(Topics in Safety, Risk, Reliability and Quality, 39) Teddy Steven Cotter - Engineering Managerial Economic Decision and Risk Analysis_ Economic Decision-Making and Risk Analysis-Springer (2021)

Topics in Safety, Risk, Reliability and Quality
Teddy Steven Cotter
Engineering
Managerial
Economic Decision
and Risk Analysis
Economic Decision-Making and Risk
Analysis
Volume 39
Series Editor
Adrian V. Gheorghe, Old Dominion University, Norfolk, VA, USA
Advisory Editors
Hirokazu Tatano, Kyoto University, Kyoto, Japan
Enrico Zio, Ecole Centrale Paris, France, Politecnico di Milano, Milan, Italy
Andres Sousa-Poza, Old Dominion University, Norfolk, VA, USA
More information about this series at https://link.springer.com/bookseries/6653
Teddy Steven Cotter
Engineering Managerial
Economic Decision and Risk
Analysis
Economic Decision-Making and Risk
Analysis
Teddy Steven Cotter
Department of Engineering Management &
Systems Engineering
Old Dominion University
Norfolk, VA, USA
ISSN 1566-0443 ISSN 2215-0285 (electronic)

ISBN 978-3-030-87766-8 ISBN 978-3-030-87767-5 (eBook)
https://doi.org/10.1007/978-3-030-87767-5
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Preface
This is not another book on engineering economics. Rather, this book is directed
to the engineering manager or the undergraduate student preparing to become an
engineering manager, who is, or will become, actively engaged in the management
of economic risk trade-off decisions for engineering investments within an organi-
zational system. In today’s global economy, this may mean managing the economic
risks of engineering investments across national boundaries in international orga-
nizations, government, or service organizations. As such, this is an applied book.
The book’s goal is to provide an easy-to-understand, up-to-date, and coherent treat-
ment of the management of the economic risk trade-offs of engineering invest-
ments. This book accomplishes this goal by cumulatively sequencing knowledge
content from foundational economic and accounting concepts to cost estimating to
the traditional engineering economics knowledge culminating in fundamental engi-
neering managerial economic decision making incorporating risk into engineering
management economic decisions.
From years of working in industry and teaching an introductory engineering
economics course, the author found that most practicing engineering managers and
students preparing for careers in engineering have little or no prior coursework or
training in accounting, micro- or business economics, finance, or cost estimation
from the engineering perspective. Accordingly, this book places these preparatory
subjects in the first four chapters of Part 1, Economic Context of Engineering Manage-
ment Decisions, so that when the student reaches fundamental engineering economic
concepts in Part 2, he or she understands cash flow accounting and the economic and
financial framework within which he or she must operate in organizational settings.
Next, this book presents the fundamentals of engineering managerial economic anal-
ysis in Part 2, Economic Analysis of Engineering Activities and Projects. Finally,
this book synthesizes engineering managerial economics into engineering manage-
rial decision and risk analysis in Part 3, Managing Engineering Investments, by tying
together prior concepts for the selection of risk-adjusted minimum attractive rate of
return, capital budgeting decisions, and benefit–cost decisions in public and regu-
lated sectors. The book culminates with making engineering economic managerial
investment risk decisions for uncertain future cash flows. The final chapter sets forth
v
vi Preface
probability and statistics fundamentals necessary to model future variable cash flows
and applies those fundamentals in sensitivity analysis and simulation modeling.
Features of This Book
Key design features of this book include:

1. The logical sequencing of engineering managerial economic knowledge from
preparatory background to engineering economics fundamentals to engineering
managerial economic decision and risk analysis of variable future cash flows.
2. A structured problem-solving approach is illustrated in manual solutions and
corresponding spreadsheet solutions. The manual solutions illustrate funda-
mental engineering managerial economic decision and risk analysis theory and
principles, and the corresponding spreadsheet solutions illustrate application in
practice.
3. A cash flow accounting approach is taken throughout to engineering manage-
rial economic analysis. Accrual accounting is introduced in chapter two and
contrasted to cash flow accounting where appropriate throughout the book, so
the engineering manager or student understands the relationship between the
two.
4. Microsoft Excel® cash flow examples are included throughout the book to
introduce the engineering manager or student to the use of spreadsheets in the
analysis of the economics risk decisions in the management of engineering
functions and projects. These examples may be used as templates to set up
actual engineering managerial economic spreadsheet analyses.
5. A mix of private enterprise and public or regulated sectors example problems to
provide the student with a robust exposure to engineering managerial economic
problems.
6. Comprehensive coverage appropriate for the engineering manager performing
or the student seeking to learn to perform engineering managerial economic
analyses including:
• Economic analyses with or without considering the time value of money.
General and cost accounting, cost estimation, and economic value-added
concepts.
• Planning horizons.
• Budgeting and the use of economic ratios.
• Economic criteria metrics including present worth, equivalent uniform
annual worth, future worth, internal rate of return, external rate of return,
benefit–cost analyses, and cost-effectiveness. Other metrics such as undis-
counted and discounted payback are also discussed.
• Historical and IRS Publication 946 MACRS depreciation methods and their
effects on cash flow accounting and economic criteria.
Preface vii
• Inflation-adjusted cash flows, indexes, and inflationary effects on before and

after-tax economic metrics.
• Challenger–defender and graphical incremental analyses to select the best
mutually exclusive alternative.
• Opportunity cost after-tax replacement analyses, optimal replacement
interval, and Section 1031 like-kind property exchanges.
• Cost of capital MARR determination.
• Capital budgeting engineering managerial decisions.
• Public and regulated sector economic analyses using benefit–cost analyses.
• Introduction to economic decision risk analysis and management of engi-
neering economic activities and projects including fundamentals of prob-
ability, structuring decisions, sensitivity analysis, and an introduction to
simulation.
• End-of-chapter problems to facilitate self-study as well as homework
assignments. Answers to problems are provided in a separate solution
manual.
Course Coverage
This book is designed for two types of students and for any type of class. First is the
student interested in preparing for the fundamentals of engineering examination. A
course for this student may be taught as a traditional engineering economics course
with material from the following chapters.
• Chapter 2, General Accounting and Finance Fundamentals.
• Chapter 4, Cost Estimating Fundamentals.
• Chapter 5, Time Value of Money.
• Chapter 6, Measures of Investment Worth.
• Chapter 7, Depreciation Effects on Investment Worth.
• Chapter 9, Inflation Effects on Engineering Investments.
• Chapter 10, Incremental Analysis.
• Chapter 15, Introduction to Management Economic Decision Theory and Risk
Analysis (with introductory probability and statistics).
Studying these chapters along with working solutions to the associated chapter
problems will prepare the student for the economics portion of the fundamentals of
engineering examination. The second type of student is the one who seeks proficiency
in engineering managerial economics as a practicing engineering manager. A course
for this student should sequentially follow the design of the book from Chap. 1
through 15.
The book and supporting lectures, homework, and homework solution manual
are designed for use in a traditional classroom lecture setting, in a blended online-
classroom setting, or as a self-contained, online asynchronous learning package. In
the traditional classroom lecture setting, this book may be used as a stand-alone
viii Preface
hardcopy or electronic book. In the blended online-classroom setting, the instructor

has multiple options: (1) hardcopy book with chapters, example problems, home-
work problems, and examinations integrated into a learning management system;
(2) electronic book with student tutorials and self-tests integrated into a learning
management system along with homework solutions and examinations to support
the traditional classroom lectures; and (3) self-contained online learning package
with integrated electronic book, student tutorials, homework assignments and solu-
tions, and examinations for use by distant learning students or supporting traditional
classroom discussions. Instructor lecture notes, Microsoft PowerPoint® or Adobe
PDF® slides, question and problem solutions along with Microsoft Excel® work-
book solutions and templates, and test questions may be downloaded from an online
source.
Norfolk, VA, USA Teddy Steven Cotter, Ph.D.

Contents
Part I Economic Context of Engineering Management Decision

1 Managerial Economics of Engineering Organizations . . . . . . . . . . . . . 3
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Engineering and Engineering Management . . . . . . . . . . . . . . . . . . 4
1.3 Types of Business Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.4 Engineering Economic Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.5 Engineering Economic Principles . . . . . . . . . . . . . . . . . . . . . . . . . . 15
1.6 Engineering Life Cycle Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1.7 Engineering Life Cycle Cost Management . . . . . . . . . . . . . . . . . . 23
1.8 Budgeting for Engineering Operations and Projects . . . . . . . . . . 27
1.9 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
1.10 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
2 General Accounting and Finance Fundamentals . . . . . . . . . . . . . . . . . 37
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
2.2 Sources of Operations Financing . . . . . . . . . . . . . . . . . . . . . . . . . . 38
2.3 The Role of Accounting in the Organization . . . . . . . . . . . . . . . . . 39
2.4 The Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
2.5 The Income Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
2.6 The Retained Earnings Statement . . . . . . . . . . . . . . . . . . . . . . . . . . 48
2.7 The Cash Flow Income Statement . . . . . . . . . . . . . . . . . . . . . . . . . 49
2.8 Financial Ratios Important to Engineering Managerial
Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
2.9 Financial Ratios—Measuring Organizational Health
and Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
2.9.1 Liquidity Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
2.9.2 Asset Management Ratios . . . . . . . . . . . . . . . . . . . . . . . . 54
2.9.3 Debt Management Ratios . . . . . . . . . . . . . . . . . . . . . . . . . 55
2.9.4 Profitability Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
2.9.5 Market Value Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
2.10 Integrated Ratio Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
ix
x Contents
2.11 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
2.12 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
3 Cost Accounting Fundamentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
3.2 Cost Terms and Purposes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
3.3 Cost Accounting in the Organization . . . . . . . . . . . . . . . . . . . . . . . 73
3.4 Cost Accounting—Material and Component Analysis . . . . . . . . 75
3.5 Cost Accounting—Labor Analysis . . . . . . . . . . . . . . . . . . . . . . . . . 77
3.6 Cost Accounting—Overhead Cost Allocation . . . . . . . . . . . . . . . 83
3.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
3.8 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
4 Cost Estimating Fundamentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.2 Cost Estimating Accuracy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
4.3 Cost Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
4.4 Cost Estimating Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
4.5 Product Costing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
4.6 Operation Costing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
4.7 Cost Estimating Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
4.8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
4.9 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Part II Economic Analysis of Engineering Activities and Projects

5 Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
5.1 Interest Equivalence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
5.2 Cash Flow Transactions with Interest . . . . . . . . . . . . . . . . . . . . . . . 133
5.3 Cash Flow Income Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
5.4 Single Payment Discrete Cash Flow Compounding . . . . . . . . . . . 135
5.5 Four Methods of Debt Repayment . . . . . . . . . . . . . . . . . . . . . . . . . 142
5.5.1 Payment Series Discrete Cash Flow
Compounding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
5.6 Compounding Periods and Payment Periods Differ . . . . . . . . . . . 157
5.7 Nominal and Effective Interest Rates . . . . . . . . . . . . . . . . . . . . . . . 158
5.8 Continuous Cash Flow Compounding . . . . . . . . . . . . . . . . . . . . . . 159
5.9 Spreadsheets for Economic Analysis . . . . . . . . . . . . . . . . . . . . . . . 161
5.10 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
5.11 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
6 Measures of Investment Worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
6.1 Investment Time Periods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
6.2 Undiscounted Payback Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
6.3 Discounted Payback Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
6.4 Net Present Worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
6.5 Equivalent Uniform Annual Worth . . . . . . . . . . . . . . . . . . . . . . . . . 180
Contents xi
6.6 Future Worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

6.7 Internal Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184
6.8 Investment Worth Metrics Under Differing Project Life
Analysis Periods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
6.9 Investment Worth Metrics in Spreadsheet Analyses . . . . . . . . . . 196
6.10 Spreadsheets for Alternatives with Multiple
Rate-of-Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
6.11 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
6.12 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
7 Depreciation Effects on Investment Worth . . . . . . . . . . . . . . . . . . . . . . . 209
7.1 Depreciation Fundamentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
7.1.1 US Tax Code Depreciation Fundamentals . . . . . . . . . . . 211
7.1.2 Depreciation Estimation Fundamentals . . . . . . . . . . . . . 212
7.2 Historical Depreciation Methods . . . . . . . . . . . . . . . . . . . . . . . . . . 213
7.2.1 Straight-Line Depreciation . . . . . . . . . . . . . . . . . . . . . . . . 214
7.2.2 Sum-of-Years-Digits Depreciation . . . . . . . . . . . . . . . . . 215
7.2.3 Declining Balance Depreciation . . . . . . . . . . . . . . . . . . . 216
7.3 Modified Accelerated Cost Recovery System (MACRS) . . . . . . 217
7.4 Depreciation at Asset Disposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
7.5 Unit-of-Production Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . 227
7.6 Depletion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
7.6.1 Cost Depletion Method . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
7.6.2 Percentage Depletion Method . . . . . . . . . . . . . . . . . . . . . 229
7.7 Spreadsheets and Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
7.8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
7.9 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
8 Tax Effects on Engineering Investments . . . . . . . . . . . . . . . . . . . . . . . . . 235
8.1 Classification of Taxable Income . . . . . . . . . . . . . . . . . . . . . . . . . . 236
8.2 Economic Analysis Taking Taxes into Account . . . . . . . . . . . . . . 237
8.2.1 Combined Federal and State Income Taxes . . . . . . . . . . 240
8.3 Capital Gains and Losses for Non-depreciated Assets . . . . . . . . . 242
8.4 After-Tax Cash Flows with Spreadsheets . . . . . . . . . . . . . . . . . . . 242
8.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
8.6 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
9 Inflation Effects on Engineering Investments . . . . . . . . . . . . . . . . . . . . . 249
9.1 The Meaning and Effect of Inflation on Investment Worth . . . . . 250
9.2 Incorporating Inflation in Engineering Managerial
Economic Estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
9.3 Investment Analysis in Real Dollars Versus Actual Dollars . . . . 254
9.4 Cash Flows That Inflate at Different Rates . . . . . . . . . . . . . . . . . . 257
9.5 Different Inflation Rates Per Period . . . . . . . . . . . . . . . . . . . . . . . . 258
9.6 Geometric Mean Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
9.7 Price and Cost Change with Indexes . . . . . . . . . . . . . . . . . . . . . . . 261
xii Contents
9.8 Inflation Effect on After-Tax Calculations . . . . . . . . . . . . . . . . . . . 264

9.9 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
9.10 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
10 Incremental Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
10.2 Graphical Incremental Rate of Return Sensitivity Analysis . . . . 274
10.3 Challenger–Defender Incremental Rate of Return Analysis . . . . 280
10.4 Observations on Incremental Rate of Return Analysis . . . . . . . . 283
10.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
10.6 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
11 Replacement Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
11.1 The Replacement Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
11.2 Economic Service Life of an Asset . . . . . . . . . . . . . . . . . . . . . . . . 288
11.3 Tax Laws Affecting Replacement Analysis . . . . . . . . . . . . . . . . . . 290
11.4 Planning Horizon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
11.5 Closing Comments on Replacement Analysis . . . . . . . . . . . . . . . 299
11.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
11.7 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
Part III Managing Engineering Investments

12 Determining the Appropriate MARR . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
12.1 Risk–Return Fundamentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
12.2 Sources of Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
12.3 Cost of Financing and Investment Opportunities . . . . . . . . . . . . . 312
12.3.1 Weighted Average Cost of Capital . . . . . . . . . . . . . . . . . . 313
12.3.2 Weighted Marginal Cost of Capital . . . . . . . . . . . . . . . . . 315
12.3.3 Opportunity Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . 318
12.4 Closing Comments on Determination of MARR . . . . . . . . . . . . . 319
12.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
12.6 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
13 Capital Budgeting Engineering Investments . . . . . . . . . . . . . . . . . . . . . 323
13.1 Capital Expenditure for Project Proposals . . . . . . . . . . . . . . . . . . . 324
13.2 Rationing Capital by Rate of Return . . . . . . . . . . . . . . . . . . . . . . . 325
13.3 Rationing Capital by Net Present Worth . . . . . . . . . . . . . . . . . . . . 327
13.4 Ranking Project Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
13.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
13.6 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
14 Benefit–Cost Ratio Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
14.1 Characteristics of Major Service Systems . . . . . . . . . . . . . . . . . . . 333
14.2 Economic Evaluation of Services . . . . . . . . . . . . . . . . . . . . . . . . . . 334
14.3 Selecting the Appropriate Interest Rate . . . . . . . . . . . . . . . . . . . . . 335
14.3.1 Public Sector Internal Rate of Return . . . . . . . . . . . . . . . 336
Contents xiii
14.3.2 Public Sector Opportunity Cost . . . . . . . . . . . . . . . . . . . . 337

14.4 Cost-Effectiveness Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
14.5 Cost-Utility Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
14.6 Benefit–Cost Ratio Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
14.7 Incremental Benefit–Cost Ratio Analysis . . . . . . . . . . . . . . . . . . . 342
14.8 Factors Affecting Benefit–Cost Ratio Analysis Decisions . . . . . 345
14.8.1 Public Sector Investment Financing . . . . . . . . . . . . . . . . 345
14.8.2 Public Sector Investment Life Cycle . . . . . . . . . . . . . . . . 346
14.8.3 Quantifying Benefits and Disbenefits . . . . . . . . . . . . . . . 347
14.8.4 Public Sector Politics and Policies . . . . . . . . . . . . . . . . . . 347
14.9 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
14.10 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
15 Introduction to Management Economic Decision Theory
and Risk Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
15.1 Elements of Engineering Managerial Economic Decisions . . . . 353
15.2 Probability and Statistics Concepts for Management
Economic Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
15.3 Structuring Decision Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
15.4 Sensitivity Analyses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
15.5 Decision Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381
15.6 Decision Tree Risk Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387
15.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398
15.8 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405
Appendix A: Use of the Microsoft® Excel® Compound Interest

Calculator Spreadsheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409
Appendix B: Discrete Payment Compound Interest Factors . . . . . . . . . . . 411
Appendix C: Selected Discrete Payment Compound Interest
Factors with Geometric Gradient Percentages . . . . . . . . . . . . . . . . . . . . . . . . 465
Appendix D: Cumulative Standard Normal Distribution . . . . . . . . . . . . . . 473
Appendix E: Fundamentals of Engineering (FE) Examination
Example Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487
Part I
Economic Context of Engineering
Management Decision
Chapter 1
Managerial Economics of Engineering
Organizations
Abstract This book is about engineering managerial decision making and the risks
associated with those decisions. Decisions and their associated risks are driven by
the context of the decision situation. For engineering managers, this context is the
management of engineering and technical functions within for-profit and not-for-
profit organizations. Chapter 1 establishes the context of engineering managerial
decision making. First, the chapter sets forth definitions of the engineering manager
and the four fundamental classes of engineering functions. Second, the basic classes
of for-profit organizations within which engineering managers work are described.
Third, the product life cycle and annual financial cycle context of capital expendi-
tures and operating costs are defined. Fourth, the chapter describes engineering and
technical function contributions to the stages of the product life cycle. Finally, the
chapter concludes with a general description of the budgeting process of engineering
operations and projects.
1.1 Introduction
All engineering activities and projects must be executed within an organizational

context, either private industry or public governmental services. All organizational
decisions are constrained by scarcity of resources. This constraint drives three
fundamental decisions for organizational survival and growth.
1. What are the organization’s objectives: (a) the customer base, (b) the product
or service will be produced, and (c) the processes that will produce the product
or service?
2. What resources are needed and available to produce the product or service: (a)
monetary, (b) human resources, (c) knowledge and information resources, (d)
materials, and (e) physical facilities and equipment?
3. How will resources be allocated: to which (a) products or services, (b) projects,
(c) departments, and (d) in what amounts given varying conditions?
© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 3

T. S. Cotter, Engineering Managerial Economic Decision and Risk Analysis,
Topics in Safety, Risk, Reliability and Quality 39,
https://doi.org/10.1007/978-3-030-87767-5_1
4 1 Managerial Economics of Engineering Organizations
This book is concerned with the third decision. More specifically, this book is
concerned with the optimum allocation of money to engineering projects for the
introduction of new products and services or the expansion of existing products and
services. Although this book focuses on the third decision, it must be recognized
that these three fundamental decisions cannot be made in isolation. Rather, they are
iterative and interactive across annual budgets and the budget planning process.
1.2 Engineering and Engineering Management
Definition: Engineeringmanagerial economics is the body of knowledge and

methods devoted to the systematic evaluation of the economic benefits resulting
from ongoing engineering activities or proposed engineering projects in relation to
the economic costs of those activities or projects.
To fully appreciate the scope of this definition of engineering managerial
economics, we must decompose it into its components. The fundamental compo-
nents are engineering, management, and economics. Management is the organi-
zational function that develops operational plans and goals, employs personnel for
productive operations, and controls productive operations to achieve economic goals.
ABET, the Accreditation Board of Engineering and Technology, 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.”
From this definition, we can derive the properties of engineering as a profession. Prop-
erty 1—Engineers gain knowledge of mathematics and natural sciences and apply
that knowledge to design and potentially build and maintain materials, structures,
or devices, processes, information, and systems. Thus, engineering is a transforma-
tion process taking as its inputs mathematical and natural science knowledge and
combining and transforming them into, at minimum, designs for, and at best, outputs
that can be used by other men and women to enhance (benefit) their lives in some
manner. Property 2—From property one, the fundamental output of the engineering
transformation process is a design. At minimum, engineering is a design process.
The engineer may or may not build the designed material, structure, or device, infor-
mation, process, or system. Others with sufficient technical knowledge can take the
engineer’s design and build the unit of intent. Likewise, the engineer may or may
not maintain the intended material, structure, or device, information, process, or
system. Again, others with sufficient technical knowledge can perform the necessary
maintenance. Property 3—The engineering transformation process is constrained
by the economics of the “… materials and forces of nature …” or technology of
the time that is available to the transformation process. Technology itself may be
defined as “the application of scientific knowledge for practical purposes.” Hence,
the economics of engineering arises from the limits of knowledge of mathematical
and natural sciences at the time it is applied. As technical knowledge increases over
time, either the same beneficial outputs may be produced at lower economic cost per
1.2 Engineering and Engineering Management 5
unit or outputs with greater benefits per unit may be produced at essentially the same
economic cost per unit. Otherwise, mankind does not benefit from the engineering
transformation process.
The engineering outputs of materials, structures, and devices can be roughly cate-
gorized as products. So, the first general engineering classification can be considered
as the product engineer. Product engineers may only design a material, structure, or
device, be the technical development interface between design and the production
process, or perform both the design and development activities. Product engineers
must deal with issues of cost, performance, producibility, quality, reliability, dura-
bility, serviceability, aesthetics, features, conformance to standards, and user expec-
tations. Given the limits of technological knowledge, trade-offs among product char-
acteristics are generally required to achieve some balance of features that will be
beneficial to others. Once in production, product engineers may also seek to enhance
certain product features without adversely impacting others. Typical knowledge and
skills required of the product engineer include:
• Fundamental mathematical principles.
• Fundamental scientific principles relative to the product (specific technology).
• Computer-aided design and simulation.
• General manufacturing processes.
• Physical analysis methods.
• Statistical analysis methods and tools.
• Reliability analysis methods and tools.
• Test equipment, tools, and methods.
• Structured problem-solving skills.
• Root cause analysis.
• Project management skills.
The engineering output of a process is considered as process engineering. Process
engineering focuses on the design, operation, control, and optimization of the produc-
tion process. Production processes may be chemical, physical, or biological and may
yield physical or service products. Like product engineers, process engineers also
may only design the process, be the technical development interface between design
and actual development of the process, or perform both the design and development
activities depending on the scope and scale of the process. Process engineers must
deal with issues of cost, performance quality, reliability, aesthetics, conformance
to standards, and client expectations. Given the limits of socio-technical knowl-
edge, trade-offs among process characteristics are generally required to achieve some
balance of process features that will yield intended benefits in the product or service.
Once released to the producers, the process engineer may also seek to enhance certain
process features without adversely impacting others. Process engineers require the
same general skills as the product engineer above with the exception that the process
engineer requires fundamental scientific principles relative to process development
and specific knowledge of the process type.
The engineering output of data, information, or knowledge falls under the general
class of information engineering. Information engineering falls into two general
categories: (1) data generation, distribution, analysis and synthesis and transforma-
tion into information or knowledge, and the use of information or knowledge in
systems and (2) the design, development, implementation, and maintenance of phys-
ical and software information systems. Like product and process engineers, informa-
tion engineers also may only design software or physical information systems, be the
technical development interface between design and actual development, or perform
both the design and development activities depending on the scope and scale of the
information system. Information engineers must deal with issues of cost, delivery,
and performance and measure software development in terms of quality, reliability,
conformance to standards, and client expectations. Information engineers require
knowledge and skills in:
• Data flow and data analysis.
• Database design.
• Information theory.
• Entity analysis and modeling.
• Cluster analysis to define the scope of design areas for proposed information
systems.
• Ontology development.
• Knowledge engineering in intelligence applications.
• Expert systems.
• Artificial intelligence.
• Data mining.
• Decision support systems.
• Geographic information system (GIS).
• Project management skills.
The engineering output of complete systems with emergent properties and behav-
iors is the domain of systems engineering. Systems engineering is interdisciplinary in
that it integrates and utilizes engineering knowledge from all engineering disciplines
within a general systems framework to design, implement, and manage complex
systems over their life cycles. Systems engineers may be involved with any or all
process of the design, development, implementation, delivery, and management of
systems. Systems engineers must deal with the broad issues of cost, delivery, and
performance of complete systems. Systems engineering requires knowledge and
skills in:
• Fundamental mathematical principles.
• Fundamental scientific principles.
• General engineering principles.
• System architecture.
• System dynamics.
• Systems analysis.
• Statistical analysis.
• Reliability analysis.
1.2 Engineering and Engineering Management 7
• Requirements analysis.
• Feasibility analysis.
• Logistics.
• Maintenance.
• System modeling and simulation.
• Optimization.
• Operations research.
• Decision making.
• Configuration management.
• Project management.
Engineering management combines technical expertise with managerial knowl-
edge to coordinate operational performance of engineering disciplines within an orga-
nizational setting or coordinate and control technical project outputs. In addition to
engineering technical expertise, engineering managers require additional knowledge
and skills in (Farr and Merino 2010):
• Basic accounting and finance.
• Decision analysis.
• Engineering economics.
• Leadership and teams.
• Management theory and concepts.
• Modeling and simulation.
• Operations research.
• Project management.
• Quality and reliability management.
• Risk analysis and management.
• Strategic management.
• Systems engineering.
1.3 Types of Business Organizations
All engineering activities take place within the context of either business (for-
profit and not-for-profit) or governmental (non-military and military) organizations.
Accordingly, the engineer and engineering manager must understand the organi-
zational type within which he or she works. There are three fundamental types of
business organizations.
A proprietorship is an unincorporated business owned by one individual. This individual
makes all initial investments in the business, personally owns all its assets, and is legally
liable for all its debts. The proprietorship is not a legal entity; rather, the individual who
owns the business is the legal entity.
Proprietorships have three distinguishing characteristics. First, a proprietorship is

