Engineering Economics & Management
CHAPTER I – BASIC PRINCIPLES IN ENGINEERING ECONOMICS
1.1 Importance of Engineering Economics
Engineering economy is a collection of mathematical techniques which simplify economic comparisons.
It is about determining the economic factors and the economic criteria utilized when one or more
alternatives are considered for selection. With these techniques, a rational, meaningful approach to
evaluating the economic aspects of different methods (alternatives) of accomplishing a given objective
can be developed. The role of engineering economics is to assess the appropriateness of a given project,
estimate its value, and justify it from an engineering standpoint.
Individuals, small-business owners, large-corporation presidents, and government agency heads are
routinely faced with the challenge of making significant decisions, when selecting an alternative over
another. These are decisions of how to invest the funds, capital, of the company and its owners. The
amount of capital is always limited, just as the cash available to an individual is usually limited. These
business decisions will invariably change the future, hopefully for the better. The usual factors considered
may be once again economic or non-economic, as well as tangible and intangible. However, when
corporations and public agencies select one alternative over the other, the financial aspects, return on
invested capital, social considerations, and time frames often increase substantially over those for an
individual selection. Alternatives usually involve information such as first cost (including purchase price,
construction, installation and delivery cost), expected life, estimated annual incomes and expenses of the
alternatives (including annual maintenance and upkeep costs), projected salvage value (resale or trade-in
value), an appropriate interest rate (rate of return), and possibly income tax effects.
Alternatives may be compared directly if they are converted to a common measure. The common
denominator applicable in economic comparisons is value expressed in terms of money. Most other
activities that appear in various activities, such as time, distance, and quantity may often be converted to
monetary terms. This is because of the pervasive nature of the economic system in which we live in.
It is essential to convert the prospective output and input items enumerated in the definition step in to
receipts and disbursements at specified dates. This phase consists of appraising the unit value of each item
of output or input and determining their total amounts by computation. On completion, each alternative
should be expressed in terms of definite cash flows occurring at specified dates in the future, plus an
enumeration of qualitative considerations that are impossible to reduce to monetary terms.
There is a popular procedure used to address the development and selection of alternatives.
Typically the steps in the approach are as follows:
Steps to problem solving
1. Understand the problem and goal
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2. Collect relevant information
3. Define the alternative solution
4. Evaluate each alternative
5. Select the best alternative using certain criteria
6. Implement the solution and monitor the result.
Engineering economy has a major role in steps 2, 3, and 5, and it is the primary technique in step 4 to
perform the economic-based analysis of each alternatives. Steps 2 and 3 set up the alternatives, and
engineering economy help structure the estimates of each one. Step 4 utilizes one or more engineering
economy model discussed in this course to complete the economic analysis upon which a decision is
made. Since Engineering Economics is involved in all these aspects, knowledge of this subject is very
vital for all engineers.
1.2 Classification of Costs and Costing
A key objective in engineering applications is the satisfaction of human needs, which will nearly always
imply a cost. Cost estimation is important in all aspects of a project. It is essential to find out various costs
involved in different projects, materials, production etc., to fix the competitive price of the products. In
engineering practice, estimation of cost receives much more attention than revenue estimation.
Cost Centres: A Cost centre is a division within a business which is financed from the profit margin
adding to the cost of the organization. A cost centre contributes to the organizations profit indirectly.
Eg: Customer service, Research development, Marketing etc.
Economic analysis may be based on a number of cost classifications:
1. First (or initial) Cost: Cost to get activity started such as property improvement, transportation,
installation, and initial expenditures.
2. Operation and Maintenance Cost: They are experienced continually over the useful life of the
activity.
3. Fixed Cost: These are Costs which do not change with process or output or over a period of time.
Fixed costs have to be paid even if the company is not producing any goods.
Eg: Salaries, Tax, and Rent etc.
4. Variable Cost: These are costs which directly vary with the output. When output increases, variable
cost also increases.
Eg: Raw material cost, Electricity cost etc.
5. Semi Variable Cost: These costs have fixed and variable elements
Eg: A person working for a company may have a fixed salary but may also earn commission on sales.
6. Total Cost: Total cost is the sum of fixed variable and semi variable cost.
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7. Incremental or Marginal Cost: Incremental (or marginal) cost is the cost of producing an extra unit.
If the total cost of 3 units is 1550 Birr and the total cost of 4 units is 1900 Birr, then the marginal cost of
the 4th unit is 350 Birr. It can also be defined as the change in total cost that arises when the quantity
produced changes by one unit
8. Sunk Cost: It cannot be recovered or altered by future actions. Usually this cost is not a part of
engineering economic analysis.
