Republic of the Philippines

CAVITE STATE UNIVERSITY-CCAT

Cavite College of Arts and Trades Campus
Rosario, Cavite
 (046)437-9505 /  (046)437-6659
[email protected]
www.cvsu-rosario.edu.ph

LEARNING MODULE

ENGINEERING ECONOMY
(ENSC 30)

Prepared by:

MICHAEL EDWARD T. ARMINTIA, REE, RME

Lecturer, Department of Engineering

First Semester
AY: 2020–2021
 CHAPTER 1: INTRODUCTION

I. OBJECTIVES
After the completion of this chapter, the students will be able to:
✓ identify common terms used in engineering economics;
✓ determine the seven principles of engineering economy;
✓ use the seven-step engineering economic analysis procedure in decision making;
✓ identify different cost terminologies being used in engineering economy; and
✓ identify common economic concepts being used in engineering economy.

II. INTRUCTIONS TO THE LEARNERS

This learning module must be utilized as follow:
✓ Keep and use it as neat as possible.
✓ For every chapter, pre-test will be given. This will be used to assess how much does a student
already know for that chapter. Answer key will be provided with this learning module. Answer key
must only be accessed right after finishing the pre-test.
✓ Lessons under each chapter will be discussed in “Learning Activities” section. Learning activities
include discussion, assignments, and exercises. Assignments and exercises will be done on this
learning module. Submission of assignments and exercises will be online for those who chose
online class and face-to-face for those who chose modular learning. NOTE: Submission of
requirements will be scheduled at least once a month to limit physical contact.
✓ Post-test will also be provided in each chapter. This will be used to assess if the students really
learned from different learning activities conducted. Answer key will also be provided and must
only be accessed after completing the post-test.
✓ This learning module is intended for electrical engineering students enrolled in Cavite State
University – CCAT Campus for academic year 2020-2021. Any form of reciprocation of this
learning module without the consent of the author is not allowed. Once caught, proper sanction
will be applied.
V. LEARNING ACTIVITIES

A. Discussion
B. Exercises
C. Assignment

A. DISCUSSION

1) Definitions
2) Principle of Engineering Economics
3) Engineering Economics and the Design Process
4) Cost Concepts for Decision Making
5) Present Economy Studies

1) Definitions

Engineering Economy is the dollars-and-cents side of the decisions that engineers make or
recommend as they work to position a firm to be profitable in a highly competitive
marketplace. Inherent to these decisions are trade-offs among different types of costs and
the performance provided by the proposed design or problem solution. The mission of
engineering economy is to balance these trade-offs in the most economical manner.

Example 1.1:
Here are some situations in which engineering economy plays a crucial role in the analysis of
project alternative:
a. Choosing the best design for a high-efficiency gas furnace.
b. Selecting the most suitable robot for welding operation on an automotive assembly.
c. Making recommendation about whether jet airplanes for an overnight delivery service
should be purchased or leased.
d. Determining the optimal staffing plan for a computer help desk
From these given situations, it can be seen that engineering economy requires technical
consideration or technical analysis. Technical analysis is significant in decision making for project
alternatives.

Engineering economy involves the systematic evaluation of economic merits of proposed solutions
to engineering problems. To be economically acceptable, solutions to engineering problems must
demonstrate a positive balance of long-term benefits over a long-term cost. Solutions to
engineering problems must also:
a. Promote the well-being and survival of the organization
b. Embody creative and innovative technology and ideas
c. Permit identification and scrutiny of their estimated outcomes
d. Translate profitability to the “bottom line” through a valid and acceptable measure of merit

2) Principles of Engineering Economy

The development, study, and application of any discipline must begin with a basic foundation. For
this chapter, the foundation of engineering economy is defined to be a set of principles that provide
a comprehensive doctrine for developing the methodology.
Seven Principles of Engineering Economy:
Principle 1: Develop the Alternatives
Principle 2: Focus on the Differences
Principle 3: Use a Consistent View Point
Principle 4: Use a Common Unit of Measure
Principle 5: Consider All Relevant Criteria
Principle 6: Make Risk and Uncertainty Explicit
Principle 7: Revisit Your Decisions

Principle 1: Develop the Alternatives

Carefully define the problem. Then, the choice or decision is among the alternatives. The
alternatives need to be identified and then defined for subsequent analysis.

A decision situation involves making a choice between two or more alternatives. Developing
and defining the alternatives for detailed evaluation is important because of the resulting
impact on the quality of the decision. Creativity and innovation are essential to this
process.

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.

If all prospective outcomes of the feasible alternatives are the same, there would be no basis
or need for a comparison. We would be indifferent among the alternatives and could make
random selection. Therefore, only the differences in the future outcomes of the alternatives
are relevant.

Example 1.2:
Mary has two choices for a rental house she need. Both choices offer the same rental fee. If
she will consider the rental fee, then she can just choose randomly. But, considering the
principle 2 of engineering economics, she must focus on the differences of her alternatives to
come up with the best decision. The differences in this example may be the location of the
house and annual operating and maintenance cost. After analysing these differences, Mary
can come up with the best selection from the two rental house.

Principle 3: Use a Consistent View Point

The prospective outcomes of the alternatives, economic and other, should be consistently
developed from a defined viewpoint or perspective.

The perspective of the decision maker, normally the owner of the firm, would be normally
used. However, there are other viewpoints in every situation. It is important that the
viewpoint for a particular decision be first defined and then used consistently in the
description, analysis, and comparison of alternatives.

Example 1.3:
Consider a public organization planning to upgrade and increase the capacity of certain
power generator. The “owners of the firm” in this example means the segment of that public
organization that will pay the cost of the upgrade. Their viewpoint should be adopted in this
case.
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 simplify the analysis of the alternatives.

