Engineering Economy

Dr. Rubayet Karim

Associate Professor
Dept. of Industrial and Production Engineering

Jashore Universiy of Science and Technology,

Jashore, Bangladesh
 Course Objective

Understand the fundamental concepts of engineering economic analysis

(cash flow, time value of money, interest, inflation, depreciation, etc.) and
tools (break-even analysis, payback period, benefit-cost ratio, rate of
return, etc.) for solving various engineering problems.

➢ References
1. Blank, L and Tarquin, A., Engineering Economy
2. Park, C.S., Fundamentals of Engineering Economics
Economy: The careful use of resources to avoid waste.

Engineering: The application of scientific, social, and practical

knowledge, in order to design, build and maintain structures,
machines, devices, systems, and materials.

Engineering Economy: The careful monetary decision on resource

utilization to avoid waste in the making of structures, machines,
devices, systems, etc.
Origin:
Arthur Wellington, a civil engineer who addressed the role of
economic analysis in engineering projects at the end of the
nineteenth century, was a pioneer in the field (his area of interest
was railroad building in the USA)

In 1930, by incorporating financial mathematics, Eugene Grant,

an American civil engineer, published a textbook that was a
milestone in the development of the engineering economy as we
know it today.
Definition:
Making decisions is central to the engineering economy.

Engineering economy is the application of economic

techniques to the evaluation of design and engineering
alternatives.
• Making a call on whether or not the project should
be proceeded
▪ The engineering economy is based primarily on estimates of
future costs and benefits. So it has to deal with risk and
uncertainty.
▪ The numbers used in engineering economy are the best
estimates of what is expected to occur.
 Time Value of Money
The change in the value of money as time passes is referred
to as the time value of money.

In expenditure, the time value of money is understood with

inflation
Example: If ten pens can be purchased for $100 today and
five pens can be purchased for $100 after one year, we can
say that the value of $100 has changed (decreased) in one
year.
The concept of the time value of money states that the purchasing
power of money changes as time passes.
 Time Value of Money
In savings, the time value of money is understood with interest
rates

Receiving a given amount of money today is more valuable than

receiving the same amount in the future due to its potential
earning capacity.

Example: If we invest $100 today, that money can start earning

interest, for example. In the future, our initial investment will be
worth more than $100 due to the earnings on that investment. So,
receiving $100 today is more valuable than receiving the same
amount in the future.
Inflation has negative effects:

Inflation affects an economy in various ways, both positive and negative.

•Uncertainty over future inflation may discourage savings.

• If inflation were rapid enough, shortages of goods as consumers
begin hoarding out of concern that prices will increase in the future.
Inflation also has positive effects:

•Fundamentally, inflation gives everyone an incentive to spend and

invest, because if they don't, their money will be worth less in the
future. This spending and investment can benefit the economy.

•Inflation reduces the real burden of debt, both public and private. If
you have a fixed-rate loan on your house, your salary is likely to
increase over time due to wage inflation, but your loan payment will
stay the same. Over time, your loan payment will become a smaller
percentage of your earnings, which means that you will have more
money to spend.
 Consumer Price Index (CPI)

• A consumer price index(CPI) measures changes in the price level

of consumer goods and services purchased by households.
• Consumer price index is calculated monthly from survey
information by the Bureau of Labor Statistics in the U.S.
Department of Labor.
• The prices of a sample of representative items are collected
periodically. This index is based on current and historical
information and may be used, as appropriate, to represent future
economic condition.
Consumer Price Index (CPI)
 Consumer Price Index (CPI)

Current Period: February

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑀𝑎𝑟𝑘𝑒𝑡 𝐵𝑎𝑠𝑘𝑒𝑡

Consumer Price Index(CPI) = ×100
𝐵𝑎𝑠𝑒 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑃𝑒𝑟𝑖𝑜𝑑 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐵𝑎𝑠𝑘𝑒𝑡

13050
= ×100
13000

=100.38

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟 𝐶𝑃𝐼 −𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑌𝑒𝑎𝑟 𝐶𝑃𝐼

Inflation rate = ×100
𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑌𝑒𝑎𝑟 𝐶𝑃𝐼
 Consumer Price Index (CPI)

Example
First we need to know how much of each good were purchased
each year and what the prices were:

Hamburger Jeans Movie Ticket

1984 Price $.80 $24 $5.00
1984 Quantity 40 1 4

Then find total expenditure by multiplying price times quantity and

adding them:
Expenditure = (.80 x 40) + (24 x 1) + (4 x 5) = $76
$32 + $24 + $20 = $76
 Consumer Price Index (CPI)
Now, 20 years later, we have new prices:
2004: Hamburger Jeans Movie Ticket
$1.20 $30 $7.00

Assume that the market basket (the amount purchased) stays the
same in 2004 as it was in 1984 and the only thing that’s
changed are prices.

