ENGINEERING ECONOMIC ANALYSIS

THIS IS ABOUT MAKING DECISIONS. DECISION MAKING IS QUITE A

BROAD TOPIC, FOR IT IS A MAJOR ASPECT OF EVERY DAY HUMAN
EXISTENCE.

EVEN VERY COMPLEX SITUATIONS CAN BE BROKEN DOWN INTO

COMPONENTS FROM WHICH SENSIBLE SOLUTIONS ARE PRODUCED.
IF ONE UNDERSTANDS THE DECISION-MAKING PROCESS AND HAS
TOOLS FOR OBTAINING REALISTIC COMPARISONS BETWEEN
ALTERNATIVES, ONE CAN EXPECT TO MAKE BETTER DECISIONS.

FOCUS ON SOLVING PROBLEMS THAT CONFRONT FIRM IN THE

MARKETPLACE.
ONE APPROACH TO CLASSIFICATION WOULD BE TO
ARRANGE PROBLEMS BY THEIR DIFFICULTY

A SIMPLE PROBLEM COULD BE, “SHALL I HAVE TOAST FOR

BREAKFAST?” OR,”SHALL WE REPLACE A BURN-OUT
MOTOR?” OR,”SHALL I STOP SMOKING?”

AN INTERMEDIATE PROBLEM MIGHT BE,”SHOULD A MANUAL

OR SEMI-AUTOMATIC MACHINE BE PURCHASED FOR THE
FACTORY?” OR,”SHALL I BUY OR LEASE MY NEXT CAR?”

A COMPLEX PROBLEM MIGHT BE,”HOW SHOULD THE U.S.

GOVERMENT BUDGET ITS MONEY?”
THE ROLE OF ENGINEERING ECONOMIC ANALYSIS

WE MAY GENERALIZE BY SAYING THAT THE PROBLEMS MOST

SUITABLE FOR SOLUTION BY ENGINEERING ECONOMIC ANALYSIS
HAVE THESE QUALITIES:
1. THE PROBLEM IS SUFFICIENTLY IMPORTANT THAT WE ARE
JUSTIFIED IN GIVING IT SOME SERIOUS THOUGHT AND EFFORT
2. THE PROBLEM CAN’T BE WORKED IN ONE’S 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.
3. THE PROBLEM HAS ECONOMIC ASPECTS THAT ARE SUFFICIENTLY
IMPORTANT TO BE A SIGNIFICANT COMPONENT OF THE
ANALYSIS LEADING TO A DECISION
SOME OF THE PROBLEMS LISTED BELOW WOLUD BE
SUITABLE FOR SOLUTION BY ENGINEERING ECONOMIC
ANALYSIS. WHICH ONES ARE THEY?
1. WOULD IT BE BETTER TO BUY AN AUTOMOBILE WITH A DIESEL
ENGINE OR A GASOLINE ENGINE?
2. SHOULD AN AUTOMATIC MACHINE BE PURCHASED TO REPLACE
THREE WORKERS NOW DOING A TASK BY HAND?
3. WOULD IT BE WISE TO ENROLL FOR AN EARLY MORNING CLASS
SO YOU COULD AVOID TRAVELLING DURING THE MORNING
TRAFFIC RUSH HOURS?
4. WOULD YOU BE BETTER OFF IF YOU CHANGED YOUR MAJOR TO
ELECTRICAL ENGINEERING?
5. ONE OF THE PEOPLE YOU MIGHT MARRY HAS A JOB THAT PAYS
VERY LITTLE MONEY, WHILE ANOTHER ONE HAS A PROFESSIONAL
JOB WITH AN EXCELLENT SALARY. WHICH ONE SHOULD YOU
MARY?
THE DECISION MAKING PROCESS—RATIONAL DECISION MAKING

