GEC 321Engineer-In-Society II

Introduction to Engineering Economics

Capital in form of money, machines and materialshas been identified as an economic necessity inmost engineering and business projects. As aresult of resource availability constraints,engineering is most often closely associated witheconomics. The designers of engineering projectsand the decision-makers (owners and managers ofsuch projects) are concerned that the availablecapital are used effectively and efficiently.

• Generally, both engineering and businessprojects are measured in terms of financialefficiency. Hence engineers, because at onetime or the other may be engaged in oneengineering or a knowledge of the techniquesand methods used for measuring and ensuringthe financial efficiency of projects.

Engineering and Management

• In general usage, the word ‘management’ isused to identify a special group of peoplewhose job is to direct the efforts and activitiesof other people toward the achievement ofcommon objectives. Simply stated,management gets things done through otherpeople.

Definition of Management

• According to Joseph L. Massie ( 1996, pp. 3),management is the ‘process’ by which acooperative group direct actions toward commongoals.

• This process involves techneques by which adistinguishable group of people (managers)managers seldom actually perform the activessthemsevles. The management of engineeringprojects therefore is the process by which acooperative group direct action towards theachievement of the project goals.

Functions of Management

• We have defined management as a ‘process’.One way to view the ‘process of management’is to identify the basic functions whichtogether make up the process.

• According to Joseph L. Massie (1996, pp. 5),the following seven (7) functions can be usedto describe the job of management:

• 1. DECISION-MAKING: This is the processwhich a course of action is consciously chosefrom available alternatives for the purpose ofachieving a desired result.

• 2. ORGANIZING: This is the process ofcombining the en and material of a business inorder to provide the most successful meansfor acchieving the objective of the business.

• 3. STAFFING: This is the process by whichmanagers select, train, promote and retiresubordinates.

• 4. PLANNING: This is the process by which amanager anticipates the future and discoversalternative courses of action open to him.

• 5. CONTROLLING: This is the process thatmeasures current performance.

• 6. COMMUNICATING: This is the process bywhich ideas are transmitted t others for thepurpose of effecting a desired result.

• 7. DIRECTING (LEADERSHIP): This is theprocess by which the actual performance ofsubordinates is guided towards commongoals. Supervising is one aspect of thisfunction at lowr levels, where physicaloverseeing of work is possible.

Engineering and Economics (Originand Definition of Engineering

Economics)• In the past, engineers were mainly concerned

with the design, construction and operation ofstructures, processes and machines, with littleor no attention given to the resourcesrequired to produce the final product. But wedo know that by nature, resources are scarce,and that such resources can be put toalternative uses; this is the reason for thestudy of economics.

• ECONOMICS: The use of resources (resources arealways in short supply) or their allocation andorganization constitute the subject matter ofeconomics. Put more compactly, economics isthe study of thing s in short supply. In anotherperspective, economics can be regarded as ascience of CHOICE. Since resources are scarce,and available resources can be put to alternativeuses, how then should the uses to which theavailable resources can be put be selected? Thisis the basic question that economics seeks toanswer.

• ENGINEERING ECONOMICS: The growingawareness of the limts of available resourcesneeded to undertake engineering projects haswelded engineering to economics.Engineering economics therefore, draws uponknowledge of engineering and economics, toidentify alternative uses of limited resources.

• Today’s engineer is espected to, in addition togenerating technological solutions, makeskillful financial analysis of the effects of theimplementation of their desings. Engineeringpractice now require cost and value analysisof engineering projects.

• For example, a project that is technologicallyfeasible (viable) may not be worthconstructing if the cost is found to be highcompared to the benefits derivable for theproject.

Decision-Making and The Decision-Making Process

• A decision can be defined as a course of actionconciously chose from available alternativesfor the purpose of achieving a desired result.Three ideas are important in this definition:

1. First is that a decision involves a choice; ifthere is but one possible course of action, nodecision is possible.

2. Secondly, a decision involves menta processesat the conscious level. The logical aspects ofdecision-making are important, yet thedecision – king process is influenced by:

• emotional factors• non-rational factors, and• subconsious factors

3. Thirdly, a decision is purposive; it is made tofacilitate the attainment of some objective(purpose).

Decision-Making

As earlier defined, decision-making is the‘process’ by which a course of action isconciously chosen from available aternativesfor the purpose of achieving a desired result.The difference between ‘decision’ and‘decision-making’ is the catch word ‘ process’.Decision-making is a process.

