinking (consensus)– Reducing dominance of one or more participants & conflicting ideas

2. /

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

3. /

Engineering Design Process4. Selection of a Decision Criterion

– Select the alternative that serve the long-terms interest – Reflect a consistent & proper viewpoint

5. Analysis & Comparison of Alternatives– TO obtain accurate forecast of cash flows & other factors

6. /

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

8. /

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Steps In Making The Best Decision

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Decision Making Process

1. Recognize & evaluate the problem2. Collect & analyze the related data3. Identify the feasible alternatives & make a realistic

projection (future cash flow expectation)4. Identify the required criterion for selecting the alternative5. Assess & compare the alternatives6. Choose & implement the alternative

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The Decision Making Process

Economic factors: production’s 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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• 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

Example

Housing Project

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IMPORTANCE

(4)Prevent conflict between engineers & financial department

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

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

(1) Pursuing monetary value in the invention to position as profitable firm

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Scope Of Engineering Economics

Engineering Economic Project

• Most investments made by the engineers will fall into 3 main categories

1. Profit-enhancing programs2. Cost control programs - to correct errors in system3. 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

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3. Public Improvement Programs

Increased public satisfaction Increased public safety Improved infrastructure

Project Ideas

These programs will lead to the project ideas like:1. Equipment or process selection2. Equipment replacement3. New product or product expansion4. Cost reduction5. 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 company’s 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) Does Sheila have a problem? If so, what is it?b) What are her alternatives (identify at least three)c) Estimate the economic consequences and other required data for

the alternatives in Part (b).d) Develop a criterion for choosing the alternatives.e) Analyze and compare the alternatives in view of at least one

criterion in addition to cost.f) What should Sheila do based on the information you and she

have generated?

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Thank You

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