Engineering Economics

Introduction: People have been designing objects and processes for thousands of years. From a simple wheel to complex computer systems, design has been a dynamic factor in personal and organizational success throughout history. With early design processes, companies considered technology and markets separately. Often, engineering and marketing departments worked independently, with different and sometimes conflicting goals. One example of the traditional design method is the railway engineers working in the 1800's, who apparently disregarded the influence of track locations upon the prospective costs and revenues of their railways. Arthur M. Wellington, a pioneer in the field of engineering economics, published "The Economic Theory of Railway Location," one of the first books on engineering economics, in 1877. In it, he addressed his disgust with the design process, stating "There is no field of professional labor in which a limited amount of modest incompetence at $150 per month can set so many picks-and-shovels and locomotives at work to no purpose whatsoever." This serious condemnation indicates that the planners didn't really plan-they didn't plan so that operating costs would be minimized and revenues maximized. Such concern finally led Wellington to state a classic definition of engineering as: "The art of doing well for one dollar what any bungler can do for two." In today's competitive world, companies can no longer afford such an ineffective approach. They need innovative product-design processes to give them a competitive advantage in the marketplace. In the modern design process, planning is key, and much of the work takes place early in the process. Note that production does not occur until the very end of a process that involves preliminary, or conceptual, design, and several iterations of optimization (analytical design). Three measurements of success of the design process are product cost, quality and time to market. This module, the second in the series on Engineering Economics, will focus on the cost aspects of good design, specifically during the analytical design process. NOTE: Portions of this module's material were taken from Engineering Economics: Principles and Concepts, a module developed at The Ohio State University under the NSF sponsored Gateway Coalition (grant EEC-9109794). Contributing members include Gary Kinzel, Project Supervisor and Amita Danak, Primary Author. The impact of design The cost of the design process is usually a small part of the overall cost of the product throughout its life; however, product design greatly affects the ability of the product to meet all three factors for success. The graph shows that about 75 percent of the manufacturing cost of a typical product is committed by the end of the conceptual phase. This means that only 25 percent of the product's cost can be influenced by decisions made after this time. Thus, if decisions made during the early design phases are poor, the company stands to lose much of the money that was committed before production even begins. The graph illustrates clearly how cost and time are affected by design decisions. There are many costs to consider when designing a project or process: initial costs; operating costs; maintenance costs; product liability costs; and the cost of borrowing money to finance the project. In order to maximize profits, the engineer must understand and manage all these costs and work cooperatively with other departments such as finance and marketing. Every company has its own design process, but these steps are common to most successful modern design practices: concept development, system-level design, detail design, testing and

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refinement and production ramp-up. Here they are depicted visually. In the engineering economics module on conceptual design, you learned that a conceptual designer is interested in a product's overall feasibility, technically as well as economically. Conceptual designers must take a broad economic view of a project, considering factors such as taxes, depreciation, the time value of money, and the investment's rate of return, as they evaluate various approaches for conducting a project or developing a product. Analytical designers, on the other hand, are concerned with optimizing the system after the approach is selected, usually by a manager or a conceptual designer. They select components, materials and processes to yield an optimum system. Consequently, they are concerned first with detail costs, second, with the initial system costs, and third, to some extent, with overall or life cycle costs. Analytical designers can often assume that the project is already funded, and that money for the design and construction of a least one prototype has been allocated. All their decisions involve optimization of initial and operating costs through their choices of: . Materials Manufacturing Methods Purchased Components Finishing Methods

Component of system optimation:

Analytical designers must examine each component within a system to ensure that it is optimized for the duty it must perform. Failure or weakness in any part of the design can jeopardize the success of the product in the marketplace, since design modifications during the later stages of the design process are extremely expensive. In reviewing the design of a component, some general questions to ask are: Will the material specified be the most economical for the part? Can the part be fabricated at an adequate production rate? Will the physical shape lend itself to processing at the minimum cost and an adequate rate or volume of production? Do dimensional tolerances permit selection of the most economical production methods? Is the part design based on consideration of scheduled production volume? Analytical designers incorporate into their systems those components that maximize the ratio of effectiveness to cost, where effectiveness is the ability of a component or system to perform its intended function when it is operating in accordance with the original design concept. For example, assume that a device is required to convert rotary motion to rectilinear motion. The "black box" for the component is represented in the figure, and the following devices are being considered to perform this function:

