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Chapter 1 all slides

  1. 1. Chapter 1 Foundations Of Engineering Economy MS291: Engineering Economy 1-1
  2. 2. Contents of the Chapter      What is Economics? Why Economics for Engineers ? What is Engineering Economy ? How to Performing Engineering Economy Study ? Some Basic Concepts – Utility & Various cost concepts – Time value of money (TVM) – Interest rate and Rate of Returns – Cash Flow – Economic Equivalence – Simple and compound interest rates 1-2
  3. 3. Setting the Scene  Lets start with a simple question ? What is Economics ? Anyone ?  There are variety of definitions of Economics but let me place the most relevant one for this course  A social science that studies how individuals, governments, firms and nations make choices on allocating scarce resources to satisfy their unlimited wants 1-3
  4. 4. Why Engineer Need to know about Economics ?  Individuals, Engineers, Managers all made choice among various alternatives in their every day life ..Any Example ?  Mostly these choice is associate with money (more specifically capital or capital funds) but money (or resources) is limited  The selection of any choice depends on the expected future return of each alternative  Engineers plays a vital role in “such decision” due to their ability and experience to design, analyze and synthesize 1-4
  5. 5. Why Engineer Need to know about Economics ? (II)  Engineers design and create  Designing involves economic decisions … Why ?  Engineers must be able to incorporate economic analysis into their creative efforts  Often engineers must select and implement from multiple alternatives  Understanding and applying “engineering economy tools ( such as time value of money, economic equivalence, and cost estimation) are vital for engineers  A proper economic analysis for selection and execution is a fundamental task of engineering 1-5
  6. 6. What is Engineering Economy ?  Engineering Economy involves – Formulating – Estimating, and – Evaluating expected economic outcomes of alternatives designed to accomplish a defined purpose Defined Purpose Different alternatives with expected economic outcomes - Formulate - Estimate - Evaluate Expected outcomes of each alternatives Select the1-6 best alternative
  7. 7. Where Engineering Economy learning is useful ? It is useful in many different engineering decisions  How should the engineering project be designed ?  Has civil or mechanical engineer chosen the best thickness for insulation ?  Which engineering projects should have a higher priority ?  Has the industrial engineer shown which factory improvement projects should be funded with the available resources  Which engineering projects are worthwhile ?  Has the mining or petroleum engineer shown that mineral or oil deposits is worth developing ? 1-7
  8. 8. Performing Engineering Economy Study  Keeping in mind, what is economics and engineering economy?  For doing any engineering study we will need to do many things such as: Problem identifications, its objectives, its various alternatives, information about each alternatives, choosing the best among all alternatives etc. 1-8
  9. 9. Steps in an Engineering Economy Study Step 1 in Study Problem description Objective statement Step 2 Available data Alternatives for solution Step 3 Cash flows and other estimates Step 4 Measure of worth criterion (PW, B/C, IRR etc) Step 5 Engineering Economic Analysis Step 6 One or more approaches to meet objectives Best alternative Selection • • • • • Expected life Revenues Costs Taxes Project Financing Tools u will be learning in this course are used here Time Passes Step 7 Step 1 in Study Implementation and Monitoring New Problem description New engineering economic study begins
  10. 10. Utility • What is Utility ? Anyone ? • In economics utility refers to the power of a good or service that satisfy human wants • E.g. A glass of water has utility that it satisfy one’s thirst • Utility is the one of the very basic and important concept of economics • Marginal Utility refers to Utility derived from one additional unit of a good 1-10
  11. 11. Law of Diminishing Marginal Utility Total Utility (3) Marginal Utility, Utils 0 ] 10 ] 18 ] 24 ] ] 28 ] 30 ] 30 28 10 8 Utils refers to Unit in which utility can be measured 30 Total Utility (Utils) 0 1 2 3 4 5 6 7 (2) Total Utility, Utils TU 20 10 0 6 4 2 0 -2 Marginal Utility (Utils) (1) Glass of water 1 2 3 4 5 6 Units Consumed Per glass 7 Marginal Utility 10 8 6 4 2 0 -2 MU 1 2 3 4 5 6 7 Units Consumed Per glass 1-11
  12. 12. Various Type of Costs • There are different type of costs and can be classified by various ways • This lecture includes costs classifications mostly use by economists • Fixed & Variable Costs, Average Costs & Marginal Costs, Private & Social Costs • Opportunity Costs • Some other important cost concept you may come across: Sunk Cost and Sinking funds, Operation & Maintenance Cost (O&M Costs), Life-cycle Costs etc. 1-12