formed simply by a person setting up and conducting business. There are no legal
or organizational requirements to set up a business as a proprietorship. Second, all
revenues, debts, profits, and losses must be recognized and taxed as the owner’s
personal income. Third, the owner is legally accountable for all regulatory and legal
debts. In addition to the personal legal liability, the major disadvantage of the propri-
etorship is that it cannot issue stocks and bonds to finance its operations. Within
engineering, the typical form of proprietorship is as an engineering consulting firm.
A partnership is owned by two or more individuals, who jointly invest money, skills, and
assets and who share in profits or losses in accordance with the terms set forth in their
partnership agreement. In the absence of a written partnership agreement, the legal system
will assume that a partnership exists where the individuals who participate in an enterprise
agree to share the associated risks, returns, and losses proportionately. The partnership is not
a legal entity; rather, the individuals entering the partnership are individual legal entities.
A partnership is a legal agreement among two or more individuals (the legal enti-
ties) to share the profits and liabilities of a business venture. Various partnership
agreement structures are available: sharing profits and liabilities equally or in stated
proportions to the individuals’ contributions to the partnership; differing contribu-
tions of capital, assets, and expertise knowledge; or involvement with management
and daily operations. Partnerships may be given favorable tax status in some states
or municipalities. There are three categories of partnerships. In a general partner-
ship (GP), the partners share profits and legal and financial liabilities equally. In
a limited partnership (LP), one partner must be the general partner and bear full
personal responsibility for the partnership’s liabilities, and at least one other silent
partner’s liability is limited to the amount invested in the partnership. Generally, the
silent partner cannot participate in the daily management of the partnership. A limited
liability partnership (LLP) is a partnership in which each partner’s liability is limited
to his or her individual assets. If one partner is sued, the other partners’ personal assets
are not at risk. LLPs are a common organizational structure for accounting, archi-
tectural, engineering consulting, and law firms. Partnerships have many advantages.
They are easy to form and have a low formation cost. Partnerships allow a mix of
investments of assets, capital, expertise, and skills necessary for a particular business
venture. Since the partners’ personal assets back the business venture, partnerships
can borrow money more easily than a proprietorship. Each partner pays only personal
income tax on his or her proportion of the partnership’s taxable income. Partnerships
also have disadvantages. Each partner is proportionally liable for the venture’s debts.
In the case of bankruptcy, if any partner cannot meet his or her proportion of the
debts, the remaining partners must cover the unresolved debts. The partnership has
a limited life. It must be dissolved and reorganized if any one partner leaves the
venture.
A corporation is a legal entity recognized under state or federal law. As a legal entity,
it is separate and distinct from its owners. A corporation possesses most of the rights an
individual possesses. It can enter into contracts, raise financing from the sale of stocks and
bonds, borrow or loan money, own productive assets, and sue or be sued. A corporation is
often referred to as a “legal person.”
1.3 Types of Business Organizations 9
A group of shareholder owners create a corporation to pursue a common objective.

The shareholder owners incorporate under the corporate laws in the jurisdiction of
residence (state or federal government). The shareholder owners are each responsible
only to pay their respective shares to the corporation’s treasury, and generally, each
receives one vote per share. Annually, each shareholder owner votes his or her shares
to elect a board of directors that, in turn, hires and oversees management of the daily
corporate activities. A corporation can be for-profit or not-for-profit. A corporation
can have an infinite or limited life. If a corporation achieves its common objec-
tive, the shareholder owners can terminate the corporation and liquidate its assets.
In this process, a liquidator is appointed, and the liquidator sells the corporation’s
assets, pays creditors, and distributes any remaining funds among the shareholder
owners. The separation of the corporation as a legal entity from its shareholder
owners provides four major advantages. First, a corporation can raise capital from
a broader base of shareholder owners and investors through the sale of stocks and
bonds. Second, he shareholder owners can easily transfer ownership by selling or
trading their shares of stock. Third, the shareholder owners have only limited liability
to the value of their respective shares of stock. Liabilities or legal judgments against
the corporation are separate and cannot be reapportioned to the shareholder owners.
Fourth, a corporation pays taxes at corporate rates, often favorable to the corporate
structure, separate from the personal taxes paid by its shareholder owners. The disad-
vantages to the corporate form of business are that it is expensive to incorporate, and
corporations are subject to numerous governmental laws and regulations.
The typical business organization starts out small and, if successful, grows. In the
USA, sole proprietorships make up the majority of businesses by number (approxi-
mately 70%). Partnerships are second most numerous (approximately 23%) followed
by corporations (7%). Proprietorships employ about 53% of the non-governmental
workforce but generate only about 6% of total sales in the USA. Typically, a propri-
etorship employs ten or fewer people. Conversely, corporations employ about 38% of
the workforce but generate about 73% of total sales, and partnerships employ about
9% of the workforce and generate about 21% of total sales. Accordingly, the majority
of engineering and engineering management positions are found in corporations and
partnerships.
This book addresses the economic decisions for the set of engineers and engi-
neering managers employed in corporations, partnerships, state and local govern-
mental agencies, and non-military federal governmental agencies. Economic deci-
sions in the business sector tend to be driven by cash flow and return on investment
criteria. Conversely, economic decisions in governmental agencies tend to be driven
by some form of benefit–cost criteria.
1.4 Engineering Economic Decisions
As can be seen in the Engineering and Engineering Management section above,

engineers and engineering managers contribute technical expertise to every aspect of
organizational, product, process, and service design, implementation, maintenance,
and responsible retirement and disposal. In these roles, engineers are responsible to
consider the effective use of capital, in the form of investment or taxes, to acquire,
implement, and use productive assets. In the design phase, engineers’ primary task
is to plan capital expenditure for equipment, facilities, and supporting infrastructure
needed for the organization to produce its products or services. For the purchase of
an asset, engineers must estimate all life cycle cash flows for capital expenditure and
installation, revenues and expenses, and salvage and disposal. The life cycle of an
asset is the minimum of its useful life, life to obsolescence, or project life (given the
asset’s life is greater than the project life). Inaccuracies in cash flow estimates can
have serious impacts on realized project net profits or benefit–cost. Overinvestment
in expensive assets can result in never recovering the cost of the asset for operations
cash flows. Conversely, underinvestment in cheap assets can result in negative net
profits (losses) due to excessive annual operating and maintenance expenses. Either
can drive up the cost denominator of the B/C ratio in governmental projects.
Capital expenditure is the purchase of an asset with a life greater than one fiscal year.
An asset is land, physical facilities, equipment, money, monetary instruments, and intel-
lectual property owned or controlled by a business organization for the purpose of producing
products or services to provide a return on investment in the asset.
A fiscal year is a 12-month time period that a business organization uses for the accounting
purpose of preparing financial statements. The fiscal year may or may not be equal to the
calendar year.
In the implementation and maintenance phases, engineers’ primary task is cost

control for the efficient operation and maintenance of productive assets. In the retire-
ment and disposal phase, engineers’ primary task is defining all activities necessary
for responsible disposal and minimizes the project costs associated with disposal.
The configuration of facilities and operations are determined by the life cycle(s)
of products and services produced and delivered. Hence, engineering decisions, and
the corresponding cash flow implications, exist along three timescales. The short-
term scale is less than one fiscal year. Short-term economic decisions are compar-
atively simple yes/no or quantity decisions with minimal cost impact and risk to
support existing products and services: i.e., replace a burned-out pump this week,
the quantity and type of maintenance supplies this month, or the purchase replace-
ment PID controller. Short-term economic cash flows are treated as expenses in the
period incurred. Intermediate-term economic decisions are tied to the budget plan-
ning period, which itself is determined by the organization’s product or service life
cycle or the time to transition assets to support innovative new products. For products
with short life cycles or short transition periods, the budget planning period may be
one to three years; intermediate life cycles or transition periods, three to seven years;
and product or service long-term life cycles or transition periods, seven to ten or
twelve years.
The product life cycle is the expected life of a product or service from the time
of its conception to its termination and disposal.
Intermediate economic decisions to support production of current products and
services within the budget planning period:
1.4 Engineering Economic Decisions 11
• Involve costs in the $10,000s or $100,000s.

• Are of intermediate risk—wrong outcomes can be fixed but at costs that may
impact profitability.
• Have organizational and stakeholder impacts—the organization’s financial status
or reputation may be adversely impacted and cause a loss of stock value.
• Require formal organized analysis.
• Require comparison to a single criterion or a limited number of criteria with
intermediate estimate variability.
Complex long-range economic decisions to develop future products and services
for future budget planning periods:
• Involve costs in the millions or even billions of dollars for new production lines
or facilities.
• Are of high risk—wrong outcomes may result in organizational failure.
• Have significant organizational and stakeholder impacts—loss of employment for
employees, loss of cash flows and tax revenues for the community, and potential
loss of a customer for its suppliers and a supplier for its customers.
• Require formal organized analysis.
• Require comparison to multiple criteria (economic, technical, legal, and societal)
with long-range variability and uncertainty.
Current, intermediate, and complex long-term economic decisions are tied to the
organization’s long-term strategic planning and budgeting as illustrated by Fig. 1.1.
Strategic Planning
Intermediate Long Range

Planning Planning
= Budget Period > Budget Period
Fiscal Year Budget Budget Cycle Forecasted Budget
Current Expenses Product Life Cycle Future Products
Intermediate Eng. Long Term Eng.

Economic Economic
Decisions Decisions
Fig. 1.1 Linkage between strategic planning and engineering economic analyses
In each of these timescales, engineering economic analysis is used to determine

which projects (investments) are worthwhile, how to prioritize those projects, and
the optimum or near-optimum effective designs given funding and other constraints.
Fundamentally, there are five basic classes of projects for which engineering
economic analysis is required.
Cost Reduction. Typically, new processes and products are implemented at
competitive costs. As processes age, they incur increasing efficiency losses due to
wear or obsolescence. If a new product is successful, competitors will enter with
competing designs at lower price per unit for the same performance or with increased
performance at the same price per unit. Both causal effects drive the need for continual
cost reductions in labor, materials, overhead, process, and service costs to remain
competitive. The primary metric for tracking cost reduction is total cost per unit.
Productivity, Quality, or Service Optimization. Whereas cost reduction seeks
to reduce the total cost per unit for some level of performance, optimization seeks to
maximize utilization of labor, materials, energy, consumables, and information for a
stated level of process output (productivity), maximize product performance relative
to quality standards or customer expectations, or maximize service responsiveness,
professionalism, and attentiveness per customer contact. Optimization projects tend
to fall into six basic categories.
1. Process optimization. In process optimization projects, the process engi-
neer seeks to adjust the process parameters, without violating technical or
economic constraints, with the goal of maximizing throughput or minimizing
the utilization of labor, materials, energy, and consumables for a stated level of
throughput.
2. Workforce optimization. In workforce optimization, the process engineer seeks
to balance workforce requirements for a stated level of product throughput.
3. Energy consumption. In highly automated manufacturing processes, energy is
the first or second highest cost element. Energy consumption may be minimized
through building or equipment redesign, production scheduling to consume high
levels of energy during low demand and low-cost times of the day or week, and
renegotiation of energy contracts with electricity and fuel suppliers.
4. Quality and reliability optimization. Quality is conformance of the totality of
product or service performance and features to design intent and customer
requirements and expectations. Quality is measured along eight dimensions:
(1) performance, (2) reliability, (3) durability, (4) serviceability, (5) aesthetics,
(6) features, (7) organizational reputation, and (8) conformance to standards.
Reliability is measured as the time to failure of product or service performance
characteristic. The longer the time to failure, the higher will be the perceived
product or service quality. Quality and reliability optimization projects involve
formal engineering analyses of the negative and positive gaps in the eight
dimensions of quality with the joint goals of reducing or eliminating the nega-
tive gaps and increasing the positive gaps. Quality and reliability improvement
projects involve making changes in the total cost of quality, levels of customer
satisfaction, or reduction in waste, rework, and scrap losses.
5. Quality and reliability optimization. Quality is conformance of the totality of

product or service performance and features to design intent and customer
requirements and expectations. Quality is measured along eight dimensions:
(1) performance, (2) reliability, (3) durability, (4) serviceability, (5) aesthetics,
(6) features, (7) organizational reputation, and (8) conformance to standards.
Reliability is measured as the time to failure of product or service performance
characteristic. The longer the time to failure, the higher will be the perceived
product or service quality. Quality and reliability optimization projects involve
formal engineering analyses of the negative and positive gaps in the eight
dimensions of quality with the joint goals of reducing or eliminating the nega-
tive gaps and increasing the positive gaps. Quality and reliability improvement
projects involve making changes in the total cost of quality, levels of customer
satisfaction, or reduction in waste, rework, and scrap losses.
6. Inventory carrying costs. The total carrying, or holding, cost of maintaining
inventory includes warehousing costs for space, wages, salaries, utilities, main-
tenance, and insurance plus the cost of the parts. Thus, maintaining raw mate-
rials, work-in-process, and finished product inventory for long periods of time
comes at a cost. On the other hand, inventories provide organizations the ability
to be responsive to customer demand while avoiding missed sales opportuni-
ties. Engineering projects to optimize inventory carrying costs involve balancing
inventory levels throughout the production process against forecasted customer
demand to minimize out-of-stock and overproduction occurrences.
Process and Equipment Selection. The construction of a new production facility
requires the selection of productive processes and equipment. In the case of product
extension to new markets, existing processes may be adapted from similar existing
production facilities. For completely new innovative products, specialized equip-
ment and processes may have to be designed. For either extreme and for mixed
cases in between, equipment and process selection are a critical factor in the future
competitive success. The selection process is driven by the process type, and equip-
ment selection is driven by fourteen key factors. There are five fundamental types of
production processes.
1. Machining and assembly production are additive processes. They are exempli-
fied by production lines with minimal changeover and setup that produce similar
or like products in long production runs. They are capital-intensive processes
that run 24 h per day, 7 days per week to cover the high fixed equipment costs.
2. Discrete processes may be additive, nonadditive, or some mix thereof. They
may require few or multiple changeovers and setups and produce a variety of
products from highly similar structures to one-off designs.
3. Job shops are a collection of production areas with internally similar process but
highly diverse intra-area processes. They may be additive, nonadditive, or some
mix thereof. The product design determines the routing through the different
production areas. Job shops are made up of a mix of highly automated and
manual processes.
4. Continuous processes are nonadditive processes that produce gases, liquids,

powders, or slurries. They are the counterpart of high-volume machining and
assembly production in that they produce their products of multiple batches
in long runs with minimal changeovers and setups. Likewise, they are capital
intensive processes that run 24 h per day, 7 days per week to cover the high
fixed equipment costs.
5. Batch processes produce specialty gases, liquids, powders, or slurries. Typically,
they produce one to a few batches. They are the counterpart of discrete processes
or job shop production processes.
For each process type, equipment selection is driven by four key factors.
1. Socio-technical suitability: Selected equipment must be technically compatible
with the product to be produced and must consider the integration of people
with the equipment.
2. Initial installed cost: Project budgets set constraints on the level and type of
available equipment technology. The total initial installed cost is the sum of
design, procurement, transportation, installation, commissioning, and scale-up
costs necessary to place the asset in service fit for use.
3. Equipment construction feasibility due to technological, lead time, and schedule,
physical installation, commissioning, and scale-up constraints.
4. Impact on overall facility design elements of size, location, interface, and inter-
ference of supporting mechanical, electrical, plumbing, and information archi-
tectures. Trade-offs among these elements are risk drivers of project change
orders and schedule and cost overruns.
Process and Equipment Replacement. Typically, process or equipment replace-
ment decisions involve large investments with moderate to high risk of failure.
Replacement decisions are necessitated by:
1. The development of operational deficiencies in the existing defender process
or equipment resulting in declining productivity, limited capacity, high or
increasing setup cost, increasing energy consumption, increasing maintenance
costs, or physical impairment.
2. Challenger replacement assets becoming available with advantages such as
newer technological capabilities, lower per-unit production costs, higher
throughput, lower energy costs, or lower maintenance costs.
3. Changing competitive environment or market demands. These can include (1)
demand-driven user preference for new products with increasing technological
capabilities, (2) supply-driven increasing functionality in competitor products
and services, (3) changing industry specifications or government regulations, or
(4) increased demand that cannot be met by existing equipment or processes.
4. 4.Obsolescence occurs when the existing defender equipment or process is no
longer economically viable even though it remains in acceptable working order.
Frequently, obsolescence occurs when a challenger replacement becomes avail-
able that has economic, productive, quality, or other technological advantages
relative to the existing defender equipment or process.
The decision regarding the replacement of an existing defender asset with a chal-
lenger asset is based on incremental internal rate of return analysis of the difference
between periodic net cash flows if the existing defender asset is kept versus the
periodic net cash flows if the challenger asset is placed in service.
Product or Service Expansion. Investments in product or service expansion
are made to increase revenues resulting from excess demand for existing products
or services or projected demand for new products or services. The basic invest-
ment decision is whether to expand throughput by outsourcing production or service
delivery through a contractor or build additional facilities. Typically, product or
service expansion decisions involve large investment with high risk of failure.
1.5 Engineering Economic Principles
Engineering economics is based on fundamental principles that, if followed, assure

maximizing investment benefits to investment costs.
1. Money has time value. All investments are made with rented borrowed money.
The rent paid for borrowed money is in the form of interest on loans or divi-
dends for stocks. From the lenders or investors’ perspective, they prefer to
receive a fixed sum of money sooner rather than later. The sooner a lender
or investor receives interest or dividend payments, the sooner he or she can
re-lend or reinvest the money in other interest or dividend-bearing assets. The
longer a loan or investment remains outstanding, the greater the risk of not
being repaid and the greater the cumulative interest for the number of loan or
investment periods.
2. All investments in productive assets must be economically justified. Production
or service assets must yield positive economic cash flows beyond the repay-
ment of the principle and accrued interest payments. These positive economic
cash flows are required for reinvestment toward the maintenance of existing
production and service capacity and for new production or service capacity.
3. All economic decisions must be based on differences in cash flows among the
alternatives considered. This principle assures that economic decisions are
made based on comparison of differences in increases of cash flows due to
differential benefits generated by the assets relative to decreases in cash flow
required for differential investment in the assets.
4. Use a common unit of measurement (metric) across alternative to make conse-
quences commensurable. Alternative consequences must be measured with a
common measurement unit to be commensurable.
5. Alternatives must be examined over a common planning horizon. The planning
period is the product or process life cycle or multiples thereof over which
alternative consequences are relevant. A common planning horizon is required
to make measurement of consequences commensurable.
6. Only differences are relevant. Prospective consequences that are common to

all alternatives under consideration need not be considered, because they affect
the outcomes of each alternative equally.
7. Only feasible alternatives can be considered. Decisions must lead only to
courses of action that can be completed within physical laws and principles,
economic laws and principles, political constraints, and legal requirements.
Investment decisions must give weight to noneconomic consequences.
8. Investment criteriamust include the time value of money due to capital
acquisition and rationing.
9. Separable decisions should be made separately. This principle requires careful
evaluation of capital allocation to determine the number and types of economic
decisions to be made.
10. The relative degrees of uncertainty associated with future cash flows must be
incorporated into the economic decision process. Since engineering economic
cash flow estimates occur in the future, there are probabilities that realized
future cash flows will differ from the original estimates.
11. The effectiveness of capital budgeting procedures is a function of their imple-
mentation across organizational levels. Capital budgeting and allocation proce-
dures must be clearly and succinctly specified, understood, and implemented
at all organizational levels having responsibility for economic decisions.
12. Post-decision audits are required to improve the quality of decisions over time.
The only way to judge and improve predictive ability is to audit the results
of economic decision over their product, process, and systems life cycles and
incorporate feedback on differences into future economic predictions.
1.6 Engineering Life Cycle Costs
The United States National Archives define products and services as (http://www.
archives.gov/preservation/products/definitions/products-services.html):
Products are tangible and discernible items that the organization produces, including digital
file-based output.
A service is the production of an essentially intangible benefit, either in its own right or
as a significant element of a tangible product, which through some form of exchange satisfies
an identified need.
Combining these definitions, products may be defined as:

Tangible and discernible items or intangible service benefits that an organization produces
to satisfy identified human needs or wants.
Key characteristics of products include:

• Tangible items or intangible services that provide benefits.
• Produced by organizations that can be either private or public.
• Intended to satisfy identified human needs or wants.
1.6 Engineering Life Cycle Costs 17
Three fundamental exchanges must take place for an organization to produce a

product.
1. Securing the capital (financing).
2. Purchasing assets (investing) by which to produce products.
3. Generating returns (producing) from the sales of its products.
Figure 1.2 illustrates the flow from capital to products. Cash can be obtained from
one of two sources to finance operations. First, organizations can borrow money from
lenders. Cash to support ongoing operations is generally obtained as unsecured, short-
term loans from a bank. A short-term loan is the acquisition of cash at a stated interest
rate that must be repaid with interest by a stated due date, which is within a year from
the loan date. For long-term financing of new facilities and equipment, organizations
will issue notes, debentures, or bonds through a financial banker. A note or debenture
is an unsecured debt, whereas a bond is secured by a mortgage on organizational
property. A bond is a fixed income instrument that represents a loan made by an
investor to a borrower. Bonds are issued by organizations, municipalities, states, and
sovereign governments to finance projects and operations. Owners of bonds are the
debtholders, or creditors, of the issuer. Bond details include the terms for variable or
fixed interest payments made by the borrower and the end date when the principal
of the loan is due to be paid to the bond owner.
Second, organizations can sell stock certificates to investors. A stock certificate is
the physical piece of paper representing ownership in a company. Stock certificates
state the number of shares owned, the date of issue, an identification number, usually
a corporate seal and signatures. There are two primary types of stock certificates.
Common stocks are shares of ownership of the organization. Common stockholders
have voting rights on corporate issues, such as the board of directors and accepting
takeover bids. Typically, common stockholders have one vote per share. Common
stockholders may receive dividends out of net profit if the organization has cash
Fig. 1.2 Fundamental exchanges in the production of tangible products and services
Fig. 1.3 Organizational annual budgeting finance cycle
available after long-term reinvestment. Conversely, preferred stocks are stock shares
issued without ownership and voting rights. Preferred stockholders have “preference”
over common stockholders in payment of dividend (preferred dividends must be paid
before issuing common stock dividends) and in receiving cash from assets in the event
of organizational liquidation.
The organization invests case from lenders and investors into productive assets
used to convert inputs into products and services. Income cash flows from the sale
of products and services to customers and clients (returns on investment) must be
sufficient to cover the total cost of producing those products and services, repay
the debt from borrowing plus interest, pay acceptable dividend rates to stockholders
(returns on capital), and reinvest maintenance of current assets plus in new assets,
products, and services.
Figure 1.3 illustrates the typical organizational annual budgeting finance cycle
needed to support ongoing productive operations. First, we need a working definition
of finance.
Finance—The acquisition of capital from lenders and investors, budgeting
scarce resources effectively, and investing funds in portfolios of assets and projects
that achieve market and financial objectives yielding the maximum return/risk
trade-offs with the goal of maximizing the wealth or value of the organization
to its stockholders.
The finance manager’s role is to interface between the organization and sources of
external financing to assure that the organization has sufficient cash flows to maintain
ongoing productive operations and has access to cash to expand future productive
capacity. The budgeting finance cycle begins with establishing the organization’s
current financial position from its income statement, balance sheet, statement of
retained earnings, and statement of cash position. The finance manager evaluates
the effects of economic, legal, political, and technical risks in the international and
national domestic markets on the availability and interest cost of capital. He or
she evaluates the competitive risks with suppliers, competitors, and customers in
the organization’s relevant business environment. He or she integrates the macroe-
conomic and industry environmental risks into the organization’s risk models and
develops market, strategic, and financial assessments. Risk assessments are integrated
with market demand for current products and proposed products and competitive
improvement projects into a new portfolio of processes and products. The organi-
zation’s management sets financial objectives for the new portfolio and develops
primary and alternate strategic and financial plans to achieve the objectives given
assessed risks. The finance manager takes the new portfolio of processes and prod-
ucts and strategic and financial plans to banks and investment bankers to secure the
financing necessary to achieve financial objectives. Financial managers at the banks
and investment banks perform their respective risk assessments and decide on the
amount of financing and interest rate for loans or the rate of return required for the
sale of stocks. The risk-adjusted, weighted interest rate on loans and rate of return
on stocks becomes the organization’s minimum attractive rate of return (MARR) or
the hurdle rate that the new portfolio must earn for the organization to remain viable.

