WELCOME TO IE 1040!

CHAPTER 1 MAKING ECONOMIC DECISIONS

Engineers are problem solvers and problem solving requires decision making. Problems range from simple, to intermediate, to complex. Many (perhaps most) decisions involve economicsand lets face it, while business owners or executives who arent engineers themselves may not always question whether the engineers solution meets the technical requirements, they will nearly always ask what the return on investment is or whether the solution is the least costly!

DEFINING ENGINEERING ECONOMY

What is Engineering Economy? What is meant by an economic analysis? Can you think of an engineering or business decision that might require an economic analysis?

DEFINITIONS OF ENGINEERING ECONOMY

This field deals with the concepts and techniques of analysis useful in evaluating the worth of systems, products, and services in relation to their cost. (Thuesen, Fabrycky, and Thuesen) 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. (Sullivan, et. al.) The economic analysis of costs, benefits, and revenues occurring over time is called engineering economic analysis and is useful in answering many different questions and making decisions -- both business and personal. (Newnan, et. al. you book). 4

THE ROLE OF ENGINEERING ECONOMY IN DECISION MAKING

Engineering economic analysis is most suitable for intermediate problems and for the economic aspects of complex problems. These types of problems have the following characteristics:
The problem is important enough to justify our giving it serious thought and effort. The problem cant be worked in ones head that is, a careful analysis requires that we organize the problem and all the various consequences, and this is just too much to be done all at once. The problem has economic aspects critical in reaching a decision
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THE DECISION MAKING PROCESS

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2

Recognize the problem

Define the goal or objective

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4 5 6 7 8

Assemble the relevant data

Identify feasible alternatives Select the criterion to determine the best alternative Construct a model Predict each alternatives outcomes or consequences Choose the best alternative

Audit the result

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Example - You work for a company that manufactures circuit breakers. The company is contemplating accepting a large order to manufacture circuit breakers for one of your most important customers. You want to take the order, but do not presently have enough capacity in your plant to complete the order per the customers due date. What should you do?

POSSIBLE DECISION MAKING CRITERIA (STEP 5)

Create the least disturbance to the environment Improve the distribution of wealth among people Minimize the expenditure of money (least cost) Ensure that the benefits to those who gain from the decision are greater than the losses of those who are harmed by the decision (known as the Kaldor criterion) Minimize the time to accomplish the goal or objective Minimize unemployment Maximize profit 8 There may be more

OTHER CONSIDERATIONS IN ENGINEERING ECONOMY

Focus on the differences Use a consistent viewpoint Consider al relevant criteria and consequences (even if they are not easily quantified) customer satisfaction, quality, safety, employee satisfaction, environmental, ethical, etc. Make risk and uncertainty explicit Ethics

ETHICS
Ethical issues might arise in any step of the decision making process and are certainly common in engineering economic analysis National Society of Professional Engineers (NSPE) fundamental canon of ethical behavior for engineering Examples
Favors for influencing choices Cost versus quality versus functionality Environmental Safety versus cost
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Sarbanes-Oxley Act of 2002 Global differences

DECISION MAKING FOR CURRENT COSTS (PRESENT ECONOMY STUDIES)

Easiest form of engineering economic decision making problems of alternatives designs, methods, materials, production amounts, etc. Consequences occur over relatively short time periods so that the influence of time on money is insignificant. Well look at three general types of problems:
How much to produce (volume or demand)? Cost driver problems Make verses buy; alternative designs and methods, etc.

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ECONOMIC ENVIRONMENT TERMINOLOGY

Consumer Goods and Services - goods and services used directly by the customer. Producer Goods and Services - goods and services used to produce consumer goods and services. Utility - value, ability to satisfy wants and needs. Necessities vs. Luxuries - basic needs vs. wants, not easy to distinguish. Price - amount that must be paid. Demand - the quantity wanted.
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ECONOMIC ENVIRONMENTS
Perfect Competition - products are supplied by a large number of vendors and there is no restriction on additional vendors entering the market. Monopoly - a perfect monopoly is the complete opposite of perfect competition. Sometimes a monopoly can be good other times it can be bad. Oligopoly - an environment that contains so few suppliers that action by one supplier results in a similar action by the others.

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MAXIMIZING TOTAL REVENUES WHEN PRICE AND DEMAND ARE INDEPENDENT

Total Revenue - money (revenue) earned through sales
Price is Fixed TR = pD

Where TR= Total Revenue

Total Revenue $

Demand to maximize revenues is infinite or to the capacity of the operation.

Demand
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CONSIDERING COSTS

Total Cost - the summation of fixed and variable costs.

CT = CF + CV where CT CF CV CV = cvD where cv Variable Cost per Unit Total Cost Fixed Cost Variable Cost

Profit (Loss) - amount gained or lost.

Profit (Loss) = TR - CT
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MAXIMIZING TOTAL PROFITS WHEN PRICE AND DEMAND ARE INDEPENDENT

Thus, if Price is Fixed, the higher the TR, the larger the profits and D* = infinity (or to capacity) will maximize Profit where D* Demand Level to Maximize Profit
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COMPUTING BREAKEVEN POINTS WHEN PRICE AND DEMAND ARE INDEPENDENT

Breakeven Point - point where total revenue is equal to total cost.

