BES 106 – ENGINEERING ECONOMICS

CHAPTER 1
INTRODUCTION
DEFINITIONS
Engineering Economics
Engineering economy involves the systematic evaluation of the
economic merits of proposed solutions to engineering problems. To
be economically acceptable (i.e., affordable), solutions to
engineering problems must demonstrate a positive balance of long-
term benefits over long-term costs, and they must also:
▪ promote the well-being and survival of an organization,
▪ embody creative and innovative technology and ideas,
▪ permit identification and scrutiny of their estimated outcomes,
and
▪ translate profitability to the “bottom line” through a valid and
acceptable measure of merit.
Objectives of
Engineering Economy
1. Finding the suitable and efficient projects
2. Using the available local resources
3. Developing the technical staff
4. Maintenance and cost decreasing
5. Reduction of operating costs with maintaining the
quality
6. Best use of capital
Examples
Engineering economic analysis can play a role in many types of
situations:
▪ Choosing the best design for a high-efficiency gas furnace.
▪ Selecting the most suitable robot for a welding operation on an
automotive assembly line.
▪ Making a recommendation about whether jet airplanes for an
overnight delivery service should be purchased or leased.
▪ Determining the optimal staffing plan for a computer help desk.
Why Engineering
Economics Matters
▪ provides a systematic framework for evaluating the economic
merits of different engineering projects and proposals
▪ helps engineers and decision-makers to assess the financial
viability and efficiency of technical options, ensuring that
resources are used optimally
▪ supports strategies that align with an organization’s financial
goals and constraints, thereby enhancing value creation and
sustainability
 PRINCIPLES OF
ENGINEERING
ECONOMY
These provide a foundation for making sound financial
decisions in engineering projects and help engineers
ev aluate alternatives, optimize resources, and assess the
economic feasibility of projects .
1: Develop the Alternatives
▪ The alternatives need to be identified and then defined for
subsequent analysis.
▪ A decision involves making a choice among two or more
alternatives.
▪ Developing and defining the alternatives for detailed evaluation is
important because of the resulting impact on the quality of decision.
▪ Engineers and managers should place a
high priority on this responsibility.
▪ Creativity and innovation are essential to
the process.
Example: Buying a Car
▪ Alternatives are:
2: Focus on the Differences
▪ Compare the differences in
costs and benefits between
alternatives.
▪ Avoid focusing on costs or
revenues common to all
alternatives, as they do not
affect the decision.
Example: Buying a Car
3: Use a Consistent Viewpoint
▪ The prospective outcomes of the alternatives,
economic or other, should be consistently
developed from a defined viewpoint
(perspective).
▪ The perspective of the decision maker
(usually the owner) would normally be used.
▪ The viewpoint for the particular decision must
be first defined and then used consistently in
the description, analysis, and comparison of
alternatives.
Example: Buying a Car
4: Use a Common Unit of Measure
▪ Express all cash flows,
benefits, and costs in a
common unit (e.g., dollars or
time-adjusted currency).
▪ This ensures a fair and
consistent comparison and
will simplify the analysis of the
alternatives.
Example: Buying a Car
5: Consider All Relevant Criteria
▪ The decision maker will normally select the alternative
that will best serve the long-term interests of the owner.

▪ In engineering economic analysis, the primary criterion

relates to long-term financial interests of the owner.

▪ Assumption is that available capital will be allocated to

provide maximum monetary return to the owners.

