CHAPTER IV

ENGINEERING ECONOMIC ANALYSIS

– STATIC METHODS

Assoc. Prof. SY TIEN DO, Ph.D

Department of Construction Engineering and Management
Faculty of Civil Engineering
Ho Chi Minh City University of Technology

Assoc. Prof. SY TIEN DO 1

01 INTRODUCTION

02 COST METHOD

03 PROFIT METHOD

04 RETURN ON EQUITY METHOD

05 PAYBACK PERIOD METHOD

06 BREAK-EVEN POINT METHOD

Assoc. Prof. SY TIEN DO 2

 INTRODUCTION

• In the past, engineers were only concerned with

design, construction, machine operation, machine
structure. They were not concerned with resources,
human or financial.

• Today's engineers are not only expected to create

unique technical solutions but also have to analyze
the financial impact of those solutions.

• Awareness of limited resources on earth has to be

strengthened in economic technical assessments.
Assoc. Prof. SY TIEN DO 3
 INTRODUCTION

• Engineering Economic analysis is based on the

accumulated knowledge of engineers and
economists

• There are many methods, but all are not

perfect. Having many analytical tools is also
disturbing or embarrassing to the user.

• However, most of methods have

complementarity together.

Assoc. Prof. SY TIEN DO 4

 INTRODUCTION

• A group of static methods was developed based

on ignoring the effect of time on money, in other
words, the value of money that changed over time
was not considered.

Assoc. Prof. SY TIEN DO 5

 COST METHOD

Cost Method

• The foundation of the method: The smallest cost

is the most beneficial

• There are two main types of costs:

– Fixed costs or Indirect Costs: The relative costs

are not changed regardless of the unit of
product.

– Variable cost or direct cost: cost is proportional

to the quantity of product.

Assoc. Prof. SY TIEN DO 6

 COST METHOD

• The total cost is the sum of fixed costs and variable

costs:

C is the total cost

F is fixed cost

V is variable cost

 is the variable cost per one unit of product

X is the unit of products produced

Assoc. Prof. SY TIEN DO 7
 COST METHOD

• The fixed cost of project

F: Fixed cost

O: Operating cost

D: Depreciation expenses (chi phí khấu hao)

Ir: Interest expenses (Chi phí lãi vay)

Assoc. Prof. SY TIEN DO 8

 Depreciation

• Most fixed assets decrease in value gradually during

use.

• Depreciation is to consider the fixed asset wear

when engaging in production and business.

• There are two types of depreciation: economic

depreciation and accounting depreciation.

Assoc. Prof. SY TIEN DO 9

 Depreciation

• Economic depreciation: continuous decrease of

asset value over time and use.

• Accounting depreciation: the systematic distribution

value of the asset over the depreciation period.

Assoc. Prof. SY TIEN DO 10

 Ledger Depreciation

• There are three main methods:

o Straight line method

o Accelerated method

o Unit of production method

Assoc. Prof. SY TIEN DO 11

 Straight Line Method
Cost

I
Ia = (I + S)/2

S
time
0 1 2 3 n
• Dn is the depreciation rate at time n

• I is the basic cost of the property

• S is the residual value of the asset after use

• N is the time period to use the property

Assoc. Prof. SY TIEN DO 12

Straight Line Method

Ex: Let's assume Company XYZ purchases a piece

of machinery for $1,000,000, and that piece of
machinery is expected to last for 10 years. If
Company XYZ were using the straight-line method
of depreciation (not accelerated)

Find depreciation expense

Assoc. Prof. SY TIEN DO 13

 Straight Line Method

• The fixed cost of project

Depreciation Interest
Operating cost expenses
expenses

Assoc. Prof. SY TIEN DO 14

Straight Line Method

– The value after depreciation at time n:

Exp: Figures of a car used for business are as

follows: the purchase price of the car is $ 10,000;
After using 5 year, the salvage is estimated at
$2,000. Calculate the depreciation rate and the
residual value for each year?

