Chapter 1 - Introduction

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Economic decisions
Everyday life:
How to nance your university education? Borrow a loan? You plan to purchase a house in the next 5 years. Starting from this month, how much do you need to save each month to make a down payment of 10% for a house that is estimated to be 1M? Plan for a higher down payment? Any advantage in mortgage payments?

Engineering problems:
Replace the current equipment with a new and more efcient one? How about the initial purchasing expense, annual maintenance costs? Make in-house or outsource? How to design a part to reduce the labor hours required for production?

Overall goal: To achieve the most benet with limited resources. Often involves trade-offs: cost versus quality, response time versus cost, etc.
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Example 1.1

You have borrowed a loan of $5,000 and you face two options for paying it back: You can pay half of the loan principal as a lump-sum at the end of four years and the other half at the end of eight years. You incur an interest rate of 8% per year and pay the interest charges monthly. You pay the principal and interest with equal monthly payments over 6 years at an interest rate of 10% per year. Which option should you choose? In the later part of this course, you will be provided some hints to help you to your decision.

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What is engineering economy?

Engineering economy involves the systematic evaluation of the economic merits of proposed solutions to engineering problems. To be economically acceptable (i.e., affordable), solutions to engineering problems must demonstrate a positive balance of long-term benets over long-term costs. The mission of engineering economy is to balance different types of costs and the performance (response time, safety, reliability, etc.) in the most economical manner.

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Principles of engineering economy

Principle 1: Develop the alternatives

The alternatives need to be identied and then dened for subsequent analysis. Since the choice (decision) is among alternatives, developing and dening the comprehensive list of alternatives for detailed evaluation is important. Creativity and innovation are essential.

Principle 2: 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. Outcomes that are common to all alternatives can be disregarded in the process of comparison and decision.

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Principles of engineering economy

Principle 3: Use a consistent viewpoint
The prospective outcomes of the alternatives, selection of the criteria and other, should be consistently developed from a dened viewpoint (perspective). Usually, the viewpoint of the decision maker would be used. For example, the perspective of the employees is used for the problem of designing the employee benet package.

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 simplify the analysis of the alternatives. For economic outcomes, a monetary unit such as "dollars" is the common unit of measure. If the outcomes cannot be quantied, describe these consequences explicitly so that the information is useful to the decision maker in the comparison of the alternatives.

Principle 5: Consider all relevant criteria

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Principles of engineering economy

Principle 6: Make uncertainty explicit

Risk and uncertainly are inherent in estimating the future outcomes of the alternatives and should be recognized in the analysis and comparison.

Principle 7: Revisit your decisions

Improved decision making results from an adaptive process. The initial projected outcomes of the selected alternative should be subsequently compared with the actual results achieved.

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Engineering economic analysis - procedure

1 2 3

Problem recognition, formulation, and evaluation. Development of the feasible alternatives. (Principle 1) Development of the outcomes and cash ows for each alternative. (Principles 2, 3 and 4) Selection of a criterion (or criteria). (Principles 3 and 5) Analysis and comparison of the alternatives. (Principle 5) Selection of the preferred alternative. (Principle 6) Performance monitoring and post-evaluation of results. (Principle 7)

4 5 6 7

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Example 1.2

While studying for the Engineering Economy exam, you and two friends nd yourself craving for a pizza. Having it delivered is the only option since you are busy. "Pick-Up-Sticks" offers a 1-1/4-inch-thick, 20-inch square pizza with two toppings for $15+5% sales tax+$1.5 delivery charge. "Freds" offers a 1-3/4-inch-thick round pizza with 20-inch diameter and two toppings for $17.25+5% sales tax. Applying the seven-step procedure.

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Step 1 - Dene the Problem

You and your friends are hungry and want a pizza to satisfy your hunger. "Hunger satisfaction with a pizza".

Step 2 - Develop Alternatives (Principle 1)

Alternative A: Order a pizza from "Pick-Up Sticks" Alternative B: Order a pizza from "Freds"

Step 3 - Outcomes and cash ows for each alternative

The outcomes should be developed from the consistent viewpoint: You and your friends perspective. (Principle 3) Compare the differences between Alternatives A and B. (Principle 2)
Alternative A and Alternative B have the common outcomes of two toppings, so the number of topping is irrelevant for decision making. Alternative A varies from B in the aspects of the size of the pizza, total cash ow and may also delivery time.

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Step 3 - Outcomes and cash ows for each alternative (Contd)

Common unit of measure: Dollars or cost per unit volumne. (Principle 4)
Alternative A: Cash outow = 15 + 15 5% + 1.5 = $17.25 for a 1-1/4-inch-thick, 20-inch square pizza. Alternative B: Cash outow = 17.25 + 17.25 5% = $18.11 for a 1-3/4-inch-thick, 20-inch diameter circular pizza.

Step 4 - Selection of criteria It is important to use consistent viewpoint (Principle 3) to dene the selection criteria. Criteria: (Principle 5)
Cost per unit volume Variety and quality of toppings Delivery time Customer service
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Step 5 - Analysis and comparison of the alternatives (Principle 5) Alternative A: Cost per unit volume = $0.035 per in3 . Alternative B: Cost per unit volume = $0.033 per in3 . Further information is required to compare both alternatives under the other criteria. Step 6 - Selection of best alternative When performing this step, the uncertainly and risk should be stated explicitly (Principle 6). Uncertainties which relevant to the decision includes
Quality Delivery time

Based on the criteria of the smallest cost per unit volume, Alternative B is the best choice. Step 7 - Performance monitoring and post-evaluation of results (Principle 7)
Tasted good? On-time delivery?
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