Principles of Engineering Economics

Different Types of Investments

Stocks Bonds Mutual Funds Treasury Notes Certificate of Deposits Rental Property Land

Typical Investment Questions

What percentage of annual income should you set aside for the investment? What is the expected annual return from the investment? How much time is needed to achieve your financial goals?

Engineering Economic Analysis

Use of quantitative and qualitative techniques to analyze economic differences among engineering design alternatives in selecting the preferred design

Time Value Of Money (TVOM)

Php 1,000 today or Php X a year from now

Time Value Of Money (TVOM)

Current VS Deferred choice Inflation Money has time value in the absence of inflation
Because of the earning power of money Borrowing & Repaying The interest rate you charge is based on TVOM

TVOM Aliases
A.K.A. Opportunity cost of money Interest rate Discount rate Hurdle rate Minimum Attractive Rate of Return (MARR) Cost of capital

Cash Flow Approach

Cash Flow when money changes hands from one individual / organization to another
Php 1,000

YR 0

YR 0

Php 2,000
Cash Inflow Cash Outflow

Discounted Cash Flows (DCF)

Movement of money backward or forward in time Because money has a time value, one should not add or subtract money unless it occurs at the same point in time

4 DCF Rules
1. Money has a time value 2. Money cannot be added or subtracted unless it occurs at the same point in time 3. To move forward one time unit, multiply by (1 + interest rate) 4. To move backward one time unit, divide by (1 + interest rate)

10 Principles of Engineering Economic Analysis

10 Principles of Engineering Economic Analysis

Principle 1 Money has a time value

10 Principles of Engineering Economic Analysis

Principle 2 Make investments that are economically justified (that yield positive economic returns)

10 Principles of Engineering Economic Analysis

Principle 3 Choose the mutually exclusive investment alternative that maximizes economic worth (consider only monetary aspects of the alternative)

10 Principles of Engineering Economic Analysis

Principle 4 Two investment alternatives are equivalent if they have the same economic worth

10 Principles of Engineering Economic Analysis

Principle 5 Marginal revenue should exceed marginal cost (added revenue > added cost)

10 Principles of Engineering Economic Analysis

Principle 6 Continue to invest as long as each additional increment of investment yields a return that is greater than the investors TVOM

10 Principles of Engineering Economic Analysis

Principle 7 Consider only differences in cash flows among alternatives

10 Principles of Engineering Economic Analysis

Principle 8 Compare investment alternatives over a common period of time (same length of time)

10 Principles of Engineering Economic Analysis

Principle 9 Risk and return tend to be positively correlated

10 Principles of Engineering Economic Analysis

Principle 10 Past costs (sunk costs) are irrelevant in engineering economic analysis unless they impact future costs

Systemic Economic Analysis Technique (SEAT)

1. What investment alternatives are available? 2. What is the length of time over which the decision is to be made? (planning horizon) 3. What TVOM will be used to move monies forward or backward in time? (interest rate) 4. What are the best estimates of the cash flows for each of the alternatives? 5. Which alternative seems best based on the economic criterion chosen? (PW, FW, AW, ROR, B/C) 6. How sensitive is the economic preference to changes in or errors in the estimates used in the analysis? (What if) 7. Which investment is recommended?

Non-Monetary Factors
Improved safety Reduced cycle times Improved quality Increased flexibility Increased customer service Improved employee morale Being first to use a particular technology Increased market visibility

Weighted Factor Comparison

Alternative A Factor 1 Weight Rating Score Alternative B Rating Score

2
3 Total 100%

Other Guidelines for Alternatives

Obtain support of the users of the recommended system before presenting it to management Pre-sell the recommendation and eliminate surprises Dont be enamored with the technical aspects of the recommended investment Managers tend to have broader perspectives The proposal is only one of many.

ABETs Engineering Definition

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.

Engineers Work on Projects

Does the projects benefits exceed its cost?

Engineering Economy
Subset of economics applied to engineering projects Engineers seek solution to problems; the economic viability of each potential solution is normally considered along with the technical aspects The goal of a solution designer is to seek out the best possible one Decisions made by engineers, managers, CEOs, and individuals are commonly the result of choosing one alternative over another

Origins of Engineering Economy

Arthur Mellen Wellington (1847 1895) was an American civil engineer remembered for his 1887 book The Economic Theory of the Location of Railways. The saying that An engineer can do for a dollar what any fool can do for two is attributed to him.