Assoc. Prof. SY TIEN DO 15

 Accelerated Method

– Given  is an accelerated coefficient (usually 𝐼

𝐷1 .
𝑁
equal to 1.5 or 2.0), depreciation at time 1:

  
– Depreciation at time 2: 𝐷2 𝐼 𝐷1 . I. 1
𝑁 N 𝑁
  
– Depreciation at time 3: 𝐷3 𝐼 𝐷2 . I. 1
𝑁 N 𝑁
 
– Depreciation at time n: 𝐷𝑛 . I. 1
N 𝑁
Assoc. Prof. SY TIEN DO 16
Accelerated Method

– Total depreciation amount at time n:


𝑇𝐷 𝐷1 𝐷2 𝐷3 ⋯ 𝐷 I. 1 1
𝑁

– The residual value at the end of time n is:


𝐵 𝐼 𝑇𝐷 I. 1
𝑁

Assoc. Prof. SY TIEN DO 17

Accelerated Method

– Exp: Consider the following information about a

computer system. Machine price (including
installation, shipping, testing) is $ 10,000; The
usage time is 5 years; The salvage is $ 778.
Calculate depreciation for this computer system
knowing that the alpha coefficient is 2?

Assoc. Prof. SY TIEN DO 18

Accelerated Method

– When the residual value after depreciation Bn> S:

– Find the location at which the accelerated method

depreciation is less than the straight-line method
depreciation.

– From this point, use straight line depreciation for the rest.

– Note that, the straight-line depreciation at time point n is:

Assoc. Prof. SY TIEN DO 19

Accelerated Method

– Company XYZ's depreciation expense under the DDB

method is $100,000 x 2 = $200,000. Company XYZ is
essentially expensing 20% of the asset's cost in the first
year, and in each subsequent year it will multiply that 20%
by the remaining balance to be depreciated.

– In year two, the value of the asset is $1,000,000 -

$200,000 = $800,000, so the depreciation expense is
$800,000 x 2 = $160,000. Once the depreciation value is
lower than the $100,000 Company XYZ would have
expensed using the straight-line method, Company XYZ will
revert to the straight-line method for all remaining years.

Assoc. Prof. SY TIEN DO 20

Accelerated Method

– Exp: Consider the following information about a

computer system. Machine price (including
installation, shipping, testing) is $ 10,000; The
usage time is 5 years; The salvage is $ 0.
Calculate depreciation for this computer system
knowing that the alpha coefficient is 2?

Assoc. Prof. SY TIEN DO 21

 Accelerated Method

– When the residual value after depreciation Bn<= S:

– Determine the time at which the residual value after

depreciation Bn <S.

– The depreciation amount from that time will be

adjusted for depreciation at N equals S

Assoc. Prof. SY TIEN DO 22

Accelerated Method

– Exp: Consider the following information about a

computer system. Machine price (including
installation, shipping, testing) is $ 10,000; The
usage time is 5 years; The salvage is $ 2,000.
Calculate depreciation for this computer system
knowing that the coefficient is 2?

Assoc. Prof. SY TIEN DO 23

 Unit of Production Method

• When asset use is not continuous or when

production stops before the end of asset use. In this
case, we can use this method to depreciate
according to the unit of production.

• Formula for depreciation calculation:

Number of unit produced

• 𝐷𝑛 (I−S)
Total unit during serviced life

Assoc. Prof. SY TIEN DO 24

 Unit of Production Method

• Exp: A truck price is $ 55,000 and it is expected to

run a total of 250,000 miles. Then the car was sold
for $ 5,000. Calculates depreciation for 30,000
miles in one year.

Assoc. Prof. SY TIEN DO 25

 COST METHOD

• Application: Select project or investment plan.

– When the options have same scale: the smallest

cost option is the most economical option.

– When the options vary in scale: the smallest

cost per unit of product option is the most
economical option.

Assoc. Prof. SY TIEN DO 26

 COST METHOD

• Disadvantage:
– This method does not consider the problem of supply-
demand in the market.

– There is no distinction the difference in the cost structure,

between the fixed cost and the variable cost.

– Only used to select the option, it can not evaluate the

economics of the options.

– The impact of time to money has not been considered.

Assoc. Prof. SY TIEN DO 27

 COST METHOD

• Disadvantage:
– This method does not consider the problem of supply-
demand in the market.

– There is no distinction the difference in the cost structure,

between the fixed cost and the variable cost.

– Only used to select the option, it can not evaluate the

economics of the options.

