ENGR 3660U: Engineering Economics

Winter 2022
Module 1: Economic Decisions, Engineering Costs, and Cost
Estimating

Based on:
Engineering Economics Analysis
by Newmann et al
 Learning Objectives
• Describe the economic decision-making process
• Choose economic criteria for different problems
• Describe common ethical issues in economic decisions
• Define various cost concepts and their importance
• Define engineering cost estimating
• Explain the three types of engineering estimates and the difficulties
encountered in making them
• Use common mathematical cost estimating models
• Discuss the effect of the learning curve on cost estimates
• Draw cash flow diagrams to show project costs/benefits
 A Sea of Problems
• Problems can be classified by levels of difficulty
• Simple (do not require much time or effort)
➢ If we use three crates of an item a week, how many crates should we buy at
a time?
• Intermediate (primarily economic)
➢ Should we buy a low-cost press requiring three operators, or a more
expensive one requiring only two operators?
• Complex (mix of economic, political, and social/ethical)
➢ The annual budget of a corporation is an allocation of resources, and all
projects are evaluated economically. The budget process is also heavily
influenced by non-economic forces such as political or national concerns,
individual concerns, and other corporation-wide impacts.
 The Role of Engineering
Economic Analysis
• Engineering economic analysis is most suitable for intermediate
problems and the economic aspects of complex problems

• Such problems should:

• be important enough to justify serious thought and effort;
• be not easily worked out in one’s head; and
• contain economic aspects that are important in making the decision.
 The
Decision-
Making
Process
 The Decision-Making Process, cont’d

1) Recognize the Problem

• Once we are aware of the problem, we solve it as best we
can
2) Define the goal or objective
• The goal can be a grand, overall goal of a person or a
firm
• An objective may be narrow and specific
 The Decision-Making Process, cont’d

3) Assemble Relevant Data

• Obtain the information through market research or other data
gathering
• An important source of data is a firm’s own accounting system
• The time horizon of the problem must be assembled
• Financial consequences (costs and benefits):
➢ Market consequences
➢ Extra-market consequences
➢ Intangible consequences
 The Decision-Making Process, cont’d

4) Identify Feasible Alternatives

• Unless the best alternative is considered, the result will always be
less than ideal
• Two types of alternatives are sometimes ignored:
➢ “Do-nothing” alternative
➢ Unglamorous alternatives
• Ensure that all alternatives have been listed
• Impractical alternatives may lead to a better possibility
➢ Brainstorming
 The Decision-Making Process, cont’d

5) Select the Criteria for Determining the Best Alternative

• We must define what we mean by “best”
• There must be at least one criterion, or a set of criteria, to
evaluate which alternative is best
• "Maximize profit” is the criterion normally selected in
engineering decision-making
 The Decision-Making Process, cont’d

6) Construct a Model
• The objective, relevant data, feasible alternatives, and selection
standards must be merged
➢ Model building
• In economic decision-making, the model is usually
mathematical
 The Decision-Making Process, cont’d
7) Predict the Outcomes for Each Alternative
• The model and data are used to predict the outcomes of each
feasible alternative
• To choose the best alternative, the outcomes for each alternative
must be stated in a comparable way
• The consequences of alternatives are usually evaluated in monetary
terms
• A common mistake for longer-term problems is to assume that the
current situation will be unchanged if the do-nothing alternative is
chosen
 The Decision-Making Process, cont’d

8) Choose the Best Alternative

• The right choice is the one that best meets the criteria after we
have considered both the numerical and intangible
consequences
• Since intangible consequences are left out of the numerical
calculations, they should be introduced into the decision-making
at this point
 The Decision-Making Process, cont’d

9) Audit the Results

• An audit of the results is a comparison of what happened
against the predictions
• Audits help keep a project on track
• Audits help future estimates and assumptions
• Audits provide an incentive to give accurate estimates
 Decision-Making: Problem 1

A company is considering two machines. Both machines

provide the same output and benefits. Machine 1 costs
$300,000 to purchase and requires four employees to
operate. The costs of maintenance of Machine 1 is
$100,000 and $50,000 per employee over the machine’s
lifetime. Machine 2 costs $500,000 to purchase and requires
two employees to operate. The machine is maintenance free
and costs $40,000 per employee over the machine's lifetime.
Which machine should the company purchase?
 Decision-Making: Problem 1, cont’d
Solution
Outputs are fixed, therefore minimize cost.
Costs = purchase price + maintenance + employee(s) cost
Machine 1
Costs = $300,000 + $100,000 + 4($50,000) = $600,000
Machine 2
Costs = $500,000 + $0 + 2(40,000) = $580,000

The company should choose Machine 2.