It is desirable to make as many prospective outcomes as possible commensurable (directly

comparable). For economic consequences, monetary unit is the common measure.

Principle 5: Consider All Relevant Criteria

Selection of a preferred alternative requires the use of a criterion (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 descriptive manner.

The decision maker will normally select the alternative that will best serve the long-term
interests of the owners of the organization. In engineering economics, the primary criterion
relates to the long-term financial interests of the owners. This is based on the assumption
that available capital will be allocated to provide maximum monetary return to the owners.

Principle 6: Make Risk and Uncertainty Explicit

Risk and uncertainty are inherent in estimating the future outcomes of the alternatives and
should be recognized in their analysis and comparison.

The magnitude and impact of future outcomes of any course of action are uncertain. Even if
the alternative involves no change from current operations, the probability is high that
today`s estimate of, for example, future cash receipts and expenses will not be what
eventually occurs.

Principle 7: Revisit Your Decisions

Improve decision making results from an adaptive process; to the extent practicable, the
initial projected outcomes of the selected alternatives should be subsequently compared with
actual results achieved.

A good decision-making process can result in a decision that has an undesirable outcome.
Other decisions, even though relatively successful, will have results significantly different
from the initial estimates of the consequences. Learning from and adapting based on
experience are essential and are indicators of good organization. Organizational discipline is
needed to ensure that implemented decisions are routinely post evaluated and that the
results are used to improve future analyses and the quality of decision making.

3) Engineering Economics and the Design Process

A sound engineering economic analysis procedure incorporates the basic principles of
engineering economics. This procedure is presented in seven steps. This seven-step
procedure can also be used to assist decision making within the engineering design process.
Engineering economic analysis procedure can be related to engineering design process
through Table 1.1.
Table 1.1 The general relationship between the engineering economic analysis procedure
and engineering design process.
Engineering Economic Analysis Procedure Engineering Design Process
1. Problem recognition, definition, and 1. Problem/need definition
evaluation. 2. Problem/need formulation and evaluation
2. Development of feasible alternatives. 3. Synthesis of possible solutions/alternatives
3. Development of the outcomes and the cash
flows for each alternative.
4. Analysis, optimization, and evaluation
4. Selection of criterion.
5. Analysis and comparison of the alternatives.
6. Selection of the preferred alternative. 5. Specification of preferred alternative
7. Performance monitoring and post evaluation 6. Communication
of results.

Engineering Economic Analysis Procedure

1. Problem Definition
This step is important for it provides the basis for the rest of the analysis. A problem must be
well understood and stated before proceeding with the rest of the analysis. Once problem is
recognized, its formulation should be viewed from a systems perspective. That is, the
boundary of extent of the situation needs to be carefully defined, thus establishing the
elements of the problem and what constitutes its environment.

2. Development of Alternatives
In this step, there are two primary actions to be done. First is to develop alternatives and
second is to screen these alternatives to come up with a fewer feasible alternatives.

Example 1.4
The management team of a small furniture manufacturing company is under pressure to
increase profitability to get a much needed loan from the bank to purchase a more modern
pattern-cutting machine. One proposed solution is to sell waste wood chips and shavings to
a local charcoal manufacturer instead of using them to fuel space heaters for the company’s
office and factory areas.
a. Define the company’s problem. Next, reformulate the problem in a variety of creative
ways.
b. Develop at least one potential alternative for reformulated problems.

Answers:
a. The company’s problem is that the revenues are not covering enough the cost.
Reformulation of the problem may be as follows:
i. The problem is to increase revenue while reducing cost.
ii. The problem is maintaining revenue while reducing cost.
iii. The problem is an accounting system that provides distorted cost information.
iv. The problem is that the new machine is really not needed and hence, there is
no need for bank loan.

b. From first reformulation, one alternative is to sell wood chips and shavings as long as
increased revenue exceeds extra expenses that maybe required to heat the buildings.
3. Development of Prospective Outcomes.
This step incorporates principle 2,3 and 4 of engineering economy and uses basic cash flow
approach applied in engineering economy. A cash flow occurs when money is transferred
from one organization or individual to another. It represents the economic effects of
alternative in terms of money spent and received.

The key to developing related cash flows for an alternative is estimating what would happen
to revenues and cost if the particular alternative was implemented.

4. Selection of Decision Criterion

Selection of criterion incorporates principle 5 of engineering economy. The decision maker
will normally select the alternative that will best serve the long term interests of the owners of
the organization.

5. Analysis and Comparison of Alternatives

This step is largely based on cash-flow estimates for the feasible alternatives selected for
detailed study.

6. Selection of Preferred Alternatives

This step is where the alternative which shows better outcome is chosen. This step can only
be done when the first five steps are conducted carefully.

7. Performance Monitoring and Post Evaluation of Results

This step aims to observe the performance of chosen alternative. This is important in
identifying if the expected outcome of the alternative is attained.

Example 1.5:
Robert bought a small apartment building for 5,000,000.00 pesos. He spent 500,000.00
pesos of his own money for the building and mortgage from a local bank for the remaining
4,500,000.00 pesos. The annual mortgage payment to the bank is 525,000.00 pesos. Robert
also expects the annual maintenance on the building to be 750,000.00 pesos. There are four
apartments of two bedrooms each in the building which can be rented for 18,000.00 per
month.
a. What is Robert’s problem?
b. What are his alternatives?
c. Estimate the economic consequences and other required data for the alternatives.
d. Select a criterion for discriminating among alternatives.
e. Analyze and compare the alternatives in view of the least one criterion in addition to
cost.
f. What should Robert do based on the analysis?

