THE BASICS OF ENGINEERING ECONOMY

Economics * It is defined as the sum total of knowledge which treats of the creation (production), distribution and utilization (consumption) of goods and services for the satisfaction of human needs and wants * The body of knowledge which deals with people and their assets or resources

Money * Anything that is generally acceptable as a means of exchange a unit of measure and acts as a store value

Engineering (Accreditation Board for Engineering and Technology) * The profession in which a knowledge of the mathematical and natural sciences gained by study, experience, and practice is applied with judgment to develop ways to utilize, economically, the materials and forces of nature for the benefit of mankind."

Engineering economy * The analysis and evaluation of the monetary consequences by using the theories and principles of economics to principles of engineering applications, designs and projects. * It may also be defined as the study of problems involving economic solutions with the concept of obtaining the maximum productivity or reward at least cost or risk. * Generally, it involves the systematic evaluation of the economic merits of proposed solutions to engineering problems. To be economically acceptable solutions should have a positive balance of long-term benefits over long-term costs. Besides it should promote the well-being and survival of an organization, embody creative and innovative technology and ideas, permit identification and scrutiny of their estimated outcomes, and translate profitability to the "bottom line" through a valid and acceptable measure of merit.

Goal of engineering economy
– balance the trade-offs among the different types of costs and performance (response time, safety, weight, reliability, etc.) provided by the proposed design or problem solution that is inherent in the decision process in the most economical manner.
Illustration: An engineer at Ford Motor Company invents a new transmission lubricant that increases fuel mileage by 10% and extends the life of the transmission by 30,000 miles, how much can the company afford to spend to implement this invention? Engineering economy can provide an answer.

Some Applications of Engineering Economy 1. Choosing the best design for a high-efficiency gas furnace. 2. Selecting the most suitable robot for a welding operation on an automotive assembly line. 3. Making a recommendation about whether jet airplanes for an overnight delivery service should be purchased or leased. 4. Determining the optimal staffing plan for a computer help desk.

ORIGINS OF ENGINEERING ECONOMY

Arthur Mellen Wellington (1847 – 1895) * “An engineer can do for a dollar what any fool can do for two” * Considered as the pioneer of Engineering Economy, he addressed the role of economic analysis in engineering projects * The Economic Theory of the Location of Railways (1887)

Eugene Grant * Credited for the development of the field when he published his first book in 1930 placing emphasis on developing an economic point of view in engineering.

Woods and DeGarmo (1942) * Authored the first edition of this book, later titled Engineering Economy.

PRINCIPLES OF ENGINEERING ECONOMY

The foundation for engineering economy is a set of principles that provide a comprehensive doctrine for developing the methodology. Once a problem or need has been clearly defined, the foundation of the discipline can be discussed in terms of seven principles.

PRINCIPLE 1 – DEVELOP THE ALTERNATIVES:
The choice (decision) is among alternatives. The alternatives need to be identified and then defined for subsequent analysis.

PRINCIPLE2 – FOCUS ON THE DIFFERENCES:
Only the differences in expected future outcomes among the alternatives are relevant to their comparison and should be considered in the decision.

PRINCIPLE 3 – USE A CONSISTENT VIEWPOINT:
The prospective outcomes of the alternatives, economic and other, should be consistently developed from a defined viewpoint (perspective).

PRINCIPLE 4 – USE A COMMON UNIT OF MEASURE:
Using a common unit of measurement to enumerate as many of the prospective outcomes as possible will make easier the analysis and comparison of the alternatives.

PRINCIPLE 5 – CONCIDER ALL RELEVANT CRITERIA:
Selection of a preferred alternative (decision making) requires the use of a criterion (or several criteria). The decision process should consider both the outcomes enumerated in the monetary unit and those expressed in some other unit of measurement or made explicit in a descriptive manner.

PRINCIPLE 6 – MAKE UNCERTAINTY EXPLICIT:
Uncertainty is inherent in projecting (or estimating) the future outcomes of the alternative and should be recognized in their analysis and comparison.

