Fundamentals of Engineering Economic Analysis

Chapter 1
Introduction
CHAPTER OUTLINE
Introduction to:
Economics
Engineering Economics
• Essential Terminologies in Engineering
Economics
• Definition of Cash Flow
• Principle of Engineering Economics
• Economic System

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Introduction
STUDENT LEARNING OBJECTIVE
From studying this chapter you will learn
• Why Engineer needs economics concepts?
• The terminologies used in the engineering economic
analysis
• Principle of Engineering Economics.
• To develop the cash flow diagram
• How economic system is carried out.

1.1 Definition of Economics

Definition 1
Economics is the social science that examines how people choose to
use limited or scarce resources in attempting to satisfy their
unlimited wants. (N. Gregory Mankiw)
Definition 2
Economics is a science which studies human behavior as a
relationship between ends and scarce means which have alternative
uses. (Lionell Robbins)
Why Engineering Economics?
The field of engineering economy is concerned with the systematic
evaluation of the benefits and costs of the projects involving
engineering design and analysis. Engineering economy quantifies
the benefits and costs associated with engineering projects to
determines if they make (or save) enough money to warrant their
capital investment. In manufacturing or construction, engineering is
involved in every detail of a product’s production (about 85%) from
conceptual design to distribution. Engineers must decide if the
benefits of a project exceed its costs and must make this comparison
in a unified framework. The frame work within which to make this
comparison is the field of engineering economics.
In the development of any product, a company’s engineers are
called upon to translate an idea into reality. A firm’s growth and
development largely depends upon a constant flow of ideas for new
products, and for the firm to remain competitive, it has to make
existing products better or produce them at a lower cost.
Traditionally, a marketing department would propose a product and
pass the recommendation to the engineering department. The
Er. Santosh K. Shrestha Er. Ishwar Adhikari
Fundamentals of Engineering Economic Analysis

engineering department would work up a design and pass it on a

manufacturing, which would make the product. With this type of
product development cycle, a new product normally takes several
months (or even years) to reach a market. Decisions made by the
engineers are commonly the result of choosing one alternative over
another. Decisions often reflect a person’s educated choice of how
to best invest funds, also called capital. The amount of capital is
usually restricted, just as the cash available to an individual is
usually limited. The decision of how to invest the capital will
invariably change the future, hopefully for the better: that is, it will
be value adding. Engineers play a major role in capital investment
decisions based on their analysis, synthesis, and design efforts. The
factors considered in making the decision are a combination of
economic and noneconomic factors.
Hence we can define Engineering Economics in a following
different way:

Definition 1“Engineering economics is the application of economic

techniques to the evaluation of design and engineering alternatives.
The role of engineering economics is to assess the appropriateness
of a given project, estimate its value, and justify it from an
engineering standpoint”. (Dr. John M.Watts)
Definition 2“Engineering economics deals with the methods that
enable one to take economics decision towards minimizing the cost
or maximizing benefits to business organization”.
Definition 3“Engineering economics deals with the concepts and
techniques of analysis useful in evaluating the worth of systems,
products, and services in relation to their costs”.
Definition 4“Engineering economy involves formulating,
estimating, and evaluating the economic outcomes when
alternatives to accomplish a defined purpose are available. Another
way to define engineering economy is as a collection of
mathematical techniques that simplify economic comparison”.

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Introduction
Knowing how to correctly apply these techniques is especially
important to engineers, since virtually any project will affect costs
and/or revenues.

1.2 Role of Engineering Economy

People make decisions: computers, mathematics and other tools do
not make. The techniques and models of engineering economy
assist people in making decisions. Since decision affect what will be
done, the time frame of engineering economy is primarily the future.
Therefore, numbers used in an engineering economic analysis are
best estimates of what is expected to occur. These estimates often
involve the three essential elements: cash flows, time of occurrence
and interest rate. These estimates are about future, and will be
somewhat different than what actually occurs, primarily because of
changing circumstances and unplanned for events. In other words
stochastic nature of estimate will likely make the observed value in
the future differ from the estimate made now. Especially, sensitivity
analysis is performed during the engineering economic study to
determine how the decision might change based on varying estimate
(discussed in chapter 7).
Engineering economy can be used equally to analyze outcomes have
met or not met a specified criterion, such as rate of return
requirement (discussed in chapter 4). There is an important
procedure used to address the development and selection of
alternatives. Commonly referred as the problem-solving approach or
the decision making process, the steps in the approach follow:

1. Understand the problem and define the objective.

2. Collect relevant information.
3. Define the feasible alternative solutions and make realistic
estimates.
4. Identify the criteria for decision making using one or more
attributes.
5. Evaluate each alternative, using sensitivity analysis to
enhance the evaluation.
6. Select the best alternative.
7. Implement the solution and monitor the results.

Er. Santosh K. Shrestha Er. Ishwar Adhikari

Fundamentals of Engineering Economic Analysis

Strategic Economic Decisions

Once project ideas are identified, they are typically classified as:
1. Equipment and process selection
2. Equipment Replacement
3. New product and product expansion
4. Cost reduction, and
5. Service improvement

1.3 Principles of Engineering Economics

The principle of engineering economics can be highlighted in the
seven points as below:
Principle 1
Develop the Alternatives: The choice is among alternatives. The
alternatives need to be identified and then defined for subsequent
analysis.
Principle 2
Focus on the Differences: Only the differences in expected future
outcomes among the alternatives are relevant to their comparison
and should be considered in the decision.
Principle 3
Use a Consistent Viewpoint: The prospective outcomes of the
alternatives, economic and other, should be consistently developed
from a defined viewpoint (perspective).
Principle 4
Use a Common Unit of Measure: Using a common unit of
measurement to enumerate as many of the prospective outcomes as
possible will make easier the analysis and comparison of the
alternatives.
Principle 5
Consider All Relevant Criteria: Selection of preferred alternative
requires the use of criteria or several criteria. The decision process
should consider both the outcomes enumerated in the monetary unit
and those expressed in some other unit of measurement or made
explicit in the descriptive manner.
Principle 6

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Introduction
Make Uncertainty Explicit: Uncertainty is inherent in projecting the
future outcomes of the alternatives and should be recognized in their
analysis and comparison.
Principle 7
Revisit the Decision: Improved decision making results from an
adaptive process to the extent practicable, the initial projected
outcomes of the selected alternative should be subsequently
compared with actual results achieved.

1.4 Essential Economics Terminology

1. Annuity:
• An amount of money payable to a beneficiary at regular
intervals for a prescribed period of time out of a fund
reserved for that purpose.
• A series of equal payments occurring at equal periods of
time
• Amount paid annually/monthly/weekly etc., including
reimbursement of borrowed capital and payment of interest.

2. Assets: An economic resource of entity (including money

resources, physical resources, and intangible resources).

3. Breakeven point:
• A graphic representation of the relation between total
income and total costs for various levels of production and
sales indicating areas of profit and loss.
• A point where the organization is in no gain and no loss
state.
4. Capital:
• The financial resources involved in establishing and
sustaining an enterprise or project.
• A term describing wealth which may be utilized to
economic advantage. The form that this wealth takes may
be as cash, land, equipment, patents, raw materials, finished
products, etc.
5. Cash flow: The statement showing actual amount coming
into the firm and/or going out of the firm.
6. Capital recovery: It is the annual equivalent cost of capital
cost.