Answers:
a. Try to solve how much money Robert spends every year:
Annual mortgage payment 525,000.00
Annual maintenance of the building 750,000.00
TOTAL 1,275,000.00
Also, solve for the total money Robert gains every year:
Number of Cost of renting Number of TOTAL
apartments an apartment months in a year
 4 18,000.00 12 864,000.00

By comparing Roberts revenue and expenses from his apartment building, it can be
concluded that Robert is losing 411,000.00 pesos every year.

b. Alternatives:
i. increase the rental fee
ii. lower the maintenance expense
iii. sell the apartment building
iv. abandon the building

c. Economic consequences:
i. Increasing rental fee by considering the total expenses of Robert.
Total expenses per month: 1,275,000/12
= 106,250.00
Divided by total number of apartments 106,250/4
= 26,562.50
Remember that this is the minimum increase in rental fee for Robert not to lose
money.

ii. Lowering monthly expense. Mortgage payment cannot be lowered so focus on

lowering monthly maintenance expenses.
First, solve for monthly revenue from four apartments: 4(18,000)
= 72,000.00
Subtract monthly mortgage from monthly revenue 72,000 - (525,000/12)
= 28,250.00
Monthly maintenance expenses at the beginning 750,000/12
= 62,500.00
Monthly maintenance expenses is decreased by: 62,500 - 28,250
= 34,250.00
Remember that this is the minimum decrease in monthly maintenance expenses
for Robert not to lose money.

iii. Robert can try to sell the apartment to recover his investment and loss.
iv. Abandoning the building will give the bank the authority to take possession of the
building and may also collect additional fees from Robert. It will also be a bad
reputation for him.

d. One criterion could be to minimize the expected loss of money. For this criterion, first
and third alternative is advisable.
e. Another criterion can be considered, which is credibility. Considering this criterion,
third and fourth alternative is not advisable. Thus, first and second alternative will be
advisable.
f. Robert can try to do market analysis of comparable housing in the area to assess if
increasing the rent will not affect the choice of people in renting in his apartment
building. He can also try to improve how his apartment building look to make it appear
worthy of increasing the rent.
4) Cost Concepts for Decision Making

COST TERMINOLOGY
There are a variety of costs to be considered in an engineering economic analysis. These
costs differ in their frequency of occurrence, relative magnitude, and degree of impact on the
study. In this section, a number of cost categories are defined and illustrated on how they
should be treated in an engineering economic analysis.

Fixed Costs are those unaffected by changes in activity level over a feasible range of
operations for the capacity or capability available. Typical fixed costs include insurance and
taxes on facilities, general management and administrative salaries, license fees, and
interest costs on borrowed capital.

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

Incremental Costs are additional cost that results from increasing the output of a system by
one or more units. Incremental cost is often associated with “go-no go” decisions that involve
a limited change in output or activity level.

Example 1.6:
In connection with surfacing a new highway, a contractor has a choice of two sites on which
to set up asphalt-mixing plant equipment. The contractor estimates that it will cost 137.5
pesos per cubic yard mile (yd3 − mile) to haul the asphalt-paving material from the mixing
plant to the job location. Factors relating to the two mixing sites are shown as follow:
Cost Factor Site A Site B
Average hauling distance 4 miles 3 miles
Monthly rental of site 100,000.00 pesos 350,000.00 pesos
Cost to set up and remove equipment 750,000.00 pesos 2,500,000.00 pesos
Hauling expense 137.5 pesos/yd3 − 137.5 pesos/yd3 −
mile mile
Flag person Not required 7,500 pesos/day

The job requires 50,000 cubic yards of mixed-asphalt-paving material. It is estimated that
four months (17 weeks of five working days per week) will be required for the job.
a. Compare the two sites in terms of their fixed, variable, and total costs. Assume that
the cost on return trip is negligible. Which is the better site?
b. For the selected site, how many cubic yards of paving material does the contractor
have to deliver before starting to make a profit if paid 600.00 pesos per cubic yard
delivered to the job location?

a. The fixed and variable cost for this job is indicated as follow:
Cost Fixed Variable Site A Site B
Rent / 400,000.00 1,400,000.00
Set up / removal / 750,000.00 2,500,000.00
Flag person / 0 637,500.00
Hauling / 27,500,000.00 20,625,000.00
TOTAL 28,650,000.00 25,162,500.00
 Site B, which has greater fixed costs, has the smaller total costs for the job. Note that
extra fixed costs of Site B are being traded off for reduced variable costs at the site.

b. The contractor will begin to make profit at the point where the total revenue equals
total costs as function of the cubic yards of asphalt pavement mix delivered. Based on
Site B:
3(137.5) = 412.5 in variable cost per cubic yard delivered
Total cost = total revenue
4,537,500 + 412.5𝑥 = 600𝑥
𝑥 = 𝟐𝟒, 𝟐𝟎𝟎 cubic yard of asphalt pavement mix delivered

Therefore, by using site B, the contractor will begin to make a profit on the job after
delivering 24,200 cubic yards of material.

Direct Costs are costs that can be reasonably measured and allocated to a specific output
or work activity. The labor and material costs directly associated with a product, service, or
construction activity are direct costs. For example, the materials needed to make a pair of
scissors would be a direct cost.

Indirect Costs are costs that are difficult to allocate to a specific output or work activity.
Normally, they are costs allocated through a selected formula (such as proportional to direct
labor hours, direct labor dollars, or direct material dollars) to the outputs or work activities.
For example, the costs of common tools, general supplies, and equipment maintenance in a
plant are treated as indirect costs. Indirect cost is sometimes referred as overhead or
burden.

