Introduction

Faculty of Applied Science and Engineering

Each engineering project should be evaluated along two

The Department of Electrical dimensions:
and Computer Engineering

• Does it meet the required technical specifications?

ECE 472S – Will it work?
– Will it achieve service level objectives?
Engineering Economic Analysis & Entrepreneurship

• Is it economically viable?
Part I
– Private sector/regulated utilities
• Will it make a profit?
• Will it increase the wealth of the shareholders?

– Public sector
• Are the benefits of the project to society greater
than the costs to society (i.e., the taxpayer)?
R. Vander Kraats

Spring Term 2010

Week 1 - 1 Week 1 - 2

Introduction The Problem Solving Process

Each technically acceptable alternative presents a

different set of economic consequences. 1. Formulation of the Problem
• Consider all of the costs and all of the benefits over the • PROBLEM (OPPORTUNITY?)
life of the project. • establish the boundaries
• The best engineering design is of little value to the • transformation required from the current state to the
company if it can’t be sold to management. desired state

Engineering Economics 2. Analysis of the Problem

• techniques to assist engineers in presenting the • detail the characteristics of the problem
economics of technical alternatives
• get the facts, determine the constraints
• techniques to evaluate projects involving long-term
investments in capital equipment from a financial point • develop the criteria to be used in evaluating the
of view alternatives
• maximize a joint achievement function
– performance objectives and costs 3. Search for Alternative Solutions to the Problem
• don’t jump at the first acceptable solution
• $$$ MONEY
• presenting the economics of technical alternatives

Week 1 - 3 Week 1 - 4
 Problem Solving Process - Example
The Problem Solving Process Telephone Dial-In Access to Multiple Computer Systems

4. Selection of the Preferred Solution

• examine the alternatives using the appropriate
criteria TA MA PA A
978-AAAA
• engineering economics provides the techniques to
measure the economic performance of each
alternative TB MB PB B
978-BBBB
5. Specification of the preferred solution
• detailed description of the solution to be
implemented TC MC PC C
978-CCCC
• predict the performance characteristics
Telephone Modem Computer
– technical Lines (ISALs) Pools Systems
– financial
TX - number of telephone lines for Computer System X
MX - number of modems for Computer System X
PX - number of computer ports on Computer System X
TX = MX - telephone line must terminate on a modem
ISAL - information System Access Line
- telephone line for use with computers
- high monthly charge

Week 1 - 5 Week 1 - 6

Step 1 - Formulation of the Problem Step 2 - Analysis of the Problem

TA MA PA A TA MA PA A
978-AAAA 978-AAAA

TB MB PB TB MB PB
B B
978-BBBB 978-BBBB

TC MC PC C TC MC PC C
978-CCCC 978-CCCC
Telephone Modem Computer Telephone Modem Computer
Lines (ISALs) Pools Systems Lines (ISALs) Pools Systems
• gather the facts
• all the telephone lines to the computer systems are
• number of calls, duration of calls, distribution of
busy too often
calls during the day
• computer users complaining
• determine peak-use periods for each system
• computers not used to capacity
• use statistics/queuing theory to determine the
• lost revenue probability of busy
• problem/opportunity? • obtain costs of ISALs, modems, ports
• establish the goal - desired probability of busy

Week 1 - 7 Week 1 - 8
 Step 3 - Search for Alternative Solutions
Data Switch Alternative
to the Problem
1980s

TA MA PA A Administrative
978-AAAA PA A Computer
PACX
System
978-AAAA

TB MB PB B D
978-BBBB S
Research
MDS W PB
A B Computing
I
Facility
TC MC PC C T
TDS T
C
978-CCCC MODEM H
Telephone Modem Computer POOL A
Lines (ISALs) Internet
Pools Systems PC C Service
• increase the number of phone lines, modems and ports Provider
System
• try a different approach
– use a data switch
– use one phone number and select the desired computer
system using a data switch TDS < TA + TB + TC
– PACX - Private Automatic Computer Exchange
• network the three machines together so that any phone line can
access all three machines

Week 1 - 9 Week 1 - 10

Step 4 - Selection of the Preferred

Networking Alternative
Solution
1990s

Firewall TA MA PA A
978-AAAA
Administrative
Computing A
System TB MB PB B
978-BBBB
Research
Computing R
Facility TC MC PC C
978-CCCC
Telephone Modem Computer
978-AAAA ISP Lines (ISALs) Pools Systems
Internet
• evaluate the financial aspects using engineering
Internet economics principles
Modem Service
Pool
• satisfy the service level objectives using engineering
Provider design principles
System
– ALTERNATIVE I - add more phone
lines/modems/ports
TNetworking < TA + TB + TC
– ALTERNATIVE II - data switch
Security - “firewall” – ALTERNATIVE III - networked environment
- secure, time-limited password