MARR = w Li × I Li × (1 − TC ) + w S j × RoE S j (1.1)
i j

where wLi = Li / ( i Li + j Sj ), wSj = Sj/( i Li + j Sj), I Li = interest rate charged
on loan i, TC = the organization’s combined tax rate, and RoESj = return on equity
interest rate for stock Sj. Given new financing, the organization then creates operating
plans, develops it portfolio of processes and products, deploys its processes incurring
cash flows and costs, and sells the portfolio of products generating revenues. Cash
flows, costs, and revenues are summarized into the annual income statement, balance
sheet, statement of retained earnings, and statement of cash position at the end of
each fiscal year, and the budgeting finance is repeated.
Example 1.1
An organization has the following outstanding loans and stock certificates and
a combined tax rate of 28.1%. Estimate the organization’s MARR.
Short term loans $1,000,000 @ 5% Solution: Total Liabilities and Equity = $20,000,000
Bonds $9,000,000 @ 7% MARR = [(1/20) 5% + (9/20) 7%](1 – 0.281) +
Preferred stock $3,000,000 @ 9% (3/20) 9% + (7/20) 14%
Common stock $7,000,000 @ 14% MARR = 2.44% + 1.35% + 4.90% = 8.69%
Like the annual budgeting finance cycle, all products, processes, and systems
progress through a life cycle and accrue costs at each stage.
Product life cycle—all the time from conception to death and disposal of a product,
process, service, or system.
Live cycle costs—sum of all cost incurred during the product, process, service,
or system life cycle.
Life cycle costing—designing with an understanding of and accounting for all
the costs associated with a product, process, service, or system during its life cycle.
The typical product, process, service, or system life cycle is illustrated in Fig. 1.4.
In general, the typical life cycle proceeds through six stages.
1. Needs assessment and justification—(a) Define the technological, economic,
legal, or socio-human performance gap. (b) Identify and research alterna-
tives and their requirements. (c) Identify technological, economic, legal, socio-
human, and political feasibility of each alternative. (d) Develop an initial
conceptual design for each feasible alternative.
Fig. 1.4 Typical product, process, service, or system life cycle

2. Conceptual design—(a) Impact analysis of each feasible alternative to measure

and predict the change in life cycle costs attributable to the alternative. Impact
analyses are based on validated and reliable cause-and-effect design models
that control for factors other than the proposed design parameters that might
account for design performance and life cycle costs. (b) Concept proof via
CAD or simulation modeling of design performance and life cycle costs. Select
the design alternative with the highest performance/cost ratio. (c) Prototype
the design by building a small-scale tangible model or full-scale simulation
to validate the design concept by presenting an early version of the design
solution to real users. (d) Based on performance and failure feedback from
prototyping, correct design deficiencies and optimize the performance/cost ratio.
(e) Refine performance design and life cycle cost estimates into initial drawings,
specifications, and total life cycle cost estimates.
3. Detailed design—(a) Identify economic, human, physical, energy, and infor-
mation resources needed for the production/construction and operational
phases. (b) Perform risk, safety, and sustainability analyses for the produc-
tion/construction and operational phases. (c) Refine initial drawings, specifi-
cations, and total life cycle cost estimates into final drawings, specifications,
and total life cycle cost estimates. (d) Select reliable suppliers of economic,
human, physical, energy, and information resources needed for the produc-
tion/construction and operational phases. (d) Develop the project management
plan. A project management plan is a formal, approved document that defines
how the production/construction phase project will be executed, monitored, and
controlled. (e) Develop the transfer to operation plan. The transfer to operation
plan is the final document of the project plan. It specifies project completion
criteria, legal/regulatory closeout, complete product support documents, the
transfer to operation documents and training.
4. Production/construction (project management/engineering)—(a) Build, add
on, or upgrade production facilities for the specified products or services. (b)
Build, add on, or upgrade supporting systems infrastructure to achieve produc-
tive efficiency and effectiveness. (c) Develop operational use plans with future
management and process engineering.
5. Operational—Acquire materials, human, energy, and information inputs,
produce products and services, manage human factors and safety, and maintain
facilities and equipment until retirement.
6. Decline and retirement—(a) Develop a phaseout project management plan. (b)
Phase out and retire products and services, equipment, and facilities. (c) Assure
responsible disposal of non-hazardous and hazardous materials and securing
production records and intellectual property.
There are three basic approaches to product life cycle design.
• Bottom-up design starts with the construction of components, bringing compo-
nents together in subassemblies, and assembling the final product (CAD-centric).
• Top-down design starts with the high-level functional requirements and decom-
poses and allocates requirements to intermediate levels and finally to components
at the physical implementation layer (concept products).
• Both-ends-against-the-middle design components are constructed within the
context of intermediate levels and intermediate levels within the high-level
functionality (emergent technologies).
The major issue in life cycle engineering is the cost impacts of design changes.
Two key concepts in life cycle engineering are: (1) Design decisions made early in
the life cycle “lock in” later benefits and costs. (2) The later in the life cycle that
design changes are made, the higher the costs of the changes. Figure 1.5 illustrates
the general relationship between committed total life cycle costs and life cycle costs
spent and the life cycle phase in which the change is made.
Figure 1.6 illustrates the general relationship between the ease and cost of design
changes and the life cycle phase in which the change is made.
From Figs. 1.5 and 1.6, it can be inferred that the needs assessment and conceptual
design phases are the minimum life cycle cost impact times to make design changes
before design costs are committed. In these early phases, engineers should consider
the life cycle cost impacts of materials, testing and quality assurance, production,
maintenance, warranty, and liability costs in the operational phase.
Fig. 1.5 Committed and spent life cycle costs versus design phase
1.7 Engineering Life Cycle Cost Management 23
Fig. 1.6 Ease and cost of design changes versus design phase
1.7 Engineering Life Cycle Cost Management
Design inputs are required from multiple engineering disciplines to maximize the
differential life cycle benefits relative to differential design costs. This section briefly
summarizes the life cycle design contributions required by different engineering
disciplines to maximize the life cycle benefit–cost ratio.
Research Engineering Management
Research Engineering—the systematic, intensive study of natural phenomena to achieve
fully scientific understanding of the phenomena.
• Basic Research—research devoted to attaining fuller knowledge of the natural

phenomena under study, rather than practical application, although it may be of
present or future interest in solving applied problems.
• Applied Research—research directed toward applying knowledge from basic
research and other applied research to solve practical problems and has commer-
cial potential for new products, processes, or systems.
Planning and organizing for research engineering activities includes:
• Staffing for the required scientific, engineering, and technical skills.
• Laboratory, shop, and office facilities.

• Raw materials.
• Computers; CAD, simulation, and modeling software; and data and knowledge
bases.
• Technical libraries.
• Publication support including word processing and conference attendance.
Typically, research engineering precedes the “market analysis” phase of the
product life cycle.
Development Engineering Management
Development Engineering—the systematic application of scientific knowledge directed
toward the production of useful materials, devices, methods, or systems through prototype
and scale-up to full processes.
Research and development, R&D, are often lumped together as a single func-
tion with dual objectives of scientific discovery and development of materials,
devices, methods, or systems with commercial potential. Planning and organizing
for development engineering activities includes:
• Staffing for the required engineering and technical skills.
• Laboratory, shop, and office facilities.
• Raw materials.
• Computers; CAD, simulation, and modeling software; and data and knowledge
bases.
• Technical libraries.
• Copyright, patent, and trademark legal support.
Typically, development engineering precedes the “market analysis” phase of the
product life cycle.
Design Engineering Management
Design Engineering—the recognition of a human or societal need, conception of an idea
to meet that need, definition of the problem, coordination with development (or R&D) to
produce a product or process or system to meet that need, and construction of a prototype
to test physical, human perception, economic, and commercial feasibility.
Planning and organizing for design engineering activities includes:

• Prototype shop and office facilities.
• Materials and component input from development.
• Computers; CAD, simulation, and modeling software; and specification
databases.
• Copyright, patent, trademark, and product safety and liability legal support.
Design engineering involves the first three phases (market analysis, conceptual
design, and detailed design) of the product life cycle.
Product Engineering Management

Product Engineering—developing a device, assembly, or system such that it can be produced
as an item for sale through some production manufacturing process.
Product engineering usually entails activities dealing with issues of cost,

producibility, quality, performance, reliability, safety, serviceability, user features,
and product disposal with an objective of making the resulting product attractive
to its intended customers. Planning and organizing for design engineering activities
includes:
• Prototype shop and office facilities.
• Test equipment and tools.
• Materials and component input from development.
• Computers; CAM software; spreadsheets; and ERP, quality/reliability, statistical
modeling software, and databases.
Product engineering involves all phases of the product life cycle.
Process Engineering Management
Process Engineering—the design, operation, control, and optimization of chemical, phys-
ical, and biological processes through the integration of technology and humans with the aid
of systematic computer-based methods.
There are three fundamental types of process engineering:

• Mechanical and assembly processes.
• Powders, liquids, and gas chemical processes.
• Biological processes.
Planning and organizing for process engineering activities includes:
• Small-scale process laboratories and office facilities.
• Product design requirements.
• Computers; simulation software; spreadsheets; large-scale linear and nonlinear
programming; and facility process control and feedback software.
Process engineering is initiated in the detailed design phase and implemented in
the production/construction and operational phases.
Information Engineering Management
Information Engineering—an architectural approach to planning, analyzing, designing, and
implementing computer hardware, network, and software applications within an enterprise.
In the twenty-first-century organization, information engineering supports all

phases of the product life cycle with data and information technology. Planning
and organizing for information engineering activities includes:

• Computer rooms, servers, computers, network equipment, operating systems,
data/information/knowledge bases, systems monitoring software.
• Data, information, and knowledge design requirements.
Information engineering supports all phases of the product life cycle.
Project Engineering Management
Project Engineering—It bridges the boundaries between engineering and project manage-
ment, leading the technical workers who contribute to the building of structures or
products.
In some cases, the project engineer is the same as a project manager but in
most cases these two professionals have joint responsibility for leading a project.
A project engineer’s responsibilities include schedule preparation, pre-planning, and
resource forecasting for engineering and other technical activities relating to the
project. Planning and organizing for project engineering activities includes:
• Staffing for the required engineering management skills.
• Project management office.
• Software: project management, data/information/knowledge base management,
spreadsheets, and configuration management.
Project engineering supports project management phase of the product life cycle,
possibly early in the operational phase, and the decline and retirement phase.
Facilities Engineering Management
Facilities Engineering—utilities engineering, maintenance, environmental, health, safety,
energy, controls/instrumentation, civil engineering, and HVAC needs.
In the twenty-first-century organization, facilities engineering is essential for

designing and maintaining controlled facility environments demanded by personnel
and processes for optimized performance and product manufacture. Planning and
organizing for facilities engineering activities includes:
• Offices, tool rooms, facilities rooms, supplies, and equipment storage.
• Process control data gathering software, facilities monitoring and control soft-
ware, maintenance resource planning software, spreadsheets.
Facilities engineering supports all phases of the product life cycle.
Systems Engineering Management
Systems Engineering —an interdisciplinary field of engineering that focuses on how to
design and manage complex engineering projects over their life cycles.
Fig. 1.7 Systems

engineering integration of
life cycle costs (Source
Systems Engineering
Fundamentals, Defense
Acquisition University Press,
2001)
Systems engineering deals with work processes, optimization methods, and risk
management tools in projects. It overlaps technical and human-centered disci-
plines such as control engineering, industrial engineering, organizational studies,
and project management. Planning and organizing for systems engineering activities
includes:
• Staffing for the required engineering management skills.
• Offices.
• Software: data/information/knowledge base management and graphical browsing;
simulation; artificial intelligence, decision, and reasoning; neutral networks; and
configuration management.
Figure 1.7 illustrates the concept that systems engineering integrates all phases
of the product life cycle into a holistic and integrated function.
1.8 Budgeting for Engineering Operations and Projects
Budget—a quantitative expression of planned sales volumes, revenues, resource quantities,

costs/expenses, assets, liabilities, and cash flows for a defined period of time.
A budget is summary of planned revenues and expenses for some future period,
usually a fiscal year, quarter, or month. The first use of a budget is as a guide for
organizational management toward attainment of financial and operational goals.
Budgets predict fiscal outcomes given current strategic, marketing, and operational
plans. Hence, budgets provide guidance on the amounts and timing of expected
revenues and expenditures. The second use of a budget is for performance eval-
uation and control. Amount and timing variances from a planned budget provide
signals of opportunities (positive variances) and under performance (negative vari-
ances). When properly applied, budgets should focus management attention on the
effectiveness of planning, communication, and coordination within the organiza-

tion. Properly applied, budgets provide the basis for performance measurement and
evaluation. However, care should be exercised in applying budgets for performance
measurement and evaluation, because each budget is a quantification of many subjec-
tive judgments in predicting future revenues and expenditures. Many future risks to
revenues and expenses cannot be fully quantified. Risks that can be quantified and
are within some level of control by responsible management are subject to perfor-
mance measurement and evaluation. Risk, imprecision, and uncertainty outside the
control be a responsible manager cannot be included in performance measurement
and evaluation. A budget cannot be allowed to become an inflexible tool. Budgets
should be flexible planning tools part of a continuous planning process during each
fiscal year to promote management response non-quantifiable risk, imprecision, and
uncertainty. The following types of budgets are most prevalent in use.
• Master budget—the projection of sales, revenues, and expenses for an organiza-
tional unit or product line.
• Capital budget—long-term planning of capital expenditures for facilities and
equipment.
• Departmental budget—a cost center plan of expenditures for resources, materials,
consumable assets, and services and the liability or equity financing required
capital assets.
• Flexible budget—an overhead budget where overhead costs are established for
a relevant range of activities rather than a single activity level. As a result, the
overhead budget is adjustable to activity levels.
• Special budgets—prepared as needed to support investment and operating
decisions outside of normal budgeting.
• Governmental budgets—expenditures made based on appropriations authorized
by a legislative body. The revenue portion of the budget indicates funding sources
for authorized expenditures. The expenditure portion establishes ceilings on the
amount of expenditures by category.
Typically, ongoing engineering operations are controlled with departmental
budgets, and engineering projects are controlled through capital budgets.
The organizational annual budgeting cycle is illustrated in Fig. 1.8. The budget
cycle allows the organization to absorb and respond to new information arising from
unquantifiable risk, imprecision, and uncertainty. The budget cycle consists of four
phases: (1) preparation and submission, (2) approval, (3) implementation, and (4)
audit and evaluation.
The responsibility for budget preparation varies with the type of budget. The
responsible manager starts by evaluating variances from the prior period budget
relative to the strategic or operations plan. She or he then estimates the revenues
and expenditures needed to support the next period’s long-term strategic plan and
operations. She or he then adjusts the cash flows to account for variances encoun-
tered in the prior period’s budget and finalizes the budget for the next operating
period. All submitted operational budgets are summarized, submitted to organiza-
tional top management, and compared to the master budget for the next operating
1.8 Budgeting for Engineering Operations and Projects 29
Fig. 1.8 Four-phase Budget Cycle
period. Variances between summarized operational budgets and the master budget are
resolved, and the master budget and operational budgets are adjusted to reflect agreed
resolutions. During the implementation phase, budgets are continually updated as
revenues and expenses are incurred and compared to the approved operational and
master budgets. Negative variances (shortfalls in revenues or overages in expenses)
are addressed, and the master and operational budgets are revised. Positive vari-
ances (overages in revenues or shortfalls in expenses) are likewise noted but provide
management flexibility in adjusting strategic plans. The final phase of the budgetary
process is audit and evaluation. The main goal is to assure compliance to strategic
and operational plans through the assessment of revenue and expenditure variances.
The secondary goal is to provide feedback to responsible managers and improve their
budget forecasting skills.
As noted, engineering operations are treated as cost centers, and only expenditure
variances are controlled. A typical cost center budget template is shown in Fig. 1.9.
Actual, budget, and variance in expenditures are accumulated by account codes. This
allows engineering managers to further analyze the sources of positive and negative
variances.
Likewise, as noted, engineering projects are controlled by a capital budget. There
are two types of engineering projects. In the first type, the addition of productive
capacity is transitioned to operations management with no scale-up operations. In
the second type, scale-up operation of the new productive capacity is required under
the project plan to resolve scale-up issues and optimize the productive capacity
before turning the new productive capacity over to operations. In the second case,
the engineering project will generate sales volumes and revenues in the early part of
the operational phase of the product life cycle to scale up to full production for line
Fig. 1.9 Engineering operations budget template
or facility testing and acceptance. Thus, product engineering and project engineering
may operate as profit centers, and in addition to costs and expenses, their budgets
must also account for:
• Sales revenues from products.
• Consulting and professional fee revenues.
• Other management fee revenues.
A typical product and project budget template is shown in Fig. 1.10. Actual,
budget, and variance in revenues and expenditures are accumulated by account codes.
This allows product and project engineering managers to further analyze the sources
of positive and negative variances.
1.9 Summary
This chapter established the context of engineering managerial decision making

within for-profit and not-for-profit organizations. Engineering managerial economic
risk decisions are constrained by organizational business goals and objectives, the
resources needed and available to produce its products and services, and the allocation
of those resources.
To frame the engineering managerial economic risk decision-making context, the
chapter set forth definitions of engineering management and engineering managerial
economics.
1.9 Summary 31
Fig. 1.10 Product and project engineering budget template
Engineering management combines technical expertise with managerial knowledge to coor-

dinate operational performance of engineering disciplines within an organizational setting
or coordinate and control technical project outputs.
Engineering managerial economics is the body of knowledge and methods devoted
to the systematic evaluation of the economic benefits resulting from ongoing engineering
activities or proposed engineering projects in relation to the economic costs of those activities
or projects.
The fundamental types of business for-profit organizations were specified.

