LECTURE NOTES ON ENGINEERING ECONOMY

LECTURE NOTES ON ENGINEERING ECONOMY Emad Elbeltagi, Ph.D., P.Eng., Professor of Construction Management Structural Engineering Department, Faculty of Engineering, Mansoura University

Engineering Economy 2013 Copyright 2013 by the author. All rights reserved. No part of this book may be reproduced or distributed in any form or by any means, or stored in a data base or retrieval system, without the prior written permissions of the author.

PREFACE In the Name of ALLAH the Most Merciful, the Most Compassionate All praise is due to ALLAH and blessings and peace be upon His messenger and servant, Muhammad, and upon his family and companions and whoever follows his guidance until the Day of Resurrection. Engineering Economy is one of the most important subjects that engineers should know about. Engineering Economy study is necessary to balance the unlimited desire versus the resource-constrained world. Engineers play a major role in investment by making decisions based on economic analysis and design considerations. Thus, decisions often reflect the engineer s choice of how to best invest funds by housing the proper alternative out of a set of alternatives. This book is dedicated mainly to undergraduate engineering students, especially Civil Engineering students where most of the applications are presented in the civil engineering field. It provides the reader with the main knowledge to model apply engineering economy principles to evaluate different alternatives considering all life cycle costs. It includes five chapters: Chapter 1 provides a general introduction of the importance of applying engineering economy and modeling issues of problems. Chapter 2 introduces the principles of calculating the time value of money considering different types of payment, single, series, gradient, etc. The economic evaluation of alternatives considering different methods of evaluation is presented in chapter 3. Chapter 4 is dedicated for introducing applications in the construction field domain. Finally, chapter 5 is dealing with the decision of selecting equipment, depreciation etc. Many solved examples have been added to enable the students to understand the material presented in this book. Also, each chapter is followed by exercises for training purposes. Finally, May ALLAH accepts this humble work and I hope it will be beneficial to its readers. i

TABLE OF CONTENTS CHAPTER 1: INTRODUCTION 1.1 What is Engineering Economy? 1 1.2 Why Engineering Economy is Important? 1 1.3 Why do Engineering Need to Learn about Economics? 1 1.4 The Decision Making Process 2 1.5 Engineering Economic Studies 4 1.6 Types of Strategic Engineering Economic Decisions 5 1.7 Costs 6 1.7.1 Fixed and Variable Costs 7 1.7.2 Recurring and Nonrecurring Costs 7 1.7.3 Cash cost and Book Cost 7 1.7.4 Other Cost Classifications 7 1.8 Exercises 8 CHAPTER 2: TIME VALUE OF MONEY 2.1 Concepts of Engineering Economics Analysis 10 2.1.1 Interest Calculations 11 2.1.2 Equivalence 11 2.1.3 Rate of Return 11 2.2 Time Value of Money 11 2.3 Single Payment 12 2.3.1 Simple Interest 12 2.3.2 Compound Interest 13 2.3.3 Use of Interest Tables 15 2.4 Cash Flow/Time Diagrams 16 2.5 Uniform Series Payments 19 2.6 Multiple Factors 25 ii

2.7 Uniform Infinite Series 29 2.8 Arithmetic Gradient Uniform Series Payments 30 2.9 Uniform Series Infinite Payments Every t Period Gradient 36 2.10 Nominal and Effective Interest 36 2.11 Exercises 38 CHAPTER 3: ECONOMIC EVALAUTION OF ALTERNATIVES 3.1 Economics Evaluation 44 3.2 Planning Horizon 45 3.3 Life Cycle Costing 46 3.4 Present Worth Analysis 47 3.4.1 Present Worth Comparison of Equal-Lived Alternatives 48 3.4.2 Present Worth Comparison of Different-Lived Alternatives 50 3.4.3 Present Worth Comparison of Infinite Analysis Periods 54 3.5 Equivalent Uniform Annual Worth Analysis 54 3.6 The Rate of Return Method 57 3.6.1 IRR for One Alternative 58 3.6.2 Comparing Two Alternative Using the IRR Method 60 3.7 Benefit/Cost Ratio Method 64 3.8 Payback Period 70 3.9 Inflation 74 3.10 Exercises 76 CHAPTER 4: 4.1 Depreciation 82 4.1.1 Straight-Line Method 83 4.1.2 Sum-of-years Digits Method 85 4.1.3 Sinking Fund Method 87 iii