▪ However, there are other non-financial criteria in an

organizational objectives you would like to achieve
with your decision, and these should be considered
and given weight in the selection of an alternative.
Example: Buying a Car
6: Make Risk and
Uncertainty Explicit
▪ Risk and uncertainty are inherent in estimating
the future outcomes of the alternatives and
should be recognized.
▪ The analysis of the alternatives involves
projecting or estimating the future
consequences associated with each of them.
▪ The magnitude and the impact of future
outcomes of any course of action are uncertain.
▪ Dealing with uncertainty is an important aspect
of engineering economy analysis.
Example: Buying a Car
7: Revisit Decisions Periodically
▪ Other decision, even though relatively
successful, will have results significantly
different from the initial estimates of the
consequences.
▪ Learning from and adapting based on
experience are essential and are
indicators of good organization.
▪ Periodically review decisions to ensure
continued relevance and optimize
performance.
Example: Buying a Car
 ENGINEERING
ECONOMY AND THE
DESIGN PROCESS
The integration of engineering economy principles into
the design process ensures that designs are not only
technically sound but also economically viable.
 The General Relationship between the
Engineering Economic Analysis
Procedure and the Engineering Design Process
Step 1: Problem Definition
▪ This is particularly important, since it provides the basis for
the rest of the analysis.
▪ A problem must be well understood and stated in an
explicit form before the project team proceeds with the
rest of the analysis.
Step 2: Development of
Alternatives
▪ This is sometimes called option development.
▪ Searching for Superior Alternatives
▪ The difference between good alternatives and great alternatives depends
largely on an individual’s or group’s problem-solving efficiency. Such
efficiency can be increased in the following ways:
1. Concentrate on redefining one problem at a time in Step 1.
2. Develop many redefinitions for the problem.
3. Avoid making judgments as new problem definitions are created.
4. Attempt to redefine a problem in terms that are dramatically different from
the original Step 1 problem definition.
5. Make sure that the true problem is well researched and understood.
Step 2: Development of
Alternatives
▪ This is sometimes called option development.
▪ Searching for Superior Alternatives
▪ In searching for superior alternatives or identifying the true problem, several
limitations invariably exist, including:
1. lack of time and money
2. preconceptions of what will and what will not work
3. lack of knowledge
Step 2: Development of
Alternatives
▪ This is sometimes called option development.
▪ Developing Investment Alternatives
1. Classical Brainstorming
▪ most well-known and often-used technique for idea generation
▪ based on the fundamental principles of deferment of judgment and that
quantity breeds quality
Step 2: Development of
Alternatives
▪ This is sometimes called option development.
▪ Developing Investment Alternatives
1. Classical Brainstorming
▪ Four rules for successful brainstorming:
i. Criticism is ruled out.
ii. Freewheeling is welcomed.
iii. Quantity is wanted.
iv. Combination and improvement are sought.
Step 2: Development of
Alternatives
▪ This is sometimes called option development.
▪ Developing Investment Alternatives
1. Classical Brainstorming
▪ A. F. Osborn lays out a detailed procedure for successful brainstorming.
i. Preparation. The participants are selected, and a preliminary statement
of the problem is circulated.
ii. Brainstorming. A warm-up session with simple unrelated problems is
conducted, the relevant problem and the four rules of brainstorming are
presented, and ideas are generated and recorded using checklists and
other techniques if necessary.
iii. Evaluation. The ideas are evaluated relative to the problem.
Step 2: Development of
Alternatives
▪ This is sometimes called option development.
▪ Developing Investment Alternatives
2. Nominal Group Technique (NGT)
▪ developed by Andre P. Delbecq and Andrew H. Van de Ven
