ADAMA SCIENCE AND TECHNOLOGY UNIVERSITY

SCHOOL OF CIVIL ENGINEERING AND

ARCHITECTURE
DEPARTMENT OF CIVIL ENGINEERING

Engineering Economics Lecture ppt.

Instructor:- Surafel L.
 Chapter one
1.1. Introduction to Engineering Economics
overview
• In engineering many decisions, which have to be
taken, concern costs quite as much as
performances.
• For better decisions interest, depreciation and
profit should also be considered when deciding
about purchasing a production facility.
• All human activities related to wealth and meant
to satisfy human wants directly or indirectly are
called “economic activities” and these are the
subject matters of “Economics”.
 Introduction to Engineering Economics…..

• The economy of any country, in terms of both local and global

markets, is a vital indicator of the wellbeing of the nation.
• High employment, business confidence and the efficient use of
natural and human resources all contribute to the wealth of a
country.
• The construction economist has to make decisions
concerning which projects to develop, where to develop, the
suitability of the project, and when to commence the work.
• Finance and capital play a major role in every economy or
business.
• Investment is often the key to the success of a construction
business, and government policies and spending can have very
real effects in terms of producing steady growth and
minimizing the impact of recessions.
 Introduction to Engineering Economics…..

• Learners will develop an understanding of the

basic economic issues that are encountered
in the construction sector, the problems a
developer can face, and the decisions that
need to be made before work can start on a
construction site.
• They will explore the use of cost control in a
project, and investigate what constitutes a
successful project outcome through the use
of simple feasibility calculations.
 Introduction to Engineering Economics…..

• Consideration will be given to the financial

and economic impact of good design and site
practice in terms of sustainability and the
impact on life cycle costing on a project.
• Learners will recognize how projects with
higher initial construction costs with improved
sustainable specifications, may have a lower
overall life cycle cost when maintenance and
running costs are taken into account.
 Introduction to Engineering Economics…
Definition
• Economics is a science as well as an art.
• It shows the relationship between cause and
effect involved in various economic
phenomena, which is the function of science.
• It also prescribes certain rules and guidelines
for maximization of material prosperity which
is the function of art.
• Engineering Economy is a discipline
concerned with systematic evaluation of
the costs and benefits of proposed
technical and business projects and ventures.
 Introduction to Engineering Economics…
• Scope
Comparison of alternative proposals, e. g.,
1. The defective machine should be replaced or
maintained.
2. By taking loan a particular sick business should be
continued or closed down.
3. A product or part should be manufactured inside or
should be subcontracted.
• When investment is required, the time value must be
considered.
• When machinery and plant are required, the depreciation
must be considered.
 Introduction to Engineering Economics…

• When material is an important requirement,

procurement policy and market analysis must be
considered.
• Most of the proposals involve organized effort. In
such cases labor costs must be considered.
• When the accepted engineering proposal
becomes successful, a net income is generated.
Thus consideration of accounting and income
tax becomes necessary.
 Introduction to Engineering Economics…

• Functions of Engineering Economy

1. Develop the alternatives.
2. Focus on the differences of the alternatives
3. Use a consistent view point for all the
alternatives
4. Use a common unit of measurement for
comparison among alternatives
5. Consider all relevant criteria
6. Make uncertainty explicit
7. Review your decisions
 Introduction to Engineering Economics…