PRINCIPLE 7 – REVISIT YOUR DECISIONS:
Improved decision making results from an adaptive process; to the extent practicable, the initial projected outcomes of the selected alternative should be subsequently compared with actual results achieved.

ENGINEERING ECONOMY AND THE DESIGN PROCESS

An engineering economy study is accomplished using a structured procedure and mathematical modeling techniques. The economic results are then used in a decision situation that involves two or more alternatives and normally includes other engineering knowledge and input.

Table 1. The general relationship between the engineering economic analysis procedure and the engineering design process Engineering Economic Analysis Procedure | Engineering Design Process | Step 1. Problem recognition, definition, and evaluation. 2. Development of the feasible alternatives. 3. Development of the cash flows for each alternative. 4. Selection of a criterion (or criteria). 5. Analysis and comparison of the alternatives. 6. Selection of the preferred alternative. 7. Performance monitoring and post-evaluation of results. | Activity 1. Problem/need definition. 2. Problem/need formulation and evaluation. 3. Synthesis of possible solutions (alternatives). 4. Analysis, optimization, and evaluation. 5. Specification of preferred alternative. 6. Communication. |

1. Problem definition
– provides the basis for the rest of the analysis. A problem must be well understood and stated in an explicit form before the project team proceeds with the rest of the analysis.

2. Development of the Feasible Alternatives
– (1) searching for potential alternatives and (2) screening them to select a smaller group of feasible alternatives for detailed analysis.
The term “feasible” means that each alternative selected for further analysis is judged, based on preliminary evaluation, to meet or exceed the requirements established for the situation.

Searching for Superior Alternatives
– creativity and resourcefulness is absolutely essential to the development of potential alternatives. The difference between good alternatives and great alternatives depends largely on an individual’s or group's problem-solving efficiency.
– in searching for superior alternatives or identifying the true problem, several limitations invariably exist, including (1) lack of time and money, (2) preconceptions of what will and what will not work, and (3) lack of knowledge. Consequently, the engineer or project team will be working with less-than-perfect problem solutions in the practice of engineering.

Developing Investment Alternatives
– two approaches that have found wide acceptance in industry for developing sound investment alternatives by removing some of the barriers to creative thinking: (1) classical brainstorming and (2) the Nominal Group Technique.
(1) Classical Brainstorming – most well-known and often-used technique for idea generation based on the fundamental principles of deferment of judgment and that quantity breeds quality. Four rules for successful brainstorming: 1. Criticism is ruled out. 2. Freewheeling is welcomed. 3. Quantity is wanted. 4. Combination and improvement are sought.
Basic steps of classical brainstorming session (A. F. Osborn): 1. Preparation. The participants are selected, and a preliminary statement of the problem is circulated. 2. Brainstorming. A warm-up session with simple unrelated problems is conducted, the relevant problem and the four rules of brainstorming are presented, and ideas are generated and recorded using checklists and other techniques if necessary. 3. Evaluation. The ideas are evaluated relative to the problem.
Generally, a brainstorming group should consist of four to seven people, although some suggest larger groups.

(2) Nominal Group Technique NGT (developed by Andre P. Delbecq and Andrew H. Van de Ven) involves a structured group (preferably 5 to 10) meeting designed to incorporate individual ideas and judgments into a group consensus. The technique can be used to obtain group thinking (consensus) on a wide range of topics. The technique, when properly applied, draws on the creativity of the individual participants, while reducing two undesirable effects of most group meetings: (1) the dominance of one or more participants and (2) the suppression of conflicting ideas.
The basic format of an NGT session is as follows: 1. Individual silent generation of ideas 2. Individual round-robin feedback and recording of ideas 3. Group clarification of each idea 4. Individual voting and ranking to prioritize ideas 5. Discussion of group consensus results
The NGT session begins with an explanation of the procedure and a statement of question(s), preferably written by the facilitator. The group members are then asked to prepare individual listings of alternatives, such as investment ideas or issues that they feel are crucial for the survival and health of the organization (the silent-generation phase). After this phase has been completed, the facilitator calls on each participant, in round-robin fashion, to present one idea from his or her list (or further thoughts as the round-robin session is proceeding). Each idea (or opportunity) is then identified in turn and recorded on a flip chart or board by the NGT facilitator, leaving ample space between ideas for comments or clarification. This process continues until all the opportunities have been recorded, clarified, and displayed for all to see. At this point a voting procedure is used to prioritize the ideas or opportunities. Finally, voting results lead to the development of group consensus on the topic being addressed.