Week 1 - 11 Week 1 - 12
 Engineering Economics - Financial Issues
Step 5 - Specification of the Preferred Solution
• purchase of equipment requires large up-front investment
• however, the need for fewer phone lines implies lower
future monthly expenses
TA MA PA A • cost of capital
978-AAAA • life of the equipment - project planning period
• tax impacts - equipment is considered a capital asset
- depreciation (Capital Cost Allowance) on
TB MB PB B
978-BBBB the equipment will reduce taxes in the
future
• return on investment - other projects compete for the
TC MC PC C limited capital funding budget available for all projects
978-CCCC
Telephone Modem
Engineering Economics helps us to answer the question:
Computer
Lines (ISALs) Pools Systems
“Is the large initial investment in the equipment worth the
future savings over the lifetime of the equipment?”
• detailed plan of the selected alternative
• predict the performance characteristics Optimize the joint achievement function of performance
– service level - probability of busy objectives and product or service costs:
– financial - costs
Probability of Busy/Capital and ongoing costs
• once implemented, monitor performance to ensure
things are going according to predictions Make a recommendation to management in terms they
understand.

Week 1 - 13 Week 1 - 14

Engineering Economics Course Outline

Engineering Economics Decision Maze 1. Introduction
• Engineering economics definition
• Time value of money
• Cash flow approach
2. Cost Concepts
• Life-cycle costs
• Direct, indirect and overhead costs
• Average and marginal costs
• Basic accounting principles
3. Time Value of Money Operations
• Interest
• Present/future value calculations
• Series of cash flows
• Equivalence
4. Comparison of Alternatives I
• no taxes - perfect certainty
• project evaluation on a cash-flow basis
• financial comparison of technical alternatives
5. Income Tax
• Depreciation
• Capital Cost Allowance
• Corporate income tax
• Income tax incentives
Week 1 - 15 Week 1 - 16
 Engineering Economic Course Outline Time Value of Money

6. Comparison of Alternatives II - Private Sector • The value of a given sum of money depends on when the
• Tax impact money is received
• Operating cash flow statements – Which would you prefer, $1,000 today or $X one
• Project evaluation on an after-tax basis year from now? Assume the payment one year from
now is guaranteed.
7. Public Sector Projects
• Cost-benefit analysis of government projects
Alternative $X
8. Decisions Under Conditions of Uncertainty
• Introduce the element of risk 1 1,000
• Descriptive models 2 1,050
• Break-even and sensitivity analysis 3 1,100
• Prescriptive/normative models 4 1,250
• Decision trees 5 2,000
9. Fundamental Economic Concepts 6 10,000
• Supply and demand

• If one is indifferent between receiving $1,000 today and

$X one year from now, then $X has a present worth or
present value of $1,000 for that particular individual.

Week 1 - 17 Week 1 - 18

Cash Flow Approach Cash Flow Approach

• Occurs when money actually changes hands

• Ask how much money is received and spent each time Cash Flow Profile
period for each alternative
• Concentrate on the differences in the alternatives End of Year Alternative A Alternative B
0 - 10,000 - 10,000
Alternative A: 1 + 7,000 + 1,000
• Workstation for computerized design 2 + 5,000 + 3,000
• If successful, competition will develop very quickly 3 + 3,000 + 5,000
• Expect declining revenue profile 4 + 1,000 + 7,000

Alternative B:
• Coal-mining venture Is one alternative preferable over the other since both return
• Coal is anticipated to increase in value $16,000 over the four year period?
• Expect increasing revenue profile

Week 1 - 19 Week 1 - 20
 Cash Flow Diagrams for Cash Flow Diagram for
Alternatives A and B Alternatives A and B

$7,000
$5,000
(+) $3,000
$1,000 $6,000
(+)
0 1 2 3 4 $2,000
(-) 3 4
Alternative A 0 1 2
$10,000 $2,000
(-)
$7,000 $6,000
$5,000
$3,000
(+) $1,000

0 1 2 3 4 Difference between alternatives

(-) (A - B)
Alternative B
$10,000
A dollar at some future time has less
value than a dollar today.

