AAIT

SCHOOL OF CIVIL AND ENVIRONMENTAL

ENGINEERING

Chapter : One
Basic Concepts of Engineering Economics

March 2023
CONTENT
 Basic
concepts of Engineering
Economics
 Introduction

 Engineering economics decisions

 Information for decision making

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 INTRODUCTION
o The process of producing goods and services requires the use of resources
such as labor, raw materials, capital, equipment, machines, etc.

o Economics deals with a certain problem faced by all societies i.e., the
problem of Scarcity.

o Economics is the study of how countries (macroeconomics) and individuals

(microeconomics) make decisions to allocate limited resources.

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 INTRODUCTION
 Trade-off: because of scarcity, producing more of one good or service
means producing less of another good or service.

 Trade-offs force society to make choices.

 Trade-offs forces engineers to make choices, particularly when

answering the following fundamental questions:
 Which engineering projects are worthwhile?

 Which engineering projects should have a higher priority?

 How should the engineering project be designed?

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 INTRODUCTION
 Law of demand: The rule that, holding everything else constant,
when the price of a product falls, the quantity demanded of the
product will increase, and when the price of a product rises, the
quantity demanded of the product will decrease.

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 INTRODUCTION

 Law of supply: The rule that, holding everything else constant,

increases in price cause increases in the quantity supplied, and
decreases in price cause decreases in the quantity supplied.

A rise in the price of an

energy bar, other things
remaining the same,
brings an increase in
the quantity supplied.

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 INTRODUCTION
 Market equilibrium: A situation in which quantity demanded equals
quantity supplied.

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 INTRODUCTION

 The Accreditation
Board for Engineering and
Technology (ABET) defines Engineering as:
“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”

 Economy is an important qualifier in the definition of

engineering.

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INTRODUCTION

 Engineering Economics is the application of economic

techniques to engineering decisions.

 Engineering economy is a collection of techniques that

simplify comparisons of alternatives on an economic
basis.
 A successfully engineered solution is one that not only works
from a technical perspective, but also from an economic one.

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ENGINEERING ECONOMICS DECISIONS

Recognize a decision problem • Need a car

Define the goals or objectives • Want mechanical security

and lower cost
Collect all the relevant • Gather technical as well as
information financial data
Identify a set of feasible • Choose between Saturn and
decision alternatives Honda
Select the decision criteria to • Want minimum total cash
use outlay
Select the best alternative • Select Honda
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FINANCIAL DATA REQUIRED TO MAKE AN ECONOMIC
DECISION

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 ENGINEERING ECONOMICS DECISIONS
FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS

 Principle 1: A nearby dollar is worth more than a distant

dollar
 Principle 2: All it counts is the differences among alternatives
 Principle 3: Marginal revenue must exceed marginal cost
 Principle 4: Additional risk is not taken without the expected
additional return

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ENGINEERING ECONOMICS DECISIONS
PRINCIPLE 1: A nearby dollar is worth more than a distant
dollar
 A fundamental concept in engineering economics is that money
has a time value associated with it.
 Money has a time value?---Reading Assignment

 It is better to receive money earlier than later.

•This concept will be the
basic foundation for all
engineering project
evaluation.

Today 6-month later 13

ENGINEERING ECONOMICS DECISIONS

Time Value of Money

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 ENGINEERING ECONOMICS DECISIONS
PRINCIPLE 2:
All that counts are the differences among alternatives.
 An economic decision should be based on the differences among the
alternatives considered.
 All that is common is irrelevant to the decision.

Cash Outlay Salvage

Monthly Monthly at Signing Monthly Value at the
Option Fuel Cost Maintenance Payment End of Year 3

Buy $960 $550 $6,500 $350 $9,000

Lease $960 $550 $2,400 $550 0

Irrelevant items in
decision making

Differential difference in total cost that results from

(Incremental)Analysis: selecting one alternative instead 15
of the
ENGINEERING ECONOMICS DECISIONS
PRINCIPLE 3:
Marginal Revenue must exceed Marginal Cost.

