Engineering Economics for Engineers

1. Engineering Economics
Week 3

2. 1. Engineering Costs
• Definition: Engineering costs refer to the financial
expenditures involved in the design, development,
production, and maintenance of engineering projects. These
can include both direct and indirect costs.
• Importance: Understanding costs is essential for project
management, budgeting, and ensuring profitability.

3. Types of Engineering Costs
• Engineering costs can be broadly categorized into:
• Fixed Costs:
• Do not vary with production or service levels.
• Examples: rent for office space, salaries of permanent staff,
machinery, and equipment.
• Variable Costs:
• Change directly with the level of production or output.
• Examples: raw materials, energy costs, wages for hourly workers.

4. • Direct Costs: Directly attributable to a specific project or product.
Examples: materials, labor, and equipment used for a specific project.
• Indirect Costs: Not directly tied to a specific project but essential for
overall operations. Examples: administrative expenses, utilities, and
security costs.
• Capital Costs (CAPEX): Costs related to the purchase of assets that
have a useful life longer than one year (e.g., machinery, buildings).
• Operational Costs (OPEX): Ongoing costs required to run the project
or production (e.g., labor, maintenance, materials).
• Life Cycle Costing: An approach that considers the total cost of a
project over its entire lifespan, from inception to disposal. This helps
in understanding not only initial costs but also long-term operational
and maintenance expenses.

5. 2. Cost Estimation
• Definition: Cost estimation is the process of predicting the
cost of a project, product, or service. In engineering, this is a
critical component for decision-making, budgeting, and
financial planning.
• Importance: Accurate cost estimation is essential for project
feasibility, funding, risk assessment, and staying within
budget constraints.

6. Key Objectives of Cost Estimation
• Project Planning: Helps in determining the financial
requirements and the economic viability of a project.
• Budgeting: Assists in allocating appropriate financial
resources.
• Bidding & Contracting: Used in competitive bidding
processes for contractors or clients.
• Cost Control: Provides a baseline to compare actual project
costs during execution.

7. Types of Cost Estimates
• Cost estimates are classified based on the stage of the project and the level of
detail available:
• Preliminary Estimates:
• Rough approximations based on limited information, often used during the conceptual
phase.
• Examples: Feasibility studies or early-stage project evaluations.
• Accuracy: +/- 30% to 50%.
• Detailed Estimates:
• More precise estimates based on finalized designs, blueprints, and complete project
details.
• Used during the execution phase for budgeting and planning.
• Accuracy: +/- 5% to 15%.

8. • Order-of-Magnitude Estimates: High-level estimates, typically made
early on, based on past experience or similar projects.
• Accuracy: +/- 50% to 100%.
• Definitive Estimates: Most detailed and accurate estimates used for
final budgeting and resource allocation.
• Accuracy: +/- 1% to 5%.

9. Factors Affecting Cost Estimates
• Several factors influence the accuracy of cost estimates in engineering
projects:
• Scope Definition: Clearly defined project scope reduces uncertainty
and increases estimate accuracy.
• Market Conditions: Fluctuations in prices for labor, materials, or
energy can significantly impact estimates.
• Project Complexity: More complex projects are harder to estimate
accurately due to potential unforeseen challenges.
• Geographical Location: Local labor rates, material availability, and
logistics costs can vary widely by region.
• Timeframe: Longer projects are more susceptible to inflation and
price changes over time.

10. Cost Estimation Process
• The cost estimation process typically follows these steps:
• Define Scope: Clearly define the work to be done.
• Gather Data: Collect historical data, material prices, labor rates, and
design specifications.
• Select Estimation Method: Choose an appropriate estimation
technique based on the available data and project stage.
• Estimate Costs: Apply the method to calculate the estimated cost for
each component of the project.
• Apply Contingency: Add a contingency percentage to account for
uncertainties.
• Review & Refine: Cross-check the estimate with experts and historical
data, and refine if needed.

