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ENGINEERING ECONOMICS

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John Ayers

September 17, 2004

Engineering Economics

Why is it important?

Value and Interest

Cash Flow Diagrams and Patterns

Equivalence of Cash Flow Patterns

Evaluating Alternatives

Break-Even Analysis

Income Tax and Depreciation

Inflation

Conclusion

Engineering Economics?

Engineering designs are intended to produce good

results.

They are accompanied by undesirables (costs).

If outcomes are evaluated in dollars, and good is

defined as profit, then decisions will be guided by

engineering economics.

This process maximizes goodness only if all

outcomes are anticipated and can be monetized.

The value of money depends on the

amount and when it is received or spent.

Example: What amount must be paid to settle a current debt of $1000 in

two years at an interest rate of 8% ?

Solution: $1000 (1 + 0.08) (1 + 0.08) = $1166

$1000

1

2

$1166

P-Pattern

F-Pattern

A-Pattern

G-Pattern

present

future

annual

gradient

Patterns

To Find Given Multiply By

F

( F / P )in

( P / F )in

( A / P )in

( A / G )in

Formula

(1 i) n

1

(1 i) n

i (1 i ) n

(1 i ) n 1

1

n

i (1 i ) n 1

save $50,000 in production costs each year and will have a

life of seven years. What is the highest price that can be

justified for the tool using a 12% interest rate?

50k 50k 50k 50k

Solution:

1

P

n

(

1

i

)

1

%

P ( P / A)12

A

A

7

n

i (1 i )

(1 0.12) 7 1

$50,000

7

0.12(1 0.12)

4.56 $50,000 $228k

Evaluating Alternatives

Present Equivalent Cost Comparisons

Incremental Approach

Rate of Return Comparisons

Benefit/Cost Comparisons

that the organization will accept.

Comparison

Incomes are converted to an A-pattern.

Costs are converted to an A-pattern.

The costs are subtracted from the incomes to

determine the ANEV.

Mutually Exclusive Alternatives choose the one

with highest ANEV

Independent Alternatives choose all with

positive ANEV

ANEV: Annual Net Equivalent Value

needed. Which should you buy?

Model

Price

JACO

$220k

$20k

$30k

10 years

Cheepo

$100k

$35k

5 years

JACO:

%

10%

ANEV ( A / P )10

220

k

20

k

(

A

/

F

)

10

10 30k

Cheepo:

%

ANEV ( A / P )10

5 100k 35k

$61.4k

JACO

Comparison

Incomes and costs are converted to P-patterns.

The costs are subtracted from the incomes to

determine the PNEV.

Mutually Exclusive Alternatives choose the one

with highest PNEV

Independent Alternatives choose all with

positive PNEV

PNEV: Present Net Equivalent Value, also called life cycle cost,

present worth, capital cost, and venture worth.

Incremental Approach

For a set of mutually exclusive alternatives, only

the differences in amounts need to be considered.

Model

Price

JACO

$220k

$20k

$30k

10 years

Cheepo

$100k

$35k

5 years

JACO- Cheepo:

%

10%

10%

PNEV 120k ( P / A)10

15

k

(

P

/

F

)

100

k

(

P

/

F

)

10

5

10 30k

120k 92.2k 62.1k 11.6k $45.9k

JACO

ANEV or PNEV is formulated

From this, we solve for the interest rate that will

give zero ANEV or PNEV

This interest rate is the ROR of the alternative

For mutually exclusive alternatives, the one with

the highest ROR is chosen

For independent alternatives, all with a ROR

greater than MARR are accepted

ROR: Rate of Return on Investment

Benefit/Cost Comparisons

The benefit/cost ratio is determined from

B

uniform net annual benefits

with the highest B/C is chosen.

For independent alternatives, all with B/C >

1 are accepted.

The MARR is used to determine the numerator (benefits).

Break-Even Analysis

Break-even point: the value of an independent

variable such that two alternatives are equally

attractive.

For values above the break-even point, one

alternative is preferred.

For values below the break-even point, the other is

preferred.

Break-even analysis is useful when dealing with a

changing variable (such as MARR).

Businesses pay the IRS a tax:

gross revenue - operating costs

TAX R

of an asset against more than one year.

An asset is depreciable if :

It is used to produce income,

Has a life greater than one year, but

Decays, wears out, becomes obsolete, or gets used up.

ACRS: Accelerated Cost Recovery System, used by IRS since 1980.

Inflation

The buying power of money changes with time.

Inflation, if anticipated, can be put to good use by

fixing costs and allowing income to rise by

Entering long-term contracts for materials or wages

Purchasing materials long before they are needed

Stockpiling product for sale later.

Conclusion

For-profit enterprises exist to make money.

Non-profit entities also make decisions to

maximize the goodness of outcomes by

assigning dollar values.

Your engineering decisions will be shaped

by economics.

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