Engineering Economics

and Costing

By: Yalelet T.
 CHAPTER ONE
Introduction to Engineering
Economics and Time Value of Money
CHAPTER OUTLINES
 Differentiate Engineering Economics ,Economics and costing
 Time value of money
 Simple and Compound interest rate
 Cash flow terms and diagram
 Compound interest factors
1.INTRODUCTION
1.1 Economics, Engineering Economics and costing

 Economics is the social science that describes the factors that

determine the production, distribution and consumption of
goods and services.
 Engineering economy is a subset of economics for the
application to engineering projects.
 it involves formulating, estimating, and evaluating the
economic outcomes when alternatives to accomplish a
defined purpose are available.
 Costing is the proposed or estimated cost of producing or
undertaking something/an estimate of all the costs involved
in a project or a business venture.
1.2.Time Value of Money(TVM)
 It is changed in amount of money over a period of time .
If a person invests his money today in bank savings, by
next year he will definitely accumulate more money than
his investment. This accumulation of money over a
specified time period is called as time value of money.
 Similarly, if a person borrows some money today, by
tomorrow he has to pay more money than the original
loan. This is also explained by time value of money.
 The time value of money is generally expressed by
interest amount. The original investment or the borrowed
amount (i.e. loan) is known as the principal.
 Cont.…
The sooner receives money is better than the future,
Because:
1. the future is uncertain and involves risk
2. The present is urgent compared to the future
3. Postponing money means postponing consumption
 The amount of interest indicates the increase between
principal amount invested or borrowed and the final
amount received or owed.
Generally, Interest is the cost of using capital as well as the
reward of parting with one’s liquidity (saved money).
Cont.…
 In case of an investment made in the past, the total
amount of interest accumulated till now is given by;
 Amount of interest = Total amount to be received –
original investment (i.e. principal amount)
 Similarly, in case of a loan taken in past, the total
amount of interest is given by;
 Amount of interest = Present amount payable/owed –
original loan (i.e. principal amount)
 In both the cases there is a net increase over the amount
of money that was originally invested or borrowed.
Cont.…
Example: A person deposited 100,000 birr in a bank for one year and
got 110,000 birr at the end of one year. Find out the total amount of
interest and the rate of interest per year on the deposited money.
 Similarly, if a person borrowed 150,000 for one year and returned
back 162,000 at the end of one year.
The total amount of interest gained over one year = 110,000 -
100,000 =10,000
The rate of interest ‘i’ per year is given by:
i (%) = *100 =10%

The total amount of interest paid = 162,000 - 150,000 = 12,000

i (%) = *100 =8%
Cont.…
 When the interest amount is expressed as the percentage
of the original amount per unit time, the resulting
parameter is known as the rate of interest and is
generally designated as “I”.
 Interest rate is said to be the earning power of money.
 The time period over which the interest rate is expressed
is known as the interest period. The interest rate is
generally expressed per unit year. However, in some
cases the interest rate may also be expressed per unit
month. We are familiar with two types of interest rates
1. simple interest rate and
2. compound interest rate.
1.3. Simple and Compound Interest rate
 The interest is said to simple, when the interest is
charged only on the principal amount for the interest
period. No interest is charged on the interest amount
accrued during the preceding interest periods. In case of
simple interest, the total amount of interest accumulated
for a given interest period is simply a product of the
principal amount, the rate of interest and the number of
interest periods.
 Interest is calculated using principal only Interest =
(principal) (number of periods) (interest rate).
I = P.n.i
1.4 Compound Interest

 Interest is based on principal plus all accrued/added

interest That is, interest compounds over time Interest =
(principal + all accrued interest) (interest rate).
 Interest for time period t is

It = (P + ) (i)

Apart from these two interest rates, some other interest

rates which are used in economic evaluation of projects
are:
Cont.…
Example: A person has taken a loan of amount of 10,000 birr from a bank for a period of 5 years.
Estimate the amount of money, the person will repay to the bank at the end of 5 years for the
following cases;
a) Considering simple interest rate of 8% per year
b) Considering compound interest rate of 8% per year.
a) Considering the simple interest @ 8% per year;
I = P.i.n
The interest for each year =10,000* 0.08 =800
Total amount owed at the end of 1st year = 10,000 +800 =10,800
Total amount owed at the end of 2nd year = 10,800 + 800 =11,600

b) Considering the compound interest @ 8% per year;

It = (P + ) (i)
The amount of interest and the total amount owed at the end of each year, considering compound interest.
Amount of interest accumulated at the end of 1st Year = 10,000*0.08 = 800
Total amount owed at the end of 1st Year 10,000 + 800 =10,800
Amount of interest accumulated at the end of 2nd Year = 10,800*0.08 = 864
Total amount owed at the end of 2nd Year 10,800 + 864 =11,664
cont.…
1.nominal interest rate,
2.effective interest rate, and
3.continuous effective interest rate.
1.Nominal interest rate is an annual interest rate which is a
product of interest rate per period and number of periods
in a year.
2.Effective interest rate (ieff) is the interest rate that is
actually earned or paid on an investment, loan or other
financial product due to the result of compounding over a
given time period.
Cont.…
 When interest rate is nominal one, then ieff =

 When m ∞, this effective interest rate becomes a

continuous one.
 Lim m ∞ ieff = lim m
∞

known as continuous effective interest rate

Cont.…

Example: If a savings bank pays 1.5% interest every three

months, what are the nominal and effective interest rates
per year?
Number of periods per year = 4
Nominal interest rate per year, r = number of periods/year*interest rate /period
= 4 x 1.5% = 6%
Effective interest rate per year, i eff =-1
=
=0.061= 6.1%
1.5. Quantifying alternatives for decision making:

 Quantifying alternatives for any item is the most

important aspect of decision making for selecting the
best option. For example, a construction company is
planning to purchase a new concrete mixer for preparing
concrete at a construction site.
 Let’s say there are two alternatives available for
purchasing the mixer;
a) an automatic concrete mixer and
b) a semi-automatic concrete mixer, Then the task is to
find out best alternative that the company will purchase
that will yield more profit
Cont...
 For this purpose, one has to quantify both the
alternatives by the following parameters;
 The initial cost that includes purchase price, sales tax,
cost of delivery and cost of assembly and installation.
 Annual operating cost.
 Annual profit which will depend on the productivity i.e.
quantity of concrete prepared.
 The expected useful life.
 The expected salvage value.
Cont.…
 Other expenditure or income (if any) associated with the
equipment.
 Income tax benefit
 Then on the basis of the economic criteria, the best
alternative is selected by calculating the present worth
or future worth or the equivalent uniform annual worth
of both alternatives by incorporating the appropriate
interest rate per year and the number of years (i.e. the
comparison must be made over same number of years
for both alternatives).
Cont.…
 Then the concrete mixer with least cost or higher net
income is considered for purchase. In addition to
economic parameters as mentioned above, the non-
economic parameters namely environmental, social, and
legal and the related regulatory and permitting process
must also be considered for the evaluation and selection
of the best alternative.
Cont.…
 These non-economic parameters are essentially required
(in addition to the economic factors) for the selection of the
best alternative for the infrastructure and heavy
construction projects like dams, bridges, roadways etc. and
other publicly and privately funded projects namely office
buildings, hospitals, apartment building and shopping
malls etc.
 When the available alternatives exhibit the same equivalent
cost or same net income, then the non-economic
parameters may play a vital role in the selection of the best
alternative. It may be noted here that the non-economic
parameters cannot be expressed in numerical values.
1.6 Cash Flow terms:

