ABE 11

Engineering Economy

Basic Economic Concepts

and Terminologies

Dennis B. Jomoc
Asso. Professor 5
Bohol Island State University
SY 2023-24
Learning Objectives

1. Understand basic terminologies in

engineering economy
Learning Objectives

2. Understand fundamental concepts

that form the foundation for
engineering economy studies
 ALTERNATIVES
- Is a stand-alone solutions for a given
situation.

- May involve items such as purchase cost

(first cost), anticipated useful life, annual
costs of maintaining an asset (annual
maintenance and operating costs),
anticipated resale value (salvage value),
and the interest rate.
ALTERNATIVE SELECTION

- Every situation has at

least two (2) alternatives

1. the one or more

formulated
alternatives

2. Do-nothing/ as-is/
status quo
 CASH FLOWS

- This is the estimated inflows

(revenues, receipts) and outflows
(costs, disbursements) of money

- The heart of an
engineering economic
analysis
 CASH FLOWS

 Engineering projects generally have

economic consequences that occur
over an extended period of time

◦ For example, if an expensive piece of machinery is

installed in a plant were brought on credit, the
simple process of paying for it may take several years

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 CASH FLOWS

 Each project is described as cash receipts or

disbursements (expenses) at different points in time

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 Categories of Cash Flows
 The expenses and receipts due to engineering
projects usually fall into one of the following
categories:

◦ First cost: expense to build or to buy and install

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 Categories of Cash Flows
 The expenses and receipts due to engineering
projects usually fall into one of the following
categories:

◦ Operations and maintenance (O&M): annual expenses,

such as electricity, labor, and minor repairs

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 Categories of Cash Flows
 The expenses and receipts due to engineering
projects usually fall into one of the following
categories:

◦ Salvage value: receipt at project termination for sale or

transfer of the equipment (can be a salvage cost)

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 Categories of Cash Flows
 The expenses and receipts due to engineering
projects usually fall into one of the following
categories:

◦ Revenues: annual receipts due to sale of products or

services

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 Categories of Cash Flows
 The expenses and receipts due to engineering
projects usually fall into one of the following
categories:

◦ Overhaul: major capital expenditure that occurs during

the asset’s life

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 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 forms the basis
for engineering economic analysis

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 Cash Flow Diagrams (CFD)

 A CFD is created by first drawing a segmented

time-based horizontal line, divided into appropriate
time unit.

 Each time when there is a

cash flow, a vertical arrow is
added − pointing down for
costs and up for revenues
or benefits. The cost flows
are drawn to relative scale
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 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
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 Drawing a Cash Flow Diagram

 The choice of time 0 is arbitrary. It can be when a project

is analyzed, when funding is approved, or when
construction begins

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 Drawing a Cash Flow Diagram

 One person’s cash outflow (represented as a negative

value) is another person’s inflow (represented as a
positive value)

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 Drawing a Cash Flow Diagram
 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

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 An Example of Cash Flow Diagram
 A man borrowed $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 $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 +$1000
1 -$580 (-$500 - $80)
2 -$540 (-$500 - $40)

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 Cash Flow Diagram

$1,000

1 2

$540
$580

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 INTANGIBLE FACTORS

- These are non-economic in nature and

difficult to quantify
Examples
Goodwill

Convenience

Friendship
 TIME VALUE OF MONEY

It is often said that “money makes money”

The statement is indeed true, for if we choose

to invest money today, we inherently expect
to have more money in the future.
 TIME VALUE OF MONEY

If a person or company borrows money

today, by tomorrow more than the original
loan principal will be owed.
 TIME VALUE OF MONEY

- The change in the amount

of money over a given period

The most important concept in the

engineering economy
II. Consumer & Producer Goods
2.1. Two (2) classes of good and
services

1. Consumer goods and services

2. Producer goods and services

II. Consumer & Producer Goods

• Consumer goods and services are the

goods and services that directly satisfy human wants

Food Opera

Clothing Medical services

Television Houses

Haircuts Shoes
II. Consumer & Producer Goods

• Producer goods and services are the

goods and services that satisfy human wants indirectly as
part of the production or construction process. They are
not desired for themselves, but they are instrumental in
producing something that can be consumed

