Engineering Economy

and Management
(MEH3450)
VI Semester
Introduction to
Engineering
Economy
Economics
Concerned with how limited
resources may be utilized to satisfy
unending human needs

Engineering Economics
It is the application of economic
techniques to evaluate design and
engineering alternatives
What is Engineering
Economy?
It is economic decision making
for engineering projects.

Engineers being familiar with

details related to various aspects
of project, are responsible for
decision making.

Engineering economy also deals

with the study of the costing
process
Contd..
Engineers act as managers as
many decisions are based on
economic criteria

It imparts knowledge and

methods used for evaluation of
projects.
Engineering economy principles
are also used by non-profit
organizations
 Importance of
Engineering Economy
for Engineers

They need to analyze and select

the most economical alternative

Play a major role in investment

decisions

Determine the manufacturing

costs during the engineering
phase of product development
 Microeconomics
• Deals with economic decisions
made at a low or micro level i.e. at
the level of individual or groups of
consumers or firms.
• The general concern is efficient
allocation of resources between
alternative uses.
• It determines price by optimizing
behaviour of economic agents
(buyers-maximising utility &
sellers-maximising profit)
 Macroeconomics
Macroeconomics deals with the
behavior of the whole economy. It
studies economic phenomena like
• changes in unemployment
• national income
• rate of growth
• gross domestic product
• inflation and price levels
 Types of cost
First Cost
The initial cost to start an activity e.g.
purchase of machine, Land for factory
Operations & Maintenance Cost
The expenditure taking place through out
the life of the asset
Fixed Cost
Remains constant for a long time and is
independent of volume of output e.g.
depreciation, insurance, rent
Variable Cost
Costs dependent on the volume of output
e.g. labor, material
Total cost= fixed costs + variable costs
Incremental or Marginal cost
Cost incurred in increasing output by one
unit associated with one additional unit
of production.

Sunk cost
Cost which has been incurred and cannot
be realized e.g. technology cost,
inventory cost, R&D costs

Life cycle cost

Cost associated with the whole life-cycle
of a product which includes feasibility,
design, prototype, process cost etc.
Capital
The money or goods spent in an
industry to generate profit

Net worth of a business

Amount by which the assets owned
by industry exceeds its liabilities. The
wealth includes money, assets,
property etc.

Price
A value which may buy goods or
service. It is the amount needed for
executing trade.
Thanks
Economic
Indicators
Economic Indicators
• An statistic about an economic
activity.
• Help analyze economic
performance and predicts future
performance.
• Study business cycles.
• Include various indices, earnings
reports, and economic summaries.

Examples: Inflation, consumer price

index, industrial production, gross
domestic product etc.
 Gross Domestic
Product (GDP)
The monetary value of all the finished
goods and services produced within a
country's borders in a specific time period,
usually a year.
It includes all private and public
consumption, government outlays,
investments and exports less imports that
occur in a defined territory.
GDP = C + G + I + NX
where:
C is all private consumption/user spending
G is the government spending
I is country's business spending on capital
NX is total net exports = Exports – Imports
 GDP (Contd..)
GDP is calculated as follows:
• Income approach: Adding up what
everybody earned in a year i.e.
adding up total compensation to
employees, gross profits for
incorporated and non incorporated
firms, and taxes less any subsidies
• Expenditure approach: Adding up
what everybody spent in a year i.e.
adding total consumption,
investment, government spending
and net exports
Gross National
Product (GNP)
GNP includes GDP and any
income earned by country’s
residents from overseas
investments, minus income
earned within the domestic
economy by foreign residents.

It is a measure of what its

citizens produced and whether
they produced these items within
its borders.
Gross National
Income (GNI)
GNI a measure of a country's
income which includes
income earned by a country's
residents, businesses, and
earnings from country’s
residents working overseas
No income earned by
foreigners residing in the
country is counted.
Difference Between
GNI and GNP
GNP is the total income of
residents generated through all
assets owned by them including
the earnings which don't flow
back into the country minus the
earnings of all foreigners living in
the country, even if the spending
is within the country.

GNI only reveals about the

income earned by the country's
citizens and businesses, no matter
whether it is spent within or
outside the country.
Difference Between
GNI and GDP

GDP measures the value of goods and

services produced in a country. It
includes national output, expenditures
and income.