Week 1 - 21 Week 1 - 22

Cash Flow Diagrams for The Time Value of

Alternatives C and D Money and Tuition Fees
$300
$200 $200 $200 1. Fees invoice sent in July.
(+) 2. U of T recommends early payment.
– at least first installment by August 15
(-) Alternative C 3. Payment by installments allowed.
$300 – Total Fee $8,668
$450 $200 $200 – Minimum First Installment $5,634
$100
(+) – Balance $3,034
(-) 4. First installment due before the first day of class.
Alternative D 5. Remainder of tuition fees due January 15.
6. Service charge (i.e. interest) charged on the balance
$200 outstanding from October 15.
$450
– Rate charged - 1.5% per month compounded
(+) 3
=> 19.56% per annum!
(-) 0 1 2 4
$100 What payment strategy is consistent with money having a
“time value?”
Difference between alternatives
(C-D)

2009-2010
Fee schedule

Week 1 - 23 Week 1 - 24
 Engineering Project Cash Flows
Cost Terminology

COSTS Compare engineering project alternatives on the basis of an

economic measure of effectiveness.
The price, or amount paid, for anything required by the Which costs should be considered?
project.
Life Cycle Costs
BENEFITS
• The sum of all expenditures associated with the project
Revenues, or cost savings, resulting from undertaking the during its entire service life
project. = Acquisition (first) costs
• purchase price of item
• shipping and installation
• training costs
Benefits • supporting equipment costs
Time + Operating and Maintenance Costs
1 2 3 4 5 6 • labour, material and overhead items
Costs • recurring costs
+ Disposal Costs
• At disposal, the item will have a market or trade-in value
Salvage Value = Market Value - Disposal Costs
Because of the time value of money, always consider costs
and benefits in terms of their associated cash flows.

Week 1 - 25 Week 1 - 26

Cost Terminology Engineering Project Life Cycle Costs

To fairly compare alternatives, one must consider all the

costs over the life of each alternative.

Often there is a trade-off between First Cost and Operating

& Maintenance costs.
Net
Which time period does one use for the length of the life Salvage
cycle? Value
0 1 2 3 4 5 6
– functional life
– economic life

Example: A solid-state telephone switch may be functionally

useful for 10 years. But due to technological Operating and
improvements, it may only have an economic life Maintenance Costs
of 6 years. First
Costs
Economic Life < Functional Life
Six-Year Economic Life
Always use the estimated economically useful life for
engineering analysis.

Week 1 - 27 Week 1 - 28
 Depreciation
Historical Costs

• assets decrease in value over their lifetime Cost Terminology

• physical deterioration and obsolescence result in a loss of
value
Past Costs - Historical costs that have occurred
• this must be included when determining operating costs
Sunk Costs - Past Costs that are unrecoverable
• allocate a portion of the lifetime loss value to annual
operating costs
Example: The salvage value for the server was estimated to
• yearly depreciation charge
be $10,000 at the end of 5 years. However, at that
time, it turned out to be worth only $2,000.
Example: Network Server Purchase Price $40,000
Estimated Salvage Value $10,000
Original Depreciation Charge (40,000 - 10,000) = $6,000
Economic Life (Years) 5
5
Should have been (40,000 - 2,000) = $7,600
Yearly Depreciation Charge: (40,000 - 10,000) = $6,000
5
5
Annual difference = $1,600
The price of the service provided by the server is set to
include the depreciation charge. Therefore, over the 5
years of useful life, the sales will recover the $30,000 This extra $1,600 was not recovered when the service was
expense of the network server. sold. It can no longer be recovered and therefore is lost.

Note that the $6,000 depreciation is not an annual cash flow. Sunk Cost = 5 × 1,600 = $8,000

Week 1 - 29 Week 1 - 30

Surplus Datasets Surplus Datasets

A telephone company has 1,000 obsolete datasets that A B A-B

cost $800 each when new. These datasets can be upgraded Benefits 1,000 × 650=650K 1,000 × 100=100K 550K
to the current release level for $300 each and then sold for
$650 each. The other alternative is to sell them as is to a Costs 1,000 × 300=300K 0 300K
local electronics hobby store for $100 each. What would
your decision be? 350K 100K 250K

Therefore, the datasets should be rebuilt.

Note that:
The original cost of $800 is irrelevant in this decision.
The unrecoverable $450 (800 – 350) per modem is a
sunk cost.

• Sunk costs are irrelevant in decisions affecting the

future.
• You can’t “unspend” money!