9. Life-Cycle Cost: This is cost for the entire life-cycle of a product, and includes feasibility, design,
construction, operation and disposal costs.
10. Manufacturing Cost: These are costs directly involved in manufacturing of products. Costs for raw
materials, charges related to workers etc are example. Manufacturing costs are divided in to 3 main
categories: Direct material costs, direct labour costs and manufacturing overhead costs
11. Non- Manufacturing costs: These are costs which are not directly involved in manufacturing a
product.
Eg: Advertisements, Salaries etc
12: Direct Costs: These are costs incurred directly for materials, Labour etc. Usually direct cost is small
compared to indirect costs.
13. Indirect Costs: These are costs incurred other than the direct costs. This may be due to an un
avoidable breakdown of a machine, or may be due to variation in market or may be due to advertisement
and other charges etc.
Following are the methods of costing:
1. Unit Costing: This method is also called ‘single output costing’. This method is used when the
product can be expressed as a identical quantitative unit and which are manufactured by continuous
manufacturing activities.
Eg: Brick making, Cement manufacturing etc.
2. Job Costing: Under this method, costing is based on the job
Eg: Car repair, Painting etc.
3. Contract Costing: Under this method, costing is done for big jobs, which involve heavy expenditure
and stretches over a long period of time. This is also known as Terminal Costing
Eg: Road construction, Bridge construction etc.
4. Multiple Costing: When the output comprises of many assembled parts or components, cost have to
be calculated for each components. There for this type of costing is called composite costing or multiple
costing. Eg: Television, Computer costing etc.
5. Process Costing: This type of costing is adopted when the final product goes through different stages
and processes
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Eg: Textile industry. Different stages involved are spinning, weaving, finishing etc. In each of the above 3
stages, costs are estimated separately.
1.3. Time value of money
The change in amount of money over a given time period is called the time value of money. It is
the most important concept in Engineering Economics. In simple words, Time value of money is
the difference between future worth of money and present worth of money. Other than economic
factors, there are many other factors attributes to time value of money. They are social,
environmental, legal, political etc.
The way interest operates reflects the fact that money has a time value. This is why amounts of
interest depend on the length of time; interest rates, for instance, are typically given in terms of
percentages per year. Because money can earn at a certain interest rate throughout its investment
period, it is recognized that a dollar received at some future date is not worth as much as a dollar
at hand in the present so long as money has earning power over time.
‘The time-value of money is the relationship between interest and time'
It could also be argued that money has a time value because the purchasing power of a dollar
changes through time. During periods of inflation, the amount of goods that can be bought for a
particular amount of money decreases as the time of purchase occurs further out in the future.
The concept of time value of money is vitally important for alternative aspects which can be
quantified in terms of dollar or birr. If we elect to invest money today (for example, in a bank, a
business or a stock mutual fund), we inherently expect to have more money in the future. This
change in the amount of money in a given time period is called the time value of money; it is the
most important concept in engineering economy. You should also realize that if a person or a
company finds it necessary to borrow money today, by tomorrow more than the original loan
principal will be owed. This fact is also explained by the time value of money.
1.4. Interest Formula
Interest: The manifestation of the time value of money is called interest, which is the difference
between an original sum of money borrowed and the final amount owed, or the original amount
owned (or invested) and the final amount accrued.
If the difference is zero or negative, then there is no interest. Interest can be further classified as
„interest paid‟ and „interest earned‟. Interest is paid when a person or organization borrow money
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and repays a larger amount. Interest is earned when a person or organization save, invest or lent
money and obtain a return of larger amount.
Interest = Amount owed now – Original amount
Interest Rate: It is the interest paid over a specific time unit (or) when interest is expressed as a
percentage of the original amount per time unit, the result is an interest rate. This rate [percent
interest rate] is calculated by using the following equation as given below:
Interest rate [%] = (Interest per time unit/original amount)*100
The time unit of rate is called Interest period. By far the most common time period in which to
express an interest rate is 1 year. However, since interest rate may be expressed over periods of
time shorter than 1 year, for example 1% per month, the time unit used in expressing an interest
rate must also be identified.
Rate of return
The word interest rate is used for the borrower‟s vantage, when money has been borrowed, or
when a fixed interest is established. There is another term known as rate of return (ROR)
which is equivalent to the term interest rate but it is commonly used when estimating the
profitability of a proposed alternative or when evaluating the results of a completed project or
investment. However, both are represented by the letter i.
Examples
1. An employee of a company borrows 10,000 birr on May first and must repay a total of 10,700
after 1 year. Determine the interest amount and interest rate paid.
