SEEM 5740: Engineering Economics 201112 Second Term

Master of Science in ECLT & SEEM

Instructor: Dr. Anthony ManCho So

Department of Systems Engineering & Engineering Management The Chinese University of Hong Kong

January 13, 2012

Course Personnel
Instructor: Dr. Anthony ManCho SO Oce: ERB 604 Phone: 3943 8477 Oce Hours: By appointment Email: manchoso@se.cuhk.edu.hk Website: http://www.se.cuhk.edu.hk/~manchoso

Teaching Assistant: Mr. Senshan JI Oce: ERB 905 Phone: 3943 4241 Oce Hours: By appointment Email: ssji@se.cuhk.edu.hk

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Course Particulars
Course Website: Textbook: http://www.se.cuhk.edu.hk/~eclt5930 Sullivan, Wicks, and Koelling Engineering Economy (15th Edition) Pearson Education Limited 2012 Chan S. Park Contemporary Engineering Economics Prentice Hall Chapters 18, 1012 + supplementary material Homework assignments (around 4 of them) 40% (Assignment Box: B12) Final examination 60%

Reference Book:

Scope: Assessment:

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Homework Policy
Working in groups allowed (even encouraged). The writeup must be your own. Copying the solution from your classmates/other sources is strictly forbidden. (Please read the Department Guidline for Plagiarism on the course website.) Homeworks are due on Fridays. Late submission will incur a 10% penalty, unless prior arrangement with the instructor has been made.

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Rules of the Class

Important: Please read the Student/Faculty Expectations on Teaching and Learning, prepared by the Faculty of Engineering, The Chinese University of Hong Kong. Active participation (asking/answering questions, making comments, etc.) encouraged Creative thinking encouraged Notes taking encouraged Discussions after the lecture encouraged Criticisms welcome Disruptions, lateness, and absence discouraged

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What is Engineering Economics?

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What is Engineering Economics?

From the US Accreditation Board for Engineering and Technology (ABET): Engineering is the profession in which a knowledge of the mathematical and natural sciences gained by study, experience, and practice is applied with judgment to develop ways to utilize, economically, the materials and forces of nature for the benet of mankind.

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 Just being able to build/create things is not enough. One must be able to do it economically. Engineering processes involve decisions and tradeos. Each has a dierent cost, i.e., something you give up (usually money). Examples Building a bridge: Where to build it? What kind of clients does it serve (pedestrians? heavy trucks? trains?) Operating equipment: Buy or rent? Designing a cellphone: What features to include? When to launch it? Managing a supply chain: When to replenish? Who are the suppliers? Sustainability issues (socalled green supply chains)?

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 The merit of a decision depends on its outcome. Being able to predict the outcome, therefore, is important. The value of an outcome is often subjective and depends on context. Factors aecting the merit of a decision Economic indicators: unemployment, debt obligations, interest rates, exchange rates, inationary/stagationary/deationary pressure, etc. Execution complexity Beneciaries: Individual, company, society, nation Strategic interactions among the parties involved: Game theory

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Eect of Strategic Interaction

Prisoners dilemma Confess Deny Two robbers got captured! If both confess, then both will get a 1year sentence. If both deny, then both will get a 3year sentence. If one of them denies, then he will be freed, but the other guy will get a 4year sentence. Both of them would deny and end up in a bad situation! Confess 1,1 0,4 Deny 4,0 3,3

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Eect of Strategic Interaction

Road Pricing
x

Travellers can go from A to B using one of two routes. The delay on the lower route is xed at one unit. The delay on the upper route depends linearly on the amount of trac. Suppose that there is one unit of trac, representing a large population of travellers. We would like to minimize delay (naturally). What is the optimal strategy for an individual? For the collective group?
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What is Engineering Economics?

Engineering economy involves the systematic evaluation of the economic merits of proposed solutions to engineering problems. To be economically acceptable, solutions must demonstrate a positive balance of longterm benets over longterm costs, promote the wellbeing and survival of an organization, embody creative and innovative technology and ideas, permit identication and scrutiny of their estimated outcomes, and translate protability to the bottom line through a valid and acceptable measure of merit.

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 The horizon over which the decisions are made is important longterm strategies can be very dierent from shortterm ones. To have a good evaluation of merits, a proper understanding of the situation is necessary i.e., need a good model. There is always a tradeo between tractability and complexity. Technologies tend to improve productivity, but only if they are properly used. Solutions should not complicate matter: Make things as simple as possible, but not simpler. Albert Einstein

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Principles of Engineering Economy

1. Problem recognition, denition, and evaluation What is the need? The more concrete the description, the better for further analysis. Evaluation of the problem typically includes renement of needs and requirements, and information from the evaluation phase may change the original problem formulation. 2. Develop the alternatives What are the possible courses of actions? Screening alternatives to select a smaller group for further analysis 3. Focus on the dierences Only the dierences in the alternatives are relevant to their comparison. If all options are equal, then taking any one of them will do.
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Principles of Engineering Economy (Contd)

4. Use a consistent viewpoint Dene and evaluate the alternatives and their outcomes from a xed persective. 5. Use a common unit of measure Make sure we are comparing options on an equal basis, i.e., not comparing oranges with apples. 6. Consider all relevant criteria and develop prospective outcomes What is the objective? Single or multiple objectives? Typically measured by cash ow Do I make money? Nonmonetary factors can also be important (e.g., reputation, customer/employee satisfaction, longterm sustainability, etc.) However, these could be tricky to measure.

