MODULE 1: INTRODUCTION TO ENGINEERING ECONOMICS THERE IS AN IMPORTANT PROCEDURE USED TO ADDRESS THE DEVELOPMENT AND

SELECTION OF ALTERNATIVES COMMONLY REFERRED AS THE PROBLEM SOLVING

1.1 PRINCIPLES OF ENGINEERING ECONOMICS AND THE DESIGN PROCESS APPROACH OR THE DECISION MAKING PROCESS, THE STEPS IN THE APPROACH
ARE THE FOLLOWING:
FUNDAMENTALLY, ENGINEERING ECONOMICS INVOLVES FORMULATING AND
EVALUATING THE ECONOMIC OUTCOMES WHEN ALTERNATIVES TO ACCOMPLISH 1. UNDERSTAND THE PROBLEM AND DEFINE THE OBJECTIVE.
A DEFINED PURPOSE ARE AVAILABLE. ANOTHER WAY TO DEFINE ENGINEERING 2. COLLECT RELEVANT INFORMATION.
ECONOMICS IS AS A COLLECTION OF MATHEMATICAL TECHNIQUES THAT 3. DEFINE THE FEASIBLE ALTERNATIVE SOLUTIONS AND MAKE REALISTIC
SIMPLIFY ECONOMIC COMPARISON. ESTIMATES.
4. IDENTIFY THE CRITERIA FOR DECISION MAKING USING ONE OF MORE
THE NEED FOR ENGINEERING ECONOMICS IS PRIMARILY MOTIVATED BY THE WORK ATTRIBUTES.
THAT ENGINEERS DO IN PERFORMING ANALYSES, SYNTHESIZING, AND COMING 5. EVALUATE EACH ALTERNATIVE, USING SENSITIVITY ANALYSIS TO ENHANCE
TO CONCLUSION AS THEY WORK ON PROJECTS OF ALL SIZES. IN OTHER WORDS, THE EVALUATION.
ENGINEERING ECONOMICS IS AT THE HEART OF MAKING DECISIONS. THESE 6. SELECT THE BEST ALTERNATIVE.
DECISIONS INVOLVE THE FUNDAMENTAL ELEMENTS OF CASH FLOWS OF MONEY, 7. IMPLEMENT THE SOLUTION AND MONITOR THE RESULTS. (SEE FIGURE 1-
TIME, AND INTEREST RATES. 1)

PEOPLE MAKE DECISIONS; COMPUTERS, MATHEMATICS, CONCEPTS, AND

GUIDELINES ASSIST PEOPLE IN THEIR DECISION- MAKING PROCESS. SINCE MOST
DECISIONS AFFECT WHAT WILL BE DONE, THE TIME FRAME OF ENGINEERING
ECONOMICS IS PRIMARILY THE FUTURE. THEREFORE, THE NUMBERS USED IN
ENGINEERING ECONOMICS ARE BEST ESTIMATES OF WHAT IS EXPECTED TO
OCCUR. THE ESTIMATES AND THE DECISION USUALLY INVOLVE FOUR ESSENTIAL
ELEMENTS:

CASH FLOWS,
TIMES OF OCCURRENCE OF CASH FLOWS, INTEREST RATES FOR TIME
VALUE OF MONEY, AND
MEASURE OF ECONOMIC WORTH FOR SELECTING AN ALTERNATIVE.

THE CHANGE IN THE AMOUNT OF MONEY OVER A GIVEN PERIOD OF TIME IS

CALLED TIME VALUE OF MONEY. IT IS A WELL-KNOWN FACT THAT MONEY MAKES
MONEY. THE TIME VALUE OF MONEY EXPLAINS THE CHANGE IN THE AMOUNT OF
MONEY OVER TIME FOR FUNDS THAT ARE OWNED (INVESTED) OR OWED
(BORROWED). THIS IS THE MOST IMPORTANT CONCEPT IN ENGINEERING
ECONOMICS.

THE TIME VALUE OF MONEY IS VERY OBVIOUS IN THE WORLD OF ECONOMICS. IF

WE DECIDE TO INVEST CAPITAL (MONEY) IN A PROJECT TODAY, WE INHERENTLY
EXPECT TO HAVE MORE MONEY IN THE FUTURE THAN WE INVESTED. IF WE
BORROW MONEY TODAY, IN ONE FORM OR ANOTHER, WE EXPECT TO RETURN
THE ORIGINAL AMOUNT PLUS SOME ADDITIONAL AMOUNT OF MONEY.
THE ECONOMIC ENVIRONMENT

ENGINEERING ECONOMY IS THE ANALYSIS AND EVALUATION OF THE FACTORS PERFECT COMPETITION – OCCURS IN A SITUATION WHERE A COMMODITY OR
THAT WILL AFFECT THE ECONOMIC SUCCESS OF ENGINEERING PROJECTS TO THE SERVICE IS SUPPLIED BY A NUMBER OF VENDORS AND THERE IS NOTHING TO
END THAT A RECOMMENDATION CAN BE MADE WHICH WILL ENSURE THE BEST PREVENT ADDITIONAL VENDORS ENTERING THE MARKET.
USE OF CAPITAL.
MONOPOLY – IS THE OPPOSITE OF PERFECT COMPETITION.
CONSUMER GOODS AND SERVICES – ARE THOSE PRODUCTS OR SERVICES THAT
ARE DIRECTLY USED BY PEOPLE TO SATISFY THEIR WANTS. PERFECT MONOPOLY – EXISTS WHEN A UNIQUE PRODUCT OR SERVICE IS
AVAILABLE FROM A SINGLE VENDOR AND THAT VENDOR CAN PREVENT THE ENTRY
PRODUCER GOODS AND SERVICES – ARE USED TO PRODUCE CONSUMER OF ALL OTHERS INTO THE MARKET.
GOODS AND SERVICES OR OTHER PRODUCER GOODS.
OLIGOPOLY – EXISTS WHEN THERE ARE SO FEW SUPPLIERS OF A PRODUCT OR
NECESSITIES – ARE THOSE PRODUCTS OR SERVICES THAT ARE REQUIRED TO SERVICE THAT ACTION BY ONE WILL ALMOST INEVITABLY RESULT IN SIMILAR
SUPPORT HUMAN LIFE AND ACTIVITIES THAT WILL BE PURCHASED IN SOMEWHAT ACTION BY THE OTHERS.
THE SAME QUANTITY EVEN THOUGH THE PRICE VARIES CONSIDERABLY.
SUPPLY – IS THE QUANTITY OF A CERTAIN COMMODITY THAT IS OFFERED FOR
LUXURIES – ARE THOSE PRODUCTS/SERVICES THAT ARE DESIRED BY HUMANS SALE AT A CERTAIN PRICE AT A GIVEN PLACE AND TIME.
AND WILL BE PURCHASED IF MONEY IS AVAILABLE AFTER THE REQUIRED
NECESSITIES HAVE BEEN OBTAINED. THE LAW OF SUPPLY AND DEMAND

