AAiT
School of Civil and Environmental
Engineering
Engineering Economics (CEng 5211)
Chapter 1: Basic Concepts of Engineering
Economics
Content
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Basic Concepts of Engineering Economics
– Introduction
– Engineering economics decisions
– Understanding financial statements
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
Basic Concepts of Engineering Economics
•• TheThe process
process of
of producing
producing goods
goods and
and services
services requires
requires the
the use
use of
of resources
resources such
such as
as
labor, raw materials, capital, equipment, machines, etc.
labor, raw materials, capital, equipment, machines, etc.
•• Making choices is
Making choices is necessary
necessary because
because everything
everything wewe want
want might
might notnot be
be available.
available.
•• Economics
Economics deal
deal with
with aa certain
certain problem
problem faced
faced by
by all
all societies
societies i.e.,
i.e., the
the problem
problem ofof
Scarcity.
Scarcity.
“Scarcity: the excess
“Scarcity: the excess of
of human
human needs
needs over
over what
what can
can actually
actually be produced.”
be produced .”
•• Economics
Economics isis the
the study
study of
of choices
choices in
in the
the face
face of
of scarcity
scarcity of
of resources.
resources.
Why
Why is
is scarcity
scarcity aa problem?
problem?
•• IfIf we
we know
know that
that we
we have
have limited
limited resources
resources wewe could
could just
just behave
behave accordingly.
accordingly. The
The
problem arises because human wants and needs are virtually
problem arises because human wants and needs are virtually unlimited butunlimited but
resources available
resources available to satisfy
to satisfy them
them are not.are not.
•• Scarcity
Scarcity implies
implies that
that we
we face
face some
some sort
sort of
of constraints
constraints every
every time
time wewe take
take an
an
economic
economic decision.
decision.
•• The
The presence
presence of of constraints
constraints has
has the
the main
main implication
implication ofof creating
creating trade-offs
trade-offs among
among
different alternatives. The concept of trade-off is one of the core principles
different alternatives. The concept of trade-off is one of the core principles in in
economics.
economics.
•• Economics
Economics is is the
the study
study of
of choices
choices under
under conditions
conditions ofof scarcity,
scarcity, or
or the
the study
study of
of
choice
choice with constraints..
with constraints
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
• Trade-off: The idea that because of scarcity, producing more of one good or
service means producing less of another good or service.
Trade-offs force society to make choices.
• Trade-offs forces engineers to make choices, particularly when answering
the following fundamental questions:
– Which engineering projects are worthwhile?
– Which engineering projects should have a higher priority?
– How should the engineering project be designed?
• As summarized by the concept of trade-off, any choice, made when
resources are scarce, involves some sacrifice.
• The opportunity cost expresses "the basic relationship between scarcity
and choice”.
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
• Law of demand: The rule that, holding everything else constant,
when the price of a product falls, the quantity demanded of the
product will increase, and when the price of a product rises, the
quantity demanded of the product will decrease.
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
• Law of supply: The rule that, holding everything else constant,
increases in price cause increases in the quantity supplied, and
decreases in price cause decreases in the quantity supplied.
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
• Market equilibrium: A situation in which quantity demanded
equals quantity supplied.
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
• Surplus: A situation in which the quantity supplied is greater than
the quantity demanded.
• Shortage: A situation in which the quantity demanded is greater
than the quantity supplied.
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
• Economic decision making for engineering systems is called
engineering economy.
• Engineering economy is a collection of techniques that simplify
comparisons of alternatives on an economic basis.
• The purpose of engineering economy is to expose us to the methods
which are widely used for evaluation of alternative projects.
• The principles and methodology of engineering economy are utilized to
analyze alternative uses of financial resources, particularly in relation to
the physical assets and the operation of an organization.
• Alternatives: Options or uses of resources.
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
• Economics Engineering Economics
• It is a subset of economics that
• The study of how limited resources deals with the analysis and
are used to satisfy unlimited human evaluation of the factors that will
wants. affect the economic success of
• The study of how people, engineering projects to the end
institutions, and society make that a recommendation can be
economic choices under conditions made which will ensure the best
of scarcity. use of capital.
• It is the application of economic
techniques to the evaluation of
design and engineering alternatives.
