Engineering Economics: Overview and Application in Process Engineering Industry
Engineering Economics: Overview and Application in Process Engineering Industry
Engineering Economics: Overview and Application in Process Engineering Industry
10.490 ICE
Kangyi MAO
02 OCT 2006
WHAT IS ECONOMICS?
“Economics is the study of how people and society choose
to employ scarce resources that could have alternative
uses in order to produce various commodities and to
distribute them for consumption, now or in the future,
…”
from Paul Samuelson and William Nordhaus, Economics, 12th Ed., McGraw-
Hill, New York, 1985.
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WHY DO WE NEED TO KNOW ABOUT THIS?!
• Optimal cost-effectiveness
• Alternative possibilities (Cal Tech Industries!)
WHAT DO WE NEED TO KNOW?
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TIME VALUE OF MONEY
+7 +7 +15
0 1 2 3 4
TIME:Year
-10 -5
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Quantification of Profitability
N
NPV = ∑ C n (1+ i) −n
n=1
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PAYBACK PERIOD
• This measure is often used as a “quick and dirty” measure of
profitability
• Also called Payout Time
• Defined in units of time (months or years)
• The time for the cumulative cash flow to achieve a value of 0.0.
Usually, payback time does not consider interest.
Cash Flow: $M
+7 +7 +15
0 1 2 3 4
TIME:Year
-10 -5
ROI=(7+7+15-10-5)/4/(10+5)=~24%
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INTERNAL RATE OF RETURN (IRR)
• The IRR is defined as any discount rate that
results in a net present value of zero, and is
usually interpreted as the expected return
generated by the investment.
RECOMMENDATION?
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TYPICAL ACCOUNTING TOOLS
• Income Statement is prepared on an accrual
basis. It records expenses when the cost is
incurred, not when the bill is paid. It gives an
overview about how much the project is actually
gaining during individual years.
Year 1 2 3 4 5 Total
Implementation Costs -22,000
System Depreciation -400 -400 -400 -400 -400 -2,000
Service Contract -1,750 -1,750 -1,750 -1,750 -1,750 -8,750
Supplies & Miscellaneous -250 -250 -250 -250 -250 -1,250
Modification of the LIMS -10,000 0 0 0 0 -10,000
Installation 0 0 0 0 0 0
Labor Savings 153,880
Salary 21,650 21,650 21,650 21,650 21,650 108,250
Tax 1,660 1,660 1,660 1,660 1,660 8,280
Benefits 6,500 6,500 6,500 6,500 6,500 32,480
Viariable Costs 970 970 970 970 970 4,870
Material Savings 10,400
Label 1,720 1,720 1,720 1,720 1,720 8,600
Ink 360 360 360 360 360 1,800
Net Income* 20,460 30,460 30,460 30,460 30,460 142,280
*: The net income here is actually net savings, so there is no income tax associated.
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Example: Project Cash Flow Statement
Year 0 1 2 3 4 5 Total
Implementation Costs -$22,000
System Cost -2,000 0 0 0 0 0 -2,000
Service Contract 0 -1,750 -1,750 -1,750 -1,750 -1,750 -8,750
Supplies & Miscellaneous 0 -250 -250 -250 -250 -250 -1,250
Installation 0 0 0 0 0 0 0
Labor Savings 153,880
Salary 0 21,650 21,650 21,650 21,650 21,650 108,250
Tax 0 1,660 1,660 1,660 1,660 1,660 8,280
Benefits 0 6,500 6,500 6,500 6,500 6,500 32,480
Viariable Costs 0 970 970 970 970 970 4,870
Material Savings 10,400
Label 0 1,720 1,720 1,720 1,720 1,720 8,600
Ink 0 360 360 360 360 360 1,800
Net Cash Flow* -12,000 30,860 30,860 30,860 30,860 30,860 142,280
Accumulative Cash Flow -12,000 18,860 49,710 80,570 111,420 142,280 142,280
*: The Net Cash Flow here is actually net savings, so there is no income tax associated.
Cost Estimation
Task of Engineers!
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TYPES OF COSTS
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ESTIMATION OF CAPITAL COSTS
details
TURNOVER RATIO
LANG’S FACTOR
(Total capital cost)
LF =
(∑ Delivered cost of major equipment )
We use this as a guideline for the ratio of major equipment to total capital
costs.
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OPERATING COSTS
etc.
OPERATING COSTS
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HINTS FOR ESTIMATION OF OPERATING COSTS
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SUMMARY
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