A proprietorship is an unincorporated business owned by one individual.
A partnership is owned by two or more individuals, who jointly invest money, skills, and
assets and who share in profits or losses in accordance with the terms set forth in their
partnership agreement.
A corporation is a legal entity recognized under state or federal law.
The fundamental types of governmental not-for-profit agencies were identified

as federal civilian and military, state, and local. This book addresses the economic
decisions for the set of engineers and engineering managers employed in corpora-
tions, partnerships, state and local governmental agencies, and non-military federal
governmental agencies.
In the design phase, engineers’ primary task is to plan capital expenditure for
equipment, facilities, and supporting infrastructure needed for the organization to
produce its products or services.
Capital expenditure is the purchase of an asset with a life greater than one fiscal year.
An asset is land, physical facilities, equipment, money, monetary instruments, and intel-
lectual property owned or controlled by a business organization for the purpose of producing
products or services to provide a return on investment in the asset.
A fiscal year is a 12-month time period that a business organization uses for the accounting
purpose of preparing financial statements. The fiscal year may or may not be equal to the
calendar year.
In the implementation and maintenance phases, engineers’ primary task is cost

control for the efficient operation and maintenance of productive assets. In the retire-
ment and disposal phase, engineers’ primary task is defining all activities necessary
for responsible disposal and minimizes the project costs associated with disposal.
Engineering decisions, and the corresponding cash flow implications, exist along
three timescales. Short term decision for expenditures within the current fiscal
year. Intermediate-term economic decisions are tied to the budget planning period,
which itself is determined by the organization’s product life cycle. Complexlong
range economic decisions to develop future products and services for future budget
planning periods.
The product life cycle is the expected life of a product or service from the time of its
conception to its termination and disposal.
Engineering economic principles:

1. Money has time value.
2. All investments in productive assets must be economically justified.
3. All economic decisions must be based on differences in cash flows among the
alternatives considered.
4. Use a common unit of measurement (metric) across alternative to make
consequences commensurable.
5. Alternatives must be examined over a common planning horizon.
6. Only differences are relevant.
7. Only feasible alternatives can be considered.
8. Investment criteria must include the time value of money due to capital
acquisition and rationing.
9. Separable decisions should be made separately.
10. The relative degrees of uncertainty associated with future cash flows must be
incorporated into the economic decision process.
11. The effectiveness of capital budgeting procedures is a function of their
implementation across organizational levels.
12. Post-decision audits are required to improve the quality of decisions over time.
Three fundamental exchanges must take place for an organization to produce a
product.
1. Securing the capital (financing).
2. Purchasing assets (investing) by which to produce products.
3. Generating returns (producing) from the sales of its products.
The finance manager oversees the financing and investing activities.
Finance—The acquisition of capital from lenders and investors, budgeting scarce
resources effectively, and investing funds in portfolios of assets and projects that achieve
market and financial objectives yielding the maximum return/risk trade-offs with the
goal of maximizing the wealth or value of the organization to its stockholders.
1.9 Summary 33
The minimum attractive rate of return (MARR) is the risk-adjusted, weighted

interest rate on loans and rate of return on stocks that the portfolio of products,
services, and processes
must earn for the organization
to remain viable.
MARR = w Li × I Li × (1 − TC ) + w S j × RoE Si
i j
All products, processes, and systems progress through a life cycle and accrue
costs at each stage.
Product life cycle—all the time from conception to death and disposal of a product, process,
service, or system.
Live cycle costs—sum of all cost incurred during the product, process, service, or system
life cycle.
Life cycle costing—designing with an understanding of and accounting for all the costs
associated with a product, process, service, or system during its life cycle.
The typical life cycle proceeds through six stages

1. Needs assessment and justification.
2. Conceptual design.
3. Detailed design.
4. Production/construction.
5. Operation.
6. Decline and retirement.
Two key concepts in life cycle engineering are: (1) Design decisions made early
in the life cycle “lock in” later benefits and costs. (2) The later in the life cycle that
design changes are made, the higher the costs of the changes.
Design inputs are required from multiple engineering disciplines to maximize the
differential life cycle benefits relative to differential design costs.
Research Engineering—the systematic, intensive study of natural phenomena to achieve
fully scientific understanding of the phenomena.
Development Engineering—the systematic application of scientific knowledge directed
toward the production of useful materials, devices, methods, or systems through prototype
and scale-up to full processes.
Design Engineering—the recognition of a human or societal need, conception of an idea
to meet that need, definition of the problem, coordination with development (or R&D) to
produce a product or process or system to meet that need, and construction of a prototype
to test physical, human perception, economic, and commercial feasibility.
Product Engineering—developing a device, assembly, or system such that it can be
produced as an item for sale through some production manufacturing process.
Process Engineering—the design, operation, control, and optimization of chemical,
physical, and biological processes through the integration of technology and humans with
the aid of systematic computer-based methods.
Information Engineering—an architectural approach to planning, analyzing, designing,
and implementing computer hardware, network, and software applications within an
enterprise.
Project Engineering—bridges the boundaries between engineering and project manage-
ment, leading the technical workers who contribute to the building of structures or
products.
Facilities Engineering—utilities engineering, maintenance, environmental, health,

safety, energy, controls/instrumentation, civil engineering, and HVAC needs.
Systems Engineering—an interdisciplinary field of engineering that focuses on how to
design and manage complex engineering projects over their life cycles.
A budget is summary of planned revenues and expenses for some future period,
usually a fiscal year, quarter, or month.
Budget—a quantitative expression of planned sales volumes, revenues, resource quantities,
costs/expenses, assets, liabilities, and cash flows for a defined period of time.
The budget cycle consists of four phases: (1) preparation and submission, (2)
approval, (3) implementation, and (4) audit and evaluation. Engineering operations
are treated as cost centers. Engineering projects are controlled by a capital budget.
1.10 Key Terms
Asset
Budget and budget cycle
Capital expenditure
Corporation
Cost center
Engineering
Engineering Management
Engineering managerial economics
Fiscal year
Finance
Life cycle cost and costing
Management
Partnership
Product
Product life cycle
Production
Proprietorship
Service.
Problems
1. The term engineering economic decision refers to any investment related to an
engineering project or investment. What facet of the decision is most important
from the engineering point of view?
2. 2. List the two properties of professional engineers.
3. List the three fundamental types of business organizations.
4. Define the product life cycle.
1.10 Key Terms 35
5. Given that an intermediate economic decision involves costs in the $10,000s,

are of intermediate risk, affect organizational and stakeholder impacts, and
require formal analysis, define simple and complex decisions.
6. List the five (5) basic classes of engineering economic analyses.
7. From the 12 engineering economic principles, explain the statement, “money
has time value” relative to the purchase and deployment of productive assets.
8. What are the three fundamental exchanges that must take place for an
organization to produce a product?
9. An organization has $22,000,000 in outstanding common stock on which
stockholders expect 15% return on equity and $5,000,000 in outstanding
preferred stock with a dividend rate of 12%. It has $9,000,000 in short-term
loans at 4% interest and $14,000,000 in bonds at an annual coupon rate of 8%.
The organization has a combined tax rate of 30%. What is the organization’s
MARR?
10. A project manager is completing the sixth quarter of a two-year project to
construct a new production facility. Per the project plan, in the sixth quarter
she initiated scale-up production on the first production line. The project budget
for the sixth quarter is shown below. Estimate the variances and note potential
corrective actions needed in the seventh quarter to keep the project cash flows
on schedule.
Proj: MF-20## Name: New manufacturing facility Period: 6th Qtr
Account desc. Acct. no. Actual $1K Budget $1K Variance $1K
Scale-up production
Sales SR1001
Operating Expenses $200 $500
Materials OE2001 $18 $40
Wages/salaries OE2002 $120 $280
Utilities OE2003 $6 $15
Fixed costs FC3001 $6 $15
Overhead OH4001 $30 $30
Production variance
Project expenses
Construction PC1001 $19,800 $20,000
Equipment PC1002 $5,600 $5,500
Materials PC1003 $900 $890
Utilities PC1004 $260 $250
Wages/salaries PC1005 $1200 $1200
Services PC1006 $500 $480
Project variance
Chapter 2
General Accounting and Finance
Fundamentals
Abstract Revenues and expenses along with capital investment costs drive decision
making in all organizations, for-profit and not-for-profit. The accounting function
collects, summarizes, and reports revenue, expense, and cost transactions. Hence,
accounting is the financial language of all organizations. The objective of this
chapter is to provide current and future engineering managers and project engineering
managers with the accounting knowledge necessary to communicate in an organi-
zation’s financial language and apply accounting and financial reports in managing
engineering operations and capital projects. First, this chapter sets forth the definition
of accounting and the information it provides for organizational decision making.
Next, the sources of operations financing are specified, and the minimum attractive
rate of return is formally defined. The role of accounting and the accounting cycle are
discussed. The three fundamental accounting reports are discussed with an example
that illustrates how the three reports integrate within the accounting cycle. Finally,
financial ratios that measure an organization’s financial health are specified.
2.1 Introduction
Definition: Accounting is the discipline that systematically measures, records,

interprets, and communicates the financial activities of an organization, providing
insight into the trustworthiness, profitability, and solvency of an organization.
Accounting is concerned with the measurement, recording, interpretation, and

communication of economic event, financial transactions, measurement of economic
value, and determination of periodic changes in economic values. Accounting
provides information on

https://doi.org/10.1007/978-3-030-87767-5_2
38 2 General Accounting and Finance Fundamentals
• Allocation of scarce resources to organizational productive processes.

• Management and direction of resources within the organizations.
• Reporting on the custodianship of resources under management control.
As a discipline, accounting can be classified according to the four primary
organizations that it serves: corporate, public, government, and forensic. Simi-
larly, accounting can be classified according to the reporting purpose: (1) Finan-
cial accounting of organizational performance to lenders, stockholders, and govern-
mental agencies. (2) Managerial accounting of organizational financial performance
relative to strategic plans and budgets to internal management. (3) Cost accounting
estimates costs, allocates overhead costs, and develops standard product costs. (4)
Tax accounting assures that all relevant tax laws and regulations are followed by the
organization. (5) Auditing provides independent analyses of organizational financial
activity to ensure that records transactions in accordance with Generally Accepted
Accounting Principles (GAAP) and applicable standards, laws, and regulations.
2.2 Sources of Operations Financing
From Chap. 1, the organization has three sources financing:

• Lenders—loans from banks and financial institutions.
• Investors—cash investment in the organization from the purchase of preferred
and common stock.
• Retained earnings—the portion of net income which is retained and invested
in productive assets by the organization rather than distributed to its owners as
dividends.
Organizational sources of financing for new products and services or for the
expansion of existing products and services are either lenders (banks) or investors
(stockholders). From Fig. 1.3, banks and stockholders provide financing through the
annual finance cycle.
• Begins with the present financial position.
• Examines financial and competitive trends and risks in the macro, business, and
microeconomic environments.
• Evaluates competitive capacities of current and proposed products as a new
portfolio of products and processes.
• Develops strategic financial plans.
• Acquires financing from lenders (banks) and investors which sets the MARR.
• Monitors financial results of operations.
Definition: Minimum Attractive Rate of Return (MARR)—the risk adjusted,

weighted, minimum acceptable rate of return, or hurdle rate that must be earned
on a project or investment, given its opportunity cost of foregoing other projects
or investments.
2.2 Sources of Operations Financing 39
From Chap. 1, MARR may be measured as

MARR = wLi × ILi × (1 − TC ) + wSj × RoESj (2.1)
i j

where wLi = Li/( i Li + j Sj), wSj = Sj/( i Li + j Sj), I Li = interest rate
charged on loan i, T C = the organization’s combined tax rate, and RoESj = return
on equity interest rate for stock Sj.
2.3 The Role of Accounting in the Organization
The overriding purpose of financial accounting is to summarize all financial activity

in the profit and loss income statement, balance sheet, retained earnings statement,
and cash flow statement. Accounting practices are standardized to ensure compliance
to all state and federal laws and to avoid fraud. Accounting principles are referred
to as Generally Accepted Accounting Principles (GAAP). In the corporate organi-
zation, the four fundamental questions that accounting statements must answer are
as follows:
1. What were the organization’s revenues and expenses during the fiscal period and
how much was retained as net profit and cash profit—answered by the income
statement?
2. How did the organization reinvest its profit into new products or services—
answered by the statement of retained earnings?
3. How much cash did the organization generate from sales and spend during the
fiscal period—answered by the statement of cash position?
4. What is the organization’s financial position in productive assets, liabilities
(loans) against those assets, and stockholder ownership at the end of the fiscal
period—answered by the balance sheet?
To obtain the answers to these questions:
Financial accounting looks at past financial data with the objective of determining
an organization’s value as a whole and at future investment opportunities with the
goal of maximizing the wealth or value of the organization.
• Shareholders and investors will use financial information to decide if a public
company is undervalued and worth investing in or overvalued and should be
avoided.
• Creditors will use financial information to decide whether an organization is a
good risk before lending money.
• Governmental agencies use financial information to levy taxes on for-profit
organizations.
Managerial accounting is used internally for planning and for moving an

organization forward in a financially sound manner.
• Accountants look at the historical financial data stream as well as the current
economy and make assumptions about trends and what these trends mean for the
organization’s future.
• Managers predict an organization’s financial future and make sound decisions
based upon those expectations.
As part of financial transactions, accounting data tracks the revenues and costs
of projects and products, which become the basis for estimating future revenues and
costs in management planning and implementation and in the engineering economic
valuation of future products, services, processes, and systems.
• Accounting measures and records financial transactions and provides the basis
for assessing the economic viability of the organization.
• Management allocates available investment funds to projects, evaluates unit and
firm performance, allocates resources, and selects and directs personnel.
• Engineering analyzes the economic impact of design and project alternatives
over their present and future life cycles.
Figure 2.1 summarizes the interrelationship among accounting, management, and
engineering.
AccounƟng Management Engineering
Recording Planning & se ng Iden fy engineering

Measuring goals needs
Interpre ng Capital budge ng Collect/analyze data
Communica ng Opera ons budget- Feasibility of design al-
ing terna ves
Organizing & Staff- Evaluating projects
ing Benefit-costs tradeoﬀs
Analyzing risks Recommending designs
Assessing impacts and projects
Controlling & Deci- Audit project results
sion Making
Financial Ac vi es Implementa on Predic on
Fig. 2.1 Financial interrelationship among accounting, management, and engineering

2.3 The Role of Accounting in the Organization 41
Fig. 2.2 Transactions accumulation in the accounting cycle
The central tenet of transaction accounting is objective costing (i.e., traceable to

a transaction record). A transaction is an exchange of money or credit for a product
or service documented by a receipt, invoice, bill of lading, etc. Accordingly,
• Accounting records financial transactions in nominal or stable actual dollars
(A$)—reference the chapter on inflation.
• Assets are valued at their acquisition cost and adjusted for depreciation and
improvement costs. If the market value is lower than the adjusted cost, the market
value is used.
Transactions are accumulated and recorded for each accounting cycle. The
accounting cycle is a set of rules within a specified methodology to ensure the accu-
racy and conformity of financial statements. Figure 2.2 illustrated the accounting
cycle for accumulating and recording transactions.
1. Transaction—financial exchange.
2. Entries—listing in original journals.
3. Posting—entering into affected accounts in the general ledgers.
4. Trial balance—end of period initial balance.
5. Worksheet—corrections tracked in worksheets.
6. Adjustments—verified corrections posted to general ledger accounts.
7. Financial statements.
8. Close the books—reduce revenue and expense accounts to zero.
Fig. 2.3 Transactions journals and ledgers
Figure 2.3 illustrates the basic journals and ledgers used in recording transactions.
• Credit sales and sales returns are recorded in their respective journals and
accumulated in the sales ledger.
• Credit purchases and purchase returns are recorded in their respective journals
and accumulated in the purchases ledger.
• Cash receipts and payments for cash sales are recorded in the cash journal.
• Other transactions are recorded in the general journal.
• Cash receipts and payments and other transactions are accumulated in the general
ledger.
Figure 2.4 shows that the input to the current accounting cycle is the four reports
of financial performance and position and that the output is the same four reports
updated for operational transactions during the current accounting cycle.
2.4 The Balance Sheet
The balance sheet summarizes the value of the organization’s assets available to
carry out its economic activities and the liabilities and ownership financing claims
against those assets on each specific date of the end of an accounting cycle.
• Assets are the plant, equipment, supplies, etc., owned by the firm. Tangible
assets (physical) include land, buildings, and equipment. Intangible assets
(non-physical) include patents, copyrights, trademarks, and amounts owned by
customers.
• Liabilities are claims against the firm from external sources of financing (notes,
bonds, loans, etc.).
• Equity is internal financing provided by the firm’s owners (stockholders).
Under double-entry accounting, the fundamental accounting equation is
2.4 The Balance Sheet 43
Fig. 2.4 Inputs and outputs of each accounting cycle
Assets value = Liabilities value + Equity value (2.2)
Assets (debits, credits) = Liabilities (debits, credits)

+ Equity (debits, credits)
On the assets side of the equation, debits increase assets value, and credits decrease
assets value. On the liabilities + equity side, debits decrease the value of liabilities
or equities, and credits increase their value. The fact that the firm’s resources (assets)
of revenue generation are balanced by its sources of financing (liabilities + equity) is
the basis for the name “balance sheet.” The fundamental accounting equation, assets
= liabilities + equities, forms the basis of double-entry accounting (Fig. 2.5).
• Any financial transaction that increases (decreases) assets must also increase
(decrease) liabilities and equity by the same amount.
• Every financial transaction must have an offsetting debit and credit.
• Debits increase assets, whereas credits increase liabilities and equity maintaining
equality.
• Credits decrease assets, whereas debits decrease liabilities and equity maintaining
equality.
Fig. 2.5 Fundamental balance sheet equation
Assets are listed on the left side of the balance sheet in order of decreasing
liquidity; current assets, fixed assets, and other assets. Liabilities are listed on the right
side in order of decreasing liquidity. Equity is listed on the right side of the balance
sheet. Liquidity describes the ease with which a non-cash asset can be quickly bought
or sold in the market at a price reflecting its intrinsic value and converted to cash. Cash
is universally considered the most liquid asset. For example, under current assets in
Fig. 2.6, accounts receivable (money owed for finished products sold on credit) can
be discounted (sold at a value less than its book value) to a bank for cash. The differ-
ence between the book value and the cash received covers the bank’s interest rate
for holding the accounts receivables until payments are received. Likewise, short-
term notes and securities with payoffs due in the current fiscal year can be sold at
discount early in the year to generate cash for operations. Conversely, inventory is
not liquid. Raw materials inventories may be liquid if they are commodities that can
easily be sold on the open market. Raw materials and components inventories that are
specially made to meet the organization’s specifications will not be liquid. Specialty
raw materials and components must be integrated into finished products for sale
to customers. Work in process (WIP) inventories are the least liquid, because they
have been partially transformed into the organization’s products. Due to intellectual
property specification differences, partially transformed WIP cannot be integrated
into competitor’s products. WIP must be processed into finished products for sale
to customers to be converted to cash. Likewise, on the liabilities side of the balance
sheet, accounts payable and notes payable in the current fiscal year are more liquid
than accrued expenses, which may or may not be due in the current accounting cycle.
The balance sheet structure is illustrated in Fig. 2.6. An example balance sheet is
illustrated in Fig. 2.7. Note that the fundamental balance sheet holds with total assets
= $629,699,100 and total liabilities plus total equity = $629,699,100.
2.5 The Income Statement 45
Balance Sheet Example Layout
Assets LiabiliƟes
Current Assets Current liabiliƟes
Cash Accounts payable
Accounts Receivable Notes payable
SecuriƟes Acrued expenses
Inventories Total current liabiliƟes
Less: Bad debt account provision
Total current assets Long term liabiliƟes
Bank notes
Fixed assets
Land Total liabiliƟes
Plant and equipment
Less: Accumulated depreciaƟon Equity
Total fixed assets Preferred stock
Common stock
Other assets Capital Surplus
Long term securiƟes Retained earnings
Prepays/deferred charges
Intangibles Total equity
Total other assets
Total assets Total liabiliƟes and equity

Fig. 2.6 Balance sheet format
2.5 The Income Statement
The income statement summarizes the firm’s revenues and expenses from ongoing
operations over a stated period (usually month, quarter, or fiscal year). These are
intervals between consecutive balance sheet statements. The fundamental outcome
of the accrual income statement is the estimate of net profit.
The AAA Company

Balance Sheet as of December 31, 20##
Assets LiabiliƟes
Current Assets Current LiabiliƟes
Cash $40,597,100 Accounts Payable $90,000,000
Accounts Receivable $76,259,000 Wages Payable $20,000,000
Inventory $38,753,000 Bond Dividend Payable $1,000,000
Total Current Assets $155,609,100 Total Current LiabiliƟes $111,000,000
Fixed Assets Long Term LiabiliƟes
Equipment $153,590,550 Bank Notes $10,000,000
Less depreciaƟon ($40,000,000) $113,590,550
Building $345,499,450 Bonds $40,000,000
Less depreciaƟon ($20,000,000) $325,499,450
Land $10,000,000 Total Long Term LiabiliƟes $50,000,000
Total Fixed Assets $449,090,000
Owner's Equity
Other Assets Preferred Stock $60,000,000
Patents $15,000,000 Common Stock
Copyrights $10,000,000 Par Value $40,000,000
Total Other Assets $25,000,000 Capital Suplus $360,000,000
Retained Earnings $8,699,100
Total Equity $468,699,100
Total Assets $629,699,100 Total LiabiliƟes and Equity $629,699,100
Fig. 2.7 Example balance sheet
Net Incomen = Revenuen − Expensesn (2.3)
Net Incomen = Rn − (On + Mn + Dn + In ) = EBTn − Tn
Net Incomen = Rn − (On + Mn + Dn + In ) − [Rn − (On + Mn + Dn + In )]TRn
where Rn = revenue in period n, On = operating expenses, M n = maintenance

expenses, Dn = depreciation expenses, I n = interest expenses, T n = tax expenses,
and TRn = combined tax rate.
In the accrual income statement in Fig. 2.8, the cost of goods sold includes labor,
materials, and indirect costs directly related to production. Under the accrual basis of
accounting (or accrual method of accounting), revenues and expenses are reported on
the income statement in the accounting period in which they are earned or incurred.
Revenues may be in both cash and credit sales. In the case of credit sales, the organi-
zation allows the customer to take possession of its products in the current accounting
period but make cash payment(s) in subsequent accounting periods. The revenue is
recognized in the current accounting period, and the balance due to the organization
is carried in an accounts receivable journal under current assets until the balance
due is paid off. Likewise, on the cost of goods sold side, the organization may order
and take possession of materials and supplies needed for production in the current
accounting period paying its suppliers with some combination of cash and credit. The
amount owed is carried in an accounts payable journal under current liabilities until
2.5 The Income Statement 47
OperaƟng revenuse
Sales
Less: Returns and allowances
Net revenues
OperaƟng Expenses Eng. Managerial
Cost of goods sold Operations/Project
Sales promoƟon Income Statement
DepreciaƟon
General and administraƟve expenses
Lease payments
Total operaƟng expenses
Earnings before interest and taxes (EBIT)
OperaƟng interest expenses
Earnings before taxes (EBT)
Taxes
Total operaƟng income (EAT)
Non-operaƟng revenues
Less: Non-operaƟng expenses
Non-operaƟng interest expenses
Total non-operaƟng income
EBIT + total non-operaƟng income
Taxes
Net income
Fig. 2.8 Accrual income statement format
the balance owed is paid off. Cost of goods sold includes labor, materials, and indi-
rect expenses. The economic design of production systems must include estimates
of labor, materials, and indirect (supervision, maintenance, operating overhead, and
other support) expenses. Also, of interest to engineering managerial economics is
depreciation expenses, which will be discussed in its own module. Note in Fig. 2.8 that
engineering managerial economic projects account for only through Total Operating
Income or Earnings After Taxes (EAT). The organization itself may have additional
non-operating revenues and expenses associated with non-operating investments in
strategic suppliers or partners or temporary investment of excess cash in notes, loans,
or stock. These accrual revenues and expenses are outside the scope of typical engi-
neering managerial operations or projects and not included in their revenue and
expenses estimates. Figure 2.9 illustrates an example accrual income statement.
The AAA Company

Income Statement for December 20##
OperaƟng Revenues
Sales $47,800,000
Less: Returns and Allowances ($1,740,000)
Total OperaƟng Revenues $46,060,000
OperaƟng Expenses
Cost of Goods and Services Sold
Labor ($10,280,000)
Materials ($9,280,000)
Indirect Costs ($4,560,000)
Total CoGS ($24,120,000)
Selling and PromoƟon Expenses ($1,860,000)
DepreciaƟon ($900,000)
General and AdministraƟve ($4,320,000)
Lease Payments ($1,020,000)
Total OperaƟng Expenses ($32,220,000)
Earnings Befort Interest and Taxes $13,840,000
OperaƟng interest ($2,000,000)
Earnings Before Taxes $11,840,000
Less: State Taxes at 9.1% ($1,077,440)
Federal Taxable Income $10,762,560
Federal Taxes at 21.0% ($2,260,138)
Net Profit $8,502,422
Fig. 2.9 Example accrual income statement
2.6 The Retained Earnings Statement
When a corporation has positive net profit, it must decide on how to reinvest that
profit. It has three options as follows:
• Pay dividends to stockholders if it does not have internal investments that have a
rate of return greater than the MARR.
• Pay some dividends to stockholders and invest in a limited number of internal
investments that have a rate of return greater than the MARR.
• Pay no dividends to stockholders, and invest all net profits into internal investments
that have a rate of return greater than the MARR.
When an organization declares stock dividends, preferred stock dividends must
be paid before common stock dividends. Much like bonds, preferred stocks have a
stated dividend. The dividend is not a legal liability until the corporation’s board of
2.6 The Retained Earnings Statement 49
The AAA Company

Retained Earnings Statement for December 20##
Beginning Balance
Retained earnings Jan. 1, 20## $711,000
Net income Dec 31, 20## $8,502,422
Total $9,213,422
Dividends declared and paid fiscal year 20##
Preferred stock dividends ($205,700)
Common stock dividends ($308,622)
Total dividends deducted ($514,322)
Retained earnings ending balance Dec 31, 20## $8,699,100
Fig. 2.10 Example retained earnings statement
directors declares it; however, many corporations view preferred stock dividends as
an indicator to the stock market of corporate financial health and viability. Not paying
dividends on preferred stock may be seen as an indicator of poor financial health and
cause devaluation of outstanding common stock market value. Net profit remaining
after preferred stock dividends is available for distribution as dividends to common
stockholders are or may be reinvested in internal investments with rates of return
greater than the MARR. As illustrated in Fig. 2.4, the retained earnings statement
is the link between the income statement and the balance sheet. The equation for the
addition of net profit to the balance sheet retained earnings is
Retained Earnings (current) = Retained Earnings (prior)