Solution: Interest = Amount owed now – Original amount
= 10,700-10,000 = 700 birr
Interest rate [%] = (700/10,000)*100 = 7% per year
2. A company plans to borrow 20,000 birr from a bank for 1 year at 9% interest. Compute the
interest and total amount due after 1 year.
Solution: Interest rate [%] = (Interest per time unit/original amount)*100
So Interest = (original amount * Interest rate)/100
= 20,000*9/100 = 1800 birr
Total amount due after 1 year = original amount + interest
= 20,000+1800 = 21,800 birr
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Simple Interest:
Simple interest is calculated on the Principal amount only. Under Simple interest, the interest
earned during each period does not earn additional interest in the remaining period. In simple
interest, interest is calculated by:
Interest = Principal * interest rate * Number of periods
Or I = P*i*N
And, the total amount available at the end of N period, F would be:
F = P + I = P + P*i*N
Or F = P*(1 + i*N)
Example:
1. A company have given an employee a loan of 1000 birr for 3 years at 5% per year interest.
How much money will the employee repay at the end of 3 years? Use the concept of simple
interest. Tabulate the result.
Solution: Interest for each of 3 years is given by
Interest/year = 1000*5/100 = 50 birr
Interest for 3 years = 50*3= 150 birr
The amount due after 3 years = 1000+150 = 1,150 birr
Alternatively by using the formula
F = P*(1 + i*N)
F = 1000*(1 + (5/100) * 3) = 1,150 birr
Tabulation
End of the year Amount Interest Amount owed Amount paid
borrowed
0 1000 - - -
1 - 50 1050 -
2 - 50 1100 -
3 - 50 1150 1150
Compound or Composite interest (The interest of the interest)
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Under a Compound interest scheme, the interest earned in each period is calculated based on the
total amount at the end of the previous period. The total amount includes the original principal +
accumulated interest that has been left in the account.
If the principal is „P‟ and the interest rate is „i‟, then after 1 period it would be P*(1+i). If the
entire amount [ P*(1+i)] is reinvested for another period, at the end of second period, it would be
P*(1+i)*(1+i) or P* (1+i)2. Similarly for the 3rd period, it would be P*(1+i)*(1+i) *(1+i) or P*
(1+i)3. There for in general after N period,
F = P*(1+i)N
Examples:
1. A company have given an employee a loan of $ 1000 for 3 years at 5% per year interest. How
much money will the employee repay at the end of 3 years? Use the concept of Compound
interest. Graphically compare the result for compound interest and simple interest.
Solution: P = 1000, i = 5%, N = 3 years
For First year
F = 1000 + (5/100)*1000 = 1000*(1+ (5/100)) = $1050 (P + i*P) or P *(1+i)
For Second year
F = 1050 + (5/100)*1050 = 1000*(1+ (5/100)) *(1+ (5/100)) = $1102.5 P *(1+i)2
For Third year
F = 1102.5 + (5/100)*1102.5 = 1000*(1+ (5/100)) *(1+ (5/100)) *(1+ (5/100)) = $1157.63
P *(1+i)3
Comparison with simple interest:
The Result obtained for F value for both the case is given below
F by simple interest = $1150
F by compound interest =$1157.63
End of Amount Interest Interest Balance
Year Borrowed Rate
0 $1,000.00 5% $1,000.00
1 $50.00 $1,050.00
2 $52.50 $1,102.50
3 $55.13 $1,157.63
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Interest = (principal + all accrued interest) x (interest) ------------------for Compound Interest
End of Amount Interest Simple Interest Compound Interest
Year Borrowed Rate Interest Balance Interest Balance
0 $1,000.00 5% $1,000.00 $1,000.00
1 $50.00 $1,050.00 $50.00 $1,050.00
2 $50.00 $1,100.00 $52.50 $1,102.50
3 $50.00 $1,150.00 $55.13 $1,157.63
Interest = (principal) x (number of periods) x (interest rate) --------------for Simple Interest
2. Suppose you deposit 1000 birr in a bank saving account that pays interest at a rate of 8%,
compounded annually. Assume that you don‟t withdraw the interest earned at the end of each
year. How much money will you get at the end of 3 years?
Solution: F = P*(1+i)N
P = 1000 birr, N= 3 years, i= 8% per year.
