ENGINEERING ECONOMICS

EASTERN VISAYAS STATE UNIVERSITY

VISION
A premier institution of learning in the ASEAN region by 2040.
MISSION
Develop Competent and Productive Professionals with Positive Values for
Sustainable Development.
CORE VALUES
E – Excellence
V – Virtue
S – Service
U – Unity

Grading System
Summative Test (Midterm and Final Exam). . . . . . . . . . 60%
Performance-based Task :
Quiz . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20%
Culminating Activity. . . . . . . . . . . . . . . . . . . . . . . . . . 10%
Board Work/Seat Work . . . . . . . . . . . . . . . . . . . . . . . 5%
Assignment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5%
TOTAL 100%
TOPICS:

Introduction
1.1 Definitions
1.2. Principles of Engineering Economics
1.3. Engineering Economics and the Design Process
1.4. Cost Concepts for Decision Making
1.5. Present Economic Studies
Money-Time Relationships and Equivalence
2.1. Interest and the Time Value of Money
2.2. The Concept of Equivalence
2.3. Cash Flows
Economic Study Methods
3.1. The Minimum Attractive Rate of Return
3.2. Basic Economic Study Methods: Present Worth, Future Worth, Annual
Worth, Internal Rate of Return, External Rate of Return
3.3. Other Methods: Discounted Payback Period, Benefit/Cost Ratio

Decisions Under Certainty

4.1. Evaluation of Mutually Exclusive Alternatives
4.2. Evaluation of Independent Projects
4.3. Effects of Inflation
4.4. Depreciation and After-Tax Economic Analysis
4.5. Replacement Studies

Decisions Recognizing Risk

5.1. Expected Monetary Value of Alternatives
5.2. Discounted Decision Tree Analysis

Decisions Admitting Uncertainty

6.1. Sensitivity Analysis
6.2. Decision Analysis Models

Course Outcomes
1. Solve problems on Interest, Discount, Annuities and capitalized cost, bonds
applying the principles of Economics
2. Compute depreciation of engineering equipment and properties using
straight line formula, sinking fund formula, Matheson formula, Sum of the
years method and others
3. Analyze economic situation of a company/industry using break-even
analysis
QUESTION
WHAT IS ECONOMICS?

ENGINEERING ECONOMY
• ECONOMICS – one of the social sciences that consists of that body of
knowledge dealing with people and their assets or resources
- Sum total of knowledge that treats the creation & and utilization of goods
and services for the satisfaction of human wants.

ENGINEERING ECONOMY

ENGINEERING – is not a science but an application of science

- art composed of skill and ingenuity in adapting knowledge to the uses of

humanity
- the profession in which a knowledge of the mathematical and natural
sciences gained by study, experience, and practice is applied with judgment to
develop ways to utilize economically, the materials and forces of nature for
the benefit of mankind

• “Science is the foundation upon which the engineer builds toward the
advancement of mankind. With the continued development of science and the
worldwide application of Engineering, the standard of living maybe expected
to improve and further increase the demand for those things that contribute
to people’s love for the comfortable and beautiful”

QUESTION
WHAT IS ENGINEERING ECONOMICS?

ENGINEERING ECONOMY/ECONOMICS
* As defined by Arreola
– branch of Economics which involves the applications of definite laws of
Economics, theories of investments and business practices to Engineering
problems involving cost.
 - the study of economic theories and their applications to Engineering
problems with the concept of obtaining the maximum benefit at the least cost
- also involves the study of cost features & other financial data and their
applications in the field of Engineering as a basis for decision.

*As defined by Kasner

– Engineering Economics is equated with practicality and economic feasibility.

It is also the search for the recognition of alternatives which are then
compared and evaluated in order to come up with the most practical
design and creation.

*As defined by Sullivan, et. al

- Engineering economy is the systematic evaluation of the merits of proposed

solutions to engineering problems.

ORIGINS OF ENGINEERING ECONOMY

INDUSTRIAL
REVOLUTION

(Late 18th to Early Formalization in Late 19th

Mid 19th Century
19th Century) Century

Early of 20th Mid 20th Century Modern Era

Century
TWO ASPECTS OF ENGINEERING

1. Concerns itself with the materials and forces of nature.

2. Concerns of the needs of people.

QUESTION
WHY SHOULD ENGINEERS STUDY ECONOMICS?

Reasons for studying Engineering Economics:

1. Engineers, as a group, have wrought immense changes in improving the

economic well-being of mankind through their inventions and their
applications of scientific principles to the varied problems of industry.

2. In the professional life of engineers, it is readily observed that the most

successful ones are those who gradually divorce themselves from the
technical aspects of Engineering and who devote their time and efforts to
financial problems related to Engineering works.