 Cash Inflows – Revenues (R), receipts, incomes,

savings generated by projects and activities that flow in.
Plus, sign used
 Cash Outflows – Disbursements (D), costs, expenses,
taxes caused by projects and activities that flow out.
Minus sign used.
 Net Cash Flow (NCF) for each time period
 NCF = cash inflows – cash outflows = R –D
1.7. Cash flow diagram
 The graphical representation of the cash flows i.e. both
cash outflows and cash inflows with respect to a time
scale is generally referred as cash flow diagram.
 The cash flows are generally indicated by vertical
arrows on the time scale as shown in Fig. 1.1.
 The cash outflows (i.e. costs or expense) are generally
represented by vertically downward arrows whereas the
cash inflows (i.e. revenue or income) are represented by
vertically upward arrows.
Cont.…
 In the cash flow diagram, number of interest periods is
shown on the time scale.
 The interest period may be a quarter, a month or a year.
Since the cash flows generally occur at different time
intervals within an interest period, for ease of
calculation, all the cash flows are assumed to occur at
the end of an interest period.
Cont.…

In Fig. 1.1 the cash outflows are Rs.100000, Rs.15000 and Rs.25000 occurring at end of year (EOY), 0 i.e. at the beginning, EOY 4 and EOY 7 respectively. Similarly, the cash inflows Rs.35000, Rs.80000 and Rs.45000 are occurring at EOY 3, EOY 6 and EOY 10 respectively.

 Thus in Fig. 1.1, the numbers on the time scale represent

the end of year (EOY).
End of year 1 35000 80000 45000
Cash inflow

End of year 10

Time 0 1 2 3 4 5 6 7 8 9 10

Year 1 Year 7

Cash outflow 1 00000 15000 25000

Fig 1.1 cash flow diagram

Cont.…

Fig 1.2 cash inflow and outflow

1.7.1 Cash flow transactions
Cash flow transactions are of five types,
A) Single cash flow
B) Uniform series cash flows are:
 uniform series present worth factor
 uniform series compound factor
 Capital recovery factor, and
 Sinking fund factor

C) Linear Gradient series

D) Geometric gradient series and
E) Irregular series
1.8.Compound interest factors
 The compound interest factors and the corresponding
formulas are used to find out the unknown amounts at a
given interest rate continued for certain interest periods
from the known values of varying cash flows. The
following are the notations used for deriving the
compound interest factors.
 P = Present worth or present value
 F = Future worth or future sum
Cont.…
 A = Uniform annual worth or equivalent uniform annual
worth of a uniform series continuing over a specified
number of interest periods.
 n = number of interest periods (years or months) , and
 i = rate of interest per interest period i.e. % per year or
% per month
 Unless otherwise stated, the rate of interest is compound
interest and is for the entire number of interest periods
i.e. for “n” interest periods.
Cont.…
 The present worth (P), future worth (F) and uniform
annual worth (A) are shown in Fig. 1.3.
 In this figure the present worth, P is at the beginning
and the uniform annual series with annual value “A”
is from end of year 1 till end of year 5. Both “P” and
“A” are cash outflows. It may be noted that the
uniform annual series with annual value “A” may be
also continued throughout the entire interest periods
i.e. from beginning till end of year 10 or for some
intermediate interest periods like commencing from
end of year 3 till end of year 8.
Cont.…
 The future worth “F” is occurring at end of year 4 (cash
outflow), at end of year 6 (cash inflow) and at the end of
year 10 (cash inflow).
F

0 1 2 3 4 5 6 7 8 9 10

P
F
A = Uniform annual worth
from EOY „1‟ till EOY „5”
Fig 1.3 Cash flow diagram showing P, F and A
Cont.…
 While deriving the different compound interest factors,
it is assumed that the interest is compounded once per
interest period i.e. discrete compounding. Further the
cash flows are assumed to be discrete i.e. they occur at
the end of interest period.
A. Single payment compound amount factor
(SPCAF)
 The single payment compound amount factor is used to
compute the future worth (F) accumulated after “n”
years from the known present worth (P) at a given
interest rate ‘i’ per interest period.
 It is assumed that the interest period is in years and the
interest is compounded once per interest period.
 The known present worth (P), unknown future worth
(F) and the total interest period “n” years are shown in
Fig. 1.4.
Cont.…
End of year F = unknown

0 1 2 3 4 5 n-4 n-3 n-2 n-1 n

P = known

Fig 1.4 Cash flow diagram for ‘known P’ and ‘unknown F’

 The future worth (F1) accumulated at the end of year 1

i.e. 1st year is given by;
……………………. (equa1)
F1 =P(1+i)
Cont.…
 The future worth accumulated at the end of year 2:

………. (equa2)
 Thus, the generalized formula for the future worth at the
end of “n” years is given by:
…………………………(equa3)
 The factor in equation (3) is known as the single
payment compound amount factor (SPCAF).
Cont.…
Example: A sum of money $5,000 is deposited in a project account
and left there to earn interest for 15 years. if the interest per year is
12%,how much the compounding amount after 15 years?
Given required
P =$5,000 F =?
n =15 years F = $5,000
i = 12% = $27,367.85
B. Single payment present worth factor
(SPPWF):
 The single payment present worth factor is used to
determine the present worth of a known future worth (F)
at the end of “n” years at a given interest rate ‘i’ per
interest period.
 The present worth (P), future worth (F) and the total
interest period “n” years are shown in Fig. 1.5.
Cont.…
 The expression for the present worth (P) can be written
as follow:
P = F()

End of year F = known

( EOY )

0 1 2 3 4 5 n -4 n -3 n -2 n -1 n

P = unknown
Fig 1.5 Cash flow diagram for ‘known F’ and ‘unknown P’
Cont.…
 The factor () is known as single payment present worth
factor (SPPWF). Thus if future worth (F) at the end of
“n” years is known, the present worth (P) at interest rate
of “i” (per year) can be calculated by multiplying the
future worth with the single payment present worth
factor.
Cont.…