3. Development of Prospective Outcomes
– Step 3 of the engineering economic analysis procedure incorporates Principles 2, 3, and 4 and uses the basic cash flow approach employed in engineering economy.

In addition to the economic aspects of decision making, nonmonetary factors (attributes) often play a significant role in the final recommendation. Examples of objectives other than profit maximization or cost minimization that can be important to an organization include: 1. Meeting or exceeding customer expectations 2. Safety to employees and to the public 3. Improving employee satisfaction 4. Maintaining production flexibility to meet changing demands 5. Meeting or exceeding all environmental requirements 6. Achieving good public relations or being an exemplary member of the community

4. Selection of a Decision Criterion
– incorporates Principle 5 (consider all relevant criteria) and select the alternative that will best serve the long-term interests of the owners of the organization. It is also true that the economic decision criterion should reflect a consistent and proper viewpoint (Principle 3) to be maintained throughout an engineering economy study.

5. Analysis and Comparison of Alternatives
– largely based on cash-flow estimates for the feasible alternatives selected for detailed study. When cash flow and other required estimates are eventually determined, alternatives can be compared based on their differences which is quantified in terms of a monetary unit.

6. Selection of the Preferred Alternative
– a result of the total effort of the first five steps of the engineering economic analysis. The soundness of the technical-economic modeling and analysis techniques dictates the quality of the results obtained and the recommended course of action.

7. Performance Monitoring and Post-evaluation of Results
– implements Principle 7 and is accomplished during and after the time that the results achieved from the selected alternative are collected. Monitoring improves the achievement of related goals and objectives and reduces the variability in desired results. Also, this step compares actual results achieved with the previously estimated outcomes. The aim is to learn how to do better analyses, and the feedback from post implementation evaluation is important to the continuing improvement of operations in any organization.

Example Defining the Problem and Developing Alternatives
The management team of a small furniture-manufacturing company in Baguio is under pressure to increase profitability in order to get a much-needed loan from a cooperative bank to purchase a more modern pattern-cutting machine. One proposed solution is to sell waste wood chips and shavings to a local charcoal manufacturer instead of using them to fuel heaters for the company's office and factory (a) Define the company's problem. Next, reformulate the problem in a variety of creative ways. (b) Develop at least one potential alternative for your reformulated problems in part (a). (Don't concern yourself with feasibility at this point.)

Solution (a) The company's problem appears to be that revenues are not sufficiently covering costs. Several reformulations can be posed: * The problem is to increase revenues while reducing costs. * The problem is to maintain revenues while reducing costs. * The problem is an accounting system that provides distorted cost information. * The problem is that the new machine is really not needed (and hence there is no need for a bank loan). (b) Based only on reformulation 1, an alternative is to sell wood chips and shavings as long as increased revenue exceeds extra expenses that may be required to heat the buildings. Another alternative is to discontinue the manufacture of specialty items and concentrate on standardized, high-volume products. Yet another alternative is to pool purchasing, accounting, engineering, and other white-collar support services with other small firms in the area by contracting with a local company involved in providing these services.

Application of the Engineering Economic Analysis Procedure
A friend of yours bought a small apartment building for $100,000 in a college town. She spent $10,000 of her own money for the building and obtained a mortgage from a local bank for the remaining $90,000. The annual mortgage payment to the bank is $10,500. Your friend also expects that annual maintenance on the building and grounds will be $15,000. There are four apartments (two bedrooms each) in the building that can each be rented for $360 per month.
From the seven-step engineering economic analysis procedure, answer the following questions: a. Does your friend have a problem? If so, what is it? b. What are her alternatives? (Identify at least three.) c. Estimate the economic consequences and other required data for the alternatives in Part (b). d. Select a criterion for discriminating among alternatives, and use it to advise your friend on which course of action to pursue. e. Attempt to analyze and compare the alternatives in view of at least one criterion in addition to cost. f. What should your friend do based on the information you and she have generated?

