Engineering

Economics
&
Its Importance for
Chemical
Engineers
Presented by
Yasir Shahzad

Contents

Definition & Types of economics

Engineering economics
Time value of money
Cash flow diagram
Cost estimation
Quantification of profitability
Income tax
Summary

What is economics?

Definition
Economics is the branch of social science which deals

with the economic problems of the people living in a

society

from sharma & Banga, Industrial Organisation & Engineering Economics

Types

Micro
Economics

Macro
Economics

Why we study Engineering Economics?

Tests for acceptable
engineering projects
1)

Technically sound

2)

Profitable !

This is where economics

comes in.

What is Engineering Economics?

Engineering economy involves formulating, estimating & evaluating the

economic outcomes when alternatives to accomplish a defined purpose
are available
from Blank & Tarquin, Engineering Economy, 6th Edition, McGraw Hill, 2008.

Example!

There is a low concentration of high molecular weight organo-metallic

compounds in gasoline that act as contaminants. These impurities form
undesirable deposits on engine components.

Engineering Economic approach!

Problem identified; objective defined

Alternative 1
synthetic adsorbents

Alternative 2
membrane separation

Description &
Info

Description &
Info

Cash flows over stated

Time period

Cost estimates & income

Financing strategies
Tax Laws

Cash flows over stated

Time period

Evaluated
Alternative 1

Time value of money

Interest rate
Pay back period

Evaluated
Alternative 2

Non-economic attributes to be considered

What we need to know?

Time value of money

Why does money have time value?

How to calculate?

Cash Flow diagrams

Tree diagram
Cumulative Cash flow

Capital Costs

Types of capital investment

Cost estimation methods

Quantification of profitability

NPV / Payback period / ROR

TIME VALUE OF MONEY

Why does money have time value?

The change in the amount of money over a given time period is

called the time value of money.
An alternative use of the money could have generated other
benefits, e.g. interests.

How to calculate time value?

We use an interest rate, so that the effect of time is

proportional to the total amount of money involved and related

with the length of time.

Net profit after tax= (Sj Cj dj)(1- )

Income tax = (Sj Cj

dj)

Gross profit after depreciation = Sj Cj - dj

Gross profit = Sj - Cj
Total income
From sales = Sj

Operations for
Complete project

Operation cost = Cj

Cash Flow Diagram

W
Working
capital
Non
manufacturing
fixed capital,
Ax

Total Capital Investment

=w + A x + V
Without land

Manufacturing
fixed capital, V

loan

Common &
Preferred stock

source &
sink

Capital

Net cash from project= (Sj Cj dj)(1- )+ dj

Repayment of loan & dividends

Cumulative Cash Flow

Cash flow statement
Initial
Investment
Alternative A
(120)

10

10

50

Annual Net Cash Flows

4
5
6
7

10

50

50

50

50

50

50

End of Year Cummulative Net Cash Flow

(120) (110) (100) (50)
0
50

100

150

200

250

300

Pay Back Period

Fraction
of First Positive
Year
Graphical
method
Pay Back Period

PV

T=0

50

1.00
4.00

+/- Cash Flows

TYPES OF CAPITAL INVESTMENT

Fixed Capital
Direct Cost

Purchased equipment
delivered
Instrumentation & controls
Electrical & Piping system

Working Capital

Indirect Cost

Engineering & Supervision

Construction expenses
Legal expenses
Contingency

Raw materials
Finished products in stock & semi
finished products
Accounts receivable
Accounts payable
Taxes payable

Capital Cost Estimates Types

from Peters & Timmerhaus, pg 235-237
Name

Accuracy

Application

Process detail

Study
estimate

-30 to +30%

Screen investments

Based on similar
previous cost data

Preliminary
estimate

-20 to +20%

Budget authorization

Block diagram

Definitive
estimate

-10 to +10

Project control
estimate

Process flow diagram

Detailed
estimate

-5 to +5%

Contractors estimate

P&I drawing, detailed

M&E Balances,
Equipment specifications

Cost Estimation Tools

A couple of very rough
techniques (initial screening)
Turnover Ratio
Langs Factor

Detailed item estimate

The primary method used in process industry

Calculate the cost of individual equipment
Specific equipment type
Material of construction
Operating pressure

Net Present Value (NPV)

The Net Present Value of an investment is simply the difference
between cash outflows and cash inflows on a present value
basis.
Where;

NPV =

Present Value (Cash Benefits) - Present Value (Cash Costs)

NPV 0

Acceptable project investment

Present Value Example

Initial Investment:
Project Life:
Salvage Value:
Annual Receipts:
Annual Disbursements:
Annual Discount Rate:

$100,000
10 years
$ 20,000
$ 40,000
$ 22,000
12%

What is the net present value for this project?

Is the project an acceptable investment?

Present Value Example Solution

Annual Receipts
$40,000(P/A, 12%, 10)

Salvage Value
$20,000(P/F, 12%, 10)

$ 226,008
$

6,440

Annual Disbursements
$22,000(P/A, 12%, 10)

Initial Investment (t=0)

Net Present Value

-$124,304
-$100,000

$8,143

Greater than zero, therefore acceptable project

Payback Period

This is one of the most common evaluation criteria used by

engineering and resource companies.
The Payback Period is simply the number of years required
for the cash income from a project to return the initial cash
investment in the project.
The investment decision criteria for this technique suggests
that if the calculated payback is less than some maximum
value acceptable to the company, the proposal is accepted.

Example
Calculation of the payback period for a given
investment proposal.
Initial
Investment

Alternative A
(45,000) 10,500

11,500

Annual Net Cash Flows

4
5
6
7

10

12,500 13,500 13,500 13,500 13,500 13,500 13,500 13,500

End of Year Cummulative Net Cash Flow

(45,000) (34,500) (23,000) (10,500) 3,000 16,500 30,000 43,500 57,000 70,500 84,000
Pay Back Period
Fraction of First Positive Year
Pay Back Period

0.78
3.78

0.78 = 10,500/13,500
3 + 0.78

Income Tax
Taxes (T) = (Taxable income) (Applicable tax rate)
Taxable Income (TI) = Gross Income Expenses Depreciation
NPAT = (TI) - (T)

Amount of money returned to corporation as a result of the

capital invested during the year.

Depreciation methods effects on taxes:

Accelerated depreciation method gives the corporation a tax

advantage relative to straight line method with the same
recovery period.
Larger rates in earlier years of the recovery period requires
less taxes due to the larger reductions in taxable income

Summary

1.
2.

Engineering Economics?
Project Estimation
Methods
Mathematical tools
Selection criteria

Study Estimate
Make a study estimate of the fixed capital investment
for a process plant if the purchased equipment cost is
$100,000.

Component

% FCI

Avg.%

Normal Estimat%
ed Cost

Purchased Equipment

15-40

27.5

20.8

Purchased Equipment
installation

6-14

10

7.6

Instrumentation &
controls (Installed)

2-12

5.3

Piping (Installed)

4-17

10.5

Electrical (Installed)

2-10

4.5

Building

2-18

10

7.6

2-5

3.5

2.6

Service facilities

8-30

19

14.4

Engineering &
supervision

4-20

12

9.1

Construction expense

4-17

10.5

Legal expense

1-3

1.5

Contractors fee

2-6

5-15

10

7.6

132

100

Yard Improvements

Contingency
TOTAL

$100,000