ENGINEERING ECONOMICS Engineering Economy and Design Process

CHAPTER 1 - INTRODUCTION TO ENGINEERING ECONOMICS - An engineering economy study is accomplished using a structured
procedure and mathematical modeling techniques.

- The economic results are then used in a decision situation that

1.1 Definition and Basic Principle normally includes other engineering knowledge and input.

Engineering
Engineering Economic Analysis Procedure
- The Accreditation Board for Engineering and Technology states
that engineering “is the profession in which a knowledge of the 1. Problem Definition
mathematical and natural sciences gained by study, experience, and 2. Development of Alternatives
practical is applied with judgment to develop ways to utilize, 3. Development of prospective outcomes
economically, the materials and forces of nature for the benefit of 4. Selection of a decision criterion
mankind. 5. Analysis and comparison of alternatives.
6. Selection of the preferred alternative
- Emphasized the economic aspects of engineering. 7. Performance monitoring and post evaluation of results.

- The physical aspects

- It is essential that the economic part of engineering practice be

accomplished well. 1.2 General Economic Environment

- Engineers use knowledge to find new ways of doing things

economically.
Consumer and Producer Goods and Services

Engineering Economy 1. Consumer Goods and services

- are those products or services that are directly used by people to
- Involves the systematic evaluation of the economic merits of satisfy their wants.
proposed solutions to engineering problems.
2. Producer Goods and services
- To be economically acceptable (i.e., affordable), solutions to - are used to produce consumer goods and services or other producer
engineering problems must demonstrate a positive balance of long- goods.
term benefits over long term costs.

Necessities and Luxuries

- An analysis and evaluation of the factors that will affect the economic
success of engineering projects to the end that a recommendation 1. Necessities
can be made which will insure the best use of capital. - are those products or services that are required to support human
life and activities, that will be purchased in somewhat the same
- Includes significant technical considerations. quantity even though the price varies considerably.
- Involves technical analysis, with emphasis on the economic aspects.
2. Luxuries
- are those products or services that are desired by humans and will
- Has the objective of assisting decisions. be purchased if money is available after the required necessities
have been obtained.
An engineer who is unprepared to excel at engineering economy is not properly
equipped for his or her job.

Demand
Solutions to Engineering Problems must: - It is the quantity of a certain commodity that is bought at a certain
price at a given place and time.
1. Promote the well-being and survival of an organization,
1. Elastic Demand
2. Embody creative and innovative technology and ideas.
- It occurs when a decrease in selling price result in a greater than
3. Permit identification and scrutiny of their estimated outcomes, and; proportionate increase in sales.
4. Translate profitability to the “bottom line” through a valid and
acceptable measure of merit.
2. Inelastic Demand

Engineering economics analysis can play a role in many types of - It occurs when a decrease in the selling price produces a less than
situations such as: proportionate increase in sales.

1. Choosing the best design for a high-efficiency gas furnace.

3. Unitary Elasticity of demand
2. Selecting the most suitable robot for a welding operation on an
automotive assembly line. - It occurs when the mathematical product of volume and price is
constant.
3. Making a recommendation about whether jet airplanes for an
overnight delivery service should be purchased or leased.

4. Determining the optimal staffing plan for a computer held desk.

Fundamental Principles of Engineering Economy

1. Develop the alternatives.

2. Focus on the differences.
3. Use a consistent viewpoint.
4. Use a common unit of measure.
5. Consider all relevant criteria.
6. Make risk and uncertainty explicit.
7. Revisit your decisions.
 Competition, Monopoly, and Oligopoly Direct, Indirect, Overhead, and Standard Costs