▪ involves a structured group meeting designed to incorporate individual
ideas and judgments into a group consensus
▪ can be used to obtain group thinking (consensus) on a wide range of topics
▪ draws on the creativity of the individual participants, while reducing two
undesirable effects of most group meetings: (1) the dominance of one or
more participants and (2) the suppression of conflicting ideas
Step 2: Development of
Alternatives
▪ This is sometimes called option development.
▪ Developing Investment Alternatives
2. Nominal Group Technique (NGT)
▪ basic format of an NGT session is as follows:
i. Individual silent generation of ideas.
ii. Individual round-robin feedback and recording of ideas.
iii. Group clarification of each idea.
iv. Individual voting and ranking to prioritize ideas.
v. Discussion of group consensus results.
Key Economic Concepts in
the Design Process
▪ Time Value of Money: Helps compare costs and benefits
occurring at different times.
▪ Cost Estimation: Provides an understanding of costs
associated with materials, labor, energy, and other
resources.
Key Economic Concepts in
the Design Process
▪ Economic Evaluation Techniques:
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Benefit-Cost Ratio (BCR)
Step 3: Development of
Prospective Outcomes
▪ This step incorporates Principles 2, 3, and 4 and uses the basic
cash-flow approach employed in engineering economy.
▪ A cash flow occurs when money is transferred from one
organization or individual to another. Thus, it represents the
economic effects of an alternative in terms of money spent
and received.
▪ The net cash flow for an alternative is the difference between
all cash inflows (receipts or savings) and cash outflows (costs
or expenses) during each time period.
Step 3: Development of
Prospective Outcomes
Objectives other than profit maximization or cost minimization
that can be important to an organization:
▪ Meeting or exceeding customer expectations
▪ Safety to employees and to the public
▪ Improving employee satisfaction
▪ Maintaining production flexibility to meet changing demands
▪ Meeting or exceeding all environmental requirements
▪ Achieving good public relations or being an exemplary
member of the community
Step 4: Selection of a
Decision Criterion
▪ This incorporates Principle 5 (consider all relevant
criteria). The decision maker will normally select the
alternative that will best serve the long-term interests of
the owners of the organization.
▪ It is also true that the economic decision criterion should
reflect a consistent and proper viewpoint (Principle 3) to
be maintained throughout an engineering economy
study.
Step 5: Analysis and Comparison
of Alternatives
▪ This is largely based on cash-flow estimates for the feasible
alternatives selected for detailed study.
▪ A substantial effort is normally required to obtain reasonably
accurate forecasts of cash flows and other factors in view of, for
example, inflationary (or deflationary) pressures, exchange rate
movements, and regulatory (legal) mandates that often occur.
Principle 6 is an essential part of an engineering economy study.
▪ When cash flow and other required estimates are eventually
determined, alternatives can be compared based on their
differences as called for by Principle 2. Usually, these differences
will be quantified in terms of a monetary unit.
Step 6: Selection of the Preferred
Alternative
▪ When the first five steps of the engineering economic analysis
procedure have been done properly, the preferred alternative
(Step 6) is simply a result of the total effort.
▪ Thus, the soundness of the technical-economic modeling and
analysis techniques dictates the quality of the results obtained
and the recommended course of action.
▪ Step 6 is included in Activity 5 of the engineering design process
(specification of the preferred alternative) when done as part of a
design effort.
Step 7: Performance Monitoring
and Post-evaluation of Results
▪ This final step implements Principle 7 and is accomplished during
and after the time that the results achieved from the selected
alternative are collected.
▪ Monitoring project performance during its operational phase