 Marginal revenue means the additional revenue made possible by

increasing the activity by one unit.

 Marginal cost is the additional cost incurred by increasing activity by

one unit

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ENGINEERING ECONOMICS DECISIONS
Marginal
Cost
Manufacturing Cost
1 Unit

Sales Revenue Marginal

1 Unit Revenue

Cost of Goods Sold $2 per

unit

Gross Revenue $4 per unit

Marginal ensures that

Analysis: Marginal Revenue>Marginal Cost
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ENGINEERING ECONOMICS DECISIONS
PRINCIPLE 4:
Additional Risk is not taken without the Expected Additional Return.
• Investors demand a minimum return that must be greater than the
anticipated rate of inflation or any perceived risk.
• Expected returns from bonds and stocks are normally higher than the
expected return from a savings account.

Investment Class Potential Risk Expected Return

Savings account (Cash) Low/None 1.5%

Bond (Debt) Moderate 4.8%

Stock (Equity) High 11.5%

Risk and Return Trade

Off 18
 INFORMATION FOR DECISION MAKING

 Classification of cost:

RELEVANT TO PREDICTING COST FINANCIAL

DECISION-MAKING BEHAVIOR STATEMENTS

- Differential costs - Fixed cost - Balance

- Marginal costs - Variable cost statement
- Sunk costs - Income
- Opportunity statement
costs - Cash flow
statement

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 INFORMATION FOR DECISION MAKING
CLASSIFICATION OF COST RELEVANT TO DECISION-MAKING
• Differential cost: Difference in costs between any two alternatives.
• Differential revenue: Difference in revenues between any two
alternatives.

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 INFORMATION FOR DECISION MAKING
CLASSIFICATION OF COST RELEVANT TO DECISION-MAKING

• Marginal costs: Is the variable for one more unit.

• Sunk costs: is the money already spent as a result of past

decision.
• Disregarded in economic analysis because current decisions cannot change
the past (Not relevant for future decisions.)

• Opportunity costs: The potential benefit or income that is given

up if alternative course of action is chosen.

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 INFORMATION FOR DECISION MAKING
CLASSIFICATION OF COST RELEVANT TO DECISION-MAKING

 Opportunity costs:
 Could also be considered as a forgone opportunity cost: because we
are giving up the benefit that could have been realized.
Example: Choosing to use a resource for one activity we are giving
up the opportunity of using the same resource at that time in some
other activity.
“what we give up” from “the road not taken.”

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INFORMATION FOR DECISION MAKING
CLASSIFICATION FOR PREDICATING COST BEHAVIORS
 Fixed Cost: The costs of providing a company’s basic operating capacity.
Cost behavior: Remain constant over the time though volume may change.
 Is constant or unchanging regardless of the level of output or activity.

Example: Annual insurance premium, property tax, and license fee, building rents,
depreciation of buildings, salaries of administrative and production personnel.

 Variable Cost: vary depending on the level of production or sales.

Cost behavior: Increase or decrease according to the level of volume change.
Example:payroll taxes, sales tax, and supplies. Fuel consumption is directly related
to miles driven.

 Average Unit Cost: activity cost on a per unit basis.

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INFORMATION FOR DECISION MAKING

FINANCIAL STATEMENTS

Balance
sheet Income
statement

Statement of
cash flows
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INFORMATION FOR DECISION MAKING
FINANCIAL STATEMENT
 What would one want to know about the company at the end of the fiscal
year?

- What is the company’s financial position at

Balance sheet statement
the end of the reporting period?

- How much profit was made during the

Income statement
reporting period?

- How much cash was generated & spent? Statement of cash flow

Statement of retained
- Where was the profit used?
earning
 Note: Fiscal year/Operation cycle: can be any 12 month term, but usually from
Jan 1-Decem 31 of a calendar year.