1. Develop the alternatives - The decision

( choice ) is among alternatives. The feasible
alternatives need to be identified and then
defined for subsequent analysis.
2. Focus on the differences of the
alternatives – Only the differences in the
expected future outcomes among the
alternatives are relevant to their comparison
and should be considered in the decision.
 Introduction to Engineering Economics…
3. Use a consistent view point for all the alternatives
– The prospective outcomes of the feasible alternatives,
economic and other, should be developed from a
consistent and defined view point.
4. Use a common unit of measurement for
comparison among alternatives – Using a common
unit of measurement to enumerate as many of the
prospective outcomes as possible will make easier the
analysis and comparison of the feasible alternatives.
5. Consider all relevant criteria – Considering all
relevant criteria, selection of preferred alternatives is
done.
6. Make uncertainty explicit – Uncertainty is inherent.
7. Review your decisions – Improved decision making
results from an adoptive process.
 Introduction to Engineering Economics…..
7 Steps of Problem Solving
1) Identify and define the problem.
2) Determine the set of alternative solutions.
3) Determine the criterion or criteria that will be used to evaluate the
alternatives.
4) Evaluate the alternatives.
5) Choose an alternative.
6) Implement the selective alternative.
7) Evaluate the results to determine whether a satisfactory solution has
been obtained.
Decision Making – term generally associated with the first five steps
of the problem- solving process.
 Introduction to Engineering Economics…..
• To illustrate the decision making process, consider the following example:

• Assume that you are currently unemployed and that you would like a position that will lead to a
satisfying career. Suppose that your job search has resulted to offers from companies in City A, City B,
City C and City D.

• Considering the above information, how would the alternatives for your decision problem be stated?

• Alternatives can be stated as follows:

1) Accept the position in City A.

2) Accept the position in City B.

3) Accept the position in City C.

4) Accept the position in City D.

• Determine the criterion or criteria to evaluate the alternatives.

• suppose you will use the ‘salary’ as the only criterion to evaluate the alternatives – “Single Criterion
Decision Problem”.

• Suppose that you have also concluded that the potential for advancement and the location of the
job are two other criteria of major importance. Now you have 3 criteria – “Multi-criteria Decision
Problem”
Introduction to Engineering Economics…..
 Introduction to Engineering Economics…..

The Role Qualitative and Quantitative Analysis

 Introduction to Engineering Economics…..
• Quantitative Analysis
• Some reasons why quantitative approach might be used in the
decision-making process:
1) The problem is complex, and the manager cannot develop a good
solution without the aid of quantitative analysis
2) The problem is especially important (e.g., a great deal of money is
involved), and the manager desires a thorough analysis before
attempting to make a decision.
3) T he problem is new, and the manager has no previous experience
from which to draw.
4) The problem is repetitive, and the manager saves time and effort by
relying on quantitative procedures to make routine
recommendations.
 Introduction to Engineering Economics…..

• Qualitative Analysis is based primarily on the

manager’s judgment and experience; it includes the
manager’s intuitive “feel” for the problem and is more an
art than a science.
• If the manager has had experience with similar
problems, or if the problem is relatively simple, heavy
emphasis may be placed upon a qualitative analysis.
• However, if the manager has had little experience with
similar problems, or if the problem is sufficiently
complex, then a quantitative analysis of the problem
can be an especially important consideration in the
manager’s final decision.
 Introduction to Engineering Economics…..

• When using the quantitative approach, an analyst

will concentrate on the quantitative facts or data
associated with the problem and develop
mathematical expressions that describe the
objectives, constraints, and other relationships that
exist in the problem.
• Then, by using one or more quantitative methods,
the analyst will make a recommendation based on
the quantitative aspects of the problem.
 Introduction to Engineering Economics…..

• When both the manager and the management scientist

agree that the problem has been adequately structured,
work can begin on developing a model to represent the
problem mathematically.
• Solution procedures can then be employed to find the
best solution for the model. This best solution for the
model then becomes a recommendation to the decision
maker. The process of developing and solving model is the
essence of the quantitative analysis process.
 Introduction to Engineering Economics…..
 Model Development
• Models are representations of real objects or situations and can be represented
in various forms.
 Classification of Models
1) Iconic models – physical replicas of a real object
• E.g. a scale model of an airplane is a representation of a real airplane.
Similarly, a child’s toy truck is a model of a real truck. The model airplane and
the toy truck are examples of models that are physical replicas of real objects.
In modeling terminology, physical replicas are referred to as “iconic models”.
2) Analog models – physical in form but do not have the same physical
appearance of the object being modeled. E.g. speedometer of an automobile;
the position of the needle on the dial represents the speed of the automobile.
3) Mathematical model – this includes representations of a problem by a system
of symbols and mathematical relationships or expressions. Mathematical
models are critical part of any quantitative approach to decision making.
 1.2. Principles of Engineering
economics

