GEC 321

Engineer-In-Society II

Introduction to Engineering Economics

Capital in form of money, machines and materials
has been identified as an economic necessity in
most engineering and business projects. As a
result of resource availability constraints,
engineering is most often closely associated with
economics. The designers of engineering projects
and the decision-makers (owners and managers of
such projects) are concerned that the available
capital are used effectively and efficiently.

 Generally, both engineering and business

projects are measured in terms of financial
efficiency. Hence engineers, because at one
time or the other may be engaged in one
engineering or a knowledge of the techniques
and methods used for measuring and ensuring
the financial efficiency of projects.

Engineering and Management

In general usage, the word management is
used to identify a special group of people
whose job is to direct the efforts and activities
of other people toward the achievement of
common objectives. Simply stated,
management gets things done through other
people.

Definition of Management
According to Joseph L. Massie ( 1996, pp. 3),
management is the process by which a
cooperative group direct actions toward common
goals.
This process involves techneques by which a
distinguishable group of people (managers)
managers seldom actually perform the activess
themsevles. The management of engineering
projects therefore is the process by which a
cooperative group direct action towards the
achievement of the project goals.

Functions of Management
We have defined management as a process.
One way to view the process of management
is to identify the basic functions which
together make up the process.
According to Joseph L. Massie (1996, pp. 5),
the following seven (7) functions can be used
to describe the job of management:

 1. DECISION-MAKING: This is the process

which a course of action is consciously chose
from available alternatives for the purpose of
achieving a desired result.
2. ORGANIZING: This is the process of
combining the en and material of a business in
order to provide the most successful means
for acchieving the objective of the business.

 3. STAFFING: This is the process by which

managers select, train, promote and retire
subordinates.
4. PLANNING: This is the process by which a
manager anticipates the future and discovers
alternative courses of action open to him.
5. CONTROLLING: This is the process that
measures current performance.

 6. COMMUNICATING: This is the process by

which ideas are transmitted t others for the
purpose of effecting a desired result.
7. DIRECTING (LEADERSHIP): This is the
process by which the actual performance of
subordinates is guided towards common
goals. Supervising is one aspect of this
function at lowr levels, where physical
overseeing of work is possible.

Engineering and Economics (Origin

and Definition of Engineering
Economics)

In the past, engineers were mainly concerned

with the design, construction and operation of
structures, processes and machines, with little
or no attention given to the resources
required to produce the final product. But we
do know that by nature, resources are scarce,
and that such resources can be put to
alternative uses; this is the reason for the
study of economics.

 ECONOMICS: The use of resources (resources are

always in short supply) or their allocation and
organization constitute the subject matter of
economics. Put more compactly, economics is
the study of thing s in short supply. In another
perspective, economics can be regarded as a
science of CHOICE. Since resources are scarce,
and available resources can be put to alternative
uses, how then should the uses to which the
available resources can be put be selected? This
is the basic question that economics seeks to
answer.

 ENGINEERING ECONOMICS: The growing

awareness of the limts of available resources
needed to undertake engineering projects has
welded engineering to economics.
Engineering economics therefore, draws upon
knowledge of engineering and economics, to
identify alternative uses of limited resources.

 Todays engineer is espected to, in addition to

generating technological solutions, make
skillful financial analysis of the effects of the
implementation of their desings. Engineering
practice now require cost and value analysis
of engineering projects.
For example, a project that is technologically
feasible (viable) may not be worth
constructing if the cost is found to be high
compared to the benefits derivable for the
project.

Decision-Making and The DecisionMaking Process

A decision can be defined as a course of action
conciously chose from available alternatives
for the purpose of achieving a desired result.
Three ideas are important in this definition:
1. First is that a decision involves a choice; if
there is but one possible course of action, no
decision is possible.

2. Secondly, a decision involves menta processes

at the conscious level. The logical aspects of
decision-making are important, yet the
decision king process is influenced by:
emotional factors
non-rational factors, and
subconsious factors

3. Thirdly, a decision is purposive; it is made to

facilitate the attainment of some objective
(purpose).

