EME3056

INDUSTRIAL
MANAGEMENT
TRIMESTER#1 (2016/2017)
CHAPTER#1
F O U N D AT I O N S O F E N G I N E E R I N G E C O N O M Y

OFFICIAL SYLLABUS
Introduction to engineering economy.
Non-linear breakeven analysis.

The material in these notes are adapted from Engineering Economy, Fifteenth Edition by William
G. Sullivan, Elin M. Wicks, and C. Patrick Koelling (Pearson Education).

LECTURE NOTES OUTLINE

1.1 INTRODUCTION TO ENGINEERING ECONOMY
1.2 COST CONCEPTS AND DESIGN ECONOMICS

1.3 COST-ESTIMATION TECHNIQUES

1.4 BREAKEVEN ANALYSIS

1.1 INTRODUCTION TO ENGINEERING

ECONOMY
1.1.1 INTRODUCTION
1.1.2 THE PRINCIPLES OF ENGINEERING ECONOMY
1.1.3 ENGINEERING ECONOMY AND THE DESIGN PROCESS

1.1.1 INTRODUCTION
Engineering economy (EE) involves the systematic evaluation of the
economic merits of proposed solutions to engineering problems.
In order to be economically acceptable, the solutions provided must
demonstrate a positive balance of long-term benefits over long-term
costs.
In addition, the solutions to the engineering problems must also:
Promote the well-being and survival of the organization
Integrate and include creativity and innovative ideas
Allow identification and scrutiny of their estimated outcomes
Translate profitability to the bottom line through a valid and
acceptable measure of merit
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 EE is the dollars-and-cents side of the decisions that engineers need to

decide and recommend so as that the organization is able to be
profitable in the competitive marketplace.
Inherent to these decisions are trade-offs among different types of costs
and the performance for each different proposed solution.

The main objective of EE is to balance these trade-offs in the most

economical manner.
EE involves technical analysis, with emphasis on the economic aspects,
and has the objective of assisting decisions.

1.1.2 THE PRINCIPLES OF ENGINEERING

ECONOMY
The foundation of EE is to supported by a set of 7 principles:
i.

Develop the Alternatives

ii. Focus on the Differences

iii. Use Consistent Viewpoint

iv. Use a Common Unit of Measure
v. Consider All Relevant Criteria

vi. Make Risk and Uncertainty Explicit

vii. Revisit Your Decision
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i.

Develop the Alternatives

Carefully define the problem.
Then the choice/decision is among the alternatives.
The alternative needs to be identified and then defined for subsequent
analysis.

ii.

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.

iii. Use a Consistent Viewpoint

The prospective outcomes of the alternatives, economic and other,
should be consistently developed from a defined viewpoint/perspective.
iv. 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 the
alternatives.

v.

Consider All Relevant Criteria

Selection of a preferred alternative requires the use of a criterion.
The decision making 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.

vi. Make Risk and Uncertainty Explicit

Risk and uncertainty are inherent in estimating the future outcomes of
the alternatives and should be recognized in their analysis and
comparison.
vii. 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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1.1.3 ENGINEERING ECONOMY AND THE

DESIGN PROCESS
An EE study is accomplished using a structured procedure and
mathematical modeling technique.
The economic results are then used in a decision situation that normally
includes other engineering knowledge and input.
A 7-step procedure is used to assist decision making within the
engineering design process.
Activities in the design process contribute information to related steps in
the economic analysis procedure.

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1.2 COST CONCEPTS AND DESIGN

ECONOMICS
1.2.1 COST TERMINOLOGY
1.2.2 THE GENERAL ECONOMIC ENVIRONMENT
1.2.3 COST-DRIVEN OPTIMIZATION
1.2.4 PRESENT ECONOMY STUDIES

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1.2.1 COST TERMINOLOGY

(a) Fixed Costs
unaffected by change in activity level over a feasible range of operation
for the capacity and capability available
(b) Variable Costs

associate with an operation that vary in total with the quantity of output
or other measure of activity level
(c) Incremental Cost
the additional cost that results from increasing the output of a system by
one (or more) units.
Associated with go-no go decisions that involve a limited change in
output or activity level
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(d) Direct Costs

Costs that can be reasonably measure and allocated to a specific output
or work activity
Labor and material costs directly associated with a product or service
(e) Indirect Costs

Costs that are difficult to attribute or allocate to a specific output or work

activity
Normally, they are costs allocated through a selected formula to the
outputs or work activities
Overhead consists of plant operating costs that are not direct labor or
direct material costs.
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(f) Standard Costs