DEMAND – IS THE QUANTITY OF A CERTAIN COMMODITY THAT IS BOUGHT AT “UNDER CONDITIONS OF PERFECT COMPETITION, THE PRICE AT WHICH A GIVEN
CERTAIN PRICE AT A GIVEN PLACE AND TIME. PRODUCT WILL BE SUPPLIED AND
PURCHASED IS THE PRICE THAT WILL RESULT IN THE SUPPLY AND THE DEMAND
ELASTIC DEMAND – OCCURS WHEN A DECREASE IN SELLING PRICE RESULT IN A BEING EQUAL.”
GREATER THAN PROPORTIONATE INCREASE IN SALES.

INELASTIC DEMAND – OCCURS WHEN A DECREASE IN SELLING PRICE PRODUCES

LESS THAN PROPORTIONATE INCREASE IN SALES.

THE LAW OF DIMINISHING RETURNS

“WHEN THE USE OF ONE OF THE FACTORS OF PRODUCTION IS LIMITED, EITHER

IN INCREASING COST OR BY ABSOLUTE QUANTITY, A POINT WILL BE REACHED
BEYOND WHICH AN INCREASE IN THE VARIABLE FACTORS WILL RESULT IN A LESS
THAN PROPORTIONATE INCREASE IN OUTPUT.”
 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 COST (OR INCREMENTAL REVENUE) IS THE ADDITIONAL COST (OR

REVENUE) THAT RESULTS FROM INCREASING THE OUTPUT OF A SYSTEM BY ONE
(OR MORE) UNITS.