Example: Suppose it is estimated that $15,000 would be needed to

complete the implementation of a project five years from now, how
much should be deposited in a special project fund now so that the
fund would accrue to the required $15,000 exactly five years from
now? If the special project fund pays interest at 9.2% per year.
Given required
F =$15,000 P =? P = F()
n =5 years P = $15,00()
i = 9.2% P = $9,660.03
C. Uniform series present worth factor
(USPWF):

 The uniform-series present worth factor is used to

determine the present worth of a known uniform series
with uniform amount “A”. Let “A” be the uniform
annual amount at the end of each year, beginning from
end of year “1” till end of year “n”.
 The known “A”, unknown “P”, and the total interest
period “n” years are shown in Fig. 1.6.
 This cash flow diagram refers to the case; if a person
wants to get the known uniform amount of return every
year, how much he has to invest now.
Cont.…
 The present worth (P) of the uniform series can be
calculated by considering each “A” of the uniform
series as the future worth.
A = known

0 1 2 3 4 5 n -4 n -3 n -2 n -1 n

End of year ( EOY )

P = unknown

Fig 1.6 Cash flow diagram for ‘known A’ and ‘unknown P’

Cont.…
 The present worth (P) of the uniform series is given by;
P= +
P =A[ ++….+]
The simplification of equation results in the following
expression;
P = A []
Cont.…

Example: Suppose the sum of $12,000 must be withdrawn from an

account to meet the annual operating expenses of a multi-year project.
The project account pays interest at 7.5% per year compounded on an
annual basis. If the project is expected to last ten years, how much must
be deposited in the project account now so that the operating expenses
of $ 12,000 can be withdrawn at the end of every year for ten years?
The project fund is expected to be depleted to zero by the end of the
last year of the project. The first withdrawal will be made one year after
the project account is opened, and no additional deposits will be made
in the account during the project life cycle.
Given required
A =$12,000 P =? P = A []
i = 7.5% P = $12,000[
n =10 years P =$82,368.92
D. Capital recovery factor (CRF)

 The capital recovery factor is generally used to find out

the uniform annual amount “A” of a uniform series from
the known present worth at a given interest rate ‘i’ per
interest period.
 The cash flow diagram is shown in Fig. 1.7. This cash
flow diagram indicates, if a person invests a certain
amount now, how much he will get as return by an equal
amount each year.
 Cont.…
A = unknown

0 1 2 3 4 5 n -4 n -3 n -2 n -1 n

End of year ( EOY )

P = known

Fig 1.7 Cash flow diagram for ‘known P’ and ‘unknown A’

A = P [] is the general equations for capital recovery

factors.
Cont.…

Example: Suppose a piece of equipment needed to launch a project

must be purchased at a cost of $50,000. The entire cost is to be
financed at 13.5% per year and repaid on a monthly installment
schedule over four years. It is desired to calculate what the monthly
loan payments will be. It is assumed that the first loan payment will
be made exactly one month after the equipment is financed. If the
interest rate of 13.5% per year is compounded monthly.
Given required
P =$50,000 A =? A = P []
i = 13.5% = $50,000[]
n = 4 years = $1,353.82
Therefore, the interest rate per month = =1.125% per month.
The number of interest periods over which the loan will be repaid is 4(12) = 48 months.
E. Uniform series compound amount factor:
The uniform series compound amount factor is used to
determine the future sum (F) of a known uniform annual
series with uniform amount “A”. The cash flow diagram is
shown in Fig. 1.8. This cash flow diagram states that, if a
person invests a uniform amount at the end of each year
continued for “n” years at interest rate of “I” per year, how
much he will get at the end of “n” years.
F =A [] is general formula for USCAF
EOY F = unknown

1 2 3 4 5 n-4 n-3 n-2 n-1 n

A = known
Cont.…
Example: If equal end-of-year deposits of $5000 are made to a
project fund paying 8% per year for ten years. How much can be
expected to be available for withdrawal from the account for capital
expenditure immediately after the last deposit is made?
Given required
A =$5,000 F =? F = A []
i = 8% F = $5,000[
n =10 years F =$72,432.50
F. Sinking fund factor(SFF):

 The sinking fund factor is used to calculate the annual

amount “A” of a uniform series from the known future
sum “F”. The cash flow diagram is shown in Fig. 1.9.
 This cash flow diagram indicates that, if a person wants
to get a known future sum at the end of “n” years at
interest rate of “i” per year, how much he has to invest
every year by an equal amount.
A = F[ ] is general formula for SSF F = known

EOY
1 2 3 4 5 n-4 n-3 n-2 n-1 n

A=unknown
Cont.…
Example: How large are the end-of-year equal amounts that must be
deposited into a project account so that a balance of $75,000 will be
available for withdrawal immediately after the twelfth annual
deposit is made? The initial balance in the account is zero at the
beginning of the first year. The account pays 10% interest per year.
Given required
F =$75,000 A =? A = F []
i = 10% = $75,000[]
n = 10 years = $3,507.25
G. Cash flow involving arithmetic gradient payments or
receipts:

 Some cash flows involve the payments or receipts in gradients by

same amount. In other words, the expenditure or the income
increases or decreases by same amount. The cash flow involving
such payments or receipts is known as uniform gradient series.
 For example, if the cost of repair and maintenance of a piece of
equipment increases by same amount every year till end of its
useful life, it represents a cash flow involving positive uniform
gradient. Similarly if the profit obtained from an investment
decreases by an equal amount every year for a certain number of
years, it indicates a cash flow involving negative uniform gradient.
 The cash flow diagrams for positive gradient and negative gradient
are shown in Fig. 1.3 and Fig. 1.4 respectively.
Cont.…
End of year (EOY)

0 1 2 3 4 5 6 7 8 9 10

5000* 6000 7000 8000 9000 10000

11000
12000 13000
14000

Fig 1.13 Cash flow diagram involving a positive uniform gradient

End of year (EOY)

0 1 2 3 4 5 6 7 8 9 10

16000 14000 12000

20000 18000
26000 24000 22000
30000* 28000
Fig 1.13 Cash flow diagram involving a negative uniform gradient
 Arithmetic Gradient

 Decompose the cash flows into a uniform series and a

pure gradient. Then add or subtract the Present Value of
the gradient to the Present Value of the Uniform series.