 Decision-Making: Problem 2
John, an auto mechanic, suddenly inherited a sum of $1,000,000 when
both of his parents died in a crash. He is making about $15 an hour
and works about 50 hours a week for 52 weeks a year (10 hour
overtime per week). He gets two weeks of paid vacation. The
overtime wage is at time-and-a-half of the regular wages.

He would like to get an income from his inheritance equivalent to his

job so that he can quit his job. He found that he could invest the
money safely to get an interest of 5% year for the rest of his life.

Will John make enough money with his investments to quit his job?
 Decision-Making: Problem 2, cont’d
Solution

John’s yearly earnings = 15(40)(52) + 15(1.5)(10)(52) = $42,900

John’s investment income = 0.05(1,000,000) = $50,000

Since John will be able to make more money from his investment, he
should certainly consider quitting his job.
 Ethics
• Ethics can be described as distinguishing right and wrong
when making decisions
• Establishing beliefs and moral obligations
• Defining values and fairness
• Determming duties and guidelines for conduct
• Ethical decision-making requires an understanding of the
“context” of the problem, the possible choices, and the
outcomes of each choice
 Ethical Dimensions in Engineering
Decision-Making
• In Canada, provincial and territorial associations of
professional engineers are responsible for the regulation of
the practice of engineering
• Engineers Canada
• For all engineers, difficulties arise when their actions are
contrary to these written or internal codes
 The Environment We Live In

• The decision maker must ask who incurs the costs for the
project and who receives the benefits
• Ethical issues can be particularly difficult because there are
often stakeholders with opposing viewpoints
• E.g., protecting the habitat of an endangered species versus flood-
control projects that protect people, animals, and structures
 Safety and Cost

• There are trade-offs between safety and cost

• Is it safe enough?
• It is “too safe,” therefore too expensive?
 Emerging Issues and “Solutions”

• Governments have started to prevent, limit, and expose

financial wrongdoing within corporations
• Globalization is an important part of ethical
discussions
• Different countries have different ethical expectations
 Importance of Ethics In Engineering and
Engineering Economy
• Though engineers and firms try to act ethically, mistakes
are made
• It is the engineers’ duty to speak out to protect the
safety of the public
• Integrity is the foundation for long-term career success
 Engineering Decision Making for Current
Costs
• If a decision is one where the results are known in a
short period of time, it can be determined by:
• Adding up costs and benefits between alternatives
• Thereby, one can determine the best alternative
Engineering Decision Making for Current
Costs, cont’d
• Example: (Tile for Plant Floor—fixed output)
• 1000 m2
• Tile A costs:
➢ Purchase: $52/m2; Installation: $37,000
• Tile B costs:
➢ Purchase: $63/m2; Installation: $28,000

• Select Tile A to minimize cost for fixed output

 Engineering Costs

• Fixed, Variable, Marginal, and Average Costs

• Fixed: Constant, unchanging costs
• Variable: Depends on the level of output or activity
• Marginal: Variable cost for one more unit
• Average: Total cost divided by the number of units
 Engineering Costs, cont’d

• Fixed, Variable, Marginal, and Average Costs, cont’d

• Break-even point: The level of activity at which the total
cost of providing the product, good, or service is equal to
the revenue generated
• Profit region: Values of the variable x greater than the
break-even point, where total revenue is greater than total
costs
• Loss region: Values of the variable x less than the break-
even point, where total cost is greater than total revenue
 Engineering Costs, cont’d
Problem
• A company operates a summer camp. The following cost data for a
12-week summer camp is as follows:
• Charge per camper =$400/week
• Variable cost per camper =$220/week
• Fixed costs =$240,000 per summer season
Capacity per week =200 campers

• Determine the following:

• The total number of campers to breakeven for the season
• The profit if the camp is operated at 90% capacity
• The additional profit that can be made if a discount of $100 per
week is given for another 10 campers
 Engineering Costs, cont’d
Solution

a) To break-even, Total costs = Total revenue

240,000 + 220 (12)x = 400 (12)x
x = 240,000/ {(400 – 220)(12)} = 111 campers

b) 90% capacity
Number of campers = 0.90 (200) = 180
Profit = 180 (400) 12 – {240,000 + 180(12)(220) =
$188,800

c) Additional profit = 10(12)(400 – 100) – 10(12)(220) = $9,600

 Engineering Costs, cont’d

• Sunk Costs
• Money already spent due to a past decision
• Should be disregarded in engineering economic
analysis
 Engineering Costs, cont’d

• Opportunity Costs
• The costs associated with a resource being used for an
alternate task
• Sometimes referred to as “forgone opportunity costs”
• “An opportunity cost is the benefit that is forgone by engaging
a business resource in a chosen activity instead of engaging
that same resource in a forgone activity.”
 Engineering Costs, cont’d

