Engineering Economics

Text book: Engineering Economic Analysis. 9th

edition. By D. Newman, Ted Eschenbach, and
Jerome Lavelle
 SCOPE OF ENGINEERING ECONOMICS
• How limited resources are used to satisfy unlimited human wants

• Concerned with the monetary consequences, financial analysis of the

projects, products and processes that engineers design

• Engineering economics helps an engineer to assess and compare the

overall cost of available alternatives for engineering projects

• Engineering economics concepts are used in the fields for improving

productivity, reducing human efforts, controlling and reducing cost
 What is it about?
 It is about decision making.
 Providing you with the tools to properly solve and
analyze.
 You need to understand the decision making process
and use the proper tools to compare between
alternatives.
 Final Goal: Make better decisions.

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 A Sea of Problems

 Simple problems
 Intermediate problems
 Complex problems
Where is Engineering Economic Analysis most suitable?

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 Intermediate Problems
 Important enough to be given serious thought

 A careful analysis requires that we organize the

problem and all the various consequences

 Has economic aspects important in reaching a decision

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 Engineering Economic Analysis

 Analysis of costs and benefits.

 Example: Construction of a road

•  Costs occur in the near future.
•  Benefits begin when construction is finished and

continues for a long time.

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 Engineering Economic Analysis
• A few more situations in which engineering economy plays a crucial role in
the analysis of project alternative come to mind:

1.Choosing the best design for a high-efficiency gas furnace

2. Selecting the most suitable robot for a welding operation on an automotive

assembly line

3. Making a recommendation about whether jet airplanes for an overnight

delivery service should be purchased or leased

• From these illustrations, it is obvious that engineering economy includes

significant technical considerations.
• Thus, engineering economy involves technical analysis, with emphasis on
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the economic aspects, and has the objective of assisting decisions
 Engineering Economic Analysis
• Mathematical Formulation, estimation and evaluation of the economic
outcomes out of various available alternatives to accomplish a defined
purpose

• Discipline that involves the systematic evaluation of the cost and benefit of
proposed technical projects

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 The Decision Making Process
 Rational
 Irrational or inadequate (Horse example)
 Should have at least two alternatives to call it
“Decision Making”

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Rational Decision Making

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 Rational Decision Making
1. Recognize the Problem

An existing problem might be obvious or hidden

►►Total Quality Management (TQM) or Continuous
Improvement (CI) programs to identify problems and
present solutions

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 Rational Decision Making
2. Define the Goal or Objective
The act of describing the task
- Overall goal (e.g. a person leading a pleasant life or a
company operating profitably)

Objective
- Specific
- Pay off the loan on my car or find a nice apartment
- The plant must produce 300 golf carts in the next 2
weeks

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 Rational Decision Making
3. Assemble Relevant Information
What are the facts? Are more data needed, and is it worth more than the cost to obtain it?
• To rent an apartment, you need information on rent, utilities, apartment age, parking,
distance to campus, distance to shopping, and others
Published Information
Unpublished Information

 Time horizon is part of the data that must be assembled

 How long will the building or equipment last?
 How long will it be needed?

 Analysis of costs and benefits.

 Example: Construction of a road
 Costs occur in the near future.
 Benefits begin when construction is finished and continues for a long time
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 Rational Decision Making
3. Assemble Relevant Information
 Analysis of costs and benefits.

Market Consequences
These consequences have an established price in the market place

Extra-Market Consequences
There are other items that are not directly priced in the marketplace

Intangible Consequences
Numerical economic analysis probably never fully describes the real differences
between alternatives

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 Rational Decision Making
The cost-accounting records of a large company show the average monthly costs for the
three person printing department. The wages of the three department members and
benefits, such as vacation and sick leave, make up the first category of direct labor. The
company’s indirect or overhead costs—such as heat, electricity, and employee insurance—
must be distributed to its various departments in some manner and, like many other firms,
this one uses floor space as the basis for its allocations.

The printing department charges the other departments for its services to recover its
$18,000 monthly cost. For example, the charge to run 30,000 copies for the shipping
department is:

The shipping department checks with a commercial printer, which would print the same
30,000 copies for $688. The shipping department foreman wants to have the work done
externally. The in-house printing department objects to this. As a result, the general
manager has asked you to study the situation and recommend what should be done. 15
 Rational Decision Making

Commercial printer, which would print the same 30,000 copies for $688.