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 PESO, OR
DIRECT MATERIAL PESO) 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.
THE EFFECT OF THE LAW OF DIMINISHING RETURNS ON THE
OVERHEAD CONSISTS OF PLANT OPERATING COSTS THAT ARE NOT DIRECT
PERFORMANCE OF AN ELECTRIC MOTOR AS ILLUSTRATED IN THE GRAPH. FOR THE
EARLY INCREASE IN INPUT, THROUGH INPUT OF 4.0 KW, THE ACTUAL INCREASE LABOR OR DIRECT MATERIAL COSTS. EXAMPLES OF OVERHEAD INCLUDE
IN OUTPUT IS GREATER THAN PROPORTIONAL; BEYOND THIS POINT THE OUTPUT ELECTRICITY, GENERAL REPAIRS, PROPERTY TAXES, AND SUPERVISION.
IS LESS THAN PROPORTIONAL. IN THIS CASE, THE FIXED INPUT FACTOR IS THE
ELECTRIC MOTOR. STANDARD COSTS ARE PLANNED COSTS PER UNIT OF OUTPUT THAT ARE
ESTABLISHED IN ADVANCE OF ACTUAL PRODUCTION OR SERVICE DELIVERY. THEY
1.2 COST CONCEPTS FOR DECISION MAKING AND PRESENT ECONOMIIC STUDIES ARE DEVELOPED FROM ANTICIPATED DIRECT LABOR HOURS, MATERIALS, AND
OVERHEAD CATEGORIES (WITH THEIR ESTABLISHED COSTS PER UNIT). BECAUSE
COST CONCEPTS FOR DECISION MAKING TOTAL OVERHEAD COSTS ARE ASSOCIATED WITH A CERTAIN LEVEL OF
PRODUCTION, THIS IS AN IMPORTANT CONDITION THAT SHOULD BE
REMEMBERED WHEN DEALING WITH STANDARD COST DATA.
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 STANDARD COSTS PLAY AN IMPORTANT ROLE IN COST CONTROL AND OTHER
MANAGEMENT AND ADMINISTRATIVE SALARIES, LICENSE FEES, AND INTEREST MANAGEMENT FUNCTIONS. SOME TYPICAL USES ARE THE FOLLOWING:
COSTS ON BORROWED CAPITAL.
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 THE INVESTMENT COST IS THE CAPITAL REQUIRED FOR MOST OF THE ACTIVITIES
CUSTOMERS; IN THE ACQUISITION PHASE. IN SIMPLE CASES, SUCH AS ACQUIRING SPECIFIC
4. ESTABLISHING THE VALUE OF WORK IN PROCESS AND FINISHED EQUIPMENT, AN INVESTMENT COST MAY BE INCURRED AS A SINGLE
INVENTORIES. EXPENDITURE. ON A LARGE, COMPLEX CONSTRUCTION PROJECT, HOWEVER, A
SERIES OF EXPENDITURES OVER AN EXTENDED PERIOD COULD BE INCURRED.
A COST THAT INVOLVES PAYMENT OF CASH IS CALLED A CASH COST (AND THIS COST IS ALSO CALLED A CAPITAL INVESTMENT.
RESULTS IN A CASHFLOW) TO DISTINGUISH IT FROM ONE THAT DOES NOT
INVOLVE A CASH TRANSACTION AND IS REFLECTED IN THE ACCOUNTING SYSTEM OPERATION AND MAINTENANCE COST (O&M) INCLUDES MANY OF THE RECURRING
AS A NON CASH COST. ANNUAL EXPENSE ITEMS ASSOCIATED WITH THE OPERATION PHASE OF THE
LIFECYCLE. THE DIRECT AND INDIRECT COSTS OF OPERATION ASSOCIATED WITH
BOOK COSTS ARE COSTS THAT DO NOT INVOLVE CASH PAYMENTS BUT RATHER THE FIVE PRIMARY RESOURCE AREAS—PEOPLE, MACHINES, MATERIALS, ENERGY,
REPRESENT THE RECOVERY OF PAST EXPENDITURES OVER A FIXED PERIOD OF AND INFORMATION—ARE A MAJOR PART OF THE COSTS IN THIS CATEGORY.
TIME. THE MOST COMMON EXAMPLE OF BOOK COST IS THE DEPRECIATION
CHARGED FOR THE USE OF ASSETS SUCH AS PLANT AND EQUIPMENT. DISPOSAL COST INCLUDES THOSE NONRECURRING COSTS OF SHUTTING DOWN
THE OPERATION AND THE RETIREMENT AND DISPOSAL OF ASSETS AT THE END OF
A SUNK COST IS ONE THAT HAS OCCURRED IN THE PAST AND HAS NO RELEVANCE THE LIFE CYCLE. NORMALLY, COSTS ASSOCIATED WITH PERSONNEL, MATERIALS,
TO ESTIMATES OF FUTURE COSTS AND REVENUES RELATED TO AN ALTERNATIVE TRANSPORTATION, AND ONE-TIME SPECIAL ACTIVITIES CAN BE EXPECTED. THESE
COURSE OF ACTION. THUS, A SUNK COST IS COMMON TO ALL ALTERNATIVES, COSTS WILL BE OFFSET IN SOME INSTANCES BY RECEIPTS FROM THE SALE OF
IS NOT PART OF THE FUTURE (PROSPECTIVE) CASHFLOWS, AND CAN BE ASSETS WITH REMAINING MARKET VALUE. A CLASSIC EXAMPLE OF A DISPOSAL
DISREGARDED IN AN ENGINEERING ECONOMIC ANALYSIS. FOR INSTANCE, SUNK COST IS THAT ASSOCIATED WITH CLEANING UP A SITE WHERE A CHEMICAL
COSTS ARE NONREFUNDABLE CASH OUTLAYS, SUCH AS EARNEST MONEY PROCESSING PLANT HAD BEEN LOCATED.
(DEPOSIT) ON A HOUSE OR MONEY SPENT ON A PASSPORT.
PRESENT ECONOMIC STUDIES
AN OPPORTUNITY COST IS INCURRED BECAUSE OF THE USE OF LIMITED
RESOURCES, SUCH THAT THE OPPORTUNITY TO USE THOSE RESOURCES TO THERE ARE MANY CASES IN ENGINEERING ECONOMY STUDIES WHERE INTEREST
MONETARY ADVANTAGE IN AN ALTERNATIVE USE IS FOREGONE. THUS, IT IS THE IS NOT A FACTOR. THESE STUDIES ARE FREQUENTLY CALLED PRESENT ECONOMY
COST OF THE BEST REJECTED (I.E., FOREGONE) OPPORTUNITY AND IS OFTEN PROBLEMS. SUCH STUDIES USUALLY INVOLVE THE SELECTION BETWEEN
HIDDEN OR IMPLIED. ALTERNATIVE DESIGNS, MATERIAL OR METHODS.

CONSIDER A STUDENT WHO COULD EARN $20,000 FOR WORKING DURING A

YEAR, BUT CHOOSES INSTEAD TO GO TO SCHOOL FOR A YEAR AND SPEND
$5,000 TO DO SO. THE OPPORTUNITY COST OF GOING TO SCHOOL FOR THAT
YEAR IS $25,000: $5,000 CASH OUTLAY AND $20,000 FOR INCOME
FOREGONE. (THIS FIGURE NEGLECTS THE INFLUENCE OF INCOME TAXES AND
ASSUMES THAT THE STUDENT HAS NO EARNING CAPABILITY WHILE IN SCHOOL.)

IN ENGINEERING PRACTICE, THE TERM LIFE-CYCLE COST IS OFTEN ENCOUNTERED.

THIS TERM REFERS TO A SUMMATION OF ALL THE COSTS RELATED TO A
PRODUCT, STRUCTURE, SYSTEM, OR SERVICE DURING ITS LIFE SPAN. BECAUSE
OF THEIR COMMON USE, HOWEVER, SEVERAL BASIC LIFE-CYCLE COST
CATEGORIES WILL NOW BE DEFINED.
 CASH FLOW DIAGRAAMS
MODULE 2: SIMPLE INTEREST, COMPOUND INTEREST, ANNUITIES, &
CAPITALIZATION A CASHFLOW DIAGRAM IS SIMPLY A VERTICAL REPRESENTATION OF CASH FLOWS
DRAWN ON A TIME SCALE. CASH FLOW DIAGRAM FOR ECONOMIC ANALYSIS
2.1 SIMPLE INTEREST PROBLEMS IS ANALOGOUS TO THAT OF FREE BODY DIAGRAM FOR MECHANICS
PROBLEMS
INTEREST- IS THE AMOUNT OF MONEY PAID FOR THE USE OF BORROWED CAPITAL
OR THE INCOME PRODUCED BY MONEY WHICH HAS BEEN LOANED.

SIMPLE INTEREST – IS CALCULATED USING THE PRINCIPAL ONLY, IGNORING ANY

INTEREST THAT HAD BEEN ACCRUED IN PRECEDING PERIODS. IN PRACTICE,
SIMPLE INTEREST IS PAID ON SHORT TERM LOANS IN WHICH THE TIME OF THE
LOAN IS MEASURED IN DAYS.

