BASIC PRINCIPLES IN ENGINEERING ECONOMICS

CHAPTER ONE
BASIC PRINCIPLES IN ENGINEERING ECONOMICS
1.1. Introduction to Engineering economics
1.1.1. Definition and Scope of Economics
Economics is a systematized body of knowledge in which economic facts are studied and analyzed
in a systematic manner. Economics is a science which has its own theories and laws which establish
a relation between cause and effect. Economics is a science because its laws possess universal validity
such as the law of diminishing returns, the law of diminishing marginal utility the law of demand,
Gresham’s law, etc.
 Economics is concerned with human beings who act irrationally and there is no scope for
experimentation in economics.
 Economics as both a Science and an Art: Economics is not only a science but also an art. It
is a science in its methodology and an art in its application. It has a theoretical aspect and is
also an applied science in its practical aspects
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.
Engineering economy, quite simply, is about determining the economic factors and the economic
criteria utilized when one or more alternatives are considered for selection. It deals with the concepts
and techniques of analysis useful in evaluating the worth of systems, products, and services in relation
to their costs
It is a branch of economics which studies patterns of development and the effectiveness of capital
construction. It is the total process of economizing construction project from inception to the
completion.
Before the Great Patriotic War of 1941–45, Engineering/ construction economics was regarded as
part of the science of organization of construction and production, only in the post-war years did it
develop as an independent branch. It refers to practicing economical solutions while not sacrificing
the benefits or comfort one can obtained from that particular project. In other words it is the process
of achieving best of quality in least possible time with best possible lowest cost.
It is used to answer many different questions
 Which engineering projects are worthwhile?
 Which engineering projects should have a higher priority?
 How should the engineering project be designed?
 How much should the project costs?
 When the project is end?
Role of the discipline
Decisions made by engineers, managers, corporation presidents, and individuals 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 capital will invariably
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 BASIC PRINCIPLES IN ENGINEERING ECONOMICS
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.
Additional factors may be intangible, such as convenience, goodwill, friendship, and others.
 Fundamentally, 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.
In other words, engineering economy is at the heart of making decisions. These decisions involve the
fundamental elements of cash flows of money, time, and interest rates.
 It is to assess the appropriateness of a given project, estimate its value, and justify it from an
engineering standpoint.
 To substantiate the transition to the planning and evaluation of the capital performance of
construction organizations on the basis of projects that are finished, turned over to the
customer, and ready to operate.
 To do in performing analysis, synthesizing, and coming to a conclusion as they work on
projects of all sizes.
 To conducts research in the economic efficiency of capital investments
 To evaluates scientific and technological progress in construction
 To works out the economic principles underlying construction planning, the standardization
of construction work and the industrialization of construction.
Role of Engineering Economy in Decision Making
 Problem Solving Approach
o Understand the problem and define the objectives
o Collect relevant information
o Define feasible alternative solution & make realistic estimates
o Identify the criteria for decision making
o Evaluate each alternative
o Select the best alternative
o Implement solution
o Monitor the results
Engineers are required to use economic concepts in the major fields such as: -
 Increasing production,
 Improving productivity,
 Reducing human efforts,
 Increasing wealth by maximizing profit,
 Controlling and reducing cost
 Resource allocation problem.
 Identification of economic choices, and
 Concerns with the decision making of engineering problems of economic in nature.