($1.20 x 40) + ($30 x 1) + ($7 x 4) = $106

$48 + $30 + $28 = $106

To find the CPI in any year, divide the cost of the market basket
in year t by the cost of the same market basket in the base year.
The CPI in 1984 = $76/$76 x 100 = 100
 Consumer Price Index (CPI)

To find the CPI in 2004 take the cost of the market basket in 2004
and compare it to the same basket in 1984:
CPI in 2004 = $106/$76 x 100 = 139.5

Now we can calculate the inflation rate between 1984 and

2004:
(139.5 – 100) /100 = 39.5/100 = 39.5%

So prices have risen by 39.5% over that 20 year period. If the

period was 1984 to 1985 we would say that inflation was 39.5 %
in 1985
 Market Interest Rate

▪ It is known as the inflated interest rate. Interest rate based on

existing market condition (Inflation).
▪ This rate is a combination of the real interest rate i and the
inflation rate f, and therefore, it changes as the
inflation rate changes.
▪ All interest rates stated by financial institutions for loans and
saving accounts are market interest rates. Most firms use a
market interest rate in evaluating their investment projects.

Real interest rate: This rate is an estimate of the true earning

power of money when the effects of inflation have been
removed. This rate can be computed if the market interest rate
and the inflation rate are known.
What will happen when we keep money in a bank ?

So it is necessary to know the market interest rate, inflation

rate, or to follow CPI regularly, otherwise, we will not be
able to understand whether we are gaining money from
investment or not.
 Minimum Attractive Rate of Return (MARR)

• The MARR is used as a criterion to decide on investing in a

project, the size of MARR is fundamentally connected to how
much it costs to obtain the needed capital funds.

• It always costs money in the form of interest to raise capital for an

investment in a business. The interest, expressed as a percentage
rate per year, is called the cost of capital.
Cost of Capital (COC)
Cost of Capital (COC)

Cost of debt
capital

Cost of equity
capital
 Minimum Attractive Rate of Return (MARR)

The MARR is a reasonable rate of return established for the

evaluation and selection of alternatives. A project/project proposal
is not economically viable unless it is expected to return at least
the MARR.

▪ If a company’s own funds are used exclusively for any

project/alternative, the cost of equity capital should be the
MARR interest rate.
▪ If a combination of debt and equity capital is applied, the
calculated WACC should be the MARR.
▪ However, the MARR is often set above the WACC or the
relevant cost of capital because management does try to
account for risk by increasing the MARR.
 Cost of Capital (COC)
Example: If someone want to purchase a new widescreen
HDTV, but do not have sufficient money (capital), he can
manage fund by considering both debt financing & equity
financing. Combinations of debt-equity financing mean that a
weighted average cost of capital (WACC) results. If the HDTV
is purchased with 40% credit card money at 15% per year and
60% savings account funds earnings 5% per year, the weighted
average cost of capital is

WACC= 0.4(15)% +0.6(5)% = 9%

 Economic Equivalence

To compensate for the time value of money (money loses value over time),
banks offer interest rates that ensure the economic value of money remains the
same at different points in time.

Example:
This year Next year Interest earned
(Bank/Financial institute
1000 1000 + ? ensure this equivalence)

This amount must

overcome inflation so that
purchasing power remain
same
 Economic Equivalence

Economic equivalence is a combination of interest rate and time

value of money to determine the different amounts of money at
different points in time that are equal in economic value.

Economic equivalence exists between individual cash flows and/or

patterns of flows that have the same value. Even though the amounts
and timing of the cash flows may differ, the appropriate interest
rate makes them equal.
i =appropriate interest rate
Same
Exercise A manufacturer of off-road vehicles is considering the
purchase of dual-axis inclinometers for installation in a new line of
tractors. The distributor of the inclinometers is temporarily
overstocked and is offering them at a 40% discount from the regular
cost of $142. If the purchaser gets them now instead of 2 years from
now, which is when they will be needed, what is the present worth
of the savings per unit? The company would pay the regular price, if
purchased in 2 years. Assume the interest rate is 10% per year.

Solution
An expression for the present worth can be determined by considering each A value
as a future worth F
Exercise The Public Service Board (PSB) awarded two
contracts worth a combined $1.07 million to improve (i.e.,
deepen) a retention basin and reconstruct the spillway that
was severely damaged in a flood 2 years ago. The PSB said
that, because of the weak economy, the bids came in
$950,000 lower than engineers expected. If the projects are
assumed to have a 20-year life, what is the annual worth of
the savings at an interest rate of 6% per year?