4.2 Estimating Equipment Costs (Rentals) 89 4.2.1 Initial Cost 89 4.2.2 Investment Cost 89 4.2.3 Operating Costs 90 4.2.4 Calculate Equipment Rentals Using Cash Flows 93 4.3 Sensitivity Analysis 94 4.4 Breakeven Analysis 99 4.5 Exercises 104 REFERENCES 106 iv

CHAPTER 1 INTRODUCTION 1.1. What is Engineering Economy? Engineering economy is a subset of economy for application to engineering projects. Engineers seek solutions to problems, and the economic viability of each potential alternative or design is normally considered along with the technical aspects. Engineering economy involves the evaluation of the costs and benefits of proposed projects. So, Engineering Economy study is necessary to balance the unlimited desire versus the resource-constrained world; to maximize output (worth) given input (cost) and to take the necessary for maximizing efficiency (output / input or worth / cost). 1.2. Why Engineering Economy is Important? There are lots of factors that are considered in making decisions. These factors are combinations of economic and non-economic ones. Engineers play a major role in investment by making decisions based on economic analysis and design considerations. Thus, decisions often reflect the engineer s choice of how to best invest funds by housing the proper alternative out of a set of alternatives. 1.3. Why do Engineering Need to Learn about Economics? Developing technological tools are the most challenge that always faces engineers. However, it is no longer possible, in most cases, to design and build things for the sake of designing and building them. Natural resources (from which engineers build things) are becoming more scarce and expensive. Also, there are negative side-effects of engineering innovations (such as air pollution from automobiles) than ever before. For these reasons, engineers are asked more and more to place their project ideas within the larger Engineering Economy 1 Dr. Emad Elbeltagi

framework of the environment. Engineers must ask if a particular project will offer some net benefit to the people who will be affected by the project, after considering its inherent benefits, plus any negative side-effects, plus the cost of consuming natural resources, both in the price that must be paid for them and the realization that once they are used for that project, they will no longer be available for any other project(s). Engineers must decide if the benefits of a project exceed its costs, and must make this comparison in a unified framework. The framework within which to make this comparison is the field of Engineering Economics. The Accreditation Board for Engineering and Technology (ABET) states that engineering "is 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". Accordingly, consideration of economic factors is as important as regard for the physical laws and science that determine what can be accomplished with engineering. 1.4. The Decision Making Process Engineering activities dealing with elements of the physical environment take place to meet human needs that arise in an economic setting. The decision making process employed from the time a particular need is recognized until it is satisfied may be divided into a number of phases: 1. Recognition of the Problem The starting point of any attempt in a decision making process is the recognition that a problem exists. Only when a problem is recognized can the work towards its solution begin in a logical manner. 2. Determination of Objectives This step involves finding out what people need and want that can be supplied by engineering. People's wants may arise from logical considerations, Engineering Economy 2 Dr. Emad Elbeltagi