1. Direct Cost
- These are costs that can be reasonably measured and allocated to
Perfect Competition a specific output or work activity. The labor and material costs directly
associated with a product, service or construction activity are direct
- It occurs in a situation where a commodity or service is supplied by costs. For example, the, materials needed to make a pair of scissors
a number of vendors and there is nothing to prevent additional would be a direct cost.
vendors entering the market.
2. Indirect Cost
- These are costs that are difficult to allocate to a specific output or
Monopoly work activity. Normally, they are costs allocated through a selected
formula to the outputs or work activities. For example, the costs of
- It is the opposite of perfect competition. A perfect monopoly exists
common tools, general supplies, and equipment maintenance in a
when a unique product or service is available from a single vendor
plant are treated as indirect costs.
and that vendor can prevent the entry of all others into the market.
3. Overheead Cost
Oligopoly - It consists of plant operating costs that are not direct labor or direct
material costs.
- It exists when there are so few suppliers of a product or service that
action by one will almost inevitably result in similar action by the 4. Standard Cost
others. - These are planned costs per unit of output that are established in
advanced of actual production or service delivery.

Law of Supply and Demand

Supply
Cash Cost vs. Book Costs
- It is the quantity of a certain commodity that is offered for sale at a
certain price at a given place and time. 1. Cash Cost
- It involves payment of cash. Are estimated from the perspective
The law of supply and demand may be stated as follows: *Under established for the analysis and are the future expenses incurred for
conditions of perfect competition the price at which a given product will be the alternatives being analyzed.
supplied and purchased is the price that will result in the supply and the
demand being equal. 2. Book Cost
- These are costs that do not involve cash payments but rather
represent the recovery of past expenditures over a fixed period of
time. Example: depreciation charged for the used assets
The Law of Diminishing Returns

“When the use of one of the factors of production is limited, either in

increasing cost or by absolute quantity, a point will be reached beyong
which an increase in the variable factors will result in a less than
proportionate increase in output.”
Sunk, Opportunity and Life Cycle Costs

1. Sunk Cost
- It is one that has occurred in the past and has no relevance to
estimates of future costs and revenues related to an alternative
course of action.

2. Opportunity Cost
- It is incurred because of the use of limited resources, such that the
opportunity to use those resources to monetary advantage in an
alternative use is foregone.
- It is the cost of the best rejected opportunity and is often hidden or
implied.

3. Life Cycle Cost

- It refers to a summation of all the costs related to a product, structure,
The effect of the law of diminishing returns on the performance of an system, or service during its life span.
electric motor is illustrated in Fig. 1-5. For the early increase in input
through input of 4.0 kw, the actual increase in output os greater than
proportional; beyond this point the output is less than proportional. In this
case, the fixed input factor is the electric motor

1.3 Cost Terminologies

Fixed, Variable, and Incremental Cost

1. Fixed Cost
- include insurance and taxes on facilities, general management and
administrative salaries, license fees, and interest costs on borrowed
capital.

2. Variable Cost
- are those associated with an operation that varies in total with the
quantity of output or other measures of activity level.
- Examples are the costs of material and labor used in product or
service because they vary in total with the number of output units,
even though the costs per unit stay the same.

3. Incremental Cost
- Also called as incremental revenue is the additional costs that results
from increasing an output of a system by one (or more) units.
CHAPTER 2 - TIME VALUE OF MONEY 2. Equal Uniform Series
- Transactions arranged as a series of equal cash flows at regular
Introduction intervals.

Capital

- Refers to wealth in the form of money or property that can be used

to produce more wealth.
- Refers to wealth in the form of money or other assets owned by a
person or organization that can be used for a particular purpose such
as starting a company or investing.
- money earns interest (or profits) over time; therefore, money has time
value. Other factors such as inflation can also affect time value of
money.

Types of Capital

1. Equity Capital 3. Linear Gradient Series

- Owned by individuals who have invested their money or property - Cash flow that increase or decrease by uniform amount each
in a business project or venture in the hope of receiving a profit. periods.
2. Borrowed Capital
- Obtained from lenders for investment, with a promise to repay the
principal amount and interest on a specific date.

3. Human Capital
- Refers to the economic value of a worker's experience and skills.

4. Social Capital
- The networks of relationships among people who live and work
in a particular society, enabling that society to function 4. Geometric Gradient Series
effectively. - Cash flows that increase or decrease by a fixed percentage.