F = uniform series + Pure gradient

P = uniform series + Pure gradient

Cont.…
Cont.…
Cont.…
Example: The cost of supplies for a 10-yr project increases by
$1,500 every year starting at the end of year two. There is no
supplies cost at the end of the first year. If interest rate is 8% per
year, determine the present amount that must be set aside at time
zero to take care of all the future supplies expenditures.
Given required
G =$1,500 P=? P=G[]*
i = 8% P = $1,500[*
n =10 years P =$38,965.20
G. Cash flow involving geometric gradient series:
 Sometimes the cash flows may have expenses or
incomes being increased by a constant percentage in the
successive time periods i.e. in successive years. Such
kind of cash flow is known as geometric gradient series.
The generalized cash flow diagram involving geometric
gradient series with expense or receipt “C” or amount
“A” at the end of year “1” and geometric percentage
increase “g” is shown below.
End of year (EOY)
P = unknown

1 2 3 4 5 n -4 n -3 n -2 n -1 n

C C(1 + g) C(1+g ) 2 3
C(1+g) 4
C(1+g) n -5
C(1+g) n -4 n -3
C(1+g) C(1+g) n -2 n -1
C(1+g) C(1+g)
  GEOMETRIC Gradient

P
where, i #g

but, i is equal to g by applying L‟Hospital”s rule :

P=

 Similarly, the future worth and equivalent uniform annual worth of the
geometric gradient series can be obtained by multiplying its present worth
“P” with the compound interest factors namely single payment compound
amount factor (SPCAF) and capital recovery factor (CRF) respectively at
the given rate of interest “i” per interest period and the number of interest
periods.
Cont.…

Example: Suppose funding for a five-year project is to increase by

6% every year with an initial funding of $20,000 at the end of the
first year. Determine how much must be deposited into a budget
account at time zero in order to cover the anticipated funding levels
if the budget account pays 10% interest per year.
Given required
A1 =$20,000 P =? P = A1 []

i = 10% = $20,000[]
n = 5 years = $84,533.60
g = 6%
Cont.…
 Annuity: is the fixed sum of money payed/saved at
regular interval of time under certain condition.
 If the cash flow deposited at the end of each year is
called regular annuity. Whereas, if the cash flow
deposited under at the beginning of each year /period is
called annuity due.

END OF CHAPTER
 CHAPTER TWO
Depreciation, Inflation and deflation
CHAPTER OUTLINES:
 What is depreciation, inflation and deflation
 Causes of depreciation
 Assumption of depreciation
 Method of Calculating Depreciation
 Effect of inflation
 Different levels of inflation
 Effect and causes of deflation
2. INTRODUCTION
 Depreciation: is the loss of value of the physical assets
used in production. It also reduces efficiency as well as
value of assets. It is permanent, continuing and gradual
shrinkage in the book value of a fixed asset.
 Inflation: is a quantitative measure of how quickly the
price of goods in an economy is increasing. Inflation is
caused when goods and services are in high demand, thus
creating a drop-in availability.
 Deflation: occurs when too many goods are available or
when there is not enough money circulating to purchase
those goods.
2.1 DEPRECIATION
Depreciation can be understood in 3 senses.
 In physical sense, depreciation is a decline in the
physical ability of equipment in the process of
production.
 In economic sense, depreciation is a decline in the worth
of an asset due to outdated technology and due to
changes in psychological factors like tastes and
preferences.
 In accounting sense, depreciation is estimated value of
fall in the worth of asset, which is generally treated as
an implicit cost.
2.2 Causes of Depreciation

 Depreciation may occur due to following few causes:

 Physical depreciation
 Time factors
 Accidental factors
 Depletion/running down
 Deferred maintenance
 Inadequacy or functional depreciation
 Obsolescence
2.3 Assumptions of depreciation
 Depreciation of an asset is calculated under the
following conditions.
a) Asset should be used in business or in production of
further income
b) It should have definite life time
c) It should be subject to wear, tear, decay and obsoleting
from natural causes.
2.4.The periodical amount of depreciation is
affected by the following factors
 The cost of the asset;
 The life of the asset;
 The expected residual value of the asset;
 and, by the method of depreciation selected for payback
of the asset which must be systematic and rational.
2.5 Common terms used in depreciation
analysis
 These terms are: initial cost,
salvage value,
book value, and
useful life.
 Initial cost is the total cost of acquiring/purchasing the asset.
 Salvage value represents estimated market value of the asset
at the end of its useful life. It is the expected cash inflow that
the owner of the asset will receive by disposing it at the end
of useful life.
Cont.…
 Book value is the value of asset recorded on the
accounting books of the firm at a given time period. It is
generally calculated at the end of each year.
 Useful life represents the expected number of years the
asset is useful in terms of generating revenue. The asset
may still be in working condition after the useful life but
it may not be economical.
 Useful life is also known as depreciable life. The asset is
depreciated over its useful life.
2.6 Method of Calculating Depreciation
 Generally five basic methods are used for calculation of
depreciation and discussed as follows.
A. Straight line method
B. Declining Balance method
C. Double declining balance method
D. sum-of-years-digits method, and
E. sinking fund method.
A. Straight-line (SL) depreciation method
 It is the simplest method of depreciation. In this method it is assumed
that the book value of an asset will decrease by same amount every year
over the useful life till its salvage value is reached. In other words the
book value of the asset decreases at a linear rate with the time period.
 The expression for annual depreciation in a given year ‘m’ is presented
as follows;
Dm =, where
 Dm = depreciation amount in year ‘m’ (m = 1, 2, 3, 4,…., n, i.e.
1≤ m ≤ n)
 P = initial cost of the asset
 n = useful life or depreciable life (in years) over which the asset
is depreciated.
 SV =Salvage value
Cont.…
 Since, the depreciation amount is same every year,
D1 = D2 = D3 = D4 = ……… = Dm: Dm = constant annual
depreciation rate
 The book value at the end of 1 st year is equal to initial cost less the
depreciation in the 1st year and is given by;
Bv1 =P-Dm ,
 Book value of 2nd year is:

Bv2 =Bv1-Dm
= (P-Dm ) -Dm
= P-2Dm
 In the same manner the generalized expression for book value at the
end of any given year ‘m’ can be written as follows;
Bvm = P-mDm
B. Declining Balance method