• It deals with the concepts and
techniques of analysis useful in
evaluating the worth of systems,
products, and services in relation
to their costs. 10
Engineering Economics Understanding
Introduction
Decisions Financial Statements
Rational Decision-Making Process
Recognize a decision problem • Need a car
Define the goals or objectives • Want mechanical security
Collect all the relevant • Gather technical as well as
information
financial data
Identify a set of feasible • Choose between Saturn and
decision alternatives Honda
Select the decision criteria to
• Want minimum total cash
use
outlay
Select the best alternative • Select Honda
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Engineering Economics Understanding
Introduction
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FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS
• Principle 1: A nearby dollar is worth more than a distant
dollar
• Principle 2: All it counts is the differences among alternatives
• Principle 3: Marginal revenue must exceed marginal cost
• Principle 4: Additional risk is not taken without the
expected additional return
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
PRINCIPLE 1:
A nearby penny is worth a distant dollar
• A fundamental concept in engineering economics is that money has
a time value associated with it.
• Money has a time value?---Reading Assignment
• It is better to receive money earlier
than later. • If you receive 100 ETB now,
you can invest it and have more
money available six months from
now.
•This concept will be the basic
foundation for all engineering
project evaluation.
Today 6-month later 13
Engineering Economics Understanding
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Time Value of Money
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
PRINCIPLE 2:
All that counts are the differences among alternatives.
• An economic decision should be based on the differences among the
alternatives considered.
• All that is common is irrelevant to the decision.
Cash Outlay Salvage
Monthly Monthly at Signing Monthly Value at the
Option Fuel Cost Maintenance Payment End of Year 3
Buy $960 $550 $6,500 $350 $9,000
Lease $960 $550 $2,400 $550 0
Irrelevant items in
decision making
Differential
difference in total cost that results from
(Incremental)Analysis
selecting one alternative instead of the other. 15
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
PRINCIPLE 3:
Marginal Revenue must exceed Marginal Cost.
• Each decision alternative must be justified on its own economic merits
before being compared with other alternatives.
• Marginal revenue means the additional revenue made possible
by increasing the activity by one unit.
• Marginal cost means that productive resources like natural resources,
human resources, capital goods available to make goods and services
are limited. Therefore, people can not have all the goods and services
they want.
• As a result, they must choose some things and give up others.
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
Marginal
Cost
Manufacturing Cost
1 Unit
Sales Revenue Marginal
1 Unit Revenue
Cost of Goods Sold $2 per
unit
Gross Revenue $4 per unit
ensures that
Marginal Analysis: Marginal Revenue>Marginal Cost
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
PRINCIPLE 4:
Additional Risk is not taken without the Expected Additional Return.
• Investors demand a minimum return that must be greater than the
anticipated rate of inflation or any perceived risk.
• Expected returns from bonds and stocks are normally higher than the
expected return from a savings account.
Investment Class Potential Risk Expected Return
Savings account (Cash) Low/None 1.5%
Bond (Debt) Moderate 4.8%
Stock (Equity) High 11.5%
Risk and Return Trade Off
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Engineering Economics Understanding
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Types of Strategic Engineering Economic Decisions
1. Equipment & process • Selecting the best course of action from
selection various alternatives to get best returns
• Decision involves considering the expenditure
2. Equipment replacement necessary to replace worn-out or obsolete
equipments
• To increase the revenue
• Two common types:
3. New product & product
expansion • Through existing production/ distribution,
• Through new product or expand to a new
geographical area
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
Types of Strategic Engineering Economic Decisions
• Attempts to lower operating costs of the
company
4. Cost Reduction • Whether a company should buy
equipment to perform an operation
currently done manually or spend money
now in order to save more money later
• To improve of the quality of products/
5. Service improvement
services
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Engineering Economics Understanding
Introduction
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• Accounting Vs Engineering Economics
Evaluating past performance Evaluating and predicting future events
Accounting Engineering Economy
Past Future
Present
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Engineering Economics Understanding
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Decisions Financial Statements
General Cost Terms
Cost of revenue = Cost of goods sold
• Raw materials inventory
• Work-in-process inventory
• Finished goods inventory
• Construction Costs
Direct Cost
Indirect labor
Overhead
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Engineering Economics Understanding
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Cost Classification of Cost Relevant to Decision-Making
• Classification of cost:
RELEVANT TO FINANCIAL PREDICTING COST
DECISION-MAKING STATEMENTS BEHAVIOR
- Differential costs - Balance statement - Fixed cost
- Marginal costs - Income statement - Variable cost
- Sunk costs - Cash flow
- Opportunity costs statement
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
Cost Classification of Cost Relevant to Decision-Making
• Differential cost: difference in costs between any two alternatives.