Standard Costs are planned costs per unit of output that are established in advance of
actual production or service delivery. They are developed from anticipated direct labor hours,
materials, and overhead categories (with their established costs per unit). Standard costs
play an important role in cost control and other management functions. Some typical uses
are the following:
1. Estimating future manufacturing costs
2. Measuring operating performance by comparing actual cost per unit with the standard
unit cost
3. Preparing bids on products or services requested by customers
4. Establishing the value of work in process and finished inventories

Cash Cost is a cost that involves the payment of cash. Those that do not involve payment of
cash transaction is reflected in the accounting system as noncash cost or book cost.

Book costs are costs that do not involve cash payments but rather represent the recovery of
past expenditures over a fixed period of time. The most common example of book cost is the
depreciation charged for the use of assets such as plant and equipment.

Sunk Cost 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. Thus, a sunk cost is common
to all alternatives, is not part of the future (prospective) cash flows, and can be disregarded
in an engineering economic analysis.
Example 1.7:
Joe College finds a motorcycle he likes and pays 2,000.00 pesos as a down payment, which
will be applied to the 65,000.00 pesos purchase price, but which must be forfeited if he
decides not to take the cycle. Over the weekend, Joe finds another motorcycle he considers
equally desirable for a purchase price of 61,500.00 pesos.

For the purpose of deciding which cycle to purchase, the 2,000.00 pesos is a sunk cost and
thus would not enter into the decision, except that it lowers the remaining cost of the first
cycle. The decision then is between paying an additional 63,000.00 (65,000-2,000) for the
first motorcycle versus 61,500.00 pesos for the second motorcycle.

Opportunity Cost 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.
Thus, it is the cost of the best rejected (i.e., foregone) opportunity and is often hidden or
implied.

Example 1.8:
Consider a student who could earn 1,000,000.00 pesos for working during a year, but
chooses instead to go to school for a year and spend 250,000 to do so. The opportunity cost
of going to school for that year is 1,250,000.00 pesos; 250,000.00 pesos cash outlay and
1,000,000.00 pesos for income foregone. (This figure neglects the influence of income taxes
and assumes that the student has no earning capability while in school.)

Life-Cycle Cost refers to a summation of all the costs related to a product, structure,
system, or service during its life span. The life cycle begins with identification of the
economic need or want (the requirement) and ends with retirement and disposal activities. It
is a time horizon that must be defined in the context of the specific situation. For example,
the amount of time that a structure or piece of equipment is able to perform economically
may be shorter than that permitted by its physical capability. Changes in the design
efficiency of a boiler illustrate this situation. The old boiler may be able to produce the steam
required, but not economically enough for the intended use. The life cycle may be divided
into two general time periods: the acquisition phase and the operation phase.

The acquisition phase begins with an analysis of the economic need or want— the analysis
necessary to make explicit the requirement for the product, structure, system, or service.
Then, with the requirement explicitly defined, the other activities in the acquisition phase can
proceed in a logical sequence. The conceptual design activities translate the defined
technical and operational requirements into a preferred preliminary design. Included in these
activities are development of the feasible alternatives and engineering economic analyses to
assist in the selection of the preferred preliminary design. Also, advanced development and
prototype-testing activities to support the preliminary design work occur during this period.

The next group of activities in the acquisition phase involves detailed design and planning for
production or construction. This step is followed by the activities necessary to prepare,
acquire, and make ready for operation the facilities and other resources needed. Again,
engineering economy studies are an essential part of the design process to analyse and
compare alternatives and to assist in determining the final detailed design. In the operation
phase, the production, delivery, or construction of the end item(s) or service and their
operation or customer use occur. This phase ends with retirement from active operation or
use and, often, disposal of the physical assets involved. The priorities for engineering
economy studies during the operation phase are:
1. achieving efficient and effective support to operations
2. determining whether (and when) replacement of assets should occur
3. projecting the timing of retirement and disposal activities

Figure 1.1 Phases of life-cycle and their relative cost

Figure 1.1 shows relative cost profiles for the life cycle. The greatest potential for achieving
life-cycle cost savings is early in the acquisition phase. How much of the life-cycle costs for a
product (for example) can be saved is dependent on many factors. However, effective
engineering design and economic analysis during this phase are critical in maximizing
potential savings.

Several Basic Life-Cycle Cost Categories:

1. Investment cost
2. Operation and Maintenance Cost
3. Disposal Cost

Investment Cost is the capital required for most of the activities in the acquisition phase.
This cost is also called a capital investment.

Operation and Maintenance Cost includes many of the recurring annual expense items
associated with the operation phase of the life cycle. The direct and indirect costs of
operation associated with the five primary resource areas—people, machines, materials,
energy, and information—are a major part of the costs in this category.
Disposal Cost includes those nonrecurring costs of shutting down the operation and the
retirement and disposal of assets at the end of the life cycle. Normally, costs associated with
personnel, materials, transportation, and one-time special activities can be expected. These
costs will be offset in some instances by receipts from the sale of assets with remaining
market value.

THE GENERAL ECONOMIC ENVIRONMENT

There are numerous general economic concepts that must be taken into account in
engineering studies. In broad terms, economics deals with the interactions between people
and wealth, and engineering is concerned with the cost-effective use of scientific knowledge
to benefit humankind. This section introduces some of these basic economic concepts and
indicates how they may be factors for consideration in engineering studies and managerial
decisions.

Consumer Goods and Services are those products or services that are directly used by
people to satisfy their wants. Food, clothing, homes, cars, television sets, haircuts, opera,
and medical services are examples.

Producer Goods and Services are used to produce consumer goods and services or other
producer goods. Machine tools, factory buildings, buses, and farm machinery are examples.

Goods and services are produced and desired because they have utility—the power to
satisfy human wants and needs. Thus, they may be used or consumed directly, or they may
be used to produce other goods or services. Utility is most commonly measured in terms of
value, expressed in some medium of exchange as the price that must be paid to obtain the
particular item.