RATIONAL DECISION MAKING IS A COMPLEX PROCESS THAT

CONTAINS A NUMBER OF ESSENTIAL ELEMENTS, ALTHOUGH
SOMEWHAT ARBITRARY, WE DEFINE THE RATIONAL DECISION
MAKING IN TERM OF EIGHT STEPS:
1. RECOGNITION OF A PROBLEM
2. DEFINITION OF THE GOAL OR OBJECTIVE
3. ASSEMBLY OF RELEVANT DATA
4. IDENTIFICATION OF FEASIBLE ALTERNATIVES
5. SELECTION OF THE CRITERION FOR JUDGING WHICH IS THE BEST ALTERNATIVE
6. CONSTRUCTION OF THE INTERRELATIONSHIPS BETWEEN THE OBJECTIVE,
ALTERNATIVES, DATA, AND THE CRITERION
7. PREDICTION OF THE OUTCOMES FOR EACH ALTERNATIVE; AND,
8. CHOICE OF THE BEST ALTERNATIVE TO ACHIEVE THE OBJECTIVE
9. POST AUDIT OF RESULT
SELECTION OF A CRITERION TO DETERMINE THE BEST ALTERNATIVE
THERE MUST BE A CRITERION , OR SET OF CRITERIA, FOR JUDGING
WHICH ALTERNATIVE IS BEST. IT IS ON ONE END OF A SPECTRUM
THAT MIGHT READ:
WORST BAD FAIR GOOD BETTER BEST
THERE MUST BE AN UNLIMITED NUMBER OF WAYS THAT ONE MIGHT
JUDGE THE VARIOUS ALTERNATIVES. SEVERAL POSSIBLE CRITERIA
ARE:
• CREATE THE LEAST DISTURBANCE TO THE ECOLOGY
• IMPROVE THE DISTRIBUTION OF WEALTH AMONG PEOPLE
• USE MONEY IN WAYS THAT ARE ECONOMICALLY EFFICIENT
• MINIMIZE THE EXPENDITURE OF MONEY
• ENSURE THAT THE BENEFITS TO THOSE WHO GAIN FROM THE DECISION ARE
GREATER THAN THE LOSSES WHO ARE HARMED BY THE DECISION
• MINIMIZE THE TIME TO ACCOMPLISH THE GOAL OR OBJECTIVE
• MINIMIZE UNEMPLOYMENT
CRITERIA FOR JUDGING ALTERNATIVE
ALL ECONOMIC ANALYSIS PROBLEMS FALL INTO ONE OF THREE
CATEGORIES:
1. FIXED INPUT.
THE AMOUNT OF MONEY OR OTHER INPUT RESOURCES (LIKE LABOR, MATERIALS,
OR EQUIPMENT) ARE FIXED. THE OBJECTIVE IS TO EFFECTIVELLY UTILIZE
THEM. EXAMPLES:
A PROJECT ENGINEER HAS A BUDGET OF $350,000 TO OVERHAUL A PORTION OF
PETROLIUM REFINERY
YOU HAVE $ 100 TO BUY CLOTHES FOR THE START OF SCHOOL
FOR ECONOMIC EFFICIENCY, THE APPROPRIATE CRITERION IS TO MAXIMIZE THE
BENEFITS OF OTHER OUTPUTS
2. FIXED OUTPUT.
THERE IS A FIXED TASK (OR OTHER OUTPUT OBJECTIVES OR RESULTS) TO BE
ACCOMPLISHED. EXAMPLES:
A CIVIL ENGINEERING FIRM HAS BEEN GIVEN THE JOB TO SURVEY A TRACK OF
LAND AND PREPARE A “RECORD OF SURVEY” MAP
YOU WISH TO PURCHASE A NEW CAR WITH NO OPTIONAL EQUIPMENT
THE ECONOMICALLY EFFICIENT CRITERION FOR A SITUATION OF FIXED OUTPUT IS
TO MINIMIZE THE COST OR OTHER INPUTS
3. NEITHER INPUT NOT OUTPUT FIXED.
THE THIRD CATEGORY IS THE GENERAL SITUATION WHERE NEITHER THE AMOUNT
OF MONEY OR OTHER INPUTS, NOR THE AMOUNT OF BENEFITS OR OTHER
OUTPUTS ARE FIXED. EXAMPLES
A CONSULTING ENGINEERING FIRM HAS MORE WORK AVAILABLE THAN IT CAN
HANDLE. IT IS CONSIDERING PAYING THE STAFF FOR WORKING EVENINGS TO
INCREASE THE AMOUNT OF DESIGN WORK IT CAN PERFORM
AN AUTOMOBILE BATTERY IS NEEDED. BATTERIES ARE AVAILABLE AT DIFFERENT
PRICES, AND ALTHOUGH EACH WILL PROVIDE THE ENERGY TO START THE
VEHICLE, THEIR USEFUL LIVES ARE DIFFERENT.
WHAT SHOULD BE THE CRITERION IN THIS CATEGORY ? OBVIOUSLY, WE WANT TO
BE AS ECONOMICALLY EFFICIENT AS POSSIBLE. THIS WILL OCCUR WHEN WE
MAXIMIZE THE DIFFERENT BETWEEN THE RETURN FROM THE INVESTMENT
(BENEFITS) AND THE COST THE INVESTMENT. SINCE THE DIFFERENT BETWEEN
THE BENEFITS AND THE COSTS IS SIMPLY PROFIT, A BUSINESSPERSON WOULD
DEFINE THIS CRITERION AS MAXIMIZING PROFIT.
COMPUTING CASH FLOWS

