ENGINEERING ECONOMICS
LECTURE 12-13
HUMA FAWAD
HITEC , TAXILA
SEPTEMBER 2015 – JANUARY 2016
1
Cost Accounting
Direct materials Selling expense
Direct Labor jobs Finished Cost of Total
(working in progress) goods inventory goods sold Expense
Factory Overheads Administrative expense
Accounting Equation
Assets = Liability + Owners Equity
Cash Short-term debt Capital Stock
Recievables Payables Retained Earnings
Inventories Long-term debt (income
earnings retained
in the firm)
Equipment
Buildings
Land
Cash Flows
i = effective interest rate per interest period
N = Number of compounding (interest) periods
P = Present Sum of money
F = Future Sum of money
A = End of Period Cash Flows
F = P (1 + i)N
Depreciation Concepts & Terminology
Depreciation is the decrease in value of physical properties with the passage
of time and use. More specifically, depreciation is an accounting concept
that establishes an annual deduction against before tax income such that the
effect of time and use on an asset's value can be reflected in a firm’s
financial statements.
Property is depreciable if it meets the following basic requirements.
1. It must be used in business or held to produce income.
2. It must have a determinable useful life and the life must be longer than
one year.
3. It must be something that wears out, decays, gets used up, becomes
obsolete or loses value from natural causes.
4. It is not inventory, stock in trade or an investment property.
Terminologies
Adjusted (cost) basis:
The original cost basis of the assets, adjusted by allowable increase or
decrease is used to compute depreciation deductions or additions
Unadjusted cost basis:
The initial value of acquiring an asset (purchase price + any sales tax)
including transportation expenses and other normal costs of making the
asset serviceable for its intended use; also called unadjusted cost basis.
Book Value (BV):
The original cost basis of the property, including any adjustments, less
all allowable depreciation deductions.
Market Value (MV):
The present value of what will be received through ownership of the
property.
Terminologies
Recovery Period:
The number of years over which the basis of the property is recovered
through accounting process.
Recovery rate:
A percentage (expressed in decimal form) for each year of the recovery
period which is applied for the deduction of depreciation.
Salvage Value:
The estimated value of a property at the end of its useful life. It is the
expected selling price of a property when the asset can no longer be
used.
Useful life:
The .expected (estimated) period that a property will be used in a trade
or business to produce income. It is not how long the property can last
but how long it can be used productively.
.
Depreciation Methods:
Straight Line (SL) Method:
SL Depreciation is the simplest depreciation method. .It assumes that a
constant amount is depreciated each year over the depreciable (useful)
life of the asset.
N = depreciable life of the asset in years
B = cost basis, including allowable adjsutments
d = annual depreciation deduction in year k (1<k<N)
k
BVk = book value at end of year k
SVN = estimated salvage value at end of year N
dk* = commutative depreciation through year k
dk = B – SVN / N
dk* = k. dk (1<k<N)
BVk = B - dk*
Other Depreciation Methods
Declining Balance (DB) Methods:
Constant Percentage Method; it is assumed that the annual cost of
depreciation is a fixed percentage of the BV at the beginning of the year.
The ratio of the depreciation in any one year to the BV at the beginning of
the year is constant throughout the life of the asset called R.
Units of Production Method:
Most depreciation methods determine depreciation on the basis of elapsed
time (function of time) while depreciation is mostly a function of use.
Depreciation per unit of production = B – SVN
Estimated lifetime Production units
Tax
Income Taxes contribute to major outflow of cash flow and are deducted as
per legalized Government rate and procedures.
Some taxes are directly related to Income producing capability while some
are not related to income and production.
Types of Taxes:
1. Income Tax: Assessed as function of gross revenues minus allowable
deductions. They are levied by the federal/state/municipal Governments.
Property Tax: Assessed as a function of the value of property owned such
as land, buildings, equipment and the applicable tax rate.
Sales Tax: Assessed on the basis of purchase of goods or services and
thus independent of gross income or profits. These add to the cost of
items and are applicable in Engg. Economy studies.
