1. Chapter 1
Foundations Of
Engineering Economy
MS291: Engineering Economy
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2. Contents of the Chapter





What is Economics?
Why Economics for Engineers ?
What is Engineering Economy ?
How to Performing Engineering Economy Study ?
Some Basic Concepts
– Utility & Various cost concepts
– Time value of money (TVM)
– Interest rate and Rate of Returns
– Cash Flow
– Economic Equivalence
– Simple and compound interest rates
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3. Setting the Scene
 Lets start with a simple question ? What is Economics ?
Anyone ?
 There are variety of definitions of Economics but let me
place the most relevant one for this course
 A social science that studies how individuals,
governments, firms and nations make choices on
allocating scarce resources to satisfy their unlimited
wants
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4. Why Engineer Need to know about
Economics ?
 Individuals, Engineers, Managers all made choice among
various alternatives in their every day life ..Any Example ?
 Mostly these choice is associate with money (more
specifically capital or capital funds) but money (or
resources) is limited
 The selection of any choice depends on the expected
future return of each alternative
 Engineers plays a vital role in “such decision” due to their
ability and experience to design, analyze and synthesize
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5. Why Engineer Need to know about
Economics ? (II)
 Engineers design and create
 Designing involves economic decisions … Why ?
 Engineers must be able to incorporate economic
analysis into their creative efforts
 Often engineers must select and implement from
multiple alternatives
 Understanding and applying “engineering economy
tools ( such as time value of money, economic
equivalence, and cost estimation) are vital for engineers
 A proper economic analysis for selection and execution
is a fundamental task of engineering
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6. What is Engineering
Economy ?
 Engineering Economy involves
– Formulating
– Estimating, and
– Evaluating
expected economic outcomes of
alternatives designed to accomplish a
defined purpose
Defined
Purpose
Different
alternatives
with expected
economic
outcomes
- Formulate
- Estimate
- Evaluate
Expected
outcomes of each
alternatives
Select the1-6
best
alternative

7. Where Engineering Economy
learning is useful ?
It is useful in many different engineering decisions
 How should the engineering project be designed ?
 Has civil or mechanical engineer chosen the best thickness for
insulation ?
 Which engineering projects should have a higher priority ?
 Has the industrial engineer shown which factory improvement
projects should be funded with the available resources
 Which engineering projects are worthwhile ?
 Has the mining or petroleum engineer shown that mineral or oil
deposits is worth developing ?
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8. Performing Engineering
Economy Study
 Keeping in mind, what is economics and
engineering economy?
 For doing any engineering study we will
need to do many things such as: Problem
identifications, its objectives, its various
alternatives, information about each
alternatives, choosing the best among all
alternatives etc.
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9. Steps in an Engineering Economy
Study
Step 1 in
Study
Problem description
Objective statement
Step 2
Available data
Alternatives for solution
Step 3
Cash flows and other
estimates
Step 4
Measure of worth criterion
(PW, B/C, IRR etc)
Step 5
Engineering Economic
Analysis
Step 6
One or more approaches to
meet objectives
Best alternative Selection
•
•
•
•
•
Expected life
Revenues
Costs
Taxes
Project Financing
Tools u will be learning in
this course are used here
Time Passes
Step 7
Step 1 in
Study
Implementation and
Monitoring
New Problem description
New engineering economic
study begins

10. Utility
• What is Utility ? Anyone ?
• In economics utility refers to the power of a
good or service that satisfy human wants
• E.g. A glass of water has utility that it satisfy
one’s thirst
• Utility is the one of the very basic and
important concept of economics
• Marginal Utility refers to Utility derived from
one additional unit of a good
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11. Law of Diminishing Marginal
Utility
Total Utility
(3)
Marginal
Utility,
Utils
0
]
10 ]
18 ]
24 ]
]
28 ]
30 ]
30
28
10
8
Utils refers to
Unit in which
utility can
be measured
30
Total Utility (Utils)
0
1
2
3
4
5
6
7
(2)
Total
Utility,
Utils
TU
20
10
0
6
4
2
0
-2
Marginal Utility (Utils)
(1)
Glass
of water
1
2
3
4
5
6
Units Consumed Per glass
7
Marginal Utility
10
8
6
4
2
0
-2
MU
1
2
3
4
5
6
7
Units Consumed Per glass
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12. Various Type of Costs
• There are different type of costs and can be
classified by various ways
• This lecture includes costs classifications
mostly use by economists
• Fixed & Variable Costs, Average Costs & Marginal
Costs, Private & Social Costs
• Opportunity Costs
• Some other important cost concept you may
come across: Sunk Cost and Sinking funds,
Operation & Maintenance Cost (O&M Costs),
Life-cycle Costs etc.
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13. Fixed and Variable Costs
• Fixed Costs: those costs that do not vary with the
quantity of output produced.…any example ?
Examples: rent to paid for factory building, interest on
invested capital, maintenance, taxes etc
• Variable Costs: are those costs that do vary with the
quantity of output produced
Examples: consumption of fuel for power generation ….it
will vary as the production of a factor increases or decrease
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14. Total Costs
• It maybe noted that Fixed Costs (FC) and
Variable Costs(VC) may consist of more than
one component and the sum of all respective
components will make up TFC and TVC
respectively
• Total Costs (TC) is equal to sum of Total Fixed
Costs (TFC) and Total variable costs (TVC):
TC = TFC + TVC
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15. Average Costs
• Average Costs
– Average costs can be determined by dividing the
firm’s costs by the quantity of output it produces
– The average cost is the cost of each typical unit of
product
• Average Costs can also be obtained by adding
Average Fixed Costs (AFC) and Average Variable
Costs (AVC) …i.e: ATC = AFC + AVC
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16. Average Costs
Example: a firm produce 100 units of output at cost of
$1000, what is the average cost of the firm?
AFC 
Fixed cost FC