IN THE EXAMPLES PRESENTED SO FAR, WE HAVE SELECTED THE

LEAST-COST ALTERNATIVE TO MEET A SPECIFICATION OR
REQUIREMENT OR SAVINGS HAVE BEEN OBTAINED IN A SHORT
PERIOD OF TIME.
THERE ARE OTHER SITUATIONS WHERE THE ALTERNATIVES HAVE
DIFFERENT CONSEQUENCES (COSTS AND BENEFITS) THAT
CONTINUE FOR AN EXTENDED PERIOD OF TIME.
IN THESE CIRCUMSTANCES, WE DO NOT ADD UP THE VARIOUS
CONSEQUENCES; INSTEAD, WE DESCRIBE EACH ALTERNATIVE AS
CASH RECEIPTS OR DISBURSEMENTS AT THE POINT IN TIME.
IN THIS WAY, EACH ALTERNATIVE IS RESOLVED INTO A CASH FLOW.
THIS IS ILLUSTRATED BY EXAMPLES BELLOW
THE MANAGER HAS DECIDED TO PURCHASE A NEW $ 30,000
MIXING MACHINE. THE MACHINE MAY BE PAID FOR BY ONE OF
TWO WAYS:
1. PAY THE FULL PRICE NOW MINUS A 3% DISCOUNT.
2. PAY $ 5000 NOW; AT THE END OF ONE YEAR, PAY $ 8000; AT THE
END OF FOUR SUBSEQUENT YEARS, PAY $ 6000 PER YEAR.
LIST THE ALTERNATIVES IN THE FORM OF A TABLE CASH FLOWS

A MAN BORROWED $ 1000 FROM A BANK AT 8% INTEREST. HE

AGREED TO REPAY THE LOAN IN TWO END-OF-YEAR PAYMENTS.
AT THE END OF THE FIRST YEAR, HE WILL REPAY HALF OF THE $
1000 PRINCIPAL AMOUNT PLUS THE INTEREST THAT IS DUE. AT
THE END OF THE SECOND YEAR, HE WILL REPAY THE
REMAINING HALF OF THE PRINCIPAL AMOUNT PLUS THE
INTEREST FOR THE SECOND YEAR. COMPUTE THE BORROWER’S
CASH FLOW
 EQUIVALENCE AND COMPOUND INTEREST
WE CREATE A CASH FLOW TABLE TO SHOW THE VARIOUS RECEIPTS
AND DISBURSEMENTS OF MONEY AND THEIR TIMING.
WE WILL BE ABLE TO COMPARE THE VALUE OF MONEY AT DIFFERENT
DATES, THIS IS ESSENTIAL TO ENGINEERING ECONOMIC ANALYSIS
THROUGH THE EQUIVALENCE RELATIONSHIP, WE WILL BE ABLE TO
RELATE A PRESENT SUM OF MONEY TO FUTURE SUM
IF THE CURRENT INTEREST RATE IS 9% PER YEAR; AND YOU PUT $ 100
IN TO THE BANK FOR ONE YEAR, HOW MUCH YOU WILL RECEIVE
BACK AT THE END OF THE YEAR? YOU WILL RECEIVE THE ORIGINAL
$ 100 TOGETHER WITH $ 9 INTEREST, FOR A TOTAL OF $ 109
THIS EXAMPLE DEMONSTRATES THE TIME PREFERENCE FOR MONEY
THIS IS BECAUSE THERE IS A TIME VALUE OF MONEY IN THE FORM
OF THE WILLINGNESS OF BANKS, BUSINESSES, AND PEOPLE TO PAY
INTEREST FOR THE USE OF MONEY.
 REPAYING DEBT
FOUR PLAN FOR REPAYMENT OF $ 5000 IN FIVE YEARS WITH
INTEREST AT 8%
PLAN 1
AT END OF EACH YEAR PAY $ 1000 PRINCIPAL PLUS INTEREST DUE

PLAN 2
PAY INTEREST DUE AT END OF EACH YEAR AND PRINCIPAL AT END
OF FIVE YEAR

PLAN 3
PAY IN FIVE EQUAL END-OF YEAR PAYMENTS

PLAN 4
PAY PRINCIPAL AND INTEREST IN ONE PAYMENT AT END OF FIVE
YEARS
 COMPOUND INTEREST
TO FACILITATE EQUIVALENCE COMPUTATIONS, A SERIES OF INTEREST
FORMULAS WILL BE DERIVED
TO SIMPLIFY THE PRESENTATION, WE’LL USE THE FOLLOWING
NOTATION:
i = INTEREST RATE PER INTEREST PERIOD. ( % OR DECIMAL)
n = NUMBER OF INTEREST PERIODS
P = A PRESENT SUM OF MONEY
F = FUTURE SUM OF MONEY. THE FUTURE SUM F IS AN AMOUNT, n
INTEREST PERIODS FROM THE PRESENT, THAT IS EQUIVALENT TO P
WITH INTEREST RATE i
A = AN END-OF-PERIOD CASH RECEIPT OR DISBURSEMENT IN A
UNIFORM SERIES, CONTINUING FOR n PERIODS, THE ENTIRE
SERIES EQUIVALENT TO P OR F AT INTEREST RATE i