Decision-Making Process

• Decision-making has been regarded as the centerof managerial activities. According to Awujo(1997), decision-making is the essence of amanager’s job. According to him, at the level ofthe organization it is expressed through the basicfuctions of a manager, which include: Planning,Organizing, Staffing, Directing and Controlling.Each of the basic functions of a manager clearlyinvolves decision. For example, which plan toimplement? What goals to use? And forth.

• Organizational decision-making is similar tothe rational individual decision-making. Thatis, the decision-making process must berational and systematic, yet, responsive to theuniqueness of the environment surroundingeach major decision.

• In engineering project development, as in allorganizations, the decision-making processconsists of the following steps:

1. Problem definition; in defining the problem,we must put into consideration, theenvironmental factors of the problem. Theenvironmental factors include:

• Technology available• Economic requirements• Social values etc.2. Defining objectives and the criteria for

measuring the achievement of the objectives.

3. Developing alternative solutions (that is,generating alternative means, plans anddesings).

4. Analyzing the alternatives; good decision-making process requires that the availableaternative solustions be evaluated toeliminate in feasible ones. The followingfeasibility analysis be carried out.

a. Technological feasibility ananlysis; areas ofinterest in technological feasibility include:

• The most appropriate process to be adopted,• The best source of raw materials,• Determing electricity requirements and

available sources etc.

b. Finanacial feasibility analysis; areas of interestin financail feasibility include:

• Projection of total market potentials of theproject in financial terms,

• Projection of costs (both fixed and operating)• Estimation of revenue stream for the entire

life of the project and• Determination of the sources of funds for

financing the project.

3. Economic feasibility analysis; areas of interestin economic feasibility include:

Impact on the economy like• The use of available raw materials• The jobs created by the project• Improvements in the welfare of the people in

local communities around the project area,like provision of roads, power, water.

• Making a choice; after analyzing the availablealternatives in step if by carrying out the threemajor feasibilty analyisis enumerated above,the result of the feasibility analysis can nowbe sued to select the most feasiblealternative.

Concept of Equity and Debt Capital

• In accounting usage, capital denotes all long-term funds placed at the disposal of abusiness firm either by the ownership class ofby leaders.Therefore, when financing engineering andbusiness ventures, there are two (2) generallyavailable sources of these long-term funds(capital). These are equity and debt; wetherefore have equity capital and debt capital.

Equity Capital

• Equity capital is the capital contributed by thosewho own th business. Equity capital is usuallysourced by any organization from the stockmarket. An example of the contributor of equitycapital to a business organization are theordinary and preferential shareholders of of theorganization. The reward for contributing capitalis that the contributors take part in the sharing inthe yearly profit of the organization. Normally,equity capital is used in financing long-termprojects or long-term investing.

Debt Capital

• Debt capital is also called borrowed capital. Inmost cases, debt capital is obtained romfinancial institutions like banks. The owners ofdebt capital are usually paid interest for theuse of the capital by the organizating that hasborrowed the capital.

Accounting – Basic Concepts

• DEFINITION OF ACCOUNTING: The AmericanInstitute of Certified Public Accountant(AICPA) has defined accounting as ‘the art ofrecording, classifying, and summarizing in asignificant manner, and in terms of money,transactions and events which are, in part, atleast, of a financial character, and interpretingthe result thereby (AICPA, 1961).

• This definition identifies the major activitiesencompassed in accounting, which include:

• Recording of data and• Summarizing of data• Interpretation of the resultant accounting

information• It should be noted that this data that is

recorded and summarized is usually expressedin monetary terms.

