Chapter 4

Engineering Economics
Topics to be covered
1. Introduction Engineering Economics
2. Total investment costs
3. Financial evaluations
4. Investment Evaluation
5. Accounting concepts
6. Classification of accounts
7. Accounting statements (reading assignment)
8. Budgets and budgetary control
 Introduction Engineering Economics
From the organization’s point of view, efficient and effective
functioning of the organization would certainly help it to provide
goods/services at a lower cost which in turn will enable it to fix a lower
price for its goods or services.
Engineering economics deals with the methods that enable one to take
economic decisions towards minimizing costs and/or maximizing
benefits to business organizations.
 It deals with the concepts and techniques of analysis useful in
evaluating the worth of systems, products, and services in relation to
their costs.
 Economists, engineering managers, project
managers, and indeed any person involved in decision
making must be able to analyze the financial
outcome of his or her decision.
 Introduction Engineering Economics
The decision is based on analyzing and evaluating the activities
involved in producing the outcome of the project. These activities
have either a cost or a benefit. Financial analysis gives us the tools to
perform this evaluation. Often the decision is to proceed or not to
proceed with a project.

Role of Engineers in the Industry

 Why do engineers care about engineering economics?
 Engineering designs are intended to produce good results.
 They are accompanied by undesirables (costs).
 If outcomes are evaluated in dollars, and “good” is defined as
profit, then decisions will be guided by engineering economics.
 This process maximizes goodness only if all outcomes are
anticipated and can be monitered.
 Role of Engineers in the Industry
 It is used to answer many different questions:
 Which engineering projects are worthwhile?
 Has the mining or petroleum engineer shown that the mineral or
oil deposits is worth developing?
 Which engineering projects should have a higher priority?
 Has the industrial engineer shown which factory improvement
projects should be funded with the available dollars?
 How should the engineering project be designed?
 Role of Engineers in the Industry
 Role of Engineers:
 Estimating a Required Manufacturing Profit
investment.
 Forecasting a product
demand. Planning
 Estimating a selling
price.
 Estimating a
manufacturing cost.
 Estimating a product life.

Investment
Marketing

5
 Types of Costs
There are usually two types of costs/Benefits associated with an
engineering project, one-time costs, which include first costs and
salvage costs, and annual costs (or benefits) that occur every year or
several years of the project.
One time costs: First Costs or Initial Costs are the costs necessary to
implement a project, including:
Costs of new equipment, Costs of shipping and installation, Costs of
renovations, Cost of engineering, Cost of permits, licenses, etc.
Salvage value is the money that can be obtained at the end of the project
by selling equipment. Salvage value is a benefit rather than a cost.

Annual Costs/Benefits:
 Direct operating costs such as labor, supervision, supplies,
maintenance, material, electricity, fuel, etc.
 Indirect operating costs sometimes included, such as a portion of
building rent, a portion of secretarial expenses, etc.
 Cash Flow Diagram
 The graphic presentation of the costs and benefits over the time is
called the cash flow diagram.
 It is a presentation of what costs have to be incurred and what
benefits are received at all points in time. CFD illustrates the size,
sign, and timing of individual cash flows, and forms the basis for
engineering economic analysis.
 A CFD is created by first drawing a segmented time-based horizontal
line, divided into appropriate time unit. Each time when there is a
cash flow, a vertical arrow is added, pointing down for costs and up
for revenues or benefits.
 Different cost flows are drawn to relative scale.
 Horizontal axis = time; vertical axis = costs and
benefits
 Cash Flow Diagram

Drawing Cash Flow Diagram

In a cash flow diagram (CFD) the end of period t is the same as the
beginning of period (t+1).
 Beginning of period cash flows are: rent, lease, and insurance
payments.
 End-of-period cash flows are: salvages, revenues, overhauls.
 The choice of time 0 is arbitrary. It can be when a project is
analyzed, when funding is approved, or when construction begins.
 Drawing Cash Flow Diagram
 Example 1: A car leasing (renting) company buys a car from a
wholesaler for $24,000 and leases it to a customer for four years at
$5,000 per year. Since the maintenance is not included in the lease,
the leasing company has to spend $400 per year in servicing the
car. At the end of the four years, the leasing company takes back
the car and sells it to a secondhand car dealer for $15,000. For the
moment, in constructing the cash flow diagram, we will not
consider tax, inflation, and depreciation.
 Solution:

9
 Financial evaluations
Financial evaluation in this case is evaluating the value of the money
with time
• Time Value of Money
Money has value and it can be leased or rented. The payment is called
interest If you put $100 in a bank at 9% interest for one time period
you will receive back your original $100 plus $9. Original amount to
be returned = $100 Interest to be returned = $100 x .09 = $9
The “value” of money depends on the amount and when it is
received or spent. Example: What amount must be paid to settle
a current debt of $1000 in two years at an interest rate of 8% ?
Solution: $1000 (1 + 0.08) (1 + 0.08) = $1166
 Interest Formulas and Their Applications
Interest rate: is the rental value of money. It represents the growth of
capital per unit period. The period may be a month, a quarter,
semiannual or a year.
Interest formulas:
Simple interest: the interest is calculated, based on the initial deposit for
every interest period. In this case, calculation of interest on interest is
not applicable.
Compound interest: the interest for the current period is computed
based on the amount (principal plus interest up to the end of the
previous period) at the beginning of the current period.
 Interest Formulas and Their Applications
 The notations which are used in various interest formulae are as
follows:
 P = principal amount (Initial amount).
 n = No. of interest periods.
 i = interest rate (It may be compounded monthly, quarterly,
semiannually or annually).
 F= future amount at the end of year n.
 A = equal amount deposited at the end of every interest period.
 Single-Payment Compound Amount: Here, the objective is to find
the single future sum (F) of the initial payment (P) made at time 0
after n periods at an interest rate i compounded every period.
 The formula to obtain the single-payment compound amount is:
 Interest Formulas and Their Applications
F= P(1 + i)n = P(F| P, i, n)
Where (F|P, i, n) is called as single-payment compound amount factor.
 Example: A person deposits a sum of $ 20,000 at the interest rate of
18% compounded annually for 10 years. Find the maturity value after
10 years.
 Solution: P= $ 20,000, i = 18% compounded annually, n= 10 years
F= P(1 + i)n = P(F|P, i, n)
= 20,000 (F|P, 18%, 10)
= 20,000 * 5.234 = $ 1,04,680
Single-Payment Present Worth Amount: Here, the objective is to find
the present worth amount (P) of a single future sum (F) which will be
received after n periods at an interest rate of i compounded at the end of
every interest period.
 Interest Formulas and Their Applications
Example: A person wishes to have a future sum of $100,000 for his
son’s education after 10 years from now. What is the single-payment
that he should deposit now so that he gets the desired amount after 10
years? The bank gives 15% interest rate compounded annually.
Ans: $24,720
Equal-Payment Series Future Worth Amount: In this type of
investment mode, the objective is to find the future worth of n equal
payments which are made at the end of every interest period till the
end of the n-th interest period at an interest rate of i compounded at
the end of each interest period.
 Interest Formulas and Their Applications
A= equal amount of deposited at the end of each interest period
n=number of interest period
I = rate of interest
F = single future amount then the formula to get F is

Where
(F/A,I,n)is termed as equal- payment series compound amount factor
Example: A person who is now 35 years old is planning for his retired
life. He plans to invest an equal sum of $10,000 at the end of every
year for the next 25 years starting from the end of the next year. The
bank gives 20% interest rate, compounded annually. Find the maturity
value of his account when he is 60 years old.
 Ans: $ 4,719,810
 Interest Formulas and Their Applications
Equal-Payment Series Sinking Fund: In this type of investment mode,
the objective is to find the equivalent amount (A) that should be
deposited at the end of every interest period for n interest periods to
realize a future sum (F) at the end of the nth interest period at an
interest rate of i.

A= equal amount of deposited at the end of each interest period

n=number of interest period, I = rate of interest
F = single future amount at the end of nth period, then the formula
to get F is