– The impact of time to money has not been considered.

Assoc. Prof. SY TIEN DO 28

 COST METHOD
No. Description Unit P1 P2

1 Total Investment Mi VND 200 140

2 Duration Year 4 4

3 Production capacity Units 20.000 20.000

4 Depreciation expenses Mi VND/year - -
5 Interest expenses (r=10%) Mi VND/year - -
6 Other fixed costs Mi VND/year 5,00 6,00
7 TOTAL FIXED COSTS Mi VND/year - -
8 Labor costs Mi VND/year 4,00 7,50
9 Material costs Mi VND/year 5,00 5,00
Fuel costs and other variable Mi VND/year
10 costs 1,50 9,00
Mi VND/year
11 TOTAL VARIABLE COST - -
12 TOTAL COST/YEAR Mi VND/year - -
Assoc. Prof. SY TIEN DO 29
 COST METHOD

No. Description Unit P1 P2

1 Total Investment Mi VND 200 140
2 Duration Year 4 4

3 Production capacity Units 20.000 20.000

4 Depreciation expenses Mi VND/year 50,00 35,00
5 Interest expenses (r=10%) Mi VND/year 10,00 7,00
6 Other fixed costs Mi VND/year 5,00 6,00
7 TOTAL FIXED COSTS Mi VND/year 65,00 48,00
8 Labor costs Mi VND/year 4,00 7,50
9 Material costs Mi VND/year 5,00 5,00
Fuel costs and other variable Mi VND/year
10 costs 1,50 9,00
Mi VND/year
11 TOTAL VARIABLE COST 10,50 21,50
12 TOTAL COST/YEAR Mi VND/year 75,50 69,50

Assoc. Prof. SY TIEN DO 30

 COST METHOD
No. Description Unit P1 P2
1 Total Investment Mi VND 200 140
2 Duration Year 4 4

3 Production capacity Units 30.000 20.000

4 Depreciation expenses Mi VND/year - -
5 Interest expenses (r=10%) Mi VND/year - -
6 Other fixed costs Mi VND/year 5,00 6,00
7 TOTAL FIXED COSTS Mi VND/year - -
8 TOTAL FIXED COSTS FOR 1 UNIT k VND/year - -
9 Labor costs Mi VND/year 4,00 7,50
10 Material costs Mi VND/year 5,00 5,00
Mi VND/year
11 Fuel costs and other variable costs 1,50 9,00
12 TOTAL VARIABLE COST Mi VND/year - -
13 TOTAL VARIABLE COST FOR 1 UNIT k VND/year - -
14 TOTAL COST FOR 1 UNIT/YEAR Mi VND/year - -
Assoc. Prof. SY TIEN DO 31
 COST METHOD
No. Description Unit P1 P2
1 Total Investment Mi VND 200 140
2 Duration Year 4 4

3 Production capacity Units 30.000 20.000

4 Depreciation expenses Mi VND/year 50 35
5 Interest expenses (r=10%) Mi VND/year 10 7
6 Other fixed costs Mi VND/year 5,00 6,00
7 TOTAL FIXED COSTS Mi VND/year 65 48
8 TOTAL FIXED COSTS FOR 1 UNIT k VND/year 2.17 2.4
9 Labor costs Mi VND/year 4,00 7,50
10 Material costs Mi VND/year 5,00 5,00
Mi VND/year
11 Fuel costs and other variable costs 1,50 9,00
12 TOTAL VARIABLE COST Mi VND/year 10.5 21.5
13 TOTAL VARIABLE COST FOR 1 UNIT k VND/year 0,35 1.08
14 TOTAL COST FOR 1 UNIT/YEAR Mi VND/year 2,52 3,48
Assoc. Prof. SY TIEN DO 32
 PROFIT METHOD

Profit Method

• The foundation of the method: The bigger the

profit, the better the option.
• Profit: is the difference between revenue and total
cost.
P=R-C
P is the profit
R is revenue
C is the total cost
• Given p is the selling price of the product, the
revenue can be calculated as follows : R = pX

Assoc. Prof. SY TIEN DO 33

 PROFIT METHOD

• Application: to evaluate an alternative .