  13. 13. Fixed and Variable Costs • Fixed Costs: those costs that do not vary with the quantity of output produced.…any example ? Examples: rent to paid for factory building, interest on invested capital, maintenance, taxes etc • Variable Costs: are those costs that do vary with the quantity of output produced Examples: consumption of fuel for power generation ….it will vary as the production of a factor increases or decrease 1-13
  14. 14. Total Costs • It maybe noted that Fixed Costs (FC) and Variable Costs(VC) may consist of more than one component and the sum of all respective components will make up TFC and TVC respectively • Total Costs (TC) is equal to sum of Total Fixed Costs (TFC) and Total variable costs (TVC): TC = TFC + TVC 1-14
  15. 15. Average Costs • Average Costs – Average costs can be determined by dividing the firm’s costs by the quantity of output it produces – The average cost is the cost of each typical unit of product • Average Costs can also be obtained by adding Average Fixed Costs (AFC) and Average Variable Costs (AVC) …i.e: ATC = AFC + AVC 1-15
  16. 16. Average Costs Example: a firm produce 100 units of output at cost of $1000, what is the average cost of the firm? AFC  Fixed cost FC  Quantity Q Variable cost VC AVC   Quantity Q ATC  Total cost Quantity TC  Q = 1000/100 => $10 1-16
  17. 17. Marginal Costs • Marginal Cost – Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production – Marginal cost helps answer the following question: • How much does it cost to produce an additional unit of output? (change in total cost) TC MC   (change in quantity) Q 1-17
  18. 18. Private / Social Cost • Private costs (benefits) of an action – accruing to the actor only • Social costs (benefits) – total costs of activity including those that accrue to people other than the actor • Example: driving a car – Private costs: fuel, maintenance – Social costs include pollution, road wear 1-18
  19. 19. Opportunity Costs I got a lottery of worth Rs 10 millions (1 core) Ranking the Choices 1 2 3 The Next best use is “buying house” that’s I forgone for paying my Credit card debts so that’s my Opportunity cost Opportunity Cost: The Next Best Decision you could make 1-19
  20. 20. Opportunity Costs • Opportunity cost is the cost of second best use of the available/used resources in a certain action • The opportunity cost of you people sitting in this class is …the next best use of your this time … in work, recreational activities, sports or facebooking  • My opportunity cost of teaching you this Course is …… the time & earning opportunity I forgone to teach you 1-20
  21. 21. Sunk Cost • Sunk Cost: is the costs that are incurred in the past and can not be recovered by any future action • Theory states: ignore sunk costs, because they are paid in either case, and cannot be recovered • For example: If you lost the movie ticket worth Rs. 800 - you can't get it back - if you decide not to buy a second ticket and go home you won't get the first ticket you lost, back 1-21
  22. 22. Sinking fund • A sinking fund is a fund established by an economic entity by setting aside revenue over a period of time to fund a future capital expense, or repayment of a long-term debt • Sinking funds can also be used to set aside money for purposes of replacing capital equipment as it becomes obsolete, or major maintenance or renewal of elements of a fixed asset, typically a building 1-22
  23. 23. Operation and Maintenance Cost (O&M Costs) • Operation and Maintenance Cost is the group of costs experienced continually over the useful life of the activity… any example ? • This includes costs like, labour costs for operating & maintenance personal, fuel and power costs, spare and repair part costs, costs for taxes etc. • These costs can be substantial and can exceed the initial costs 1-23
  24. 24. Life-cycle Costs • Life-cycle - all the time from the initial conception of an idea to the death of a product (process) • Life-cycle costs - sum total of all the costs incurred during the life cycle • Life-cycle costing - designing a product with an understanding of all the costs associated with a product during it’s life-cycle 1-24
  25. 25. Product Life-cycle Begin Needs assessment and justification Time Conceptual or preliminary design phase Impact Analysis Requirements Overall Feasibility Conceptual Design Planning Proof of concept Prototype Development and testing Detailed design planning Detailed design phase Allocation of resources Detailed specification Component and supplier selection Production or construction phase Production or Construction Phase Product, goods and service built All supporting facilities built Operation al use planning End Operational Phase Decline and retirement phase Operational Use Use by ultimate customer Maintenance and support Process, materials and methods use Declined and retirement planning Decaling Use Phase out Retirement Responsible disposal 1-25
  26. 26. Cumulative Life-cycle Costs Committed and Dollars Spent Total life-cycle cost % 100% Life-cycle costs committed 80% 60% Life-cycle costs spent 40% 20% 0% Definition and conceptual design Detailed design Production Operational use Decline/ Retirement Project Phase 1-26