I = Pin
F=P+I A LOAN OF 100 PESOS AT SIMPLE INTEREST OF 10% WILL BECOME 150 PESOS
F = P + Pin AFTER 5 YEARS
F = P (1+ IN) CASHFLOW DIAGRAM ON THE VIEWPOINT OF THE LENDER:

WHERE:

I= INTEREST
P= PRINCIPAL OR PRESENT WORTH N= NUMBER OF INTEREST PERIOD, YR CASH FLOW DIAGRAM ON THE VIEWPOINT OF THE BORROWER:
R OR I= RATE OF INTEREST PER INTEREST PERIOD F= ACCUMULATED AMOUNT
OR FUTURE WORTH

A) ORDINARY SIMPLE INTEREST- IS BASED ON THE BASIS OF 12 MONTHS

OF 30 DAYS EACH OF 360 DAYS A YEAR. IN CALCULATIONS OF COMPOUND INTEREST, THE INTEREST FOR AN INTEREST
PERIOD IS CALCULATED ON THE PRINCIPAL PLUS TOTAL AMOUNT OF INTEREST
1 INTEREST PERIOD = 360 DAYS ACCUMULATED IN PREVIOUS PERIODS. THUS, COMPOUND INTEREST MEANS
B) EXACT SIMPLE INTEREST- IS BASED ON EXACT NUMBER OF DAYS IN A “INTEREST ON TOP OF INTEREST”.
YEAR, 365 DAYS FOR AN ORDINARY YEAR AND 366 DAYS FOR A LEAP
YEAR. COMPOUND INTEREST ALSO REFLECTS THE EFFECT OF THE TIME VALUE OF
MONEY ON THE INTEREST.

LEAP YEAR- A YEAR OF 366 DAYS OCCURRING EVERY 4TH YEAR. THE ADDITIONAL
DAY IS FEB. 29. IT IS A YEAR WHOSE NUMBER IS EXACTLY DIVISIBLE BY 4, OR IN
THE CASE OF CENTURY YEARS BY 400.
COMPOUND INTEREST (BORROWER’S VIEWPOINT)

𝐹 = 𝑃(1 + 𝑖)𝑛 NOMINAL INTEREST RATE, R=12%

NO. OF YEARS OF INVESTMENT, T= 5 YRS
THE QUANTITY (1 + 𝑖)𝑛 IS COMMONLY CALLED THE “SINGLE PAYMENT COMPOUND
AMOUNT FACTOR“ AND IS • COMPOUNDED SEMI- ANNUALLY ( M = 2 )
DESIGNATED BY THE FUNCTIONAL SYMBOL F/P, I%, N. THUS, 𝑖= 0.12 , N= 5(2) = 10
2
𝐹 = 𝑃(𝐹/𝑃, 𝑖%, 𝑛) • COMPOUNDED ANNUALLY ( M = 1 )
𝑖= 0.12 = 0.12, N= 5(1) = 5
THE SYMBOL F/P, I%, N IS READ AS “F GIVEN P AT I PERCENT IN N INTEREST 1
PERIODS.” • COMPOUNDED QUARTERLY ( M = 4 )
𝑖= 0.12 = 0.03, N= 4(5)=20
𝑃 = 𝐹(1 + 𝑖)−𝑛 4
• COMPOUNDED MONTHLY ( M = 12 )
THE QUANTITY (1 + 𝑖)−𝑛 IS CALLED THE “SINGLE PAYMENT PRESENT WORTH 𝑖= 0.12 = 0.01, N= 12(5)=60
FACTOR“ AND IS DESIGNATED BY THE 12
FUNCTIONAL SYMBOL P/F, I%, N. THUS, • COMPOUNDED BI-MONTHLY ( M = 6 )
𝑖= 0.12 = 0.02, N= 6(5)=30
𝑃 = 𝐹(𝑃/𝐹, 𝑖%, 𝑛) 6

THE SYMBOL P/F, I%, N IS READ AS “P GIVEN F AT I PERCENT IN N INTEREST

PERIODS.” CONTINUOUS COMPOUNDINGS ( M∞ ∞ )

INTEREST MAY BE COMPOUNDED DAILY, HOURLY, PER MINUTE ETC. AS A LIMIT,

ELEMENTS OF COMPOUND INTEREST INTEREST MAY BE CONSIDERED TO BE COMPOUNDED IN INFINITE NO. OF TIMES
PER YEAR.
P= PRESENT WORTH OR PRINCIPAL
F= FUTURE WORTH OR COMPOUND AMOUNT THE FUTURE WORTH OF P AT AN INTEREST RATE OF R COMPOUNDED
I= EFFECTIVE INTEREST PER COMPOUNDING PERIOD (PER INTEREST PERIOD) CONTINUOUSLY FOR T YEAR IS;
𝑟
𝑖=𝑚 𝐹 = 𝑃𝑒𝑟𝑡
N= TOTAL NO. OF COMPOUNDINGS
N= T X M
I= INTEREST EARNED NOMINAL AND EFFECTIVE RATE OF INTEREST
I= F – P
R= NOMINAL INTEREST RATE NOMINAL RATE IS THE RATE QUOTED DESCRIBING A GIVEN VARIETY OF
T= NO. OF YEARS OF INVESTMENT COMPOUND INTEREST. CONSIDER A BANK DEPOSIT P1000 TO EARN 6%
M= NO. OF COMPOUNDING PER YEAR COMPOUNDED QUARTERLY. AFTER ONE YEAR, THE COMPONENT AMOUNT F IS;