Measures of Economic Worth

Much of business activities, including engineering, focus on increasing the utility (value) of
materials and products by changing their form or location. Thus, iron ore, worth only a few
dollars per ton, significantly increases in value by being processed, combined with suitable
alloying elements, and converted into razor blades.

Necessities and Luxuries

Goods and services may be divided into two types: necessities and luxuries. Obviously,
these terms are relative, because, for most goods and services, what one person considers
a necessity may be considered a luxury by another. For example, a person living in one
community may find that an automobile is a necessity to get to and from work. If the same
person lived and worked in a different city, adequate public transportation might be available,
and an automobile would be a luxury.

Price-Demand
For all goods and services, there is a relationship between the price that must be paid and
the quantity that will be demanded or purchased. This general relationship is depicted in
Figure 1.2. As the selling price per unit 𝑝 is increased, there will be less demand 𝐷 for the
product, and as the selling price is decreased, the demand will increase.
 Figure 1.2 General price-demand relationship (Note that price is considered to be
the independent variable but is shown as the vertical axis. This convention is
commonly used by economists.)

The relationship between price and demand can be expressed as the linear function:

𝑝 = 𝑎 − 𝑏𝐷
𝑎
for 0 ≤ 𝐷 ≤ and 𝑎 > 0, 𝑏 > 0
𝑏

where 𝑎 is the intercept on the price axis and −𝑏 is the slope. Thus, 𝑏 is the amount by
which demand increases for each unit decrease in 𝑝. Both 𝑎 and 𝑏 are constants.

Competition
Because economic laws are general statements regarding the interaction of people and
wealth, they are affected by the economic environment in which people and wealth exist.
Most general economic principles are stated for situations in which perfect competition
exists.

Perfect competition occurs in a situation in which any given product is supplied by a large
number of vendors and there is no restriction on additional suppliers entering the market.
Under such conditions, there is assurance of complete freedom on the part of both buyer
and seller. Perfect competition may never occur in actual practice, because of a multitude of
factors that impose some degree of limitation upon the actions of buyers or sellers, or both.
However, with conditions of perfect competition assumed, it is easier to formulate general
economic laws.

Monopoly is at the opposite pole from perfect competition. A perfect monopoly exists when
a unique product or service is only available from a single supplier and that vendor can
prevent the entry of all others into the market. Under such conditions, the buyer is at the
complete mercy of the supplier in terms of the availability and price of the product. Perfect
monopolies rarely occur in practice, because:
1. few products are so unique that substitutes cannot be used satisfactorily
2. governmental regulations prohibit monopolies if they are unduly restrictive
Total Revenue Function
The total revenue that will result from a business venture during a given period is the product
of the selling price per unit, p, and the number of units sold, D. Thus,

𝑇𝑅 = price 𝑥 demand = 𝑝 ∙ 𝐷

If the relationship between price and demand is used, then:

𝑇𝑅 = (𝑎 − 𝑏𝐷)𝐷 = 𝑎𝐷 − 𝑏𝐷2

The relationship between total revenue and demand for the condition expressed in above
equation may be represented by the curve shown in Figure 1.3.

Figure 1.3 Total revenue function as a function of demand

̂ , that will produce maximum total revenue can be obtained by

From calculus, the demand 𝐷
solving:

𝑑𝑇𝑅
= 𝑎𝐷 − 2𝑏𝐷2
𝑑𝐷
𝑑𝑇𝑅
= 𝑎 − 2𝑏𝐷 = 0
𝑑𝐷
𝑎
̂=
𝐷
2𝑏

Cost, Volume, and Breakeven Points Relationships

Fixed cost remains constant over a wide range of activities, but variable costs vary in total
with the volume of output. Thus, at any demand 𝐷, total cost is:

𝐶𝑇 = 𝐶𝐹 + 𝐶𝑉

Where 𝐶𝐹 and 𝐶𝑉 denote fixed and variable costs, respectively. For the linear relationship
assumed here,

𝐶𝑉 = 𝑐𝑣 ∙ 𝐷

where 𝑐𝑣 is the variable cost per unit.

In this section, we consider two scenarios for finding breakeven points. In the first scenario,
demand is a function of price. The second scenario assumes that price and demand are
independent of each other.

Scenario 1. When total revenue and total cost are combined, the typical results as a function
of demand are depicted in Figure 1.4.

Figure 1.4 Combined cost and revenue functions, and breakeven

points as functions of volume, and their effect on typical profit

At breakeven point 𝐷1′ , total revenue is equal to total cost, and an increase in demand will
result in a profit for the operation. Then at optimal demand, 𝐷 ∗ , profit is maximized. At
breakeven point, 𝐷2′ , the total cost are again equal to the total revenue, but additional volume
will result in an operating loss instead of profit. Obviously, the conditions for which breakeven
and maximum profit occur are our primary interest. First, at any volume (demand), 𝐷,

Profit (loss) = total revenue − total costs

= (𝑎𝐷 − 𝑏𝐷2 ) − (𝐶𝐹 + 𝑐𝑣 𝐷)
= −𝑏𝐷2 + (𝑎 − 𝑐𝑣 )𝐷 − 𝐶𝐹

Based on above equation, in order for profit to occur, two conditions must be met:
1. (𝑎 − 𝑐𝑣 ) > 0; that is, the price per unit that will result in no demand has to be greater
than the variable cost per unit.
2. Total revenue must exceed total cost for the period involved.

