Advanced Engineering Economy & Costing

D.Prakash Adminstrative block; Room no: 28 duraiprakash83@gmail.com 0932120816

Aim To develop economic and cost analysis models for decisions making. Course Description Formulation of economic problems models. Analysis of capital Investments, Decision analysis methods: decision tree analysis, multi-attribute decisions, probabilistic analysis and sensitivity/risk analysis. Stochastic techniques and risk to evaluate design alternatives, Capital budgeting models: multi-criteria optimization, certainty equivalence. Replacement analysis. Costing techniques applicable in manufacturing: activity based costing, life cycle costing, theory of constraints, cost of quality.

What Kinds of Questions Can Engineering Economics Answer?

ENGINEERING ECONOMICS INVOLVES: FORMULATING, ESTIMATING, AND EVALUATING ECONOMIC OUTCOMES WHEN CHOICES OR ALTERNATIVES ARE AVAILABLE

How Does It Do This?

BY USING SPECIFIC MATHEMATICAL RELATIONSHIPS TO COMPARE THE CASH FLOWS OF THE DIFFERENT ALTERNATIVES (typically using spreadsheets)

Here is an approach to problem-solving:

Understand the problem Collect all relevant data/information Define the feasible alternatives Evaluate each alternative

Where Does Engineering Economics Fit?

Select the best alternative

Implement and monitor the decision
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Where Does Engineering Economics Fit?

1. Understand the Problem 2. Collect all relevant data/information (difficult!) 3. Define the feasible alternatives 4. Evaluate each alternative 5. Select the best alternative
This is the major role of engineering economics

6. Implement and monitor

What Makes the Engineering Economic Decision Difficult? - Predicting the Future
Estimating a Required investment Forecasting a product demand Estimating a selling price Estimating a manufacturing cost Estimating a product life

Contemporary Engineering Economics, 4th edition, 2007

Role of Engineers in Business

Create & Design

Engineering Projects

Analyze Production Methods Engineering Safety Environmental Impacts Market Assessment

Evaluate Expected Profitability Timing of Cash Flows Degree of Financial Risk

Evaluate Impact on Financial Statements Firms Market Value Stock Price

Contemporary Engineering Economics, 4th edition, 2007

The five main types of engineering economic decisions are

(1) service improvement, (2) equipment and process selection, (3) equipment replacement, (4) new product and product expansion, and (5) cost reduction.

Accounting Vs. Engineering Economics

Evaluating past performance Evaluating and predicting future events

Accounting
Past Present

Engineering Economy
Future

Contemporary Engineering Economics, 4th edition, 2007

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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
Contemporary Engineering Economics, 4th edition, 2007 11

Principle 1: A nearby dollar is worth more than a distant dollar

Today

6-month later

Contemporary Engineering Economics, 4th edition, 2007

12

Principle 2: All it counts is the differences among alternatives

Option
Monthly Fuel Cost Monthly Cash Maintena outlay at nce signing Monthly payment Salvage Value at end of year 3

Buy Lease

$960 $960

$550 $550

$6,500 $2,400

$350 $550

$9,000 0

Irrelevant items in decision making

Contemporary Engineering Economics, 4th edition, 2007 13

Principle 3: Marginal revenue must exceed marginal cost

Marginal cost Manufacturing cost 1 unit

Sales revenue

1 unit

Marginal revenue

Contemporary Engineering Economics, 4th edition, 2007

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Principle 4: Additional risk is not taken without the expected additional return
Investment Class Potential Risk Expected Return 1.5%

Savings account Low/None (cash) Bond (debt) Stock (equity) Moderate High
Contemporary Engineering Economics, 4th edition, 2007

4.8% 11.5%
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Simple Methods
Simple Payback Period (SPP)- The time required for savings to offset first costs. Simple Return on Investment (ROI)- The simple percent return the project pays over its life. These methods are simple because they do not consider the time value of money. Simple methods are OK for investments that are very good and pay off over short time periods.

