CE 314 Engineering Economy. Chapter 1. Foundations of Engineering Economy. Why is the study of Engineering Economy important to Engineers?

Transcription

1 CE 314 Engineering Economy Chapter 1 Foundations of Engineering Economy Why is the study of Engineering Economy important to Engineers? Engineers are called upon to analyze and select the most economical alternative among several design alternatives. Engineers often play a major role in investment decisions based on the analysis and design of new products or processes. Decisions made by the engineer during the engineering phase of a product s development determine the majority of the costs of manufacturing the product. 1

2 What is Engineering Economy? Two Definitions: Engineering Economy is a collection of mathematical techniques that simplify economic comparisons. Engineering Economy involves formulating, estimating, and evaluating the economic outcomes when alternatives to accomplish a defined purpose are available. An Engineering Economic Decision A local Manufacturing Firm produces crankshafts. They have been using a lathe that was purchased twelve years ago. As the production engineer in charge of producing the crankshafts, you expect demand to continue into the foreseeable future. Over the past two years the lathe has broken frequently and has now stopped operating altogether. You must now decide to repair the lathe or purchase a new lathe or if a more efficient lathe will be available in the future you may wait to buy the new lathe in a couple of years. The economic decision is whether you should make the considerable investment in a new lathe now or later. Complicating the decision is the fact that the demand for crankshafts has begun to decline. 2

3 What do we need to know to make a decision? We basically have two alternatives: 1) Repair the existing lathe 2) Purchase a new lathe now or later For the existing lathe we need to know: The cost of repairing the lathe. Frequency or Probability of break down of the lathe. Time when the lathe becomes obsolete. Estimate the future demand for the crankshafts. Estimate the salvage value or cost to remove the old lathe. For the new lathe we need to know: The cost of the new lathe including installation. The cost of educating the operator to use the new lathe. How often will the lathe require repairs and how much will cost? The estimated economic and service life of the new lathe. The estimated salvage value of the new lathe. Are there any additional operational costs to the new lathe over the old lathe? Will the operational costs increase as the new lathe ages? If so how much will they increase over the years? Will the new lathe produce more crankshafts to increase income? What are the tax implications of purchasing the new lathe? Will the new lathe enhance or lower employee morale? What are the financing costs of purchasing the new lathe? 3

4 Many of these questions may be difficult to answer! That is why Engineers make the big bucs! (pun intended) My suggestion is to purchase an ACME 3000 crystal ball or to hire a personal Psychic. Or you can call the McGinnis Psychic hotline at GETREAL. (if no one answers it is just a joke) Bottom Line: Your analysis is only as good as your estimated variables! Good News for you: At this point in your career you are only learning the techniques for making economic comparisons. The data will be given to you for you to learn how to make economic analyses. Economic Decision-Making Process 1) Collect relevant information regarding the project: Initial Costs: Design, Manufacturing, Marketing, Testing, Installation, Construction, Taxes, Down payments, etc. Annual Costs: Operating, Maintenance, Finance Payments, Insurance, Income Taxes, etc. Periodic Costs: Overhauls, Improvements and Modifications. Annual Receipts: Income generated and Savings due to increased Productivity. Salvage Value: Income generated by sale or cost to remove obsolete equipment. Financing Method and Interest Rate. 4

5 Economic Decision-Making Process 2) Recognize and Define Feasible Alternatives: Consider all possible options including the DO NOTHING alternative. The generated alternatives may not be economically viable. Examine each alternative and remove any overlapping options. If the productivity is the about the same for each alternative, focus only on the costs. 3) Consider the future consequences of each alternative: Look at environmental impacts, effects on employee productivity, marketing potential, public relations, etc. 4) Determine whose viewpoint is to be selected when evaluating alternatives: Private vs. Governmental viewpoint. Very important when the public sector is involved. Economic Decision-Making Process 5) The consequences of each alternative must be expressed in monetary units for us dollars : You must consider the time value of money. It is sometimes very difficult to put a monetary value on a consequence. 6) When comparing alternatives, focus on the differences between the alternatives: The past is common to all alternatives: look towards the future when comparing alternatives. There can be no consequences before the moment of decision. 7) Develop several criteria to be used in evaluating the alternatives: Primary criterion: Economic analysis of alternatives based on a Minimum Attractive Rate of Return (MARR) value. Secondary criterion: Look at intangibles and side-effects. 5