Solution a. A quick set of calculations shows that your friend does indeed have a problem. A lot more money is being spent by your friend each year ($10,500+$15,000 = $25,500) than is being received (4 x $360 x 12 = $17,280). The problem could be that the monthly rent is too low. She's losing $8,220 per year. (Now, that's a problem!) b. Option (1). Raise the rent. (Will the market bear an increase?)
Option (2). Lower maintenance expenses (but not so far as to cause safety problems). Option (3). Sell the apartment building. (What about a loss?)
Option (4). Abandon the building (bad for your friend's reputation). c. Option (1). Raise total monthly rent to $1,440 + $R for the four apartments to cover monthly expenses of $2,125 and the interest that could be earned on $10,000 if your friend had invested it elsewhere. Note that the minimum increase in rent would be ($2,125 – $1,440)/4 = $171.25 per apartment per month (almost a 50% increase!). And this figure doesn't include the interest she could have been earning on the $10,000.
Option (2). Lower monthly expenses to $2,125 – $C so that these expenses and the interest earning ability of $10,000 is covered by the monthly revenue of $1,440 per month. This would have to be accomplished primarily by lowering the maintenance cost. (There's not much to be done about the annual mortgage cost unless a favorable refinancing opportunity presents itself.) If she could have earned just 0.25% per month on the $10,000 (which comes to $25 per month in interest), monthly maintenance expenses would have to be reduced to ($15,000-$8,220)/12 – $25) = $540. This represents more than a 50% decrease in maintenance expenses.
Option (3). Try to sell the apartment building for $X, which recovers the original $10,000 investment and (ideally) recovers the $685 per month loss ($8,220 =12) on the venture during the time it was owned. It would also be wonderful to recover the lost interest that could have been earned on the $10,000.
Option (4). Walk away from the venture and kiss your investment good-bye. The bank would likely assume possession through foreclosure and may try to collect fees from your friend. This option would also be very bad for your friend's credit rating.

d. One criterion could be to minimize the expected loss of money. In this case, you might advise your friend to pursue option (2) or (3). e. For example, let's use "credit worthiness" as an additional criterion. Option (4) is immediately ruled out. Exercising option (3) could also harm your friend's credit rating. Thus, options (1) and (2) may be her only realistic and acceptable alternatives. f. Your friend should probably do a market analysis of comparable housing in the area to see if the rent could be raised (option 1). Maybe a fresh coat of paint and new carpeting would make the apartments more appealing to prospective renters. If so, the rent can probably be raised while keeping 100% occupancy of the four apartments.

Stan Moneymaker: Personal Interest Problem
Stan Moneymaker prides himself on how much money he can save by being frugal. Today Stan needs 15 gallons of gasoline to top off his automobile's gas tank. If he drives eight miles (round trip) to a gas station on the outskirts of town, Stan can save $0.10 per gallon on the price of gasoline. Suppose gasoline costs $2.00 per gallon and Stan's car gets 25 miles per gallon for in-town driving. Should Stan make the trip to get less expensive gasoline? What other factors (cost and otherwise) should Stan consider in his decision making?

Solution * Savings = 15 gallons x $0.10/gallon = $1.50 for the trip. * The cost of gasoline only for the trip is (8 miles ÷ 25 miles per gallon)($2.00 per gallon) = $0.64 * If basing only on the cost of gasoline incurred versus the savings generated, Stan should make the trip. * However as an engineer, we know that other indirect driving costs exist, such as insurance, maintenance, and depreciation. We can also factor in the value of his time and the risk involved in driving additional 8 miles. In end, both qualitative and quantitative factors must be factored in when making decisions.