improves the achievement of related goals and objectives and
reduces the variability in desired results.
▪ This is also the follow-up step to a previous analysis, comparing
actual results achieved with the previously estimated outcomes.
Step 7: Performance Monitoring
and Post-evaluation of Results
▪ The aim is to learn how to do better analyses, and the feedback
from postimplementation evaluation is important to the continuing
improvement of operations in any organization.
▪ Unfortunately, like Step 1, this final step is often not done
consistently or well in engineering practice; therefore, it needs
particular attention to ensure feedback for use in ongoing and
subsequent studies.
Example 1: Application of the Engineering
Economic Analysis Procedure
Your friend is considering investing in a two-year MBA program. Tuition costs will be
$60,000 for two years while living expenses will be $25,000 per year. She has $10,000 in
savings, which she can spend on her education, and will need to borrow the rest from
her bank. Her annual loan repayment will be $10,500. She currently works as an analyst
and makes $60,000 a year; after she gets her degree she hopes to work as a manager
for $150,000 a year.
Refer to the seven-step procedure in Table 1-1 (left-hand side) to answer these
questions:
a. How should your friend formulate her problem?
b. What are her projected costs? (Identify all costs)
c. Suggest alternatives to your friend to reduce the uncertainty associated with finding
a high-income job to pay off her loan
 Example 1: Application of the Engineering
Economic Analysis Procedure
Your friend is considering investing in a two-year MBA program. Tuition costs will be
$60,000 for two years while living expenses will be $25,000 per year. She has $10,000 in
savings, which she can spend on her education, and will need to borrow the rest from
her bank. Her annual loan repayment will be $10,500. She currently works as an analyst
and makes $60,000 a year; after she gets her degree she hopes to work as a manager
for $150,000 a year.
Refer to the seven-step procedure in Table 1-1 (left-hand side) to answer these
questions:
d. Select a criterion for discriminating among alternatives, and use it to advise your
friend on which course of action to pursue.
e. Attempt to analyze and compare the alternatives in view of at least one criterion in
addition to cost.
f. What should your friend do based on the information you and she have generated?
 COSTS AND
CONCEPTS FOR
DECISION MAKING
These are essential in engineering and business to guide
effective resource allocation and optimize outcomes.
Understanding different types of costs and their roles in
decision-making helps organizations evaluate
alternatives and make economically sound choices.
Fixed Costs
▪ those unaffected by changes in activity level over a
feasible range of operations for the capacity or
capability available
▪ e.g., insurance and taxes on facilities, general
management and administrative salaries, license fees,
and interest costs on borrowed capital
▪ relevant for decisions about scaling production or
entering long-term commitments
Variable Costs
▪ costs that change with production levels
▪ e.g., raw materials, labor
▪ crucial for decisions involving production volume
and pricing
▪ also known as avoidable costs
Incremental Costs
▪ the additional cost (or revenue) that results from
increasing the output of a system by one (or more) units
▪ is often associated with “go–no go” decisions that
involve a limited change in output or activity level
▪ e.g., “incremental cost of producing a barrel of oil” and
“incremental cost to the state for educating a student”
▪ often quite difficult to determine in practice
Example 2: Fixed and Variable Costs
In connection with surfacing a new highway, a contractor has a choice of two sites on which to
set up the asphalt-mixing plant equipment. The contractor estimates that it will cost $2.75 per
cubic yard mile (yd3-mile) to haul the asphalt-paving material from the mixing plant to the job
location. Factors relating to the two mixing sites are as follows (production costs at each site are
the same):