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 BASIC PRINCIPLES IN ENGINEERING ECONOMICS
1.2. Project Concept
We call an investment plan a project. A project is undertaken for a particular goal or objective to be achieved
within a limited period of time and with limited resources (manpower, money, etc.). A project is framework
for organizing the use of certain amount of resource in a specific way in order to achieve concrete result in a
period of time. A project is characterized by:
A construction period
An operational period
(expected) life time
Specific desired output (benefits)
Use of scarce and valuable resources and/or undesired outputs (costs).
Sometimes a well-defined target.
Different scholars classify project period into different phases:
I. Project identification
II. Project formation and preparation
III. Project appraisal
IV. Project implementation
V. Project monitoring and evaluation
Project appraisal or investment analysis is about the comparison of different investment alternatives or projects
say: A0, A1, A2… Aj, An One of these alternatives say A0 is the without case i.e. the alternative of doing none
of the projects A1, A2,…, Aj, An. sometimes there may be only one project without any alternatives. But in
project appraisal there are at least two alternatives: doing the project or not doing it.
The objective of economic analysis of such projects is three fold:
 The evaluation as to whether a specific project is economically desirable.
 The identification of the most desirable project among several desirable alternatives.
 The placement of the more economically desirable projects in rank order.
Projects are classified into:
 Private owned
 Public or state owned
This distinction is closely related to the nature of goods and services in terms of excludability and
subtractibility.
o Excludability: the degree to which users can be excluded. It is the capacity to prevent consumers
who do not meet the conditions set out by the supplier from using the resource. Example: flood
protection offered by the construction of dikes has low excludability. People living in a flood
protected area cannot easily be excluded from the benefit of flood protection.
o Subtractibility: the degree to which consumption by one user reduces the possibility for consumption
by the others.
Example: -Fisheries have high subtractibility
-Flood control has low subtractibility
-Navigation has low subtractibility.
Public goods have low subtractibility and low excludability. Eg. Service of flood protection.
Private goods have high subtractibility and high excludability. Eg. Individual pit (waste water).
The following are important criteria for public sector decisions;
 Economic efficiency: deals with efficiency of resource allocation. A project is economically feasible
if the total benefits which result from the project exceed those which could accrue without the project

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 BASIC PRINCIPLES IN ENGINEERING ECONOMICS
by an amount in excess of the project cost. The concepts of opportunity cost and willingness to pay
have to be addressed while economic prices, representing real scarce values which often differ from
real market prices are introduced in the analysis. According to established economic theory if a market
is competitive, then the forces within that market will ensure that resources are allocated in an efficient
(economic) manner.
However where there are:
o Economics of scale: i.e. fixed costs are higher than variable costs as in any large capital
investment.
o Economics of scope: I.e. the unit costs of producing several products simultaneously are lower
than producing them separately.
Such activities tend to become natural monopolies. Monopolies both tend to produce less and charge more for
goods and services than they would under competitive conditions. Market mechanism may be deficient in
generating competition. Many water infrastructure projects such as large dams, sewerage systems, water supply
systems and canal head works provide ready examples of such natural monopolies.
 Equity: distribution of costs and benefits over different social classes and different regions.
Eg. Block tariffing in public water supply.
 Inter-generation effects or long term aspects: distribution of costs and benefits over time.
Distribution of natural resources may be beneficial to actual generation but hampers future
development potential. Level of national debt may become a burden to future generation.
 Feasibility of implementation: should be evaluated in technical, financial, social, and administrative
senses. Socially in the sense that reluctance of social groups to accept certain effects of the project may
be there. Administrative wise compatibility with other development plans of the government has to be
considered.
Classification of cost
A key objective in engineering applications is the satisfaction of human needs, which will nearly always imply
a cost. Economic analyses may be based on a number of cost classifications:
1. First (Initial) Cost: Cost to get activity started such as property improvement, transportation,
installation, and initial expenditures.
2. Operation and Maintenance Cost: They are experienced continually over the useful life of the
activity.
3. Fixed Cost: Fixed costs arise from making preparations for the future, and includes costs associated
with ongoing activities throughout the operational life-time of that concern. Fixed costs are relatively
constant; they are decoupled from the system input/output, for example.
4. Variable Cost: Variable costs are related to the level of operational activity (e.g. the cost of fuel for
construction equipment will be a function of the number of days of use).
5. Incremental or Marginal Cost: Incremental (or marginal) cost is the additional expense that will be
incurred from increased output in one or more system units (i.e. production increase). It is determined
from the variable cost.
6. Sunk Cost: It cannot be recovered or altered by future actions. Usually this cost is not a part of
engineering economic analysis.
7. Life-Cycle Cost: This is cost for the entire life-cycle of a product, and includes feasibility, design,
construction, operation and disposal costs.
1.3. Time value of money
Time Value of Money is defined as the time-dependent value of money stemming both from changes
in the purchasing power of money (inflation or deflation) and from the real earning potential of
alternative investments over time.
 The change in the amount of money over a given time period is called the time value of money;