Where (A /F,I,n)is termed as equal- payment series sinking fund

 Interest Formulas and Their Applications
Example: A company has to replace a present facility after 15 years at
an outlay of $500,000. It plans to deposit an equal amount at the end
of every year for the next 15 years at an interest rate of 18%
compounded annually. Find the equivalent amount that must be
deposited at the end of every year for the next 15 years.
Ans: $ 8,200.
Equal-Payment Series Present Worth Amount : The objective of this
mode of investment is to find the present worth of an equal payment
made at the end of every interest period for n interest periods at an
interest rate of i compounded at the end of every interest period.
 Interest Formulas and Their Applications
Equal-Payment Series Present Worth Amount
P = Present worth , A=annual equivalent payment,
n=number of interest period, i = rate of interest and
the formula to compute P is

where is called equal –payment series present worth factor

 Example: A company wants to set up a reserve which will help the
company to have an annual equivalent amount of $1,000,000 for the
next 20 years towards its employees welfare measures. The reserve is
assumed to grow at the rate of 15% annually. Find the single-payment
that must be made now as the reserve amount.
 Ans: $ 6,259,300
 Equal-Payment Series Capital Recovery Amount: The objective of
this mode of investment is to find the annual equivalent amount (A)
which is to be recovered at the end of every interest period for n
interest periods for a loan (P) which is sanctioned now at an interest
rate of i compounded at the end of every interest period.
 Interest Formulas and Their Applications

Equal-Payment Series Capital Recovery Amount:

P = Present worth (loan amount), A=annual equivalent
payment(recovery amount), n=number of interest period,
i = rate of interest and the formula to compute P is as follows

where (A/P,I,n) is called equal – payment series capital recovery

 Example: A bank gives a loan to a company to purchase an equipment
worth $ 1,000,000 at an interest rate of 18% compounded annually.
This amount should be repaid in 15 yearly equal installments. Find the
installment amount that the company has to pay to the bank. Ans:
$196,400
 Investment Evaluation:
Investment is allocation of large resources to the business or a project in
order to get revenue
Some Criteria that a good procedure for evaluating proposed investments
should meet. (1) Base the analysis on incremental costs and benefits, and
don’t arbitrarily exclude any costs or benefits from the analysis.(2)
Allow for time value of money and for the risk involved. (3) If forced to
choose among proposals, select the one that does shareholders the most
good.
Our recommended approach to evaluating proposed investments is Net
Present Value (NPV) analysis.
NPV = Present Value of the Incremental Benefits - Present Value of
Incremental Costs.
NPV-based decision rules:
When evaluating independent projects, take those with positive NPVs,
reject those with negative NPVs. \
 Investment Evaluation
When evaluating interdependent projects, take the combination with the
highest combined NPV. Other techniques are prevalent (or somewhat
prevalent) in practice
Economic Analysis Methods Investment Evaluation
 Four commonly used economic analysis methods are:
 Present Worth Analysis
 Future Worth Analysis
 Annual Worth Analysis
 Rate of Return Analysis (on investment )
 Present Worth Analysis
 In this method of comparison, the cash flows of each alternative will
be reduced to time zero by assuming an interest rate i. Then,
depending on the type of decision, the best alternative will be selected
by comparing the present worth amounts of the alternatives.
 Economic Analysis Methods
 Steps to do present worth analysis for a single alternative
(investment):
 Select a desired value of the return on investment (i).
 Using the compound interest formulas bring all benefits and costs
to present worth.
 Select the alternative if its Net Present Value (Present worth of
benefits – Present worth of costs) ≥ 0.
 Steps to do present worth analysis for selecting a single alternative
(investment) from among multiple alternatives:
 Step 1: Select a desired value of the return on investment (i).
 Step 2: Using the compound interest formulas bring all benefits
and costs to present worth for each alternative.
 Step 3: Select the alternative with the largest net present worth
(Present worth of benefits – Present worth of costs).
 Present Worth Analysis
 Example 1:
A construction enterprise is investigating the purchase of a new dump
truck. Interest rate is 9%. The cash flow for the dump truck are as
follows:
First cost = $50,000, annual operating cost = $2000, annual income =
$9,000, salvage value is $10,000, life = 10 years. Is this investment
worth undertaking?
P = $50,000, A = annual net income = $9,000 - $2,000 = $7,000, S =
10,000, n = 10.
Evaluate net present worth = present worth of benefits – present worth
of costs.
 Present Worth Analysis
Present worth of benefits = $9,000(P|A,9 %,10) = $9,000(6.418) =
$57,762
Present worth of costs = $50,000 + $2,000(P|A,9 %,10) - $10,000(P|
F,9 %,10)= $50,000 + $2,000(6.418) - $10,000(.4224) = $58,612
Net present worth = $57,762 - $58,612 < 0  do not invest.
What should be the minimum annual benefit for making it a
worthy of investment at 9% rate of return?
Present worth of benefits = A(P|A,9 %,10) = A(6.418)
Present worth of costs = $50,000 + $2,000(P|A,9 %,10) - $10,000(P|
F,9 %,10)= $50,000 + $2,000 (6..418) - $10,000(.4224) = $58,612
A(6.418) = $58,612  A = $58,612/6.418 = $9,312.44
 Present Worth Analysis
 Example 2: Alpha Industry is planning to expand its production
operation. It has identified three different technologies for meeting the
goal. The initial outlay and annual revenues with respect to each of
the technologies are summarized below. Suggest the best technology
which is to be implemented based on the present worth method of
comparison assuming 20% interest rate, compounded annually.
Initial Outlay ($) Annual Revenue ($) Life (yrs)
Technology 1 1,200,000 400,000 10
Technology 2 2,000,000 600,000 10
Technology 3 1,800,000 500,000 10