emotional drives, or a combination of the two. The goal must specific not general or wide. 3. Assembly of Relevant Data To make a good decision, one must first assemble good information. From all data related to a given problem, it might be difficult to decide which data are important or relevant and which data are not. In engineering decision making, an important source of data is a firm s own accounting system. 4. Identification of Strategic Factors The factors that stand in the way of attaining objectives are known as limiting factors. Once the limiting factors have been identified, they are examined to locate strategic factors; those factors which can be altered to remove limitations restricting the success of an undertaking. A man who wants to empty the water from his swimming pool might be faced with the limiting factor that he only has a bucket to do the job with, and this would require far greater time and physical exertion than he has at his disposal. A strategic factor developed in response to this limitation would be the procurement of some sort of pumping device which could do the job much more quickly. 5. Determination of means (engineering proposals) This step involves discovering what means exist to alter strategic factors in order to overcome limiting factors. In the previous example, one means was to buy (or rent) a pump. Of course, if the man had a garden hose, he might have been able to siphon the water out of the pump. In other engineering applications, it may be necessary to fabricate the means to solve problems from scratch. 6. Evaluation of Engineering Proposals It is usually possible to accomplish the same result with a variety of means. Once these means have been described fully, in the form of project proposals, Engineering Economy 3 Dr. Emad Elbeltagi

economic analysis can be employed to determine which among them, if any, is the best means for solving the problem at hand. 7. Decision Making It is common place for the final decision-making responsibility to fall on the head(s) of someone other than the engineer(s). The person(s) so charged, however, may not be sufficiently knowledgeable about the technical aspects of a proposal to determine its relevant worth compared to other means. The engineer can help to bridge this gap. 1.5. Engineering Economic Studies The four key steps in planning an economic study are: 1. Creative Step : People with vision and initiative adopt the premise that better opportunities exist than are known to them. This leads to research, exploration, and investigation of potential opportunities. 2. Definition Step : System alternatives are synthesized with economic requirements and physical requirements, and enumerated with respect to inputs/outputs. 3. Conversion Step : The attributes of system alternatives are converted to a common measure so that systems can be compared. Future cash flows are assigned to each alternative, consisting of the time-value of money. 4. Decision Step : Qualitative and quantitative inputs and outputs to/from each system form the basis for system comparison and decision making. Decisions among system Engineering Economy 4 Dr. Emad Elbeltagi

alternatives should be made on the basis of their differences. For a small number of real world systems there will be complete knowledge. All information and their relationships, judgments and predictive behavior become a certainty. For most systems, however, even after all of the data that can be brought to bear on it has been considered, some areas of uncertainty are likely to remain. If a decision must be made, these areas of uncertainty must be bridged by consideration of non-quantitative data/information, such as common sense, judgment and so forth. Decisions among system alternatives should be made on the basis of their differences. For a small number of real world systems there will be complete knowledge. All information and their relationships, judgments and predictive behavior become a certainty. For example: infrastructure expenditure decision, replace versus repair decisions, selection of inspection method and selection of a replacement for an equipment. So, briefly, performing an engineering economy study involves the following: - Understand the problem. - Define objectives. - Collect relevant information. - Define the set of feasible alternatives. - Identify the criteria for decision making. - Evaluate the alternatives and apply sensitivity analysis. - Select the best alternative. - Implement the alternative and monitor results. 1.6. Types of Strategic Engineering Economic Decisions Engineering Economy is an important tool for decision makers. It is widely used to model the economical behavior of each alternative and thus may assist in selecting the best economic decision. There are several types of strategic decision that may only be Engineering Economy 5 Dr. Emad Elbeltagi

considered using engineering economy analysis. The following are samples of these strategic engineering economic decisions: - Equipment and process selection. - Equipment replacement. - New Product and Product Expansion. - Cost reduction. - Service and quality improvement. Engineering economic analysis may be used as a part in energy efficiency studies. This may be considered by correlating energy efficiency with the annual expense of operation. For example an electrical device such as a pump or motor will require more power consumption in case of lower energy efficiency. Typically, a more energy-efficient device requires a higher capital investment than does a less energy-efficient device, but the extra capital investment usually produces annual savings in electrical power expenses relative to a second pump or motor that is less energy efficient. If an electric pump, for example, can deliver a given power rating to an industrial application, the input energy requirement is determined by dividing the given output by the energy efficiency of the device. The input requirement in hp or kw is then multiplied by the annual hours that the device operates and the unit cost of electric power. 1.7. Costs There are many classifications for costs. In engineering economy analysis there are three main cost classifications, these are: - Fixed and variable costs, classified by activity level. - Recurring and non-recurring costs, classified by repetition rate. - Cash cost and book cost, classified by involvement of cash payments. The following sections describe these cost classifications, each with illustrative examples. Engineering Economy 6 Dr. Emad Elbeltagi

