ENGINEERING ECONOMICS

Ayodeji E OLULEYE

DEPT. OF INDUSTRIAL & PRODUCTION ENGINEERING,

UNIVERSITY OF IBADAN, IBADAN.
 FACILITATORS

• Professor A.E Oluleye

• Engr. Sarah Okunade

 Course Objectives and Goals

* Understanding economic principles

applied to engineering concepts like
the time value of money
* Learning to perform cost analysis
and economic evaluations
* Developing skills for financial
decision-making in engineering
projects
• Familiarization with cost-benefit
analysis, and economic optimization
 Methodology
• Assignments
• Discussions
• Presentations
• Case Studies

• [PHILOSOPHY IS ACTIVE EARNING]

 EVALUATION
• Continuous Assessment (40%)
– Homework
– Quiz (written and online)
– Group Work (tracking participation)
– Mini Project (Semester Paper)

• Examination (60%)
• At end of Semester
 Revert To Class
• Introductions:
– Name
– Affiliation
– Designation
– Function

• What are your expectations?

 Introduction
• Engineering Economics deal with the concepts and
techniques of analysis useful in evaluating the worth of
systems, products, and services in relation to their
costs.
• Problem solving involves both physical and economy
aspects. Engineers have concerned themselves too long
with resolving the physical problems forgetting that
any useful idea must of necessity be economically
viable for it to be worthwhile.
• With the current worldwide cut-throat competition the
economics have been projected to the fore.
• Any organization must have set objectives.
The operations of the system should in turn
further the primary objectives of the
organization. Usually, the primary objective
of a business or Industry can be stated as :

• "To manufacture (provide) a product

(service) in order to satisfy a demand"
• All too often, however, the objectives of such
organizations are stated in such terms as:

• ‑ to maximize profits (minimize costs

• ‑ to employ labour

• ‑ to provide a useful commodity/product

• All of the above are simply secondary objectives, which
can be satisfied if the primary objective is vigorously
pursued.
• Whether the primary objective is realised on the long
run depends on:
• ‑ producing the right quantity of product
(service)
• ‑ producing the right quality of product
(service)
• ‑ producing both the above at the right time and
cost
 Things to Note:
• Investments on technology should be justified on
economic as well as technical grounds.
• Projects selected should be such that meet the
immediate as well as future needs of the establishment.

• The technologies chosen should be such that will not be

obsolete in a short while; although they must
necessarily be appropriate.
• Technology is defined as the systematic application of
knowledge to practical skills. Technology involves men,
machines, materials, methods etc.
• Prestige should be played down in deciding
which technologies should be funded.
• Reliability of equipment and services is also
very important. Endless breakdowns or
delays in services rendered may lead to loss
in goodwill for an organisation.
• An organisation must also be planned to
carry some excess capacity if necessary as
part of fulfillment of some long term plan.
• Quality to a large extent decides amount of patronage to be
enjoyed. Nowadays it represents a veritable avenue for
performance enhancements in terms of revenue returns.

• In choosing between options, it is important that a proper

surveillance be made of feasible options, as any option not
identified, even if the best, cannot be implemented.

• In essence, in deciding to invest money at all, the objective

must necessarily be to either maximize profits (benefits) or
minimize costs depending on whether the establishment is a
production or service type.
 SIMPLE INTEREST

• Suppliers of capital receive some recompense for

supply it. This is often called interest or return on
capital. This is usually justified by the fact that the
supplier or capital has to get paid for foregoing the
use of his money.
• I = P x i x N
where P = principal amount.
• N = number of interest periods
• i = interest rate per period
• I = interest in Naira value over N periods.
 COMPOUND INTEREST

• F = P(1 + i)n
• where F = worth of principal P in
period N
• In this case the principal and
interest per year increases.
 INTEREST FORMULAE

• INTEREST FORMULAE
• Money can be transformed in time by the use of factors to get
equivalents. The factors are obtainable from tables available in
most engineering economy texts.
• Express:

• A = P(A/P, i, N) P = A(P/A, i N)
• F = P(F/P, i, N) P = F(P/F, i, N)
• A = F(A/F, i, N) F = A(F/A, i, N)
• A = annuity; a constant series amount
• P = Principal amount
• F = Future amount
• Consider an example such that:

• P = 20,000, i = 20%, N = 5 years,

Find the annuity equivalent:
A = P x (A/P, i, N) = 20,000(.33438) = 6,687.60
(the factor is obtained from the 20% table)
• This indicates that N 20,000 now is equivalent to N
6,687.60 per year for a period of 5 years.
• We achieve fairness based on time value of money
• It must be noted that a "do nothing"
alternative always exists, i.e. keep your
money in a savings account.
• Investments must therefore necessarily be
better than it to be justifiable.
• This is the underlying basis for discounting
cash flows at certain interest rates.
 QUICK TESTS OF VIABILITY

