Session 6 VEA Evaluation & Development

Engineering Economy In Brief

In industrial engineering, it is often necessary to compare among alternative designs, procedures, plans and methods. Since the available alternative courses of action involve different amounts of investment and different operating costs and benefits, the inevitable question is Will it pay? The method of solution requires us to express each alternative in some common form and then choose the best, taking both the monetary and intangible factors into account. It answers one of 2 questions: (1) Which of the choices considered is best from a financial point of view? (i.e., which equipment offers the required service at lowest cost?), or (2) What is the expected return on investment (ROI) in using this equipment? (i.e., if I were to purchase this equipment, would I make a satisfactory return for the money invested?). In most computations, a minimum attractive rate of return (MARR) is used. This is the smallest interest rate, or rate of return, at which one is willing to invest money. It represents the interest rate a company expects to make on its investments.

Interest Rate
The interest rate is the rent charged on the money lent for a defined period of time.

Simple Interest
Under simple interest, the interest owed upon repayment of a loan is proportional to the length of time the principal sum has been borrowed.

Compound Interest
Whenever the interest charged for any interest period is based on the remaining principal amount plus any accumulated interest charged up to the beginning of that period, the interest is said to be compounded. [Put simply, the interest earned is added to the principal, and the total (principal + interest) is carried forward to the following period to continue to earn interest.] Compound interest is much more common in practice than simple interest, and the interest obtained due to the effect of compounding is higher than that obtained from simple interest calculation. The difference would be much greater for a larger amount of money, a higher interest rate, or a greater number of interest periods.

IED 210 VE Session 6 Engg Econ 17/06/10 WCH

Consider the following variables in an engineering economy problem: P = present value (or principal sum); F = future value; I = interest owed; i = interest rate (in decimals) per year; n= no. of interest periods To calculate simple interest, I = Pin, or F = P (1 + in). To calculate compound interest, F = P (1+ i) n, or P = F / (1+ i) n.

Another variable commonly used is the uniform annual amount A, which represents a constant value, A, occurring at the end of each interest period over a continuous number of interest periods.

Time Value Of Money

As money can earn a certain interest through its investment for a period of time, a dollar received at some future date is not worth as much as a dollar in hand at present. The relationship between interest and time leads to the concept of the time value of money. [The concept of time value of money is related directly to the concept of opportunity cost. If instead of receiving a certain sum right now, and you had to wait until the end of a whole year for it, you would have lost the interest that you could have earned.]

The Future Value of Present Money

F = P (1+ i) n,

The Present Value of Future Money

P = F / (1+ i) n or F (1+ i) n. Both present value and future value represent sums of money at points in time. The only requirement is that present value precedes future value in time.

IED 210 VE Session 6 Engg Econ 17/06/10 WCH

Functional Notation
(1+ i)n is also given the factor notation: (F/P, i %, n) and 1 / (1+ i)n given the notation (P/F, i %, n), where the top letter of the ratio is the sum of money you want to find, given the bottom sum, i is the interest rate, and n the number of periods.

Interpreting The Functional Notation

F = P (F/P, i %, n) means the calculated amount, F, at the point in time it occurs (i.e., n periods from when P occurs), is equivalent to the known value of P at the point in time it occurs, for the given interest rate, i %. Tables of different values of i and n are available for engineering economy calculations.

Economic Equivalence
In engineering economy, 2 things are said to be equivalent when they have the same effect. When 2 or more alternatives are to be compared, their relative merits are often not directly apparent from a simple statement of their future receipts and disbursements. To compare, these amounts must first be placed on an equivalent basis, for example, at the same point in time. When interest is earned, monetary amounts can be directly added only if they occur at the same point in time. The factors involved in the equivalence of sums of money are: - the amounts of the sums; - the times of occurrence of the sums; and - the interest rate. In the interest formulas, P occurs at the start of an interest period, and F and A payments occur at the end of interest periods.