Decision-Making
As earlier defined, decision-making is the
process by which a course of action is
conciously chosen from available aternatives
for the purpose of achieving a desired result.
The difference between decision and
decision-making is the catch word process.
Decision-making is a process.

Decision-Making Process
Decision-making has been regarded as the center
of managerial activities. According to Awujo
(1997), decision-making is the essence of a
managers job. According to him, at the level of
the organization it is expressed through the basic
fuctions of a manager, which include: Planning,
Organizing, Staffing, Directing and Controlling.
Each of the basic functions of a manager clearly
involves decision. For example, which plan to
implement? What goals to use? And forth.

 Organizational decision-making is similar to

the rational individual decision-making. That
is, the decision-making process must be
rational and systematic, yet, responsive to the
uniqueness of the environment surrounding
each major decision.
In engineering project development, as in all
organizations, the decision-making process
consists of the following steps:

1. Problem definition; in defining the problem,

we must put into consideration, the
environmental factors of the problem. The
environmental factors include:
Technology available
Economic requirements
Social values etc.
2. Defining objectives and the criteria for
measuring the achievement of the objectives.

3. Developing alternative solutions (that is,

generating alternative means, plans and
desings).
4. Analyzing the alternatives; good decisionmaking process requires that the available
aternative solustions be evaluated to
eliminate in feasible ones. The following
feasibility analysis be carried out.

a. Technological feasibility ananlysis; areas of

interest in technological feasibility include:
The most appropriate process to be adopted,
The best source of raw materials,
Determing electricity requirements and
available sources etc.

b. Finanacial feasibility analysis; areas of interest

in financail feasibility include:
Projection of total market potentials of the
project in financial terms,
Projection of costs (both fixed and operating)
Estimation of revenue stream for the entire
life of the project and
Determination of the sources of funds for
financing the project.

3. Economic feasibility analysis; areas of interest

in economic feasibility include:
Impact on the economy like
The use of available raw materials
The jobs created by the project
Improvements in the welfare of the people in
local communities around the project area,
like provision of roads, power, water.

 Making a choice; after analyzing the available

alternatives in step if by carrying out the three
major feasibilty analyisis enumerated above,
the result of the feasibility analysis can now
be sued to select the most feasible
alternative.

Concept of Equity and Debt Capital

In accounting usage, capital denotes all longterm funds placed at the disposal of a
business firm either by the ownership class of
by leaders.
Therefore, when financing engineering and
business ventures, there are two (2) generally
available sources of these long-term funds
(capital). These are equity and debt; we
therefore have equity capital and debt capital.

Equity Capital
Equity capital is the capital contributed by those
who own th business. Equity capital is usually
sourced by any organization from the stock
market. An example of the contributor of equity
capital to a business organization are the
ordinary and preferential shareholders of of the
organization. The reward for contributing capital
is that the contributors take part in the sharing in
the yearly profit of the organization. Normally,
equity capital is used in financing long-term
projects or long-term investing.

Debt Capital
Debt capital is also called borrowed capital. In
most cases, debt capital is obtained rom
financial institutions like banks. The owners of
debt capital are usually paid interest for the
use of the capital by the organizating that has
borrowed the capital.

Accounting Basic Concepts

DEFINITION OF ACCOUNTING: The American
Institute of Certified Public Accountant
(AICPA) has defined accounting as the art of
recording, classifying, and summarizing in a
significant manner, and in terms of money,
transactions and events which are, in part, at
least, of a financial character, and interpreting
the result thereby (AICPA, 1961).

 This definition identifies the major activities

encompassed in accounting, which include:
Recording of data and
Summarizing of data
Interpretation of the resultant accounting
information
It should be noted that this data that is
recorded and summarized is usually expressed
in monetary terms.

Major Brances of Accounting

Generally, accounting can be grouped into the
following branches:
i. Financial accounting
ii. Cost accounting
iii.Management accounting

Financial Accounting
Financial accounting is the branch of
accounting that reports in aggregate terms,
the overall results of the organizations
operations during a given period and its
financial condition, that is, the organization
strengths and weaknesses at a particular point
in time. Two major components of the
financial accounting reports are:
i. Profit and loss account
ii. Balance sheet

 Financial accounting reports are usually

meant for users who are external to the
organization, for example:
Investors
Lenders
The government

Cost Accounting
Cost accounting is the process and technique
of ascertainting cost. Costing is the process of
classifying, recording and appropriate
allocation of expenditure for the purpose of
determining the costs of products or services.
This class of accounting is very important to
the Engineering Economist since it is the
source of most of the cost data needed for
making economic studies.