𝐹 = 𝑃(1 + 𝑖)𝑛
0.06 4(1)
𝐹 = 1000 (1 + 4 )
𝐹 = 𝑃1061.36 1. AS PAYMENT OF A DEBT BY A SERIES OF EQUAL PAYMENT AT EQUAL TIME
INTERVALS, ALSO KNOWN AS AMORTIZATION.
NOTICE THAT THE INTEREST EARNED IS P61.36 REPRESENTING 6.136% OF 1000
(NOT 6% AT P1000). FOR THIS CASE, 6% (COMPOUNDED QUARTERLY) IS CALLED 2. TO ACCUMULATE A CERTAIN AMOUNT IN THE FUTURE BY DEPOSITING
THE NOMINAL RATE AND 6.136% IS THE EFFECTIVE RATE. EQUAL AMOUNTS AT EQUAL TIME INTERVALS.
THESE AMOUNTS ARE CALLED “SINKING FUND”.
THUS, THE EFFECTIVE RATE (ER) OF INTEREST IS THE ACTUAL INTEREST EARNED
IN ONE YEAR PERIOD. THIS CAN BE COMPUTED BY EITHER OF THE FOLLOWING 3. AS A SUBSTITUTE PERIODIC PAYMENT FOR A FUTURE LUMP SUM.
FIGURE.
𝒓𝒎 ELEMENTS OF ANNUITY
𝑬𝑹 = (𝟏 + 𝒎) − 𝟏
4(1) A= PERIODIC PAYMENT
THUS, THE EFFECTIVE RATE OF 6% COMPOUNDED QUARTERLY IS 𝐸𝑅 = (1 + P= PRESENT WORTH OF ALL PERIODIC PAYMENT
0.06) − 1 = 6.136% F OR S= FUTURE WORTH OF ALL PERIODIC PAYMENT FOR AND AFTER THE LAST
4 PAYMENT IS MADE. I= INTEREST RATE PER PAYMENT
THE EFFECTIVE RATE OF (R%) COMPOUNDED CONTINUOUSLY IS 𝑬𝑹 = 𝒆𝒓 − 𝟏 N= NO. OF PAYMENTS

EQUIVALENT NOMINAL RATES TYPES OF ANNUITY

FROM THE PREVIOUS DISCUSSION, WE SEE THAT 6% COMPOUNDED QUARTERLY A. ORDINARY ANNUITY
IS NOT THE SAME AS 6% COMPOUNDED MONTHLY, FOR THE REASON THAT THEY IN ORDINARY ANNUITY, THE PAYMENT IS MADE AT THE END OF EACH PERIOD
HAVE DIFFERENT EFFECTIVE RATES. STARTING FROM THE 1ST
PERIOD, AS IN DIAGRAM SHOWN BELOW.
THE NOMINAL RATES ARE EQUAL, IF THEY HAVE THE SAME EFFECTIVE RATES.

CONSIDER A NOMINAL INTEREST RATE OF 10% COMPOUNDED QUARTERLY. THE

EQUIVALENT NOMINAL RATE COMPOUNDED WITH MONTHLY IS:

𝐸𝑅𝑚 = 𝐸𝑅𝑞
𝑟 12 0.10 4
(1 + 12) − 1 = (1 + 4)−1
𝑟 = 0.09918 𝑜𝑟 9.918%

THUS, 10% COMPOUNDED QUARTERLY WILL HAVE THE SAME INTEREST AS FUTURE WORTH OF A
9.918% COMPOUNDED MONTHLY.

ANNUITY IS A SERIES OF UNKNOWN PAYMENTS MADE AT EQUAL INTERVALS OF

TIME. THE FACTOR (1+𝑖) −1 IS CALLED “EQUAL-PAYMENT-SERIES-COMPOUND-
AMOUNT FACTOR” AND IS DENOTED AS (𝐹 , 𝑖, 𝑛) VALUE OF A WITH KNOWN F
ANNUITIES ARE ESTABLISHED FOR THE FOLLOWING PURPOSES: (SINKING FUND).
 C. ANNUITY DUE
THE FACTOR 𝑖 IS KNOWN AS “EQUAL-PAYMENT-SERIES-PRESENT- IF THE PAYMENT IS MADE AT THE BEGINNING OF EACH PERIOD STARTING FROM
WORTH FACTOR” AND IS DESIGNED AS (𝑃 , 𝑖, 𝑛) VALUE OF A WITH KNOWN P THE 1ST PERIOD, THE ANNUITY IS CALLED THE ANNUITY DUE.
(CAPITAL RECOVERY)
FOR THE DIAGRAM BELOW

THE FACTOR (1+𝑖) 𝑖 , IS KNOWN AS THE EQUAL-PAYMENT SERIES CAPITAL-

RECOVERY FACTOR AND DESIGNATED AS (𝐴 , 𝑖, 𝑛).

B. DEFERRED ANNUITY
IN THIS TYPE, THE 1ST PAYMENT IS DEFERRED A CERTAIN NO. OF PERIODS AFTER
THE 1ST. CONSIDER THE CASH FLOWS DIAGRAM BELOW.

FROM THE PREVIOUS EXAMPLES, THE FORMULA FOR P CAN BE GENERALIZED AS

WHERE IT IS THE NUMBER OF PAYMENTS AND N IS THE NO. OF PERIODS FROM

ZERO PERIOD UP TO LAST PERIOD.

FOR THE CASH FLOW DIAGRAM SHOWN ABOVE, THE FOLLOWING CALCULATION
CAN BE MADE FOR P & F. ONE OF THE MOST APPLICATIONS OF PERPETUITY IS IN CAPITALIZED COST. THE
CAPITALIZED COST OF ANY PROPERTY IS THE SUM OF THE 1ST COST AND THE
PRESENT WORTH OF ALL COST OF REPLACEMENT, OPERATION, AND
FOR THE FUTURE WORTH F: MAINTENANCE FOR A LONG TIME OR FOREVER.

FC= FIRST COST

OM= OPERATION AND MAINTENANCE RC= REPLACEMENT COST
SV= SALVAGE VALUE

FOR THE FUTURE WORTH P:

CASE #1
NO REPLACEMENT ONLY MAINTENANCE AND OR OPERATION EVERY PERIOD.
CC= FC + PRESENT WORTH OF PERPETUAL OPERATION AND OR MAINTENANCE.