 Solution: Technology 1  Technology 2

Initial outlay, P= $ 1,200,000
Annual revenue, A= $ 400,000
Interest rate, i= 20%,
n= 10 years
Net Present Value (NPV) = revenue – cost
 NPV= A(P|A, i, n) – p = $ 477,000
 Technology 2 has more NPV value so
it is the best alternative.
Initial outlay, P= $ 2,000,000
Annual revenue, A= $ 600,000
Interest rate, i= 20%,
 NPV= A(P|A, i, n) – p = $ 515,500
 Technology 3
Initial outlay, P= $ 1,800,000
Annual revenue, A= $ 500,000
Interest rate, i= 20%,
 NPV= A(P|A, i, n) – p = $ 296,250
 Future Worth Analysis
In the future worth method of comparison of alternatives, the future
worth of various alternatives will be computed. Then, the
alternative with the maximum future worth of net revenue or with
the minimum future worth of net cost will be selected as the best
alternative for implementation. If it is for single alternative select the
alternative if it has positive NFV (net future value). Example: A
man must decide which of the several alternatives to select in trying
to obtain a desirable return on his investment. After much study and
calculation, he decides that the two best alternatives are as given in
the following table:
Building Gas Station Building Restaurant
First cost ($) 2,000,000 3,600,000
Annual property taxes ($) 80,000 150,000
Annual income ($) 800,000 980,000
Life 20 20
Salvage value ($) 0 0
 Future Worth Analysis
Solution: Alternative 1—Build gas station
First cost = $ 2,000,000, Life (n) = 20 years, Interest rate (i) = 12%,
Net annual income = Annual income – Annual property tax
= $ 800,000 – $ 80,000 = $ 720,000
Net future value (NFV) = Future benefit – Future cost
= 720,000 (F|A, 12%, 20) – 2,000,000 (F|P, 12%, 20)
= 7,20,000 (72.052) – 2,000,000 (9.646) = $ 32,585,440
Alternative 2—Build restaurant
First cost = $ 3,600,000, Life (n) = 20 years, Interest rate (i) = 12%,
Net annual income = Annual income – Annual property tax =
$980,000 – $ 150,000 = $ 830,000
Net future value (NFV) = Future benefit – Future cost = 830,000 (F|A,
12%, 20) – 3,600,000 (F|P, 12%, 20) = 830,000 (72.052) – 2,000,000
(9.646) = $ 25,077,560 Alternative 1 is best option with highest NFV.
 Annual Worth Analysis
 In the annual equivalent method of comparison, first the
annual equivalent cost or the revenue of each alternative will
be computed. Then the alternative with the maximum annual
equivalent revenue in the case of revenue-based comparison or
with the minimum annual equivalent cost in the case of cost-
based comparison will be selected as the best alternative.
 Example: A company wants to invest in one of the following two
alternatives. The life of both alternatives is estimated to be 5
years with the following investments, annual returns and
salvage values. Determine the best alternative based on the
annual equivalent method by assuming i= 25%.