• Principle 1: A nearby dollar is worth more

than a distant dollar.
• A fundamental concept in engineering
economics is that money has a time value
associated with it.
• Because we can earn interest on money received
today, it is better to receive money earlier than
later. This concept will be the basic foundation
for all engineering project evaluation.
 Basic concepts of Engineering economics…

• Principle 2: All that counts is the differences among

alternatives.
• An economic decision should be based on the differences
among alternatives considered.
• All that is common is irrelevant to the decision. Certainly,
any economic decision is no better than the alternatives
being considered.
• Therefore, an economic decision should be based on the
objective of making the best use of limited resources.
Whenever a choice is made, something is given up.
• The opportunity cost of a choice is the value of the best
alternative given up.
 Basic concepts of Engineering economics…

• Principle 3: Marginal revenue must exceed marginal

cost.
• Any increased economic activity must be justified based on
the following fundamental economic principle: marginal
revenue must exceed marginal cost. Here, the marginal
revenue is the additional revenue made possible by
increasing the activity by one unit (or a small unit).
• Similarly, marginal cost is the additional cost incurred by
the same increase in activity. Productive resources such as
natural resources, human resources, and capital goods
available to make goods and services are limited.
• Therefore, people cannot have all the goods and services
they want; as a result. they must choose those things that
produce the most.
 Basic concepts of Engineering economics…

Principle 4: Additional risk is not taken without

the expected additional return.
• For delaying consumption, investors demand
minimum return that must be greater than the
anticipated rate of inflation or any perceived risk.
• If they didn't receive enough to compensate for
anticipated inflation and perceived investment
risk, investors would purchase whatever goods
they desired ahead of time or invest in assets that
would provide a sufficient return to compensate
for any loss from inflation or potential risk.
 1.3. Terminologies in
Engineering economics
1.3.1. Accounting Of Business Transactions
 Definition of Accounting
• Accounting may be defined as the process of
collecting, recording, classifying, summarizing,
analyzing and communicating financial
information.
• Accounting is the art of recording, classifying and
summarizing in significant manner and in terms of
money transactions and events which are, in part,
at least of financial character and interpreting the
results thereof.
 Introduction to Engineering Economics…

According to AAA (American Accounting

Association) :
• Accounting is the process of identifying,
measuring and communicating economic
information to permit informed judgment and
decision by user of the information.
 Introduction to Engineering Economics…

Functions of Accounting
i. Recording of all financial transactions -
Journal
ii. Classifying - Ledger
iii. Summarizing - Trial Balance, Income
Statement (Profit & Loss Account), Balance
Sheet (Assets & Liabilities)
iv. Analysis and Interpreting - Ratio Analysis
v. Communication - Ratios, Graphs,
Diagrammes etc.
Introduction to Engineering Economics…
 Introduction to Engineering Economics…

Some terms in accountancy

 BOOK KEEPING
• Book keeping is an art of keeping written records
of all the dealings in money, goods or services in a
business, so that they may not be forgotten.
• Book keeping may be defined as an activity
concerned with the recording of financial data
relating to business operations in a significant and
orderly manner.
• Book keeping is the record making, classifying and
summarizing phase of accounting.
• As a matter of fact, accounting begins where
book-keeping ends.
 Introduction to Engineering Economics…

 JOURNAL
• A journal may be defined as a book containing a
chronological record of all business transactions.
This is known as the original record.
 LEDGER
• A ledger may be defined as a book containing
various accounts, like Cash , Capital, Purchase
etc. Each account usually occupies one page in
the ledger, but sometimes it may occupy two or
three pages also depending upon the length of the
account.
 Introduction to Engineering Economics…

• The account is the permanent record kept by

sorting out all the transactions related to the
same person or thing.
• This process of sorting out or classifying the
business transactions from the journal and
transferring them to their respective accounts
in the ledger is called “ledger posting”.
TRIAL BALANCE
• Trial Balance is prepared at the end of a
closing period to check the accuracy of
posting into the ledger.
 Introduction to Engineering Economics…