If these conditions are met, we can find the optimal demand at which maximum profit will
occur by taking the first derivative of above equation with respect to 𝐷 and setting it equal to
zero:

𝑑(profit)
= 𝑎 − 𝑐𝑣 − 2𝑏𝐷 = 0
𝑑𝐷
𝑎 − 𝑐𝑣
𝐷∗ =
2𝑏
To ensure that we have maximized profit, (rather than minimized), the sign of the second
derivative must be negative. Getting the second derivative of above equation will result to:

𝑑 2 (profit)
= −2𝑏
𝑑𝐷2

An economic breakeven point for an operation occurs when total revenue equals total cost.
Then for total revenue and total cost:

Total revenue = Total cost

𝑎𝐷 − 𝑏𝐷 2 = 𝐶𝐹 + 𝑐𝑣 𝐷
2
−𝑏𝐷 + (𝑎 − 𝑐𝑣 )𝐷 − 𝐶𝐹 = 0

Above equation is a quadratic equation where 𝐷 serves as the unknown variable. Solving for
the roots of the equation will result to the two breakeven points 𝐷1′ and 𝐷2′ .

Example 1.9:
A company produces an electronic timing switch that is used in consumer and commercial
products. The fixed cost is $73,000 per month, and the variable cost is $83 per unit. The
selling price per unit is 𝑝 = $180 − 0.02𝐷.
a. Determine the optimal volume for this product and confirm that a profit occurs at this
demand.
b. Find the volumes at which breakeven occurs; that is, what is the range of profitable
demand?

𝑎−𝑐𝑣 180−83
a. 𝐷 ∗ = = = 2,425 units per month
2𝑏 2(0.02)
To confirm that profit occurs, (𝑎 − 𝑐𝑣 ) > 0 and total revenue exceeds total costs.

(180 − 83) = $𝟗𝟕 > 𝟎

total revenue > total costs
180(2,425) − 0.02(2,425)2 > 73,000 + 83(2,425)
𝟑𝟏𝟖, 𝟖𝟖𝟕. 𝟓 > 𝟐𝟕𝟒, 𝟐𝟕𝟓

To confirm that profit occurs:

Profit = total revenue − total costs; for 𝐷 ∗ = 2,425

Profit = (𝑎𝐷 − 𝑏𝐷2 ) − (𝐶𝐹 + 𝑐𝑣 𝐷)
Profit = (180(2,425) − 0.02(2,425)2 ) − (73,000 + 83(2,425)) = $𝟒𝟒, 𝟔𝟏𝟐. 𝟓

b. Breakeven points occurs when total revenue = total costs

−𝑏𝐷 2 + (𝑎 − 𝑐𝑣 )𝐷 − 𝐶𝐹 = 0
2
−0.02𝐷 + (180 − 83)𝐷 − 73,000 = 0
−0.02𝐷2 + 97𝐷 − 73,000 = 0

−97 ± √972 − 4(97)(−0.02)(−73,000)

𝐷′ =
2(−0.02)
 −97+59.74
𝐷1′ = = 931.5 units per month
−0.04
−97−59.74
𝐷2′ = = 3,918.5 units per month
−0.04

Thus, the range profitable demand is 931.5 to 3,918.5 units per month.

Scenario 2. When the price per unit 𝑝 for a product or service can be represented more
simply as being independent of demand and is greater than the variable cost per unit 𝑐𝑣 , a
single breakeven point results. Then, under the assumption that demand is immediately met,
total revenue 𝑇𝑅 = 𝑝 ∙ 𝐷.

Figure 1.5 Typical breakeven chart with price (𝑝) as constant

Example 1.10:
An engineering consulting firm measures its output in a standard service hour unit, which is a
function of the personnel grade levels in the professional staff. The variable cost 𝑐𝑣 is $62
per standard service hour. The charge-out rate (selling price 𝑝) is $85.56 per hour. The
maximum output of the firm is 160,000 hours per year, and its fixed cost 𝐶𝐹 is $2,024,000 per
year. For this firm,
a. What is the breakeven point in standard service hours and in percentage of total
capacity?
b. What is the percentage reduction in the breakeven point if:
i. Fixed cost are reduced by 10%
ii. Variable cost per hour is reduced by 10%
iii. Selling price per unit is increased by 10%

a. Breakeven point is when the total revenue is equal to the total cost.
𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡
𝑝𝐷′ = 𝐶𝐹 + 𝑐𝑣 𝐷′
𝑝𝐷′ − 𝑐𝑣 𝐷′ = 𝐶𝐹
𝐷 ′ (𝑝 − 𝑐𝑣 ) = 𝐶𝐹
𝐶𝐹
𝐷′ =
𝑝 − 𝑐𝑣
 2,024,000
𝐷′ = ≈ 85,908 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
85.56 − 62
85,908
𝐷′ = ≈ 0.5369 or 53.69% 𝑜𝑓 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦
160,000

b. Percentage reduction in breakeven:

i. A 10% reduction in fixed cost 𝐶𝐹 :

0.9(2,024,000)
𝐷′ = ≈ 77,317 ℎ𝑜𝑢𝑟𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
85.56 − 62
and
85,908 − 77,317
𝐷′ = ≈ 0.1 or 10 % 𝑟𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑖𝑛 𝐷′
85,908

ii. A 10% reduction in variable cost per hour 𝑐𝑣 :

2,024,000
𝐷′ = ≈ 68,011 ℎ𝑜𝑢𝑟𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
85.56 − (0.9)(62)
and
85,908 − 68,011
𝐷′ = ≈ 0.2083 or 20.83% 𝑟𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑖𝑛 𝐷′
85,908

iii. A 10% increase in selling price per unit 𝑝:

2,024,000
𝐷′ = ≈ 63,022 ℎ𝑜𝑢𝑟𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
(1.1)(85.56) − 62
and
85,908 − 63,022
𝐷′ = ≈ 0.2664 or 26.64% 𝑟𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑖𝑛 𝐷′
85,908

Thus, the breakeven point is more sensitive to a reduction in a variable cost per hour
than to the same percentage reduction in the fixed cost. Furthermore, breakeven
point in this example is highly sensitive to the selling price per unit 𝑝.