ENGINEERING ECONOMY TECHNIQUES:

1. The Economy Analysis – considers all factors affecting the economy of the
project which can be reduced to specific monetary values.
2. The Financial Analysis – determines the methods and sources of financing
the project either through equity capital or borrowed or a combination of
both. It is dependent on the Economy analysis for necessary data.
3. The Intangible Analysis – determines all the aspects of the proposed
project which cannot be reduced to monetary values and considers the
uncertainty and the risks inherent in the project.
Special characteristics of Engineering Economics:
Engineering Economics

1. is closely aligned with Conventional Micro-Economics.

2. is devoted to the problem solving and decision making at the operations
level.
3. can lead to sub-optimization of conditions in which a solution satisfies
tactical objectives at the expense of strategic effectiveness.
4. is useful to identify alternative uses of limited resources and to select the
preferred course of action.
5. is pragmatic in nature. It removes complicated abstract issues of economic
theory.
6. mainly uses the body of economic concepts and principles.
7. integrates economic theory with engineering practice.

Principles of Engineering Economics:

Principle 1. Develop the alternatives, the choice is among the alternatives.

Principle 2. Focus on the differences. Only the difference in expected

outcomes is considered.

Principle 3. Use a consistent viewpoint. Prospective outcomes of the

alternatives, economic, etc.

Principle 4. Use a common unit measurement of the possible outcomes in

comparing alternatives.

Principle 5. Consider all relevant criteria. Consider both monetary & other
unit of measure in measurement of outcomes.

Principle 6. Make uncertainty explicit. Uncertainty is inherent in projecting

future outcomes and should considered in their analysis and comparison.

Principle 7. Revisit your decisions. Projected results & decisions should be

compared with actual results to improve the decision process.
 Engineering Economic Analysis Procedure

1. Problem recognition, definition, and evaluation.

2. Development of the feasible alternatives.
3. Development of the cash flows
4. Selection of a criterion (or criteria)
5. Analysis and comparison of the alternative
6. Performance monitoring & post evaluation results

COST CONCEPTS AND DESIGN ECONOMICS TERMINOLOGIES

TERMINOLOGIES

Fixed cost – those that are unaffected by changes in activity level over a
feasible range of operations for the capacity or capability available.
(Insurance and taxes on facilities, general management and administrative
salaries, license fees and interest costs of borrowed capital).

Variable cost – are those associated with an operation that vary in relation
to changes in quantity of output or other measures of activity level. For the
example, the cost of materials and labor used in a product or service are
variable costs – because they vary with the number of output units even
though the costs per unit stay the same.

Incremental cost (incremental revenue) – refers to the additional cost or

revenue that will result for increasing the output of a system by one of more
units. This is often quite difficult to determine in practice. Thus, if to produce
100 units will cost P200, and the total cost for producing 110 units is P215,
then the increment cost for additional 10 units is P15 or 1.50 per unit.

Recurring costs – costs that are repetitive and occur where an organization
produces similar goods or services on a continuing basis. Variable cost are
also recurring costs, because they repeat with each unit of output. Fixed cost
that is paid on a repeatable basis is a recurring cost (ex. office space rental).

Non-recurring costs – are those that are not repetitive even though the total
expenditures maybe cumulative over a relatively short period of time. Usually
it involves the developing or establishing a capability or capacity to operate.

Direct cost – those that can be reasonably measured and allocated to a

specific output or work (labor and materials).

Indirect cost – costs that are difficult to attribute or allocate to a specific

output. They are costs allocated through a selected formula (such as
proportional to direct labor hours or direct materials) to the outputs or work
activities (ex. Cost of common tools, general supplies equipment
maintenance).

Overhead cost – used to mean all expenditures that are not direct cost
(administrative, insurance, taxes, electricity, general repairs).

Standard cost – representation cost per unit of output that are established in
advance of actual production or service delivery. They are developed from
anticipated direct labor hours, materials and overhead categories. Standard
costs play an important role in cost control and other management functions
like estimating future manufacturing costs.

Cash cost – cost that involves payment of cash.

Book cost – does not involve cash transaction; non-cash. The most common
example of book cost is the depreciation. It is included in an analysis for it
affects income taxes, which are cash flows.

Opportunity cost – is incurred because of the use of limited resources such

that the opportunity to use those resources to monetary advantage in
alternative use is foregone. It is the cost of the best rejected opportunity and is
often hidden or implied.

Sunk cost – is one that has occurred in the past and has no relevance to
estimates of future costs and revenues related to an alternative course of
action. It represents money which has been invested and which cannot be
recovered due to certain reasons. A sunk cost is common to all alternatives
and is not part of the future cash flows and can be disregarded in an
engineering economic analysis.