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 BASIC PRINCIPLES IN ENGINEERING ECONOMICS
The following are reasons why $1000 today is “worth” more than $1000 one year from today:
 Inflation
 Risk
 Cost of money
Of these, the cost of money is the most predictable, and, hence, it is the essential component of
economic analysis. Cost of money is represented by
(1) Money paid for the use of borrowed money, or
(2) Return on investment. Cost of money is determined by an interest rate.
1.4. Interest formula and Equivalence
Interest is the manifestation of the time value of money. Computationally, interest is the difference
between an ending amount of money and the beginning amount. If the difference is zero or negative,
there is no interest. There are always two perspectives to an amount of interest-interest paid and
interest earned. Interest is paid when a person or organization borrowed money (obtained a loan) and
repays a larger amount. Interest is earned when a person or organization saved, invested, or lent
money and obtains a return of a larger amount. It is shown below that the computations and numerical
values are essentially the same for both perspectives, but there are different interpretations. Interest
paid on borrowed funds (a loan) is determined by using the relation
Interest = amount owed now - original amount…………………. Equation [1.1]
When interest paid over a specific time unit is expressed as a percentage of the original amount
(principal), the result is called the interest rate.
interest accrued per time unit∗100%
Interest Rate (%) = ………………… Equation [1.2]
Original amount

The time unit of the rate is called the interest period. By far the most common interest period used to
state an interest rate is 1 year. Shorter time periods can be used, such as, 1% per month. Thus, the
interest period of the interest rate should always be included. If only the rate is stated, for example,
8.5%, a 1-year interest period is assumed.
Example 1
An employee at LaserKinetics.com borrows $10,000 on May 1 and must repay a total of $10,700
exactly 1 year later. Determine the interest amount and the interest rate paid.
Solution
The perspective here is that of the borrower since $10,700 repays a loan. Apply Equation [1.1] to
determine the interest paid.
Interest earned = $10,700 - 10,000 = $700
Equation [1.2] determines the interest rate paid for 1 year.
Percent interest rate = [$700 /$10,000] * 100% = 7% per year

Example 2
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 BASIC PRINCIPLES IN ENGINEERING ECONOMICS
Stereophonics, Inc., plans to borrow $20,000 from a bank for 1 year at 9% interest for new recording
equipment. (a) Compute the interest and the total amount due after I year. (b) Construct a column
graph that shows the original loan amount and total amount due after 1 year used to compute the loan
interest rate of 9% per year.
Solution
(a) Compute the total interest accrued by solving Equation [1.2] for interest accrued.
Interest = $20,000(0.09) = $1800
The total amount due is the sum of principal and interest.
Total due = $20,000 + 1800 = $21, 800

Interest earned over a specific period of time is expressed as a percentage of the original amount and
is called rate of return (ROR).
interest accrued per time unit∗100%
Rate of return (%) = ………………….. Equation [1.3]
Original amount