The job requires 50,000 cubic yards of mixed-asphalt-paving material. It is estimated that four
months (17 weeks of five working days per week) will be required for the job. Compare the two
sites in terms of their fixed, variable, and total costs. Assume that the cost of the return trip is
negligible. Which is the better site?
For the selected site, how many cubic yards of paving material does the contractor have to
deliver before starting to make a profit if paid $12 per cubic yard delivered to the job location?
Cost Fixed Variable Site A Site B
Direct Costs
▪ costs that are easily traceable to a specific
product or project
▪ are labor and material costs directly associated
with a product, service, or construction activity
▪ e.g., materials needed to make a pair of scissors
Indirect Costs
▪ costs that are difficult to allocate to a specific output or work activity

▪ normally, they are costs allocated through a selected formula (such as

proportional to direct labor hours, direct labor dollars, or direct material
dollars) to the outputs or work activities

▪ e.g., the costs of common tools, general supplies, and equipment

maintenance in a plant

▪ Overhead consists of plant operating costs that are not direct labor or
direct material costs.

▪ e.g., electricity, general repairs, property taxes, and supervision

Standard Costs
▪ are planned costs per unit of output that are established in advance of actual
production or service delivery

▪ are developed from anticipated direct labor hours, materials, and overhead
categories (with their established costs per unit)

▪ play an important role in cost control and other management functions

▪ Estimating future manufacturing costs

▪ Measuring operating performance by comparing actual cost per unit with the
standard unit cost

▪ Preparing bids on products or services requested by customers

▪ Establishing the value of work in process and finished inventories

Cash Cost versus Book Cost
▪ A cost that involves payment of cash is called a cash cost (and results in a cash
flow) to distinguish it from one that does not involve a cash transaction and is
reflected in the accounting system as a noncash cost. This noncash cost is often
referred to as a book cost.

▪ Cash costs are estimated from the perspective established for the analysis
(Principle 3) and are the future expenses incurred for the alternatives being
analyzed.

▪ Book costs are costs that do not involve cash payments but rather represent
the recovery of past expenditures over a fixed period of time.

▪ e.g., depreciation charged for the use of assets such as plant and equipment
Sunk Costs
▪ costs that have already been incurred and cannot be recovered
▪ not relevant for future decision-making, as they do not affect the
outcome
▪ is common to all alternatives, is not part of the future (prospective)
cash flows, and can be disregarded in an engineering economic
analysis
▪ e.g., nonrefundable cash outlays, such as earnest money on a
house or money spent on a passport
Example 3: Sunk Costs in Replacement Analysis
A classic example of sunk cost involves the replacement of assets.
Suppose that your firm is considering the replacement of a piece of
equipment. It originally cost $50,000, is presently shown on the
company records with a value of $20,000, and can be sold for an
estimated $5,000. For purposes of replacement analysis, the $50,000
is a sunk cost. However, one view is that the sunk cost should be
considered as the difference between the value shown in the
company records and the present realizable selling price. According
to this viewpoint, the sunk cost is $20,000 minus $5,000, or $15,000.
Neither the $50,000 nor the $15,000, however, should be considered
in an engineering economic analysis, except for the manner in
which the $15,000 may affect income taxes.
Opportunity Costs
▪ is incurred because of the use of limited resources, such that the
opportunity to use those resources to monetary advantage in an
alternative use is foregone
▪ is the cost of the best rejected (i.e., foregone) opportunity and is
often hidden or implied
Example 4: Opportunity Costs in Replacement Analysis
The concept of an opportunity cost is often encountered in
analyzing the replacement of a piece of equipment or other capital
asset. Let us reconsider Example 3, in which your firm considered the
replacement of an existing piece of equipment that originally cost
$50,000, is presently shown on the company records with a value of
$20,000, but has a present market value of only $5,000. For purposes
of an engineering economic analysis of whether to replace the
equipment, the present investment in that equipment should be
considered as $5,000, because, by keeping the equipment, the firm
is giving up the opportunity to obtain $5,000 from its disposal. Thus,
the $5,000 immediate selling price is really the investment cost of not
replacing the equipment and is based on the opportunity cost
concept.
Life-Cycle Cost
▪ summation of all the costs related to a product, structure, system, or
service during its life span
▪ essential for long-term investment decisions
▪ Investment cost (capital investment) is the capital required for most of
the activities in the acquisition phase.
▪ Operation and maintenance cost includes many of the recurring annual
expense items associated with the operation phase of the life cycle.
▪ Disposal cost includes those nonrecurring costs of shutting down the
operation and the retirement and disposal of assets at the end of the life
cycle.
 Phases of the Life
Cycle and Their
Relative Cost
The cumulative committed life-
cycle cost curve increases
rapidly during the acquisition
phase. In general,
approximately 80% of life-cycle
costs are “locked in” at the end
of this phase by the decisions
made during requirements
analysis and preliminary and
detailed design. In contrast, as
reflected by the cumulative
life-cycle cost curve, only about
20% of actual costs occur during
the acquisition phase, with
about 80% being incurred during
the operation phase.
Decision-Making Scenarios
Using Cost Concepts
▪ Make-or-Buy Decisions: Compare costs of producing in-house
versus outsourcing.
▪ Pricing Decisions: Use marginal and fixed costs to set competitive
prices.
▪ Expansion Decisions: Evaluate incremental costs and benefits of
expanding operations.
▪ Shutdown Decisions: Assess fixed and variable costs to decide if
continuing operations is viable.
▪ Investment Analysis: Use life-cycle costs and opportunity costs to
evaluate long-term investments.
Cost-Driven Design Optimization
▪ In general, the cost models developed in these problems
consist of three types of costs:
1. fixed cost(s)
2. cost(s) that vary directly with the design variable
3. cost(s) that vary indirectly with the design variable
Cost-Driven Design Optimization
▪ A simplified format of a cost model with one design variable is