Market competition often creates pressure to lower the breakeven point of an operation; the
lower the breakeven point, the less likely that a loss will occur during market fluctuations.
Also, if the selling price remains constant (or increases), a larger profit will be achieved at
any level of operation above the reduced breakeven point.

5) Present Economy Studies

When an alternative for accomplishing a specific task are being compared over one year or
less and the influence of time on money can be ignored, engineering economic analyses are
referred to as present economy studies. There are rules, or criteria, to select preferred
alternative for present economy studies.

Rule 1: When revenues and other economic benefits are present and vary among
alternatives, chose the alternative that maximizes overall profitability based on
the number of defect-free units of a product or service produced
Rule 2: When revenues and other economic benefits are not present or are constant
among all alternatives, consider only the costs and select the alternative that
minimizes total cost per defect-free unit of product or service output.

Total Cost in Material Selection

In many cases, economic selection among materials cannot be based solely on the costs of
materials. Frequently, a change in materials will affect design and processing costs, and
shipping costs may be altered.

Example 1.11:
A good example in this situation is illustrated by part for which annual demand is 100,000
units. The part is produced on a high-speed turret lathe, using 1,112 screw-machine steel
costing $0.30 per pound. A study was conducted to determine whether it might be cheaper to
use brass screw stock costing $1.40 per pound. Because the weight of steel required per
piece was 0.0353 pounds and that brass was 0.0384 pounds, the material cost per piece was
$0.0106 for steel and $0.0538 for brass. However, when the manufacturing engineering
department was consulted, it was found that, although 57.1 defect-free parts per hour were
being produced by using steel, the output would be 102.9 defect-free parts per hour if brass
were used. Which material should be used for this part?

Answer:
The machine attendant is paid $15.00 per hour, and the variable overhead costs for the turret
lathe are estimated to be $10.00 per hour. Thus, the total cost comparison for the two
materials is as follows:
1112 Steel Brass
Material 0.30𝑥0.0353 0.0106 1.40𝑥0.0384 0.0538
Labor 15.00/57.1 0.2627 15.00/102.9 0.1458
Variable Overhead 10.00/57.1 0.1751 10.00/102.9 0.0972
Total Cost per Piece $𝟎. 𝟒𝟒𝟖𝟒 $𝟎. 𝟐𝟗𝟔𝟖
Saving per piece by using brass = 0.4484 − 0.2968 = %0.1516

Because 100,000 parts are made each year, revenues are constant across the alternatives.
Rule 2 would select brass, and its use will produce a savings of $151.60 per thousand (a
total of $15,160 for the year). It is also clear that costs other than the cost of material (such
as labor or overhead) were important in study.
B. EXERCISES

Exercise Number 1
Objective(s) Identify common terms used in engineering economics.
Instruction Identify what is being asked in each number. Write your answer on the space
provided.

_________________1. Only the _______ in expected future outcomes among the alternatives
are relevant to their comparison and should be considered in the
decision.
_________________2. Occurs when money is transferred from one organization or individual to
another.
_________________3. Engineering economy involves the systematic evaluation of economic
merits of proposed solutions to __________.
_________________4. A ______ situation involves making a choice between two or more
alternatives
_________________5. If all prospective outcomes of the feasible alternatives are the same,
there would be no basis or need for a _______.
_________________6. The mission of engineering economy is to balance ______ in the most
economical manner.
_________________7. In engineering economics, the ______ relates to the long-term financial
interests of the owners.
_________________8. _____ and innovation are essential in developing alternatives.
_________________9. Common unit of measure for economic consequences.
_________________10. Dollars-and-cents side of the decisions that engineers make or
recommend as they work to position a firm to be profitable in a highly
competitive marketplace.

Exercise Number 2
Objective(s) Determine the seven principles of engineering economy.
Instruction Identify which principle of engineering economy is being described in each
number. Write your answer on space provided.

Selection of a The prospective The alternatives Improve decision

preferred alternative outcomes should be need to be identified making results from
requires the use of a developed from a and then defined for an adaptive process.
criterion. defined perspective. subsequent analysis.

PRINCIPLE PRINCIPLE PRINCIPLE PRINCIPLE

NUMBER: NUMBER: NUMBER: NUMBER:

Using common unit Risk and uncertainty Only the differences

of measurement will should be recognized should be
simplify the analysis in analysis of considered in the
of the alternatives. alternatives. decision.

PRINCIPLE PRINCIPLE PRINCIPLE

NUMBER: NUMBER: NUMBER:
Exercise Number 3
Objective(s) Use the seven-step engineering economic analysis procedure in decision
making.
Instruction Analyse the situation and answer the questions provided after given.

Situation:
While studying for the engineering economy final exam, you and two friends find yourselves
craving a fresh pizza. You can’t spare the time to pick up the pizza and must have it delivered.
“Pick-Up-Sticks” offers a 1-1/4-inch-thick (including toppings), 20-inch square pizza with your
choice of two toppings for $15 plus 5% sales tax and a $1.50 delivery charge (no sales tax on
delivery charge). “Fred’s” offers the round, deep-dish Sasquatch, which is 20 inches in diameter.
It is 1-3/4 inches thick, includes two toppings, and costs $17.25 plus 5% sales tax and free
delivery.

Questions:

1. Identify the problem in the situation.

2. Develop alternatives for the problem.
3. Develop prospective outcome(s) for the alternatives.
4. Select criterion to be used in discriminating alternatives.
5. Select the best alternative for the situation.

Answers:
Exercise Number 4
Objective(s) Identify different cost terminologies being used in engineering economy.
Instruction Identify what is being asked or described in each number. Write your answer
on the space provided.