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 10% interest for one time period you will receive back your original $100 plus $10

Original amount to be returned = $100 Interest to be returned = $100 x .10 = $10

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Compound Interest
Interest that is computed on the original unpaid debt and the unpaid interest Compound interest is most commonly used in practice Total interest earned = In = P (1+i)n - P
Where,
P present sum of money i interest rate n number of periods (years) I2 = $100 x (1+.09)2 - $100 = $18.81
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Present and Future Value

Present Value is the value now of an amount of money F received n years in the future. Future Value is value n years in the future of an amount of money P received now. If we can earn interest rate i on investments, the relationship between P and F is:

F = P(1 + i)n

or

P = F/(1 + i)n

ECONOMIC MODELS
Economic modeling is at the heart of economic theory. Modeling provides a logical,abstract template to help organize the analyst's thoughts. The model helps the economist logically isolate and sort out complicated chains of cause and effect and influence between the numerous interacting elements in an economy. Through the use of a model, the economist can experiment, at least logically, producing different scenarios, attempting to evaluate the effect of alternative policy options, or weighing the logical integrity of arguments presented in prose.

Types of Models
visual models, Mathematical models, Empirical models, Simulation models.

1. Visual Models - Visual models are simply pictures of an

abstract economy; graphs with lines and curves that tell an economic story

2. Mathematical Models
The most formal and abstract of the economic models are the purely mathematical models. These are systems of simultaneous equations with an equal or greater number of economic variables.

3.Empirical Models
Empirical models are mathematical models designed to be used with data. The fundamental model is mathematical, exactly as described above. With an empirical model, however, data is gathered for the variables, and using accepted statistical techniques, the data are used to provide estimates of the model's values.

 "What will happen to investment if income rises one percent?" The purely mathematical model might only allow the analyst to say, "Logically, it should rise. The user of the empirical model, on the other hand, using actual historical data for investment, income, and the other variables in the model, might be able to say, "By my best estimate, investment should rise by about two percent."

4.Simulation Models
Simulation models, which must be used with computers, embody the very best features of mathematical models without requiring that the user be proficient in mathematics. The models are fundamentally mathematical (the equations of the model are programmed in a programming language like Pascal or C++) but the mathematical complexity is transparent to the user. The simulation model usually starts with initial or "default" values assigned by the program or the user, then certain variables are changed or initialized, then a computer simulation is done. The simulation, of course, is a solution of the model's equations. The user can usually alter a whole range of variables at will.

 The computerized simulation model can show the interaction of numerous variables all at once, including hidden feedback and secondary effects that are not so apparent in purely mathematical or visual models. Macroeconomic simulation model called HMCMacroSim

Static and Dynamic Models

Most of the models used in economics are comparative statics models. Some of the more sophisticated models in macroeconomics and business cycle analysis are dynamic models.

 The initial equilibrium (point 'a') identifies the price and level of output that would obtain, given assumptions about supply and demand and the level of inflationary expectations. Then the model is shocked by introducing a higher level of expectations, demonstrating a new equilibrium at point 'b'. Obviously this movement in equilibria and the shift in the model's solution happened over time, but neither the visual model nor its mathematical counterpart can demonstrate what happened in the interim. The model shows only the starting point and the ending point. The comparative statics approach is roughly analogous to using snapshots from a camera to record developments during a dynamic event. With each snapshot a static but informative picture is presented.

Dynamic Model

Why Comparative Statics Models are Usually Used?

The answer is simple - comparative statics models are much easier to solve. Any student of calculus knows the difficulty of solving systems of difference or (especially) differential equations. The latter, as soon as they achieve any complexity, are sometimes impossible to solve. Therefore dynamic models must be kept extremely simple and are therefore so elementary that more is lost than gained.