+ New Profit + new stock − dividends (2.4)
where “current” = current accounting period balance sheet, “prior” = prior

accounting period balance sheet, net profit from the current accounting period income
statement, “new stock” = cash inflow from the sale of new shares of preferred or
common stock—cash outflow for stock buybacks, and dividends = cash outflow for
preferred stock and common stock dividends. Figure 2.10 illustrates the retained
earnings statement for The AAA Company.
2.7 The Cash Flow Income Statement
The accrual income statement indicates net profit or net loss regardless of how prod-
ucts were sold (cash or credit) and cost of goods sold was incurred (cash or credit).
In the extreme case in a given accounting period, it is possible for an organization
to sell its products on credit and make all its purchases on credit with no change in
cash position. In the worst-case scenario, an organization could sell all its product
on credit and make all of its purchases with cash, that is, until the cash is depleted.
Lack of cash to maintain ongoing operations is one of the major causes of business
failure. Additionally, the accrual income statement ignores cash from financing and
investments. Hence, it is essential that an organization maintains a cash flow income
statement to track its cash position.
The cash flow income statement reports the difference between the sources and
uses of cash during a fiscal accounting period. The fundamental outcome of the cash
flow income statement is the estimate of cash net profit.
Net profit (cash flow) = Revenues − Expenses

+ Financing − Investments
Net Profitn = Rn − (On + Mn + In ) − Tn + RF − CI (2.5)
where RF = revenues from financing, C I = costs due to investments, and all transac-
tions are stated in cash flows. Accrual revenue from accounts receivable, debts from
accounts payable, and depreciation expenses are omitted from the cash flow income
statement.
In preparing the cash flow income statement, accountants identify the sources and
uses of cash according to the type of business activity.
• Operating activities—those cash flows from the production and sale of products
and services.
• Financing activities—cash from borrowing, the sale of stock, or interest payments
on notes and bonds the organization may own.
• Investing activities—cash for the purchase of new or used fixed assets (facili-
ties and equipment), the sale of old equipment, the purchase of stocks in other
organizations, or the purchase of bonds let by other organizations.
Summarizing the cash inflows and outflows from the three activities results in the
change in cash flow position for the accounting period.
Figure 2.11 presents the cash flow income statement for The AAA Company
for the period ending December 31, 20##. Note in this example, investment in
capital expenditures for new equipment and facilities ($5,000,000) was financed
by issuing bonds ($2,000,000) and common stock ($4,100,000–$1,100,000 repur-
chase preferred stock and declared dividend). The difference between the savings on
future dividends not paid on preferred stock and current dividends must be less than
or equal to the return on investment from future cash flows from the new equipment
and facility as justified by engineering economic analysis.
2.7 The Cash Flow Income Statement 51
The AAA Company

Cash Flow Income Statement for December 20##
OperaƟng Revenues
Cash Sales $43,566,400
Less: Cash Returns and Allowances ($1,545,120)
Total OperaƟng Revenues $42,021,280
OperaƟng Expenses
Cash Cost of Goods and Services Sold
Labor ($9,904,640)
Materials ($6,885,760)
Indirect Costs ($4,049,280)
Total CoGS ($20,839,680)
Cash Selling and PromoƟon Expenses ($1,651,680)
Cash General and AdministraƟve ($3,836,160)
Lease Payments ($1,020,000)
Total OperaƟng Expenses ($27,347,520)
Financing
Issue Bonds $2,000,000
Repurchase Preferred Stock ($1,000,000)
Issue Common Stock $4,100,000
Declared Dividend ($100,000)
Net Financing $5,000,000
Investments
Capital Expenditures ($2,000,000)
Purchase Facility ($4,000,000)
Net Investments ($6,000,000)
Cash Flow Before Taxes

Net Cash Flow $13,673,760
Less: Taxes Paid ($2,260,138)
Net Increase(Decrease) Cash $11,413,622
Cash at Beginning of Period $29,183,478
Cash at End of Period $40,597,100
Fig. 2.11 Example cash flow income statement

2.8 Financial Ratios Important to Engineering Managerial

Economics
An engineering project to install new facilities and equipment or upgrade existing

facilities and equipment must account for its effect on the organization’s finan-
cial health. An organization’s current financial health, or liquidity, is measured by
working capital. Working capital is the difference between current assets and current
liabilities and indicates the firm’s liquidity or ability to pay its current debts.
Working Capital = Current Assets − Current Liabilities (2.6)
An alternate measure of an organization’s current financial health, or liquidity, is

its current ratio which provides insight into the organization’s short-term solvency.
Current Ratio = Current Assets/Current Liabilities (2.7)
Although working capital and the current ratio indicate the organization’s ability
to meet maturing debts in the current accounting period, they do not account for
the structure of current assets in meeting those debts. Recall from discussion of the
balance sheet that current assets are ordered by liquidity, and it was observed that
inventory is not liquid. Hence, the greater proportion of current assets tied up in
inventory the lower the organization’s ability to make payments on current debts.
The acid-test ratio (also termed the quick ratio) indicates the organization’s ability
to pay its currently due debts by subtracting the value of inventory from current
assets.
Acid-test ratio = (Current Assets − Inventories)/Current Liabilities (2.8)
Thorough financial analyses must consider working capital, the current ratio,
and the quick ratio, including comparison to industry or sector normal values for
these indicators over time. Trends will indicate favorable or adverse changes in
organizational financial health.
2.8 Financial Ratios Important to Engineering Managerial Economics 53
Example 2.1
From The AAA Company balance sheet:
The AAA Company

Balance Sheet as of December 31, 20##
Assets LiabiliƟes
Current Assets Current LiabiliƟes
Cash $40,597,100 Accounts Payable $90,000,000
Accounts Receivable $76,259,000 Wages Payable $20,000,000
Inventory $38,753,000 Bond Dividend Payable $1,000,000
Total Current Assets $155,609,100 Total Current LiabiliƟes $111,000,000
Current Ratio = Current Assets/Current Liabilities

Working Capital = Current Assets
= $155, 609, 000/$111, 000, 000
− Current Liabilities
= 1.40
= $155, 609, 000
Quick Ratio = (Current Assets − Inventories)/Current Liabilities
− $111, 000, 000
$155, 609, 000 − $38, 753, 000 /$111, 000, 000
= $44, 609, 000
= 1.053
A third measure of an organization’s current financial health is its profit margin

from current operations. Profit margin is the ratio of net profit to net sales revenue
and indicates the efficiency at which sales are converted into profits which can be
reinvested into productive assets or paid as dividends.
Profit margin on sales = Net profit/Net sales revenue (2.9)
Example 2.2
From The AAA Company income statement:
Profit margin = Net profit/Net sales revenue

= $8, 502, 422/$46, 060, 000
= 0.1846
The AAA Company
Income Statement for December 20##
Opera ng Revenues
Sales $47,800,000
Less: Returns and Allowances ($1,740,000)
Total Opera ng Revenues $46,060,000

Federal Taxes at 21.0% ($2,260,138)
Net Profit $8,502,422
2.9 Financial Ratios—Measuring Organizational Health

and Performance
The four primary financial statements report on an organization’s financial position

at a point in time and on its operations over some past period. The same financial
statements can be applied to predict the organization’s future earnings and financial
health. Analysis of an organization’s financial ratios provides predictive capability
because financial ratios are designed to reveal relationships among the four primary
financial statements. There are five categories of financial ratios.
• Liquidity ratios measure firm solvency or how able the firm is in meeting its
maturing debt obligations.
• Asset management ratios measure how effectively the firm manages its assets.
• Debt management ratios measure the extent to which the firm uses debt financing.
• Profitability ratios measure the combined effects of liquidity, asset management,
and debt management on operating results.
• Market value ratios relate the firm’s stock price to its earnings and book value per
share.
2.9.1 Liquidity Ratios
Liquidity ratios measure firm solvency or how able the firm is in meeting its maturing
debt obligations. The current ratio (2.7) provides insight into the firm’s short-term
solvency.
The quick or acid-test ratio (2.8) provides insight into an organization’s ability
to pay debts currently due.
Acid-test ratio = (Current Assets − Inventories)/Current Liabilities
From Example 2.1, The AAA Company’s current ratio is 1.40, but its acid-test
ratio is 1.053 indicating that it can meet debt payments in the current fiscal accounting
period, but it will have to convert WIP inventory into finished goods and sales in order
to maintain minimum cash.
2.9.2 Asset Management Ratios
Asset management ratios measure how effectively the firm manages its assets in the
production of products and services. The inventory turnover ratio measures how
quickly the firm converts inventory into cash from sales.
2.9 Financial Ratios—Measuring Organizational Health … 55
Sales
Inventory turnover ratio = (2.10)
Inventory
From its income statement and balance sheet, The AAA Company inventory
turnover ratio is $47,800,000/$38,753,000 = 1.233, which indicates that it takes
AAA about 3.5 weeks to convert inventory into sales. As with other ratios, AAA’s
inventory turnover ratio must be compared to industry or sector normal values and
trends over time.
The average collection period measures how quickly accounts receivable is
converted into cash from sales.
Receivables
Average collection period = (2.11)
Average sales/day
Assuming a 30-day month, for the AAA Company, the average collection period
was $76,259,000/($47,800,000 / 30) = 47.86 days.
The fixed assets turnover ratio measures the utilization of plant and equipment
in generating sales.
Sales
Fixed assets turnover ratio = (2.12)
Net fixed assets
For the AAA Company, the fixed assets turnover ratio was
$47,800,000/$449,090,000 = 0.106, which indicates that it takes AAA about
40.7 weeks production to convert plant and equipment value into sales.
The total assets turnover ratio measures the utilization of the organization’s
assets in generating sales.
Sales
Total assets turnover ratio = (2.13)
Total assets
For the AAA Company, the total assets turnover ratio was
$47,800,000/$629,699,100 = 0.0759, which indicates that it takes AAA about
57.1 weeks production to convert total asset value into sales.
2.9.3 Debt Management Ratios
Debt management ratios measure the extent to which the firm uses debt financing
or financial leverage. The use of financial leverage has three implications.
1. The use of debt allows stockholders to maintain control of the organization with
minimal investment.
2. Banks and financial bankers consider the proportion of owner-supplied financing
as an indication of the risk of lending. The less stockholder supplied financing
the greater are the risks bourne by its lenders.
3. The more debt is used in financing assets, the greater the return on investment
for stockholders.
When examining an organizations financial statements, financial analysts consider
two types of debt management ratios.
• Balance sheet ratios to determine how much debt has been used to finance assets.
• Income statement ratios to determine the number of turns that fixed charges are
covered by operating profits.
The total debt ratio measures the total financing provided by creditors. Total debt
= current liabilities + long-term debt.
Total debt
Debt ratio = (2.14)
Total assets
The interest coverage ratio indicates how much revenue must decrease to affect
the firm’s ability to finance its debt from ongoing operations.
EBIT
Interest coverage ratio = (2.15)
Interest payments
From its income statement, The AAA Company’s interest coverage ratio =
$13,840,000/$2,000,000 = 6.92.
The fixed charge coverage ratio indicates how much revenue must decrease to
affect the firm’s ability to finance its debt plus leases from ongoing operations.
EBIT + Lease payments

Fixed charge coverage ratio = (2.16)
Interest payments + Lease payments
The AAA Company’s fixed charge coverage ratio = ($13,840,000 +

$1,020,000)/($2,000,000 + $1,020,000) = 4.92.
2.9.4 Profitability Ratios
Profitability ratios measure the combined effects of liquidity, asset management,

and debt management on operating results. The profit margin on sales measures
firm efficiency in generating profits from sales.
Net Income
Profit margin on sales = (2.17)
Sales
The AAA Company’s profit margin on sales = $8,502,422/$46,060,000 = 0.1846.

The basic earning power ratio measures firm efficiency in generating income
from assets.
2.9 Financial Ratios—Measuring Organizational Health … 57
EBIT
Basic earning power = (2.18)
Total assets
The AAA Company’s basic earning power = $13,840,000/$629,699,100 = 0.022.

The return on total assets measures firm efficiency in generating profits from
assets.
Net Income
Return on total assets = (2.19)
Total assets
The AAA Company’s return on total assets = $8,502,422/$629,699,100 = 0.0135.

The return on common equity measures actual rate of return to common
stockholders from investment in assets.
Net Income
Return on common equity = (2.20)
Common stock equity
The AAA Company’s return on common equity = $8,502,422/$400,000,000 =

0.021.
2.9.5 Market Value Ratios
Market value ratios relate the firm’s stock price to its earnings and book value per
share. The price/earnings ratio indicates how much investors are willing to pay per
dollar of reported profits.
Price per share

Price/Earnings Ratio = (2.21)
Net income/Number of shares
The market/book ratio indicates how investors regard the firm’s future potential
as in investment.
Price per share
Market/Book Ratio = (2.22)
Book value per share
2.10 Integrated Ratio Analysis
The chart in Fig. 2.11 shows how the financial ratios integrate into a unified analysis
of organizational financial health. The left side of the chart develops the profit margin
on sales analysis. On the right side, the chart lists asset categories, totals them, and
divides sales by total asset to estimate the number of times an organization turns over
its assets. The profit margin multiplied by the total assets turnover yields the rate of
Fig. 2.12 Integrated ratio analysis yielding ROA
return on assets (ROA), and ROA multiplied by the ratio of total assets to equity
yields return on equity (ROE) (Fig. 2.12).
Net Income Total Assets

ROE = ×
Total Assets Common Equity
Net Income Sales Total Assets
ROE = × ×
Sales Total Assets Common Equity
Total Assets
ROE = Profit Margin × Total Asset Turnover ×
Common Equity
2.11 Summary
Definition: Accounting is the discipline that systematically measures, records,

interprets, and communicates the financial activities of an organization, providing
insight into the trustworthiness, profitability, and solvency of an organization.
Accounting is concerned with the measurement, recording, interpretation, and

communication of economic event, financial transactions, measurement of economic
value, and determination of periodic changes in economic values. The four funda-
mental types of accounting are (1) financial accounting, (2) managerial accounting,
(3) cost accounting, and (4) tax accounting.
Sources of operations financing include (1) lenders, (2) investors, and (3) retained
earnings.
Definition: Minimum Attractive Rate of Return (MARR) —the risk adjusted,

or investments.
2.11 Summary 59

MARR = wLi × ILi × (1 − TC ) + wSj × RoESj
i j
The overriding purpose of financial accounting is to summarize all financial

activity in the profit and loss income statement, balance sheet, retained earnings
statement, and cash flow statement.
• Accounting measures and records financial transactions and provides the basis
for assessing the economic viability of the organization.
• Management allocates available investment funds to projects, evaluates unit and
firm performance, allocates resources, and selects and directs personnel.
• Engineering analyzes the economic impact of design and project alternatives
over their present and future life cycles.
The central tenet of transaction accounting is objective costing (i.e., traceable to
a transaction record). A transaction is an exchange of money or credit for a product
or service documented by a receipt, invoice, bill of lading, etc.
The balance sheet summarizes the value of the organization’s assets available to
carry out its economic activities and the liabilities and ownership financing claims
against those assets on each specific date of the end of an accounting cycle. The
fundamental accounting equation is
Assets (value) = Liabilities (value) + Equity (value)
The income statement summarizes the firm’s revenues and expenses from ongoing
operations over a stated period (usually month, quarter, or fiscal year). These are
intervals between consecutive balance sheet statements. The fundamental outcome
of the accrual income statement is the estimate of net profit.
Net profit (accrual) = Revenues − Expenses
Under the accrual basis of accounting (or accrual method of accounting), revenues
and expenses are reported on the income statement in the accounting period in which
they are earned or incurred.
The retained earnings statement is the link between the income statement and
the balance sheet. The equation for the addition of net profit to the balance sheet
retained earnings is
Retained Earnings (current) = Retained Earnings (prior)

+ New Profit + new stock − dividends
The cash flow income statement reports the difference between the sources and
uses of cash during a fiscal accounting period. The fundamental outcome of the cash
flow income statement is the estimate of cash net profit.
Net profit (cash flow) = Revenues − Expenses + Financing

− Investments
An organization’s current financial health, or liquidity, is measured by working

capital. Working capital is the difference between current assets and current liabilities
and indicates the firm’s liquidity or ability to pay its current debts.
Working Capital = Current Assets − Current Liabilities
An alternate measure of an organization’s current financial health, or liquidity, is

its current ratio which provides insight into the organization’s short-term solvency.
The acid-test ratio (also termed quick ratio) indicates the organization’s ability
to pay its currently due debts by subtracting the value of inventory from current
assets.
Acid − test Ratio = (Current Assets−Inventories)/Current Liabilities
Profit margin is the ratio of net profit to net sales revenue and indicates the
efficiency at which sales are converted into profits which can be reinvested into
productive assets or paid as dividends.
Profit margin on sales = Net profit/Net sales revenue
2.12 Key Terms
Accounting
Accrual
Assets
2.12 Key Terms 61
Balance Sheet
Cash Flow
Cash Flow Income Statement
Current Ratio
Equity
Finance
Financial Ratios
Income Statement
Investors
Lenders
Liabilities
Minimum Attractive Rate of Return
Profit Margin
Quick Ratio
Retained Earnings
Retained Earnings Statement
Stock
Stockholders
Problems
1. The following data is taken from Yetep Factory Works balance sheet. Determine
the working capital, current ratio, and quick ratio.
Cash $100,000
Net accounts receivable $285,000
Inventories $220,000
Prepaid expenses (long-term) $6,000
Accounts payable $210,000
Notes payable (short term) $110,000
Accrued wage expenses $150,000
Accrued salary expenses $47,000
2. Account data (×$1,000) for Telsa Engineering Corporation for the fourth month
of its fiscal year is given below. Construct Telsa’s balance sheet, and estimate its
working capital, current ratio, quick ratio, and the proportion of debt provided
by lenders.
* Prepaid expenses cover a three-year fixed minimum purchase contract for
specialty consulting to exclusively for Telsa. The original contact was signed at
the start of the current fiscal year for $36,000,000 with minimum $1,000,000
services delivered each month.
Accounts receivable $160,000 Accum depreciation building $84,000

Accrued wage expenses $80,000 Accum depreciation equip. $126,000
Accrued salary expenses $9000 Building $200,000
Cash $110,000 Equipment $310,000
Inventories $250,000 Capital surplus $145,000
Prepaid expenses (short term)* $1000 Land $25,000
Prepaid expenses (long term)* $32,000 Long-term liabilities $100,000
Securities (short term) $40,000 Common stock par value $15,000
Accounts payable $120,000 Retained earnings Not given
3. The income statement data ($1,000) for Telsa Engineering Corporation for the
fourth month of its fiscal year is given below. Construct Telsa’s income state-
ment, and estimate its profit margin, basic earning power, inventory turnover
ratio, fixed assets turnover, total assets turnover, interest coverage ratio, return
on total assets, and return on common equity.
Sales $480,700 Depreciation building $5200

Returns allowances $10,400 Depreciation equipment $54,000
Labor expense $160,000 Operating interest $400
Salary expense $18,000 State income tax rate 6.0%
Materials $8900 Federal income tax rate 21.0%
Indirect costs $4200
Selling and Adm expenses $6400
4. The cash flow income statement data ($1,000) for Telsa Engineering Corporation
for the fourth month of its fiscal year is given below. Construct Telsa’s cash flow
income statement.
Sales $360,500 Depreciation building $5,200

Returns allowances $7800 Depreciation equipment $54,000
Labor expense $120,000 Operating interest $400
Salary expense $13,500 State income tax rate 6.0%
Materials $6,700 Federal income tax rate 21.0%
Indirect costs $3200
Selling and Adm expenses $4800
Chapter 3
Cost Accounting Fundamentals
Abstract Whereas managerial accounting tracks financial performance relative to

strategic plans and budgets, cost accounting estimates costs, allocates overhead costs,
and develops standard product costs. This chapter will provide an overview of cost
accounting fundamentals. First, the chapter will define the different types of costs
and cost purposes. Next, cash flow diagram conventions and uses are discussed in
terms of breakeven, profit, and loss. Finally, the fundamentals of cost accounting for
materials and components, labor, and overhead allocation are presented.
3.1 Introduction
Definition: Cost accounting is the discipline that captures an organization’s total

cost of production by assessing the variable costs of each production step, the
associated fixed costs needed to support production, and the allocation of those
fixed costs to each production step to determine standard production costs and
product costs.
• Unlike general accounting, which provides information to external financial state-
ment users, cost accounting is not required to adhere to set standards and can be
flexible to meet the needs of management.
• Cost accounting considers all input costs associated with production, including
both variable and fixed costs.
• Cost accounting is used internally by management to make fully informed business
decisions.
• Types of cost accounting include standard costing, activity-based costing, lean
accounting, and marginal costing.

https://doi.org/10.1007/978-3-030-87767-5_3
64 3 Cost Accounting Fundamentals
Cost accounting was first developed during the Industrial Revolution. The
economics of industrial supply and demand forced manufacturing organizations
to track their fixed and variable costs to understand cost structure, determine the
breakeven point their production processes, and decide on ways to increase prof-
itability. Cost accounting allowed manufacturing organizations to control costs,
become more efficient, and provide return on investment to stockholder owners. By
the beginning of the 20th century, cost accounting had become accounting discipline.
The general types of cost accounting include
• Activity-based costing (ABC) identifies the support and production activities
needed to produce a unit of product or service in an organization and assigns
the production cost of each activity to all products and services according to the
actual consumption. This model assigns more indirect costs (overhead) into direct
costs compared to conventional costing.
• Lean accounting, an extension of the philosophy of lean manufacturing, has
the goals of improving financial management practices within an organization,
minimizing waste, and maximizing productivity.
• Marginal costing (also termed cost–volume–profit analysis) assesses the impact
on the cost of a product by adding one additional unit into production. Marginal
costing assists management in identifying the impact of varying levels of costs
versus varying levels of production volume on operating profit.
• Standard costing develops “standard” process and product costs used to determine
the value of inventory and the cost of goods sold (COGS). Standard costs are based
on an efficient use of labor and materials to produce the product or service under
standard operating conditions. Assessment of the difference between the standard
cost and actual cost incurred is termed “variance analysis.”
3.2 Cost Terms and Purposes
Definition: Manufacturing expense is the monetary consumption of labor, mate-

rials, tools, equipment, and facilities to increase the value of resultant products
and services.
In theory, private firms pursue two economic objectives: (1) At minimum,

economic survival. (2) Optimally, maximize wealth creation value to its shareholder
owners.
Definition: Service or governmental cost is the monetary value of resources that
have been, or must be, consumed to yield a particular service.
In theory, service organizations exist to fill intangible client or public needs such
as entertainment, food, transportation, communications, or health care. Democratic
governmental and regulated organizations exist to promote the general welfare of its
citizens by maximizing benefits to those who receive them while minimizing the costs
to those who pay for them. A service organization or government’s cost objectives
3.2 Cost Terms and Purposes 65
are a function of its service objectives to its clients or citizens. Cost is measured
in monetary units (exchange price) attached to the resources (raw materials, goods,
and services) consumed by those activities necessary to attain a specific performance
objective.
Types of costs include
• Cash costs: movement of money from one owner to another—also known as a
cash flow (engineering economy).
– Payment this month on a short-term loan.
– Purchase of supplies paid in cash.
• Accrued costs: expenses which are incurred but for which no payment is made
during an accounting period. They are shown in the balance sheet as a current
(short term) liability.
– Wages payable.
– Salaries payable.
– Utility charges.
• Book cost: Cost of a past transaction that is recorded in an accounting journal.
– Asset initial cost.
– Asset depreciation.
– Stock par value.
• Operating expenses: associated with the productive operations of an organiza-
tion. Operating costs may be either fixed or variable.
• Direct costs: non-operating costs directly related to producing a product or
service.
• Indirect costs: cannot be directly linked to a product or service but are required
for productive activities to exist.
• Controllable costs: can be influenced or regulated by the manager responsible
for it (i.e., budgeted costs for labor, materials, and processes, controlled by the
manager).
• Non-controllable costs: those costs that a manager cannot affect or change (i.e.,
space rental cost, equipment lease costs, and insurance costs).
• Period costs: are not directly related to the productive activities. Overhead sales,
general, and administrative (SG&A) costs are considered period costs.
A general framework for cost terminology is illustrated in Fig. 3.1. Cost
information is required for various purposes and costing objects. Cost purposes
include
• Planning: determines the economic feasibility of a new or upgraded productive
facility or line, process, or product or service.
• Control: the management budgeting process of identifying and reducing business
expenses with a focus on increasing profit.
Fig. 3.1 Cost terminology framework
• Report: a process used to inform management about the magnitude of a process’s

or product’s budgeted versus predicted cost or a client about the magnitude of a
project’s budgeted versus actual cost.
• Analysis: the process of decomposing summarized costs into their components
for the purpose if identifying cost drivers.
Cost objects include
• Product: the per-unit cost incurred to produce a product or service. Generally,
product costs include labor, raw materials, indirect consumable manufacturing
supplies, and general overhead.
• Process: the allocation of the total costs of production to homogenous units
produced via a continuous process that usually involves multiple steps or
departments.
• Project: all estimated and actual costs or monetary obligations incurred or esti-
mated to be incurred to complete a project that has a specified beginning and end
time, scope of resources and objective.
• Facility: building maintenance, property taxes, insurance, cleaning services, net

costs of cafeteria services, depreciation, utilities, security, parking, and all other
non-capital expenditure costs relating to a facility as a whole or to the common
areas of a facility.
• System: all costs incurred in connection with the financing, development,
construction, care, custody, control, and retirement of a system.
Only manufacturing and retail merchandising organizations must consider product
and period costs for direct materials, direct labor, and manufacturing overhead
(supporting supervisory, engineering, maintenance, and logistics support personnel
necessary for process functioning). Manufacturing overhead includes additional costs
for indirect materials, indirect labor, depreciation, extraordinary maintenance and
repairs, utilities, taxes, and insurance.
Conversely, service organizations and governments need not consider product and
period costs. Due to the non-repetitive nature of services, the costs which should be
considered in service and governmental management budgeting are not past recorded
costs but rather predicted future costs that will differ among the possible alternative
courses of action. Data for budgeting costs should be found in well-constructed, full-
cost databases of past transactions. The full-cost information on past transactions
must then be adjusted for cost trends, anticipated general inflation, and changes in
service offerings or governmental programs.
Fixed, Variable, and Overhead Cost
The engineering economic analyst’s most important task is the analysis differences in
cost behaviors among feasible alternatives. This analysis reveals how costs respond to
changes in activity levels within a relevant range. The relevant range is the bounded
(minimum, maximum) of activity level over which the costs (dependent variable)
and activity level (independent variable) relationships are expected to hold. Outside
of that relevant range, the cost versus activity-level relationship will likely differ.
Expected costs include
Fixed—constant (relatively) over a time period or range of activity level.
• Investment in a manufacturing facility.
• Rent for additional warehouse space.
Variable—depends on activity level.