The shipping department would reduce its cost by $105 (= $793 – $688) by using
the outside printer.

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 Rational Decision Making

If the firm uses outside printing option

1. Direct Labor. there might be a $228 saving, it is much more likely that there will be no
reduction in direct labor.
2. Materials and Supplies. There would be a $294 saving in materials and supplies.
3. Allocated Overhead Costs. There will be no reduction in the printing department’s
monthly $5000 overhead, and in fact the firm will suffer additional expenses in purchasing
and accounting to deal with the outside printer

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 Rational Decision Making

The firm will save $294 in materials and supplies and may or may not save
$228 in direct labor if the printing department no longer does the shipping
department work.

The maximum saving would be $294 + 228 = $522.

Either value of $294 or $522 is less than the $688 the firm would pay the
outside printer.

For this reason, the shipping department should not be allowed to send its
printing to the outside printer

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 Rational Decision Making
4. Identify Feasible Alternatives
►It is good to list practical and impractical alternatives. However, do
not seriously consider an alternative that cannot be adopted.

►An alternative might be infeasible for violating the safety, violating the
religious laws, requiring resource materials that cannot be obtained.

►Only the feasible alternatives are retained for further analysis.

►Sometimes a group of people considering alternatives in an

innovative atmosphere—brainstorming—can be helpful

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 Rational Decision Making
5. Select the Criterion to Determine the Best Alternative
Now that we listed the alternatives in step 4, it is time to
compare. How do you make a choice?

 Least disturbance to the environment.

 Improve the distribution of wealth among people
 Minimize the time to accomplish the goal
 Minimize unemployment
 Maximize profit (usually selected in Eng. Decision making
Fixed input → need to maximize the benefits or other outputs
Fixed output → need to minimize the costs or other inputs
Neither input or output fixed → need to maximize the benefits
minus the costs
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 Rational Decision Making
6. Constructing the Model

 Bring the decision-making elements (objective, relevant

data, feasible alternatives, and selection criterion) together in
relationships (build a model)
 Mathematical relationship, which is the common in economics
 Physical model
 Example: Borrowing money to pay for a car: use a
mathematical relationship combining the amount, interest
rate, duration, and monthly payments.

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 Rational Decision Making
6. Constructing the Model
To an engineer, modeling may be a scaled physical representation of the real
thing or system or a mathematical equation, or set of equations, describing
the desired interrelationships.

In economic decision making, the model is usually mathematical

The mathematical model of the student capacity of a classroom can be

Capacity = lw /k

where l = length of classroom, in meters

w = width of classroom, in meters
k = classroom arrangement factor

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 Rational Decision Making
7. Predicting the Outcome for Each Alternative

 A model and the data are used to predict the outcomes for
each feasible alternative
 Example: Motorcycle vs. bicycle:
 A motor cycle makes fuel suppliers happy, makes neighbors unhappy,
makes the environment more polluted, and lowers saving account.
 Use single criterion to measure the relative attractiveness of
the various alternatives
 Example: a pavement that uses demolition wastes vs a pavement that
does not. The criterion might be to maximize the use of the waste
material.
 To choose the best alternative, you need to state the
outcomes for each alternative in a comparable way (usually
in terms of money; i.e. costs and benefits)

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 Rational Decision Making
8. Choose The Best Alternative

 Choose the alternative that best meets the choice criterion

after considering both the numerical consequences and the
consequences not included in the monetary analysis.
 Time to consider intangible consequences.
 Eliminate certain feasible alternatives if clearly dominated
by other better alternatives (process becomes more efficient).
 Example: On-line vs. in-store purchase of a computer.

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 Rational Decision Making
9. Audit the Results

 A comparison of what happened against the predictions

 Example: A new machine purchased to save labor and improve
quality, did it?
 If yes → your analysis worked well
 If not → what was overlooked?
 Auditing checks if the economic analysis was extremely
optimistic so that the mistakes leading to such inaccurate
projections are not repeated.
 Auditing is an effective way to promote realistic economic
analysis calculations (when involved people know that the
results will be audited)

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 Engineering Decision Making for
Current Costs
 Costs and benefits occur over a short period of time.
 Just add up the costs and benefits for each alternative.
 Choose the best alternative using the suitable economic
criterion.

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Example 1-3
Example 1-4

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