𝑪𝑪 = 𝑭𝑪 + 𝑶𝑴/I
CASE #2
REPLACEMENT ONLY, NO MAINTENANCE AND OR OPERATION COST.
CC= FC + PRESENT COST OF PERPETUAL REPLACEMENT
𝑪𝑪 = 𝑭𝑪 + RC-SV/(𝟏 + 𝒊)𝒏 − 𝟏

CASE #3:

REPLACEMENT, MAINTENANCE, AND OR OPERATION EVERY PERIOD.

CC= FC + PRESENT WORTH OF COST OF PERPETUAL OPERATION AND OR

MAINTENANCE + PRESENT WORTH OF COST OF PERPETUAL REPLACEMENT.

𝑪𝑪 = 𝑭𝑪 + 𝑶𝑴 /𝒊 + 𝑹𝑪 − 𝑺𝑽 /(𝟏 + 𝒊)𝒏 – 𝟏
MODULE 3: ECONOMIC STUDY METHODS: PRESENT WORTH ANALYSIS, ANNUAL ANNUAL OPERATING COST = P32,000 ANNUAL LABOR COST = P50,000
WORTH ANALYSIS, & THE RATE OF RETURN(ROR) METHOD INSURANCE AND PROPERTY TAXES = 3%
PAYROLL TAXES = 4% ESTIMATED LIFE = 10 YEARS
3.1 ECONOMIC STUDY METHODS: PRESENT WORTH ANALYSIS, ANNUAL WORTH
ANALYSIS, & THE RATE OF RETURN (ROR) METHOD. TYPE B:
FIRST COST = P300,000
ECONOMIC STUDY METHODS ANNUAL OPERATING COST = P24,000 ANNUAL LABOR COST = P32,000
INSURANCE AND PROPERTY TAXES = 3% PAYROLL TAXES = 4%
AN ENGINEERING PROJECT OR ALTERNATIVE IS FORMULATED TO MAKE OR ESTIMATED LIFE = 10 YEARS
PURCHASE A PRODUCT, TO DEVELOP A PROCESS, OR TO PROVIDE A SERVICE
WITH SPECIFIED RESULTS. AN ENGINEERING ECONOMIC ANALYSIS EVALUATES IF THE MINIMUM REQUIRED RATE OF RETURN IS 15%, WHICH EQUIPMENT SHOULD
CASH FLOW ESTIMATES FOR PARAMETERS SUCH AS INITIAL COST, ANNUAL BE SELECTED? USE PRESENT WORTH COST METHOD.
COSTS AND REVENUES, NONRECURRING COSTS, AND POSSIBLE SALVAGE VALUE
OVER AN ESTIMATED USEFUL LIFE OF THE PRODUCT; PROCESS, OR SERVICE.
HOWEVER, MOST ENGINEERING AND BUSINESS PROJECTS CAN BE 2. ANNUAL WORTH ANALYSIS
ACCOMPLISHED BY MORE THAN ONE METHOD OR ALTERNATIVE. THE
ALTERNATIVE THAT REQUIRES THE MINIMUM INVESTMENT OF CAPITAL AND WILL TO APPLY THIS METHOD, THE ANNUAL COST OF THE ALTERNATIVES INCLUDING
PRODUCE SATISFACTORY FUNCTIONAL RESULT WILL ALWAYS BE USED UNLESS INTEREST ON INVESTMENT IS DETERMINED. THE ALTERNATIVE WITH THE LEAST
THERE ARE DEFINITE REASONS WHY AN ALTERNATIVE REQUIRING A LARGER ANNUAL COST IS CHOSEN. THIS PATTERN, LIKE THE RATE OF RETURN ON
INVESTMENT SHOULD BE ADOPTED. ADDITIONAL INVESTMENT PATTERN, APPLIES ONLY TO ALTERNATIVES WHICH HAS
A UNIFORM COST DATA FOR EACH YEAR AND A SINGLE INVESTMENT OF CAPITAL
THERE ARE SEVERAL METHODS FOR COMPARING ALTERNATIVES, BUT ONLY FIVE AT THE BEGINNING OF THE FIRST YEAR OF THE PROJECT LIFE.
METHODS OR PATTERNS WILL BE DISCUSSED IN THIS CHAPTER: PRESENT WORTH
ANALYSIS, ANNUAL WORTH ANALYSIS, RATE OF RETURN ON ADDITIONAL EXAMPLE
INVESTMENT ANALYSIS, BENEFIT/COST ANALYSIS, BREAKEVEN AND PAYBACK
ANALYSIS. 1. A COMPANY IS CONSIDERING TWO TYPES OF EQUIPMENT FOR ITS
MANUFACTURING PLANT. PERTINENT DATA ARE AS FOLLOWS:

1. PRESENT WORTH ANALYSIS TYPE A:

FIRST COST = P200,000
IN COMPARING ALTERNATIVES BY THIS METHOD, DETERMINE THE PRESENT ANNUAL OPERATING COST = P32,000 ANNUAL LABOR COST = P50,000
WORTH OF THE NET CASH OUTFLOWS FOR EACH ALTERNATIVE FOR THE SAME INSURANCE AND PROPERTY TAXES = 3% PAYROLL TAXES = 4%
PERIOD OF TIME. THE ALTERNATIVE WITH THE LEAST PRESENT WORTH OF COST ESTIMATED LIFE = 10 YEARS
IS SELECTED.
TYPE B:
EXAMPLE FIRST COST = P300,000
ANNUAL OPERATING COST = P24,000 ANNUAL LABOR COST = P32,000
1. A COMPANY IS CONSIDERING TWO TYPES OF EQUIPMENT FOR ITS INSURANCE AND PROPERTY TAXES = 3% PAYROLL TAXES = 4%
MANUFACTURING PLANT. PERTINENT DATA ARE AS FOLLOWS: ESTIMATED LIFE = 10 YEARS

TYPE A: IF THE MINIMUM REQUIRED RATE OF RETURN IS 15%, WHICH EQUIPMENT SHOULD
FIRST COST = P200,000 BE SELECTED? USE ANNUAL COST METHOD.
3. THE RATE OF RETURN (ROR) METHOD