Quantity
Q
Variable cost VC
AVC 

Quantity
Q
ATC 
Total cost
Quantity
TC

Q
= 1000/100 => $10
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17. Marginal Costs
• Marginal Cost
– Marginal cost (MC) measures the increase in
total cost that arises from an extra unit of
production
– Marginal cost helps answer the following
question:
• How much does it cost to produce an additional unit of
output?
(change in total cost) TC
MC 

(change in quantity)
Q
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18. Private / Social Cost
• Private costs (benefits) of an action
– accruing to the actor only
• Social costs (benefits)
– total costs of activity including those that accrue
to people other than the actor
• Example: driving a car
– Private costs: fuel, maintenance
– Social costs include pollution, road wear
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19. Opportunity Costs
I got a lottery of
worth Rs 10 millions
(1 core)
Ranking the Choices
1
2
3
The Next best use is “buying house” that’s I
forgone for paying my Credit card debts so that’s
my Opportunity cost
Opportunity Cost:
The Next Best Decision you could make
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20. Opportunity Costs
• Opportunity cost is the cost of second
best use of the available/used
resources in a certain action
• The opportunity cost of you people
sitting in this class is …the next best
use of your this time … in work,
recreational activities, sports or
facebooking 
• My opportunity cost of teaching you
this Course is …… the time & earning
opportunity I forgone to teach you
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21. Sunk Cost
• Sunk Cost: is the costs that
are incurred in the past
and can not be recovered
by any future action
• Theory states: ignore sunk costs, because they are
paid in either case, and cannot be recovered
• For example: If you lost the movie ticket worth Rs. 800 - you
can't get it back - if you decide not to buy a second ticket and go
home you won't get the first ticket you lost, back
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22. Sinking fund
• A sinking fund is a fund established by
an economic entity by setting aside revenue
over a period of time to fund a future capital
expense, or repayment of a long-term debt
• Sinking funds can also be used to set aside
money for purposes of replacing capital
equipment as it becomes obsolete, or major
maintenance or renewal of elements of a fixed
asset, typically a building
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23. Operation and Maintenance Cost
(O&M Costs)
• Operation and Maintenance Cost is the group of costs
experienced continually over the useful life of the
activity… any example ?
• This includes costs like, labour costs for operating &
maintenance personal, fuel and power costs, spare
and repair part costs, costs for taxes etc.
• These costs can be substantial and can exceed the initial
costs
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24. Life-cycle Costs
• Life-cycle - all the time from the initial
conception of an idea to the death of a
product (process)
• Life-cycle costs - sum total of all the costs
incurred during the life cycle
• Life-cycle costing - designing a product with
an understanding of all the costs associated
with a product during it’s life-cycle
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25. Product Life-cycle
Begin
Needs
assessment
and
justification
Time
Conceptual or
preliminary
design phase
Impact Analysis
Requirements
Overall
Feasibility
Conceptual
Design
Planning
Proof of
concept
Prototype
Development
and testing
Detailed design
planning
Detailed
design
phase
Allocation of
resources
Detailed
specification
Component
and supplier
selection
Production or
construction
phase
Production or
Construction
Phase
Product,
goods and
service
built
All
supporting
facilities
built
Operation
al use
planning
End
Operational
Phase
Decline and
retirement
phase
Operational Use
Use by ultimate
customer
Maintenance and
support
Process,
materials and
methods use
Declined and
retirement
planning
Decaling
Use
Phase out
Retirement
Responsible
disposal
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26. Cumulative Life-cycle Costs
Committed and Dollars Spent
Total life-cycle cost %
100%
Life-cycle costs committed
80%
60%
Life-cycle costs spent
40%
20%
0%
Definition and
conceptual design
Detailed
design
Production
Operational use
Decline/
Retirement
Project Phase
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27. Time Value of Money (TVM)
• A Rupee (or dollar) received today is worth
more than a rupee received tomorrow
– because a dollar received today can be invested
to earn interest
– The amount of interest earned depends on the
rate of return that can be earned on the
investment
• Time value of money quantifies the value of
a dollar through time
The time value of money is the most important concept in
engineering economy
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28. Interest
•
What is Interest ?
– It is the manifestation (or display) of the time value of
money
– Fee that one pays to use someone else’s money
– Computationally, interest is the difference between an
ending amount of money and a beginning amount of
money
• There are two perspectives for interest:
1- Borrower’s perspective – Interest paid
Interest Paid= amount owed now – principal
2- Lender’s or investor’s perspective – Interest Earned
Interest Earned= Total amount now – principal
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29. Interest Rate &
Rate of Return (ROR)
• Interest rate – Interest paid over a time period expressed
as a percentage of principal
• ROR refers to Interest earned over a period of time
expressed as a percentage of the original amount
(principal)
interest accrued per time unit
Rate of return (%) =
x 100%
original amount
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30. Interest paid
Interest rate (i)
Interest earned
Rate of Return
(ROR)
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31. Cash Flows (CFs): Basics
• CFs are amount of money estimated for future
projects or observed for project events that have
taken place
• CFs are during specific time period
• CF is difficult to estimate as its predicting future
• There are three important concepts related to
Cash flows: Cash Inflows, Cash Outflows, Net
Cash flows
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32. Cash Flows: 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
• End-of-period assumption:
Funds flow at the end of a given interest period
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33. Cash Flows: Estimating
There are two ways for estimating Cash flows:
Point estimate – A single-value estimate of a
cash flow element of an alternative
Cash inflow: Income = $150,000 per month
 Range estimate – Min and max values that
estimate the cash flow
Cash outflow: Cost is between $2.5 M and $3.2 M
- Point estimates are commonly used;
- however, range estimates with probabilities attached provide a better
understanding of variability of economic parameters used to make
decisions
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34. Cash Flow: Diagrams
What a typical cash flow diagram might look like
Draw a time line
Always assume end-of-period cash flows
Time
0
1
---
2
---
--- --- ---
n-1
n
One time
period
Show the cash flows (to approximate scale)
0
1
2
---
---
--- --- ---
n-1
Cash flows are shown as directed arrows: + (up) for inflow
n
- (down) for outflow
Remember: One and only one of the perspectives is selected to develop CF diagrams
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35. Cash Flow Diagram: Example
Plot observed cash flows over last 8 years and estimated
sale next year for $150. Draw a Net Cash flow diagram
$650
-7 -6
$625
-5
$600
-4
$600
$575
-3
$550
$525
-2
-1
$500
0
1
Years
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$-2500