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Cam-and-follower Rack-and-pinion Power screw (or ball screw) Slider-crank The analytical designer must first determine how well each mechanism fulfills the technical design requirements. Such an analysis might eliminate some of the alternates from the list. The final choice, though, would be made by comparing effectiveness-to-cost ratios such as mechanical efficiency to cost, life to cost, or power per pound per dollar. To evaluate a complete system, consider areas such as these listed below for possible cost savings (these are examples appropriate to a manufacturing environment): 1. selection of materials. 2. choice of fits, limits, and tolerances between parts - generally, costs increase rapidly as the degree of precision is increased. 3. selection of plain bearings versus anti-friction bearings - anti-friction bearings are often used for low-volume productions while inexpensive plain bearings are used in high-volume production. 4. the quality of insulation used to reduce noise. 5. the type and amount of thermal insulation, and the associated size of pipe or duct employed. 6. the degree of precision or quality of purchased parts - a common example is the replacement of a low-class (low precision) ball-bearing with an equivalent high-class ball bearing. Here a significant increase in life (effectiveness) can be realized but only with a significant initial cost penalty. We trade off initial cost for performance, and the effectiveness-to-cost ratio may increase or decrease depending on whether the cost factor reflects the total cost. 7. The quality of surface finish employed - this can have a significant effect on cost. If hand finishing is required the added cost is notoriously large, but a high-grade finish can have a significant effect on the fatigue life of a critically loaded part. 8. the type and amount of plating and/or painting which is used to protect a component in an adverse environment. In general, this leads to large, but necessary, additional costs. Economy is also closely associated with production volume and with the manufacturing process. The best choice of manufacturing processes depends on the projected production volume and the desired market life. Production volume is usually divided into three categories: one-of-a-kind low-volume manufacturing (less than 250,000 units per year) high-volume manufacturing (more than 250,000 units per year)

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When a one-of-a-kind machine is produced, as little as possible should be spent on tooling, since hand made parts are very expensive. Standard or purchased parts usually represent at least 60 percent of the total costs under these circumstances. In fact, even low-volume products parts should be designed so that they can be manufactured on standard tools. If high-volume production is indicated, only then can expensive tooling be amortized effectively. The effectiveness of forging parts, for example, can be realized because the volume of production can easily produce the necessary money to amortize the high initial cost of the forging dies and forging machine tools.

Design Analysis Tools:

There are a number of design analysis tools available to predict product performance, life, cost and failure modes before the prototype stage. Some of these are: Finite Element Analysis (FEA) Boundary Element Analysis (BEA) Computational Fluid Dynamics (CFD) Design for Manufacturing (DFM) Tools Design for Assembly (DFA) Tools Fault Tree Analysis (FTA) Dynamic Analysis Fluid Flow Network Analysis Finite element analysis, boundary element analysis, fluid flow network analysis and computational fluid dynamics programs model products and systems, and allow the designer to determine how a product will perform. Design for Manufacture and Assembly involves designing products with ease of manufacture in mind. DFM considers the part count; labor, tooling method, and the actual manufacturing capabilities, while DFA considers the part count, attachment time, and model complexity. Fault tree analysis specifies an unwanted event (a fire, for example) and then identifies all the elements in the system that could cause the event to occur. Dynamic analysis is the analysis of the properties of a running program. Cost Comparison: In design situations, the costs which should be compared are not immediate ones, but long-range ones. While as an analytical designer you will be more directly concerned with the initial product costs, you should keep in mind that operating costs, maintenance costs, product liability costs, cost of capital (interest lost), etc., as well as initial costs, will in the long run decide the fiscal success of the product. Consider the following example. The Smith Company has decided to manufacture a new product, and in the conceptual design process has narrowed the number of possible manufacturing methods down to two. You, the analytical engineer, must select between them. The performance characteristics for both machines are similar, so at this point, the cost factor will have the deciding effect on your final choice. A market study has produced estimates of sales volume, prices, etc., and its sale is expected to bring in an average of $200,000 per year, regardless of how the product is made. Fixed costs (associated with sales, distribution, raw materials, etc.) are expected to average