F = 1000*(1+ [8/100])3 = 1259,71 birr
Total interest earned = 1259.71 – 1000 = 259.71 birr
Let’s tabulate the result now
Period Amount at the beginning Interest earned Amount at the end of
of the interest period the interest period
1 1000 birr 1000*0.08 = 80 1080 birr
2 1080 birr 1080*0.08 = 86.4 1166.40 birr
3 1166.40 birr 1166.40*0.08 = 93.31 1259.71 birr
3. In 1626, Peter Minuit of Dutch West Indian Company paid $ 24 to purchase Manhattan Island
in Newyork from the Indians. In respond to that Peter Minuit had invested $ 24 in a saving
account that earns 8% interest. How much would it be worth in 1996? Calculate it by both
Simple and Compound interest method.
Solution: P = $ 24, i = 8% / year, N = 370 years
By Simple interest method
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F = P*(1 + i*N) = 24* [1+ (0.08*370)] = $ 734
By Compound interest method
F = P*(1+i)N = 24*(1 + 0.08)370 = $55,847,118,732,148
From the above it is very clear that there is a huge difference between the two calculations.
Nominal and Effective Interest Rates
In economic analysis a year is usually used as the interest period. In financial transactions,
however the interest period may be of any duration. We use the terms nominal interest rate and
effective interest rates to describe more precisely the nature of compounding schemes. Even
though financial institutions may use more than one interest period per year in compounding the
interest, they usually quote the interest on an annual basis. For example, a year‟s rate at 1.5%
compounded monthly is typically quoted as “18% compounded monthly”. When stated in this
fashion, the 18% is called a nominal interest rate or annual percentage rate. The effective
interest rate represents the actual interest earned or charged for a specified time period. The
effective interest rate based on a year is referred to as the effective annual interest rate ia. The
effective interest rate based on the payment period is called the effective interest rate per
payment period ie.
1.5 Minimum attractive rate of return (MARR).
For any investment to be profitable, the investor expects to receive more money than the amount
invested. Or in other words, Investment alternatives are evaluated upon the prognosis that a
reasonable ROR can be expected. Some reasonable rate must therefore be selected and utilized in
the selection criteria phase of the engineering economy study approach. The reasonable rate is
called the minimum attractive rate of return (MARR). MARR would be higher than the rate
expected from a bank or some safe investments. MARR is also called as „Hurdle rate’ projects.
MARR is not calculated like ROR, but it is decided based upon the policy of top management.
The below figure indicates the relation between different ROR values.
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Rate of return percentages
Expected ROR on new proposals
Range of ROR on accepted proposals when
other proposals were rejected
MARR [all proposals should
offer at least MARR]
ROR on safe investments
1.7. Cash Flow Diagram
The estimated inflows (Revenues) and outflows (costs) of money are called cash flows. The easiest way
to approach problems in economic analysis is to draw a picture. The picture should show three things:
1. A time interval divided into an appropriate number of equal periods
2. All cash outflows (deposits, expenditures, etc.) in each period
3. All cash inflows (withdrawals, income, etc.) for each period
A cash flow diagram is simply a graphical representation of cash flows drawn on a time scale.
Cash flows are described by the actual inflow and outflow of money. Cash inflow is otherwise
called as ‘receipts’ and cash outflow is otherwise called as ‘disbursement’.
Cash inflows:
• Revenues, Salvage value, operating cost reductions, Receipts of loan principals, Income tax
savings, Savings of returns etc.
Cash outflows:
• First cost of asset, engineering design costs, Operating Costs, Maintenance Cost, Loan interest,
Income taxes etc.
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Once receipts and disbursements are developed, the net cash flow can be determined.
Net Cash flow = Receipts – Disbursement
= Cash Inflows – Cash Outflows
Net cash flows are usually calculated at the end of Interest period.
Figure below is a cash-flow diagram showing an outflow or disbursement of $1000 at the
beginning of year 1 and an inflow or return of $2000 at the end of year 5 "end-of-year"
conventions.
$2000
1 2 3 4 5
$1000
Notation
To simplify the subject of economic analysis, symbols are introduced to represent types of cash
flows and interest factor. The following symbols will be used here:
P = Present sum of money
F = Future sum of money
N =Number of interest periods
i = Interest rate per period (%)
Cash flow diagrams & interest factors
1. Single Cash flow: It deals with a single present amount and its future worth. Thus in a
single cash flow, only 2 values will be there, P and F.
F
i [%]
1 2 3 4 5 6
P
Years
The Single Payment Factors (F/P and P/F)
A formula is developed which allows determination of the future amount of money F that is
accumulated after n years from a single investment P when interest is compounded one time per
year.