6 Economic Decision-Making Process 8) Evaluate each alternative, using a sensitivity analysis to enhance the evaluation: Evaluation methods include: Present Worth (PW), Annual Worth (AW), Future Worth (FW), Rate of Return (ROR), Capitalized Cost (CC), Benefit/Cost Ratio (B/C) and Payback Period Analysis using a Minimum Attractive Rate of Return (MARR). 9) Select the best alternative based on the economic analysis while remembering the secondary criterion. Time Value of Money Concept: Money can make money if Invested Money made depends on the interest rate The change in the amount of money over a given time period is called the time value of money; by far, the most important concept in engineering economy 6

7 Interest Rates Interest: Money paid for the use of money Investment: INTEREST = CURRENT VALUE - ORIGINAL AMOUNT Loan: INTEREST = CURRENT TOTAL OWED - ORIGINAL AMOUNT The original amount of the loan is called the Principal. Interest Rate - Interest paid per unit time. INTEREST PAID PER TIME UNIT INTEREST RATE = ORIGINAL AMOUNT The interest rate is expressed as a percentage. Remember: Interest can be viewed from two perspectives: Lending situation Investing situation 7

8 Rate of Return (ROR) - Interest accumulated per unit time. INTEREST ACCRUED PER TIME UNIT RATE OF RETURN = ORIGINAL AMOUNT The rate of return is expressed as a percentage. Economic Equivalence Two sums of money at two different points in time can be made economically equivalent if: We consider an interest rate and, The number of time periods between the two sums Equality in terms of Economic Value $15,000 now is economically equivalent to $16,500 one year from now IF the interest rate is 10%/year. 8

9 Economic Equivalence Cash Flow Diagram: $16,500 10% Per Year 1 Year $15,000 Interest Paid = Principal (Interest Rate) Interest Paid = $15,000 (0.10) = $1,500 Amount After one Year = Principal + Interest Amount After one Year = $15,000 + $1,500 = $16,500 Simple and Compound Interest Two types of interest calculations Simple Interest Compound Interest Compound Interest is more common worldwide and applies to most analysis situations. Although some institutions do pay simple interest on savings accounts and most bonds pay simple interest. 9

10 Simple Interest Calculated on the principal amount only Easy to calculate The formula for Simple Interest is: I = (Principal)(Number of Time Periods)(Interest Rate) I = (P)(n)(i) Compound Interest Calculated on the principal amount plus the total amount of interest accumulated in previous periods. Compound Interest can be computed using the formula for Simple Interest: Interest = (Principal + All Accrued Interest)(Interest Rate) 10

11 Example: An individual borrows $18,000 at an interest rate of 7% per year to be paid back in a lump sum payment at the end of 4 years. Compute the total amount of interest charged over the 4-year period using the simple interest and compound interest formulas. Compute the total amount owed after 4 years using simple and compound interest. Terminology and Symbols: P represents the value or amount of money at a time designated as the present or time t=0 on the cash flow diagram. P is also referred to as present worth (PW), present value (PV), net present value (NPV), discounted cash flow (DCF), and capitalized cost (CC) in dollars. F represents the value or amount of money at some future time on the cash flow diagram. F is also called future worth (FW) and future value (FV) in dollars. 11

12 Terminology and Symbols: A represents a series of consecutive, equal, endof-time-period amounts of money. A is also called the annual worth (AW) and equivalent uniform annual worth (EUAW) in dollars per year, dollars per month, etc. n represents the number of interest periods in years, months, days, etc. i represents the interest rate or rate of return per time period in percent per year, percent per month, etc. t represents time stated in years, months, days, etc. 12