Engineering Economy
Engineering Economy is applied microeconomics where the fundamental question is
Is it in the best interest of the enterprise to invest its limited resources in a proposed technical endeavor, or would the same endeavor produce a higher return elsewhere?

Engineers use knowledge to find ways of doing things economically

Solutions to Engg Problems Must

Demonstrate a positive balance of long-term benefits over long-term costs Promote the well-being and survival of the organization Embody creative and innovative technologies and ideas Permit identification and scrutiny of estimated outcomes

Trade-Offs
Cost vs. Performance Response Time Safety Weight Reliability

Fundamental Principles in Engineering Economics

Principle 1 A peso today is worth more than a peso tomorrow (or at a later time) Principle 2 All that counts is the difference among alternatives Principle 3 Marginal revenue must exceed marginal cost Principle 4 Additional risk is not taken without the expected additional return

Principles in Engineering Economics

1. 2. 3. 4. 5. 6. 7. Develop the alternatives Focus on the differences Use a consistent viewpoint Use a common unit of measure Consider all relevant criteria Make Uncertainty Explicit Revisit your decisions

Principles in Engineering Economics

1. Develop the alternatives The choice (decision) is among alternatives. The alternative needs to be identified and then defined for subsequent analysis

Principles in Engineering Economics

2. Focus on the differences Only the differences in expected future outcomes among the alternatives are relevant to their comparison and should be considered in the decision Goal should be to recommend a future course of action based on the differences among feasible alternatives

Principles in Engineering Economics

3. Use a consistent viewpoint The prospective outcomes of the alternatives, economic and other, should be consistently developed from a defined viewpoint (perspective).

Principles in Engineering Economics

4. Use a common unit of measure Using a common unit of measurement to enumerate as many of the prospective outcomes as possible will simplify the analysis of alternatives

Principles in Engineering Economics

5. Consider all relevant criteria Selection of a preferred alternative (decision making) requires the use of a criterion (or several criteria). The decision process should consider both the outcomes enumerated in the monetary unit and those expressed in some other unit of measurement or made explicit in a descriptive manner

Principles in Engineering Economics

6. Make risk and uncertainty explicit Risk and uncertainty are inherent in estimating the future outcomes of the alternatives and should be recognized in their analysis and comparison.

Principles in Engineering Economics

7. Revisit your decisions Improved decision making results from an adaptive process To the extent practicable, the initial projected outcomes of the selected alternatives should be subsequently compared with actual results achieved.

Engineering Economic Analysis Procedure (EEAP)

1. Problem recognition, definition & evaluation 2. Development of feasible alternatives (Search & Screen) 3. Development of outcomes and cash flows for each alternative 4. Selection of a criterion (or criteria) 5. Analysis and comparison of alternatives 6. Selection of the preferred alternative 7. Performance monitoring and post-evaluation results

Seatwork
Complete the 7 steps of EEAP for the following problem:
Long lines during enrollment

Limitations
1. Lack of time and money 2. Preconceptions of what will work and what will not 3. Lack of knowledge

2 Approaches to Developing Alternatives

1. Classical Brainstorming 2. Nominal Group Technique

2 Approaches to Developing Alternatives

1. Classical Brainstorming Deferment of judgment Quantity breeds quality Rules 1. Criticism is ruled out 2. Freewheeling is welcome 3. Quantity is wanted 4. Combination and improvement are sought

2 Approaches to Developing Alternatives

2. Nominal Group Technique Andre P. Delbecq & Andrew H. Van de Ven Reduces dominance of one or more participants Avoids suppression of conflicting ideas Rules 1. Individual silent generation of ideas 2. Individual round-robin feedback and recording of ideas 3. Group clarification of each idea 4. Individual voting and ranking to prioritize ideas 5. Discussion of group consensus results

Non-monetary Objectives
1. 2. 3. 4. Meeting and exceeding customer expectations Safety to employees and to the public Improving employee satisfaction Maintaining production flexibility to meet changing demands 5. Meeting or exceeding all environmental requirements 6. Achieving good public relations or being an exemplary member of the community.

Sources
http://en.wikipedia.org/ Sullivan, William G., Elin M. Wicks and James T. Luxhoj, Engineering Economy, 14th Ed., Prentice Hall, Inc., 2009 White et. al. Principles of Engineering Economic Analysis, 5th Ed. John Wiley & Sons. Inc., 2010