Capital Investment Vs Operating Expense

The distinction between the above depends on the expected service life & the first cost. Generally, items with long service lives & high first costs are treated as investments they are capitalized & increase the asset of the company. A capitalised item is depreciated over a number of operating periods which coincide with the expected service life of the item. It is tagged with an asset number & is physically counted during annual stock-taking or physical inventory exercise. Generally, the first cost of an equipment or plant includes: - the purchase price; - transportation cost;
IED 210 VE Session 6 Engg Econ 17/06/10 WCH

government taxes & duties; cost of installation.

Depreciation
A fixed or physical asset decreases in value because of the reduction in usefulness with the passage of time, usually over its expected service life. The process by which it loses its value is called depreciation. Regardless of the reason for a decrease in value of an asset, the depreciation should be taken into account in engineering economy studies because of favourable income tax allowances. Taxes are paid on net income less depreciation for the year, thus lowering the taxes paid. [It is an operation cost, affecting the profitability of a company.] Depreciation is usually charged once a year, in keeping with the end-of-year convention.

Book Value
The book value of an asset is the acquisition cost of an asset less its accumulated depreciation charges. It represents the current worth of an asset as indicated in the books of accounts.

Straight-line (SL) Depreciation

The book value of the asset decreases linearly with time, because the same depreciation charge is made each year. The yearly depreciation is determined by dividing the first cost minus its salvage value by the life of the asset. D t = (P V) / n where: t = year, D t = annual depreciation charge, P = first cost, V = salvage value, and n = expected depreciable life or recovery period. Since the asset is depreciated by the same amount each year, Book value after t years, BV t = P D t.

IED 210 VE Session 6 Engg Econ 17/06/10 WCH

Cash Flow Diagrams

A cash flow diagram is a means of visualizing and simplifying the flow of receipts and disbursements for the acquisition and operation of items in an enterprise. The horizontal line is a time scale with progression of time moving from left to right, with the interest periods or years written below the intervals of time. It is marked off in equal increments, one per period, up to the duration of the project. The arrows represent cash flows. Arrows may go in opposing directions as cash flows may represent either costs or incomes. Costs, expenditures, payments and disbursements (negative cash flows or cash outflows) will be shown as downward pointing arrows. Benefits, revenues, incomes or receipts (positive cash flows or cash inflows) are shown as upward pointing arrows. Arrow lengths are approximately proportional to the magnitude of the cash flow. The end-of-year convention is used, where all disbursements and receipts (i.e., cash flows) are assumed to take place at the end of the year in which they occur. Expenses incurred before time = 0 are sunk costs and are not relevant to the problem. However, salvage value is income, so it is drawn as positive. The net cash flow is the arithmetic sum of receipts (+) and disbursements () that occur at the same point in time. It is important to draw the cash flow diagram for any proposal as it does not only give us a pictorial view of the cash flows, it also allows us to write the cash flow equation (with functional notations) more easily.

A = $14,667/+ 1 P = $123,545/2 3 4

F = $44,560/-

5 years

E.g., PW = $123,545 + $14,667 (P/A, i %, 5) + $44,560 (P/F, i %, 5) Once we know the interest rate, it is a matter of checking the interest factor tables, substitute the factors into the equation, and calculate the PW.

IED 210 VE Session 6 Engg Econ 17/06/10 WCH

Procedure in Decision-Making
1) Define alternatives clearly and determine the differences in consequences; 2) Quantify these differences in terms of money; 3) Apply evaluation criteria to the quantifiable monetary figures to provide a basis for objective decision making. 4) Consider other non-quantifiable factors before a final decision is made. The no. of initial alternatives may be large but analysis of 6 major factors cost, volume, human resource constraints, technology, quality & reliability typically reduces the large number to only a few. [Note: One alternative often ignored is to do nothing & maintain existing conditions.