Price is Fixed
Breakeven Point: Breakeven Point: D' = CF / (p - cv) where D' is the demand level to breakeven TR = CT pD' = CF + cvD'

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RELATIONSHIP BETWEEN PRICE AND DEMAND (DEPENDENT)

p p=a-bD
The shape of the curve will vary depending on whether the item is considered to be a necessity or luxury, the type of market the item is in, etc.. where p a Price D

Price-axis intercept

b
D

Slope
Demand
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MAXIMIZING TOTAL REVENUES WHEN PRICE AND DEMAND ARE DEPENDENT

Total Revenue Function TR = (a - bD)D

TR = aD - bD2
To maximize TR, take the first derivative and set it equal to 0 dTR / dD = a - 2bD = 0

= a / 2b D is the demand where D level to maximize TR

Take the second derivative to see if we have truly maximized d2TR / dD2 = -2b which will always be negative, thus we have maximized.

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MAXIMIZING TOTAL PROFITS WHEN PRICE AND DEMAND ARE DEPENDENT

Profit (Loss) = TR - CT Profit (Loss) = (aD - bD2) - (CF + cvD) Profit (Loss) = -CF + (a - cv)D - bD2

To maximize Profit, take the first derivative and set it equal to 0

d(Profit) / dD = a - cv - 2bD = 0 D* = (a - cv) / 2b Take the second derivative to see if we have truly maximized d2(Profit) / dD2 = -2b which will always be negative, thus we have maximized .

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COMPUTING BREAKEVEN POINTS WHEN PRICE AND DEMAND ARE DEPENDENT

Breakeven Point: Breakeven Point: Breakeven Point: TR = CT aD - bD2 = CF + cvD -bD2 + (a - cv)D - CF = 0

Solving for both roots of this quadratic equation will yield D' = -(a - cv) [(a - cv)2 - 4(-b)(-CF)]1/2 2(-b)

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FORMULA REVIEW AND EXAMPLES PRICE-DEMAND-REVENUES-COSTS-PROFITS

Price and Demand may be independent or dependent If dependent, usually such that: p = a bD

What Demand will maximize Total Revenues (TR)?

Independent Case: Dependent Case: Profits = TR CT Independent Case: D* = infinity or capacity Dependent Case: D* =

= infinity or capacity D
a D 2b

What Demand will maximize Profits (optimal Demand)?

(a cv ) 2b

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What is the Breakeven Demand? Independent Case:

D'

Dependent Case:

( p cv )

CF

D'

1 (a cv ) [(a cv )2 4(b)(CF )] 2 2(b)

Examples

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EXAMPLE INDEPENDENT CASE

The annual fixed costs for a plant are $100,000 and the variable costs are $140,000 at 70% utilization of available capacity, with net sales of $280,000.
What is the breakeven point in units of production if the selling price per unit is $40? What demand will maximize profits (i.e. what is the capacity of the operation)?

From Sullivan, et. al. Engineering Economy , 14 edition.

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EXAMPLE DEPENDENT CASE

A large wood products company is negotiating a contract to sell plywood overseas. The fixed cost that can be allocated to the production of plywood is $900,000 per month. The variable cost per thousand board feet is $131.50. The price charged will be determined by p=$600-.05D per 1,000 board feet.
What is the optimal monthly sales volume for this product? What is the profit at this volume (demand)? What is the domain of profitable demand during a month? From Sullivan, et. al. Engineering Economy , 14 edition.
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COST-DRIVEN DESIGN OPTIMIZATION

Engineers cannot simply design something and then think about costs because the design process often locks in nearly 80% of the costs!
Design for the Environment (DFE) or Green Engineering is cost-driven (elimination of waste) Simple (general) Cost Model with One Design Variable:
Cost = aX + b / X + k a Costs that vary directly X Design variable b Costs that vary indirectly k Fixed costs
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EXAMPLE OF A COST-DRIVER PROBLEM

The fixed cost for a steam line per meter of pipe is $450X + $50 per year. The cost for loss of heat from the pipe per meter is 4.8 / X1/2 per year. Here X represents the thickness of the insulation in metersa continuous design variable.
What is the optimum thickness of the insulation? How do you know that your answer minimizes the cost? What is the basic trade-off being made in the problem?

From Sullivan, et. al. Engineering Economy , 14 edition.

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OTHER PRESENT ECONOMY STUDIES

The bottom line in choosing between alternatives in economic decision making:

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

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EXAMPLE
A company is analyzing a make-versus-purchase situation for a component used in several of its products. The engineering department has provided the following: Purchase 10,000 items per year at a fixed price of $8.50 per item. Manufacture 10,000 items per year, using available capacity in the factory. Direct materials are $5 per item, direct labor is $1.50 per item, and overhead is allocated at 200% of direct labor. Should the company make or purchase the item? What if we consider other consequences of the decisionwould your decision change?
From Sullivan, et. al. Engineering Economy , 14 edition.

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