• Recurring and Non-Recurring Costs

• Recurring: A cost that reoccurs at regular intervals
• Non-recurring : One-of-a-kind cost recurring at
irregular intervals
 Engineering Costs, cont’d

• Incremental Costs
• Incremental: Cost differences between alternatives
 Engineering Costs, cont’d

• Cash Costs versus Book Costs

• Cash costs: require a cash transaction out of one person’s
pocket into the pocket of someone else
• Book costs are recorded but are not transactions
➢ Do not represent cash flows, thus are not included in engineering
economic analysis
 Engineering Costs, cont’d
• Life-Cycle Costs
• Designing products, goods, and services with a full and
explicit recognition of the associated costs over their life
cycles
• Two key concepts:
➢ The later a design change is made, the higher the cost
➢ Decisions made early in the life cycle tend to “lock in” costs that
will be incurred later
 Engineering Costs, cont’d
• Life-Cycle Costs
 Cost Estimating
• Types of Estimate
• Rough Estimates
➢ Quick/easy, high-level estimates where accuracy varies widely (accuracy
of −30% to +60%)
• Budget Estimates
➢ Used for budgeting projects where the accuracy is better than a rough
estimate due to the extra effort used to make a determination (accuracy
of −15% to +20%)
• Detailed Estimates
➢ Estimates made from detailed designs using quantitative models and
vendor quotes. High level of accuracy (accuracy of −3% to +5%)
 Cost Estimating, cont’d

• Difficulties in Estimation
• One-of-a-Kind Estimates
➢ First-run projects and projects that have never been done before
• Time and Effort Available
➢ Human resources and time available for making estimates
 Estimating Models
• Per-Unit Model
• Uses a per-unit factor (e.g., cost per square metre)
• Segmenting Model
• “Divide and conquer” approach
• Individual and component estimates are added together
• Cost Indexes
• Historical change in costs as a ration relationship

Cost at Time A Index value at Time A

=
Cost at Time B Index value at Time B
 Estimating Models, cont’d
• Power-Sizing Model
• Used to “scale up” or “scale down” known costs
𝑥
Cost of A Capacity of A
=
Cost of B Capacity of B

Where x is the power-sizing component

• x = 1.0 shows a linear power sizing component
• x < 1.0 shows the “economies” of scale
➢ i.e., the more you buy, the cheaper per unit
• x > 1.0 shows a “diseconomies” of scale
 Estimating Models, cont’d

• Triangulation
• Approaching the estimate using different sources of data or
different quantitative models to confirm the value initially
calculated
 Estimating Models, cont’d
• Improvement and the Learning Curve
• A percentage or rate at which output is increased due to
repetition

𝑇𝑁 = 𝑇𝑖𝑛𝑖𝑡𝑖𝑎𝑙 × 𝑁 𝑏

• TN = time required for Nth unit of production

• Tinitial = time required for the first unit of production
• N = number of completed units
• b = learning curve exponent
log(learning curve expressed as a decimal)
𝑏=
log 2.0
 Estimating Models, cont’d
• The Learning Curve: Problem
• In a complex assembly operation, it is found the learning curve rate is 70%.
The standard time of 3 minutes per assembly is reached after the 110th
unit.

• Calculate the time required for the very first unit.

• Calculate the time required for the 200th unit.
 Estimating Models, cont’d
Solution

a) TN = Tinitial × N b
log(0.70)
𝑇110 = 𝑇1 × 𝑁 log2.0

log(0.70)
3 = 𝑇1 × 110 log2.0

𝑇1 = 33.70 minutes

log(0.70)
b) T200 = (33.70) × 200 log2.0

= 2.21 minutes
 Estimating Benefits
• Economic analysis often requires considering the benefits as well
as the costs

• Many of the same methods used to calculate costs can be used

to calculate benefits

• Benefits are typically in the future, which sometimes makes them

more difficult to estimate
 Cash Flow Diagrams
• Categories of Cash Flow
• First cost: Expense of building or of buying and installing
• Operations and maintenance (O&M): Annual expense, such
as electricity, labour, and minor repairs
• Salvage value: Receipt at project termination for sale or
transfer of the equipment (can be a salvage cost)
• Revenues: Aannual receipts due to sale of products or services
• Overhaul: Major capital expenditure that occurs during the life
of the asset
 Cash Flow Diagrams

• Drawing a Cash Flow Diagram

• The Cash Flow Diagram (CFD) shows when all cash flows
occur
• Look at Figure 1-7 and the $100 positive cash flow at the
end of Period 2
• In a CFD, the end of Period N is always the same time as
the beginning of Period N+1
 Cash Flow Diagrams
• Illustrates the size, sign, and timing of individual cash flows
Thank you!............. Questions