• Differential revenue: difference in revenues between any two alternatives.
Current/Adoptin Make or Buy Make Buy Differential
g: new
Current/Adopting: new Current Better Differential
production Decision Option Option Cost
method
production method Dies Dies Cost Variable cost
Variable costs: Direct materials $100,000 -$100,000
Materials $150,000 $170,000 $20,000 Direct labor 190,000 -190,000
Machining labor 85,000 64,000 -21,000 Power and water 35,000 -35,000
Gas filter 340,000 340,000
Electricity 73,000 66,000 -7,000 Fixed costs
Fixed costs: Heating light 20,000 20,000 0
Supervision 25,000 25,000 0 Depreciation 100,000 100,000 0
Taxes 16,000 16,000 0 Rental income -35,000 -35,000
Depreciation 40,000 43,000 3,000 Total cost $445,000 $425,000 -$20,000
Total $392,000 $387,000 -$5,000 Unit cost $22.25 $21.25 -$1.00
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
Cost Classification of Cost Relevant to Decision-Making
• Marginal costs: is the variable for one more unit.
• Sunk costs: is the money already spent as a result of past decision.
Disregarded in economic analysis because current decisions cannot change the
past (Not relevant for future decisions.)
Example: money spent to buy a new machine last year.
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
Cost Classification of Cost Relevant to Decision-Making
• Opportunity costs: The potential benefit that is given up as an
alternative course of action is chosen.
• The benefit that is forgone by engaging a resource in a chosen activity instead of
engaging that same resource in the forgone activity. Is the best or next highest
ranked alternative foregone because of choosing the given action.
• Could also be considered as a forgone opportunity cost: because we are giving
up the benefit that could have been realized.
Example: Choosing to use a resource for one activity we are giving up the
opportunity of using the same resource at that time in some other activity.
• Economists use the term opportunity cost to highlight the fact that making choices
in the face of scarcity implies a cost (exactly related to the concept of trade-off).
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Engineering Economics Understanding
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Classification for Predicating Cost Behaviors
• Fixed Cost: The costs of providing a company‟s basic operating capacity.
• company's fixed cost does not vary with the volume of production. It remains the
same even if no goods or services are produced, and therefore, cannot be avoided.
Cost behavior: Remain constant over the time though volume may change.
Is constant or unchanging regardless of the level of output or activity.
Example: Annual insurance premium, property tax, and license fee, building rents,
depreciation of buildings, salaries of administrative and production personnel.
• Variable Cost: is a company's cost that is associated with the amount of goods
or services it produces. A company's variable cost increases and decreases with its
production volume.
Cost behavior: Increase or decrease according to the level of production.
Example: Production of ceramic tiles.
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
Classification for Financial Statement
• Matching Concept: states that the
costs incurred to generate
particular revenue should be
recognized as expenses in the
same period that the revenue is
recognized.
• Period costs: Those costs that are
charged to expenses in the time
period basis (advertising, executive
salaries, sales commissions, public
relations, other non manufacturing
costs).
• Product costs: Those costs that are
involved in the purchase or How the period costs and product costs flow
manufacturing of goods. Since through financial statement
product costs are assigned to
inventories, known as inventory
costs. (all costs related to
manufacturing process). 28
Engineering Economics Understanding
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Financial Statement
Net Worth: is a statement that “shows where one stands financially at a give
point in time.” At time of asking financial support from financial institutions:
Determine how credit worthy you are by examining the net worth.
• It is used:
o Financial planning and Report Financial Health of a corporation: an
information presented to investors
o By lender: to see borrower‟s ability to meet scheduled payments.
o Includes future projection and revenue: based on accounting information.
Net worth= Asset + Liabilities
Cash Debts
Investment
Stocks
• NW means what you would be left with if you sold everything and paid off
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what you owe.
Engineering Economics Understanding
Introduction
Decisions Financial Statements
Financial Statement or Report
• Annual report is the most important report issued by organizations and
contains financial statement and future prospects.
• What would one want to know about the company at the end of the fiscal year?
- What is the company’s financial position at
Balance sheet statement
the end of the reporting period?
- How much profit was made during the
Income statement
reporting period?