Planned cost per unit of output that are established in advance of actual
production or service delivery
Develop from anticipated direct labor hours, materials and overhead
categories
Plays an important role on cost control and other management
functions:
estimating future manufacturing costs,
measuring operating performance by comparing actual cost per unit
with the standard unit cost
preparing bids
establishing the value of work in process and finished goods
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(g) Cash Cost

A cost that involves payment of cash (and results in cash flow)
In the accounting system, noncash cost is a cost that does not involve a
cast transaction. It is often referred to as a Book Cost.
Cash costs are estimated from the perspective established for the
analysis and are the future expenses incurred for the alternatives being
analysed.
Book costs are costs that do not involve cash payments but rather
represent the recovery of past expenditures over a fixed period of time.
Most common example of book cost is the depreciation charged for the
use of assets (example plan and equipment)
In EE analysis, only those costs that are cash flows or potential cash
flows from the defined perspective for the analysis need to be
considered.

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(h) Sunk Cost

Cost that has occurred in the past and has no relevance to estimates of
future costs and revenues related to an alternative course of action
Therefore, sunk cost is common to all alternatives, not part of the future
(prospective) cash flows and disregarded in an EE analysis
In summary, sunk costs are irretrievable consequences of past
decisions and therefore are irrelevant in the analysis and comparison of
alternatives that affect the future.
(i) Opportunity Cost
Cost that is incurred because of the use of limited resources, such that
the opportunity to sue those resources to monetary advantage in an
alternative use is foregone
It is a cost of the best rejected opportunity and is often hidden or
implied.
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(j) Life-Cycle Cost

This cost is the summation of all the costs related to a product,
structure, system, or service during its life span.

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 The life cycle begins with the identification of the economic

need/want/requirement and ends with the retirement/disposal activities.
Viewed as a Time horizon where the end of life cycle may be projected
on a functional or an economic basis.

It is divided into 2 general time periods:

i.

acquisition phase

Begins with the analysis of the economic need

With the requirement explicitly defined, the conceptual design

activities translate the defined technical and operational
requirements into a preliminary design. Advanced development and
prototype-testing activities that support are also included.
The following step is the detailed design and planning for production.
Subsequently, the next activities necessary to prepare, acquire, and
make ready for operation the facilities and other resources needed
are followed.
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ii. operation phase

In this phase, the production, delivery or construction of the end
product/service and their operation or customer use occurs.
It ends with retirement from the active operation or use.
The priorities for the EE studies in this phase are:
Achieving efficient and effective support to operations
Determining whether or when replacement assets should occur
Projecting the timing of retirement and disposal activities.
The earlier figure shows the relative cost profiles for the life cycle.

The greatest potential for achieving life-cycle cost savings is early in the
acquisition phase. Effective engineering design and economic analysis
are critical in maximizing potential savings.
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 As observed from the figure, the cumulative life-cycle cost curve

increases rapidly during the acquisition phase.
Approximately, 80% of life-cycle cost are locked in at the end of the
acquisition phase by the decisions made during the requirement
analysis and preliminary and detailed design.
On the other hand, only about 20% of the actual costs occur during the
acquisition phase and 80%being incurred during the operation phase.
An objective of the design process is to minimize the life-cycle cost,
while meeting other performance requirements, by making the right
trade-offs between prospective costs during the acquisition phase and
those during the operation phase.
Several basic life-cycle cost terms are introduced next.
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 Investment cost (also called capital investment) is the capital required

for most of the activities in the acquisition phase.
It can be as a single expenditure or even a series of expenditures
over an extended period.
Examples: purchase of equipment, large construction project etc.
Working capital refers to the funds required for current assets (other
than fixed assets) that are needed for the start-up and support of
operational activities.
The amount of working capital needed will vary with the type of
project and some or all of the investment is usually recovered at the
end of the projects life.
Examples: inventory materials, spare parts, cash etc.
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 Operation and maintenance cost (O&M) includes many of the

recurring annual expense items associated with the operation phase of
the life cycle.
The direct and indirect costs of operation (people, machines,
materials, energy and information) are a major part of the costs in
this category.

Disposal cost includes those nonrecurring costs of shutting down the

operation and the retirement/disposal of assets at the end of the life
cycle.
These costs will be offset in some cases with the sale of the assets
with remaining market value.