5. Natural Capital
- It is another term for the stock of renewable and non-renewable
resources (e.g. plants, animals, air, water, soils, minerals) that
combine to yield a flow of benefits to people.

Cash Flow Diagram

- A graphical representation of cash flows drawn on a time scale.

Elements of Cash Flow Diagram

1. Horizontal Line 5. Irregular Series

- Represents the time with progression of time moving from left to - Consists of cash flow that change with no pattern.
right (i.e. month, year).

2. Arrows
- Represents cash flows

a. Upwards ( )
- positive cash flow or cash inflow i.e income.

b. Downwards ( )
- negative cash flow or cash outflow i.e expenses.

3. Depends on the person’s viewpoint

a. Borrower’s viewpoint

b. Lender’s viewpoint

Types of Cash Flows

1. Single Cash Flows

- simplest case involves

the equivalence of a
single present amount
(P)and its future worth
(F).
1. INTEREST d. Rate of Interest
- The cost of borrowing money or the amount earned by a unit principal
- The amount of money paid for the use of borrowed capital or income per unit time.
produced by money which has been loaned.
- Single Cash Flow i. Nominal Rate of Interest
- It is the basic annual rate of interest.
- It specifies the rate of interest and the number of interest
a. Simple Interest periods in one year.

- The interest on a loan that is based only on the principal. Usually

used for short-term loans where the period is measured in days
rather than years.

ii. Effective rate of Interest

- It is the actual or the exact rate of interest earned on the
principal during a one-year period.

i. Ordinary Simple Interest

- Interest is computed on the basis of 12 months of 30

days each which is equivalent to 360 days a year. In this
case, the value of n that is used in the preceding formulas
may be computed as:

n= d/360

where d is the number of days the principal was invested.

ii. Exact Simple Interest

- Interest is computed based on the exact number of days e. Continuous Compounding

each year which is 365 days for a normal year and 366 - Based on the assumption that cash payments occur once per
days during a leap year (which occurs every 4 years, or if year, but compounding is continuous throughout the year
it is a century year, it must be divided by 400). - “Compounded Continuously” is indicated in the problem.

- Note that during leap years, February has 29 days and

28 days only during a normal year. In this case, the
value of n that is used in the preceding formulas may be
computed as:

n= d/365 for a normal year

N= d/366 for a leap year

b. Dicount
- It is the interest deducted in advance.
- It is the difference between the amount a borrower receives in
cash (present worth) and the amount he pays in the future (future
worth).

i. Rate of Discount (%)

- It is the discount on one unit of principal for one unit of
time.

c. Compound Interest

- Interest which is based on the principal plus the previous

accumulated interest.
- It may also be defined as ‘interest on top of interest.”
- This is usually used in commercial practice especially for longer
periods.
2. ANNUITY 3. GRADIENT SERIES

- a series of equal payments occurring at equal interval of time. - a series of cash flows where the amounts change every period.
- Equal Uniform Series - Linear & Geometric Series

a. Ordinary Annuity

- This type of annuity is one where the payments are made at the
end of each period beginning from the first period. a. Arithmetic Gradient Series
- It is one wherein the cash flow changes (increase or decreases)
by the same amount in each cash flow period. The amount of
increase or decrease is called gradient.

Finding P given A

The factor in the bracket is called sinking fund factor and can be
designated by the symbol (A/P, I, n).

Where:
b. Deferred Annuity
- It is a contract with an insurance company that promises to pay PA= the present worth of the first cash flow diagram which is an
the owner a regular income, or a lump sum, at some future date. ordinary annuity
Investors often use deferred annuities to supplement their other
retirement income, such as Social Security.

PG= the present worth of the second cash flow diagram

c. Annuity Due
- It is when payments are made at the beginning of the payment
period.
Finding F given A

Where:

FA= the future worth of the first cash flow diagram which is an
ordinary annuity

d. Perpetuity
- It is a type of annuity where there is no end to the payments. It
may have fixed or growing payments depending on its nature.