- How much cash was generated & spent? Statement of cash flow
Statement of retained
- Where was decided to use the profit?
earning
• Note: Fiscal year/Operation cycle: can be any 12 month term, but usually from
Jan 1-Decem 31 of a calendar year.
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Engineering Economics Understanding
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Balance Sheet
“….where one stands financially…”
• It lists the assets, liabilities, and equity of a business entity on a specified date.
Makes use of the “Accounting Equation”- The equality between the assets and
the claims against the assets is always maintained.
Asset = Liability + Equity
• Resources are balanced by the source of funding, hence the name „Balanced
Sheet‟.
• Liabilities and equity are understood as claim against assets and
indicate sources of fund to acquire assets and operate the business.
• These three balance sheet segments give investors an idea as to what
the company owns and owes, as well as the amount invested by
shareholders.
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Engineering Economics Understanding
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Balance Sheet Statement
1. Asset: how much the company owns at the time of reporting. Based on liquidity
and the time required to convert into cash asset is divided into current assets
and long term asset .
a. Current Asset: can be converted into cash in less than one year.
– Cash and its equivalent: short-term certificates of deposit, as well as
hard currency.
– Account receivable: money which customers owe the company
(Owned but not received yet)
– Inventories: investment on raw material, work-in-progress, goods available
for sale.
– Prepaid expenses: representing value that has already been paid
for, such as insurance, rent…
b. Long Term Asset: relatively permanent and take time to converted into cash.
– Fixed assets: these include land, machinery, equipment, buildings
and other durable, generally capital-intensive assets
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Engineering Economics Understanding
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Balance Sheet Statement
b. Long Term Asset: relatively permanent and take time to converted into cash.
– Long-term investments: securities that will not or cannot be
liquidated in the next year
– Intangible assets: these include non-physical, but still valuable,
assets such as goodwill. Are only listed on the balance sheet if
they are acquired.
2. Liability: money that a company owes to outside parties, from bills it has
to pay to suppliers to utilities and salaries.
a. Current liability: that is due within one year and are listed in order of their
due date.
– Short term debt
– Interest payable
– Wages payable
– Dividends payable and other
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Engineering Economics Understanding
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Balance Sheet Statement
b. Long-term liability: money the company owes and is due at any point after one
year.
– Long-term debt
3. Owners’/ Shareholders‘/ Stockholder Equity: portion of the assets of a
company which are provided by the investors (owners). It is the liabilities of the
company to the owner.
• Retained earnings: are the net earnings a company either reinvests in
the business or uses to pay off debt; the rest is distributed to
shareholders in the form of dividends.
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Engineering Economics Understanding
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Decisions Financial Statements
Balance Sheet Statement
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Engineering Economics Understanding
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Decisions Financial Statements
Balance Sheet Statement
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Engineering Economics Understanding
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Decisions Financial Statements
Income Statement/ Profit and Loss Statement
• It is a financial statement that reports a company's financial
performance over a specific accounting period.
• Summarizes the revenue and expenses over the month, quarter, or year.
• It is possible to evaluate revenues, and expenses that occur in the interval
between consecutive balance sheet statement.
• Unlike the balance sheet, which covers one moment in time, the
income statement provides performance information about a time
period.
Net Profit (Loss) = Revenue-Expense
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Engineering Economics Understanding
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Income Statement/ Profit and Loss Statement
Example
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Engineering Economics Understanding
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Cash Flow Statement
• It is a financial report that provides aggregate data regarding all
cash inflows a company receives as well as all cash outflows
during a given quarter. (cash inflows: ongoing operations and
external investment sources; cash outflows: payment for business
activities and investments during a given quarter.)
• It includes cash flows from operations, investment, and financing.
• Cash flows from operations starts with net income and then
reconciles all noncash items to cash items within business
operations. Includes accounts payable, depreciation.
• Cash flows from investing activities includes cash spent on
property, plant and equipment.
• Cash flows from financing is the section that provides an overview
of cash used in business financing.
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Engineering Economics Understanding
Introduction
Decisions Financial Statements
Income Statement/ Profit and Loss Statement
Example
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Engineering Economics Understanding
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Summarizing Remark
• Engineers design and create
• Designing involves economic decisions
• Engineers must be able to incorporate economic analysis into
their creative efforts
• Often engineers must select and implement from multiple
alternatives
• Understanding and applying time value of money, economic
equivalence, and cost estimation are vital for engineers
• A proper economic analysis for selection and execution is a
fundamental task of engineering
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Questions ?
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