1.7.1 Fixed and Variable Costs Fixed costs: Fixed costs are the costs that are not affected by the level of activity over a feasible range of operation. Examples for fixed costs are: depreciation, taxation, insurance and interest. Variable costs: Variable costs are the costs that vary with the operation and level of activity. Examples for variable costs are; labor, energy and maintenance. 1.7.2 Recurring and Nonrecurring Costs Recurring costs: Recurring costs are costs that are repeated when an organization produces similar goods or services on a continuing basis. Examples of recurring costs are variable costs, because they repeat with each unit of output. Nonrecurring costs: Nonrecurring costs are those costs which are not repetitive with the production of a merchandise or service. Examples of recurring costs are purchase cost for real estate upon which a plant will be built and construction costs. 1.7.3 Cash cost and Book Cost Cash costs: Cash costs are costs that involve cash payments and results in cash flow. They are the estimated costs and future expenses for the alternatives being analyzed. Book costs: Book costs are costs that do not involve cash payments but it represent the recovery of past expenditures over a fixed period of time. Examples: depreciation charge is a book value for the use of plant and equipment. In engineering economy these costs should be considered as it affect the cash costs for example depreciation is not a cash cost and it is important in analysis because it affects income taxes which are a cash costs. 1.7.4 Other Cost Classifications Opportunity Costs: Is the cost of forgoing the chance to earn profit on investment. Question: Is it in my best interest to keep my home because it is all paid for? I have Engineering Economy 7 Dr. Emad Elbeltagi

rented my former home, valued at about LE185000, for LE400 per month. Answer: There is little reason to continue owning your former home as a rental. To see this, consider the opportunity cost, i.e., the return you are giving up, of ownership. The same LE185000 invested in secure bonds at 7% will provide almost LE13000 in yearly income. This is many times what is obtained from continual rental. Sunk Costs: Sunk costs are the unrecoverable past costs and not relevant for decision making purposes. Suppose the heating, ventilating and air conditioning (HVAC) system in your home has just experienced a major failure. You immediately call the Air Condition Company for an estimate to replace your system. Their price is LE4200 and you sign a contract and write a check for the required LE1000 down payment. At this point the weather warms and the urgency for replacement of your system eases somewhat. You then get a second estimate for a new HVAC system. It is LE3000. You call the company back and they inform you that the LE1000 down payment is not refundable! 1.8. Exercises 1. Write a maximum of 4-pages report on the subject of this course Engineering Economy showing the following: a. What is Engineering Economy; b. Why is it important; c. What ate the role of engineers in using it; and d. Give an example of how using engineering economy can be useful. 2. Many people write books explaining how to make money in the stock market. Apparently, the authors plan to make their money selling books telling other people how to profit from the stock market. Why don t these authors forget about the books, and make their money in the stock market? Engineering Economy 8 Dr. Emad Elbeltagi

3. Company A has fixed expenses of LE15,000 per year and each unit of product has a LE0.002 variable cost. Company B has fixed expenses of LE5,000 per year and can produce the same product at a LE0.05 variable cost. At what number of units of annual production will Company A have the same total cost as Company B? 4. Consider the three situations below. Which ones appear to represent rational decision making? Explain. a. Ahmed s best friend has decided to become a civil engineer, so Ahmed has decided that he, too, will become a civil engineer. b. Nadia needs to get to the university from her home. She bought a car and now drives to the university each day. When Mona asked her why she didn t buy a bicycle instead, she replies, Mona, I never thought of that. c. Samir needed a wrench to replace the sparkplugs in his car. He went to the local automobile supply store and bought the cheapest one they had. It broke before finished replacing all the sparkplugs in hi car. Engineering Economy 9 Dr. Emad Elbeltagi