FG= the future worth of the second cash flow diagram

e. Annuity with Continuous Compounding

- It is used to calculate the ending balance on a series of periodic
payments that are compounded continuously.
- “Equal payments & Compounded Continuously” is indicated in
G = Increament
the problem.
 i. Equivalent Uniforn Amount Amortization
- A’ is the equivalent uniform amount taking the
equivalent of the series as ordinary annuity. - It is any mode of paying debt, the principal and the interest
included, usually by a series of uniform amount every period.

Amortization Schedule

- A table showing the payments throughout the total interest

period.

Ex.

b. Geometric Gradient Series

- It is when the periodic payment increases or decreases by a
constant percentage.

Capitalized Cost (CC)

- This is one of the most important applications of perpetuity.

- The capitalized cost of any property is the sum of its first cost
and the present worth of all costs for replacement, operation,
and maintenance for a long period or forever.

a. Case 1: No Replacement, maintenance and/or operation every

period.

b. Case 2: Replacement only, no operation and maintenance

Note: If RC is not given, RC=FC

CHAPTER 3 – DEPRECIATION AND DEPLETION
Introduction 7. Recovery Period (n)
- The number of years over which the basis of property is
Depreciation recovered through the accounting process.
- the decrease in the value of a physical property with the passage of
time. 8. Recovery Rate (i)
- It is an allowable expense in general accounting purposes and - A percentage for each year of the recovery period that utilized
income tax accounting purposes. to compute an annual depreciation deduction.
- But it differs categorically from other conventional expenses because
depreciation charge does not occur any outflow of business fund.
- This allows for the companies to recover cost of an asset when it was
purchased. It allows the companies to cover the total cost of an asset Depreciation Symbols
over its lifespan. This is important aspect in analyzing cost because
it represents a significant portion of expenses.

Types of Depreciation

a. Physical Depreciation
- This is due to the reduction of the physical ability of an
equipment or asset to produce results.
- Factors affecting physical depreciation includes tear & wear,
passage of time, action of elements, and casualty/accident,
desease/decay.

b. Functional Depreciation
- This is due to the lessening in the demand for the function
which the property was designed to render.
Methods of Depreciation
- Factors affecting physical depreciation includes inadequency,
obsolescence, and supersession 1. Straight Line Method (SLM)
- The simplest depreciation method. this method assumes that
the loss in the value is directly proportional to the age of the
equipment or asset.
Purpose of Depreciation
a. Annual cost of depreciation
1. To enable the cost of depreciation to be included as a cost in the
production of goods and services.
2. Annual costs of depreciation are being put up in a fund called
depreciation reserve for replacement of the property.
3. To recover capital invested in the property. b. Total depreciation after “n” years
4. Provide as an additional capital termed as depreciation reserve.

c. Book value at the end of “n” years

Properties of Dereciable Assets

1. It must have a determinable life and the life must be greater than 1
year.
2. It must be something used in business or held to produce income.
2. Sinking Fund Method (SFM)
3. It must be something that gets used up, wears out decays, become
- This method assumes that a sinking fund is established in which
obsolete, or loses its value due to natural causes.
funds will accumulate for replacement. The total depreciation
4. It must not be an inventory stock in trade or investment property.
that has taken place up to any given times is assumed to be
equal to the accumulated amount in the sinking fund at that time.

a. Annual cost of depreciation

Dereciation Terminologies

1. Initial Investment/First Cost

- The cost of acquiring an asset, including transportation
expenses and other normal costs of making the asset
serviceable for its intended use. b. Total depreciation after “n” years

2. Book Value (BV)

- Worth of property or an asset as shown on the accounting
records of the company.
- It is the original cost of the property less all allowable
depreciation deductions.
c. Book value at the end of “n” years
3. Salvage Value (SV)
- The amount that will be paid by a willing buyer to a willing seller
for a property after depreciation is competed.