Solution
Exercise In an effort to reduce childhood obesity by reducing the
consumption of sugared beverages, some states have imposed taxes
on soda and other soft drinks. According to Arshad Islam's survey of
7300 fifth-graders, if taxes were imposed at 4 cents per dollar of
soda, there would be no discernible difference in overall
consumption. However, Islam calculated that increasing taxes to 18
cents per dollar would make a significant difference. What is the
future value of the extra cost from 4 cents to 18 cents per soda for a
student who consumes 100 sodas per year? Each soda costs one
dollar. Assume the student consumes sodas from grade 5 through
graduation in grade 12. Use an interest rate of 6% per year.
Solution 100 cents = 1 dollar
18 cents = $0.18 and 4 cents = $ 0.04
Increasing the tax from 4 cents to 18 cents per dollar would cost a student $14 ((0.18-
0.04)x 1x100) in tax to consume 100 sodas annually.
A = P (A/P, 10, 4)
= 10,000× 0.31547
The equivalent net present worth of cash flows for all plans is approximately $0, which
means that we must pay $10,000 now to choose any plan. As we need to make a decision
right now. So, our choice is indifferent, which means we can choose any plan:
Plan 1/2 /3 / 4.
The use of linear polynomials to generate new data points within the
range of a discrete set of known data points is known as linear
interpolation.

Linear polynomial equation

 Arithmetic Gradient Series

The total present worth 𝑃𝑇 for a series that includes a base amount A
and conventional arithmetic gradient must consider the present
worth of both the uniform series defined by A and the arithmetic
gradient series. The addition of the two results in 𝑃𝑇 .

𝑃𝑇 = 𝑃𝐴 ± 𝑃𝐺
• Here 𝑃𝐴 is the present worth of the uniform series only,
𝑃𝐺 is the present worth of the gradient series only.
• The + or - sign is used for an increasing (+ G ) or
decreasing (- G ) gradient, respectively.
 Arithmetic Gradient Series

Conventional arithmetic gradient

• Gradient starts between periods 1 and 2.

 Arithmetic Gradient Series
Shifted arithmetic gradient
• Gradient starts after period 2.
• It is usually advantageous to renumber the diagram so that the gradient
year 0 and the number of years n of the gradient are determined.
• Identify where the gradient begins, label that time as year 2, and then
work backward and forward.
• The gradient is referred to as shifted gradient because it shifts from
period 2 to period 4. At period 2, PG changes to F, and the equivalent P at
period 0 must be calculated for F.
 Geometric Gradient
Constant percentage

• Year 1 : A
Year 2 : A +Ag = A(1+g)
Year 3 : A(1+g) + A(1+g)g = A(1+g) 𝟐
Year 4 : A(1+g)𝟐 + A(1+g)𝟐 g = A(1+g) 𝟑
.
.
.
• Year n : A(1+g)𝒏−𝟏
Interest period (t) —The period of time over which the interest is
expressed. This is the t in the statement of r % per time period t , for
example, 1% per month. The time unit of 1 year is by far the most
common. It is assumed when not stated otherwise.

Compounding period (CP) —The shortest time unit over which interest
is charged or earned. This is defined by the compounding term in the
interest rate statement, for example, 8% per year, compounded monthly. If
CP is not stated, it is assumed to be the same as the interest period.

Compounding frequency (m)—The number of times that compounding

occurs within the interest period t. If the compounding period CP and the
time period t are the same, the compounding frequency is 1, for example,
1% per month, compounded monthly
 Effective Interest Rate

How do we recognize an effective interest rate?

❑ If it is directly stated that it is an effective rate.

❑ The compounding period is not mentioned.
❑ The compounding period is mentioned, and if the interest period and
compounding period are the same, the nominal and effective interest
rates are the same.
i: effective rate per CP
Exercise
High-tech companies such as IBM, AMD, and Intel have been using
nanotechnology for several years to make microchips with faster speeds
while using less power. A less well-known company in the chip
business has been growing fast enough that the company uses a
minimum attractive rate of return of 60% per year. If this MARR is an
effective annual rate compounded monthly, determine the effective
monthly rate.

𝑖𝑎 = 60% 𝑚 = 12, 𝑖 =?
The equivalent P , F , or A values are determined using the effective
interest rate per compounding period.
 Policy 1

AllStar has a net investment of $262,111 in CAN at the end of the year.
Interest rates for a corporation vary from year to year. It depends
on…..

❑ The financial health of the corporation.

❑ The national and international economies
❑ Inflation

Example: Loan rates or interest rates offered by the bank may

increase from one year to another
𝑃1 =

𝑃2 =

𝑃3 =
” It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that
is most adaptable to change.” – Charles Darwin