 PROFIT & LOSS ACCOUNT

• It is also prepared at the end of a closing period to
know the net profit or loss.
 BALANCE SHEET
• It is the last and most important statement. BS is
prepared at the end of a closing period to
• know the financial position of the business. It is not
an account, but only a statement containing the
assets and liabilities at the end of the closing
period.
• Balance sheet are normally drawn up annually,
quarterly, monthly or at other regular intervals
 Introduction to Engineering Economics…
 ASSETS
• Assets are the resources owned by a business. These are the
things of value possessed by the owner of the business, e.g.,
building, plant and machinery, furniture, stock of goods.
 There are three types of Assets :
• 1. Fixed Assets – These assets are of permanent character.
They are also called Capital Assets. They are not bought to
sell again, but are intended for use in the business.
• 2. Current Assets – They are also called Floating Assets.
These are purchased or made with the intention of selling
them.
• 3. Fictitious Assets – They are usually expenses or losses of
large amount which can not be changed against the profit for
the period in which they arise. They are shown as assets and
are gradually depreciated. “Preliminary expenses” in the head
under which comes the cost of floating a company, paying for
the prospectus, stamp duty, legal and banking fee etc.
 Introduction to Engineering Economics…
 EQUITY
• Equities are the claims of various parties against the
assets. Equities are of two types :
1) Owners’ Equity – It is also called “Capital”
2) Outsiders’ Equity – It is also called “Liabilities”
• Equities = Assets
• Or, Liabilities + Capital = Assets
• This is called “Accounting Equation”
 CAPITAL
• The amount of cash or goods which the proprietor of a
business invests in it is called the proprietor’s capital.
 Basic concepts of Engineering economics…

LIABILITIES
• They are debts due by a business to its
proprietors and others, e.g., capital,
creditors etc.
PURCHASE
• Goods purchased for the business are
called purchases.
 Basic concepts of Engineering economics…

The income statement:

 Is a form of financial statement that shows whether the
company has made or lost money during that reporting
period.
 Can prepared monthly, quarterlly or etc.
 Shows:
 Revenues: prices for sold goods or services during the
accounting period.
 Production cost = cost of revenue
 Net sales: Gross sales minus sales returned & allowances
 Gross Margin: net sales – Cost of revenue
 Operating income: Gross Margin – (cost of capital,lease,admin.
Expenses etc.)
 Basic concepts of Engineering economics…

 Gross Profit or Income before income tax:

operating income + other incomes.
 Net Profit: Gross profit – income tax.
Profit and loss account:
 Is also prepared at the end of closing period to know the net
profit or loss.
Earning per share/EPS/:
 EPS = Net Income/Number of Shares
Retained Earnings:
 This is money which is retained from the net profit to be used
for expansion purposes or saved as security for risk. The
remaining balance, which is net profit minus retained earning,
will be given as dividend to owners.
 Basic concepts of Engineering economics…

The cash flow statement:

 The income statement shows how much the company
has lost or gained, but does not indicate financing and
investment activities during the period.
 Therefore, an additional financial statement is required
which can show how the company generated the cash
and how it has spent or utilized it. This statement is
known as the Cash Flow Statement.
 The operating cash flow represents all cash flows related
to the production and sales of goods and services.
 All non-cash expenses like depreciation is added back
as income to the net profit.
 Basic concepts of Engineering economics…

 Financing Activities:
Purchasing stocks……………….(outflow)
Selling Stocks………...................(inflow)
Paying loans…………………… (outflow)
Purchase of new fixed assets……(outflow)
Reselling an old equipment……...(inflow)
Etc.
 Basic concepts of Engineering economics…
Examples to show the relationship of assets and equities

1. A company A deposits 10,000Birr in the bank

Assets = Capital
10,000 = 10,000
2. The company bought land for 6,000Birr.
Assets = Capital
cash + Land
4,000 6,000 10,000
3.The company purchased a supplies commodity, promising
to pay 750Birr at a later date.
Assets Equities
cash + supplies + Land = Liabilities + Capital
4,000+ 750 + 6,000 = 750 + 10,000
 Basic concepts of Engineering economics…

4.After one month, 500Birr is paid to partly cover the supplies.