Management Accounting
Management accounting is the application of
accounting principles and techniques to the
process of provideing information designed to
help all levels of management in planning and
controlling the activities of an enterprise.

Elements of Fianancial Accounting

The main purpose of accounting is to record
the financial transaction of any organization
through the periodic preparation of financial
statements and reports. We had earlier
mentioned that, the two major financial
accounting reports are: the profit and loss
account and the balance sheet.

The Profit and Loss Account (Income

Statement)
The profit and loss account (also known as the
income statement) shows the income and
expenditure of an organization during a stated
period (usually twelve (12) months, six (6)
months) of time.

Balance Sheet
The balance sheet of a business organization
shows the financial position of the
organization at a point in time, usually the last
day of the organizations accounting year.
There are three (3) basic elements in the
balance sheet:
i. Assets
ii. Liability
iii.Owners funds (equity)

Assets
These are things that have value. Assets may
be:
Tangible, e.g. buildings, motor vehicles
Intangible, e.g. goodwill, patents, trademarks
In the balance sheet, assets are usually
summarized into two broad categories: fixed
assets and current assets.

Fixed Assets
These are assets that have a durable life (i.e.
life of more then one (1) year), and are held
not for conversion or resale, but for purposes
of assisting in the conduct of business.
Examples fixed assets are: lend and buildings,
plant and machinery, funiture and fittings,
motor vehicles, patents and trademarks, etc.

Current Assets
These are assets which change form in the
course of the business or during the conduct
of the organizations operations. They
frequently form the substances of the
organizatiions activities. Examples of current
assets are: inventories (stocks of raw
materials or finished goods), trade debtors,
and cash in hand or at the bank).

Liabilities
These are debts incurred by an organization
arising from either borrowings or credit
purchases from other parties. In the balance
sheet, liabilities are usually summarized into
two broad categories: long-term and shortterm (also referred to a current liabilities).

Current Liability
This is a indebtedness which is expected to be
discharged withing a short period, i.e. less
than one (1) year. Examples of current liability
include: trade creditors, bank overdraft.

Long-Term Liability
This is a source of funding which comprises
principally loans (secured or unsecured) which
may not be repaid in less then one (1) year.
Some long- term liabilities are of much longer
duration extending to even up to ten (10)
years.

Equity
This is a source of funding which comprises of
funds belonging to the owners. This is known
as owners funds. Owners funds are made up
of the capital orignally introduced (either in
the form of cash or tangible assets), plus any
profits or surplus generated in the course of
operation which have not yet been
withdrawn.

 In the case of a business firm, undistributed

surplus is called retained earnings.
We should next look at how the balance sheet
looks like.

Example
Consider an individual, Alhaji (Chief) J.
Moyosore, who is commencing business on 1
January, 2008 with a capital of N3,000 all of
which he contributed as cash. The balance
sheet at commencement would be as follows:

Alhaji (chief) J. Moyosore

Balance Sheet as at 1 January, 2008
_______________________________________
Liabilities and Capital
Assets

Capital

3,000

3,000

3,000

3,000

 The above balance sheet is simply saying that,

the business of Alhaji (Chief) J. Moyosore
holds assets worth N3,000 consisting entirely
of cash; and that the assets have been
financed solely by capital paid int the business
by Alhaji (Chief) Moyosore.
The capital introduced into a business may
not consist soley of cash alone, but may
include other forms of assets as is shown by
the following example:

Example:
Suppose that Alhaji (Chief) J. Moyosore has
commenced business on 1 January, 2008 with
sundry assets which were valued as follows:
N
Blackmaking machinery

10,500

Used Peugeot 404 Pick-Up Van

3,600

Miscellaneous office furniture and

equipment

1,800

Cash paid into bank

3,000

 Prepare the balance sheet of Alhaji (Chief) j.