GNI consists of GDP plus wages,

salaries, and property income of the
country's residents earned in the country
and abroad. It also comprises net taxes
and subsidies received from abroad.
 Employment
• A state in which all existing
labor resources are being used
in an efficient manner.
• Full employment
Skilled and unskilled labor is
employed to the maximum
extent within an economy at
any given time.
• Frictional unemployment
The amount of unemployment
resulting from workers who are
in between jobs, but are still in
the labor force
Inflation
Inflation is an increase in the general
level of prices measured against some
reference point

or a decrease in the value of money

Occurs due to increase in money supply

more than the increase in goods and
services

Demand-pull inflation: Sustained rise in

the prices due to increase in total demand

Cost-push inflation: Increase in cost

causes an increase in prices
Consumer price
index (CPI)
CPI is a price index which
represents the average price of a
basket of goods over time. It
determines the average price paid by
the consumer to the shopkeepers. It
deals with the prices of both goods
and services
Producer Price
Index (PPI)
PPI is a measure of change in average price
of goods over time produced domestically. It
is divided into following stages

Commodity Index is the average change

in price in a defined time period for
commodities like crude oil, iron, coal etc.

Stage of processing comprises of goods that

are in between raw and finished goods stage
e.g. cotton, steel

Finished goods are the final products to be

sold to customers
Wholesale Price
index (WPI)
WPI measures the change
in the price of goods that
are sold in bulk to different
business houses rather than
consumers
It is used as an indicator of
level of inflation.
 Fiscal policy
Fiscal Policy is the use of government
spending and revenue collection to
influence economy
◼ Expansionary fiscal policy that
encourages economic growth (higher
spending, tax cuts)
◼ Contractionary fiscal policy that
discourages economic growth (lower
spending, higher taxes)
Fiscal year is a 12 month period
starting on any date
Monetary Policy
Monetary policy is an
instrument of managing
finances where government
takes several steps to promote
economic development. It
influences supply of money
credit policy, rate of interest,
regulates banking system to
meet credit needs of economy
and creates positive
environment for saving and
investment.
Thanks
Necessities &
Luxuries
 Goods & Services
Goods
• Tangible in nature
• First produced and used later
• can move from one place to another

Services
• Non-tangible in nature
• No time gap between production
and use of services
• Services cannot be stored
• No transfer of service possible
Consumer goods
and Producer goods
• Consumer goods satisfy the
human needs directly e.g.
bread, fruits, clothes etc.

• Producer goods satisfy the

human needs indirectly e.g.
machines, tools, raw materials,
tractor
Consumer services
& producer services
• Consumer services are used
by consumers directly e.g.
tailoring, health, transport

• Producer services indirectly

satisfy human needs. They
used to produce other goods
and services e.g. transporting
raw material, production of
machines, tools etc.
Necessities
Necessities for life
Things necessary to meet the
physiological needs to sustain life.

Necessities for efficiency

Things necessary to maintain strength,
and efficiency during work e.g. healthy
food, proper clothing, education, safety
vehicle etc.

Conventional necessities
Wants developed due to habit, social
customs etc. Though these are not
necessary but can’t be shunned e.g.,
tea, wine, functions etc.
Luxuries
Things people need merely for pride
or superiority e.g. expensive clothing,
jewelry, high end cars,. Luxuries
provide pleasure to the owner

The distinction of goods into

necessities and luxuries is not clear-
cut and fixed. Factors like need,
social setup, economic status play an
important role in their classification.
Market Segments
The different market segments
or structures are
• Perfect Competition
• Monopolistic Competition
• Oligopoly
• Monopoly
• Inadequate Competition
 Perfect Competition
Perfect competition occurs when
• There are many sellers and buyers
of a product in the market
• Producers have no control over
industry so prices can’t be swayed
• Goods produced are same and sold
for the same price
• Both sellers and buyers are well
aware about the product
• Sellers can move in or out of the
market at their will
 Monopolistic Competition