 Simple dynamic models, nonetheless, often provide valuable insights into the complex interactions between variables over time. They can capture remarkably subtle feedback effects that are easily missed by static models. It should be noted that dynamic models are much easier to simulate on computers than they are to solve outright. The user can experiment with an endless variety of values and assumptions to see whether results obtained are realistic or insightful. Since computers are now powerful and cheaper, the importance of dynamic simulation models should gradually grow in importance.

Expectations-Enhanced Models
Economic models often incorporate economic expectations, such as inflationary expectations. Such models are called expectations-enhanced models. Generally, expectations-enhanced models include one or more variables based upon economic expectations about future values. For example, if consumers, for whatever reason, expect the inflation rate to be much higher next year than this year, they are said to have formed inflationary expectations.

 There are many types of expectations found in economics. In addition to inflationary expectations, economists might consider interest rate expectations, income expectations, and wealth expectations. This list is hardly exhaustive.

Adaptive Expectations
The theory of adaptive expectations presumes that expectations are primarily learned from experience. For example, the theory of adaptive expectations would say that if consumers begin to actually see prices rising, say from three percent to five percent to seven percent, over a period of, say, two years, they will begin to form robust expectations of inflationary expectations perhaps even expectations of doubledigit inflation. The same theory might claim that consumers will expect an economic recovery to begin only after ample evidence that the turning point has been passed.

Rational Expectations
The theory of rational expectations presumes that expectations are formed when economic agents see new developments in the economy and they logically deduce expectations based upon the information they have. For example, if the Federal Reserve System were to suddenly increase the money supply, according to the theory of rational expectations, consumers would immediately form inflationary expectations, not because prices are actually rising, but because they deduce that excessive money supply growth is likely to cause inflation. The theory of rational expectations emphasizes the effects of changes in economic policy upon expectations, although the theory is not restricted to policy decisions alone.

The Limitations of Models

Improper Assumptions Oversimplification Mathematical Intractability

The Model as an "Image" of Economic Activity

Two important points are being made here: 1. This model, like most in economies, is not an applied model, where anyone actually uses it to determine appropriate prices and levels of production. (To be more specific, it is not an applied management model; corporations don't use these models to make pricing decisions). Instead, the model represents a type of consistent behavior that economists see in the market place, and it presents an image of that behavior. It allows an economist to both ask and answer the question, "What would we expect to happen in a market where prices are too high or too low? What kind of adjustment would take place, and why? 2. The market reactions of the economic decision-makers are not undertaken by virtue of their use of this model or any other, but is instead motivated by their necessary response to market signals that tell them that they must alter their decisions. The model, therefore, simply captures their responses to a series of market signals.

Analysis of capital investment

Present value method Future value technique Annual equivalent cost method Rate of return method

Present value method

Using the compound interest formulas bring all benefits and costs to present worth Select the alternative if its net present worth 0
Net present worth =Present worth of benefits Present worth of costs

Present Worth Analysis

A construction enterprise is investigating the purchase of a new dump truck. Interest rate is 9%. The cash flow for the dump truck are as follows: First cost = $50,000, annual operating cost = $2000, annual income = $9,000, salvage value is $10,000, life = 10 years. Is this investment worth undertaking? P = $50,000, A = annual net income = $9,000 - $2,000 = $7,000, S = 10,000, n = 10. Evaluate net present worth = present worth of benefits present worth of costs

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Present Worth Analysis

Present worth of benefits = $9,000(PA,9%,10) = $9,000(6.418) = $57,762 Present worth of costs = $50,000 + $2,000(PA,9%,10) - $10,000(PF,9%,10)= $50,000 + $2,000(6..418) - $10,000(.4224) = $58,612 Net present worth = $57,762 - $58,612 < 0 do not invest

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Future value technique

The future value technique of evaluating alternatives is almost identical to the present value method except that all costs and revenues are stated in terms of future value.