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$85,000 per year. Manufacturing method A uses semi-automatic machines. The machines will cost $250,000 to buy and install, and are expected to last 10 years (and be practically worthless after that time.) The additional yearly expenses for labor, maintenance, and power - the out-of-pocket expenses - are $50,000. Manufacturing method B uses automatic machines that are more expensive to buy ($400,000 initial cost and 10 years of life), but cut out-of-pocket expenses to $30,000 per year. Gross income from sale Marketing, distribution, material costs Operating costs Depreciation (machine lasts 10 years) Total annual cost Profit (Income - Cost) $200,000 $ 85,000 $ 50,000 $ 25,000 __________ $160,000 $ 40,000

This includes an annual $25,000 depreciation of the semi-automatic machines, calculated here as the initial cost of the machine divided by its life span of 10 years. Following the same steps, Method B yields a $45,000 annual profit. Thus, it would appear from this analysis that the Smith Company will make $5,000 more per year by adopting method B. this is actually not the case! One very important item has been overlooked: method A requires an initial investment of $250,000, while method B requires an investment of $400,000. Initial investment is a very different kind of expenditure than, for example, wages, which are paid on a weekly basis, usually out of current income. In order to buy machinery, the company must spend money before any products have been made and sold. If Method A is adopted, the $150,000 savings (compared to purchasing the automatic machines) could be invested to earn money. At 8 percent, it can earn approximately $12,000 per year. Adding this to the initial profit of $40,000 gives a more accurate profit of $52,000. This is $7,000 more than Method B. Even at an interest rate of 4%, Method A would be more attractive economically. The important point is that money can earn money. The question to be asked about any investment, then, is not simply 'Will it earn a profit?' but rather 'Will it earn a bigger profit here or somewhere else?' In a problem of this sort, in which it has already been decided that one of a group of alternatives will be used, and in which some items are the same for all alternatives, it is possible to simplify the arithmetic considerably. You can set up a table or a spreadsheet that includes only those costs that differ for the alternatives, and include an interest-on-investment term as if it were a cost. Minimum-cost Analysis: If the cost of an alternative is a function of variables that take on a range of values, it is useful to determine when that cost is minimized. Multiple alternatives that depend on the same variable or variables can be compared on the basis of their minimum-cost points. This is known as minimumcost analysis. Example:

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Suppose a mechanical engineering firm is to build a double-walk pedestrian bridge for a 1,200foot crossing and is considering two girder designs. The first will have a superstructure weight per foot of where S is the span between piers. The second will have a superstructure weight per foot of In both cases, the piers will cost $220,000 each and the superstructure will cost 22 cents per pound. The engineering firm wants to know the minimum-cost pier spacing for each design. As the number of piers increases, the amount of superstructure required decreases, and vice versa. This situation involves increasing and decreasing cost components, the sum of which will be a minimum for a certain number of piers. The total cost for the superstructure and piers for design 1 can be described by: Solving this equation yields By taking the derivative of TC with respect to S, setting it to zero and solving for S, we find that S is 213 feet. Using this value in the equation above to solve for TC1, we get: Performing the same steps for design 2 results in S = 224 feet and On the basis of this analysis, the designer would choose design 2 because of its lower cost. Exercise # 1 - Consider that same situation at two other crossing points, but let W1 = 22(S) + X and W2 = 20(S) + Y, where X and Y range in increments of 100, from 500 to 1,500. Build a spreadsheet to allow repeated calculations to determine the minimum cost for each situation. When you are finished, click here for the solution. Overview: According to John H. Batten, former president of Twin Disc Inc., Racine, Wisconsin, profits and jobs are inseparable. He says, "Profits build factories and buy machine tools. Profits support the cost of Research and Development. Profits perpetuate the economic cycle that has given Americans better educations, more leisure time and a higher standard of living than any other country in the history of the world. Profit is the food by which a company lives. Take away that food and everyone suffers." Profits can be increased by reducing costs, raising productivity and permitting companies to establish and charge a price that permits a fair and reasonable return on investment. Only profitable companies are able to grow, increase employment, and pay wages and dividends. Most likely, your job will depend on whether your company is able to make a profit on its goods and services. You can help by providing accurate cost estimates for the projects in which you are involved. Sometimes, selling price is the bottom line, and your job in the analytical design process is to ensure that you can manufacture a product to realize a profit. At other times, your job is to provide your company with an estimate on selling price, given the costs and the acceptable profit margin. In both cases, you must conduct a selling price analysis.