  27. 27. Time Value of Money (TVM) • A Rupee (or dollar) received today is worth more than a rupee received tomorrow – because a dollar received today can be invested to earn interest – The amount of interest earned depends on the rate of return that can be earned on the investment • Time value of money quantifies the value of a dollar through time The time value of money is the most important concept in engineering economy 1-27
  28. 28. Interest • What is Interest ? – It is the manifestation (or display) of the time value of money – Fee that one pays to use someone else’s money – Computationally, interest is the difference between an ending amount of money and a beginning amount of money • There are two perspectives for interest: 1- Borrower’s perspective – Interest paid Interest Paid= amount owed now – principal 2- Lender’s or investor’s perspective – Interest Earned Interest Earned= Total amount now – principal 1-28
  29. 29. Interest Rate & Rate of Return (ROR) • Interest rate – Interest paid over a time period expressed as a percentage of principal • ROR refers to Interest earned over a period of time expressed as a percentage of the original amount (principal) interest accrued per time unit Rate of return (%) = x 100% original amount 1-29
  30. 30. Interest paid Interest rate (i) Interest earned Rate of Return (ROR) 1-30
  31. 31. Cash Flows (CFs): Basics • CFs are amount of money estimated for future projects or observed for project events that have taken place • CFs are during specific time period • CF is difficult to estimate as its predicting future • There are three important concepts related to Cash flows: Cash Inflows, Cash Outflows, Net Cash flows 1-31
  32. 32. Cash Flows: Terms • Cash Inflows – Revenues (R), receipts, incomes, savings generated by projects and activities that flow in. Plus sign used • Cash Outflows – Disbursements (D), costs, expenses, taxes caused by projects and activities that flow out. Minus sign used • Net Cash Flow (NCF) for each time period: NCF = cash inflows – cash outflows = R – D • End-of-period assumption: Funds flow at the end of a given interest period 1-32
  33. 33. Cash Flows: Estimating There are two ways for estimating Cash flows: Point estimate – A single-value estimate of a cash flow element of an alternative Cash inflow: Income = $150,000 per month  Range estimate – Min and max values that estimate the cash flow Cash outflow: Cost is between $2.5 M and $3.2 M - Point estimates are commonly used; - however, range estimates with probabilities attached provide a better understanding of variability of economic parameters used to make decisions 1-33
  34. 34. Cash Flow: Diagrams What a typical cash flow diagram might look like Draw a time line Always assume end-of-period cash flows Time 0 1 --- 2 --- --- --- --- n-1 n One time period Show the cash flows (to approximate scale) 0 1 2 --- --- --- --- --- n-1 Cash flows are shown as directed arrows: + (up) for inflow n - (down) for outflow Remember: One and only one of the perspectives is selected to develop CF diagrams 1-34
  35. 35. Cash Flow Diagram: Example Plot observed cash flows over last 8 years and estimated sale next year for $150. Draw a Net Cash flow diagram $650 -7 -6 $625 -5 $600 -4 $600 $575 -3 $550 $525 -2 -1 $500 0 1 Years 1-35 $-2500
  36. 36. Economic Equivalence Different sums of money at different times may be equal in economic value at a given rate $110 Year 0 1 $100 now Rate of return = 10% per year $100 now is economically equivalent to $110 one year from now, if the $100 is invested at a rate of 10% per year Economic Equivalence: Combination of interest rate (rate of return) and time value of money to determine different amounts of money at different points in time that are economically equivalent 1-36
  37. 37. Commonly used Symbols t = time, usually in periods such as years or months P = value or amount of money at a time t designated as present or time 0 F = value or amount of money at some future time, such as at t = n periods in the future A = series of consecutive, equal, end-of-period amounts of money n = number of interest periods; years, months i = interest rate or rate of return per time period; percent per year or month 1-37
  38. 38. Simple and Compound Interest Simple Interest Interest is calculated using principal only Interest = (principal) (number of periods) (interest rate) I=Pxnxi Example: $100,000 lent for 3 years at simple i = 10% per year. What is repayment after 3 years? Here P=$100,000 n= 3 i= 10% Interest = 100,000(3)(0.10) = $30,000 Total due = 100,000 + 30,000 = $130,000 1-38
  39. 39. Simple and Compound Interest Compound Interest Interest is based on principal plus all accrued interest That is, interest compounds over time Interest = (principal + all accrued interest) (interest rate) Interest for time period t is 1-39
  40. 40. Compound Interest Example Example: $100,000 lent for 3 years at i = 10% per year compounded. What is repayment after 3 years? Interest, year 1: Total due, year 1: I1 = 100,000(0.10) = $10,000 F1 = 100,000 + 10,000 = $110,000 Interest, year 2: Total due, year 2: I2 = 110,000(0.10) = $11,000 F2 = 110,000 + 11,000 = $121,000 Interest, year 3: Total due, year 3: I3 = 121,000(0.10) = $12,100 F3 = 121,000 + 12,100 = $133,100 Compounded: $133,100 Simple: $130,000 1-40
  41. 41. THANK YOU 1-41