– An economic (business) plan is considered to be
good when earned profits over a period of time is
larger than 0.

P>0
– Questions: If profit of an option is 0.1 > 0, is it
a good option?

Assoc. Prof. SY TIEN DO 34

 PROFIT METHOD

• Application: Compare economic alternatives.

– When the options have the same scale, the most
profitable option is the most economical option.

– When the options vary in scale and the amount of

investment is tight, the option has the largest
profit per unit of investment is the most
economical option.

P1 > P2
P1 > 0
Assoc. Prof. SY TIEN DO 35
 PROFIT METHOD

• Disadvantage:
– Only consider the maximum profit but not
consider the profit earned on a unit of capital.

– There is no distinction the difference in the cost

structure, between the fixed cost and the
variable cost.

– The impact of time to money has not been

considered.

Assoc. Prof. SY TIEN DO 36

 PROFIT METHOD - Example

• A company is faced with the choice of one of 3 factory projects

(the same product, the same quality, different production
capacity, operating costs and procurement). Unit price is 10
VNĐ/unit, if the product only hits 80,000 units/year. If the
company offers more then the price will drop to 9VNĐ/unit
(i=10%)
No Description Alternatives
I II III
1 Investment(VNĐ) 500.000 600.000 1.200.000
2 Duration (year) 5 4 6
3 Production capacity (Unit/year) 60.000 80.000 100.000
4 Variable costs (VND/unit) 6 5 4
5 Other fixed costs (VND/year) 80.000 170.000 140.000
Assoc. Prof. SY TIEN DO 37
 PROFIT METHOD - Example
No Description Alternatives
I II III
1 Investment(VNĐ) 500.000 600.000 1.200.000
2 Duration (year) 5 4 6
3 Production capacity (Unit/year) 60.000 80.000 100.000
4 Variable costs (VND/unit) 6 5 4
5 Other fixed costs (VND/year) 80.000 170.000 140.000
6 Total revenue for maximum
product and corresponding unit
price (VND)
7 Variable costs (VND/year)
8 Fixed costs
Depreciation expenses
(VND/year)
Interest expenses (I = 10%)
Other fixed costs (VND/year)
9 Profit (year)
Assoc. Prof. SY TIEN DO 38
 PROFIT METHOD - Example
No Description Alternatives
I II III
1 Investment(VNĐ) 500.000 600.000 1.200.000
2 Duration (year) 5 4 6
3 Production capacity (Unit/year) 60.000 80.000 100.000
4 Variable costs (VND/unit) 6 5 4
5 Other fixed costs (VND/year) 80.000 170.000 140.000
6 Total revenue for maximum
product and corresponding unit
price (VND)
7 Variable costs (VND/year)
8 Fixed costs
Depreciation expenses
(VND/year)
Interest expenses (I = 10%)
Other fixed costs (VND/year)
9 Profit (year)
Assoc. Prof. SY TIEN DO 39
 RETURN ON EQUITY METHOD

• Return on equity (ROE) is the amount of net

income returned as a percentage of shareholders
equity.

• Return on equity measures a corporation's

profitability by revealing how much profit a company
generates with the money shareholders have
invested.

Assoc. Prof. SY TIEN DO 40

 RETURN ON EQUITY METHOD

If, for example, you spend $100,000 to open a

laundromat and make a net profit of $15,000 in one
year. The owner have invested $60,000 out of pocket
and secured a loan for $40,000

Assoc. Prof. SY TIEN DO 41

 RETURN ON EQUITY METHOD

• Application:
– To evaluate an alternative: a good option is the one which
has a RoE that is not less than the minimum

RoE1 ≥ RoE min

– Select alternatives: the best option is the one with the

highest RoE and larger than the minimum RoE.

RoE1 > RoE2

RoE1 ≥ RoE min

Assoc. Prof. SY TIEN DO 42

 RETURN ON EQUITY METHOD

• Disadvantage:
– The yearly return is considered unchanged.

– The impact of time to money has not been considered.