Machine Coal

Tools Buses

Equipments Factory Buildings

III. Classifications and
Elements of Cost
o First cost
o It is the initial cost of capitalized property, including
transportation, installation, and other related initial
expenditures
o Normally made of elements that do not recur
o Occurs once

o Operation and Maintenance Cost

o It is that group of costs experienced continually over the
useful life of the activity
o Labor cost for operating and maintenance, fuel and power
cost, spares and repair cost, insurance and taxes
o Fixed Cost

o Fixed cost is that group of costs involved in a going activity

whose value is constant in the future regardless of
operation
o Or costs that are unaffected by changes in activity level
over a feasible range of operation for the capacity or
capability available

o Lease, rent, insurance and taxes on facilities, general

management and administrative salaries, license fees,
interest cost on borrowed capital

o Investment that give rise to fixed cost are made in the

present with the hope that it will be recovered with a profit
as a result of reduction in variable cost or increase in the
income
o Variable Cost

o It is that group of costs that vary in some relationship to

the level of operational activity
o It is related to the rate of use or activity level
o Are those associated with an operation that vary in total
with the quantity of output or other measures of activity
level

o Cost of material and labor (direct), fuel, power

consumption, value-added tax,
o Material needed per unit of product is expected to be
constant
Amount of paint used may be expected to be proportional to
the area painted
o Exercise:

o In connection with surfacing the old farm to market road, an

agricultural engineer has a choice of two sites on which to set up the
asphalt mixing plant equipment. The engineer estimates that it will cost
$1.15 per cubic yard per mile to haul the asphalt paving material from
the mixing plant to the job location. Factors relating to the two mixing
sites are as follows:

Item Site A Site B

Average hauling distance 6 miles 4.3 miles

Monthly rental site $1,000 $5,000

Cost to set up and remove $15,000 $25,000
equipment
Hauling expense $1.15/cu.yd-mile $1.15/cu.yd-mile

Flagperson Not required $96/day

General Cost Terms

 Manufacturing Costs
Direct materials
Direct labor
Mfg. Overhead
 Non-manufacturing Costs
Overhead
Marketing
Administrative

(c) 2002 Contemporary Engineering

Economics 33
Unit Price of an Ice Cream Cone
Items Total Cost Unit Price % of Price
Ice cream (cream, sugar, milk and
milk solids) $120,250 $0.65 26%
Cone 9,250 0.05 2%
Rent 112,850 0.61 24%
Wages 46,250 0.25 10%
Payroll taxes 9,250 0.05 2%
Sales taxes 42,550 0.23 9%
Business taxes 14,800 0.08 3%
Debt service 42,550 0.23 9%
Supplies 16,650 0.09 4%
Utilities 14,800 0.08 3%
Other expenses (insurance,
advertising, fees) 9,250 0.05 2%
Profit 24,050 0.13 5%
Total $462,500 $2.50 100%
 Classifying Costs for Uptown Ice Cream
Shop

Unit Price of an Ice Cream

Ice cream (cream, sugar, milk, and milk solids) $0.65
Cone 0.05
Product/ Rent 0.61
Variable
Wages 0.25
Cost
Payroll taxes 0.25
Sales taxes 0.23
Business taxes 0.08
Debt service 0.23
Period/ Supplies 0.09
Fixed Utilities 0.08
Cost Other (insurance, advertising,professional fees) 0.05
Profit 0.13
$2.50
 Cost Flows and Classifications in a Mfg. Co.

Cost of revenue =
Cost of goods
sold
 Raw materials
inventory
 Work-in-process
inventory
 Finished goods
inventory
Cost Classification for Predicting Cost
Behavior

 Volume index
 Cost Behaviors
Fixed costs
Variable costs
Mixed costs
 Average unit costs
 Volume Index

 Def: The unit measure

used to define
“volume”
 Examples:
◦ Automobile – “miles”
driven
◦ Generating plant –
“kWh” produced
◦ Stamping machine –
“parts” stamped
Fixed Costs

 Def: The costs of

providing a company’s
basic operating
capacity
 Cost behavior:
Remain constant over
the relevant range
Variable Costs
 Def: Costs that vary
depending on the level
of production or sales
 Cost behavior:
Increase or decrease
proportionally
according to the level
of volume
 Average Unit Cost

 Def: activity cost per

unit basis
 Cost Behaviors:
◦ Fixed cost per unit
varies with changes in
volume.
◦ Variable cost per unit of
volume is a constant.