Annual equivalent cost method

The annual equivalent cost method of evaluating alternative projects states all costs and revenues over the useful life of the project in terms of an equal annual payment series 1. It requires less effort and fewer calculations. 2. It eliminates the problem of alternatives with incompatible useful lives. 3. It allows for much more sophistication when considering inflation, increasing equipment cost, equipment depreciation schedules, etc.

Rate of Return (ROR)

The rate of return (ROR) method of comparing alternatives calculates the interest rate for each alternative and selects the highest ROR. ROR evaluates INVESTED capital and the costs of operation and maintenance as opposed to revenues or benefits received from the project.

Cost-Benefit Analysis
Project is considered acceptable if B C 0 or B/C 1. Example (FEIM): The initial cost of a proposed project is $40M, the capitalized perpetual annual cost is $12M, the capitalized benefit is $49M, and the residual value is $0. Should the project be undertaken? B = $49M, C = $40M + $12M + $0 B C = $49M $52M = $3M < 0 The project should not be undertaken.

Rational Decision-Making Process

1. 2. 3. 4. 5. 6. Recognize a decision problem Define the goals or objectives Collect all the relevant information Identify a set of feasible decision alternatives Select the decision criterion to use Select the best alternative

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Which Car to Lease? Saturn vs. Honda

1. 2. 3. 4. 5. 6. Recognize a decision problem Define the goals or objectives Collect all the relevant information Identify a set of feasible decision alternatives Select the decision criterion to use Select the best alternative Need a car Want mechanical security Gather technical as well as financial data Choose between Saturn and Honda Want minimum total cash outlay Select Honda

52

Financial Data Required to Make an Economic Decision

53

Predicting the Future

Estimating a Required investment Forecasting a product demand Estimating a selling price Estimating a manufacturing cost Estimating a product life

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Types of Strategic Engineering Economic Decisions in Manufacturing Sector

Service Improvement Equipment and Process Selection Equipment Replacement New Product and Product Expansion Cost Reduction

Contemporary Engineering Economics, 4th edition, 2007

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Service Improvement - Healthcare Delivery

Which plan is more economically viable?

Traditional Plan: Patients visit each service provider.

New Plan: Each service provider visits patients

: patient : service provider

Contemporary Engineering Economics, 4th edition, 2007 56

Equipment & Process Selection

How do you choose between the Plastic SMC and the Steel sheet stock for an auto body panel? The choice of material will dictate the manufacturing process for an automotive body panel as well as manufacturing costs.

Contemporary Engineering Economics, 4th edition, 2007

57

Equipment Replacement Problem

Now is the time to replace the old machine? If not, when is the right time to replace the old equipment?

Contemporary Engineering Economics, 4th edition, 2007

58

New Product and Product Expansion

Shall we build or acquire a new facility to meet the increased demand? Is it worth spending money to market a new product?

Contemporary Engineering Economics, 4th edition, 2007

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Types of Strategic Engineering Economic Decisions in Service Sector

Commercial Transportation Logistics and Distribution Healthcare Industry Electronic Markets and Auctions Financial Engineering Retails Hospitality and Entertainment Customer Service and Maintenance
Contemporary Engineering Economics, 4th edition, 2007

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Which Material to Choose?

New plant design Alternative 1 Description

Upgrade old plant

Alternatives
Income, cost estimations Financing strategies Tax laws

Alternative2 Description Cash flows over some time period Analysis using an engineering economy model Evaluated alternative2

Cash flows over some time period

Analysis using an engineering economy model Evaluated alternative 1

Planning horizon Interest Measure of worth Calculated value of measure of worth

Noneconomic issues-environmental considerations

I select alternative 2 Rate of return (Alt 2) >Rate of return (Alt 1)

Methods of Economic Selection

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Example 7.2
Compare the following machines on the basis of their equivalent uniform annual cost. Use an interest rate of 18% per year. Cash flows of the two machines.
Comparison point Capital cost Annual operating cost Annual repair cost Overhauling Salvage value New Machine 44000 m.u. 7000 m.u. Used Machine 23000 m.u. 9000 m.u.