11. Challenges in Cost Estimation
• Cost estimation is prone to several challenges:
• Uncertainty: It’s difficult to predict exact costs, especially in
large or innovative projects.
• Inaccurate Data: Using outdated or incomplete data can
result in large cost overruns.
• Scope Creep: Changes in the project scope during execution
can lead to underestimated costs.
• Inflation and Market Changes: Rising costs for materials or
labour over time can disrupt initial estimates.

12. •Common Estimation Methods :
•Analogous Estimating: Using historical data from
similar projects.
•Parametric Estimating: Using statistical relationships
between historical costs and other variables (e.g., size,
weight, square foot in construction).

13. 3. Benefit Estimation
• Definition: Benefit estimation refers to the process of
predicting and quantifying the positive outcomes or returns
from a project, product, or service. These benefits can be
tangible (e.g., financial gains) or intangible (e.g., improved
customer satisfaction, environmental impact).
• Importance: Benefit estimation is crucial for decision-making
in engineering projects, as it helps justify the project by
showing the expected returns relative to the costs.

14. Types of Benefits
• Benefits from engineering projects can be categorized into several types:
• Tangible Benefits:
• Quantifiable and can be directly measured.
• Examples: Revenue generation, cost savings, productivity improvements.
• Intangible Benefits:
• Harder to measure and usually qualitative in nature.
• Examples: Improved brand reputation, customer satisfaction, environmental sustainability,
employee morale.
• Direct Benefits:
• Arise directly from the project outcomes.
• Examples: Increase in production capacity, reduced operational downtime.
• Indirect Benefits:
• Indirect outcomes that may emerge over time or as a consequence of the direct benefits.
• Examples: Enhanced market competitiveness, better regulatory compliance.

15. Objectives of Benefit Estimation
• Project Justification: Demonstrates the value and worth of
undertaking a project by quantifying the expected benefits.
• Cost-Benefit Analysis: Helps compare the benefits with the
estimated costs to determine whether a project is financially viable
or should be pursued.
• Strategic Decision-Making: Assists stakeholders in making informed
choices about project selection, prioritization, and resource
allocation.
• Risk Management: Helps assess the potential risks and
uncertainties associated with realizing the expected benefits.

16. Common Methods for Estimating Benefits
• Several techniques are used for estimating the benefits of
engineering projects. These include both qualitative and
quantitative approaches :
• Cost-Benefit Analysis (CBA): A quantitative method where the costs
of a project are compared to its expected benefits.
• Formula:
• Net Benefit=Total Benefits−Total Costs
• Advantages: Provides a clear, numerical basis for decision-making.
• Disadvantages: May oversimplify intangible benefits or non-
monetary gains.

17. Common Methods for Estimating Benefits
(Cont..)
• Return on Investment (ROI): A performance measure used to evaluate the
efficiency or profitability of an investment.
• Formula: ROI=Net Profit/Total Investment×100
• Advantages: Simple and commonly understood metric.
• Disadvantages: Does not account for time value of money.
• Payback Period: Measures the time it takes for a project to recover its initial
costs through benefits.
• Formula: Payback Period=Initial Investment/Annual Benefits
• Advantages: Simple and useful for assessing short-term profitability.
• Disadvantages: Does not consider benefits after the payback period or the time
value of money.

18. 4. Cash Flow Diagram
• Definition: A cash flow diagram is a graphical representation
of cash inflows and outflows over a period of time. It visually
illustrates how money moves in and out of a project or
investment.
• Purpose: Cash flow diagrams are used to help engineers,
managers, and financial analysts understand the timing and
magnitude of costs (outflows) and revenues or savings
(inflows) associated with a project.