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a. Single Payment Compound amount Factor (F/P factor)
F = P (1+i)N
F/P = (1+i)N.................................................. (1)
The factor (1+i)N is called the Single payment compound amount factor (SPCAF) or F/P factor
Standard notation is F = P [F/P, i, N]
b. Single Payment Present Worth factor(P/F factor)
By Rearranging Equation (1)
P = F (1/ [1+i]N)
P/F = (1/ [1+i]N)........................................................(2)
The expression in the bracket is known as Single payment present worth factor (SPPWF) or P/F
factor
Standard notation is P = F [P/F, i, N]
2. Uniform Series Cash flow: It represents transactions arranged as a series of equal cash
flows at regular intervals. For example, Repayment of loan in equal periodic instalments.
a a a a a
0 1 2 3 4
Years
The Uniform series factors (A/F, A/P, F/A and P/A Factors)
a. Sinking Fund Factor (A/F Factor)
A = F (i / [(1+i)N- 1])
A / F = (i / [(1+i)N- 1])...............................................(3)
The expression in the bracket is the Sinking fund factor (SFF) or A/F factor
Standard notation is A = F [A/F, i, N]
b. Capital recovery Factor (A/P Factor)
A = P (i( 1+i)N / [(1+i)N- 1])
A / P = (i( 1+i)N / [(1+i)N- 1])...............................................(4)
The expression in the bracket is the capital recovery factor (CRF) or A/P factor
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Standard notation is A = P [A/P, i, N]
c. Uniform series Compound Factor (F/A Factor)
F = A ((1+i)N - 1 / i)
F / A = ((1+i)N- 1 / i)...........................................................(5)
The expression in the bracket is the Uniform series Compound factor (USCF) or F/A factor
Standard notation is F = F [F/A, i, N]
d. Uniform series Present worth Factor (P/A Factor)
P = A / ([(1+i)N- 1] / i( 1+i)N)
P / A = ([(1+i)N- 1] / i( 1+i)N)...............................................(6)
The expression in the bracket is the capital recovery factor (CRF) or A/P factor
Standard notation is P = A [P/A, i, N]
3. Linear gradient Series Cash flow: It represents transactions with the amount which are not
uniform but vary in some regular way
100 + 4i
100 + 3i
100 + 2i
100 + i
100
0 Years 5
4. Geometric gradient Series Cash flow: In this type of cash flow, the transaction amount does
not vary by a fixed amount, but by some fixed rate, expressed as percentage. For example, for a
financial project the rate of a particular raw material is increasing at 4 % per year.
100*(1+i)2
100*(1+i)
100
0 1 2 3
Years
Analysis of Cash flow Diagram
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1. A person take a loan of 10,000 birr at 8% per year and the amount is given back after 5 years.
Draw the cash flow diagram.
+ P = 10,000 birr
i = 8%
0 1 2 3 4 5
Years
F
-
The present sum [P] is a cash inflow of the loan principal at year 0. The future sum F is the cash outflow
of repayment at the end of year 5. Interest rate of 8% is shown at the top of the cash flow diagram.
2.A father wants to deposit an unknown large amount in to a bank. He will get back 4,000 birr 3
years from now which will continue for another 4 years. The investment is made 2 years from
now. The returns are utilized for conducting free tuitions. If the rate of return is 15.5% per year,
construct a cash flow diagram.
A = 4,000 birr
+
i = 15.5%
0 1 2 3 4 5 6 7
Years
P
-
[Link] Engineer of Mexico spends 1 million now and for another 4 years for the improvement of a
pressure release valve. Construct the cash flow diagram to find the equivalent value of these
expenditures as a return at the end of year 4. Assume the rate of interest as 12% per year.
F
+
i = 12%
0 1 2 3 4
- A = 1 million
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4. If you have 2,000 birr now and invested it at 10%, how much would it be worth in 8 years?
Use Compound interest method. Construct Cash flow diagram for the same.
Solution: P = 2,000 birr, i = 10% / year, N = 8 years
F = P (1+i)N
F = 2000(1+0.1)8 = 4287.18 birr
+ F = 4287.18 birr
i = 10 %
0 1 2 3 4 5 6 7 8
P = 2,000 birr Years
-
5. You have just purchased 100 shares of Intel at 60 birr per share. You will sell the stock when
market price gets doubled. If you expect the stock price to increase 20% per year, how long do
you expect to wait before selling the stock. Construct a cash flow diagram for the same.
Solution:
P = 60 * 100 =6,000 birr
F = 12,000 birr
i = 20% /year
To find N
F = P (1+i)N
12,000 = 6,000 (1+0.2)N 2 = ( 1.2)N Log 2 = N Log 1.2
N = 3.8 ≈ 4 years
+ F = 12,000 birr
i = 20 %
0 1 2 3 4
P = 6,000 birr Years
-
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