Alternatives
A B
Investment ($) 150,000 175,000
Annual equal return ($) 60,000 70,000
Salvage value ($) 15,000 35,000
 Annual Worth Analysis
 Solution: Alternative A
 Initial investment, P= $150,000, Annual equal return, A= $ 60,000,
Salvage value at the end of machine life, S= $ 15,000
 Life = 5 years, Interest rate, i= 25%, compounded annually.
 Annual Equivalent Value (AEV) = Annual Revenue- Annual cost
= 60,000 + 15,000(A|F, 25%, 5) – 150,000(A|P, 25%, 5) = 60,000 +
15,000(0.1218) – 150,000(0.3718) = $ 6,057
 Alternative B
 Initial investment, P= $175,000, Annual equal return, A= $
70,000, Salvage value at the end of machine life, S= $ 35,000
 Life = 5 years, Interest rate, i= 25%, compounded annually.
 Annual Equivalent Value (AEV) = Annual Revenue- Annual cost
= 70,000 + 35,000(A|F, 25%, 5) – 175,000(A|P, 25%, 5)
= 70,000 + 35,000(0.1218) – 175,000(0.3718) = $ 9,198
 Alternative B is the best option with highest annual return.
 Rate of Return Analysis (Reading Assignment)
 The rate of return of a cash flow pattern is the interest rate at
which the present worth of that cash flow pattern reduces to zero.
In this method of comparison, the rate of return for each alternative
is computed. Then the alternative which has the highest rate of
return is selected as the best alternative.
 Rate of return (ROR) is the interest rate earned on unrecovered
project balances such that an investment’s cash receipts make the
terminal project balance equal to zero.
 Rate of return is an intuitively familiar and understandable measure
of project profitability that many managers prefer to NPW or other
equivalence measures.
 Mathematically we can determine the rate of return for a given
project cash flow series by locating an interest rate that equates the
net present worth of its cash flows to zero. This break-even interest
rate is denoted by the symbol i*.
 Accounting concepts
Accounting is much more. It includes identifying, measuring,
recording, reporting, and analyzing business events and
transactions, and helps information users to make economic decisions.
External Users
Consumer Groups, External Auditors, Lenders, Shareholders,
Governments and Customers
Financial accounting provides external users with financial statements
• Internal users Managers, Officers, Internal Auditors, Sales Staff,
Budget Officers and Controllers
Managerial accounting provides information needs for internal
decision makers.
Account; A group of items having common characteristics
Classification of accounts
• Asset Liability
• Income Expense and Equity
 Classification of accounts
 Asset Accounts
Items of Value Characterized as current and non-current
Liability Accounts
Claims that others have against the assets, Have a known:
Amount Date to be paid Person to whom payment owed
Also current and non current
Equity Accounts
Claims that the owner has against the assets
Sometimes called net worth Difference between value of assets and
liabilities
Income(Revenues: ) accounts
gross increase in equity from a company’s earnings activities
Expense Accounts
: the cost of assets or services used to earn revenue. Expenses decrease
owner’s equity.
 Budget
Budget is a financial and / or quantitative statement or plan for a
business, prepared in advance and approved prior to a defined period of
time of the policy to be pursued during that period for the purpose of
attaining a given objective. Budgets are prepared for main areas of the
business – purchases, sales (revenue), production, labor, trade
receivables, trade payables, cash and provide detailed plans of the
business for the next time e.g. for three, six or twelve months etc
Benefits of budgets
Budgets provide benefits both for the business, and also for its managers
and other staff:
the budget assists planning
the budget communicates and co-ordinates
the budget helps with decision-making
the budget can be used to monitor and control
the budget can be used to motivate
 Budget control

Budget control is the establishment of budgets relating to the

responsibilities of executives of policy and the continuous
comparison of the actual with the budgeted results , either to
secure by individual action the objective of the policy or to provide
a basis for its revision . It is the system of management control and
accounting in which all the operations are forecasted and planed in
advance to the extent possible and the actual result compared with
forecasted and planed ones. In short It is a process that ensures
available budget exists for a given expense/transaction.
Budgetary control involves
1. Establishment of budgets
2. Continuous comparison of actual with budgets for achievement
of targets
3. Revision of budgets after considering changed circumstances
4. Placing the responsibility for future to achieve the budgets target
 Limitations Of Budgets And Budgetary Control
Whilst most businesses will benefit from the use of budgets,
there are a number of limitations of budgets to be aware of:
• the benefit of the budget must exceed the cost
• budget information may not be accurate
• the budget may demotivate
• budgets may lead to dysfunctional management
• budgets may be set at too low a level
Accounting statements
(reading assignment)