Excise Taxes: Assessed as a function of the sale of certain goods or
services often considered non-necessities and are often independent of
the income or profit of a business. This is usually charged to the
manufacturer or original provider of the goods or services, a portion of the
cost is passed on to the purchaser.
Taxable Income
Taxable Income = Gross Income – All expenses except
capital investments – Depreciation Deductions
Evaluating Economic Profitablity
Engineering Economy focuses on return that a given project
or capital investment will or should produce. Five methods for
evaluating the economic profitability of a single proposed
problem solutions (i.e alternatives):
1. PW - Present Worth
2. FW – Future Worth
3. AW – Annual Worth
4. IRR – Internal Rate of Return
5. ERR – External Rate of Return
1, 2, 3 Converts Cash Flows into their equivalent worth by using
interest rate known as MARR
4, 5 computes annual rate of profit or return resulting from an
investment and are then compared to MARR
TYPES OF PROJECTS
Private Public
Purpose Provide goods or services Protect health, protect
at a profit, maximize profit lives and property. Provide
or minimize costs services (at no profit)
provide jobs
Sources of Private Investors & Taxation; private lenders
Capital Lenders
Method of Individual Ownership; Direct Payment of Taxes,
Financing partnership, corporations Loans without interest;
loans at low interest; self
liquidating bonds; indirect
subsidies; guarantee of
private loans
Multiple Moderate Common (e.g. reservoir
Purposes project for flood control,
irrigation, drinking water,
electrical power,
recreation
Private Public
Project Life Usually Short (5-10 Usually Long (20 – 60
years) years)
Relationship of Direct Indirect or None
suppliers of
capital to capital
in projects
Nature of Benefits Monetary or relatively Often non monetary,
easy to equate to difficult to quantify ,
monetary terms difficult to equate to
monetary terms
Beneficiaries of Primarily early General Public
Project undertaking project
Conflict of Moderate Quite Common (dam
Purpose for flood control or
environment
protection
Private Public
Conflict of Moderate Very common
Interests (between agencies)
Effect of Politics Little to Moderate Frequent Factors,
short term tenure for
decision makers,
pressure groups,
financial and
residential
restrictions, etc
Measurement of Rate of Return on Capital Very Difficult, no
Efficiency direct comparison
with prvate projects
Project Cost Estimates
Labor
Materials
Subcontractors & Consultants
Equipment & Facilities Rental
Travel
Contingencies
Cost Control
Project cost control includes
monitoring cost performance
ensuring that only appropriate project changes are
included in a revised cost baseline
informing project stakeholders of authorized changes
to the project that will affect costs
Earned value analysis is an important tool for
cost control
The Gantt Chart and Progress Reporting
Time Now
Activity A Complete
Activity B Behind
Activity C Complete
Activity D Ahead
Activity E Behind
Activity F
Activity G
Activity H
The Need for Earned Value Analysis
cost progress
actual
budget
time now time now
time time
Over-budget Ahead of schedule
We need to be able to resolve this as we may be
• under-budget and ahead of schedule
• over-budget and ahead on schedule
• on budget and ahead of schedule
Cannot make management decisions until we know the status of the project
Earned Value Analysis (EVA)
EVA is a project performance measurement
technique that integrates scope, time, and
cost data.