Life cycle cost (LCC) – refers to the summation of cost estimates from
inception to disposal for both equipment and projects as determined by an
analytical study and estimate of total costs experienced during their life. The
objective of LCC analysis is to choose the most cost effective approach from a
series of alternatives so the least long term cost of ownership is achieved.
LCC analysis helps engineers justify equipment and process selection based
on total costs rather than the initial purchase price. Usually the cost of
operation, maintenance, and disposal costs exceed all other costs many times
over. Life cycle costs are the total costs estimated to be incurred in the
design, development, production, operation, maintenance, support, and final
disposition of a major system over its anticipated useful life span (DOE,
1995). The best balance among cost elements is achieved when the total LCC
is minimized (Landers, 1996).

Investment cost – first cost or cost incurred during the acquisition phase. It
is the capital required for most of the activities in the acquisition phase.

Capital investment – series of expenditures over an extended period on a

large construction project.

Working capital – refers to the funds required for current assets

(equipment, facilities) that are needed for the start-up and support of
operational activities.
Disposal cost – includes those non recurring costs of shutting down the
operation and the retirement and disposal of assets at the end of the
life cycle. Ex. Costs associated with personnel, materials.

Operation and maintenance cost – includes many of the recurring annual

expense items associated with the operation phase of the life cycle.

The direct and indirect costs of operation in five primary resource areas,
1) people
2) machines
3) Materials
4) energy
5) information – are major parts of the costs in this category.

BASIC TERMS and PRINCIPLES OF ECONOMICS

Two basic types of factors:

1. Tangible Factors- those which can be expressed in terms of monetary
values.
2. Intangible Factors – those which are difficult to express or impossible to
express in terms of monetary values. Also called irreducible factors.

Perfect Competition – occurs when a certain product is offered for sale by

many. vendors or suppliers, and there is no restriction against other vendors
from entering the market.

Monopoly – the opposite of perfect competition. It occurs when a unique

product or service is available only from a single supplier and entry of all
other possible suppliers is prevented.

Oligopoly – occurs when there are few suppliers and any action taken by
anyone will definitely affect the course of action of the others.
State whether Monopoly, perfect competition or oligopoly

1. A businessman sells a new product very sellable to the students. New

buyers can only buy this from him. Since the product became an instant need
and the demand for it increases, the businessman produces more at a higher
cost.
2. In a certain barangay, a barbecue stall was becoming popular since many
bought the food especially for those who had no time to cook in the evening.
Knowing the situation, another stall was placed the next week and the
following week, two additional stalls were installed making the area as the
BARBEQUE CORNER. This is advantageous to the customers since the price
became cheaper and they can choose among the many stalls.
3. Saudi Arabia reduced the amount of oil sent the Philippines thus it created a
big chaos in the business world. There were no air flights thus other products
were not transported from Metro Manila to the provinces.
4. A certain university required students to wear their uniform but they have
to buy it from the school coop since the cloth has the school logo printed on it
and no other store sells it.

Price – the amount of money or its equivalent which is given in exchange for
it.

Price regulates production. If prices go up, production will increase. If price

decreases, production will also decrease or cease.

Market – a place where sellers and buyers come together.

Local market – when goods which are perishable are sold in a limited
locality.

National market – certain goods which are sold all over the country

World market – goods which are exported to other countries

SOME ECONOMIC RELATIONSHIPS
Two kinds of goods:
1. Consumer goods – those that are consumed or used directly by people.
Examples: clothes, shoes, food, medical and dental services
2. Producer goods – those which produce goods and services for human .
consumption.
Examples: generators, ships, bus, airplanes.

Necessities and Luxuries

Necessities are those products Luxuries are those products

or services that are desired
or services that are required to by human and will be
purchased if money
support human life and available after the required
necessities have been
activities, that will be obtained.

Demand – the quantity of a certain commodity that is bought at a certain

price at a new given place and time.
The higher the
LAW OF DEMAND
The higher the
“The demand for a commodity varies inversely as the price of the PRICE, the lower
commodity, though not proportionately. the DEMAND
• ELASTICITY OF DEMAND
Elastic Demand – occurs when a decrease in selling price will cause a greater
increase in the volume of sales. Included here are the luxuries.
Inelastic Demand – occurs when a decrease in selling price will cause a less
than proportionate increase in sales. Included here are the necessities.

Utility – the capacity of a commodity to satisfy human want. If the utility of a

certain good to a certain individual is great, his demand for that good will be
great.
If the ballpen writes well
Then next time you buy same kind
(Because the utility of the pen is great)
If the ballpen does not function well
Then you will never buy this kind again
(Because the utility of the pen is less)

LAW OF DIMINISHNG UTILITY

“An increase in the quantity of any good consumed or acquired by an
individual will decrease the amount of satisfaction”
Marginal Utility of a commodity –the additional satisfaction or benefit
(utility) that a consumer derives from buying an additional unit of a
commodity or service. The concept implies that the utility or benefit to a
consumer of an additional unit of a product is inversely related to the number
of units of that product he already owns

Marginal Unit – the last unit of similar commodities consumed or acquired.