 Declining Balance Method: This method is also known

as Written down method.
 It is assumed that the value of an asset declines at a
decreasing rate. So, more depreciation is charged during
the beginning of the life time and less is charged during
the end.
 The depreciation in 1st year is calculated by multiplying
the initial cost (i.e. book value at beginning) with the
depreciation rate and is given by;
 D1 = P*dm , Where
Cont.…
D1 = depreciation amount in 1st year
P = initial cost of the asset as already mentioned
dm = constant annual depreciation rate
The book value at the end of 1st year is equal to initial cost
less the depreciation in the 1st year calculated as follows;
Bv1 = P-D1
= P – (P*dm)
= P (1 -dm)
Cont.…
 The depreciation in 2nd year (D2):
 D2 = Bv1*dm, from the above expression Bv1 = P(1 -dm)
= P(1-dm) *dm
 Book value at the end of 2nd year(Bv2)
Bv2 = Bv1 – D2, since Bv1 = P (1 -dm) and D2 = P(1-dm) *dm
Bv2 = [P (1 -dm)] – [P(1-dm) *dm]
Bv2 = P

 The depreciation in 3rd year (D3):

 D3 = Bv2*dm, So
Cont.…
 D3 = P*dm
 The generalized expression for depreciation in any
given year ‘m’ can be written as follows:
Dm =P
 Similarly, the generalized expression for book value at
the end of any year ‘m’ is given as follows:
Bvm = P
Cont...
 The book value at the end of useful life is theoretically
equal to the salvage value of the asset. Thus equating
the salvage value (SV) of the asset to its book value
(BVm) at the end of useful life results in the following;
 SV =Bvm =P
C. Double declining balance method
 The double declining balance depreciation method is an
accelerated depreciation method that counts as an
expense twice as much of the asset’s book value each
year compared to straight-line depreciation.
dm = ………depreciation rate
Dm = P
 The book value at the end of a given year is calculated
by subtracting the annual depreciation amount from
previous year’s book value.
Cont.…

 Depreciation amount for year 1:

D1 =P*dm
 Book value at the end of 1st year:
Bv1 = P – D1, and
Bv2 = Bv1- D2
D. Sum-of-years-digits method(SOY):
 In this method the annual depreciation rate for any year
is calculated by dividing the number of years left (from
the beginning of that year for which the depreciation is
calculated) in the useful life of the asset by the sum of
years over the useful life.
 The depreciation rate ‘dm’ for any year ‘m’ is given by:
 dm = , since SOY =
 Where, n = useful life of the asset
Cont.…
 The depreciation amount in any year is calculated by
multiplying the depreciation rate for that year with the
total depreciation amount (i.e. difference between initial
cost ‘P’ and salvage value ‘SV’) over the useful life.
Dm = dm(P – SV)
= (P -SV)
 The book value at the end of 1styear and is given by;
Bv1 = P –D1
 The book value at the end of 2nd year and is given by;
Bv2 = Bv1 –D2
E. sinking fund method:
 In this method it is assumed that money is deposited in a
sinking fund over the useful life that will enable to
replace the asset at the end of its useful life.
 In this method it is assumed that money is deposited in a
sinking fund over the useful life that will enable to
replace the asset at the end of its useful life.
 The first component of depreciation i.e. uniform
depreciation amount ‘A’ at the end of each year is given
by;
A = ( P – SV)* ,Where i = interest rate per year
Cont.…
 Depreciation amount for 1st year is equal to only ‘A’ as
this is the amount (set aside every year from the revenue
generated) to be deposited in sinking fund at the end of 1st
year and hence there is no interest accumulated on this
amount.
 Therefore, D1 =A
Bv1 = P - D1 = P - A
D2 = A + D1*i
= A(1 +i)
Bv2 = BV1 –D1 = P – A[+]
Dm = A
2.7.Inflation
Inflation may be defined:
In economic terms, as the increase in the amount of currency in
circulation, resulting in a relatively high and sudden fall in its
value.
To a producer, inflation means a sudden increase in the cost of
items that serve as inputs for the production process
(equipment, labor, materials, etc).
To the retailer, inflation implies an imposed higher cost of
finished products.
To an ordinary citizen, inflation portends an unbearable
/intolerable escalation of prices of consumer goods.
Cont.…
Inflation and Deflation are majorly affected by supply and demand.
2.8 Effects of Inflation

 Inflation is a major player in financial and economic analyses of

projects. Multi-year projects are particularly subject to the
effects of inflation. Inflation can be defined as the decline in
purchasing power of money. Some of the most common causes
of inflation are:
 Increase in amount of currency in circulation
 Shortage of consumer goods
 Escalation of the cost of production
 Arbitrary increase of prices by resellers
Generally, The effects of inflation are felt in terms of increase in
the prices of goods and decrease in the worth of currency.
2.9 The different levels of inflation may be
categorized
1.MILD INFLATION
 When inflation is mild (2 to 4 percent) the economy actually
prospers. Producers strive to produce at full capacity in order
to take advantage of the high prices to the consumer. Private
investments tend to be risk and more jobs become available.
2. MODERATE INFLATION
 Moderate inflation occurs when prices increase at 5 to 9
percent. Consumers start purchasing more as an edge against
inflation. They would rather spend their money now than
watch it decline further in purchasing power. The increased
market activity serves to fuel further inflation.
Cont.…
3. SEVERE INFLATION
 Severe inflation is indicated by price escalations of 10 percent or
more. Double-digit inflation implies that prices rise much faster
than wages do. Debtors tend to be the ones who benefit from this
level of inflation because they repay debts with money that is less
valuable than the one borrowed.
4. HYPERINFLATION
 When each price increase signals the increase in wages and costs,
which again sends prices further up, the economy has reached a
stage of hyperinflation. Rapid and uncontrollable inflation
destroys the economy. The currency becomes economically
useless as the government prints it excessively to pay for
obligations.
2.10. Deflation
 Deflation is the reduction of prices of goods, Rather, deflation is
an indication that economic conditions are deteriorating.
 Deflation is usually associated with significant unemployment,
which is only corrected after wages drop considerably.
Furthermore, businesses’ profits drop significantly during
periods of deflation, making it more difficult to raise additional
capital to expand and develop new technologies.
 Deflation is often confused with “disinflation.” While
deflation represents a decrease in the prices of goods and
services throughout the economy, disinflation represents a
situation where inflation increases at a slower rate.
2.11. What Causes Deflation?