The time unit for rate of return is called the interest period, just as for the borrower's perspective.
Again, the most common period is 1 year. The term return on investment (ROI) is used equivalently
with ROR in different industries and settings, especially where large capital funds are committed to
engineering-oriented programs. The numerical values in Equation [1.2] and Equation [1.3] are the
same, but the term interest rate paid is more appropriate for the borrower's perspective, while the rate
of return earned is better for the investor's perspective.
Example 3
(a) Calculate the amount deposited 1 year ago to have $1000 now at an interest rate of 5% per year.
(b) Calculate the amount of interest earned during this time period.
Solution
(a) The total amount accrued ($1000) is the sum of the original deposit and the earned interest. If X
is the original deposit,
Total accrued = original + original (interest rate)
$1000 = X + X (0.05) = X (l + 0.05) = 1.05X
The original deposit is
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X= $1000/1.05 = $952.38
(b) Apply Equation [1.1] to determine interest earned.
Interest = $1000 - 952.38 = $47.6
Equivalence
Equivalent terms are used very often in the transfer from one scale to another. Some common
equivalencies or conversions are as follows:
Length: 100 centimeters = 1 meter, 1000 meters = 1 kilometer, 12 inches = 1 foot. 3 feet = 1 yard
39.370 inches = 1 meter,
Pressure: 1 atmosphere = 1 newton/meter2, 1 atmosphere = 103 pascal = 1 kilopascal
Many equivalent measures are a combination of two or more scales. For example, 110 kilometers per
hour (kph) is equivalent to 68 miles per hour (mph) or 1.133 miles per minute, based on the
equivalence that 1 mile = 1.6093 kilometers and 1 hour = 60 minutes. We can further conclude that
driving at approximately 68 mph for 2 hours is equivalent to traveling a total of about 220 kilometers,
or 136 miles. Three scales-time in hours, length in miles, and length in kilometers-are combined to
develop equivalent statements. An additional use of these equivalencies is to estimate driving time in
hours between two cities using two maps, one indicating distance in miles, a second showing
kilometers. Note that throughout these statements the fundamental relation 1 mile = 1.6093 kilometers
is used. If this relation changes, then the other equivalencies would be in error.
Examples 4
With an interest rate of 6%, show that $94.34 last year, $100 now, and $106 one year from now are
equivalent. This is the concept of equivalence;
When considered together, the time value of money and the interest rate help develop the concept of
economic equivalence, which means that different sums of money at different times would be equal
in economic value. For example, if the interest rate is 6% per year, $100 today (present time) is
equivalent to $106 one year from today.
Amount accrued = 100 + 100(0.06) = 100(1 + 0.06) = $ 106
So, if someone offered you a gift of $100 today or $106 one year from today, it would make no
difference which offer you accepted from an economic perspective. In either case you have $106 one
year from today. However, the two sums of money are equivalent to each other only when the interest
rate is 6% per year. At a higher or lower interest rate, $100 today is not equivalent to $106 one year
from today.
Examples 5
AC-Delco makes auto batteries available to General Motors dealers through privately owned
distributorships. In general, batteries are stored throughout the year, and a 5% cost increase is added
each year to cover the inventory carrying charge for the distributorship owner. Assume you own the
City Center Delco facility. Make the calculations necessary to show which of the following statements
are true and which are false about battery costs.
(a) The amount of $98 now is equivalent to a cost of $105.60 one year from now.

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(b) A truck battery cost of $200 one year ago is equivalent to $205 now.
(c) A $38 cost now is equivalent to $39.90 one year from now.
(d) A $3000 cost now is equivalent to $2887.14 one year ago.
(e) The carrying charge accumulated in 1 year on an investment of $2000 worth of batteries is $100.
Solution
(a) Total amount accrued = 98(1.05) = $102.90 ≠ $105.60; therefore, it is false.
Another way to solve this is as follows: Required original cost is 105.60/1.05 = $100.57 ≠ $98.
(b) Required old cost is 205.00/1.05 = $195.24 ≠ $200; therefore, it is false.
(c) The cost 1 year from now is $38(1.05) = $39.90; true.
(d) Cost now is 2887.14(1.05) = $3031.50 ≠$3000; false.
(e) The charge is 5% per year interest, or 2000(0.05) = $100; true.
Simple and Compound Interest
The terms interest, interest period, and interest rate (introduced in Section 1.4) are useful in
calculating equivalent sums of money for one interest period in the past and one period in the future.
However, for more than one interest period, the terms simple interest and compound interest become
important.
Simple interest is calculated using the principal only, ignoring any interest accrued in preceding
interest periods. The total simple interest over several periods is computed as
Interest = (principal)*(number of periods)*(interest rate)…………… Equation [1.4]
Where the interest rate is expressed in decimal form.
Examples 5
Pacific Telephone Credit Union loaned money to an engineering staff member for a radio controlled
model airplane. The loan is for $1000 for 3 years at 5% per year simple interest. How much money
will the engineer repay at the end of 3 years? Tabulate the results.
Solution
The interest for each of the 3 years is Interest per year = 1000*(0.05) = $50
Total interest for 3 years from Equation [1.4] is Total interest = 1000*(3)*(0.05) = $150
The amount due after 3 years is Total due = $1000 + 150 = $1 150