Assets Equities
Cash + Supplies + Land = Liabilities + Capital
3,500 + 750 + 6,000 = 250 + 10,000
5.From operations the company obtained 5,000Birr as revenue.
Assets Equities
Cash+supplies+land = Liabilities + Capital
3,500 250 + 10,000
+5,000 5,000
8,500 750 6000 = 15,000
15,250 15,250
 Basic concepts of Engineering economics…

6. various payments like

wages(1000Birr),rent(800Birr) utilities(200Birr) and
miscellaneous(100Birr) is paid.

Assets Equities
Cash+Supplies+Land = Liabilities + Capital
8,500 15,000
-2,100 -2,100
6,400 750 6,000 = 250 12,900
13,150 13,150
 Basic concepts of Engineering economics…

7.From the supplies, amount worth of 600Birr is consumed.

Assets Equities
Cash+Supplies+Land = Liabilities + Capital
750 12,900
-600 -600
6400 150 6,000 = 250 12,300
12,550 12,550
8.The Manager withdraws 1500Birr for his personal use.
Assets Equities
Cash+supplies+Land = Liabilities + Capital
6400 12,300
-1500 -1,500
4,900 150 6000 = 250 10,800
11,050 11,050
 Balance sheet

A list of assets, liabilities and capital of a business entity

as of a specific data, usually at the close of the last day of
month or year.
Assets
Cash 4,900
Supplies 150
Land 6,000
Total assets 11,050
Liabilities
Accounts payable 250
Capital
Capital 10,800
Total liabilities & capital 11,050
 Income statement

Summary of the revenue and the expenses of a business

entity for a specific period of time(a month or year)
Earned 5,000
Operating expenses
 Wages 1000
 Rent 800
 Supplies 600
 Utilities 200
 Miscellaneous 100
2,700
Net income 2,300
 Capital statement

Summary of changes in capital that have occurred

during a specific period(a month or a year)
 Capital 10,000
 Net income 2,300
 Less withdrawals 1,500
 Increase in capital 800
 Capital 10,800
 1.3.2. Ratios to make Business Decisions

I. Debt management analysis

 This helps to see how a company manages or uses its
debt and its ability to meet its repayment obligations.
 There are two ratios used to determine.
a. Debt ratio: total debt / total assets
 This shows the proportion of the company's asset that has
been financed through debt.
 If DR = 1 implies that all assets are financed through
debt.
 One has to try to keep DR as low as possible to attract
further financing from creditors.
b.Time-interest-earned ratio /TIER/
reading assignment
II. Liquidity analysis:
 Working capital is the excess of current assets to current liabilities.
 Liquid means simply a strong operating income/working capital/.
 The net working capital shows the extent of the liquidity of the company.
There are two ratios to determine.
a. Current ratio: current asset / current liability
 good value of CR is difficult to give, but it is good to be b/n 1 & 2.
If CR = 1 implies no remaining working capital
If CR < 1 current assets could not cover the current liabilities.
If CR = 2 the company has 100% more amount /double/ than current
liabilities or has a /working capital/.
b. Quick /acid test/ ratio:
(current assets – inventories) / current liabilities.
 This shows the ability of the company to settle its
current liabilities immediately.
 Good value is grater than 1.
III. Asset management analysis:
 This indicates the effectiveness of a company in
managing its assets.
 Too many assets may lead to high cost of capital
 Too low assets implies to less profitable sales.
There are three ratios under this category.
1.Inventory turn over ratio /ITR/
 This measures how many times the company sold and
replaced its inventory during the period.
 The higher ITR the less stock holding and money is not
tied.
2. Days sales standing DSO
( accounts receivable / turnover )
Reading assignment
3. Total Assets Turnover /TATR/
Reading assignment
There are three ratios under this category.
1.Inventory turn over ratio /ITR/
 This measures how many times the company sold and
replaced its inventory during the period.
 The higher ITR the less stock holding and money is not
tied.
2. Days sales standing DSO
( accounts receivable / turnover )
Reading assignment
3. Total Assets Turnover /TATR/
Reading assignment
IV. Profitability analysis:
This is a method to show HOW PROFTABLE a
company is, using a ratios:
1.Profit Margin on sales /PMS/ (net income/sales)
Lower values indicate less efficient operation,
heavy debt and large inventory volume.