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1.2.2 THE GENERAL ECONOMIC

ENVIRONMENT
Several general economic concepts need to be taken into account in EE
analysis.
(a) Consumer and Producer Goods and Services

Goods and Services may be divided into 2 classes:

Consumer goods and services products and services that are
directly used by the people to satisfy their needs. Examples are
food, clothing, medical services etc.

Producer goods and services used to produce consumer goods

and services or other producer goods. Examples are machinery,
buses etc.
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(b) Measures of Economic Worth

Goods and services are produced and wanted because they have
utility, which is the power to satisfy the human wants and needs.
Therefore, they can be used or consumed directly, or even used to
produce other good/services.

Utility is measured in terms of value, which is expressed as the price

that must be paid to obtain the item.
In most engineering activities, the focus is on increasing the
utility/value of materials and products by changing their
form/location.

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(c) Necessities, Luxuries and Price Demand

Good and services can also be divided into necessities and luxuries.

However, these two terms are relative because what one person
considers a necessity may be considered a luxury by another.
For all goods and service, there is a general relationship between
the prices that must be paid and the quantity that will be demanded
or purchased.

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 The relationship between price and demand is expressed as a linear

function:
=
for 0

, and

> 0, > 0

where a is the intercept on the price axis and b is the slope

Thus, b is the amount by which demand increases for each unit
decrease in p
Both a and b are constants
Also, =

( 0)

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(d) Competition
Most general economic principles are stated for situations in which
perfect competition exists.
However, perfect competition occurs in situations where any given
product is supplied by a large number of producers/vendors and
there is no restriction on additional suppliers entering the market.
Under such conditions, there is assurance of complete freedom on
the part of both the buyer and seller.
However, in real practice perfect competition may never occur
because of the multitude of factors that impose some degree of
limitation on the buyers and sellers.
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 Monopoly is at the opposite pole from perfect competition.

A perfect monopoly exists when a unique product/service is available
from a single supplier and that supplier can prevent the entry of all
others into the market.
However, this hardly occurs because few products are that unique
that there are no other alternatives available in the market and also
government regulations prohibits monopolies if there are unduly
restrictive.
(e) The Total Revenue Function
The total revenue (TR) what will result from a project for a given
period is the product of the selling price per unit (p) and the number
of units sold (D).
TR = price x demand = .
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 Using the earlier equation on the relationship between price and

demand
TR = = 2

for 0 , and > 0, > 0

From calculus, the demand
that will produce the maximum total
revenue can be obtained by solving:
TR

= 2 = 0

Therefore,

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(f) Cost, Volume, and Breakeven Point Relationship

Fixed costs remain constant over a wide range of activities, but
variable costs vary in total with the volume of output.
Thus, at any demand D, the total cost is:
= +

where and denote fixed and variable costs

respectively.

For the linear relationship assumed here,

= .

where is the variable cost per unit

2 scenarios are considered for finding breakeven points. In Scenario

1, the demand is a function of price. Scenario 2 assumes price and
demand are independent of each other.
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1.2.3 COST-DRIVEN OPTIMIZATION

Engineers need to maintain a life-cycle viewpoint as they design
products, processes and services.
Factors such as initial investment costs, operation and maintenance
expenses and even environmental consequences over the life of their
designs need to be taken into consideration.
For cost-driven design optimization problems, 2 main tasks are:
Determine the optimal value for a certain alternatives design
variable

Select the best alternative, each with its own unique value for the
design variable.
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1.2.4 PRESENT ECONOMY STUDIES

Present economy studies is the EE analyses term used when
alternatives for accomplishing a specific task are being compared over a
period of one year or less and the influence of time on money can be
ignored.
(a) Total Cost in Material Selection
Economic selection among materials should not be based just on the cost
of the materials.
A change in material will somehow affect the design, processing costs and
even shipping costs.

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(b) Making versus Purchasing (Outsourcing) Studies

A company (in the short run) could consider producing an item in-house
even though the item can be purchased or outsourced from another
supplier at a lower price.

This may occur when the direct, indirect and overhead costs are incurred
regardless of whether the item is purchased from an outside supplier.
However, in the long run capital investments in additional manufacturing
plans and capacity are often feasible alternatives to outsourcing

(c) Trade-Offs in Energy Efficiency Studies

Energy efficiency affects the annual expense of operating electrical
equipment
Typically, a more energy-efficient equipment requires higher capital
investment but the annual savings in electrical power expenses is better

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1.3 COST-ESTIMATION TECHNIQUES

1.3.1 INTRODUCTION
1.3.2 AN INTEGRATED APPROACH
1.3.3 PARAMETRIC COST ESTIMATING

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1.3.1 INTRODUCTION
This sections addresses Step#3 Development of the outcomes and
cash flows for each alternative from the 7 steps used in the EE analysis
procedure.
Since EE deals with outcomes that extend into the future, estimating the
future cash flows for feasible alternatives is an important step.
This estimation step can be the most difficult, expensive and timeconsuming part of EE.