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Principles of Engineering Economy (Contd)

7. Making risk and uncertainty explicit Can be philosophical, e.g., what is risk? Also, what kind of information about the uncertainty do we know? Scenarios? Probabilities? 8. Revisit your decisions Things may not turn out as expected. Typically, decisions and outcomes are not in oneshot, i.e., they evolve dynamically over time. Factors aecting the outcome may change, and hence the decisions must adapt. Monitoring project performance during its operational phase improves the achievement of related goals and reduces the variability in desired results.

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Engineering Economic Analysis & Engineering Design Process

1. Problem denition 2. Problem formulation and evaluation 3. Synthesis of possible solutions (alternatives) 4. Analysis, optimization, and evaluation 5. Specication of preferred alternative 6. Communication via performance monitoring

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Application: Buy, Rent or Repair?

You wreck your car! And you absolutely need one to get around. A wholesaler oers $2,000 for the wrecked car, and $4,500 if it is repaired. The cars standing mileage is 58,000 miles. Your insurance company oers $1,000 to cover the cost of the accident. To repair the car costs $2,000. A newer secondhand car costs $10,000 with a standing mileage of 28,000 miles. A parttime technician can repair the car for $1,100, but it takes a month. In the meantime, you need to rent a car, which costs $400 per month. Question: What should you do?

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Application: Buy, Rent or Repair? (Contd)

No panic! Apply the engineering economic analysis procedure. Step 1: Dene the problem In this case, it is simple you need a car!

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Application: Buy, Rent or Repair? (Contd)

Step 2: Develop alternatives You have several options. (A) Sell the wrecked car and buy the secondhand car. (Of course you would not just dispose the wrecked car.) (B) Repair the car and keep it. (C) Repair the car, sell it, and then buy the secondhand car. (D) Let the parttime technician repair the car and rent in the meantime. Afterwards, keep the car. (E) Let the parttime technician repair the car and rent in the meantime. Afterwards, sell the car and buy the secondhand car.

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Application: Buy, Rent or Repair? (Contd)

Step 3: Develop prospective outcomes via cash ows (A) Sell the wrecked car and buy the secondhand car. $2,000 + $1,000 $10,000 = $7,000 (B) Repair the car and keep it. $1,000 $2,000 = $1,000 (C) Repair the car, sell it, and then buy the secondhand car. $1,000 $2,000 + $4,500 $10,000 = $6,500 (D) Let the parttime technician repair the car and rent in the meantime. Afterwards, keep the car. $1,000 $1,100 $400 = $500 (E) Let the parttime technician repair the car and rent in the meantime. Afterwards, sell the car and buy the secondhand car. $1,000 $1,100 $400 + $4,500 $10,000 = $6,000

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Application: Buy, Rent or Repair? (Contd)

Step 4: Use a consistent criterion Let us just focus on your asset value immediately after the decision is made. (We are ignoring other things, such as higher future insurance costs, resell value of the secondhand car, etc.) Step 5: Compare the alternatives (A) Sell the wrecked car and buy the secondhand car. $10,000 $7,000 = $3,000 (B) Repair the car and keep it. $4,500 $1,000 = $3,500 (C) Repair the car, sell it, and then buy the secondhand car. $10,000 $6,500 = $3,500 (D) Let the parttime technician repair the car and rent in the meantime. Afterwards, keep the car. $4,500 $500 = $4,000 (E) Let the parttime technician repair the car and rent in the meantime. Afterwards, sell the car and buy the secondhand car. $10,000 $6,000 = $4,000
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Application: Buy, Rent or Repair? (Contd)

Step 6: Choose a preferred alternative after considering risk and uncertainties From the asset value pointofview, (D) and (E) are equally good. To dierentiate them, we need other criteria. Say, if the repaired car has a higher risk of failing, then we would prefer (E). Step 7: Revisit the decision Road test the newer car and conrm your decision.

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Another Application: Apartment Financing

Your friend bought an apartment building for $100,000. She spent $10,000 of her own money, got a mortgage for the remaining $90,000. Annual mortgage payment to the bank is $10,500. Expected annual maintenance of the apartment building at $15,000. She can rent out the 4 apartments in the building, at $360 per month. Question: Is your friend in a good position? If not, what can be done?

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Another Application: Apartment Financing (Contd)

As before, we can apply the engineering economic analysis procedure to solve this problem. Step 1: Dene the problem Her annual net cash ow is $10,500 $15,000 + 4 12 $360 = $8,220. Seems she is not doing so well. The problem then is whether it is possible for her to achieve a better position. Step 2: Develop alternatives What are her alternatives?

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Another Application: Apartment Financing (Contd)

Some alternatives include: (A) Raise the rent. (B) Lower the maintenance expenses. (C) Sell the apartment building. (D) Abandon the building.

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Another Application: Apartment Financing (Contd)

Step 3: Develop prospective outcomes (A) Raise the rent. To cover the monthly expense of $25,500/12 = $2,125, the rent has to be increased to $2,125/4 = $531.25, which is a 47.6% increase! (B) Lower the maintenance expenses. To break even with the current rent level, the monthly cost has to be decreased to $1,440. This means that the monthly maintenance cost should be at $1,440 $10,500/12 = $565. This amounts to a 54.8% drop in maintenance cost. (C) Sell the apartment building. Ideally, the selling price should cover the original investment of $10,000 plus the $8,220/12 = $685 per month loss. (D) Abandon the building. A very bad idea!
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Another Application: Apartment Financing (Contd)

Step 4: Use a consistent criterion It could be that of minimizing the expected loss of money. What other criteria can we use?

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Whats Next?
Assignment: Read Chapter 1 of the course textbook. Next: Cost concepts and design economics (Chapter 2 of the course textbook)

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