210 m.u.
2500 m.u. every 5 years 4000 m.u. after 15 years
63

350 m.u.
1900 m.u. every 2 years 3000 m.u. after 8 years

New machine i= 18% m.u.4000

10

11

12

13

14

15

m.u.7210/year m.u.2500 m.u.2500 m.u.2500

m.u.44000-2500

EUACnew = 7,210 + (44000 2500) (A/P, 18%, 15) + 2500 (A/P, 18%, 5) 4000 (A/F, 18%, 15)
= 7210 + 41500 (0.18 (1.1815) / (1.1815 1)) + 2500 (0.18 (1.185) / (1.185 1)) 4000 (0.18/ (1.1815-1)) EUACnew = 16094.55 m.u. per year.
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Used machine m.u.3000

i= 18 % 0 1 2 3 4 5 6 7

m.u.9350/year

m.u.1900

m.u.1900

m.u.1900

m.u.23000

EUACused = 9350 + (23000 1900) (A/P, 18%, 8) + 1900 (A/P, 18%, 2) 3000 (A/F, 18%, 8) = 21100 (0.18 (1.18)8 / (1.188 1)) + 9350 + 1900 (0.18 (1.18)2 / (1.182 1)) 3000 (0.18 / (1.188 1)) = 15542.4 m.u. per year.
65

Since we have found that: EUACused <EUACnew

Then it would be more economical to purchase the used

machine instead of the new one.

Providing that both have same productivity and quality. NB: The overhauling cost is not taken into consideration at the end of the equipment life.
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Spreadsheet Solution for example 7.2

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Analysis
The acceptance or rejection of a project based on the IRR criterion is made by comparing the calculated rate with the required rate of return, or cutoff rate established by the firm. If the IRR exceeds the required rate the project should be accepted; if not, it should be rejected. If the required rate of return is the return investors expect the organization to earn on new projects, then accepting a project with an IRR greater than the required rate should result in an increase of the firms value.

Analysis
There are several reasons for the widespread popularity of the IRR as an evaluation criterion: Perhaps the primary advantage offered by the technique is that it provides a single figure which can be used as a measure of project value. Furthermore, IRR is expressed as a percentage value. Most managers and engineers prefer to think of economic decisions in terms of percentages as compared with absolute values provided by present, future, and annual value calculations.

Analysis
Another advantage offered by the IRR method is related to the calculation procedure itself:

As its name suggests, the IRR is determined internally for each project and is a function of the magnitude and timing of the cash flows.
Some evaluators find this superior to selecting a rate prior to calculation of the criterion, such as in the profitability index and the present, future, and annual value determinations. In other words, the IRR eliminates the need to have an external interest rate supplied for calculation purposes.

Sensitivity and Breakeven Analysis:

These techniques are used to see how sensitive a decision is to estimates for the various parameters. BREAKEVEN ANALYSIS is done to locate conditions under which various alternatives are equally desirable. Examples include single vs. multi-stage construction ,hours of equipment utilization, production volume required, and equipment replacement analysis

Break-Even Analysis
Excel using a Goal Seek function

Analytical Approach

Excel Using a Goal Seek Function

Goal Seek Set cell: To value:

? $F$5 0

X
NPW

Breakeven Value
Demand

By changing cell: $B$6 Ok Cancel

A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Example 10.3 Break-Even Analysis

Input Data (Base): Unit Price ($) Demand Var. cost ($/unit) Fixed cost ($) Salvage ($) Tax rate (%) MARR (%) $ $ $ $ 50 1429.39 15 10,000 40,000 40% 15% Output Analysis: Output (NPW) $0

0 Income Statement Revenues: Unit Price Demand (units) Sales Revenue Expenses: Unit Variable Cost Variable Cost Fixed Cost Depreciation