Basic Methods for Making Engineering Economy Studies

All engineering economy studies of capital projects should be made so as to include consideration of the return that a given project will or should produce. As the patterns of capital investment, revenue or saving flows and cost flows can be quite different in various projects, there is no single method for making engineering economy studies that is ideal for all cases. There are 3 commonly used methods for comparing the relative financial merits of competing alternatives in engineering economy problems: (1) Payback period method; (2) Present Worth (PW) method; and (3) Internal Rate of Return (IRR) method. Other methods are discussed in the IED module Engineering Economy. The alternative selected will be that which offers the shortest payback period, the most return, or is of the lowest cost, for the same investment. Or, we can determine the Rate of Return by solving for i * and choosing the alternative offering the greatest rate of return, irreducible considerations being equal.

IED 210 VE Session 6 Engg Econ 17/06/10 WCH

Payback Period Method

This method is concerned primarily with the period of time required to recover an investment. This is useful when there are different rates of investment and annual cash flow spread over the period. The payback period is obtained when the cumulative cash flow curve intersects the x-axis. The alternative that returns the initial investment in the shortest time period is preferred. Mathematically, payback period = net investment / net annual cash flow after taxes. The merit of an investment may be judged by comparing the pay-back period with the estimated life of the equipment. This is the most popular method in general use. However, it will provide the wrong answer as this method does not consider: the returns after payback (i.e., the economic life & the salvage value); the time value of money during the economic life of the equipment.

The Present Worth (PW) Method

The concept of PW discounts the future cash flows arising from an investment at a predetermined standard rate of interest. This gives the present value which is then compared to the amount being invested. To be realistically profitable, the PW must be greater than the sum invested. The rate considered is usually the cost of capital. The criterion is that as long as the present worth of the net cash flows is equal to or greater than zero, the project is economically justified. There must be a common analysis period when comparing alternatives. It is incorrect to compare the PV of cost of Pump A, say, which is expected to last 6 years, with the PV of cost of Pump B, expected to last 12 years. In this example, the assumption would be that Pump A will be replaced by another identical Pump A at the end of 6 years. This gives a common analysis period of 12 years. In situations like this, restructure the problem so there is a common analysis period. This is easy when the different lives of the alternatives have a practical least common multiple. When this is not the case, some assumptions must be made to select a suitable common analysis period. Or, just dont use the PW method. Selection on the basis of present worth gives the same result as rate of return unless the discount rate is unusually high.

IED 210 VE Session 6 Engg Econ 17/06/10 WCH

Internal Rate of Return (IRR) Method

Also known as the Return on Investment (ROI) method. It answers the question If I make this investment, will there be a sufficient return (i.e., interest) on the money invested? For any set of disbursements-receipts relationships, there is some rate of return that will exactly reduce the worth of the investment to zero at the end of the time period. The computed interest or profit rate, i *, which will fulfill this condition, is the internal rate of return. To determine the ROI for an investment, derive the mathematical expression for the present worth by bringing all the cash flows to the present. This expression will be in terms of the appropriate functional notations as the interest rate is unknown. The interest rate, i *, that reduces the expression to zero is found by trial and error (including interpolation), and uses the discount factors for the appropriate number of years at different rates of interest. Other things being equal, the preferred alternative is the one with the highest IRR. As a rule, the IRR must be able to cover the sum of savings interest rate (if the principal is deposited in a bank to earn interest) and business risk, to make the investment proposal attractive. The IRR is the interest (profit) rate earned by all capital that is invested in the project each year.

Need to Invest?
Sometimes when an unsatisfactory condition is under review and an investment in fixed asset is proposed to correct this condition, no thought is given to possible methods of improving the conditions without a substantial investment. For example, new machinery may be proposed to reduce high labour costs on a certain operation. However, work simplification methods based on motion study may provide an alternative way to reduce these costs Or, new equipment may be proposed to reduce product quality rejects. Yet, it could be possible that the same result might be obtained through the use of statistical quality control techniques.

IED 210 VE Session 6 Engg Econ 17/06/10 WCH