Major Brances of Accounting

• Generally, accounting can be grouped into thefollowing branches:

i. Financial accountingii. Cost accountingiii.Management accounting

Financial Accounting

• Financial accounting is the branch ofaccounting that reports in aggregate terms,the overall results of the organization’soperations during a given period and itsfinancial condition, that is, the organizationstrengths and weaknesses at a particular pointin time. Two major components of thefinancial accounting reports are:

i. Profit and loss accountii. Balance sheet

• Financial accounting reports are usuallymeant for users who are external to theorganization, for example:

• Investors• Lenders• The government

Cost Accounting

• Cost accounting is the process and techniqueof ascertainting cost. Costing is the process ofclassifying, recording and appropriateallocation of expenditure for the purpose ofdetermining the costs of products or services.This class of accounting is very important tothe Engineering Economist since it is thesource of most of the cost data needed formaking economic studies.

Management Accounting

• Management accounting is the application ofaccounting principles and techniques to theprocess of provideing information designed tohelp all levels of management in planning andcontrolling the activities of an enterprise.

Elements of Fianancial Accounting

• The main purpose of accounting is to recordthe financial transaction of any organizationthrough the periodic preparation of financialstatements and reports. We had earliermentioned that, the two major financialaccounting reports are: the profit and lossaccount and the balance sheet.

The Profit and Loss Account (IncomeStatement)

• The profit and loss account (also known as theincome statement) shows the income andexpenditure of an organization during a statedperiod (usually twelve (12) months, six (6)months) of time.

Balance Sheet

• The balance sheet of a business organizationshows the financial position of theorganization at a point in time, usually the lastday of the organization’s accounting year.

• There are three (3) basic elements in thebalance sheet:

i. Assetsii. Liabilityiii.Owners funds (equity)

Assets

• These are things that have value. Assets maybe:

• Tangible, e.g. buildings, motor vehicles• Intangible, e.g. goodwill, patents, trademarks• In the balance sheet, assets are usually

summarized into two broad categories: fixedassets and current assets.

Fixed Assets

• These are assets that have a durable life (i.e.life of more then one (1) year), and are heldnot for conversion or resale, but for purposesof assisting in the conduct of business.Examples fixed assets are: lend and buildings,plant and machinery, funiture and fittings,motor vehicles, patents and trademarks, etc.

Current Assets

• These are assets which change form in thecourse of the business or during the conductof the organization’s operations. Theyfrequently form the substances of theorganizatiion’s activities. Examples of currentassets are: inventories (stocks of rawmaterials or finished goods), trade debtors,and cash in hand or at the bank).

Liabilities

• These are debts incurred by an organizationarising from either borrowings or creditpurchases from other parties. In the balancesheet, liabilities are usually summarized intotwo broad categories: long-term and short-term (also referred to a current liabilities).

Current Liability

• This is a indebtedness which is expected to bedischarged withing a short period, i.e. lessthan one (1) year. Examples of current liabilityinclude: trade creditors, bank overdraft.

Long-Term Liability

• This is a source of funding which comprisesprincipally loans (secured or unsecured) whichmay not be repaid in less then one (1) year.Some long- term liabilities are of much longerduration extending to even up to ten (10)years.

Equity

• This is a source of funding which comprises offunds belonging to the owners. This is knownas owners’ funds. Owners’ funds are made upof the capital orignally introduced (either inthe form of cash or tangible assets), plus anyprofits or surplus generated in the course ofoperation which have not yet beenwithdrawn.

• In the case of a business firm, undistributedsurplus is called retained earnings.

• We should next look at how the balance sheetlooks like.

Example

• Consider an individual, Alhaji (Chief) J.Moyosore, who is commencing business on 1January, 2008 with a capital of N3,000 all ofwhich he contributed as cash. The balancesheet at commencement would be as follows:

Alhaji (chief) J. MoyosoreBalance Sheet as at 1 January, 2008

_______________________________________Liabilities and Capital Assets

Capital N N

3,000 3,000

3,000 3,000

• The above balance sheet is simply saying that,the business of Alhaji (Chief) J. Moyosoreholds assets worth N3,000 consisting entirelyof cash; and that the assets have beenfinanced solely by capital paid int the businessby Alhaji (Chief) Moyosore.

• The capital introduced into a business maynot consist soley of cash alone, but mayinclude other forms of assets as is shown bythe following example:

Example:

• Suppose that Alhaji (Chief) J. Moyosore hascommenced business on 1 January, 2008 withsundry assets which were valued as follows:

N

Blackmaking machinery 10,500

Used Peugeot 404 Pick-Up Van 3,600

Miscellaneous office furniture andequipment

1,800

Cash paid into bank 3,000

• Prepare the balance sheet of Alhaji (Chief) j.Moyosore Sole Proprietorship at thecommencement of business on 1 January,2008.