(original plan plus approved changes), you
can determine how well the project is
meeting its goals
Earned Value Analysis Terms
Budgeted cost of work performed (BCWP), also called
earned value, is the percentage of work actually
completed multiplied by the planned cost
Budgeted cost of work scheduled (BCWS), also called
planned value, is that portion of the approved total cost
estimate planned to be spent on an activity during a
given period
Actual cost of work performed (ACWP), also called
actual cost, are the total direct and indirect costs
incurred in accomplishing work on an activity during a
given period
Earned Value Analysis--EVA
Earned value = Budgeted Cost of Work
Performed (BCWP)
Planned value = Budgeted Cost of Work
Scheduled (BCWS), and
Actual Cost = Actual Cost of Work Performed
(ACWP)
When you complete an activity, you earn the
budgeted value of that activity
Schedule Performance Index (SPI)
Defined as the ratio BCWP/BCWS
A value close to 1 indicates an activity
that is on schedule
Values greater than 1 suggest the activity
is ahead of schedule
Values less than 1 indicate a schedule
overrun
Cost Performance Index (CPI)
Defined as the ratio BCWP/ACWP
A value close to 1 indicates an activity
that is on budget
Values greater than 1 suggest the activity
is below budget
Values less than 1 indicate a budget
overrun
Cost Variance (CV)
Defined as the difference between the
budgeted cost of work performed and the
actual cost of work performed
= BCWP - ACWP
A positive CV indicates a lower actual cost
than budgeted for the control period, while a
negative CV indicates a cost overrun
Schedule Variance (SV)
Defined as the difference between the budgeted
cost of work performed and the budgeted cost of
work scheduled
= BCWP - BCWS
Indicates the deviation between the work
content performed and the work content
scheduled for the control period
Table Earned Value Formulas
Term Formula
Earned Value Budgeted Cost of Work Performed (BCWP) =
budgeted cost to date X % complete
Cost Variance CV=BCWP-ACWP (actual cost of work performed)
Schedule Variance SV=BCWP-BCWS (budgeted cost of work
scheduled)
Cost Performance Index CPI=BCWP/ACWP
Schedule Performance Index SPI = BCWP/BCWS
Earned Value Calculations for One
Activity
Activity
After Week One
Week 1 Week 2 Total % Complete EarnedValue
after Week 1 after Week 1
(BCWP)
Purchase web server 10,000 0 10,000 75% 7,500
Weekly Plan (BCWS) 10,000 0 10,000
Weekly Actual (ACWP) 15,000 5,000 20,000
Cost Variance (CV) -7,500
Schedule Variance (SV) -2,500
Cost Performance 50%
Index (CPI)
Schedule Performance 75%
Index (SPI)
Earned Value Calculations for One
Activity After Week One
Activity Week 1 Week 2 Total % Complete EarnedValue
after Week 1after Week 1
(BCWP)
Purchase web server 10,000 0 10,000 75% 7,500
Weekly Plan (BCWS) 10,000 0 10,000
Weekly Actual (ACWP) 15,000 5,000 20,000
Cost Variance (CV) -7,500
Schedule Variance (SV) -2,500
Cost Performance 50%
Index (CPI)
Schedule Performance 75%
Index (SPI)
Rules of Thumb for EVA Numbers
Negative numbers for cost and schedule
variance indicate problems in those areas.
The project is costing more than planned or
taking longer than planned
CPI and SPI less than 100% indicate
problems
Why Earned Value Analysis??
You can’t tell what your true cost variance is
because you don’t know where you are
relative to schedule
Suppose you are behind schedule but also you
have spent less than what the schedule has
called for. Are you really under budget?
Budgeted Cost of Work Performed
(BCWP) = Earned Value
Defined as the monetary value of the work actually
accomplished within the control period.