Monopolistic Competition exists

between perfect competition and
monopoly
Companies produce similar but not
identical products
Many sellers
Free entry and exit of producers
Product diversity
Prices are reduced to increase sales
 Oligopoly
Oligopoly exists when there are few
sellers of a product
• Act in collusion i.e. they among
themselves decide about the prices,
production volume
• Form a cartel i.e. formally agree to
control price and output
• Difficult market entry
• Oligopolies are mutually dependent
as an action by one may lead to
reaction by another
 Monopoly
Monopoly occurs when there is
One seller & several buyers of a product
Happens when barriers to entry exists due
to legal restrictions, economies of scale
and resource control
Firm decides/increase product price at will
They become monopolies through vertical
integration (controlling supply chain) or
horizontal integration (buy up rivals)
Monopoly rarely exists due to competition
from firms producing substitutes
Comparison of
Market Segments
Perfect Monopolistic Oligopoly Monopoly
Competition Competition

Companies Many Many Few Single

Product None Few Few None

variety

Price None Slight Few Full

control

Entry exit None Low High Complete

restrictions
Demand
&
Supply
Demand
Demand may be defined
as consumer's desire to
purchase goods and
services and willingness to
pay a price for a specific
good or service.
Demand = Desire + Ability
to pay+ Willingness to pay
 Factors responsible
for demand
• Price of other goods
(substitute or complementary)
• Outlook (consumer
expectation of the future)
• Income (normal goods versus
inferior goods)
• Number of potential
customers (pop. of market)
• Taste (fads or trends)
 Law of Demand
• Other things equal, the
quantity demanded for goods
fall when the prices rise
• Price and quantity demanded
are inversely proportional
• Quantity demanded is the
total goods consumers are
willing to buy
 Demand Curve
D2
Price D1
$700
Increase in demand
600
D3
500
400
300
200 D2
Decrease in demand
100 D3
D1
0 50 60 70 80 90 100 110
Quantity
Supply
Supply is the willingness &
ability of manufacturers to
produce goods and services
to sell them in the market.
Higher product prices
encourage suppliers to
supply more as it will
generate more revenue and
profits.
Factors responsible
for supply
• Productivity (workers, machines,
and/or assembly)
• Inputs (Change in the price of
materials needed to make goods)
• Government Actions (Subsidies,
Taxes and Regulations)
• Technology (Improvements in
machines and production)
• Outputs (Price changes in other
products)
• Expectations (outlook of the future)
• Size of Industry (Number of
companies in the industry)
Law of supply
•Other things equal, the
quantity of goods supplied
increase with the increase in
prices of goods
•Quantity supplied is directly
proportional to the prices of
goods
•Supply schedule is the
relationship between the price
of goods and the quantity
supplied
 Supply Curve
S1
Price

$800
S
700 S2
Decrease in supply
600
500
400 Increase in supply
300 S1
200 S2
S
0 25 50 75 100 125 150 175
Quantity
Law of Supply
and Demand
Under conditions of
perfect competition, the
price at which a given
product will be supplied
and purchased is the
price that will result in
demand and supply
being equal
 Price Supply

Equilibrium
P point

Demand
QD,S Quantity

• Equilibrium: Quantity supplied and

quantity demanded are equal
• Shortage or excess demand: Quantity
demanded exceeds quantity supplied
• Surplus or excess supply: Quantity
supplied exceeds quantity demanded
PRICE ELASTICITY OF DEMAND
Measures the responsiveness of quantity
demanded to changes in a good’s own price

P
elastic

P*

Inelastic

Q* Q
Observations
If demand is elastic, a
reduction in price will result
in an increase in revenue
If demand is inelastic, a
reduction in price will result
in a decrease in revenue
If demand is unit-elastic, an
increase/decrease in price will
have no change on revenue
 Law of Diminishing
Returns
The law of diminishing returns states
that

In all productive processes when one

or more of the input factors of
production is limited, either by
absolute quantity or by increasing
cost, adding more of the variable
input factors will result in an output’s
being reached beyond which such
additions will result in a less than
proportionate increase in output.
Time Value of
Money
 What Is the Time
Value of Money ?
TVM is the concept that money
has more value now than the same
amount would have in future
because of its potential to grow.
Money has value as it can be let
out or rented (interest).
Return to capital
Interest and profit is the recompense to
capital for forgoing its use during the
time the capital is in use.

Interest and profit are paid by the user of

the capital towards the risk associated in
lending the capital.

The return should be attractive for lender

to motivate him to lend the money.
Equivalence
Alternatives can be evaluated
using equivalence
Equivalence is dependent on
interest rate, amount of money,
timings of money in/out flow
Equivalent values of
alternatives are calculated for
the same interest rate at the
same point of time.