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We will describe a basic method of analyzing the selling price for a simple system, defined as one which contains a small number of components. A complex system such as a supersonic transport contains a large number of components, usually arranged into what are called sub-systems. The same principles could be applied to estimate the selling price of a complex system, with a corresponding increase in effort and an uncertainty dependent on how accurately the costs of the various sub-systems can be quantified. Costs: When a company develops a new process or product, there are costs associated. Initial costs are one-time expenses, such as labor for installation, material, amortization and overhead, which must be covered at the start of a project. Operating costs, such as power and maintenance, must be covered as long as the company manufactures the product or runs the process. The analytical designer must optimize both these costs by choosing the most cost-effective materials, for example, and the best manufacturing method. The analytical designer must also consider warranty costs, since original equipment manufacturers increasingly are assuming the burden of unusual repair costs for a specified period. Car manufacturers, for example, usually warranty their parts for a specified time. In some industries, the cost of preventing or settling legal disputes is also a substantial portion of the product cost. Production costs can be divided into the following four categories: 1. Direct material costs (dollars per lb x the number of lbs) and purchased parts 2. Direct labor costs (dollars per hour x the number of hrs) 3. Indirect (overhead) material and purchased parts cost. 4. Indirect (overhead) labor costs

Direct costs are easy to estimate, but indirect costs are intangible and generally difficult to estimate. Usually, a company establishes overhead factors to be used in estimating indirect costs, but the numbers are only valid for that company. As an engineer, you will have to work closely with colleagues in finance to ensure you are using reasonable estimates for both direct and indirect costs. Additional Costs: Miscellaneous and administrative costs, sometimes called GA (general and administration) costs, cover general manufacturing overhead items such as: advertising and market analysis warranty costs taxes equipment insurance lost interest equipment depreciation administrative and legal costs research costs

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Depreciation of the physical plant (7 to 10 years) and depreciation of utilities (15 to 20 years) may or may not be included in this list, depending on whether they are taken into account in the overhead on production labor. Likewise, the overhead on engineering and drafting labor may include the necessary physical plant and utilities for the engineering department. Facility costs include the necessary physical plant and utilities. Determining selling price: Selling price is the sum of initial cost and profit, SP = IC + P (Eq. 1) where IC includes labor costs, overhead on labor, material costs, overhead on material costs of purchased parts, amortization costs of all tooling, engineering and development costs, and miscellaneous overhead items. All costs and depreciation are included in the determination of initial cost, because corporation taxes are paid on profits. Initial Cost: Selling price is the sum of initial cost and profit, SP = IC + P (Eq. 1) where IC includes labor costs, overhead on labor, material costs, overhead on material costs of purchased parts, amortization costs of all tooling, engineering and development costs, and miscellaneous overhead items. All costs and depreciation are included in the determination of initial cost, because corporation taxes are paid on profits. Profit: Profit normally varies from 5 percent to 28 percent of IC, depending upon various factors such as risk, competition, safety and product image. Assuming that profit is 28 percent of the total initial cost, the selling price can be found - using Equation 1 - to be 1.28*IC. Example: Estimation of Selling Price Your Company is charged with designing a wheel-less dolly for stockers in warehouses. The vehicle must operate on the air-cushion principle and use at least some of the intake air to sweep the floor. The dolly will carry a payload of up to 1,000 pounds. It will be powered by a regular 220V, 60 cycles, 3-phase line. The cost is to be based upon yearly production of 10,000 units, and your company wishes to attain a profit margin of 20 percent. You have determined that direct material costs are $94.95/unit, the direct cost of purchased components is $71.52/unit, and the overhead factor on labor, materials, and purchased parts is 1.1. The important design criteria are that the dolly be lightweight and affordable - less than $375. Is this feasible? Let's find out.