 Deflation can be caused by a number of factors, all of

which stem from a shift in the supply-demand curve.
Remember, the prices of all goods and services are
heavily affected by a change in the supply and demand,
which means that if demand drops in relation to supply,
prices will have to drop accordingly.
 Causes of deflation:
1. Change in Structure of Capital Markets
When many different companies are selling the same
goods or services, they will typically lower their prices as
a means to compete.
Cont.…
2. Increased Productivity
Innovative solutions and new processes help increase efficiency,
which ultimately leads to lower prices. Although some
innovations only affect the productivity of certain industries,
others may have a profound effect on the entire economy.
3. Decrease in Currency Supply
As the currency supply decreases, prices will decrease so that
people can afford goods.
4. Austerity Measures
Deflation can be the result of decreased governmental, business,
or consumer spending, which means government spending cuts
can lead to periods of significant deflation.
2.12. Effect of deflation
1. Reduced Business Revenues
Businesses must significantly reduce the prices of their products in order to
stay competitive.
2. Wage Cutbacks and Layoffs
When revenues start to drop, companies need to find ways to reduce their
expenses to meet their bottom line. They can make these cuts by reducing
wages and cutting positions.
3. Changes in Customer Spending
The relationship between deflation and consumer spending is complex and
often difficult to predict. When the economy undergoes a period of deflation,
customers often take advantage of the substantially lower prices. Initially,
consumer spending may increase greatly; however, once businesses start
looking for ways to support their bottom line, consumers who have lost their
jobs or taken pay cuts must start reducing their spending as well. Of course,
when they reduce their spending, the cycle of deflation worsens.
Cont..
4. Reduced Stake in Investments
When the economy goes through a series of deflation, investors tend to
view cash as one of their best possible investments. Investors will watch
their money grow simply by holding onto it. Additionally, the interest
rates investors earn often decrease significantly as central banks attempt
to fight deflation by reducing interest rates, which in turn reduces the
amount of money they have available for spending.
5. Reduced Credit
When deflation rears its head, financial lenders quickly start to pull the
plugs on many of their lending operations for a variety of reasons. First of
all, as assets such as houses decline in value, customers cannot back their
debt with the same collateral. In the event a borrower is unable to make
their debt obligations, the lenders will be unable to recover their full
investment through foreclosures or property seizures.