Alhaji (Chief) J. Moyosore’s Sole ProprietorshipBalance Sheet as at 1 January, 2008

Liabilities andCapital

N Assets N N

Capital Fixed Assets

Alhaji (Chief) J.Moyosore

18,900 Machinery 10,500

3,600

Furniture andEquipment

1,800

Current Assets 15,900

Cash at bank 3,000

18,900 18,900

• The above balance sheet portrays the positionof a business which has not engaged inbusiness transactions. The following is ahypothetical balance sheet of Alhaji (Chief)Moyosore one year later after engaging insome business transaction (assuming that thefixed assets has not suffered depreciation orloss in value as a result of use).

Alhaji (Chief) Moyosore’s Sole ProprietorshipBalance Sheet as at 31 December, 2008

Liabilities andCapital

Assets

N N N

Capital 18,900 Fixed Assets

Profit 2,260 Machinery 10,500

21,160 Motor vehicle 3,600

Furniture andequipment

1,800 15,900

Currentliabilities

Current Assets

Trade creditors 1,200 Inventories 3,400

Bank overdraft 600 Trade debtors 2, 610

Cash 1,050 7,060

22,960 22,960

Accounting Equation

• What appears to be an equation can be seento have emerged from the above two balancesheets, that is, a situation where the totalassets always agree with the sum of liabilitiesand equity. This is expressed briefly asfollows:A = L + E

Where A = sum of all assetsL = sum of all liabilities which include

short – term and long – term debtsE = sum of all equity items, which

include capital and retained earnings(undistributed profit)

• In other words, the accounting equationis usually expressed in the balance sheet-that is, the financial position statement.

Example

• An ABC firm decided to undertake aninvestment opportunity and the followingsequence of events occurred over a periodone year.

i) Organize the firm and invest N5,000 cash ascapital.

ii)Purchase equipment for a total cost of N4,000by paying cash.

iii) Borrowed N3,000 through note to bankiv) Incurred N1,400 account payable for raw

materialsv) Recognized the partial loss in value of the

equipment (depreciation) amounting to N500Prepare a balance sheet for ABC firm at the end

of the year (assume it is year 2008).

Fundamental Economic Concept ofCost

• Although the ultimate objective of anyengineering applicatioin is the satisfaction ofhuman wants and needs. It is imperative tonote those needs and wants cannot besatisfied without costs. Generally, anengineering proposal resulting in the best costwill be considered the best if its end result isbetter or identical to that of competingproposals.

• As a basis for the economic analysis ofengineering proposals, cost concepts cangenerally be classified into the following:

i. First costii. Operation and maintenance costiii.Fixed costiv.Variable costv. Incremental and marginal costvi.Sunk costvii.Opportunity costviii.Average cost

First Cost

The first cost represents that initial cost ofcapitalized property, which includestransportation, installation, and other relatedinitial expenditure. The initial cost is made upof those cost elements that do not reoccurafter the initiation of the project or activity.

For example, if a new equipment is purchasedby a firm, the first cost will include:

• Purchase price

• Shipping cost

• Installation cost

• Cost of training for operators

Operation and Maintenance Cost

The operation and maintenance cost refer tothat cost or group of costs which areexperienced continually over the useful life ofthe project or activity. This type of cost willgenerally include:

• Labour costs for operation and maintenance• Fuel and power costs• Spare and repair parts costs• Insurance costs and taxes

• Part of overhead cost

Generally, the aggregate total of operation andmaintenance cost often exeeds the first costof a given project.

Fixed Cost

These costs represent that group of costinvolved in an on-going activity whose totalwill remain relatively constant throughout therange of operational activity. This type of costis made of the following cost items:

• Depreciation• Taxes• Insurance

• Interest on capital• Research• Annual rentsCertain administrative expenses, for example,

the salaries of employees which must bepaide irrespective of output. It is important tonote that, the investments that give rise tofixed costs are made in the present with thehope that they will be recovered throughprofit as a result of reductions in variable costor of increase in income.