Week 1 - 31 Week 1 - 32
 Corporate Financing: The Cost of Capital
COST TERMINOLOGY
Cost of Capital

40.0%
Future Costs iE
35.0%
• future costs must be estimated over the project planning
period 30.0%

• estimates of future costs are uncertain and subject to error

Percentage Cost of Capital

25.0% k
• uncertainty introduces risk into the project
20.0% iD
• assume for now future costs are known with certainty
15.0%

Opportunity Costs 10.0%

• the cost of foregoing the opportunity to earn a return on 5.0%

investment funds
0.0%
0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50 0.55 0.60 0.65 0.70 0.75 0.80 0.85
Debt Ratio

Cost of Capital
• the cost of obtaining funds for financing engineering D - $ Value of Debt; E - $ Value of Equity; V - $ Raised
projects V = D + E; Debt Ratio = D / V
• MARR - minimum attractive rate of return iD – Cost of debt financing
iE – Cost of equity financing
Sources of Capital k – Cost of capital (weighted average cost)
• bonds (DEBT FINANCING) – Used as the Minimum Attractive Rate of Return (MARR)
• shares (EQUITY FINANCING) in engineering projects
• risk-return relationship
k = D iD + E iE
V V
Week 1 - 33 Week 1 - 34

Direct, Indirect and Overhead Costs

• Everything a firm does costs money Direct, Indirect and Overhead Costs

Example: Management wants to set a rate for a computer

printing service. Monthly maintenance for the printer is
$1,000. The depreciation charge is $2,000 per month.
The cost of a sheet of paper is one cent. The monthly
print volume is 50,000 pages. The printer shares the I/O
area in the computer room with other services. The
printing service is allocated 15% of the monthly costs of
the I/O area of $4,000.

Direct Costs
– Paper 0.01
Direct (Material and Labour) Costs Total Direct Costs 0.01
The costs of material and labour that are easily measured Indirect (Allocated) Costs
and conveniently allocated to a specific project.
– Maintenance ($1,000/50,000) 0.02
Indirect (Material and Labour) Costs
Material and labour costs of production that are either – Depreciation ($2,000/50,000) 0.04
practically impossible or uneconomical to assign to a ⎛ $4,000 × 0.15 ⎞
specific project. – I/O area share ⎜ ⎟ 0.01
Total Indirect Costs
⎝ 50,000 ⎠
0.07
Overhead Costs
All costs other than direct material and labour.
Cost Base (per page) 0.08
• factory overhead
• general and administration overhead
Must “burden” the direct costs to ensure all costs are recovered.

Week 1 - 35 Week 1 - 36
 Fixed and Variable Costs Fixed and Variable Costs
Automobile Example Automobile Example

Fixed Costs
– Those costs which do not vary in proportion to the
quantity of output
– May be “fixed” only at certain levels of output
e.g. - Car insurance, registration, depreciation
Dollars
Total Annual Costs ⎫
Variable Costs ⎪ Variable
– Costs which vary in proportion with quantity of ⎬ Costs
⎪
output
– Normally direct material and labour costs
e.g. - Gas, oil, tire replacement $2,850
⎭
⎫
– Every cost is variable in the long run. ⎪ Fixed
⎬
⎪ Costs
⎭
Total Costs (TC) = Fixed Costs (FC) + Variable Costs(VC)
Distance Traveled

TC (x) = $2,850 + $0.10x (/km)

where x is the number of kilometres driven per year.

Week 1 - 37 Week 1 - 38

Average and Marginal Cost Incremental Cost

Average Cost The costs of one alternative minus the cost of the other
– Ratio of total cost to quantity of output alternative.
TC(x)
AC = Costs A B A-B
x
Marginal Cost
– The additional (incremental) cost required to increase First Cost 250,000 200,000 50,000
the quantity of output by one Maintenance 25,000 30,000 (5,000)
– Derivative of the cost function with respect to output
quantity Revenues 100,000 100,000 0
Example: Automobile Cost Function

TC = $2850 + $0.10 x 5,000

$2850 + $0.10 A-B
AC = x
0
1 2 3 4 5 6
MC = $0.10

x = 10,000 km AC = 0.39/km
x = 15,000 km AC = 0.29/km 50,000
x = 20,000 km AC = 0.24/km
1) If MC<AC - increase in output reduces unit cost • The evaluation of marginal/ incremental costs is key to
2) If MC>AC - increase in output increases unit cost engineering economic analysis.

Week 1 - 39 Week 1 - 40