2. Return on total assets /RTA/

Reading assignment
3. Returned on common equity /RCE/
Reading assignment
V. Market value analysis:
 When one purchases a stock from a company one is
interested on:
 How liquid the stock is to resell?
 How much dividend it can generate?
 Thus one uses two ratios to measure the above mentioned
criteria.
1 Book value per share /BVS/
It is the measure of the amount distributed to stockholders
per share /BVS/
For an asset BV = initial cost – depreciation
2. Price / Earning ratio.
Reading assignment
 Construction Contract Revenue Recognition

 Construction follows the same accounting principles like

other industries. However, revenue recognition in
construction is an exception.
 This is due to
 The long term nature of the construction contracts
 Variation order and
 Unexpected conditions
Which makes estimation of events and amounts difficult.

 Mostly the revenue is recognized at the point of sale.

 Different methods of revenue recognition

1. Cash Method
 Record of revenue and costs are made when payments
are received and bills paid, respectively to actual date.

Example:
Payment received to date: 500,000.00
Payment made to date: 300,000.00
Revenue to date: 200,000.00

 This is however does not indicate project progress and the

profit or loss.
2. Straight Accrual method:
 In this method one enters costs and revenue to date
which are effected plus billed, even if actual payment
is not made.
Payments billed to date 500,000.00
Costs incurred to date 250,000.00
Revenue to date 250,000.00

3. Completed contract method

 Percentage of Completion Method

 The method is applicable when all parties satisfy their

respective obligations.
 the owner pays on time and the contractor does his job
on time.
 Example for a certain contractor financial data
Contract amount 8,000,000.00 anticipated
Estimated initial cost 7,200,000.00 profit 800,000.00
Billed to date 5,600,000.00
Received to date 5,040,000.00
Costs to date 3,600,000.00
Costs forecasted to complete 3,200,000.00
Cost paid to date 3,200,000.00
Percentage completion
PC = cost incurred to date * 100(%)
( cost incurred to date + cost to complete)

= 3,600,000.00 * 100
(3,600,000 + 3,200,000)
= 52.9%
Revenue to date = 52.9 * contract price
= 52.9 * 8,000,000.00
= 4,232,000.00 Birr
Gross profit = 4,232,000 – 3,600,000
= 632,000.00
Over/Under Billing
 For the previous example
Initial estimated cost and estimate of the cost during
progress have changed from
7,200,000 to (3,200,000+3,600,000) 6,800,000 Birr
 As the work progressed, the contractor has presented an
invoice for 5,600,000 birr and incurred a cost of
3,600,000birr.thus,the cash balance with the contractor is
2,000,000 birr
Invoice 5,600,000.00
Incurred cost 3,600,000.00
2,000,000.00
 From this cash balance, the 632,000.00birr is true gross
profit. But the rest 1,368,000.00 birr is over billing.
Invoice to date: 5,600,000.00
Revenue to date: 4,232,000.00
Over billing 1,368,000.00

Overbilling is usually take place in lump sum contracts,

when payments concentrate on initial activities.

Over billing = invoice to date – revenue

Under billing = revenue – invoiced to date
 Normally, a contractor is in an under billing situation
during start up of a project and even at the later
stages, when variation orders exist and the
contractor performs the works from his own cash.

 Risks
 Over billing: if money is siphoned somewhere else,
there will be no cash for regular payments.
 Under billing: working capital deficiency for the
contractor and the risk of unsetting of payments by
the owner.