SUPPLY – the quantity of a certain commodity that is offered for sale at a

certain price at a given place and time.

LAW OF SUPPLY
“The supply of a commodity varies directly as the price of the commodity,
though not proportionately”
PRICE – SUPPLY Relationship

There is scarcity of ginger supply in the market since many are using it as
salabat so the price of ginger in the market increases.

Most high school students use school items printed with their favorite actor/
actress even at higher price. Knowing this, the producer manufactures more
of this product thus increasing the supply. But when time comes that the
celebrities are not that popular, buyers reduces thus supply of same product
should be reduced or stopped.

Supply refers to the amount of goods that are available.

Demand refers to how many people want those goods.

When supply of a product goes up, the price of a product goes down and
demand for the product can rise because it costs loss.

•At some point, too much of a demand for the product will cause the supply to
diminish. As a result, prices will rise. The product will then become too
expensive, demand will go down at that price and the price will fall.
 LAW OF SUPPLY AND DEMAND

“When free competition exists, the price of a product will be that value where
supply is equal to the demand”

This is a combination of the laws of demand and supply.

No sale exists if the buyers and the sellers do not agree on a common price for
the commodity.

The price is determined only when the demand is equal to the supply and a
sale occurs.

PRICE – SUPPLY – DEMAND RELATIONSHIP

Corn crops are very plentiful over the course of the year and there is more
corn than people would normally buy. To get rid of the excess supply, farmers
need to lower the price of corn and thus the price is driven down for
everyone.

A huge wave of new, unskilled workers come to a city and all of the workers
are willing to take jobs at low wages. Because there are more workers than
there are available jobs, the excess supply of workers drives wages
 downward.

There is a drought and very few strawberries are available. More people want
the strawberries than there are berries available. The price of strawberries
increases dramatically.

LAW OF DIMINISHING RETURNS

“When one of the factors of production is fixed in quantity or is difficult to

increase, increasing the other factors of production will result in a less than
proportionate increase in output”

Example:
The use of fertilizer improves crop production on farms and in gardens; but at
some point, adding increasingly more fertilizer improves the yield by less per
unit of fertilizer, and excessive quantities can even reduce the yield.

MARGINAL REVENUE – that amount

received from the sale of an additional unit
of a product.
MARGINAL COST – the additional cost of
producing one more unit.
 The effectiveness of the utilization is measured by the well-known equation:

Efficiency = Output
Where physical units are involved: Input
Physical Efficiency = Output in physical units

Input in physical units

[this can never exceed 100%]

When money is the material, effectiveness of the utilization is measured by:

Economic Efficiency = Income in Pesos

Cost in Pesos

Note: Unless the economic or financial efficiency exceeds 100%, the investment
of capital, from a strictly financial viewpoint is not recommended.

A common measure of financial efficiency is:

Rate of Return = Annual Net Profit

Capital Invested

and also

Payout Period = Capital Invested

Net annual cash flow

Let's say Rolan opens a lemonade stand. He invests ₱500 in the venture, and
the lemonade stand makes about ₱10 a day. Considering 300 days in a year
(with days-off), what is the rate of return in 1 year?

SOLUTION:
 There is one fundamental relationship you should be aware of when thinking

about rates of return:

the riskier the venture, the higher the expected rate of return.

Physical processes perform at less than 100% efficiency while economic

ventures are only feasible if they achieve greater than 100% efficiency.

Therefore, it is clear that in feasible economic ventures

the economic worth per unit of physical output must always be greater
than the economic cost per unit of physical input.
Example:
In making 50 native bags, the total cost is ₱9,000.00.

SOLUTION:

In selling the bag, what is economic worth of each bag? (Physical output)
It should be greater than ₱180.00 say ₱200.00 or more

At ₱200.00/bag, how much is your profit if all 50 bags were sold?

What is the total income?

SOLUTION:
Consequently, economic efficiency must depend more upon the worth and
cost per unit of physical outputs and inputs than upon physical efficiency.
Physical efficiency is significant, but only to the extent that it contributes to
economic efficiency.

Physical processes perform at less than 100% efficiency while economic

ventures are only feasible if they achieve greater than 100% efficiency.

Therefore, it is clear that in feasible economic ventures

the economic worth per unit of physical output must always be greater
than the economic cost per unit of physical input.

Economic Efficiency = Income in Pesos

Cost in Pesos

Consequently, economic efficiency must depend more upon the worth and
cost per unit of physical outputs and inputs than upon physical efficiency.
Physical efficiency is significant, but only to the extent that it contributes to
economic efficiency.