19. Importance of Cash Flow Diagrams
• Visual Aid: Helps to easily visualize when and how much
money will be spent or earned throughout the life of a
project.
• Decision-Making Tool: Assists in evaluating the feasibility of
projects, comparing alternative investments, and
understanding the financial impacts of project decisions.
• Basis for Financial Calculations: Provides the foundation for
more complex financial analyses, such as net present value
(NPV), internal rate of return (IRR), and payback period
calculations.

20. Components of a Cash Flow Diagram
• A cash flow diagram typically contains the following
elements:
• Time Axis: A horizontal line representing the time periods
(usually in years, months, or quarters) of the project or
investment. Each point along this axis represents a specific
time.
• Cash Inflows (Revenues or Savings): Represented by arrows
pointing upwards. These indicate money coming into the
project at specific times (e.g., revenues, cost savings).

21. •Cash Outflows (Costs or Investments): Represented by
arrows pointing downwards. These indicate money
going out of the project at specific times (e.g., initial
investment, operating expenses).
•Magnitude of Cash Flows: The length of the arrows
represents the magnitude of the cash flow (how much
money is involved). Larger cash flows have longer
arrows.
•Time Periods: Time intervals are marked along the
time axis, indicating when the cash flows occur (e.g.,
year 1, year 2, etc.).

22. Drawing a Cash Flow Diagram
• To construct a cash flow diagram, follow these steps:
• Draw the Time Axis: Draw a horizontal line and label it with time
periods (0, 1, 2, 3…).
• Identify Cash Inflows: Draw upward arrows at the appropriate time
periods where inflows occur and label them with the corresponding
dollar amounts.
• Identify Cash Outflows: Draw downward arrows at the appropriate
time periods where outflows occur and label them with the
corresponding dollar amounts.

23. • Magnitude of Arrows: Ensure the length of the arrows is
proportional to the size of the cash flows.
• Net Cash Flows: For each time period, you can calculate the
net cash flow (inflows – outflows) and show it on the
diagram if needed.
• Example of a Cash Flow Diagram
• Consider a project with the following cash flows:
• Initial investment of $100,000 at time 0 (cash outflow).
• Annual revenue of $30,000 for 5 years (cash inflows).
• Annual operating costs of $10,000 for 5 years (cash
outflows).

24. • Steps to draw the cash flow diagram:
• Draw the time axis, marking 0, 1, 2, 3, 4, 5 (years).
• At time 0, draw a downward arrow of $100,000 to represent
the initial investment.
• At each of the years (1 to 5), draw an upward arrow of
$30,000 to represent the revenue.
• At each of the years (1 to 5), draw a downward arrow of
$10,000 to represent the operating costs.
• This will result in a series of alternating arrows—larger
upward arrows (for revenue) and smaller downward arrows
(for costs)—at each time period.

25. Uses of Cash Flow Diagrams
• Capital Budgeting: Cash flow diagrams are used to assess the
financial feasibility of capital projects (e.g., new equipment,
infrastructure projects).
• Investment Analysis: They help in visualizing the returns and
expenditures over the life of an investment.
• Loan and Mortgage Analysis: They are used to represent loan
repayments, interest payments, and savings.
• Project Feasibility: Cash flow diagrams help in comparing
alternative projects by representing the cash flows of each
alternative.

26. Benefits of Using Cash Flow Diagrams
• Clarity: Cash flow diagrams provide a clear and
straightforward way to present financial data visually.
• Communication Tool: They serve as an effective tool to
communicate complex financial information to stakeholders,
particularly those who may not be financially trained.
• Foundation for Further Analysis: Cash flow diagrams simplify
the process of moving on to more advanced financial
calculations like NPV and IRR.

27. • Conclusion
• Cash flow diagrams are a vital tool in engineering economics
and financial analysis.
• They provide a visual representation of cash inflows and
outflows over time, helping to evaluate project feasibility,
make informed decisions, and perform detailed financial
analysis.
• By mastering the construction and interpretation of cash
flow diagrams, engineers and project managers can better
plan, execute, and assess the financial impacts of their
projects.