_______________ 1. Costs that can be reasonably measured and allocated to a specific output or
work activity.
_______________ 2. Additional cost resulting from increasing the output of a system by one or
more units.
_______________ 3. Includes those nonrecurring costs of shutting down the operation and the
retirement and disposal of assets at the end of the life cycle.
_______________ 4. Planned costs per unit of output that are established in advance of actual
production or service delivery.
_______________ 5. Capital required for most of the activities in the acquisition phase. This cost
is also called a capital investment
_______________ 6. Costs that do not involve cash payments but rather represent the recovery of
past expenditures over a fixed period of time.
_______________ 7. Refers to a summation of all the costs related to a product, structure,
system, or service during its life span.
_______________ 8. Costs associated with an operation that varies in total with the quantity of
output or other measures of activity level.
_______________ 9. Includes many of the recurring annual expense items associated with the
operation phase of the life cycle.
_______________ 10. Cost that involves the payment of cash.
_______________ 11. Costs which are difficult to allocate to a specific output or work activity.
_______________ 12. Cost that has occurred in the past and has no relevance to estimates of
future costs and revenues related to an alternative course of action.
_______________ 13. Costs unaffected by changes in activity level over a feasible range of
operations for the capacity or capability available.
_______________ 14. Cost of the best rejected (i.e., foregone) opportunity and is often hidden or
implied.
_______________ 15. Often associated with “go-no go” decisions that involve a limited change in
output or activity level.

Exercise Number 5
Objective(s) Identify common economic concepts being used in engineering economics
Instruction Identify what is being asked or described in each number. Encircle the letter
corresponding to your answer.

1. Much of business activities, including engineering, focus on increasing the ______ of materials
and products by changing their form or location.
a. number b. need
c. choices d. utility

2. Exists when a unique product or service is only available from a single supplier and that vendor
can prevent the entry of all others into the market.
a. perfect competition b. competition
c. perfect monopoly d. monopoly

3. Products or services that are directly used by people to satisfy their wants.
a. needs and wants b. consumer goods and services
c. output material d. necessities and luxuries
4. Occurs in a situation in which any given product is supplied by a large number of vendors and
there is no restriction on additional suppliers entering the market.
a. perfect competition b. competition
c. perfect monopoly d. monopoly

5. Product of selling price and number of units sold.

a. income b. revenue
c. cost d. profit

6. Total cost can be presented as ___

a. product of fixed and variable cost b. difference of fixed and variable cost
c. sum of fixed and variable cost d. equivalent of fixed cost

7. An economic breakeven point for an operation occurs when ___

a. total revenue is greater than total cost b. total revenue is less than total cost
c. total cost is greater than total revenue d. total revenue is equal to total cost

8. The relationship between price and demand can be expressed as the linear function:
a. 𝐷 = 𝑎𝑏 + 𝑝 b. 𝑝 = 𝑏𝐷 − 𝑎
c. 𝑝 = 𝑎 − 𝑏𝐷 d. 𝐷 = 𝑏𝑝 + 𝑎

9. The ______ the breakeven point, the less likely that a loss will occur during market fluctuations.
a. higher b. lower

10. The power to satisfy human wants and needs.

a. utility b. cost
c. demand d. breakeven

Exercise Number 6
Objective(s) Identify common economic concepts being used in engineering economics
Instruction Solve the following problems using the formulas discussed in this chapter.
Show your solution on the space provided.

A large company in the communication and publishing industry has quantified the relationship
between the price of one of its products and the demand for this product as 𝑝 = 150 − 0.01𝐷 for
an annual printing of this particular product. The fixed costs per year (i.e., per printing) is $50,000
and the variable cost per unit is $40.
a. What is the maximum profit that can be achieved if the maximum expected demand is
6,000 units per year?
b. What is the unit price at this optimal demand?
A cell phone company has a fixed cost of $1,500,000 per month and a variable cost of $20 per
month per subscriber. The company charges $39.95 per month to its cell phone customer.
a. What is the breakeven point for this company?
b. The company currently has 73,000 subscribers and proposes to raise its monthly fees to
$49.95 to cover add-on features such as text messaging, song downloads, game playing,
and video watching. What is the new breakeven point if the variable cost increases to
$25 per customer per month?
c. If 10,000 subscribers will drop their service because of the monthly fee increase in part b,
will the company still be profitable?
C. ASSIGNMENT

Read and analyse the situation and answer the questions that follow.

During your first month as an employee at Greenfield Industries (a large drill-bit manufacturer), you
are asked to evaluate alternatives for producing a newly designed drill bit on a turning machine.
Your boss’ memorandum to you has practically no information about what the alternatives are and
what criteria should be used. The same task was posed to a previous employee who could not finish
the analysis, but she has given you the following information: An old turning machine valued at
$350,000 exists (in the warehouse) that can be modified for the new drill bit. The in-house
technicians have given an estimate of $40,000 to modify this machine, and they assure you that
they will have the machine ready before the projected start date (although they have never done any
modifications of this type). It is hoped that the old turning machine will be able to meet production
requirements at full capacity. An outside company, McDonald Inc., made the machine seven years
ago and can easily do the same modifications for $60,000. The cooling system used for this
machine is not environmentally safe and would require some disposal costs. McDonald Inc. has
offered to build a new turning machine with more environmental safeguards and higher capacity for
a price of $450,000. McDonald Inc. has promised this machine before the start-up date and is willing
to pay any late costs. Your company has $100,000 set aside for the start-up of the new product line
of drill bits.

Questions:
a. Define the problem
b. List key assumptions
c. List alternatives
d. Select a criterion for evaluation of alternatives
e. Introduce risk into this situation
f. Discuss how monetary considerations may impact the selection