Goal Seek Function Parameters

50 $ 50 $ 50 $ 50 $ 50 1429.39 1429.39 1429.39 1429.39 1429.39 $ 71,470 $ 71,470 $ 71,470 $ 71,470 $ 71,470 $ 15 21,441 10,000 17,863 22,166 8,866 13,299 $ 15 21,441 10,000 30,613 9,416 3,766 5,649 $ 15 21,441 10,000 21,863 18,166 7,266 10,899 $ 15 21,441 10,000 15,613 $ 15 21,441 10,000 5,581 34,448 13,779 20,669

26 Taxable Income 27 28 Income Taxes (40%) 29 30 31 32 33 34 35 36 37 38 39 Net Income Cash Flow Statement Operating Activities: Net Income Depreciation Investment Activities: Investment Salvage Gains Tax

$ $

$ $

$ $

$ 24,416 9,766 $ 14,649

$ $

13,299 17,863 (125,000)

5,649 30,613

10,899 21,863

14,649 15,613

20,669 5,581

40,000 (2,613) $ (125,000) $ 31,162 $ 36,262 $ 32,762 $ 30,262 $ 63,636

40 Net Cash Flow 41

Analytical Approach
Unknown Sales Units (X)
0 1 2 3 4 5

Cash Inflows:
Net salvage X(1-0.4)($50) 0.4 (dep) Cash outflows: Investment -X(1-0.4)($15)

37,389 30X 7,145 -125,000 -9X -9X -9X -9X -9X 30X 12,245 30X 8,745 30X 6,245 30X 2,230

-(0.6)($10,000)
Net Cash Flow

-6,000
-125,000 21X + 1,145

-6,000
21X + 6,245

-6,000
21X + 2,745

-6,000
21X + 245

-6,000
21X + 33,617

 PW of cash inflows PW(15%)Inflow= (PW of after-tax net revenue) + (PW of net salvage value) + (PW of tax savings from depreciation = 30X(P/A, 15%, 5) + $37,389(P/F, 15%, 5) + $7,145(P/F, 15%,1) + $12,245(P/F, 15%, 2) + $8,745(P/F, 15%, 3) + $6,245(P/F, 15%, 4) + $2,230(P/F, 15%,5) = 30X(P/A, 15%, 5) + $44,490 = 100.5650X + $44,490

 PW of cash outflows: PW(15%)Outflow = (PW of capital expenditure_ + (PW) of after-tax expenses = $125,000 + (9X+$6,000)(P/A, 15%, 5) = 30.1694X + $145,113 The NPW: PW (15%) = 100.5650X + $44,490 - (30.1694X + $145,113) =70.3956X - $100,623. Breakeven volume:
PW (15%) Xb = 70.3956X - $100,623 = 0 =1,430 units.

Demand X 0 500 1000 1429 1430 1500

PW of inflow
100.5650X - $44,490 $44,490 94,773 145,055 188,197 188,298 195,338

PW of Outflow
30.1694X + $145,113 $145,113 160,198 175,282 188,225 188,255 190,367

NPW 70.3956X -$100,623 100,623 65,425 30,227 28 43 4,970

2000
2500

245,620
295,903

205,452
220,537

40,168
75,366

Break-Even Analysis Chart

$350,000 300,000 250,000 PW (15%) Break-even Volume Outflow Profit

200,000
150,000 100,000 50,000

Xb = 1430

Loss

0
-50,000 -100,000 0 300 600 900 1200 1500 1800 2100 2400

Annual Sales Units (X)

Scenario Analysis
Variable Considered Unit demand Unit price ($) Variable cost ($) WorstCase Scenario 1,600 48 17 Most-LikelyCase Scenario 2,000 50 15 Best-Case Scenario 2,400 53 12

Fixed Cost ($)

Salvage value ($) PW (15%)

11,000
30,000 -$5,856

10,000
40,000 $40,169

8,000
50,000 $104,295

The decision making processs

Identifying objectives Identifying options for achieving the objectives Identifying the criteria to be used to compare the options Analysis of the options Making choices, and Feedback.