engineering economics sp06

8/3/2019 Engineering Economics Sp06

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Engineering Economics

.

Rajeev Bansal

February 1, 2006


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Engineering Economics

Why is it important?

Value and Interest

Cash Flow Diagrams and Patterns Equivalence of Cash Flow Patterns

Evaluating Alternatives

Break-Even Analysis

Income Tax and Depreciation

Inflation

Conclusion


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Why do we care about

Engineering Economics? Engineering designs are intended to produce good

results.

They are accompanied by undesirables (costs). If outcomes are evaluated in dollars, and good is

defined as profit, then decisions will be guided by

engineering economics.

This process maximizes goodness only if all

outcomes are anticipated and can be monetized.

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Value and Interest

The value of money depends on the

amount and when it is received or spent.

1 2

$1000

$1166

Example: What amount must be paid to settle a current debt of $1000 in

two years at an interest rate of 8% ?

Solution: $1000 (1 + 0.08) (1 + 0.08) = $1166


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Cash Flow Diagrams

P-Pattern1 2 3 n

present

F-Pattern1 2 3 n

future

A-Pattern1 2 3 n

annual

G-Pattern1 2 3 n

gradient


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Equivalence of Cash Flow

PatternsTo Find Given Multiply By Formula

F P

P F

A P

A G

n

iPF )/(

n

iFP )/(

n

iPA

)/(

n

iGA )/(

ni)1(

+

ni)1(

1

+

1)1(

)1(

+

+n

n

i

ii

1)1(

1

+

ni

n

i


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Example: A new circuit board component insertion tool will

save $50,000 in production costs each year and will have a

life of seven years. What is the highest price that can be

justified for the tool using a 12% interest rate?

Solution:

1 2 3 74 5 6

P

50k 50k 50k 50k 50k 50k 50k

k

Aii

iAAPP

n

n

228$000,50$56.4

000,50$)12.01(12.0

1)12.01(

)1(

1)1()/(

7

7

%127

==+

+=

++

==


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Evaluating Alternatives

Annual Equivalent Cost Comparisons

Present Equivalent Cost Comparisons

Incremental Approach

Rate of Return Comparisons

Benefit/Cost Comparisons

Minimum Attractive Rate of Return (MARR): The lowest rate of return

that the organization will accept.


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Annual Equivalent Cost

Comparison Incomes are converted to an A-pattern.

Costs are converted to an A-pattern.

The costs are subtracted from the incomes todetermine the ANEV.

Mutually Exclusive Alternatives choose the one

with highest ANEV Independent Alternatives choose all with positive

ANEV

ANEV: Annual Net Equivalent Value


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Example: A new circuit board component insertion tool is

needed. Which should you buy?

Solution: The ANEV is calculated for each:

kkkk

kFAkkPAANEV

9.539.1208.35

30)/(20220)/( %1010%10

10

=+=+=

Model Price Annual Maintenance Salvage Value Life

JACO $220k $20k $30k 10 years

Cheepo $100k $35k 0 5 years

JACO:

k

kkPAANEV

4.61$

35100)/( %105

==Cheepo:

JACO


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Present Equivalent Cost

Comparison Incomes and costs are converted to P-patterns.

The costs are subtracted from the incomes to

determine the PNEV. Mutually Exclusive Alternatives choose the one

with highest PNEV

Independent Alternatives choose all with positivePNEV

PNEV: Present Net Equivalent Value, also called life cycle cost,

present worth, capital cost, and venture worth.


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Incremental Approach

For a set of mutually exclusive alternatives, only

the differences in amounts need to be considered.

kkkkk

kFPkFPkAPkPNEV

9.45$6.111.622.92120

30)/(100)/(15)/(120 %1010%10

5%10

10

=+++=+++=

Model Price Annual Maintenance Salvage Value Life

JACO $220k $20k $30k 10 years

Cheepo $100k $35k 0 5 years

JACO- Cheepo:

JACO


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Rate of Return Method

ANEV or PNEV is formulated

From this, we solve for the interest rate that will

give zero ANEV or PNEV This interest rate is the ROR of the alternative

For mutually exclusive alternatives, the one with

the highest ROR is chosen For independent alternatives, all with a ROR

greater than MARR are accepted

ROR: Rate of Return on Investment


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Benefit/Cost Comparisons

The benefit/cost ratio is determined from

For mutually exclusive alternatives, the one

with the highest B/C is chosen.

For independent alternatives, all with B/C >

1 are accepted.

The MARR is used to determine the denominator (cost).

costinitialofequivalentannual

benefitsannualnetuniform=C

B


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Break-Even Analysis

Break-even point: the value of an independentvariable such that two alternatives are equallyattractive.

For values above the break-even point, onealternative is preferred.

For values below the break-even point, the other is

preferred. Break-even analysis is useful when dealing with a

changing variable (such as MARR).


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Income Tax and Depreciation

Businesses pay the IRS a tax:

Depreciation: method of charging the initial cost ofan asset against more than one year.

An asset is depreciable if :

It is used to produce income,

Has a life greater than one year, but

Decays, wears out, becomes obsolete, or gets used up.

=ondepreciati-paidinterest-

costsoperating-revenuegrossRTAX

ACRS: Accelerated Cost Recovery System, used by IRS since 1980.


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Inflation

The buying power of money changes with time.

Inflation, if anticipated, can be put to good use by

fixing costs and allowing income to rise by Entering long-term contracts for materials or wages

Purchasing materials long before they are needed

Stockpiling product for sale later.


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Conclusion

For-profit enterprises exist to make money.

Non-profit entities also make decisions to

maximize the goodness of outcomes byassigning dollar values.

Your engineering decisions will be shaped

by economics.

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engineering economics sp06

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