END OF CHAPTER
 CHAPTER THREE
Cost comparison of alternation methods

Chapter outlines
 What is cost comparison?
 Different types of Cost comparison methods
 Different types of analysis-period situations
3.1 INTRODUCTION
 Comparisons of assets or investment projects are
necessary in order to select the best among the
alternatives, i.e., to accept one and reject others.
 When these alternatives are mutually exclusive in
nature, comparisons need to be taken into account a
particular point of time, i.e. At current or base period as
the reference year.
 Moreover, as the value of any currency keeps on
changing over time, comparisons cannot be made across
time unless the value of the projects is transferred into a
particular time.
Cont.…
 Let’s take an example: An invested amount of 10, 00000
in the year 2014 cannot be compared with 10, 00000 in
the year 2011 as both the investment occurred in two
different times. These two amounts need to be
transferred to the same time for comparison purpose.
 Comparison of alternatives: For most of the engineering
projects, equipments etc., there are more than one
feasible alternative. It is the duty of the project
management team (comprising of engineers, designers,
project managers etc.) of the client organization to select
the best alternative that involves less cost and results
more revenue.
Cont.…
 . For this purpose, the economic comparison of the
alternatives is made.
 The different cost elements and other parameters to be
considered while making the economic comparison of
the alternatives are initial cost, annual operating and
maintenance cost, annual income or receipts, expected
salvage value, income tax benefit and the useful life.
When only one, among the feasible alternatives is
selected, the alternatives are said to be mutually
exclusive.
Cont.…
 The differences in different parameters namely initial
capital investment, annual operation cost, annually
generated revenue, expected salvage value, useful life,
magnitude of output and its quality, performance and
operational characteristics etc. may exist among the
mutually exclusive alternatives.
 Thus, the economic analysis of the mutually exclusive
alternatives is generally carried out on the similar or
equivalent basis, since each of the feasible alternatives
will meet the desired requirements of the project, if
selected.
Cont.…
 The economic comparison of mutually exclusive
alternatives can be carried out by different equivalent
worth methods:
1. Present worth method,
2. Future worth method and
3. Annual worth method.
In these methods all the cash flows i.e. cash outflows and
cash inflows are converted into equivalent present worth,
future worth or annual worth considering the time value of
money at a given interest rate per interest period.
1.Comparison of alternatives by present
worth method:
 In the present worth method for comparison of mutually
exclusive alternatives, the future amounts i.e.
expenditures and incomes occurring at future periods of
time are converted into equivalent present worth values
at a certain rate of interest per interest period and are
added to present worth occurring at “0” time.
 The different compound interest factors namely single
payment present worth factor, uniform series present
worth factor and present worth factors for arithmetic
and geometric gradient series etc. will be used to
convert the respective future amounts to the equivalent
present worth values for different alternatives.
Cont.…
 The converted equivalent present worth values are always
less than the respective future amounts since the rate of
interest is normally greater than zero.The methodology for
the comparison of mutually exclusive alternatives by the
present worth method depends upon the magnitude of useful
lives of the alternatives.
 There are two cases:
A) the useful lives of alternatives are equal and
B) the useful lives of alternatives are not equal.
The alternatives having equal useful lives are designated as
equal life span alternatives whereas the alternatives having
unequal life spans are referred as different life span
alternatives.
A) Equal life span alternatives
 The comparison of mutually exclusive alternatives
having equal life spans by present worth method is
comparatively simpler than those having different life
spans.
 In case of equal life span mutually exclusive
alternatives, the future amounts as already stated are
converted into the equivalent present worth values and
are added to the present worth occurring at time zero.
Then, the alternative that exhibits maximum positive
equivalent present worth or minimum negative
equivalent present worth is selected from the considered
feasible alternatives.
B) Different life span alternatives:
 If the comparison of the alternatives is not made over
the same life span, then the cost alternative having
shorter life span will result in lower equivalent present
worth i.e. lower cost than the cost alternative having
longer life span. Because in this case, the cost of the
short span alternative is considered only for a shorter
period of time, even though this alternative may not be
economical.
Cont.…
 In case of mutually exclusive investment alternatives,
the alternative with longer life span will result in higher
equivalent present worth i.e. higher positive equivalent
worth, as the costs, revenues, savings through reduced
costs is considered over a longer period of time than the
alternative with shorter life span.
 Thus, in order to minimize the effect of such kind of
discrepancy on the selection of best alternative from the
considered feasible alternatives, the comparison is made
over the same life span.
Cont...
 The two approaches used for economic comparison of
different life span alternatives are as follows;
i) Comparison of mutually exclusive alternatives over a
time period that is equal to least common multiple (LCM)
of the individual life spans
ii) Comparison of mutually exclusive alternatives over a
study period which is not necessarily equal to the life span
of any of the alternatives.
Cont.…
 In the first approach the comparison is made over a time
period equal to the least common multiple of the life spans of
mutually exclusive alternatives. The cash flow of the
alternatives i.e. cash flow of the first cycle is repeated and the
number of repetitions depends upon the value of least
common multiple of life spans between the mutually
exclusive alternatives.
 In the second approach, a study period is selected over which
the economic comparison of mutually exclusive alternatives
is carried out. The length of the study period will depend on
the overall benefit of the project i.e. it may be shorter or
longer (as compared to useful lives of the individual
alternatives) depending upon the short-term or long-term
benefits as desired for the project.
Cont.…
 Thus the cash flows of the alternatives occurring during
the study period are only considered for the economic
comparison.
 However; if any alternative possesses salvage value at
the end of its useful life and that occurs after the study
period, then its equivalent value must be included in the
economic analysis.
 The values of equivalent present worth of the mutually
exclusive alternatives are calculated over the selected
study period and the alternative showing maximum
positive equivalent present worth or minimum negative
equivalent present worth is selected.
1. Comparison by Present worth method
 Now present worth criterion of an investment is the net
equivalent amount at present time. So basically in any
cash flow, you have the receipts and disbursements
occurring at different times. So basically you have to
find the net value of all these receipts - that of the
disbursements and basically that is to be evaluated at the
present time.
 Now some examples showing the use of present worth
method for comparison of mutually exclusive
alternatives are presented. First the comparison of equal
life span mutually exclusive alternatives by present
worth method will be illustrated followed by
Cont.…
 Example 1:There are two alternatives for purchasing a
concrete mixer. Both the alternatives have same useful
life. The cash flow details of alternatives are as follows;
 Alternative-1: Initial purchase cost = 3,00,000, Annual
operating and maintenance cost = 20,000, Expected
salvage value = 1,25,000, Useful life = 5 years.
 Alternative-2: Initial purchase cost = 2,00,000, Annual
operating and maintenance cost = 35,000, Expected
salvage value = 70,000, Useful life = 5 years. Using
present worth method, find out which alternative should
be selected, if the rate of interest is 10% per year.
Cont.…
 Example 2: A material testing laboratory has two
alternatives for purchasing a compression testing
machine which will be used for determining the
compressive strength of different construction materials.
The alternatives are from two different manufacturing
companies.
 The cash flow details of the alternatives are as follows;
 Alternative-1: Initial purchase price = Rs.1000000,
Annual operating cost = Rs.10000, Expected annual
income to be generated from testing of different
construction materials = Rs.175000, Expected salvage
value = Rs.200000, Useful life = 10 years.
Cont.…
 Alternative-2: Initial purchase price = Rs.700000,
Annual operating cost = Rs.15000, Expected annual
income to be generated from testing of different
construction materials = Rs.165000, Expected salvage
value = Rs.250000, Useful life = 5 years. Using present
worth method, find out the most economical alternative
at the interest rate of 10% per year
2. Comparison of alternatives by Future
worth method:
 In the future worth method for comparison of mutually
exclusive alternatives, the equivalent future worth (i.e.
value at the end of the useful lives of alternatives) of all
the expenditures and incomes occurring at different
periods of time are determined at the given interest rate
per interest period.
 As already mentioned, the cash flow of the mutually
exclusive alternatives may consist of expenditures and
incomes in different forms.
Cont.…
 Therefore the equivalent future worth of these
expenditures and incomes will be determined using
different compound interest factors namely single
payment compound amount factor, uniform series
compound amount factor and future worth factors
for arithmetic and geometric gradient series etc.
 Similarto present worth method, first the
comparison of equal life span alternatives by future
worth method will be illustrated followed by
comparison of different life span alternatives.
Cont.…
 Example 3: There are two alternatives for purchasing a
concrete mixer. Both the alternatives have same useful
life. The cash flow details of alternatives are as follows;
 Alternative-1: Initial purchase cost = Rs.300000, Annual
operating and maintenance cost = Rs.20000, Expected
salvage value = Rs.125000, Useful life = 5 years.
 Alternative-2: Initial purchase cost = Rs.200000, Annual
operating and maintenance cost = Rs.35000, Expected
salvage value = Rs.70000, Useful life = 5 years. Using
future worth method, find out which alternative should
be selected, if the rate of interest is 10% per year.
Cont.…
 Example 4 : A material testing laboratory has two
alternatives for purchasing a compression testing
machine which will be used for determining the
compressive strength of different construction materials.
The alternatives are from two different manufacturing
companies.
 The cash flow details of the alternatives are as follows;
 Alternative-1: Initial purchase price = Rs.1000000,
Annual operating cost = Rs.10000, Expected annual
income to be generated from testing of different
construction materials = Rs.175000, Expected salvage
value = Rs.200000, Useful life = 10 years.
Cont.…
 Alternative-2: Initial purchase price = Rs.700000,
Annual operating cost = Rs.15000, Expected annual
income to be generated from testing of different
construction materials = Rs.165000, Expected salvage
value = Rs.250000, Useful life = 5 years. Find out the
most economical alternative at interest rate of 10% per
year by future worth method.
3.Comparison of alternatives by Annual
worth method:
 In this method, the mutually exclusive alternatives are
compared on the basis of equivalent uniform annual
worth. The equivalent uniform annual worth represents
the annual equivalent value of all the cash inflows and
cash outflows of the alternatives at the given rate of
interest per interest period.
 In this method of comparison, the equivalent uniform
annual worth of all expenditures and incomes of the
alternatives are determined using different compound
interest factors namely capital recovery factor, sinking
fund factor and annual worth factors for arithmetic and
geometric gradient series etc.
Cont.…
 Example 5:There are two alternatives for purchasing a
concrete mixer and following are the cash flow details;
 Alternative-1: Initial purchase cost = 300000, Annual
operating and maintenance cost =20000, Expected salvage
value =125000, Useful life = 5 years.
 Alternative-2: Initial purchase cost = 200000, Annual
operating and maintenance cost = 35000, Expected salvage
value = 70000, Useful life = 5 years. The annual revenue to
be generated from production of concrete (by concrete
mixer) from Alternative-1 and Alternative-2 are 50000 and
45000 respectively. Compute the equivalent uniform annual
worth of the alternatives at the interest rate of 10% per year
and find out the economical alternative.
Cont.…
 Example 6: Compare the following equipment on the
basis of the equivalent uniform annual worth and find
out the most economical one at the interest rate of 9.5%
per year.
 Equipment-A
 Cash flow details:
 Initial purchase cost = 5000000, Annual operating cost
= 60000 at the end of year “1” and increasing by 3000
in the subsequent years till the end of useful life.
Annual income = 770000 , Cost of one time major
repair = 200000 at the end of year “8” Expected
salvage value = 1400000, Useful life = 12 years.
Cont.…
 Equipment-B
 Cash flow details:
 Initial purchase cost = 4600000, Annual operating cost
= 75000 Annual income =710000 for the first 5 years
and increasing by 5000 in the subsequent years till the
end of useful life. Cost of one time major repair =
230000 at the end of year “6”, Expected salvage value =
1200000, Useful life = 12 years.
 CHAPTER FOUR
Economic Analysis of industrial
operation
Chapter outlines
 How to calculate Break even and payback
period?
 Linear and non-linear break even point
analysis
 Decision making with probability
4.1 INTRODUCTION
 Economic analysis is the study of economic systems. It may
also be a study of a production process or an industry. The
analysis aims to determine how effectively the economy or
something within it is operating. For example, an economic
analysis of a company focuses mainly on how much profit it
is making.
4.2 Break Even Analysis:
 The break-even point is the point at which total revenue
is equal to total cost. At this point, the profit is zero. (A
particular company neither makes nor loses money at
this point).
 There are two types of costs to consider: variable and
fixed.
 Fixed costs include things like rent, lease payment,
insurance payment, etc. Fixed costs do not depend on
the number of units (e.g. number of pizzas sold).
Cont.…
 Variable costs vary with the number of units. For
example, the more pizzas you make, the greater the food
cost. Revenue will vary with the number of units.
 Generally, as the number of units increases, revenue also
increases.
 Break-even analysis finds a point at which TR=TC. It is
a point of output at which there is no profit and no loss.
 Some Formulas Total revenue = price x number of units
(TR = P*Q). This is also known as the revenue function.
Cont.…
 Total cost = variable cost x number of units + total fixed
cost (TC = VC*Q + FC). This is also known as the cost
function.
 At break-even point, TR = TC.
 When TR and VC are directly proportional to output,
then it is called linear break-even analysis. If this
condition is not satisfied, the concerned break-even
analysis is known as non-linear break-even analysis.
Cont..
 Let’s calculate break-even point by algebraic method
TC= FC+ VC
Q×P = FC+ VC
QP-Qv-FC=0
Q(P-V)-FC=0
Q =break-even quantity=
Break-even sales = QP = P [] =
Cont.…
 Break-even sales can be found out by the
difference between actual sales and break-even
sales or [profit×sales]/ [sales-VC]
 Margin of safety is an important concept in B-E
analysis. It is defined as the sales over and above
the break-even sales. It represents the strength of
an investment situation.
 Margin of safety = actual sales-break even sales
Cont.…