• Raw materials—greater production levels require more materials.
• Direct labor—greater production levels require more direct labor.
Overhead—all operating costs that are not raw materials or direct labor.
The summation of fixed, variable, and overhead costs yields total costs of
production.

CT = C F + C V /U × U + {COH } (3.1)
U
where C T = total cost for the activity level, C F = fixed cost for the activity level,
C V/U = variable cost per unit, U = number of units produced, and C OH = allocated
overhead cost for the activity level. C OH is shown in brackets because its estimate
may not be applicable to all engineering projects.
Figure 3.2 illustrates four possible relationships between fixed cost and variable
cost per unit. In the upper left corner, both the fixed cost level and variable cost
per unit remain constant over the relevant range. In the upper right corner, the fixed
cost increases by steps (semifixed cost) from relevant range to relevant range, but
the variable cost per unit remains constant across the relevant ranges. In the lower
left corner, the fixed cost remains constant across the ranges, but the variable cost
per unit decreases across the relevant ranges. This is termed economies of scale and
occurs in manufacturing operations as a result of cost savings gained by increased
production activity. Economies of scale allow suppliers to offer “price breaks” on
differing purchase volumes of materials or components. Price breaks may also occur
when suppliers total cost is planned to cover a fixed cost plus the variable cost per
unit up to an upper bound activity level, and beyond that upper bound, the fixed cost
is covered, and only additional cost per unit is incurred. In the lower right corner,
both the fixed cost and variable cost per unit vary across the relevant ranges.
Prime, Conversion, Total, and Unit Costs
In manufacturing, cost components are also classified as prime costs, conversion
costs, total cost, and unit cost.
Prime—cost of direct material and direct labor to transform raw materials and
components into finished products.
Conversion—direct labor and manufacturing overhead costs.
Fig. 3.2 Cost behaviors over a relevant range

Total—indirect product costs + direct product costs + fixed product costs

Unit—total product cost/number of units
Direct cost—direct material and direct labor (prime costs) traceable directly to
the manufacture of a particular product.
Indirect cost—general administrative, marketing and sales, factory management
and staff, indirect materials, and other fixed costs not traceable directly to a
particular product.
Product costs are accumulated on either:
Full absorption costing—direct material, direct labor, fixed overhead, and factory
overhead.
Direct variable costing—direct material, direct labor, and factory overhead.
The relationships among these costs and their accumulation into total product
costs and cost per unit are illustrated in Fig. 3.3 and described in Table 3.1.
Average, Marginal, and Incremental Costs
Engineering economic analysts use average cost as an estimate of expected costs.
The average cost = total product cost/number of units produced. Incremental cost is
the cost incurred to add another unit of activity or the difference in total cost between
two alternatives. Marginal cost is the change in the total cost that arises when the
quantity produced changes by one unit.
Fig. 3.3 Relationship among prime, conversion, total, and unit cost
Table 3.1 Description of prime, conversion, total, and unit cost

Category Type Source Measurement Cost
General Fixed Gen Mgt/staff Allocated Indirect production
management
Marketing/sales Fixed Sales/staff Allocated
Factory Fixed Mgt/super/staff/Eng Allocated
overhead
Direct Labor Variable Labor Measured
Direct materials Variable Materials Measured
Indirect Variable–Fixed Supplies Allocated Direct Production
Materials
Fixed costs Fixed Gen facilities Allocated Product fixed

dC T d C F + C V /U × U + {COH } dC V /U
= = (3.2)
dQ dQ dQ
Since U = 1-unit change, CF is the fixed cost, and C OH is a fixed overhead

allocation charge, marginal cost may be approximated in the production quantity
range as
TotalCost2 − TotalCost1
MC = (3.3)
Quantity2 − Quantity1
Opportunity and Sunk Costs

Two costs for which there are no journal or ledger accounts but are of key importance
to engineering economic analysis are opportunity cost and sunk cost.
Opportunity cost—a benefit that is foregone by engaging a resource in a chosen
activity instead of engaging that same resource in the foregone activity.
Sunk cost—money spent due to a past decision. We cannot do anything about
these costs.
Organizations apply resources to accomplish tasks. Each resource has associated
costs of maintenance and use. However, the cost of owning, maintaining, and using
resources is not just the monetary value. Resource costs also include the opportunity
cost of not applying a resource to a potentially more profitable use. An organization
that uses a resource for one task chooses to forego benefits from applying the resource
to a potentially more profitable use. The potential benefit cash flow or return that
would be realized by applying the resource to the alternate task is the foregone
opportunity cost.
A sunk cost is monetary value of a past decision for the acquisition or application
of a resource. In engineering economic analysis, sunk costs are ignored, because
engineering decisions are current improvements or future projects to expand organi-

zational capacity or capability. There is one exception to the rule to ignore sunk cost
in engineering economic analyses. When an asset resource is disposed of or sold,
U.S. Internal Revenue Service tax code requires that the original sunk cost monetary
value paid for the asset be accounted for in determining the organization’s income
taxes for the accounting period in which the asset is disposed or sold.
Additional Cost Terms
Six additional cost terms are defined by the way in which they are incurred or
recognized in the accounting system.
Separate—costs incurred that can be exclusively identified with the production
of an individual product.
Joint—costs of products of relatively significant sales values that are simultane-
ously manufactured by a process or series of processes.
Actual—actual direct labor, direct material, and overhead costs directly traceable
and charged to a product or process.
Standard—a predetermined cost derived from cost analysis of a product or
process.
Historical—the original monetary value of an economic item based on the stable
measuring unit assumption.
Replacement—or replacement value refers to the amount that an entity would
have to pay to replace an asset at the present time, according to its equivalent
current worth.
Cash Flow Diagram Conventions

The cash flow revenues and costs resulting from engineering projects occur over time
and may be summarized on a cash flow diagram. A cash flow diagram graphically
illustrates the magnitude, sign, and timing of individual cash flows. A cash flow
diagram is created by drawing a time-incremented horizontal line. Time increments
may be days, weeks, months, quarters, or years. Cash flows are accumulated over
each time increment and represented at the end of each time increment by an arrow
drawn to scale whose length indicates the magnitude and direction indicated the
direction (negative or positive). The cash flows resulting from engineering projects
may be categorized typically by one of the following categories.
First cost—time 0 capital expense to build or to buy and install an asset.
Operations costs—annual expenses for the manufacture of a product or service.
Maintenance costs—annual maintenance expenses in support of manufacturing.
Overhaul—major capital expenditure that occurs during an assets life possibly
to extend its life beyond the original project termination.
Revenues—annual receipts due to sale of products or services from the project.
Market value—the most likely trading price that may be generated for an asset
under market circumstances that exist at the time of exchange during the asset’s
useful life.
Fig. 3.4 Typical cash flow diagram
Salvage value—the estimated value that will be realized upon the sale or other
disposition of an asset at the end of its useful life.
Figure 3.4 illustrates a typical cash flow diagram.
Related Cost Terminology—Profit, Loss, and Breakeven
Equation (3.1) defined total cost as the summation of fixed, variable, and over-
head costs. When total cost is subtracted from total revenue (either on an accrual
or cash basis), the organization’s profit or loss regions and breakeven point may be
determined for any accounting period.
• Breakeven: total revenue = total costs. Zero profit.
• Profit region: total revenue > total costs. Positive profit.
• Loss region: total revenue < total costs. Negative profit or increasing debt.
Example 3.1
Halley, Inc., produces one product with a fixed cost $160,000 and variable cost
of $3.00 per unit. In its current facility, Halley can produce a maximum of
100,000 units per month. The price is $6.20 per unit. Halley has the potential
to move into a new market at the same price and increase demand by 50,000
units per month; however, Halley will have to add production capacity. The
new production capacity will increase Halley’s fixed cost to $200,000 but
will reduce the variable cost to $2.25 per unit. Should Halley undertake this
expansion. Estimate Halley’s breakeven number of units under both capacities.
Estimate Halley’s total cost, total revenue, and total profit at 100,000, 110,000,
120,000, 130,000, 140,000, and 150,000 units
Breakeven: Revenue = Revenue = Total Cost(2)

Total Cost(1) $6.20 U = $200,000 +
$6.20 U = $160,000 + $2,25 U
$3.00 U ($6.20 – $2.25) U =
($6.20 – $3.00) U = $200,000
$160,000 $3.95 U = $200,000
$3.20 U = $160,000 U = 50,633
U = 50,000
Units Total cost Revenue Profit
100,000 $425,000 $620,000 $195,000
110,000 $447,500 $682,000 $234,500
120,000 $470,000 $744,000 $274,000
130,000 $492,500 $806,000 $313,500
140,000 $515,000 $868,000 $353,000
150,000 $537,500 $930,000 $392,500
3.3 Cost Accounting in the Organization
Definition: Cost accounting is the systematic recording and analysis of direct

material and direct labor costs and allocation of indirect overhead costs to the
production of an organization’s products or services.
Cost accounting objectives include

• Develop product costs.
• Determine the mix of labor, materials, and overhead costs for an organization.
• Evaluate opportunities for outsourcing or subcontracting.
Process Transformations and Cost Flows

Costs are incurred to produce and distribute products and services. When the final
product is sold or service delivered, the sum of product costs becomes the expense that
is subtracted from revenues by the products or services to estimate the operations
profitability. Figure 3.5 summarizes the cost flows necessary to support product
transformation processes.
Direct Material and Components—All materials and components that are
directly integrated into the finished product or are necessary as part of a service
represent direct materials. Usually, only the more significant items are costed as
direct materials. Minor items (screws, nuts, fasteners, tape, glue, thread, labels, etc.)
that are common across products or services are too costly to trace and are accounted
for as factory overhead.
Fig. 3.5 Cost flows into transformation processes
Direct Labor—Labor used in the transformation process that directly affects or

controls the conversion of materials, components, energy, and information into the
finished product is considered direct labor. From transaction accounting, direct labor
must be physically traceable to the finished product.
Manufacturing Overhead—All other fixed and variable costs necessary to
directly support the transformation process are considered as manufacturing over-
head. These costs typically include fixed and variable costs for indirect materials,
indirect labor, factory equipment depreciation, maintenance, repairs, and process
engineering.
Facilities and Equipment Depreciation—As will be discussed in Chap. 7, depre-
ciation is an annual allocation for the initial expense of a capital asset (facility or
equipment) as set forth by governmental tax code. Depreciation must be consid-
ered in estimating after-tax cash flow net income for each accounting fiscal period,
because the depreciation amount reduces income taxes that must be paid.
Work-in-Process Inventory—As materials, components, energy, and informa-
tion flow into each process transformation step, their value is accumulated in the
partially finished product or service exiting each step. This accumulated value
is termed “work-in-process” inventory and re-valued as partially finished product
passes each transformation step.
Finished goods Inventory—As completed products or services exit the final
production step, their work-in-process value is transferred into finished goods inven-
tory value. This transfer recognizes that work-in-process inventory value is only a
book value, because work-in-process inventory does not have a market. Conversely,
finished goods inventory is available for sale to customers and clients and can generate
revenue.
3.3 Cost Accounting in the Organization 75
General Administration and Sales Overhead—Corporations are required to

have top management who, as part of their responsibility, legally represent the orga-
nization. A proprietor assumes legal liability as the owner, and partnerships assign
legal liability as part of the partnership agreement. Sales personnel provide place
and time value-added to finished products and services by making the customer or
client aware of the benefits of the organization’s products and services and negoti-
ating sales contracts that specify the price, time, and place of delivery. Since general
administrative and sales costs cannot be directly traced through transactions to each
individual product, they must be allocated to the finished goods cost of each product
or service, which is the subject of this chapter.
Cost of Goods or Services Sold—The total cost = Sum(indirect product costs
+ direct product costs + product fixed costs) = Sum(G&A + sales allocation +
Sum(direct materials + direct labor + manufacturing overhead + depreciation) as
shown in Fig. 3.3.
3.4 Cost Accounting—Material and Component Analysis
Material and components cost analyses are based on engineering bill of materials and
bill of components which specify materials or components descriptions for standard
and customized products. Manufacturing organizations may have bill of materials
and bill of components for thousands, if not millions, of material and component
types. A vertically integrated processing organization must identify the raw and
intermediate materials cost values for partially and completely processed products.
A horizontally integrated organization must identify the work-in-process product
value for transfer between process steps or between production facilities. Fluctuation
in raw materials and commodity prices due to supply and demand and inflation
must be continually tracked and incorporated into costs. Cost determination includes
historical organizational records and current market information.
Material/Component Cost—quantities of materials or components that can be
specifically identified with a product, contract, project, organizational subdivision or
function for which a unit price is to be determined.
Direct Material—an input substance or information or service element to be
altered into a component of the finished product or service.
Direct Component—a designed grouping of partially altered raw materials,
information, services, or other components which will be further altered into a
component of the finished product or service.
The scope of what constitutes a direct material or component depends on the
product to be manufactured. Raw materials or components are those that have been
purchased from external supplier and not manufactured by the organization. Design
documents are the engineering bill of materials or bill of components and design
engineering drawings and specifications.
• Engineering bill of materials/components—itemized list with part numbers,

descriptions, and units.
• Specifications—drawings, physical, and performance technical requirements.
• Purchasing units and quantities per unit or lot of finished product.
Direct materials or components may be further classified into raw materials,
standard commercial-off-the-shelf (COTS) materials or components, subcontracted
materials or components, and interdivisional transfer items. Raw materials are fabri-
cated, intermediate, or processed material in a form that will be further converted by
the organization’s transformation processes. Raw components are components of the
organization’s design and specification that are manufactured on contract by other
organizations and may require further conversion. Raw materials or components
include partially converted or fabricated intermediate items that require final conver-
sion into the finished product by the organization. Standard commercial materials and
components are other organizations’ finished product materials or components that
will be incorporated into the finished product with no further conversion (i.e., brakes
or tires assembled onto a finished automobile, earphones added to the packaging of
smartphones, etc.). Standard purchased materials and components may incorporate
a lower purchasing overhead rate than the general overhead rate of the organization’s
manufacture products. Standard purchased materials and components may be costed
by the purchasing department rather than design engineering.
Subcontracted materials and components are items that are manufactured by a
supplier to the organization’s purchasing and engineering requirements. Interdivi-
sional transferred materials or components are items transferred at cost (no mark-up
profit) between divisions, subsidiaries, or affiliates wholly owned and controlled
by the organization. Commodities are raw materials that are traded on commodities
markets or exchanges (metals, timber, minerals, food, etc.). Accordingly, commodity
prices are volatile and costed at spot prices. Semi-engineered materials (steel, copper,
plastic pellets, etc.) pricing may behave as either like a standard engineering item or
a commodity. Normative materials or components costs are fixed by governmental
regulation or cartel price controls.
Indirect materials are those materials that are necessary for the transforma-
tion of direct materials into finished products and are not directly traceable to any
single product (cleaning chemicals, fluxes, thinners, catalysts, gasses, lubricants,
and perishable fixtures). Operating supplies (pens, pencils, brooms, rags, etc.) are
too inexpensive to be costed in engineering drawings and specifications. Operating
supply costs are usually allocated as part of product fixed costs.
The problem of estimating direct materials costs is decomposed into three parts:
(1) shape measurement, (2) cost per-unit shape, and (3) salvage value of recyclable
materials (blanking or machining webs, chemical byproducts, etc.). The cost of direct
materials is estimated as
cost
Cost direct material = unitshape × − salvage value (3.4)
unitshape
3.4 Cost Accounting—Material and Component Analysis 77
Unit shape implies engineering dimensional units such as mass, area, length, or
another physical or service units or count. Salvage value is a recovered material
having a debit or credit applied against the original direct material cost.
3.5 Cost Accounting—Labor Analysis
Depending on the level of automation, labor can comprise one of the most important
cost components of an organization. To estimate labor cost, we must identify an
objective unit of labor time. Time study, man-hour reports, and work sampling are
the methods applied to identify the units of labor time consumed to manufacture a
unit of finished product or service. Once the unit of labor time is determined, it is
multiplied by the wage and fringe cost per unit of labor time.
Labor can be in classified as (1) direct or indirect, (2) non-recurring or recurring,
(3) non-designated or designated, non-exempt or exempt, line or supervisory or
management, or non-union or union. Wages and salaries may be based on time
attendance, performance, or services. This discussion of labor cost will be restricted
to direct and indirect labor.
Labor cost is the wage or payroll per person-hour or fraction thereof that can
be specifically and consistently assigned to or associated with the manufacture of a
product, a particular work order, or provision of a service.
Direct labor is the people who directly contribute to manufacture a specific
product, complete a work order, or provide a service.
Indirect labor is the people who do not directly produce products or services,
but who make their production possible or more efficient. Indirect labor costs are
not readily identifiable with a specific task, work order, or service. They are termed
indirect costs and are charged to overhead accounts.
The simple formula for direct, non-exempt labor cost is
Labor cost = number time units worked × wage/timeunit (3.5)
Inputs for direct labor cost analysis include

• Measured time—predetermined time standards, time study analysis, work
sampling, standard data, man-hour reports. May be stated in units of hours, quarter
hours, pieces, bags, bundles, or standard number of units.
• Wage and benefit rates—drawings, physical, and performance technical require-
ments.
• Efficiency improvement—learning curve estimates as adjustments to measured
time.
Labor Analysis of Measured Time

Time standards development is the analysis of an operation to eliminate unneces-
sary elements and to determine the most cost-effective method of performing the
operation. Time standards development is accomplished in the following sequence.
1. Identify operation input and output boundaries.
2. Standardize the operation’s methods, equipment, and conditions.
3. Decompose each operation into its motion elements, and identify motion
boundaries.
4. Determine by measurement the standard time for each element and the number
of standard hours required for an average worker to complete the operation.
5. File motion study and record standard hours into the labor time database.
6. Layout the operation in the correct and most efficient motion sequence and the
correct presentation of tools.
7. Redesign tooling to support quick changeover, and contact mistake proofing.
8. Redesign materials input system to automatically present materials ergonomi-
cally and in the correct sequence.
9. Verify that the process and product meet quality requirements and standards.
There are four basic techniques used on time standards development.
• Predetermined time standards system.
• Time study analysis.
• Work sampling.
• Man-hour reports.
Predetermined time standards are most useful in the conceptual design phase of
new products when there is only limited information on future production. Predeter-
mined time standards are based on standard work elements encoded in measurements
time methods (MTM) work factors. MTM was developed by Maynard, Stegemarten,
and Schwab in 1948 and is still the most widely used predetermined time system.
• MTM-1 has ten elements. Each element is assigned a number of measured time
unit (TMUs), which are in 0.00001 h. Requires 350 cycle times to analyze and
operation. MTM-1 accuracy is ±7.0%.
• MTM-2 uses the same ten elements and TMUs but requires only 150 cycle times.
MTM-2 accuracy is ±15.6%.
• MTM-3 uses the same ten elements and TMUs but requires only 50 cycle times.
MTM-3 accuracy is ±20.0%.
The ten MTM time motion elements are as follows:
Reach—move a hand or finger to a destination.
Move—transport an object to a destination.
Turn—hand is turned or rotated about the long axis of the forearm.
Apply Pressure—apply a force to an object.
Grasp—secure sufficient control of one or more objects with the fingers or the
hand.
3.5 Cost Accounting—Labor Analysis 79
Fig. 3.6 Example predetermined time standard analysis sheet
Position—motion is employed to align, orient, and/or engage one object with

another.
Release—relinquish control of an object.
Disengage—break contact between two objects.
Eye Times—eyes direct hand or body motions.
Body Motions—motions made by the entire body, not just the hands, fingers, or
arms.
Figure 3.6 shows an example of a predetermined time standard analysis sheet for
a workstation.
Time study analysis is defined as an engineering study to determine the time
required by a skilled, properly trained operator working at a normal pace to complete
a specific task. The general time study procedure is
Preparation:
1. Analyze the operation’s methods, equipment, and conditions; improve where
necessary.
2. Define the operation’s start and end boundaries and list the sequence of
significant transformation points.
3. Decompose each transformation point into motion elements for a sample of n
operations.
Acquire time study information.
4. Time study—record the time consumed by each motion element for a sample
of n operations.
5. Rate the pace of each motion element.
6. Determine process and personal allowances.
7. Convert each rated motion element into normal times with allowances.
8. Express the standard time as the normal time per common unit(s) production.
Time study equipment is just a clipboard, standardized time study worksheet, and
a stopwatch of a stated resolution. There are two basic time study procedures: (1)
Fig. 3.7 Completed continuous time study worksheet
continuous time study used for short-duration tasks, and (2) long-cycle time study
used for processing that requires long-duration tasks. Figure 3.7 shows an example
of a completed continuous time study worksheet.
Work sampling gathers task information from large samples of a work force
population. Work sampling involves taking observations of specific activities within
an operation at random intervals.
1. Each observation is classified into predefined work categories such as “trans-
port,” “setup,” “work,” “inspection,” “clean up,” “idle,” or “absent.”
2. The number of observations within each category are divided by the total number
of observations to yield the proportion of time spent in each category.
3. The binomial distribution is applied to estimate expected proportions and
standard deviations.
No
pi = (3.6)
N

pi (1 − pi )
σ pi = (3.7)
N
4. Given very large sample sizes, the standard normal distribution approximation
of the binomial distribution is applied to estimate the sample size N i necessary
to achieve a desired sampling interval I at a stated confidence.
1/2
pi (1 − pi )
I = 2Z (3.8)
Ni
4Z 2 pi (1 − pi )
Ni = (3.9)
I2
Work sampling continues until the maximum N i is reached. Z values for

various areas under the standard normal distribution curve are as follows:
5. The standard hours per category are estimated as
(Ni /N )HR(1 + PF&D)