4. Useful Life (L) 3. Declining Balance Method (DBM)

- The expected period that a property will be used in trade or - In this method, sometimes called the constant percentage
business to produce income. method or the Matheson Formula
- it is assumed that the annual cost of depreciation is a fixed
5. Physical Life percentage of the salvage value at the beginning of the year.
- the length of time during which the property can perform the - The ratio of the depreciation in any year to the book value at the
function. beginning of that year is constant throughout the life of the
property and is designated by k, the rate of depreciation.
6. Economic Life
- Length of time during which the property may be operated at a
profit.
 - - This method has the advantage of making the unit cost of
depreciation constant and giving low depreciation expense
during periods of low production.

a. Annual depreciation
a. Service Method (Number of hours used)

b. Salvage Value

c. Total Depreciation

b. Output Method (Number of units produced)

d. Book value at the end of “n” years

4. Double Declining Balance Method (DDBM)

- This method is very similar to the DBM except that the rate of
depreciation k is replaced by 2/L.

a. Annual depreciation
Depletion

- This method is generally applied in case of wasting assets e,g,

mines, quarries and natural resources.
- Here the rate of production is measured by the rate of exhaustion of
the asset. Under this method the total reserve of asset is measured
b. Salvage Value by an expert valuer. After that the cost per unit of reserve asset is
ascertained by dividing the cost of acquisition of the asset by the
total reserve of that asset.
- Periodic depreciation is calculated by multiplying the reserve of
assets exhausted during the period by the cost per unit of reserve
asset. The asset reduced to zero at ends of the total exhaustion, so
c. Total Depreciation the method is known as depletion method.

Cost Depletion

- The capitalized costs that generally go into the cost depletion

basis for petroleum and mining projects are for mineral rights
d. Book value at the end of “n” years acquisition and/or lease bonuses or their equivalent ascertained
costs:

5. Sum of the year digit method (SOYDM)

- It is a method of evaluating depreciation where the depreciation
changes from year to year.

a. Annual depreciation

Steps in computing under Depletion Method

1. Determination of the depletion base

The depletion base comprises of cost incurred to acquire or lease
b. Total Depreciation the asset, exploration cost, development cost and any cost
incurred to restore the property to its original condition after the
assets or resources have been fully depleted.

2. Computation of depletion rate per unit

The depletion rate per unit of a natural resource or asset depends
c. Book value at the end of “n” years upon the total number of units expected to be extracted. This is
calculated by dividing the depletion base less salvage value (if any)
by the number of units expected to be extracted.

3. Computation of depletion/depreciation charge

6. Service Output Method (SOM) Finally, the units extracted during the period are multiplied by the
- - This method assumes that the total depreciation that has taken depletion rate per unit to compute the depletion or depreciation
place is directly proportional to the quantity of output of the charge for the period.
property up to that time.
The above three steps can be combined to make the following CHAPTER 4 – CAPITAL FINANCING
formula for computing depletion or depreciation charge for a
particular period. Introduction

Business runs on money. Capital is more the just money. Capital

financing refers to methods you use to raise money in launching your
business. Your business can have several types of capital such as financial,
human, and even natural capital.

Financial capital keeps your business running. After you start

earning a profit, some of your capital comes from your revenues. If your
business starting small or you have deep pockets, you may be able to
survive with your own resources.

Equity and Borrowed Capital

Equity

- Equity capital or ownership funds are those supplied and used by

the owners of an enterprise in the expectation that a profit will be
earned.

Borrowed Funds or Capital

- Are those supplied by others on which a fixed rate of interest must

be paid, and the debt must be repaid at a specific time.

Types of Business Organizations

a. Individual Ownership
- The individual ownership or sole proprietorship is the simplest
form of business organization, wherein a person uses his or her
own capital to establish a business and is the sole owner.

Advantages
1. It is easy to organize.
2. The owner has full control of the enterprise.
3. The owner is entitled to whatever benefits and profits that
accrue from the business.
4. It is easy to dissolve.