For compound interest, the interest accrued for each interest period is calculated on the principal plus
the total amount of interest accumulated in all previous periods. Thus, compound interest means
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 BASIC PRINCIPLES IN ENGINEERING ECONOMICS
interest on top of interest. Compound interest reflects the effect of the time value of money on the
interest also. Now the interest for one period is calculated as
Interest = (principal + all accrued interest)*(interest rate) …………… Equation [1.5]
Or
Total due after a number of years = Principal*(l + interest rate) number of years……. Equation [1.6]
Examples 5
If an engineer borrows $1000 from the company credit union at 5% per year compound interest,
compute the total amount due after 3 years. Compare the results of this and the previous example.
Solution
The interest and total amount due each year are computed separately using Equation [1.6].
Year 1 interest: $1000(0.05) = $50.00
Total amount due after year 1: $1000 + 50.00 = $1050.00
Year 2 interest: $1050(0.05) = $52.50
Total amount due after year 2: $1050 + 52.50 = $1102.50
Year 3 interest: $1102.50(0.05) = $55.13
Total amount due after year 3: $1102.50 + 55.13 = $1157.63
Or
1
Year 1: $1000(1.05) = $1050.00
Year 2: $1000(1.05)2 = $1102.50
Year 3: $1000(1.05)3 = $1157.63
An extra $1157.63 - $1150 = $7.63 of interest is paid compared with simple interest over the 3 yrs.
period.
If $7.63 does not seem like a significant difference in only 3 years, remember that the beginning
amount here is $1000. If we make these same calculations for an initial amount of $100,000 or $1
million, multiply the difference by 100 or 1000, and we are talking real money. This indicates that
the power of compounding is vitally important in all economics-based analyses.

1.5. Cash Flow Diagram

Cash flow is the stream of monetary (dollar) values-costs (inputs) and benefits (outputs)-resulting
from a project investment.
Cash-Flow Diagrams
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

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3. All cash inflows (withdrawals, income, etc.) for each period
The following symbols will be used here:
P=Present sum of money ($)
F=Future sum of money ($)
N=Number of interest periods
I=Interest rate per period (%)
Interest is the money paid for the use of borrowed money or the return on invested capital. The
economic cost of construction, installation, ownership, or operation can be estimated correctly only
by including a factor for the economic cost of money.

Interest factors derivation

 Most of the time two types of operation are used
Compounding : - Future value
Discounting : - Present value
A. Single Payment Factors (F/P and P/F) or Single Deposit
I. Future value of money
A formula is developed which allows determination of the future amount of money F that is
accumulated after n years from a single investment P when interest is compounded one time per year.
If an amount of money P is invested at some time t = 0, the amount of money F1 that will be
accumulated 1 year hence at an interest rate of i percent per year will be:
F1= P + Pi = P (1+i)
At the end of the second year, the amount of money accumulated F2 is the amount that is accumulated
after year 1 plus the interest from the end of year 1 to the end of year 2. Thus;
F2 = F1 + F1i= P (1+i) + P (1+i) i = P (1+i+i+i2)
= P (1+2i+i2) = P (1+i) 2
Similarly, F3 = P (1+i) 3
From the preceding values, it is evident by mathematical induction that the formula for compounding
can be generalized for n years to:

The factor (1+i) n is called the single payment compound-amount factor (SPCAF) or the F/P factor.
Examples 6
P= $1000 i=8% to return after 20 yrs. F=?
Solution F= P (1+i) n= 1000(1+.08)20=1000(1.08)20 F= $4,661

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II. Present value of money
By rearranging the above equation discounting equation can be given as:

Examples 7
F= $5000 i=8% to return after 20 yrs. F=?
Solution
P= F/[1/ (1+i) n]= 5000[1/(1+.08)20]= 5000[1/(1.08)20] P= $1,073
The expression in the brackets is known as single-payment present-worth factor (SPPWF), or the P/F
factor.