HS = (3.10)
U
where H s = standard man-hours per unit for each job element, H = total man-
hours worked during the study, R = rating factor, PF&D = personal fatigue and
delay allowance decimal, and U = total number of units produced during the
study. The following table presents the estimated work time in each category
from preliminary work sampling and the required N i for a 95% confidence
interval I = 0.10 for a ±0.05 or ±5.0% error allowance.
The following table presents work sampling results for the machining maximum
N i = 384 observations and actualIestimates (3.8) for the observations.
Element Observations pi I
Setup 59 0.075 0.134
Transport 1 90 0.113 0.131
(continued)
(continued)
Element Observations pi I
Machining 384 0.485 0.100
Inspection 71 0.090 0.133
Transport 2 147 0.186 0.126
Clean up 41 0.051 0.135
A total of H = 293 man-hours were worked producing U = 510 units during the
study yielding the following H s standard man-hour per-unit estimates (3.10).
Element Observations R PF&D HS

Setup 59 1.00 0.00 0.0428
Transport 1 90 1.00 0.10 0.0718
Machining 384 1.20 0.20 0.4011
Inspection 71 0.90 0.20 0.0556
Transport 2 147 1.00 0.10 0.1173
Clean up 41 0.85 0.05 0.0265
Man-hour reports are used to gather work data and estimate time standards
for non-repetitive work (construction, long-cycle production or processing, job
shops, maintenance, or professional). The basic metrics for man-hour reports are
as follows:
Man-hour—one worker working for 1 hour.
Man-month—based on a standard 40-h work week and 4.33 work weeks per
month. This yields one man-month = 40 × 4.33 = 173.33 man-hours per month.
Man-year—based on a standard 40-h work week and 52 work weeks per year.
This yields one man-year = 40 × 52 = 2080 man-hours per year.
In practice, quantification reflects either (1) actual clock hours or (2) effort adjust-
ment to allow time. The first quantification captures the complete time including
productive effort, wait time, and idle time. In the second quantification, a standard
PF&D allowance decimal is added to productive time. Man-hour reports may be
replaced by the term “person-hour” reports to reflect modern concepts of equal
opportunity.
Man-hour report information is compiled from job tickets. A job ticket is a printed
form that accompanies a work order. A job ticket provides instructions for recording
time spent on the work tasks, traveling to and from inventory stores, extraordinary
time spent on unplanned tasks, and identifying materials and components used. An
example job ticket is illustrated in Fig. 3.8.
Job tickets are collected for similar work tasks, and the data is entered into a
database or spreadsheet for analysis. Average time and 95% or 99% prediction inter-
vals are estimated for each activity that comprise the common task. These times then
Fig. 3.8 Example job ticket
Fig. 3.9 Example man-hour report analysis
become guidelines for planning future similar non-repetitive tasks and estimating the
number of personnel required to support non-repetitive tasks. For man-hour analysis
to be of value, provision must be made for the original job tickets, databases, or
spreadsheet to be retained as permanent backups. This permits engineering managers
to identify future unusual task times and re-estimate average times and prediction
intervals as needed to reflect non-repetitive task conditions. An example man-hour
report analysis with 95% prediction intervals is illustrated in Fig. 3.9.
3.6 Cost Accounting—Overhead Cost Allocation
An organization’s cost accounting function collects, analyzes, and summarizes raw

cost data into performance cost data (overhead costs allocation, product unit cost,
utilization rated, etc.). Cost accounting performance data is then applied to allocate
overhead and establish product unit cost, determine the mix of materials, labor, and
indirect costs for future production, and evaluate the outsourcing and subcontracting
possibilities. There are two primary methods of expensing allocated fixed overhead
costs: (1) direct or contribution expensing, and (2) absorption or functional expensing.
Under the direct expensing method, overhead costs are said “to expire immediately”
and are accounted for in the fiscal period in which they are incurred and are charged
against product sold or services delivered, regardless of when the products were
placed in finished goods inventory or the services completed. Under the absorption
expensing method, overhead costs are charged to products or services and become
expenses when the product is sold or the service complete. Direct versus absorption
expensing allocation is illustrated in Fig. 3.10. Regardless of the expensing allocation
method, overhead allocation accounting methods are the same.
The choice between direct and absorption expensing of allocated fixed overhead
costs depends on cost accounting purpose. Direct expensing evaluates only the costs
directly associated with production and makes it easier for an organization to compare
the potential profitability of manufacturing one product over another (cost–volume–
profit analysis). However, direct expensing makes it more difficult for an organization
to determine profit maximizing pricing for its goods and services, since it does not
directly consider all the costs that must be covered to be profitable. On the other
hand, absorption expensing provides a more accurate accounting of net profitability,
especially when an organization does not sell all its products in the same accounting
Fig. 3.10 Expensing allocated fixed overhead costs

3.6 Cost Accounting—Overhead Cost Allocation 85
period in which they are manufactured. However, absorption expensing is not as

helpful as direct expensing for comparing the profitability of different product lines.
The major advantage of absorption expensing is that it is required for an organization
to comply with Generally Accepted Accounting Principles and U.S. tax law.
Since it is required legally, this overhead cost allocation discussion will present
only the absorption expensing method. As previously defined, the costs incurred to
produce a product or service are either direct or indirect.
• Direct costs for labor and materials are activity-based and can be linked directly
to specific products or projects.
• Indirect costs for management, support functions, sales, and administrative
expenses cannot be linked directly to products or projects.
Generally, the proportion of direct labor hours, direct labor costs, direct material
costs, or total direct (prime) costs is used as the burden vehicle. The burden vehicle
is just the denominator by which total indirect overhead cost is divided to yield the
burden rate that is then applied to absorb the indirect overhead cost. The selection of
the burden vehicle is based on its dominance in determining total product cost.
• Direct labor hours—large quantity of direct labor hours at a low hourly rate for
manual labor.
• Direct labor costs—small quantity of direct labor hours at a high hourly rate for
highly skilled or technical labor.
• Material costs—total material cost is much greater than direct labor cost.
• Prime costs (direct labor and material costs)—total direct labor cost approximately
equals total material costs.
Overhead Cost Allocation Based on Direct Labor Hours
1. Determine base period total overhead cost and direct labor hours for the
manufacturing unit.
2. Calculate the rate per direct labor hour.
Total overhead cost

Rate = (3.11)
Total direct labor hours
3. Estimate the direct labor hours for a product.
4. Calculate the overhead cost for the job as
Overhead cost = Rate estimated direct labor hours (3.12)
Overhead Cost Allocation Based on Direct Labor Cost

1. Determine base period total overhead cost and total direct labor cost for the
manufacturing unit.
2. Calculate the rate per direct labor cost.
Total overhead cost

Rate = (3.13)
Total direct labor cost
3. Estimate the direct labor cost for a product.

Overhead cost = Rate estimated direct labor cost (3.14)
Overhead Cost Allocation Based on Direct Material Cost

1. Determine base period total overhead cost and total direct material cost for the
manufacturing unit.
2. Calculate the rate per direct material cost.
Total overhead cost

Rate = (3.13)
Total direct material cost
3. Estimate the direct material cost for a product.
Overhead cost = Rate estimated direct material cost (3.14)
Overhead Cost Allocation Based on Prime Cost

1. Determine base period total overhead cost, direct labor cost, and direct material
cost for the manufacturing unit.
2. Calculate the rate per direct labor cost plus direct material cost.
Total overhead cost

Rate = (3.15)
Total direct material cost + Total Direct Material Cost
3. Estimate the total direct labor and total direct material cost for a product.
Overhead cost = Rate estimated(direct labore + direct material)cost (3.16)
Example 3.2
Robotics Control, Inc. (RCI), manufactures computer control systems for
industrial robots. The individual robot controller (IRC) computer is a generic
personal computer with software customized to accommodate all robotic
control languages and industrial robot types. The IRC computer can work
as a stand-alone controller for an individual robot application or as a fron-
tend controller integrated into RCI’s systems robot controller (SRC) computer
system. SRC is a server-based system that runs all robotic control languages and
can control multiple industrial robots directly or can act as a central controller
for a computer controller distributed system. RCI’s units produced, total direct
labor cost, and total direct components cost for each controller are given in
the following table. RCI’s fixed overhead cost for the last fiscal year was
$4,250,000. Estimate the per-unit cost of each controller allocating the fixed
overhead cost by direct labor cost, direct components cost, and prime cost as
the burden vehicles. Given the per-unit cost differentials, which fixed overhead
allocation method is applicable to each controller type?
Units/cost IRC SRC

Units produced 7500 200
Total direct labor cost each $450 $1100
Total direct components cost each $500 $3900
Allocation by Direct Labor Cost:
IRC SRC Total

Total direct labor cost $3,375,000 $220,000 $3,595,000
$4, 250, 000

Rate = = 1.1822
$3, 595, 000
Overhead allocation for the base production period is
Overhead(IRC) = $3, 375, 0001.1822 = $3, 989, 917
Overhead(SRC) = $220, 0001.1822 = $260, 083
Cost/Unit Estimates:
Cost IRC SRC

Total direct labor cost $3,375,000 $220,000
Total direct components cost $3,750,000 $780,000
Allocated overhead $3,989,917 $260,083
Total cost $11,114,917 $1,260,083
Units 7500 200
Cost/Unit $1481.99 $6300.42
Allocation by direct components cost:

IRC SRC Total

Total direct components cost $3,750,000 $780,000 $4,530,000
$4, 250, 000

Rate = = 0.93819
$4, 530, 000
Overhead(IRC) = $3, 750, 0000.93819 = $3, 518, 212
Overhead(SRC) = $780, 0000.93819 = $731, 788
Cost IRC SRC

Total cost $10,642,212 $1,731,788
Units 7500 200
Cost/Unit $1,418.96 $8,658.94
Allocation by Prime Costs:
IRC SRC Total

Total labor cost $3,375,000 $220,000
Total components cost $3,750,000 $780,000
Prime (total) cost $7,125,000 $1,000,000 $8,125,000
$4, 250, 000

Rate = = 0.52308
$8, 125, 000

Overhead(IRC) = $7, 125, 0000.52308 = $3, 726, 923
Overhead(SRC) = $1, 000, 0000.52308 = $523, 077
Cost IRC SRC

Total cost $10,851,923 $1,532,077
Units 7500 200
Cost/Unit $1,446.92 $7615.39
Comparison of Cost/Unit by Allocation Methods:
Burden vehicle IRC cost/Unit SRC cost/Unit

Direct labor cost $1481.99 $6300.42
Direct components cost $1418.96 $8658.94
Prime cost $1446.92 $7615.39
Given that the labor cost per unit ($450) approximately equals the components
cost per unit ($500) for the IRC computer, allocating overhead using prime cost
per unit provides a near average cost per unit that reflects both direct cost drivers.
For the SRC server, the components cost per unit is the cost driver and should be
used to allocate fixed overhead; however, prime cost per unit as a burden vehicle
biases the SRC cost/unit upward also reflecting the components cost per unit. If the
IRC computer and SRC server are manufactured on the same production line, prefer
prime cost as the burden vehicle. If they are manufactured on separate production
lines, prefer direct labor cost per unit as the burden vehicle for the IRC computer,
and prefer direct components cost per unit as the burden vehicle for the SRC server.
3.7 Summary
Definition: Cost accounting is the discipline that captures an organization’s total

cost of production by assessing the variable costs of each production step, the
associated fixed costs needed to support production, and the allocation of those
fixed costs to each production step to determine standard production costs and
product costs.
Definition: Cost accounting is the systematic recording and analysis of direct
material and direct labor costs and allocation of indirect overhead costs to the
production of an organization’s products or services.
Definition: Manufacturing cost is the monetary consumption of labor, materials,
tools, equipment, and facilities to increase the value of resultant products and
services.
Definition: Service or governmental cost is the monetary value of resources that
have been, or must be, consumed to yield a particular service.
Types of costs include

• Cash costs: movement of money from one owner to another—also known as a
cash flow (engineering economy).
• Accrued costs: expenses which are incurred but for which no payment is made
during an accounting period. They are shown in the balance sheet as a current
(short term) liability.
• Book cost: cost of a past transaction that is recorded in an accounting journal.
• Operating costs: associated with the productive operations of an organization.
Operating costs may be either fixed or variable.
• Direct costs: non-operating costs directly related to producing a product or
service.
• Indirect costs: cannot be directly linked to a product or service but are required
for productive activities to exist.
• Controllable costs: can be influenced or regulated by the manager responsible
for it (i.e., budgeted costs for labor, materials, and processes, controlled by the
manager).
• Non-controllable costs: those costs that a manager cannot affect or change (i.e.,
space rental cost, equipment lease costs, and insurance costs).
• Period costs: are not directly related to the productive activities. Overhead sales,
general, and administrative (SG&A) costs are considered period costs.
A general framework for cost terminology:
• Planning: determines the economic feasibility of a new or upgraded productive
facility or line, process, or product or service.
• Control: the management budgeting process of identifying and reducing business
expenses with a focus on increasing profit.
• Report: a process used to inform management about the magnitude of a process’s
or product’s budgeted versus predicted cost or a client about the magnitude of a
project’s budgeted versus actual cost.
• Analysis: the process of decomposing summarized costs into their components
for the purpose if identifying cost drivers.
Cost objects include
3.7 Summary 91
• Product: the per-unit cost incurred to produce a product or service. Generally,

product costs include labor, raw materials, indirect consumable manufacturing
supplies, and general overhead.
• Process: the allocation of the total costs of production to homogenous units
produced via a continuous process that usually involves multiple steps or
departments.
• Project: all estimated and actual costs or monetary obligations incurred or esti-
mated to be incurred to complete a project that has a specified beginning and end
time, scope of resources, and objective.
• Facility: building maintenance, property taxes, insurance, cleaning services, net
costs of cafeteria services, depreciation, utilities, security, parking, and all other
non-capital expenditure costs relating to a facility as a whole or to the common
areas of a facility.
• System: all costs incurred in connection with the financing, development,
construction, care, custody, control, and retirement of a system.
Expected costs include
• Fixed—constant (relatively) over a time period or range of activity level.
• Variable—depends on activity level.
• Overhead—all operating costs that are not raw materials or direct labor.

CT = C F + C V /U × U + {COH }
U
In manufacturing, cost components are also classified as prime costs, conversion

costs, total cost, and unit cost.
• Prime—cost of direct material and direct labor to transform raw materials and
components into finished products.
• Conversion—direct labor and manufacturing overhead costs.
• Total—indirect product costs + direct product costs + fixed product costs.
• Unit—total product cost/number of units.
• Direct cost—direct material and direct labor (prime costs) traceable directly to
the manufacture of a particular product.
• Indirect cost—general administrative, marketing and sales, factory management
and staff, indirect materials, and other fixed costs not traceable directly to a
particular product.
Product costs are accumulated on either:
• Full absorption costing—direct material, direct labor, fixed overhead, and
factory overhead.
• Direct variable costing—direct material, direct labor, and factory overhead.
The average cost = total product cost/number of units produced.
Incremental cost is the cost incurred to add another unit of activity or the
difference in total cost between two alternatives.
Marginal cost is the change in the total cost that arises when the quantity produced
changes by one unit.

dC T d C F + C UV × U + {COH } dC UV
= =
dQ dQ dQ
TotalCost2 − TotalCost1
MC =
Quantity2 − Quantity1

Sunk cost—money spent due to a past decision. We cannot do anything about
these costs.
A cash flow diagram graphically illustrates the magnitude, sign, and timing of
individual cash flows over the lifetime of a project.
• Breakeven: total revenue = total costs. Zero profit.
• Profit region: total revenue > total costs. Positive profit.
• Loss region: total revenue < total costs. Negative profit or increasing debt.
Material and Component Analysis
• Material/Component Cost—quantities of materials or components that can be
specifically identified with a product, contract, project, organizational subdivision,
or function for which a unit price is to be determined.
• Direct Material—an input substance or information or service element to be
altered into a component of the finished product or service.
• Direct Component—a designed grouping of partially altered raw materials,
information, services, or other components which will be further altered into
a component of the finished product or service.
cost
Cost direct material = unitshape × − salvage value
unitshape
Labor Analysis
• Labor cost is the wage or payroll per person-hour or fraction thereof that can be
specifically and consistently assigned to or associated with the manufacture of a
product, a particular work order, or provision of a service.
• Direct labor is the people who directly contribute to manufacture a specific
product, complete a work order, or provide a service.
• Indirect Labor is the people who do not directly produce products or services,
but who make their production possible or more efficient. Indirect labor costs
are not readily identifiable with a specific task, work order, or service. They are
termed indirect costs and are charged to overhead accounts.
3.7 Summary 93
wage
Labor cost = number time units worked ×
timeunit
Overhead Cost Allocation
1. Determine base period total overhead cost and burden vehicle hours or costs for
the manufacturing unit.
2. Calculate the rate per burden vehicle hours our costs.
Total overhead cost

Rate =
Total burden vehicle hours or costs
3. Estimate the direct labor hours for a product.
Overhead cost = Rate estimated burden vehicle hours or cost
3.8 Key Terms
Accrued cost
Actual cost
Average cost
Book cost
Breakeven
Burden vehicle
Cash cost
Controllable cost
Conversion cost
Direct component cost
Direct cost
Direct labor
Direct material cost
Direct variable cost
First cost
Fixed cost
Full absorption costing
Government cost
Historical cost
Indirect cost
Indirect labor
Joint costs
Loss region
Maintenance cost
Manufacturing cost
Marginal cost
Market value
Non-controllable cost
Operating cost
Opportunity cost
Overhead cost
Predetermined time
Period cost
Prime cost
Profit region
Replacement cost
Salvage value
Standard costs
Service cost
Sunk cost
Time standard
Total cost
Variable cost
Work sampling.
Problems
1. Chapman Automotive Remanufacturers refurbish 23,000 brake pads per month
using only one daytime shift. CAR’s fixed cost per month to support brake refur-
bishing is $200,000, and the total labor cost is $910,900. CAR is considering
doubling its brake refurbishing capacity to 46,000 pads per month by adding a
second shift. Second shift labor will require a 10% premium, and the fixed cost
will increase to $240,000. (a) Estimate the current manufacturing cost and the
cost per brake pad for the daytime shift operation. (b) Will adding the second
shift increase or decrease the brake pad cost per unit?
2. Company A1 has total indirect fixed expenses of $150,000 per year, and each
product unit has $2.00 per-unit variable cost. Company A2 has total indirect
fixed expenses of $50,000 per year, and each product unit has $5.00 per-unit
variable cost. What is the breakeven number of units for the two companies in
comparison with each other?
3. Kitchen Gadget’s assembly line produces 160 blenders per hour at a cost of
$9,000 per hour on straight time (the first 8-h of work). Operators are guaranteed
a minimum of 6 hours of work each day. Overtime is paid at 150% of straight
time for each hour worked beyond straight time. Industrial engineering time
study indicates that productivity drops by 2% for all hours worked after the first
6 hours and by 5% for all hours worked after 8 hours. Estimate the average and
marginal cost per unit for the 6, 8, 9, and 10-h workdays.
4. Collate Commodities is considering adding a hand sanitizer production line.
Industrial engineering has identified three alternative line configurations with
the following fixed and variable cost over the relevant range of 1–50,000 unit/day
3.8 Key Terms 95
production. Determine the ranges of production (units/day) over which each

alternative would yield the minimum total cost.
Alternative Fixed cost Variable cost/unit

A $150,000 $ 7.00
B $ 70,000 $14.00
C $250,000 $ 4.00
5. A medium-size manufacturing company produces a product with fixed cost

of $32,400 and variable cost of $15 per unit. The Marketing Department has
determined that the quantity-demanded versus price relationship is P = $425 -
$0.35/unit, where P = unit price. Using the following financial relationships,
Total cost = Fixed cost + Variable cost/Unit Units
Revenue = Price Units sold
Profit = Revenue—Total cost
Estimate the (a) total cost equation and total revenue equation, (b) breakeven
quantities, (c) the number of units sold that maximizes total revenue and the
maximum total revenue, and (d) the number of units sold that maximizes net
profit and the maximum net profit.
6. An air handling unit has failed and must be replaced for a cleanroom production
area that itself will be replaced in 5 years. An equivalent air handling unit,
with an expected life of 5 years, can be purchased and installed for $12,000.
However, the maintenance shop has a refurbished unit of greater air handling
capacity in stock. The refurbished unit cost $23,000 new, but the accounting
department indicates that its current value is $14,000 today. The maintenance
manager indicates that it will cost $1000 to reconfigure the refurbished unit for
the cleanroom application. He also says that the refurbished unit can be sold
for $10,000 market value. (a) What is the book cost of the refurbished unit?
(b) What is the opportunity cost of the refurbished unit? (c) What is the cost
differential to install the refurbished unit over purchasing the equivalent unit?
7. The following work standard table sets for the standard times (minutes) for a
machining operation. The operation has an 11% fatigue allowance for an 8-h
shift. Estimate the standard minutes, absolute minimum case minutes, abso-
lute maximum case standard minutes, and the 95% prediction interval for a
completed machined piece. What is the expected number of units in for an
8-hour shift with two 10-min personal breaks?
Seq. Element Unit normal time Range Standard deviation

No. frequency
1 WSP 1 0.048 0.02 0.02256
2 C15C 1 0.159 0.04 0.03546
(continued)
(continued)
Seq. Element Unit normal time Range Standard deviation
No. frequency
3 W10P 2 0.093 0.04 0.03546
4 C10C 1 0.115 0.04 0.03546
5 W15P 3 0.140 0.04 0.03546
6 CSC 1 0.070 0.02 0.02256
8. The following table summarizes the man-hour reports for the last calendar year.
Estimate the average, standard deviation, and 95% prediction interval for transit
time, setup time, and work time.
Work Date Transit Transit end Setup start Setup end Work start Work end
order start
WO-059 3-Feb 9:44 9:55 AM 10:00 AM 11:44 AM 11:44 AM 2:20 PM
AM
WO-060 4-Mar 3:39 3:45 PM 3:45 PM 5:42 PM 5:54 PM 7:04 PM
PM
WO-061 18-Mar 6:19 6:24 PM 6:26 PM 7:17 PM 7:20 PM 9:51 PM
PM
WO-062 3-Apr 10:59 11:14 AM 11:20 AM 12:12 PM 12:12 PM 1:28 PM
AM
WO-063 10-May 9:12 9:19 PM 9:19 PM 10:56 PM 11:10 PM 12:23 AM
PM
WO-064 20-May 10:31 10:41 PM 10:44 PM 11:29 PM 11:42 PM 12:13 AM
PM
WO-065 10-Jun 8:41 8:51 PM 8:55 PM 10:03 PM 10:03 PM 12:42 AM
PM
WO-066 8-Jul 10:22 10:30 AM 10:31 PM 10:51 PM 11:07 PM 1:47 AM
AM
WO-067 9-Jul 8:55 8:57 PM 9:03 PM 10:12 PM 10:12 PM 11:36 PM
PM
WO-068 25-Aug 5:13 5:23 PM 5:23 PM 6:45 PM 6:54 PM 9:56 PM
PM
WO-069 12-Sep 10:56 11:03 AM 11:05 PM 11:18 PM 11:18 PM 11:39 PM
AM
WO-070 15-Dec 9:37 9:49 AM 9:49 AM 10:18 AM 10:24 AM 12:33 PM
AM
9. Best Aluminum, Inc., manufactures aluminum tubing. Total direct labor hours,
direct labor cost, direct material cost are given in the following table. Use direct
labor hours, direct labor cost, direct material cost, and prime cost as the burden
3.8 Key Terms 97
vehicle to allocate overhead of $18,592,000 for the past fiscal year, and estimate
the cost for unit of each aluminum tube product.
Item Product A Product A+ Product A++