ACTIVITY BCWP
1 $12,000
2 $20,000
3 $25,000
CUMULATIVE $57,.000
Budgeted Cost of Work Scheduled
(BCWS)
Defined as the value of the work
scheduled to be accomplished in a given
period of time
ACTIVITY BCWS
1 $12,000
2 $30,000
3 $32,000
CUMULATIVE $74,000
Actual Cost of Work Performed (ACWP)
Defined as the cost actually incurred and
recorded in accomplishing the work performed
within the control period
ACTIVITY ACWP
1 $10,000
2 $25,000
3 $16,000
CUMULATIVE $51,000
Table Earned Value Formulas
Term Formula
Earned Value Budgeted Cost of Work Performed (BCWP) =
budgeted cost to date X % complete
Cost Variance CV=BCWP-ACWP (actual cost of work performed)
Schedule Variance SV=BCWP-BCWS (budgeted cost of work
scheduled)
Cost Performance Index CPI=BCWP/ACWP
Schedule Performance Index SPI = BCWP/BCWS
Let’s try it
For each of the activities in the examples
above, calculate
SCHEDULE VARIANCE
COST VARIANCE
Calculate cumulative schedule and cost
variance
Let’s try it
For each of the activities in the examples
above, calculate
SCHEDULE PERFORMANCE INDEX
COST PERFORMANCE INDEX
Calculate cumulative cost and schedule
performance indices
Answers to Schedule and Cost
Variance
Cumulative schedule variance =
-17,000
Cumulative cost variance = 6,000
Budgeted Cost
Total Budgeted Cost
Cumulative Budgeted Cost
Cumulative Actual Cost
Cumulative Earned Value
Cost Performance Index
CPI = Cumulative Earned Value
Cumulative Actual Cost
If CPI is below one – corrective action required
If CPI is above one – project is going with
economy/profit generating
Cost Variance
CV = CEV – CAC
Cost Forecast
Forecasted Cost at completion =Total Budgeted Cost
Cost Performance Index
FCAC = TBC
CPI
Forecasted Cost at completion = Cumulative
Actual Cost + Total Budgeted Cost –
Cumulative Earned Value
Benefit Cost Ratios with Present
Worth
Conventional Benefit Cost Ratio with PW
B-C= PW (Benefits of Proposed Project)
PW (Total Cost of the Proposed Project)
B-C= PW (B)
I – PW (MV) + P (O&M)
Modified Benefit Cost Ratio with PW
B-C= PW (B) – PW (O & M)
I – PW (MV)
Benefit Cost Ratio with Annual
Worth
Conventional Benefit Cost Ratio with AW
B-C= AW (Benefits of Proposed Project)
AW (Total Cost of the Proposed Project)
B-C= AW (B)
CR+ AW (O&M)
CR = Capital Recovery Per Annum
Modified Benefit Cost Ratio with PW
B-C= AW (B) – AW (O & M)
CR
Example
The city of Columbia is considering extending the runways of its municipal
airport so that commercial jets can use the facility. The land necessary for
runway extension is currently a farmland that can be purchased for
$350,000. Construction costs for the runway extension are projected to be
$600,000 and the additional annual maintenance costs for extension are
estimated to be $22500. If runways are extended, a small terminal will be
constructed at a cost of $250,000. The annual operating and maintenance
cost are estimated at $75,000. The projected increase in flights will require
the addition of two traffic controllers at an annual cost of $100,000. Annual
benefits of the runway extension have been estimated as follows:
$ 325,000 - Rental from airline leasing space
$65000 – Airport tax charged to passengers
$50,000 - Convinience benefits for residents of Columbia
$50,000 – Additional tourism benefits for Columbia
Study Period is 20 years and MARR is 10% per year to determine if runway
should be extended or not?
Conventional B-C (Here MV is considered negligible as expenditure
incurred in non refundable)
B-C= PW (Benefits of Proposed Project)
PW (Total Cost of the Proposed Project)
= $490,000 (P/A 10%, 20)
$1,200,000 + $ 197000
(by using Interest and Annuity Tables for discrete
compounding)
= 1.448 > 1 (therefore extend runways)
Assignment 3 – Presentation/Video
Clip
Coming Economic Disaster prediction and reasons
Current Economic Threats Globally - Unemployment
Current Economic Threats Globally – Deflation of Euro currency
Global Economic Challenges – Energy & Environmental Security
Global Economic Challenges – Water is the new Oil
Pakistan Economy 2015
Drivers of Economic Growth
Macro Driver – Increase of Export
Micro Driver – Human Driver
Micro Driver – Information and Communication Technology
Micro Driver – Innovation & entrepreneurship are key elements of competitiveness
Economic Problems of Pakistan and their solutions
Economic Problems due to war on terror
Load shedding issue and its effect on economy
Poorly managed Tax system
Inflation
Low Export & High Imports
Low Tourism
Successful Economic Models
Malaysian Model
Denmark Model
Chinese Model
Any TED Talk