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INFORMATION FOR DECISION MAKING
1. BALANCE SHEET
“….where one stands financially…”
 It lists the assets, liabilities, and equity of a business entity on a
specified date.
 Makes use of the “Accounting Equation”- The equality between the
assets and the claims against the assets is always maintained.
Asset = Liability + Equity

 Resources are balanced by the source of funding, hence the

name ‘Balanced Sheet’.

 These three balance sheet segments give investors an idea as

to what the company owns and owes, as well as the amount
invested by shareholders.
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 INFORMATION FOR DECISION MAKING
BALANCE SHEET STATEMENT
1. Asset: how much the company owns at the time of reporting.
 Based on liquidity and the time required to convert into cash asset is
divided into current assets and long term asset .
a. Current Asset: can be converted into cash in less than one year.
 Cash and its equivalent: short-term certificates of deposit, as well as hard
currency.
 Account receivable: money which customers owe the company (Owned
but not received yet)
 Inventories: investment on raw material, work-in-progress, goods available
for sale.
 Prepaid expenses: representing value that has already been paid for, such
as insurance, rent…
b. Long Term Asset: relatively permanent and take time to converted into cash.
 Fixed assets: these include land, machinery, equipment, buildings and other
durable, generally capital-intensive assets
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 INFORMATION FOR DECISION MAKING
BALANCE SHEET STATEMENT
2. Liability: money that a company owes to outside parties, from bills
it has to pay to suppliers to utilities and salaries.
a. Current liability: that is due within one year and are listed in order
of their due date.
 Short term debt
 Interest payable
 Wages payable
 Dividends payable and other

b. Long-term liability: money the company owes and is due at any

point after one year.
 Long-term debt

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INFORMATION FOR DECISION MAKING
BALANCE SHEET STATEMENT
3. Owners’/ Shareholders‘/ Stockholder Equity: portion of the
assets of a company which are provided by the investors
(owners). It is the liabilities of the company to the owner.
 Retained earnings: are the net earnings a company either
reinvests in the business or uses to pay off debt; the rest is
distributed to shareholders in the form of dividends.

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INFORMATION FOR DECISION MAKING
BALANCE SHEET STATEMENT

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 INFORMATION FOR DECISION MAKING
INCOME STATEMENT/ PROFIT AND LOSS STATEMENT

 It is a financial statement that reports a company's financial

performance over a specific accounting period.

 Summarizes the revenue and expenses over the month, quarter, or

year.

 Unlike the balance sheet, which covers one moment in time, the
income statement provides performance information about a time
period.

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INCOME STATEMENT/ PROFIT AND LOSS STATEMENT
 Income statement itemizes :
 Revenues: prices for sold goods or services during the
accounting period.
 Net sales: Gross sales minus sales returned and allowances
 Production Costs = Cost of revenue
 Gross margin = Net Sales – Cost of revenue
 Operating Income = Gross margin- { cost of capital, lease,
admin, expense etc}
 Gross Profit or Income before income tax: operating
income + other incomes.
 Net Profit = Gross profit – Income tax.
 Earnings per Share (EPS) = net income/number of shares
 Retained earnings: This is money which is retained from
the net profit to be used for expansion purposes or saved as
security for risks.
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 INFORMATION FOR DECISION MAKING
RELATIONSHIP BETWEEN BALANCE SHEET AND INCOME
STATEMENT

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INFORMATION FOR DECISION MAKING
CASH FLOW STATEMENT
 It is a financial report that provides aggregate data regarding all cash
inflows a company receives as well as all cash outflows during a given
quarter. (cash inflows: ongoing operations and external investment sources;
cash outflows: payment for business activities and investments during a
given quarter.)
 It includes cash flows from operations, investment, and financing.
 The operating cash flows represents all cash flows related to the
production and sales of goods and services. Including accounts payable,
depreciation.
 Cash flows from investing activities includes cash spent on property,
plant and equipment. E.g purchase of new fixed assets (outflow),
reselling an old equipment (inflow)
 Cash flows from financing is the section that provides an overview of
cash used in business financing. E.g Purchasing Stocks (outflow), Selling
Stocks (inflow), Paying loans (outflow)
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QUESTIONS ?
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