Linear break-even point by graphic method:

Cont.…
 Fixed Costs are those costs which remain unchanged
irrespective of number of outputs, whereas Variable
costs are those costs which change with respect to
number of outputs.
 Non-linear break-even point analysis
Cont.…
Example: A plant produces 15,000 units/month. Find breakeven
level if FC is $75,000 /month, revenue is $8/unit and variable cost is
2.50/unit. Determine expected monthly profit or loss.
Solution: Find QBE and compare to 15,000;
calculate Profit
QBE= 75,000 / (8.00-2.50) = 13,636 units/month
Production level is above breakeven Profit
Profit = TR –TC = (8*$15,000) – ($75,000 – (2.5*$15,000))
= $120,000 -$112,500
= $7,500
4.3 Payback Period

 Payback period refers to the length of time it will take to

recover an initial investment. The approach doesn't
consider the impact of time value of money.
Consequently it is not an accurate method of evaluating
the worth of an investment. However, it is a simple
technique that is used widely a “quick and dirty”
assessment of investment performance. Also the
technique considers only the initial cost. Other costs that
may occur after time zero are not included in the
calculation.
Cont.…
 The payback period is defined as the smallest value of
“n”(n min) that satisfies the following expression:
Co, Where
Rt is the revenue at time t and Co is an initial investment.
The procedure calls for a simple addition of the revenue
period by period until enough total has been accumulated
to offset the initial investment.
nmin , So nmin is number of years ,months or weeks to
return initial investment of an organization.
Cont.…
 To calculate the payback period, simply work out how
long it will take to recover the initial outlay. It is given
by as follow

Example: Determine the payback period for a proposed investment as follows:

The sum of the first three yearly cash inflows, $37 000, is less than the initial investment,
$50 000; but the sum of the first four yearly cash inflows, $55 000, exceeds the initial
investment. Hence the payback period will be somewhere between 3 and 4 years.
Linear interpolation yields
PBP= 3 + {(50,000 – 37,000)/(55,000 – 37,000)}*(4 – 3) = 3.72 years
Because it ignores the time value of money
CHAPTER FIVE
Re-Engineering and Reverse Engineering
Introduction
5.1 Re-Engineering
 Re-engineering is the investigation and redesign of individual
components.
 It may also describe the entire overhaul of a device by taking the
current design and improving certain aspects of it. The aims of re-
engineering may be to improve a particular area of performance or
functionality, reduce operational costs or add new elements to a
current design.
 The methods used depend on the device but typically involve
engineering drawings of the amendments followed by extensive
testing of prototypes before production. The rights to re-engineer a
product belong solely to the original owner of the design or relevant
Cont.….
5.2 Reverse Engineering
 Unlike re-engineering, reverse engineering takes a finished
product with the aim of discovering how it works by testing
it.
 Typically this is done by companies that seek to infiltrate a
competitor's market or understand its new product. In doing
so they can produce new products while allowing the
original creator to pay all the development costs and take all
the risks involved with creating a new product.
 Analysis of a product in this way is done without technical
drawings or prior knowledge of how the device works, and
the basic method used in reverse engineering begins by
identifying the system's components, followed by an
investigation into the relationship among these components.
Cont.…
 Reengineering is an engineering process to reconstitute an existing system into a
new form through a combination of reverse engineering, restructuring, and
forward engineering.
Cont.…
 Reengineering relates closely to maintenance, which is generally
viewed as consisting of corrective, perfective, preventive, and
adaptive maintenance.
5.3 Re-engineering Framework
 Problem solving involves an understanding of the problem, i.e., a
clear understanding of the root causes in terms of its existing
state, an understanding of the desired state, and a path (plan) to
evolve from the current state to the desired state. The current
state reflects properties of the existing system and the process by
which the system is engineered (developed and maintained). A
subset of those properties is undesirable, reflecting the problem to
be solved. System understanding reflects the process of creating
and maintaining an understanding of a system (through analysis,
elicitation, and capture).
Cont.…

System evolution represents the engineering activity of migrating the existing system to the desired state. Based on an understanding of the current and desired system state and available (re)engineering technology, an analysis making engineering tradeoffs by considering technical, management, and economic risks and constraints results in a (re)engineering plan. During the execution of this plan (i.e., the actual evolution of the system through engineering activity), the plans may be reassessed taking into consideration changes in the context (e.g., technical changes such as promising new technologies or economic changes such as budget
reductions or increases).

Figure 5-2: Reengineering Problem Solving

THANK YOU!!