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Cash Flow
First cost is the expenditure to
buy/make or to install the setup
Salvage value is the amount
received/spent at the end of project
after selling the assets
Annual income due to sale of
goods/services (revenue)
Major expenditure (overhaul) taking
place at different points of time
Annual expenditure related to
operations and maintenance (O&M)
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Cash Flow Diagram (CFD)

In a CFD the end of period t is the

same as the beginning of period
(t+1)
The time 0 is generally when a
project starts
A person’s cash outflow is
another one’s cash inflow
Two or more cash flows taking
place in the same period should
be shown individually for better
understanding.

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CFD contd….
The cash flow over time is shown by a
CFD.
The cash flow is shown at the end of
period.
The first cost is shown at the start of the
period
It is shown by a horizontal line, divided
into different time periods.
The cash inflow is shown by an arrow
pointing upward while downward arrow
show cash out flow.
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 Example of CFD
A man borrowed $1,000 at 8%
interest. He paid $ 500, $ 400 and $ X
at the end of year 1,2 & 3 respectively
and received $450 & $300 at the end
of year 2 & 4 respectively. Draw the
cash flow diagram.
$1000

$450 $300

0 1 2 3 4

$500 $400 $X
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Interest
Simple interest
Interest earned on the original
amount or principal only
Compound interest
Interest earned on principal
and on interest received
Interest is earned on
reinvestment of previous
interest payments
Simple Interest Formula

Amount of money = P x i x n

P: Principal amount

i: Interest Rate per Period

n: Number of Time Periods

Compound Interest

Most commonly used in practice

Total interest earned = P (1+i)n - P

Where

P : Present amount of money

i : interest rate

n : number of time periods

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Effective Annual
Interest Rate
The actual rate of interest
earned (paid) after adjusting
the nominal rate for number of
compounding periods per year.
Effective Interest Rate = ie = [1+i / m ] m --1
Thanks
Money Time
Relationships
Types of cash flows

Following types of cash flows

are generally witnessed
1. Single payment
2. Uniform annuity
3. Deferred annuity
4. Gradient series (increasing or
decreasing gradient)
 Notations

i = rate of interest
n = no. of compounding periods
P = Present sum of money
F = Future sum of money
A = Annuity amount
G = Gradient series
 Interest Formulae
Single Payment Relationship
Finding F when given P
F=P(1+i)n
The functional symbol is
F = P (F/P, i%, n )

Finding P when given F

P=F/(1+i)n
The functional symbol is
F
P = F (P/F, i%, n )

---
0 1 2 3 n

P 4
Uniform series (Annuity)
A series of uniform cash flow of amount A
occurring at the end of every period
Finding F when given A
F = A [ 1 + i n – 1] / i
The functional symbol is F = A (F/A, i%, n )
• Finding F when given A
P = A [ 1 + i n – 1] / i [ 1 + i n
The functional symbol is P = A (P/A, i%, n )

A A A A A

0 1 2 3 n
 Deferred Annuity
If cash flow begins at some later date,
the annuity is known as deferred annuity.
Here the annuity has been deferred by j
periods. The present worth at j period will
be equal to

Pj = A( P/A, i%, n-j)

The Present worth at time 0 will be

P0 = A(P/A, i%, n-j) ( P/F, i%, j)

A A A A A

0 1 2 J J+1 J+2 J+3 n-1 n

Gradient series (n-1)G
(n-2)G
3G
2G
G

0 1 2 3 4 n-1 n

1 n
A= G[ - n ]
𝑖 1+i −1

G 1+i n −1 nG
F= { }−
i i i
1 1+i n −1 n
P= G{ [ n − n ]}
i i 1+i 1+i
Comparison Among Alternatives

Commonly used comparison /

evaluation methods are

Present Worth Analysis

Annual Worth Analysis

Future Worth Analysis

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Comparison of alternatives

The projects to be compared may

have

Equal lives

Unequal lives
Perpetuities
Regular payments are made for
an infinite period of time i.e.
may be termed as infinite
annuity

There is no Future value of a

perpetuity as there is no end
point
Capitalised Cost
Capitalised cost refers to the present
worth of a project that is supposed to
last for ever (dams, railroads,
irrigation system etc.).

Capitalised cost = A / i

Where A is Equivalent uniform

annual worth through one life cycle
and i is the rate of interest
Thanks