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 Results of cost estimating are used for:

Providing information used in setting a selling price
Determining whether a proposed product can be made and distributed at a
profit

Evaluating how much capital can be justified for process changes or

improvements
Establishing benchmarks for productivity improvement programs

There are two fundamental approaches to cost estimating: top-down

and bottom-up approach.
The top-down approach uses historical data from similar engineering
projects to estimate the costs, revenues and other data for the current
data.
However, modification of the data to consider changes in
inflation/deflation, activity level, energy usage etc. needs to be updated.
This approach is best used early in the estimating process when
alternatives are still being developed and refined.

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 The bottom-up approach is a more detailed method.

This method breaks down a project into small, manageable units and
estimates their economic consequences.
The smaller units are then added together with other types of costs to
obtain an overall cost estimate.
This approach works best when the detail concerning the desired
output has been defined.

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1.3.2 AN INTEGRATED APPROACH

The integrated approach to developing the net cash flows for feasible
project alternatives includes 3 basic components:
Work breakdown (WBS)
Cost and revenue structure (classification)

Estimating techniques (models)

These three basic components, together with the integrating procedural
steps, provide an organized approach for developing the cash flows for
the alternatives.

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 The integrated approach begins with a description of the project in terms of a

WBS.
WBS is used to describe the project and each alternatives unique
characteristics in terms of design, labor, material requirements etc.
Then these variations in design, resources requirements etc. are then reflected
in the estimated future costs and revenues (net cash flow) for that alternative
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(a) The Work Breakdown Structure (WBS)

The WBS is a basic tool in project management but also an important
tool in EE.

The WBS serves as a framework for:

defining all project work elements and their interrelationships
collecting and organizing information
developing relevant cost and revenue data
and integrating project management activities.

The figure shows a typical 4-level WBS:

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 Characteristics of a project WBS:

Both functional (example: logistical support, project management,
marketing etc.) and physical (example: parts that make up a structure,
product, labor, materials etc.) work elements are included in it.
The content and resource requirements for a work element are the sum of
the activities and resources of related sub elements below it.
A project WBS usually includes recurring (e.g. maintenance) and
nonrecurring (e.g. initial construction) work elements.

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(b) The Cost and Revenue Structure

This structure is used to identify and categorize the costs and revenues
that need to be included in the analysis.

The life-cycle concept and the WBS are important aids in developing the
cost and revenue structure for a project.
The life-cycle defines a maximum time period and establishes a range of
cost and revenue elements that need to be considered in developing cash
flows.
The WBS focuses the analysts effort on the specific functional and
physical work elements of a project and on its related costs and revenues.

Examples of categories of costs and revenues are capital investment

(fixed and working), labor costs, materials costs, maintenance costs,
overhead costs, quality (and scrap) costs etc.
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(c) Estimating Techniques (Models)

This technique, together with the detailed cost and revenue data, are
used to develop individual cash-flow estimates and the overall net cash
flow for each alternative.
The purpose of estimating is to develop cash-flow projections and not to
produce exact data about the future.

The estimates should adequately suit the need at a reasonable cost and
is often presented as a range of numbers.
Cost and revenue estimates can be classified according to detail,
accuracy, and their intended use.

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(i) Order-of-magnitude estimates

Used in the planning and initial evaluation stage of a project
Used in selecting the feasible alternatives for the study

Accuracy in the range of 30 to 50%

Developed through semiformal means such as conferences,
questionnaires and generalized equations applied at Level1 or 2 of
the WBS
(ii) Semi detailed, or budget, estimates
Used in the preliminary or conceptual design stage of a project
Compile to support design effort and decision making

Accuracy in the range of 15%

Estimating equations applied at Levels 2 and 3 of the WBS
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(iii) Definitive (detailed) estimates

Used in the detailed engineering or construction stage of the project
Used as the basis for bids and to make detailed design decisions

Accuracy in the range of 5%

Made from specifications, drawings, site surveys, vendor quotations,
in-house historical records
Done at Levels 3 and successive levels in the WBS
The level of detail and accuracy of estimates should depend on:
Time and effort available
Difficulty of estimating the items
Methods or techniques used
Qualifications of the estimator(s)
Sensitivity of study results to particular factor estimates

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 Potential important information sources for estimating the data in cost

and revenue estimation are:
Accounting records
Prime source of information but unsuitable for direct, unadjusted use.