Er. Santosh K. Shrestha Er. Ishwar Adhikari

Fundamentals of Engineering Economic Analysis

7. Discount rate: The interest rate used to calculate the

present value of the future cash flows. It is inverse of
compounding.
8. Decision making: A program of action undertaken as a
result of established policy to influence the final decision.
9. Decision making under certainty: Simple decisions that
assume complete information and no uncertainty connected
with the analysis of the decisions.
10. Decision making under uncertainty: Decision for which
the analyst elects to consider several possible futures, the
probabilities of which cannot be estimated.
11. Decisions under risk: A decision problem in which the
analyst elects to consider several possible futures, the
probabilities of which can be estimated.
12. Depreciation:
• Decline in value of a capitalized asset.
• A form of capital recovery applicable to a property with two
or more years' life span, in which an appropriate portion of
the asset's value is periodically charged to current
operations.
13. Economic life: The timeframe an asset will be
economically useful.
14. Economic efficiency: It is the ratio of output to input of a
business system
Economic efficiency (%) = Output/Input*100
= Worth/ cost *100
15. Interest: Interest is the fee that is charged for use of
someone else’s money. The size of the fee will depend upon
the total amount of money borrowed and the length of time
over which it is borrowed.
Simple interest: It is defined as the fixed percentage of the
principal (the amount of money borrowed) multiplied by the
life of the loan.
Compound interest: The type of interest that is periodically
added to the amount investment (or loan) so that subsequent
interest is based on the cumulative amount.
16. Inflation: An increase in the average price paid for goods
and services bringing about reduction in the purchasing
power. The converse of inflation is deflation.

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Introduction
17. Intangibles:
• In economic studies, conditions or economy factors that
cannot be readily evaluated in quantitative terms as in
money.
• In accounting, the assets that cannot be reliably evaluated
(e.g., goodwill, social values).
18. Labour: The capacity of human effort (both mind and
muscles) available for use in producing goods and services.
19. Opportunity cost:
• The value of benefits sacrificed in selecting a course of
action among alternatives.
• The value of the next best opportunity foregone by deciding
to do one thing rather than another.
20. Salvage Value: Receipt at project termination for sale or
transfer of the equipment (can be a salvage cost).
21. Time value of money: Since money has the ability to earn
interest, its value increases with time. Hence it is the
relationship between interest and time.
22. Utility: Satisfaction that a consumer obtains from goods
and services that are consumed. It is a measure of
satisfaction.

1.5 Definition of cash flow

Cash flow is the stream of monetary (Rupees) values—costs
(inputs) and benefits (outputs)—resulting from a project investment.
The analysis of events and transactions that affects the cash position
of company is termed as cash flow. A cash flow is the difference
between total receipts (inflows) and total cash disbursement
(outflows) for a given period of time. It is the statement that shows
the actual amount coming into firm or going out of the firm.

Cash Inflows: Actual rupees coming into a firm.

Cash outflows: Actual rupees going out from the firm.

Cash Flow diagrams (CFD)

The costs and benefits of engineering projects over time are
summarized on a cash flow diagram (CFD). Specifically, CFD
illustrates the size, sign, and timing of individual cash flows, and
Er. Santosh K. Shrestha Er. Ishwar Adhikari
Fundamentals of Engineering Economic Analysis

forms the basis for engineering economic analysis. It is difficult to

solve a problem if you cannot see it. The easiest way to approach
problems in economic analysis is to draw a picture. The picture
should show three things:
1. A time interval divided into an appropriate number of equal
periods
2. All cash outflows (deposits, expenditures, etc.) in each period.
3. All cash inflows (withdrawals, income, etc.) for each period.
Unless otherwise indicated, all such cash flows are considered to
occur at the end of their respective periods.

Drawing a Cash Flow Diagram

• In a cash flow diagram (CFD) the end of period t is the
same as the beginning of period (t+1).
• Beginning of period cash flows are: rent, lease, and
insurance payments
• End-of-period cash flows are: O&M, salvages, revenues,
overhauls
• The choice of time zero is arbitrary. It can be when a project
is analyzed, when funding is approved, or when
construction begins
• One person’s cash outflow (represented as a negative value)
is another person’s inflow (represented as a positive value)
• It is better to show two or more cash flows occurring in the
same year individually so that there is a clear connection
from the problem statement to each cash flow in the
diagram
• Arrow lengths are approximately proportional to the
magnitude of cash flow.

