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Engineering Economics

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

Why do we care about


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.

Value and Interest


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

Cash Flow Diagrams


P-Pattern
F-Pattern
A-Pattern
G-Pattern

present
future
annual
gradient

Equivalence of Cash Flow


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

Example: A new circuit board component insertion tool will


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

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

Annual Equivalent Cost Comparisons


Present Equivalent Cost Comparisons
Incremental Approach
Rate of Return Comparisons
Benefit/Cost Comparisons

Minimum Attractive Rate of Return (MARR): The lowest rate of return


that the organization will accept.

Annual Equivalent Cost


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

Example: A new circuit board component insertion tool is


needed. Which should you buy?
Model

Price

Annual Maintenance Salvage Value Life

JACO

$220k

$20k

$30k

10 years

Cheepo

$100k

$35k

5 years

Solution: The ANEV is calculated for each:


JACO:

%
10%
ANEV ( A / P )10
220
k

20
k

(
A
/
F
)
10
10 30k

35.8k 20k 1.9k 53.9k


Cheepo:

%
ANEV ( A / P )10
5 100k 35k

$61.4k

JACO

Present Equivalent Cost


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

Annual Maintenance Salvage Value Life

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

Rate of Return Method


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

C annual equivalent of initial cost

For mutually exclusive alternatives, the one


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).

Income Tax and Depreciation


Businesses pay the IRS a tax:
gross revenue - operating costs
TAX R

- interest paid - depreciati on

Depreciation: method of charging the initial cost


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.