Assoc. Prof. SY TIEN DO 43

 RETURN ON INVESTMENT

• Return on investment (ROI) is the amount of the net

income from a business or a project returned as a
percentage of the total money invested in the
venture

• If, for example, you spend $100,000 to open a

laundromat and make a net profit of $15,000 in one
year

$ ,
$ ,

Assoc. Prof. SY TIEN DO 44

 Impact of Interest Expense

• Assume you can invest $60,000 and open a small

laundromat that will return a $12,000 annual profit.
Or, you can borrow $40,000 more and open a far
larger laundromat that will net $19,000 profit

Assoc. Prof. SY TIEN DO 45

 PAYBACK PERIOD METHOD

Payback Period Method

• The payback period is the time needed to recover the

invested capital.

• When the yearly payback is constant:

Invested Capital − Salvage

Tpp =
Yearly Revenue Yearly Cost + Yearly Depreciation

• When the yearly payback is oscillated, we use the

cumulative method to determine Tpp.

Assoc. Prof. SY TIEN DO 46

 PAYBACK PERIOD METHOD

• Application:
– To evaluate an alternative: An economic option is good if
its payback period is less than the limited payback period.
Tpp ≤ T limited

– Compare economic alternatives: the best option is the one

with the shortest payback period and shorter than the
limited payback period.

– Tpp1 ≤ Tpp2

– Tpp1 ≤ T limited

Assoc. Prof. SY TIEN DO 47

 PAYBACK PERIOD METHOD

Payback Period Method (cont.)

• The static payback period method does not consider

the impact of time to the payback.

• The short payback period is not necessarily the best

way to get the most profit.

Assoc. Prof. SY TIEN DO 48

 BREAK-EVEN POINT METHOD

Break-even Point Method

• Break-even Point is the point at which total cost and

total revenue are equal. Break-even Point method is
based on three assumptions:
– Revenue only derived from business activities are under
consideration.

– Fixed costs, variable costs per product, product prices do

not change with time and quantity of production.

– Products are sold out.

Assoc. Prof. SY TIEN DO 49

 BREAK-EVEN POINT METHOD

• The total cost to produce X products is:

• The revenue from X products is:

• Break-even point is the point where C = R, we have

the quantity of product is:

Assoc. Prof. SY TIEN DO 50

 BREAK-EVEN POINT METHOD

• Application: economic analysis

– If X < : loss

– If X > : profit

– If X = : break-even

Assoc. Prof. SY TIEN DO 51

EXAMPLES
𝐼 𝑆
𝑇
𝑅 𝐷

Options
No. Description Unit
I II

1 Investment Mi VND 100 100

2 Duration Year 4 4
3 Depreciation expenses Mi VND
4 Yearly revenue Mi VND 9 7
5 Annual payback Mi VND/year

6 Payback period Year

Assoc. Prof. SY TIEN DO 52

EXAMPLES
𝐼 𝑆
𝑇
𝑅 𝐷

Options
No. Description Unit
I II

1 Total Investment Mi VND 100 100

2 Duration Year 4 4
3 Depreciation expenses Mi VND 25 25
4 Yearly revenue Mi VND 9 7
5 Annual payback Mi VND/year 34 32

6 Payback period Year 2,94 3,13

Assoc. Prof. SY TIEN DO 53

 EXAMPLES

No. Description Unit P1 P2 P3

1 Investment Mi VND 500.000 600.000 1.200.000

2 Duration Year 5 4 6

3 Depreciation expenses Mi VND 100000 150000 200000

4 Yearly revenue Mi VND 35.000 50.000 100.000

Mi VND
5 Annual payback 135000 200.000 300.000
/year

6 Payback period Year 3.7 3 4

Assoc. Prof. SY TIEN DO 54

 EXAMPLES

Options
No. Description Unit
I II
1 Investment Mi VND 100 100
2 Duration Year 4 4
Mi VND
3 Annual payback /year
4 Year 1 40 20
5 Year 2 40 60

6 Year 3 20 10

7 Year 4 40 40

8 Payback period Year

Assoc. Prof. SY TIEN DO 55

 EXAMPLES

Options
No. Description Unit
I II
1 Investment Mi VND 100 100
2 Duration Year 4 4
Mi VND
3 Annual payback /year
4 Year 1 40 20
5 Year 2 40 60

6 Year 3 20=100 10=90

7 Year 4 40 40=130

8 Payback period Year 3 3.25

Assoc. Prof. SY TIEN DO 56