Introduction to Engineering Economics

From the organization’s point of view, efficient and effective

functioning of the organization would certainly help it to
provide goods/services at a lower cost which in turn will
enable it to fix a lower price for its goods or services.
Engineering economics deals with the methods that enable
one to take economic decisions towards minimizing costs
and/or maximizing benefits to business organizations.
It deals with the concepts and techniques of analysis useful in
evaluating the worth of systems, products, and services in
relation to their costs.

2
 Role of Engineers in the Industry
Why do engineers 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.

3
 Engineering Decision Making
Role of Engineers:
Manufacturing Profit
− Estimating a
Required investment. Planning
− Forecasting a
product demand.
− Estimating a selling
price.
− Estimating a
manufacturing cost.
− Estimating a product
life. Investment Marketing

4
 Accounting Vs Engineering Economy
Evaluating past performance Evaluating and predicting future events

Accounting Engineering Economy

Past Present Future

 Types of Strategic Engineering Economic Decisions in

Manufacturing Sector:
 Service Improvement.
 Equipment and Process Selection.
 Equipment Replacement.
 New Product and Product Expansion.
 Cost Reduction.
5
 Time Value of Money
 Money has value
 Money can be leased or rented
 The payment is called interest
 If you put $100 in a bank at 9% interest for one time period you will
receive back your original $100 plus $9.
Original amount to be returned = $100
Interest to be returned = $100 x .09 = $9

 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

6
 Types of Costs
• There are usually two types of costs/Benefits associated with an
engineering project, one-time costs, which include first costs
and salvage costs, and annual costs (or benefits) that occur
every year or several years of the project.
 One time costs:
First Costs or Initial Costs are the costs necessary to implement a
project, including: Costs of new equipment, Costs of shipping and
installation, Costs of renovations needed to install equipment, Cost
of engineering, Cost of permits, licenses, etc.
Salvage value is the money that can be obtained at the end of the
project by selling equipment. Salvage value is a benefit rather than
a cost.
7
 Types of Costs
Annual Costs/Benefits:
 Direct operating costs such as labor, supervision,
supplies, maintenance, material, electricity, fuel, etc.
 Indirect operating costs sometimes included, such as a
portion of building rent, a portion of secretarial
expenses, etc.
 Depreciation of equipment.
 Finally, need to include savings or profits from the
project and tax.

8
 Cash Flow Diagram
 The graphic presentation of the costs and benefits over the
time is called the cash flow diagram.
 It is a presentation of what costs have to be incurred and
what benefits are received at all points in time.
 The costs and benefits of engineering projects over time are
summarized on a cash flow diagram (CFD).
 Specifically, CFD illustrates the size, sign, and timing of
individual cash flows, and forms the basis for engineering
economic analysis.

9
 Cash Flow Diagram
A CFD is created by first drawing a segmented time-based horizontal line,
divided into appropriate time unit. Each time when there is a cash flow, a
vertical arrow is added, pointing down for costs and up for revenues or
benefits. The cost flows are drawn to relative scale.
Horizontal axis = time;
vertical axis = costs and benefits.

10
 Cash Flow Diagram

P-Pattern “Present”
1 2 3 n

F-Pattern “Future”
1 2 3 n

A-Pattern “Annual”
1 2 3 n

G-Pattern “Gradient”
1 2 3 n

11
Example 1: A man borrowed $1,000 from a bank at 8% interest. Two end-
of-year payments
– At the end of the first year, he will repay half of the $1000 principal
plus the interest that is due.
– At the end of the second year, he will repay the remaining half plus the
interest for the second year. Cash flow for this problem is:
End of year Cash flow
0 +$1000
1 -$580 (-$500 - $80)
2 -$540 (-$500 - $40)
• q1

12
 Interest and their applications
Interest rate:
 Is the rental value of money. It represents the growth of capital per
unit period. The period may be a month, a quarter, semiannual or
a year.
 An interest rate 15% compounded annually means that for every
hundred dollar invested now, an amount of $15 will be added to
the account at the end of the first year. So, the total amount at the
end of the first year will be $ 115.
 At the end of the second year, again 15 % of $ 115, i.e. $ 17.25
will be added to the account. Hence the total amount at the end
of the second year will be $ 132.25. The process will continue
thus till the specified number of years.