THE RATE OF RETURN ON THE CAPITAL INVESTED IS GIVEN BY THE FORMULA,

RATE OF RETURN = NET ANNUAL PROFIT/CAPITAL INVESTED

RATE OF RETURN IS A MEASURE OF THE EFFECTIVENESS OF AN INVESTMENT OF

CAPITAL. IT IS A FINANCIAL EFFICIENCY. WHEN THIS METHOD IS USED, IT IS
NECESSARY TO DECIDE WHETHER THE COMPUTED ROR IS SUFFICIENT TO JUSTIFY
THE INVESTMENT. THE ADVANTAGE OF THIS METHOD IS THAT IT IS EASILY
UNDERSTOOD BY MANAGEMENT AND INVESTORS. THE APPLICATIONS OF THE
ROR METHOD IS CONTROLLED BY THE FOLLOWING CONDITIONS: A SINGLE
INVESTMENT OF CAPITAL AT THE BEGINNING OF THE FIRST YEAR OF THE PROJECT
LIFE AND IDENTICAL REVENUE AND COST DATA FOR EACH YEAR. THE CAPITAL
INVESTED IS THE TOTAL AMOUNT OF CAPITAL INVESTMENT REQUIRED TO FINANCE
THE PROJECT, WHETHER EQUITY OR BORROWED.

RATE OF RETURN ON ADDITIONAL INVESTMENT ANALYSIS

THE FORMULA FOR RATE OF RETURN ON ADDITIONAL INVESTMENT IS,

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠

/ 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

IF THE RATE OF RETURN ON ADDITIONAL INVESTMENT IS SATISFACTORY, THEN,

THE ALTERNATIVE REQUIRING A BIGGER INVESTMENT IS MORE ECONOMICAL AND
SHOULD BE CHOSEN.
MODULE 4: ECONOMIC STUDY METHODS: BENEFIT/COST ANALYSIS & BREAK N = BREAK-EVEN POINT OR QUANTITY PRODUCED AND SOLD FOR BREAK-EVEN.
EVEN ANALYSIS P = INCREMENTAL REVENUE OR SELLING PRICE PER UNIT
R = TOTAL REVENUE
4.1 ECONOMIC STUDY METHODS: BENEFIT/COST ANALYSIS 𝑅 = 𝑝𝑁
C= TOTAL COST
BENEFIT/COST ANALYSIS 𝐶 = 𝑓 + 𝑎𝑁

THE METHOD OF SELECTING ALTERNATIVES THAT IS MOST COMMONLY USED BY

GOVERNMENT AGENCIES FOR ANALYZING THE DESIRABILITY OF PUBLIC PROJECTS ASSUMING THERE IS NO CHANGE IN INVENTORY. THE BREAK-EVEN POINT CAN BE
IS THE BENEFIT/COST RATIO (B/C). THE B/C METHOD OF ANALYSIS IS BASED ON FOUND FROM:
THE RATIO OF THE BENEFITS TO COSTS ASSOCIATED WITH A PARTICULAR
PROJECT.

THE B/C RATIO INTRODUCES OBJECTIVITY INTO THE ECONOMIC ANALYSIS OF

PUBLIC SECTOR EVALUATION, THUS REDUCING THE EFFECTS OF POLITICS AND
SPECIAL INTERESTS. THE B/C ANALYSIS CAN USE EQUIVALENCY COMPUTATIONS
BASED ON PW, AW, OR FW VALUES. PERFORMED CORRECTLY, THE BENEFIT/COST
METHOD WILL ALWAYS SELECT THE SAME ALTERNATIVE AS PW, AW, AND ROR
ANALYSES.

B/C: BENEFITS-DISBENEFITS/ COSTS

BENEFITS ARE ADVANTAGES, EXPRESSED IN TERMS OF PESOS WHICH HAPPEN

TO THE OWNER. ON THE OTHER HAND, WHEN THE PROJECT UNDER
CONSIDERATION INVOLVES DISADVANTAGES TO THE OWNER, THESE ARE KNOWN
AS DISBENEFITS. THE COSTS ARE THE ANTICIPATED EXPENDITURES FOR
CONSTRUCTION, OPERATION, MAINTENANCE, ETC. A B/C RATIO GREATER THAN
OR EQUAL TO 1.0 INDICATES THAT THE PROJECT UNDER CONSIDERATION IS
ECONOMICALLY ADVANTAGEOUS.

BREAK-EVEN ANALYSIS
IS PERFORMED TO DETERMINE THE VALUE OF A VARIABLE OR PARAMETER OF A
PROJECT OR ALTERNATIVE THAT MAKES TWO ELEMENTS EQUAL, FOR EXAMPLE,
THE SALES VOLUME THAT WILL EQUATE REVENUES AND COSTS. A BREAKEVEN
STUDY IS PERFORMED FOR TWO ALTERNATIVES TO DETERMINE WHEN EITHER
ALTERNATIVE IS EQUALLY ACCEPTABLE.
- IS A METHOD OF DETERMINING WHEN COSTS EXACTLY EQUAL REVENUE.

F = FIXED COST WHICH DOES NOT VARY WITH PRODUCTION.

A = AN INCREMENTAL COST WHICH IS THE COST TO PRODUCE ONE ADDITIONAL
ITEM. IT MAY ALSO BE CALLED THE MARGINAL COST OR DIFFERENTIAL COST.
MODULE 5: DEPRECIATION METHODS PURPOSES OF DEPRECIATION
1. TO PROVIDE FOR THE RECOVERY OF CAPITAL WHICH HAS BEEN INVESTED
5.1 DEPRECIATION METHODS: STRAIGHT LINE, SINKING FUND, & SUM OF YEARS IN PHYSICAL PROPERTY.
2. TO ENABLE THE COST OF DEPRECIATION TO BE CHARGED TO THE
COST OF PRODUCING PRODUCTS OR SERVICES THAT RESULTS FROM THE USE
DEPRECIATION OF THE PROPERTY.

