Engineering Economics

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Engineering Economics
John Ayers September 17, 2004
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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

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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.

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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
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Cash Flow Diagrams
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Equivalence of Cash Flow Patterns
To Find Given Multiply By Formula
F P
P F
A P
A G
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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?
Solution
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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.
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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
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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 0 5 years
Solution The ANEV is calculated for each
JACO
Cheepo
JACO
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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.
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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 0 5 years
JACO- Cheepo
JACO
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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
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Benefit/Cost Comparisons

• The benefit/cost ratio is determined from
• For mutually exclusive alternatives, the one with
  the highest B/C is chosen.
• For independent alternatives, all with B/C gt 1
  are accepted.

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

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Income Tax and Depreciation

• Businesses pay the IRS a tax
• 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.
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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.

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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.