13
Interest formulas:
 Simple interest: the interest is calculated, based on the initial
deposit for every interest period. In this case, calculation of interest on
interest is not applicable.
 Compound interest: the interest for the current period is computed
based on the amount (principal plus interest up to the end of the
previous period) at the beginning of the current period.
 The notations which are used in various interest formulae are as
follows:
 P = principal amount (Initial amount).
 n = No. of interest periods.
 i = interest rate
 F= future amount at the end of year n.
 A = equal amount deposited at the end of every interest period.

14
Single-Payment Compound Amount:
 Here, the objective is to find the single future sum (F) of the initial
payment (P) made at time 0 after n periods at an interest rate i
compounded every period. The formula to obtain the single-payment compound
amount is:

F= P(1 + i)n = P(F| P, i, n)

Where:
 P = principal amount (Initial amount).
 n = No. of interest periods.
 i = interest rate
 F= future amount at the end of year n.
 A = equal amount deposited at the end of every interest period.
 (F|P, i, n) is called as single-payment compound amount factor.

15
Example: A person deposits a sum of $ 20,000 at the interest
rate of 18% compounded annually for 10 years. Find the
maturity value after 10 years.

Solution: P= $20,000, i = 18% compounded annually, n= 10

years
F= P(1 + i)n = P(F|P, i, n)
= 20,000 (F|P, 18%, 10)
= 20,000 * 5.234 = $ 104,680

16
Single-Payment Present Worth Amount:
Here, the objective is to find the present worth amount (P)
of a single future sum (F) which will be received after n
periods at an interest rate of i compounded at the end of
every interest period.

Example:
 A person wishes to have a future sum of $100,000 for his son’s
education after 10 years from now. What is the single-payment that he
should deposit now so that he gets the desired amount after 10 years?
The bank gives 15% interest rate compounded annually.

Ans: $24,720
17
Equal-payment series future worth amount:
 The objective is to find the future worth of n equal payments which are
made at the end of every interest period till the end of the n-th interest
period.

18
Example:
 A person who is now 36 years old is planning for his retired
life. He plans to invest an equal sum of $10,000 at the end
of every year for the next 24 years starting from the end of
the next year. The bank gives 20% interest rate,
compounded annually. Find the maturity value of his
account when he is 60 years old.

Ans: $ 3,262,368

19
Equal-payment series sinking fund:
 In this type of investment mode, the objective is to find the equivalent
amount (A) that should be deposited at the end of every interest period
for n interest periods to realize a future sum (F) at the end of the nth
interest period at an interest rate of i.

 Example: A company has to replace a present facility after 15 years at an outlay of

$500,000. It plans to deposit an equal amount at the end of every year for the next 15
years at an interest rate of 18% compounded annually. Find the equivalent amount that
must be deposited at the end of every year for the next 15 years.

 Ans: $ 8,200, The annual equal amount which must be deposited for 15 years is $ 8,200.
20
Equal-payment series present worth amount :
 The objective of this mode of investment is to find the present worth of
an equal payment made at the end of every interest period for n interest
periods at an interest rate of i compounded at the end of every interest
period.

Example: A company wants to set up a reserve which will help the

company to have an annual equivalent amount of $1,000,000 for the next
20 years towards its employees welfare measures. The reserve is assumed
to grow at the rate of 15% annually. Find the single-payment that must be
made now as the reserve amount. Ans: $ 6,259,300
21
 Equal-Payment Series Capital Recovery Amount:
 The objective of this mode of investment is to find the annual equivalent
amount (A) which is to be recovered at the end of every interest period
for n interest periods for a loan (P) which is sanctioned now at an interest
rate of i compounded at the end of every interest period.

Example: A bank gives a loan to a company to purchase an equipment worth

$ 1,000,000 at an interest rate of 18% compounded annually. This amount
should be repaid in 15 yearly equal installments. Find the installment
amount that the company has to pay to the bank. Ans: $196,400
22
23