You can calculate the total production costs as shown above. You know direct costs of materials and purchased components. Assuming that labor costs $4.50 per hour, and that each unit takes 26 hours to make, direct labor costs can be calculated as: DLC = 26 hrs x $4.50/hr = $117 per unit

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Then ICT = (DLC +DMC + DPC)*OVH or ICT = ($117+$94.95+$71.52)*1.1 = $311.82 per unit You calculate the selling price for a profit of 20 percent of total initial cost, Using Equation 1. The per-unit selling price is: SP = IC + P = 1.2(IC) = $374.18 per unit You can do it, but only if your assumptions were accurate or conservative. In general, cost information varies with time and location. Usually, manufacturing costs will be lower if items are obtained locally. Exercise #2 $4.50 may strike you as a ridiculously low hourly wage to use in a calculation, and it is, by U.S. standards. It may not be possible to produce this wheel-less dolly in the United States if the selling price needs to be $375. Assuming that you have been given a maximum selling price of $475, what is the highest hourly wage rate that will allow you to achieve that, assuming that material, purchased components, the time required to make each unit, and indirect costs remain constant? In how many countries would it be economically feasible to produce the dolly? For your analysis, use the 2002 costs available in the "Hourly compensation costs in U.S. dollars for production workers in manufacturing, 30 countries or areas and selected economic groups, selected years, 1975-2002," available from the Bureau of Labor Statistics at http://www.bls.gov/news.release/ichcc.t02.htm. Conclusion: Economics is a central concern in any engineering project, so you must understand engineering economics equations and the impact of your design choices on cost as well as performance. While these equations are easy to manipulate and simple to grasp, their complexity increases as the component or machine being analyzed requires special machining processes, treatment for manufacture, etc. Along with the complexities in technical considerations are the uncertainties in making accurate estimates for material, labor, operating, and component costs, especially if you are considering diverse locations across the globe. The implications of engineering economics are vast, and affect many aspects of your work, as more and more manufacturing takes place in countries around the globe, to capitalize on lower wage and material costs. Analytical designers aim to get the best performance for the least number of dollars, but they must also keep in mind that it is in their company's best interest to give value to the customer at a fair price. Their designs should incorporate reasonable safeguards to minimize risks to the consumer, for example, to reduce product liability costs.

As competition increases, overall costs or life cycle costs will be of increasing interest to analytical designers and their managers. Engineers are estimating costs much earlier in the

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design process than they once did. It's vitally important to work closely with finance and marketing experts in the cost analysis of projects, to ensure you are using accurate estimates and making reasonable assumptions in your analyses. Many other factors contribute to your ability to cooperate in this manner, e.g. communication and negotiation skills and your ability to present the results of your analysis clearly and concisely. In our free enterprise system, in the long run, your career and salary will depend on whether your company is able to realize a profit. Accurate estimation of costs will help predict whether a profit is possible. Money will always be a constraint, and understanding how to work with it will put you ahead in the game! Website Editor,

R. Benny Wahyuadi, S.T., M.B.A. Part-time Lecturer FT-Unisma, AWM.

Graduated from: Mechanical Engineering, Polytechnic University of Indonesia Industrial Engineering, School of Industrial & Management Engineering The Pitts burg State University, Business School, Kansas, USA.

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