(c) 2002 Contemporary Engineering

Economics 41
Cost Classification of Owning and Operating a
Passenger Car
Cost Classification References Cost
Variable Costs:
Standard miles per gallon 20 miles/ gallon
Average fuel price per gallon $1.34/ gallon
Fuel and oil per mile $0.0689
Maintenance per mile $0.0360
Tires per mile $0.0141

Annual Fixed Costs:

Insurance:
Comprehensive $250 Deductible $90
Collision $500 Deductible $147
Body injury & Property damage $460
License & Registration $95
Property tax $272

Mixed Costs: Depreciation

Fixed portion per year $3,106
Variable portion per mile $0.04
 Cost-Volume Relationship

Volume Index (miles) 5,000 10,000 15,000 20,000

Variable costs ($0.1190/mile) $595 $1,190 $1,785 $2,380

Mixed costs:
Variable portion 200 400 600 800
Fixed portion 3,106 3,106 3,106 3,106
Fixed costs: 1,064 1,064 1,064 1,064
Total variable cost 795 1,590 2,385 3,180
Total fixed cost 4,170 4,170 4,170 4,170
Total costs $4,965 $5,760 $6,555 $7,350
Cost per mile $0.9930 $0.5760 $0.4370 $0.3675
Cost-Volume Relationship
Average Cost per Mile
 Differential (Incremental) Costs

 Def: Costs that

represent the
differences in total
costs, which results
from selecting one
alternative instead of
other
Example: Differential Cost Associated with Adopting a New Production
Method

Current Dies Better Dies Differential Cost

Variable costs:
Materials $150,000 $170,000 $20,000
Machining labor 85,000 64,000 -21,000
Electricity 73,000 66,000 -7,000
Fixed costs:
Supervision 25,000 25,000 0
Taxes 16,000 16,000 0
Depreciation 40,000 43,000 3,000
Total $392,000 $387,000 -$5,000
 Example: Break-Even Volume Analysis

 Option 1: Adding
overtime or Saturday
operations: 36Q
 Option 2: Second-shift
operation: $13,500 +
31.50Q
 Break-even volume:
36Q = $13,500 + 31.50Q
Q = 3,000 units
 Example: -Make or Buy

Example 3.5 - Make or Buy Decision

Make Option Buy Option Differential Cost

Variable cost
Direct materials $100,000 -$100,000
Direct labor 190,000 -190,000
Power and water 35,000 -35,000
Gas filter 340,000 340,000
Fixed costs
Heating light 20,000 20,000 0
Depreciation 100,000 100,000 0
Rental income -35,000 -35,000
Total cost $445,000 $425,000 -$20,000
Unit cost $22.25 $21.25 -$1.00
 Opportunity Costs

 Def: The potential benefit

that is given up as you
seek an alternative course
of action
 Example: When you
decide to pursue a college
degree, your opportunity
cost would include the 4-
year’s potential earnings
foregone.
 Sunk Costs

 Def:Cost that has already

been incurred by past
actions
 Economic Implications:
Not relevant to future
decisions
 Example: $500 spent to
replace tires last year—
not relevant in making
selling decision in the
future
 Marginal Costs

 Def: Added costs that

result from increasing
rates of outputs,
usually by single unit
 Example: Cost of
electricity—
decreasing marginal
rate
Unit Marginal Contribution
 Def: Difference
between the unit sales
price and the unit
variable cost
MC = Sales price –
Variable cost
 Application: Break-
even volume analysis:

Fixed costs
Break - even volume =
MC
 Marginal Analysis

Principle: “Is it

worthwhile?” Product A
 Decision rule: To
justify any course of Marginal Revenue $12/unit
action, Marginal Cost $8/unit
Marginal revenue >
Marginal cost Profit margin $4/unit
Example: Profit Maximization Problem

Branded Generic
Marginal Revenue $30/case $10/case
Marginal Cost $7/case $7/case
Profit margin $23/case $3/case

Sunday Operation
Marginal Revenue $10/case
Marginal Cost $12/case
Profit margin ($2) /case (loss)
BASIC CONCEPTS AND TERMINOLOGIES