B. Uniform-series present worth factor & capital recovery factor (P/A & A/P)
I. Future value of money

The present worth P of the uniform series shown above can be determined by considering each A
value as a future worth F and using the above equation with the P/F factor and then summing the
present-worth values.

 1   1   1   1 
P  A 1
 A 2
 A 3
 A N 
 1  i    1  i    1  i   ….. +  1  i  

 1 1 1 
P  A   ....  
 1  i  1  i  1  i n 
1 2

Multiplying both sides by 1/ (1+i) then subtract the above equation;

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After some simplification of the above equation, we come up with:

 1  i n  1
P  A n 
....i  0
 i 1  i  
The terms in brackets is called the uniform-series present-worth factor (US-PWF) or the P/A factor.
 i1  i n 
A  P 
 1  i   1
n

Examples 7
A. If i = 15% and n = 25 years. This will find the equivalent present worth at 15% per year for
any amount A that occurs uniformly from years 1 through 25. Calculate the P/A factor, the
result is the same except for round-off errors.
B. How much money should you be willing to pay now for a guaranteed $600 per year for 9
years starting next year, at a rate of return of 16 % per year?
Solution

A.
B.

 1  0.169  1 
P  600 9 
 600 * [4.6066]  2763.96
 0.16 1  0.16  
In equation the terms in the bracket is called capital-recovery factor (CRF), or A/P factor, yields the
equivalent uniform annual worth A over n years of a given investment P when the interest rate is i.

C. Sinking fund factor & uniform-series compound amount factor (A/F & F/A)
While the sinking-fund factor (SFF), or A/F factor, and the uniform-series compound-amount factor
(USCAF), or F/A factor, could be derived using the F/P factor, the simplest way to derive the formula
is to substitute into those already developed. Hence,

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 i 
A  F  …………………….A/F factor
 1  i   1
n

 1  i n  1
F  A  ……………..F/A factor
 i 
D. Arithmetic gradient factors (P/G and A/G)
An arithmetic gradient is a cash flow series that either increases or decreases by a constant amount.
The cash flow, whether income or disbursement, changes by the same arithmetic amount each period.
The amount of the increase or decrease is the gradient.
For example, if a manufacture ring engineer predicts that the cost of maintaining a robot will increase
by $500 per year until the machine is retired, a gradient series is involved and the amount of the
gradient is $500.

P/G factor for present worth, the A/G factor for annual series and the F/G factor for future worth.
There are several ways to derive them. We use the single-payment present worth factor (P/F, i, n),
but the same result can be obtained using the F/P, F/A, or P/A factor.
G = constant arithmetic change in the magnitude of receipts or disbursements from one time period
to the next; G may be positive or negative.
From P/F formula
1 2 3 𝑛−2 𝑛−1
𝑃 = 𝐺[(1+𝑖)2 + (1+𝑖)3 + (1+𝑖)4 + ⋯ + (1+𝑖)𝑛−1 + (1+𝑖)𝑛−2 ]
Multiplying both sides by (1+i) 1
1 2 3 𝑛−2 𝑛−1
𝑃(1 + i)1 = 𝐺[(1+𝑖)1 + (1+𝑖)2 + (1+𝑖)3 + ⋯ + (1+𝑖)𝑛−2 + (1+𝑖)𝑛−1 ]
Subtract from the multiplied one
Then;

And

The total present worth PT for a gradient series must consider the base and the gradient separately.
Thus, for cash flow series involving conventional gradients:
 The base amount is the uniform-series amount A that begins in year 1 and extends through
year n. Its present worth is represented by PA.
 For an increasing gradient, the gradient amount must be added to the uniform series amount.
The present worth is PG.

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 BASIC PRINCIPLES IN ENGINEERING ECONOMICS
 For a decreasing gradient, the gradient amount must be subtracted from the uniform-series
amount. The present worth is - PG.
The general equations for calculating total present worth PT of conventional arithmetic gradients are
PT =PA + PG and PT =PA - PG
Similarly, the equivalent total annual series are
AT = AA + AG and AT = AA - AG
Where AA is the annual base amount and AG is the equivalent annual amount of the gradient series.
Engineering Economics Formula

14 | P a g e By Eng. Dawit K