where:
a is a parameter that represents the directly varying cost(s),
b is a parameter that represents the indirectly varying cost(s),
k is a parameter that represents the fixed cost(s), and
X represents the design variable in question
Cost-Driven Design Optimization
▪ In general, the cost models developed in these problems
consist of three types of costs:
1. fixed cost(s)
2. cost(s) that vary directly with the design variable
3. cost(s) that vary indirectly with the design variable
Cost-Driven Design Optimization
1. Identify the design variable that is the primary cost driver (e.g., pipe diameter or
insulation thickness).
2. Write an expression for the cost model in terms of the design variable.
3. Set the first derivative of the cost model with respect to the continuous design variable
equal to zero. For discrete design variables, compute the value of the cost model for
each discrete value over a selected range of potential values.
4. Solve the equation found in Step 3 for the optimum value of the continuous design
variable.∗ For discrete design variables, the optimum value has the minimum cost
value found in Step 3. This method is analogous to taking the first derivative for a
continuous design variable and setting it equal to zero to determine an optimal value.
5. For continuous design variables, use the second derivative of the cost model with
respect to the design variable to determine whether the optimum value found in Step
4 corresponds to a global maximum or minimum.
Example 5: How Fast Should the Airplane Fly?
The cost of operating a jet-powered commercial (passenger-carrying)
airplane varies as the three-halves (3/2) power of its velocity; specifically,
CO = knv3/2, where n is the trip length in miles, k is a constant of
proportionality, and v is velocity in miles per hour. It is known that at 400
miles per hour, the average cost of operation is $300 per mile. The
company that owns the aircraft wants to minimize the cost of operation,
but that cost must be balanced against the cost of the passengers’ time
(CC), which has been set at $300,000 per hour.
a. At what velocity should the trip be planned to minimize the total cost,
which is the sum of the cost of operating the airplane and the cost of
passengers’ time?
b. How do you know that your answer for the problem in Part (a)
minimizes the total cost?
 THE GENERAL
ECONOMIC
ENVIRONMENT
Consumer and Producer
Goods and Services
▪ Consumer goods and services are those products or
services that are directly used by people to satisfy their
wants.
▪ Producer goods and services are used to produce
consumer goods and services or other producer goods.
Necessities and Luxuries
▪ Necessities are those products or services that are
required to support human life and activities, that will be
purchased in somewhat the same quantity even though
the price varies considerably.
▪ Luxuries are those products or services that are desired
by humans and will be purchased if money is available
after the required necessities have been obtained.
Demand
▪ Demand is the quantity of a certain commodity that is bought at a
certain price at a given place and time.
▪ Elastic demand occurs when a decrease in selling price result in
a greater than proportionate increase in sales.
▪ Inelastic demand occurs when a decrease in the selling price
produces a less than proportionate increase in sales.
▪ Unitary elasticity of demand occurs when the mathematical
product of volume and price is constant.
Demand
Competition, Monopoly,
and Oligopoly
▪ Perfect competition occurs in a situation where a commodity or service
is supplied by a number of vendors and there is nothing to prevent
additional vendors entering the market.
▪ Monopoly is the opposite of perfect competition. A perfect monopoly
exists when a unique product or service is available from a single vendor
and that vendor can prevent the entry of all others into the market.
▪ Oligopoly exists when there are so few suppliers of a product or service
that action by one will almost inevitably result in similar action by the
others.
The Law of Supply and Demand
▪ Supply is the quantity of a certain commodity that is offered
for sale at a certain price at a given place and time.
▪ The law of supply and demand may be stated as follows:
"Under conditions of perfect competition, the price at which
a given product will be supplied and purchased is the price
that will result in the supply and the demand being equal."
The Law of Supply and Demand
The Law of Diminishing Returns
▪ "When the use of one of the factors of production is
limited, either in increasing cost or by absolute quantity,
a point will be reached beyond which an increase in the
variable factors will result in a less than proportionate
increase in output."
The Law of Diminishing Returns
 PRESENT ECONOMY
STUDIES
These are engineering economic analyses where
alternatives for accomplishing a specific task are being
compared over one year or less and the influence of
time on money can be ignored.
Rule #1
▪ When revenues and other economic benefits are
present and vary among alternatives, choose the
alternative that maximizes overall profitability based on
the number of defect-free units of a product or service
produced.
Rule #2
▪ When revenues and other economic benefits are not
present or are constant among all alternatives, consider
only the costs and select the alternative that minimizes
total cost per defect-free unit of product or service
output.
Situations Where Present
Economy Studies are Involved
▪ MATERIAL SELECTION
• Involves selection among materials available that will result
in the most economical product and give the best results.
▪ SELECTION OF METHOD
• Two or more different methods may give the same
satisfactory results.
• Involves selection of the most economical way to
accomplish operations.
Situations Where Present
Economy Studies are Involved
▪ SELECTION OF DESIGN
• The design to be selected must be best suited for the work
to be done with particular care being given to the one
which will do the work with the utmost economy.
▪ SITE SELECTION
• Costs relevant to selecting sites must be carefully
considered (land cost, construction cost, cost of available
labor, cost of transporting equipment and materials).
Situations Where Present
Economy Studies are Involved
▪ PROFICIENCY OF WORKERS
• Bear in mind that workers have varying efficiency and
proficiency.
• Worker proficiency can be translated into monetary
values.
▪ ECONOMY OF TOOL AND EQUIPMENT MAINTENANCE
• Consider the costs of acquiring tools and equipment and
the costs of maintaining them.
Situations Where Present
Economy Studies are Involved
▪ ECONOMY IN THE UTILIZATION OF PERSONNEL
• Only a certain number of personnel will lead to the
highest productivity; increasing this number will not cause
a proportional increase in productivity.
Example 6: Choosing the Most Economic Material for a Part
A part has an annual demand of 100,000 units. The part is produced
on a high-speed turret lathe, using 1112 screw-machine steel costing
$0.30 per pound. A study was conducted to determine whether it
might be cheaper to use brass screw stock, costing $1.40 per pound.
Because the weight of steel required per piece was 0.0353 pounds
and that of brass was 0.0384 pounds, the material cost per piece
was $0.0106 for steel and $0.0538 for brass. However, when the
manufacturing engineering department was consulted, it was found
that, although 57.1 defect-free parts per hour were being produced
by using steel, the output would be 102.9 defect-free parts per hour if
brass were used. Which material should be used for this part?
Example 7: Choosing the Most Economical Machine for Production
Two currently owned machines are being considered for the production of a part. The capital
investment associated with the machines is about the same and can be ignored for purposes of
this example. The important differences between the machines are their production capacities
(production rate × available production hours) and their reject rates (percentage of parts
produced that cannot be sold). Consider the following table:

The material cost is $6.00 per part, and all defect-free parts produced can be sold for $12 each.
(Rejected parts have negligible scrap value.) For either machine, the operator cost is $15.00 per
hour and the variable overhead rate for traceable costs is $5.00 per hour.
a. Assume that the daily demand for this part is large enough that all defect-free parts can be
sold. Which machine should be selected?
b. What would the percent of parts rejected have to be for Machine B to be as profitable as
Machine A?
Example 8: Choosing the Better Process
Process A produces 1,000 defect-free parts per hour. After every 2
hours, the equipment must be adjusted. This adjustment takes 15
minutes. The machine operator, who also makes the adjustment, is
paid $25 per hour (this includes fringe benefits).
Process B produces 750 defect-free parts per hour. The equipment
needs to be adjusted by the operator every 4 hours. This adjustment
requires 10 minutes of the operator’s time (paid at $15 per hour
which includes fringe benefits). Both processes are operated 8 hours
a day.
If each defect-free part can be sold for $0.10, which process should
be selected? Be sure to list your key assumptions.
Problem Set 1
1. Your friend works as a software analyst and earns $80,000 a
year. She also has a part-time job of baking cookies for
school and party events. She earns up to $500 per event
and caters as many as five events a month. She is
wondering if she should switch to baking cookies full-time
when she might be able to cater 25 events a month. Her
operating expenses would be expected to rise by $10,000
per year. What is the opportunity cost for her if she switches
to full-time catering? What recommendation would you
make to your friend about her career, after weighing the
pros and cons of each option?
Problem Set 1
2. The cost of operating a large ship (CO) varies as the square
of its velocity (v); specifically, CO = knv2, where n is the trip
length in miles and k is a constant of proportionality. It is
known that at 12 miles/hour, the average cost of operation
is $100 per mile. The owner of the ship wants to minimize the
cost of operation, but it must be balanced against the cost
of the perishable cargo (Cc), which the customer has set at
$1,500 per hour. At what velocity should the trip be
planned to minimize the total cost (CT), which is the sum of
the cost of operating the ship and the cost of perishable
cargo?
Problem Set 1
3. Either tool steel or carbon steel can be used for the set of tools on a certain
lathe. It is necessary to sharpen the tools periodically. Relevant information
for each is shown below:

The cost of the lathe operator is $14.00 per hour, including the tool-changing
time during which he is idle. The tool changer costs $20.00 per hour for just the
time he is changing tools. Variable overhead costs for the lathe are $28.00 per
hour, including tool-changing time. Which type of steel should be used to
minimize overall cost per piece?
Problem Set 1
4. Two alternative designs are under consideration for a tapered fastening pin. The
fastening pins are sold for $0.70 each. Either design will serve equally well and will
involve the same material and manufacturing cost except for the lathe and drill
operations.
Design A will require 16 hours of lathe time and 4.5 hours of drill time per1,000 units.
Design B will require 7 hours of lathe time and 12 hours of drill time per 1,000 units.
The variable operating cost of the lathe, including labor, is $18.60 per hour. The
variable operating cost of the drill, including labor, is $16.90 per hour. Finally, there is
a sunk cost of $5,000 for Design A and $9,000 for Design B due to obsolete tooling.
a. Which design should be adopted?
b. What is the annual savings over the other design if 125,000 units are sold each
year?
Problem Set 1
5. Ocean water contains 0.9 ounce of gold per ton. Method A costs
$220 per ton of water processed and will recover 85% of the
metal. Method B costs $160 per ton of water processed and will
recover 65% of the metal. The two methods require the same
investment and are capable of producing the same amount of
gold each day. If the extracted gold can be sold for$350 per
ounce, which method of extraction should be used? Assume that
the supply of ocean water is unlimited. Work on this problem on
the basis of profit per ounce of gold extracted.
Problem Set 1
6. A bicycle component manufacturer produces hubs for bike wheels. Two
processes are possible for manufacturing, and the parameters of each process
are as follows:

Assume that the daily demand for hubs allows all defect-free hubs to be sold.
Additionally, tested or rejected hubs cannot be sold. Find the process that
maximizes profit per day if each part is made from $4 worth of material and can be
sold for $30. Both processes are fully automated, and variable overhead cost is
charged at the rate of $40 per hour.