Year 1 Year 5
0 1 2 3 4 5
Fig1.1: A typical cash flow time scale for 5 years

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Introduction

+
Cash
Flow
Rs/$ Time

-
Fig1.2: Example of positive and negative cash flow

P - Pattern
“Present”
0 1 2 3 N-1 N

F - Pattern “Future”
0 1 2 3 N-1 N

A – Pattern
A A A A A

“Annual”
0 1 2 3 N-1 N

(N-1)G
G – Pattern (N-2)G
2G
G
“Linear”
0 1 2 3 N-1 N

(N-2)G
2G
“Geometric”
0 1 2 3 N-1 N
Fig 1.3: Pattern of Cash Flow

Er. Santosh K. Shrestha Er. Ishwar Adhikari

Fundamentals of Engineering Economic Analysis
Rs.1, 000

1 2 3 4 5
0
200 200 200 200

Rs.1, 200
Borrower’s point of view

Rs.1, 200

200 200 200 200

0
1 2 3 4 5

Rs1, 000

Lender’s point of view

Fig1.4: Example of Cash flow diagrams

Example 1.1
A man borrowed Rs. 1,000 from a bank at 8% interest. Two end-of-
year payments: at the end of the first year, he will repay half of the
Rs.1000 principal plus the interest that is due. At the end of the
second year, he will repay the remaining half plus the interest for
the second year.
Cash flow for this problem is:
End of year Cash flow
0 +Rs1, 000
1 -Rs5, 80 (-Rs500 - Rs80)
2 -Rs5, 40 (-Rs500 - Rs40)

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Introduction
Rs1000

1 1
0

Rs580 Rs540

1.6 Economic System

Economic system is the institutional framework within which a
society or country carries on its economic activities. Mainly, there
are three types of systems:
1. Private enterprise system (Capitalistic Economic
System)
2. Pure socialistic system
3. Combination of both (Mixed Economic System)

1. Private enterprise system (Capitalistic Economic

System)
Under this system, all firms, factories and other means of
productions are the property of private individuals and
organizations. They are free to use them with a view to making
profit. What to produce how to produce and for whom to produce,
all these central problems of economic are settled by the free
working of the forces of demand and supply.
Features
• Right of private property
• Freedom of enterprise
• Freedom of choice by consumers
• Profit motive
• Class conflict
Merits
• Individual initiative
• Perfect competition
• Dynamic economy
Demerits
• Inequality of incomes
• Inefficient production

Er. Santosh K. Shrestha Er. Ishwar Adhikari

Fundamentals of Engineering Economic Analysis

• Monopoly and exploitation

• Unemployment

2. Pure socialistic system

In pure socialistic system there is no private property. Resources,
goods and services are owned and controlled by the government.
Production takes place in government enterprises and the
government specifies the conditions under which exchange can
occur.
Features
• Social ownership of means of production
• No private enterprise
• Economic equality
• Equality of opportunity
• Economic planning
• Social welfare and social security.
Merits
• In the absence of private profit, production will be shifted
from more profitable goods to more useful goods.
• Many things, consumption of which is considered essential
for health and efficiency, may be supplied free or below
cost.
• Socialist economy will prevent cyclical fluctuations in
business activity and will bring about smooth working of
the economy.
Demerits
• Bureaucratic running of the system
• It will lead to concentration of both political and economic
power in the hands of government.
• There is no proper basis of cost calculation and in the
absence of such a basis, the economy cannot function in an
efficient manner or allocate the resources in the best
possible way.

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Introduction
3. Combination of both (Mixed Economic System)
The private enterprise system is decentralized where as socialistic
system is highly centralized. In present days, economy is the
mixture of socialism and private enterprises. According to mixed
economy, some part of an economy’s output will be produced by
the profit oriented private sectors and another part will be produced
in a socialistic manner by the public sector. There are also nonprofit
sectors like hospitals, schools etc.
Features
• Co-existence of the public and private sectors
• Role of government directions
• Government protection of labor
• Control of monopoly

Review Questions
1. Define Engineering economics.
2. Why Engineering Economics is necessary for the
Engineers? Discuss.
3. Discuss on Principle of Engineering Economics.
4. Discuss briefly the terminologies used in the engineering
economics.
5. Suppose that today you borrowed Rs 10,000 from a friend
and you asked a friend to repay the loan within 5 years
beginning with Rs 2000 at the end of first year, Rs 1,500 at
the end of 2nd year, Rs 1,000 at the end of 3rd year, Rs 500 at
the end 4th year and 5th year. Draw the cash flow diagram of
this transaction.
6. Define economic system. Discuss on its types.

Er. Santosh K. Shrestha Er. Ishwar Adhikari