Moyosore Sole Proprietorship at the
commencement of business on 1 January,
2008.

Alhaji (Chief) J. Moyosores Sole Proprietorship

Balance Sheet as at 1 January, 2008
Liabilities and
Capital

Capital
Alhaji (Chief) J.
Moyosore

Assets

Fixed Assets
18,900

Machinery

10,500

3,600
Furniture and
Equipment

18,900

1,800

Current Assets

15,900

Cash at bank

3,000
18,900

 The above balance sheet portrays the position

of a business which has not engaged in
business transactions. The following is a
hypothetical balance sheet of Alhaji (Chief)
Moyosore one year later after engaging in
some business transaction (assuming that the
fixed assets has not suffered depreciation or
loss in value as a result of use).

Alhaji (Chief) Moyosores Sole Proprietorship

Balance Sheet as at 31 December, 2008
Liabilities and
Capital

Assets
N

Capital

18,900

Fixed Assets

Profit

2,260

Machinery

10,500

21,160

Motor vehicle

3,600

Furniture and
equipment

1,800

Current
liabilities

15,900

Current Assets

Trade creditors

1,200

Bank overdraft

600
22,960

Inventories

3,400

Trade debtors

2, 610

Cash

1,050

7,060
22,960

Accounting Equation
What appears to be an equation can be seen
to have emerged from the above two balance
sheets, that is, a situation where the total
assets always agree with the sum of liabilities
and equity. This is expressed briefly as
follows:
A=L+E

Where A = sum of all assets

L = sum of all liabilities which include
short term and long term debts
E = sum of all equity items, which
include capital and retained earnings
(undistributed profit)

 In other words, the accounting equation

is usually expressed in the balance sheetthat is, the financial position statement.

Example
An ABC firm decided to undertake an
investment opportunity and the following
sequence of events occurred over a period
one year.
i) Organize the firm and invest N5,000 cash as
capital.
ii)Purchase equipment for a total cost of N4,000
by paying cash.

iii) Borrowed N3,000 through note to bank

iv) Incurred N1,400 account payable for raw
materials
v) Recognized the partial loss in value of the
equipment (depreciation) amounting to N500
Prepare a balance sheet for ABC firm at the end
of the year (assume it is year 2008).

Fundamental Economic Concept of

Cost
Although the ultimate objective of any
engineering applicatioin is the satisfaction of
human wants and needs. It is imperative to
note those needs and wants cannot be
satisfied without costs. Generally, an
engineering proposal resulting in the best cost
will be considered the best if its end result is
better or identical to that of competing
proposals.

 As a basis for the economic analysis of

engineering proposals, cost concepts can
generally be classified into the following:
i. First cost
ii. Operation and maintenance cost
iii.Fixed cost
iv.Variable cost
v. Incremental and marginal cost
vi.Sunk cost
vii.Opportunity cost
viii.Average cost

First Cost
The first cost represents that initial cost of
capitalized property, which includes
transportation, installation, and other related
initial expenditure. The initial cost is made up
of those cost elements that do not reoccur
after the initiation of the project or activity.
For example, if a new equipment is purchased
by a firm, the first cost will include:

 Purchase price
Shipping cost
Installation cost
Cost of training for operators

Operation and Maintenance Cost

The operation and maintenance cost refer to
that cost or group of costs which are
experienced continually over the useful life of
the project or activity. This type of cost will
generally include:
Labour costs for operation and maintenance
Fuel and power costs
Spare and repair parts costs
Insurance costs and taxes

 Part of overhead cost

Generally, the aggregate total of operation and
maintenance cost often exeeds the first cost
of a given project.

Fixed Cost
These costs represent that group of cost
involved in an on-going activity whose total
will remain relatively constant throughout the
range of operational activity. This type of cost
is made of the following cost items:
Depreciation
Taxes
Insurance

 Interest on capital
Research
Annual rents
Certain administrative expenses, for example,
the salaries of employees which must be
paide irrespective of output. It is important to
note that, the investments that give rise to
fixed costs are made in the present with the
hope that they will be recovered through
profit as a result of reductions in variable cost
or of increase in income.