DEPRECIATION IS THE DECREASE IN THE VALUE OF PHYSICAL PROPERTY WITH THE TYPES OF DEPRECIATION
PASSAGE OF TIME. DEPRECIATION TAKES THE AMOUNT YOU SPENT TO BUY AN 1. NORMAL DEPRECIATION
ASSET, AND ALLOCATES A PROPORTIONATE AMOUNT TO EACH OF THE PERIODS
OF ITS USEFUL LIFE. A. PHYSICAL DEPRECIATION
- IS DUE TO THE LESSENING OF THE PHYSICAL ABILITY OF A PROPERTY TO
DEFINITIONS OF VALUE: PRODUCE RESULTS. ITS COMMON CAUSES ARE WEAR AND DETERIORATION.

VALUE B. FUNCTIONAL DEPRECIATION

IN A COMMERCIAL SENSE, VALUE IS THE PRESENT WORTH OF ALL FUTURE - IS DUE TO THE LESSENING IN THE DEMAND FOR THE FUNCTION WHICH THE
PROFITS THAT ARE TO BE RECEIVED THROUGH OWNERSHIP OF A PARTICULAR PROPERTY WAS DESIGNED TO RENDER. ITS MOST COMMON CAUSES ARE
PROPERTY. INADEQUACY, CHANGES IN STYLE, POPULATION CENTERS SHIFT, SATURATION OF
MARKETS OR MORE EFFICIENT MACHINES ARE PRODUCED.
MARKET VALUE
THE MARKET VALUE OF A PROPERTY IS THE AMOUNT WHICH A WILLING BUYER 2. DEPRECIATION DUE TO CHANGES IN PRICE LEVELS
WILL PAY TO A WILLING SELLER FOR THE PROPERTY WHERE EACH HAS EQUAL - IS ALMOST IMPOSSIBLE TO PREDICT AND THEREFORE IS NOT
ADVANTAGE AND IS UNDER NO COMPULSION TO BUY OR SELL. CONSIDERED IN ECONOMY STUDIES.

THE UTILITY OR USE VALUE OF PROPERTY 3. DEPLETION

THE UTILITY OR USE VALUE OF PROPERTY IS WHAT THE PROPERTY IS WORTH TO - REFERS TO THE DECREASE IN THE VALUE OF A PROPERTY DUE TO THE
THE OWNER AS AN OPERATING UNIT. GRADUAL EXTRACTION OF ITS CONTENT.

FAIR VALUE PHYSICAL LIFE OF A PROPERTY

IT IS THE VALUE WHICH IS USUALLY DETERMINED BY A DISINTERESTED 3RD PARTY IS THE LENGTH OF TIME DURING WHICH THE PROPERTY IS CAPABLE OF
IN ORDER TO ESTABLISH A PRICE THAT IS FAIR TO BOTH SELLER AND BUYER. PERFORMING THE FUNCTION FOR WHICH IT WAS DESIGNED AND MANUFACTURED.

BOOK VALUE ECONOMIC LIFE

SOMETIMES CALLED DEPRECIATED BOOK VALUE, IT IS THE WORTH OF A IS THE LENGTH OF TIME DURING WHICH THE PROPERTY MAY BE OPERATED AT A
PROPERTY AS SHOWN ON THE ACCOUNTING RECORDS OF AN ENTERPRISE. PROFIT.

SALVAGE OR RESALE VALUE REQUIREMENTS OF DEPRECIATION

IT IS THE PRICE THAT CAN BE OBTAINED FROM THE SALE OF THE PROPERTY AFTER 1. IT SHOULD BE SIMPLE.
IT HAS BEEN USED. 2. IT SHOULD RECOVER CAPITAL.
3. THE BOOK VALUE WILL BE REASONABLY CLOSE TO THE MARKET VALUE
SCRAP VALUE AT ANY TIME.
IT IS THE AMOUNT THE PROPERTY WOULD SELL FOR IF DISPOSED OFF AS JUNK. 4. THE METHOD SHOULD BE ACCEPTED BY THE BUREAU OF INTERNAL
REVENUE.
DEPRECIATION METHODS:

1. STRAIGHT LINE METHOD (SLD)

ANNUAL DEPRECIATION= FC-SV/N

TOTAL DEPRECIATION AFTER “X” YEARS

DEPRECIATION= (FC-SV/N)(X)
BV= FC-DEPRECIATION

FC= FIRST COST 5. DOUBLE DECLINING BALANCE METHOD (DDB)

SV= SALVAGE VALUE THE DOUBLE DECLINING BALANCE DEPRECIATION (DDB) METHOD, ALSO KNOWN
N= LIFE IN YEARS AS THE REDUCING BALANCE METHOD, IS ONE OF TWO COMMON METHODS A
BUSINESS USES TO ACCOUNT FOR THE EXPENSE OF A LONG-LIVED ASSET. THE
2. SINKING FUND METHOD DOUBLE DECLINING BALANCE DEPRECIATION METHOD IS AN ACCELERATED
DEPRECIATION METHOD THAT COUNTS AS AN EXPENSE MORE RAPIDLY (WHEN
COMPARED TO STRAIGHT-LINE DEPRECIATION THAT USES THE SAME AMOUNT OF
DEPRECIATION EACH YEAR OVER AN ASSET'S USEFUL LIFE). SIMILARLY,
COMPARED TO THE STANDARD DECLINING BALANCE METHOD, THE DOUBLE
DECLINING METHOD DEPRECIATES ASSETS TWICE AS QUICKLY.

3. SUM OF YEARS DIGIT METHOD (SOYD)

4. DECLINING BALANCE METHOD(MATHESON’S METHOD) OR CONSTANT

PERCENTAGE OF DECLINING VALUE

THE DECLINING BALANCE METHOD IS AN ACCELERATED DEPRECIATION SYSTEM

OF RECORDING LARGER DEPRECIATION EXPENSES DURING THE EARLIER YEARS OF
AN ASSET’S USEFUL LIFE AND RECORDING SMALLER DEPRECIATION EXPENSES
DURING THE ASSET'S LATER YEARS.