Disadvantages
1. The amount of equity capital which can be accumulated is
limited.
2. The organization ceases upon the death of the owner.
3. It is difficult to obtain borrowed capital, owing to the uncertainty.
4. The liability of the owner for his debts is unlimited.

b. The Partnership
- A partnership is an association of two or more persons for the
purpose of engaging in a business for profit.

Advantages
1. More capital may be obtained by the partners pooling their
resources together.
2. It is bound by few legal requirements as to its accounts,
procedures, tax forms and other items of operation.
3. Dissolution of the partnership may take place at any time by
more agreement of partners.
4. It provides an easy method whereby two or more persons of
differing talents may enter into business, each carrying those
burdens that he can best handle.

Disadvantages
1. The amount of capital that can be accumulated is limited.
2. The life of the partnership is determined by the life of the
individual partners. When any partner dies, the partnership
automatically ends.
3. There may be serious disagreement among the individual
partners.
4. Each partner is liable for the debts of the partnership.

c. The Corporation
- A corporation is a distinct legal entity, separate from the
individuals who own it, and which can engage in almost any type
of business transaction in which a real person could occupy
himself or herself.
 Advantages Methods of Bond Retirement
1. It enjoys perpetual life without regard to any change in the
person of its owners, the stockholders. 1. The corporation may issue another set of bonds equal to the
2. The stockholders of the corporation are not liable for the debts amount of bonds due for redemption.
of the corporation. 2. The corporation may set up a sinking fund into which periodic
3. It is relatively easier to obtain large amount of money for deposits of equal amount are made. The accumulated amount in
expansion, due to its perpetual life. the sinking fund is equal to the amount needed to retire the bonds
4. The ownership in the corporation is readily transferred. at the time they are due.
5. Authority is easily delegated by the hiring of managers.

Disadvantages
1. The activities of a corporation are limited to those stated in its (𝟏 + 𝒊)𝒏 − 𝟏
charter.
𝑷(𝟏 + 𝒊)𝒏 = 𝒅 ( )+𝑹
𝒊
2. It is relatively complicated information and administration.
3. There is a greater degree of governmental control as compared
to other types of business organizations.
𝒅 = 𝒇𝒓

Source of Capital for Business Organization

Where:
Capitalization of a Corporation
P = Bond Price
- The capital of a corporation is acquired through the sale of
stock. i = Interest Rate
- There are two principal types of capital stock: common stock
and preferred stock. d = Periodic Deposit

a. Common Stock f = Face Value

- Common stock represents ordinary ownership without
r = Bond Rate
special guarantees of return.
- Common stockholders have certain legal rights, among R = Redemption Price
which are the following:
• Vote at stockholder's meeting.
• Elect directors and delegates to them power to
conduct the affairs of the business. Note: If R is not given, therefore R=f
• Sell or dissolve the corporation.
• Make and amend the bylaws of the corporation.
• Subject to government approval, amend, or change
the charter or capital structure.
• Participate in the profits.
• Inspect the books of the corporation.

a. Preferred Stock
- Preferred stocks are guaranteed a define dividend on
their stocks.
- In case the corporation is dissolved, the assets must be
used to satisfy the claims of the preferred stockholders
before those of the holders of the common stock.
- Preferred stockholders usually have the right to vote in
meetings, but not always.

Financing with Bonds

Bond

- A bond is a certificate of indebtness of a corporation usually for a

period not less than ten years and guaranteed by a mortgage on
certain assets of the corporation or its subsidiaries.
- Bonds are issued when there is need for more capital such as for
expansion of the plant or the services rendered by the corporation.
- The face or par value of a bond is the amount stated on the
bond. When the face value has been repaid, the bond is said to
have been retired or redeemed.
- The bond rate is the interest rate quoted on the bond.\

Classification of Bonds

a. Registered Bonds
- The name of the owner of this bond is recorded on the
record books of the corporation and interest payments are
sent to the owner periodically without any action on his part.

a. Coupon Bonds
- Coupon bond have coupon attached to the bond for each
interest payment that will come due during the life of the
bond. The owner of the bond can collect the interest due by
surrendering the coupon to the offices of the corporation or
at specified banks.