• Some quick tests can be used as guides for

making decisions concerning investments.
Some of them follow from intuition.
• Characteristics of these tests are stated in the
following sections. It should be noted that (+)
denotes and advantage, while (-) denotes a
disadvantage.
 PAYBACK PERIOD (PB)
• PB is concerned with the time an investment is
recovered:
• (+) easy to understand
• (+) eliminates high risk projects
• (+) encourages short and medium term
liquidity
• (‑) it ignores cash flow after payback period
• (‑) ignores time value of money
• Example
•
• Project
• ___________________________________________
• A B
• ___________________________________________
•
• Investment 110,000 215,000
• Annual Profit 15,000 26,000
• Payback Period 8 years 9 years
• ___________________________________________
•
• Project A is to be preferred because it has a shorter payback period.
 RETURN ON INVESTMENT

• Expresses average annual profits as percentage of investment:

• (+) uses all cash flows
• (‑) ignores timing of cash flows
• (‑) does not discriminate between asset lives and capital
costs

• For the earlier example,

• - Project A return on investment is 14%
• - Project B return on investment is 12%

• By this, Project A is to be preferred.

 BREAK EVEN ANALYSIS

• A new business may need to ponder on:

• ‑ when business will earn profits
• ‑ what level of operations for profits
• ‑ what relationship between activity and profits
• Existing businesses may need to ponder on:

• ‑ effects of activity levels on profits

• ‑ level of costs that hamper profits

• It must be noted that breakeven point is the point of no profit. Usually,

singular forecasts of cost and revenue are not enough. There is usually a
need to look at ranges as methods, equipment may only be best over
ranges.
 DISCOUNTING METHODS

• The most common discounting methods that take into

consideration time, value of money invested are:

• (1) Annual worth method ‑ all cash flows reduced to an

annuity basis.

• (2) Present worth method ‑ all cash flows reduced to a "now"

value.

• (3) Rate of return method ‑ rate of return at which cash

outflows equals inflows is found.
• Example:

• Consider a case of 3 mutually exclusive alternatives with cash

flows as below. It is intended that the best alternative be found.
• ALTERNATIVES
• -----------------------------------------------------------------
• Year(s) A1 A2 A3
• -----------------------------------------------------------------
• 0 -5,000 -8,000 -10,000
• 1-10 1,400 1,900 2500
• ------------------------------------------------------------------
• If interest rates average 20%, the solution to the problem
can be found as follows:
• (i) Present worth of A1 (PW A1) = -5,000 +
1,400(P/A,20,10)
• = -5000 + 1400( 4.1925 ) = 869.5
• (ii) Present worth of A2 (PW A2) = -8000 + 1900(P/A,20,10)
• = -8000 + 1900( 4.1925 ) = - 34.25
• (iii) Present worth of A3 (PW A3) = -10000
+2500(P/A,20,10)
• = -10000 + 2500( 4.1925 ) = 481.25
• It can be seen that alternative A1 gives the
best returns, hence it is preferred. Note that
option A2 is not profitable.

• The problem can also be solved using annual

worth basis. Do this as a quick exercise.
 Example:

• Consider a case of 3 mutually exclusive alternatives with cash

flows as below. It is intended that the best alternative be found.
You can use PW or AW methods.
• ALTERNATIVES
• -----------------------------------------------------------------
• End of year A1 A2 A3
• -----------------------------------------------------------------
• 0 -5,000 -8,000 -10,000
• 1-81,400 1,900 2500
• 9 – 10 1600 2100 3000
• ------------------------------------------------------------------
 CO-TERMINATION
• Used in Present Worth Analysis
• Puts alternatives on same platform
• Assumes service is required for same
TIMELINE
• Use LCM to get timeline
• Compare and then choose better alternative
 Capitalised Cost
• Used to estimate all resources required
to ensure project is a going concern
• Reduce all cash flows to NOW (time
zero).
• Remember the concept of perpetuity:
may be needed sometimes to ensure
sustainability.
 Perpetuity
• Use for alternatives with long lives
• Useful to ensure continuity perceptually.
• Good for Scholarships, maintenance etc
• P = (A/i)
• Logic is: use interest to service annual
requirements.
• Examples: Road maintenance, production
systems, critical recurrent expenditures etc
 Effective & Nominal Interests
• Effective Interest Rate Per Period
I = (r/m); r represents nominal, m the cycle

• Effective Annual Interest Rate:

• Ie = (1 + (r/m))m – 1