Other sources within the firm

People (and their records) from departments such as engineering,
sales, production, purchasing and personnel.

Sources outside the firm

Published information (technical directories, publications, reference
books, journals etc.) and personal contacts (vendors, salespeople,
customers, banks etc.)

Research and development (R&D)

Undertake R&D to generate the required information (pilot plant, test
market program)
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1.3.3 PARAMETRIC COST ESTIMATING

Use of historical cost data and statistical techniques to predict future
costs.
Statistical techniques are used to develop cost estimating relationships
(CERs) that tie the cost or price of an item to one or more independent
variables.
Parametric models are use in the early design stages to get an idea of
how much the product (project) will cost, on the basis of a few physical
attributes.

The output of the parametric models (an estimated cost) is used to

gauge the impact of design decisions on the total cost.
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 Two commonly used estimating relationships are the power-sizing

technique and the learning curve.
The power-sizing technique (also called exponential model) is
frequently used for developing capital investment estimates for
industrial plants and equipment. This CER recognizes that cost
varies as some power of the change in capacity or size.
The learning curve is a mathematical model that explains the
phenomenon of increased worker efficiency and improved
organizational performance with repetitive production of
goods/services. It is also called an experience curve or a
manufacturing progress function. The basic concept of learning
curves is that some input resources decrease, on a per-output-unit
basis, as the number of units produced increases.
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DEVELOPING A COST ESTIMATING RELATIONSHIP (CER)

A Cost Estimating Relationship (CER) is a mathematical model that
describes the cost of an engineering project as a function of one or
more design variables.
CERS are useful tools because they allow the estimator to develop a
cost estimate quickly and easily.

The 4 basic steps in developing a CER are:

i.

Problem definition

ii. Data collection and normalization

iii. CER equation development
iv. Model validation and documentation

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1.4 BREAKEVEN ANALYSIS

When the selection between two engineering project
alternatives/outcomes is dependent on a single factor, we can solve for
the value of that factor at which the conclusion is a standoff.
That value is know as the breakeven point, that is, the value at which we
are indifferent between the two alternatives.
Breakeven analysis is commonly applied in make-or-buy decisions
when a decision is needed about the source for manufactured
components, services etc.

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BREAKEVEN ANALYSIS FOR A

SINGLE PROJECT
Figure (a) presents different
shapes of revenue relation
identified as R.
A linear revenue relation is
commonly assumed, but a
nonlinear relation is often more
realistic.
Nonlinear relations can model an
increasing per unit revenue with
larger volumes (curve 1) or a
decreasing per unit revenue that
usually prevails at higher
quantities.

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 At a specific but unknown value Q

of the decision variable, the
revenue R and total cost TC
relations will intersect to identify the
breakeven point QBE .
If Q > QBE, there is a predictable
profit; but if Q < QBE, there is a loss.
Profit = Revenue Total Cost

= R TC
= R (FC +VC)
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 A relation for the breakeven point may be derived when revenue and
total cost are linear functions of quantity Q by setting the relations for R
and TC equal to each other, indicating a profit of zero

R = TC
rQ = FC + vQ

(r = revenue per unit and v = variable cost per unit)

Therefore, for breakeven quantity Q = QBE for linear R and TC functions:
FC
BE =

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 If nonlinear R or TC
models are used, there
may be more than one
breakeven point.
The maximum profit
occurs at QP between the
two breakeven points
where the distance
between the R and TC
relations is greatest.

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BREAKEVEN ANALYSIS BETWEEN TWO ALTERNATIVES

This breakeven analysis determines the value of a common variable or
parameter between two alternatives.
Equating the two Present Worth (PW) and Annual Worth (AW) relations
determines the breakeven point.
Selection of the alternative is different depending upon:
i.

Slope of the variable costs curve

ii.

Parameter value relatives to the breakeven point

If the anticipated level of the common variable is BELOW the breakeven

value, select the alternative with the higher variable cost (larger slope).
If the level is above the breakeven point, select the alternative with the
lower variable cost
In make-or-buy analysis, where the two cost relations cross is the makeor-buy decision quantity. Amounts above this quantity, indicate that the
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item should be made and not purchased outside.