For example, a computer can be purchased now

in order that labour cost may be reduced in
the future. Fixed costs are sometimes called
indirect costs because in a production setup
for example, they do not vary with output. In
practical terms, fixed costs are only relatively
fixed, as their total may be expected to
increase with increased activity.

Variable Cost
Variable costs refer to that group of costs which
vary in relation to the level or operational
activity. For example, since the amount of
material needed per unit of product in
manufacturing is expected to remain
constant, it means that the material cost will
vary directly with the number of units
produced. Variable costs are also called direct
costs.

Examples of direct costs include:

Direct labour cost
Direct material cost
Direct power cost
Generally, those direct costs can readily be
allocated to each unit produced and hence,
they are regarded as variable costs.

Incremental and Marginal Costs

These two cost concepts are basically the same.
Incremental Cost: This is the additional cost that
will be incurred as a result of increasing output
by one more unit.
Marginal Cost: Marginal cost strictly speaking,
can be regarded as the cost of producing one
more unit; in practice, however, it is normally
impossible to employ labour in sufficiently small
amounts to produce only one unit and then
dismiss the workers.

We therefore define marginal cost as:

MC = Increased in total costs
Increase in output

Sunk Cost
A sunk cost is the cost incurred in the past which
cannot be altered by future action. Since it is
only the future consequences of investment
alternatives that can be affected by current
decisions, an important principle of
engineering economy studies have been to
disregard costs incurred in the past (sunk
costs).

It is the acquisition cost of an asset less the

accumulated depreciation charges.

Book Cost
Book cost relates to accounting for assets or
property. The fact that assets are assumed to
depreciate with time (not minding inflation)
means that the book value (value of the asset
recorded in the accounting books) reduces with
time.
The book cost of an asset can therefore be defined
as the original cost of the asset less the amount
that have been charged to depreciation account.

Cash Cost
Cash cost is the cost of acquiring an asset; this is
the price paid for the acquisition of an asset. This
approach to valuation has led to the
overwhelming reliance on historical cost as the
basis of valuation in financial accounting.
Alternative market derived values emerge soon
after the acquisition of an asset replacement cost
(if it were the wish to replace the asset) and
realisable value (if on the other hand, the
firmware to decide to discontinue the business).

Calculation of Book Cost

The book cost of any asset at the end of any
year = book cost at the beginning of the year
depreciation expense charged during the year
on the asset.
Let P = first cost of an asset
S = estimated saluage(residual) value
Bt= book cost at the end of the year t
Dt= depreciation charge during year t

N = estimated useful life (depreciable life in

years)
Where t = 1, 2, 3, . . . . . . , N,
Then, Bt = P
Where Bo = P

GRAPH NEEDED

Residual or salvage value represents the price

that can be obtained from the asset after it
has been used.
Book cost is also called unexpired value of an
asset.
Depreciation: Deprecation can be defined as a
fall in value of an asset resulting from usage or
passage of time.

Obsolescence: This is the fall in value of an asset

resulting from change in technology, taste or
fashion.
Depreciation is said to have taken place when
an asset deteriorates or shrinks in value due
to one or more of the following:
i. Application in the business or undertaking;
ii. Passage of time, whether or not the asset was
in use and whether or not the asset made any
contribution to the business;

iii. When the asset is overtaken by new and

better models which produce substitutes or
competing goods or services more efficiently.

Reasons Why Assets Are Depreciated

The following are the main reason why assets are
depreciated:
i. It is important to recognise depreciation in the
accounts because it is a cost which if not taken
into account, could lead to the overstatement of
the periods profit or surplus.
ii. Also, unless the loss in value of an asset during a
period is written off (against the income for the
period), the assets value carried forward in the
balance sheet into the next period is also likely to
be overstated.

iii. Provision for depreciation also enable an

amount to be set aside during the assets
useful life and held against the eventual
replacement of the asset when it is no longer
serviceable.

Methods of Computing Depreciation

Several methods of computing depreciation are
used; some of them are:
a) The straight-line method;
b)The diminishing balance method;
c) The sum-of-the-year digit method
d)The revaluation method.
Each of these methods is based on some hypothesis
regarding the loss of an assets value with age.
We will treat only the straight line method in this
course.