36. Economic Equivalence
Different sums of money at different times may
be equal in economic value at a given rate
$110
Year
0
1
$100 now
Rate of return = 10% per year
$100 now is economically equivalent to $110 one year from
now, if the $100 is invested at a rate of 10% per year
Economic Equivalence: Combination of interest rate (rate of
return) and time value of money to determine different amounts of
money at different points in time that are economically equivalent
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37. Commonly used Symbols
t = time, usually in periods such as years or months
P = value or amount of money at a time t
designated as present or time 0
F = value or amount of money at some future
time, such as at t = n periods in the future
A = series of consecutive, equal, end-of-period
amounts of money
n = number of interest periods; years, months
i = interest rate or rate of return per time period;
percent per year or month
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38. Simple and Compound Interest
Simple Interest
Interest is calculated using principal only
Interest = (principal) (number of periods) (interest rate)
I=Pxnxi
Example: $100,000 lent for 3 years at simple i = 10%
per year. What is repayment after 3 years?
Here P=$100,000
n= 3
i= 10%
Interest = 100,000(3)(0.10) = $30,000
Total due = 100,000 + 30,000 = $130,000
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39. Simple and Compound Interest
Compound Interest
Interest is based on principal plus all accrued interest
That is, interest compounds over time
Interest = (principal + all accrued interest) (interest rate)
Interest for time period t is
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40. Compound Interest Example
Example: $100,000 lent for 3 years at i = 10%
per year compounded. What is repayment
after 3 years?
Interest, year 1:
Total due, year 1:
I1 = 100,000(0.10) = $10,000
F1 = 100,000 + 10,000 = $110,000
Interest, year 2:
Total due, year 2:
I2 = 110,000(0.10) = $11,000
F2 = 110,000 + 11,000 = $121,000
Interest, year 3:
Total due, year 3:
I3 = 121,000(0.10) = $12,100
F3 = 121,000 + 12,100 = $133,100
Compounded: $133,100 Simple: $130,000
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41. THANK YOU
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