For example, a computer can be purchased nowin order that labour cost may be reduced inthe future. Fixed costs are sometimes calledindirect costs because in a production setupfor example, they do not vary with output. Inpractical terms, fixed costs are only relativelyfixed, as their total may be expected toincrease with increased activity.

Variable Cost

Variable costs refer to that group of costs whichvary in relation to the level or operationalactivity. For example, since the amount ofmaterial needed per unit of product inmanufacturing is expected to remainconstant, it means that the material cost willvary directly with the number of unitsproduced. Variable costs are also called directcosts.

Examples of direct costs include:• Direct labour cost• Direct material cost• Direct power costGenerally, those direct costs can readily be

allocated to each unit produced and hence,they are regarded as variable costs.

Incremental and Marginal Costs

These two cost concepts are basically the same.• Incremental Cost: This is the additional cost that

will be incurred as a result of increasing outputby one more unit.

• Marginal Cost: Marginal cost strictly speaking,can be regarded as the cost of producing onemore unit; in practice, however, it is normallyimpossible to employ labour in sufficiently smallamounts to produce only one unit and thendismiss the workers.

We therefore define marginal cost as:

MC = Increased in total costsIncrease in output

Sunk Cost

A sunk cost is the cost incurred in the past whichcannot be altered by future action. Since it isonly the future consequences of investmentalternatives that can be affected by currentdecisions, an important principle ofengineering economy studies have been todisregard costs incurred in the past (sunkcosts).

It is the acquisition cost of an asset less theaccumulated depreciation charges.

Book Cost

Book cost relates to accounting for assets orproperty. The fact that assets are assumed todepreciate with time (not minding inflation)means that the book value (value of the assetrecorded in the accounting books) reduces withtime.

The book cost of an asset can therefore be definedas the original cost of the asset less the amountthat have been charged to depreciation account.

Cash Cost

Cash cost is the cost of acquiring an asset; this isthe price paid for the acquisition of an asset. Thisapproach to valuation has led to theoverwhelming reliance on historical cost as thebasis of valuation in financial accounting.Alternative market derived values emerge soonafter the acquisition of an asset replacement cost(if it were the wish to replace the asset) andrealisable value (if on the other hand, thefirmware to decide to discontinue the business).

Calculation of Book Cost

The book cost of any asset at the end of anyyear = book cost at the beginning of the year –depreciation expense charged during the yearon the asset.

Let P = first cost of an assetS = estimated saluage(residual) valueBt= book cost at the end of the year tDt= depreciation charge during year t

N = estimated useful life (depreciable life inyears)

Where t = 1, 2, 3, . . . . . . , N,

Then, Bt = P –

Where Bo = P

GRAPH NEEDED

Residual or salvage value represents the pricethat can be obtained from the asset after ithas been used.

Book cost is also called unexpired value of anasset.

Depreciation: Deprecation can be defined as afall in value of an asset resulting from usage orpassage of time.

Obsolescence: This is the fall in value of an assetresulting from change in technology, taste orfashion.

Depreciation is said to have taken place whenan asset deteriorates or shrinks in value dueto one or more of the following:

i. Application in the business or undertaking;ii. Passage of time, whether or not the asset was

in use and whether or not the asset made anycontribution to the business;

iii. When the asset is overtaken by new andbetter models which produce substitutes orcompeting goods or services more efficiently.

Reasons Why Assets Are Depreciated

The following are the main reason why assets aredepreciated:

i. It is important to recognise depreciation in theaccounts because it is a cost which if not takeninto account, could lead to the overstatement ofthe period’s profit or surplus.

ii. Also, unless the loss in value of an asset during aperiod is written off (against the income for theperiod), the asset’s value carried forward in thebalance sheet into the next period is also likely tobe overstated.

iii. Provision for depreciation also enable anamount to be set aside during the asset’suseful life and held against the eventualreplacement of the asset when it is no longerserviceable.

Methods of Computing Depreciation

Several methods of computing depreciation areused; some of them are:

a) The straight-line method;b)The diminishing balance method;c) The sum-of-the-year digit methodd)The revaluation method.Each of these methods is based on some hypothesis

regarding the loss of an asset’s value with age.We will treat only the straight line method in thiscourse.