Direct labor hours 128,000 40,000 64,000
Direct labor cost $1,200,000 $760,000 $820,000
Direct material cost $7,600,000 $3,060,000 $4,210,000
Units/year 200,000 100,000 64,500
Chapter 4
Cost Estimating Fundamentals
Abstract Cost engineering arises from need for engineering managers to act as stew-
ards of organizational and project resources. Professional Certified Cost Engineers
are often required for organizations to bid on US government or military contracts.
Cost engineering is generally recognized as the application of engineering princi-
ples, techniques, judgment, and experience to cost estimation, engineering function
or project planning and scheduling, and cost control for the purposes of contributing
to organizational profitability or the measurement and management of project costs
throughout project life cycles. This chapter provides an introduction to engineering
cost estimating fundamentals. First, the chapter will set forth a definition of cost esti-
mating and the reasons for cost estimates. Next, the chapter will provide an overview
of cost models in the design maturity process. The cost estimating process will be
described as a general level of detail. The fundamentals of product and operations
costing will be presented. Finally, widely used cost estimating models will be defined
with example calculations.
4.1 Introduction
As established in Chap. 2, introduction to accounting fundamentals, all production

and service organizations are driven by the need to generate a positive return on
investment (ROI) to cover the cost of borrowing money from lenders (interest rate)
and obtaining investment money from stockholders (dividend rate). Governmental
organizations are driven by the need to promote the general welfare of the citizens
they serve (at least theoretically) through the efficient allocation of taxes and fees
collected to public projects and services. Even nonprofit organizations must maintain
a positive cash flow balance between short-term income and long-term debt. To
remain economically viable, each of these organizational types must estimate and
predict costs in budgeting their operations.

https://doi.org/10.1007/978-3-030-87767-5_4
100 4 Cost Estimating Fundamentals
Definition: Cost estimating is the approximation of the probable future cost

of a product, program, or project, computed on the basis of currently available
information.
Cost estimates are made for a variety of reasons. The most common include:
• Investment decisions—accurate cost estimates are essential to determine the
potential return on investment.
• Comparing alternative investments—selecting the investment or set of invest-
ments that yield a return on investment greater than the minimum attractive rate
of return (MARR) given an available spending budget.
• Deciding on which products should be produced or services delivered—detailed
cost estimates assist management in making maximizing return on investment
development decisions in the selection of new products and in setting the mix of
current products to produce.
• Determining selling price—the selling price must cover the indirect, direct, and
fixed costs necessary to produce a product or service plus sufficient profit to allow
reinvestment in maintenance and growth of the organization and cover debt costs
and stock dividends.
• Validating suppliers and contractors price quotes—cost quotations must be vali-
dated to assure that all partied understand the scope of work and accurately price
for materials, components, or services.
• Make-or-buy decisions—accurate cost estimates are essential to assist manage-
ment in deciding whether to make components and modules internally or to
purchase them from vendors who specialize in their production and can make
them at a low per unit.
• Estimating temporary work standards—temporary work standards are usually
necessary in the early production of new products until time–motion studies can
establish permanent standards.
• Cost control—to fulfill its responsibility to be a good steward of stockholders’
investments, management must be able to assess actual versus budgeted costs,
interpret the effects (positive or negative) of variances, and adjust strategy and
project or production plans to maintain the required return on investment. Accurate
project and operational budgets require accurate cost estimates.
• Performance evaluation and benchmarking—during project or operations execu-
tion, management must also benchmark its performance against that of competi-
tors or industry standards. Positive or negative variances indicate project or
organizational health and viability.
As illustrated in chapter one, engineering cost estimation arises in development
and design activities and continues through the product life cycle. Table 4.1 gives
the fundamental classification of cost estimates.
4.1 Introduction 101
Table 4.1 Cost estimates classification

Category Fundamental Measure
characteristic
Product Cost/unit and Price—[(liabilities + capital)/unit] that achieves a stated level of
price/unit performance
Operation Worker, tool, Cost—consumption of labor, materials, and tools to increase the
equipment, value of some object
space costs

Project Project Bid— CDL + CDM + CCap + CEng + COh + CInt + CProfit to
deliverable cost win a project
System Configuration Effectiveness = Max(Benefits/Costs)
cost
The cost estimate of an operation is a forecast of labor and material or compo-

nents necessary to produce a component, module, or product at a transformation
point. Labor may be further classified as unskilled, skilled, craftsman, apprentice,
journeyman, or professional requiring different pay or wage grades. Depending on
traceability to the product, operations labor may be direct or indirect. Cost esti-
mating for a product accumulates the operations costs necessary to produce one unit
of finished product. The purpose of product cost estimation is to set its unit price
such that its value per-unit price is positioned against competitors’ products yielding
sufficient profit to allow reinvestment in maintenance and growth of the organiza-
tion and cover debt costs and stock dividends. Project cost estimation predicts the
quantity and cost of the resources required by the scope of a project. The purpose of
project cost estimation is to produce a bid low enough to win the project contract but
still cover all project costs. Systems cost estimation is the configuration of design,
project, operations, and product flow costs to maximize systemic effectiveness as
measured by the benefit–cost ratio. The fundamental element of a system is the
configuration of its material, labor, product, and information flows within its inter-
acting operations. Any system may have combinatorically multiple configurations;
hence, systemic configurations benefit–cost ratios provide a normalized comparison
of systemic effectiveness.
4.2 Cost Estimating Accuracy
As shown in Fig. 2.1, the focus of economic analyses of engineering projects is

on predicting future cash flows. Prediction of future data always involves inherent
uncertainty in the estimates. In the case of engineering projects, variance is induced
in revenue and cost estimates, interest rates, stock dividend rates resulting from
political, macroeconomic, and business economic uncertainty. Prediction uncertainty
in estimated future cash flows is only as accurate and precise as the organization’s
existing financial data and records and external estimates of macroeconomic and
business economic forecasts.
Definition: Risk is observed in those situations in which the potential outcomes
can be described by well-known probability distributions.
Definition: Imprecision is observed in those situations in which the potential
outcomes cannot be described by well-known probability distributions but can be
estimated by subjective probabilities.
Definition: Uncertainty is observed in those situations in which the potential
outcomes cannot be described by well-known probability distributions and cannot
be estimated by subjective probabilities.
Definition: Accuracy is the difference between an average or median estimated
cash flow at any life cycle design phase and its actual realized cash flow.
Definition: Precision is (1) the best-fit variance distribution under risk, (2)
fuzzy membership or rough set membership under imprecision, or (3) fuzzy
membership, rough set membership, or allowable greyness under uncertainty.
Thus, it is incumbent on the engineering or project manager to progressively
improve the accuracy and precision of cash flow estimates as design moves through
the first three phases of the product, process, service, or system life cycle in Fig. 1.4.
The following accuracy of cash flow estimates is reported as observed in associated
life cycle phases.
Needs Assessment and Justification—Rough estimates are composed of educated guesses
from a high-level macro-feasibility perspective.
Conceptual Design—Refined estimates based on historical accounting and financial perfor-
mance records and on the latest macroeconomic and business economic data. These estimates
are reasonably accurate for initial budgeting purposes.
Detailed Design—Further refined estimates based on current revenue and cost cash flows
of detailed design specifications. These estimates are used for contract bids.
Typically, the accuracy and precision of investment cash flow estimates must
proceed from very rough to very refined as design proceeds through the first three
life cycle phases.
Figure 4.1 shows the information and cost refinement as designs mature through
the first three life cycle phases. The initial recognition of the problem results in a vague
statement of a need to satisfy some gap in performance. At this stage, only rough
technical, non-technical, and cost data bounds are necessary to answer the question
of whether it is feasible to seek a solution to the problem. If the answer to the issue
of feasibility is affirmative, technical and non-technical design concepts and their
associated costs are refined into semi-detailed estimates. The semi-detailed estimates
need to be only sufficient to filter out non-feasible designs. Retained designs may then
be modeled and prototype tested based on ranked feasibility strength. The physical
and technological constraints are traded off against economic and time constraints
through design simulations and prototype performance testing. Ranking based on
feasibility strength permits the organization to invest scarce development money
efficiently in designs with the highest probability of success. Cost estimates must now
4.2 Cost Estimating Accuracy 103
Fig. 4.1 Cost estimates design maturity
be bounded with sufficient accuracy to permit return on investment estimates. Tightly

bounded detailed design estimates are necessary to minimize the risk of not attaining
the required return on investment. Ultimately, the final design must be evaluated for
legal, regulatory, intellectual property, and other non-technical constraints. The final
cost estimate accuracy boundaries must be refined to the accuracy range necessary
to seek external debt and stock financing and commit those funds to the construction
of assets to produce the design.
Cost estimating in the first three life cycle design phases is further complicated
by innovative new products or services, one-of-a-kind designs, the time-to-market,
and technical and economic expertise. Innovative new products or services and one-
of-a-kind products or services exhibit the same problem of novelty. Novelty infers
unknown or completely missing technical, non-technical, and economic data and
information. Such missing data and information increase the risks of committing
large investments in the first three life cycle design phases (Fig. 1.5) that may result in
expensive design changes in the construction or operational phases (Fig. 1.6). Further,
the first three life cycle design phases must be completed in time to be first to market
with the new product or service. Typically, product releases that are first to market
command a profit premium for a short time window until competitors can release
new products that address the same performance gap. This constraint on design time
limits the amount and level of detail of technical, non-technical, and economic data
and information that can be gathered and the time for review, re-estimation, and
refinement. Likewise, the time-to-market constraint also limits the organization’s
ability to access or create technical, non-technical, financial, economic, and industry-
specific knowledge to refine design details and the corresponding cost estimates
within the accuracy bounds necessary to assure return on investment.
4.3 Cost Models
Cost estimates are expressed and cash flow models of cost components over time.
Definition: Model is a mathematical description of the static or dynamic func-
tional relationship between a variable, or vector of variables, of interest and
another variable, or vector or matrix of variables that determine the functionality
of the variable(s) of interest.
The most important step in modeling is the development of a succinct problem
statement that yields a model whose mathematical functional relationship approxi-
mates the behavior of the variable(s) of interest such that the functional relationship
is understood, and the problem resolution will be effective. In modeling engineering
managerial economic problems, the model must admit all feasible alternatives:
• Do nothing; do not invest in any alternative product, process, or equipment because
each return on investment is less than the MARR.
• Patch and delay the current product, process, or equipment. An alternative’s return
on investment justifies replacement, but external or internal economic constraints
prohibit the investment.
• Continue with the current product, process, or equipment and re-evaluate the
investment decision at a later time.
• Upgrade the current product, process, or equipment
• Purchase a replacement for the current process or equipment.
• Innovate a new product, process, or equipment.
4.3 Cost Models 105
Once the model’s functional relationship is sufficiently described, the next

problem is to gather relevant data. For engineering managerial economic analyses,
relevant data includes:
• Hard-to-acquire as well as easily assessable data.
• Accounting, financial, macroeconomic, industry, engineering, sociotechnical,
regulatory, and political data. The later six contribute primarily to risk assessment.
This book is concerned primarily with the first two types of data.
• Market data.
• Intangible consequences data.
The final model must integrate the relevant data into the mathematical relationship
such that:
• The functional relationship approximates physical and economic reality;
• All physical, economic, sociotechnical, regulatory, and political constraints are
observed;
• The relevant data span the modeling space;
• The model admits all feasible alternative outcomes; and
• Selection criterion assists the decision-maker in choosing the “best” alternative.
Model validity is the degree that a model achieves these objectives. Finally, in
engineering managerial economics, models must observe engineering principles,
physical laws, and economic and financial theory.
By cost estimating model, we seek to establish Cost estimating Relationships
(CERs) or Time estimating Relationships (TERs).
Definition: Cost estimating relationship is a model that estimates a cost or price
by using an established relationship with one or more independent variables.
Definition: Time estimating relationship is a model that estimates activity dura-
tion by connecting an established relationship with one or more independent
variables to the duration time of the activity.
In engineering managerial economics, we seek to identify the best-fit parameters
that accurately describe the CER or TER {e.g., in C T = C F + U × C V /U, we seek
to identify the values of the fixed cost and variable cost per-unit parameters that best
estimates the total cost}.
4.4 Cost Estimating Process
Cost estimating is a managerial engineering process. Accordingly, the cost estimating

process must observe managerial and engineering theory, principles, and best prac-
tices. Based on a survey of industry and governmental cost estimating processes, this
work recommends the following cost estimation process:
1. Define the Cost Estimate Scope—determines the cost elements and structure
of the model.
2. Identify Assumptions and Constraints—assumptions limit the scope of the
model, and constraints are limiting boundaries.
3. Develop Cost Element Structure—all revenue and costs must be included,
and none duplicated.
4. Collect and Normalize Cash Flow Data—apply relevant monetary exchange
rates and adjust for inflation to the project base zero year. Normalization
ensures that revenue and cost data are comparable across alternatives and time.
5. Develop Cost Estimating Relationships—equations that fully describe the
cost model.
6. Select the Discounted Cash Flow Criterion—present worth, equivalent
uniform annual worth, future worth, internal rate of return, external rate of
return, benefit–cost analyses, or cost-effectiveness. The decision criterion must
reflect the decision-maker or customer’s economic drivers.
7. Compute the Cost Estimate—compare the criterion value against the
decision-maker or customer’s economic requirement.
8. Document and Present the Cost Estimate—only the decision-maker or
customer can make the final decision to invest or not invest in the alternative.
9. Audit Actual Life Cycle Cash Flows Versus Model Cash Flow Esti-
mates—explain all variances and use those explanations to improve future
cost estimation models.
10. Develop a Cost Estimation Database—engineering and project managers
use a cost database to store cost and model data in structured way which is
easy to manage, retrieve, and apply to the formulation of future cost estimates.
4.5 Product Costing
Definition: Product costing is the estimation of the cost of a unit of product (or
service delivered) through the determination or allocation of all expenses related
to the creation of the product (or service).
Information required for product cost estimates include:

• Engineering bill of materials, specifications, and designs.
• Due date for completion of the estimate.
• Quantity, rate of production, and schedule for the product.
• Special test, inspection, and quality control requirements.
• Packaging, warehousing, and shipping instructions.
• Marketing information.
A bill of materials (BOM) is a complete list of all the materials, subcompo-
nents, components, subassemblies, and assemblies and the exact quantities of each
necessary to produce one unit of a finished product. There are two fundamental
4.5 Product Costing 107
types of bill of materials. An engineering bill of materials (EBOM) defines one unit
of finished product as it was originally designed. An EBOM may be generated by
design or product engineers depending on the organizational size and complexity. An
EBOM ensures that purchasing agents acquire the correct direct materials, subcom-
ponents, components, and subassemblies from suppliers and have them in stock at the
time of manufacture. A manufacturing bill of materials (MBOM) specifies all the
direct and indirect materials, supplies, subcomponents, components, subassemblies,
assemblies, and packaging materials required to build a unit of shippable product.
Typically, and MBOM will have a valid date range to reflect a stable revision of the
product. A correctly designed, hierarchical BOM will contain the following essential
descriptions.
• BOM level—a number or ranking that codes where a unit of material or a part
fits in the BOM hierarchy.
• Part number—a code that uniquely identifies each material or part and allows
manufacturing personnel to reference and identify materials and parts throughout
the production cycle.
• Part name—a detailed, unique name that allows manufacturing personnel to
identify the part easily without having to reference the part number or engineering
specifications.
• Phase—the life cycle stage of each material or part in the BOM; development,
prototype, unreleased, released, production, or obsolete.
• Description—a narration of each material or part to aid in identification and
distinguish between similar materials and parts.
• Quantity—the number or units of each material or part used in each manufac-
turing step.
• Unit of measure—quantification unit of material or part (e.g., each, cubic liter,
gram, etc.). Quantity information assures that correct quantities are purchased,
stocked, and delivered to manufacturing.
• Procurement type—source such as make or buy, commodity, commercial-off-
the-shelf (COTS), modified-off-the-shelf (MOTS), or purchased according to
engineering specifications.
• BOM notes—all additional information necessary for those who will use the
BOM.
The last five elements required for product cost estimates are coordinated in a
materials requirements planning (MRP) system. An MRP system is a software
application that assists management in purchasing materials and parts, acquiring
and staging resources, controlling inventory, and planning and tracking of produc-
tion activities. MPR systems first input is independent demand by customers for
finished products. The MRP system then uses BOM information to decompose
the independent demand into internal dependent demand for packaging materials,
finished product, assemblies, subassemblies, components, subcomponents, supplies,
and direct and indirect materials working backwards through the manufacturing
process to suppliers.
In product costing, only the materials, supplies, and resources that are required to
produce a unit of finished product are included. How product costs are summarized
costing method selected. The three primary product costing techniques are:
• Full absorption costing—tracing all direct and indirect manufacturing-related
costs and allocating all indirect overhead costs for the product and absorbing
them into the cost per finished product unit.
• Variable costing—variable costs are counted in the cost of a product unit. Fixed
manufacturing costs are treated as period costs and expensed in the period they
are incurred. The accumulated variable costs are divided by the number of product
units produced to estimate the cost per finished product unit.
• Activity-based costing—accumulates the indirect, direct, and fixed costs of each
activity in the production of on unit of finished product. The sum of activity costs
divided by the number of finished units to estimate the cost per finished product
unit.
Since it is required by GAAP and US tax law, only full absorption costing will be
considered in this text.
The finished product is decomposed into individual components in a bill of mate-
rial (BOM) tree. Starting at the lowest level cost estimates are made for each material
or component, individual material and component costs are multiplied by respective
quantities required, and the estimates are summed as the material cost for the next
higher level in the product hierarchy.

Mhi = Q i (Mi + Hi × PHCi ) (4.1)
i
where M hi = material cost for next higher assembly, Qi = quantity of component i, M i

= unit material/component cost, H i = hours per unit, and PHCi = unit productive
hour cost (standard operation cost). The unit productive hour cost is the sum of
standard direct labor cost, standard direct equipment cost, and allocated cost per unit
of space. PCH i is estimated as:

PCHi = C(sdl)i j + C(sdm)ik + Cspi (4.2)
j k
where C (sdl)ij = standard unit cost direct labor j for product i, C (sdm)ik = standard unit
cost direct material or component k for product i, and C spi = allocated direct unit
cost of the manufacturing space for product i as established by industrial engineering
studies.
Example 4.1
Below is the bill of material tree for the X-512 small, unmanned aircraft. Using
Eq. (4.1), hierarchically compute the per-unit cost of each X-512 unmanned
aircraft.
The costed BOM for X-512 small, unmanned aircraft:
Harness wiring assembled cost = 3($50 + 4.0 × $18) = 3($50 + $72) =

3($122) = $366.
Control system material cost = $366 + $2870 + $4340 + $2200 = $9776.
Control system assembled cost = 1($9776 + 12.0 × $50) = 1($9776 +
$600) = $10,376.
Jet engine assembled cost = 1($1200 + 16.0 × $25) = 1($1200 + $400)

= 1($1600) = $1600.
Wing assembly assembled cost = 2($575 + 8.0 × $30) = 2($575 + $240)

= 2($815) = $1630.
Airframe assembly material cost = $300 + $1630 + $850 + $100 + $650
= $3530.
Airframe assembly cost = 1($3530 + 12.0 × $35) = 1($3530 + $420) =
$3950.
X-512 UAV material cost = $10,376 + $1600 + $3950 = $15,926.

X-512 UAV assembled cost = 1($15,926 + 16.0 × $100) = 1($15,926 +
$1600) = $17,526.
To make a product decision, the product cost estimate (from the BOM), quantity,
rate of production, and schedule are summarized into:
1. A cash flow statement.

2. Rate of return analysis.
3. Income statement.
This text focuses on developing the product cash flow statement. The income
statement was discussed in lecture two. Rate of return analysis will be discussed
in lecture six. The product cash flow statement summarizes the value of money
flowing into and out of an organization from the production of the given product.
The fundamental product cash flow equation is:

F p = R p − C p − D p (1 − TR) + D p (4.3)
where F p = total source or use of money (after-tax cash flow) per year, Rp = revenues
from the sale of the product, C p = cost to manufacture the product, Dp = depreciation
cost due to the investment of capital related to the product, and TR = applicable tax
rate. As will be discussed in Chap. 7, depreciation is a non-cash expense that reduces
tax expense at the tax rate, hence the addition of the depreciation amount Dp to
after-tax cash flow.
4.6 Operation Costing
Definition: Operation costing is the estimation of the total hourly cost of labor
plus the operation hourly rate for indirect materials, tools, equipment/space, util-
ities, and factory overhead to operate a transformation point in value-increasing
processes over a stated time frame.
Example 4.2
Assume that for the X-512 small, unmanned aircraft the firm needs to realize
a profit sufficient to cover its 16% MARR (lecture two). The price per unit
was estimated by trial and error in a spreadsheet to be $22,198 to achieve the
16% MARR. Also assume straight-line depreciation with a 5-year life and $0
salvage value (to be discussed in Chap. 7) and that the firm has a combined
federal and state tax rate of 30% (to be discussed in lecture 8). The cash flow
statement from the spreadsheet analysis for a five-year product life is shown
below.
X-512 Small Unmanned AircraŌ Product CosƟng
MARR 16.0% Unit Price $22,198 (Trial)

Tax Rate 30.0% Unit Cost $17,526
Cash Flow Statement
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
IniƟal assets cost ($700,000)
QuanƟty 25 50 75 75 50
Revenue $554,950 $1,109,900 $1,664,850 $1,664,850 $1,109,900
Cost (x $17,526) $438,150 $876,300 $1,314,450 $1,314,450 $876,300
DepreciaƟon $140,000 $140,000 $140,000 $140,000 $140,000
Taxable cash flow ($23,200) $93,600 $210,400 $210,400 $93,600
AŌer tax income ($16,240) $65,520 $147,280 $147,280 $65,520
Add depreciaƟon $140,000 $140,000 $140,000 $140,000 $140,000
AŌer tax cash flow ($700,000) $123,760 $205,520 $287,280 $287,280 $205,520
IRR 16.00%
Operation costing is a microeconomic analysis that subdivides a facility into

transformation points, activities needed to complete each transformation, and the
motion tasks required to complete each activity. Transformations are a change in
product value through the designed integration of labor, materials or components,
energy, and information at each activity. The measure of the change of product
economic value through the combination of inputs at each activity is measured as
cost. Operation costing is limited as to their valid time horizon because they are
sensitive to:
• Time frame—general and commodity-specific inflation affects operations costs.
• Product mix—differing mixes will demand differing combinations of materials,
labor, and factory overhead.
• Technology mix—the increasing application of technology may increase or
decrease operations costs depending on changes in efficiency and yields.
Figure 4.2 shows how the product mix/technology mix over time drives changes in
PCH. To remain efficient and competitive, organizations must innovate new products
and obsolete old products. The demand for new products drives the demand for new
technologies, and new technologies force changes in PHC components (overhead,
utilities, equipment/space, materials, and labor) to support each new technology
mix. Conversely, constraints in PHC components limit technology mix, innovation,
product mix, and competitiveness.
The general process for determining operation costs is as follows.
1. Determine the future time frame over which the PHC of the operation will be
applied (determines the actual dollar value given inflation and the technology
mix).
2. Determine standard categories of product mix.
3. Determine the operation input and output boundaries and process flow.
4. For each product mix category, estimate the productive hour cost PHC.
4.6 Operation Costing 113
Fig. 4.2 Time horizon effects of operations costs and PHC

PHC = SUM Labor, Id. Materials, Eq./Space , Utilities, Factory OH

/HrPHC = SUM Labor, Id. Materials, Eq./Space ,
Utilities, Factory OH)/Hr (4.4)
Figure 4.3 shows the typical flow of inputs into, through, and out of a value-added
transformation process and the relationship of PHC components (overhead, utilities,
equipment/space, materials, and labor) to needed to support the interacting activities
in the process flow.
Once the productive hour cost standards have been determined, the operations
cost for a given product category can be estimated. First, lot hours are found using
the relationship,
Fig. 4.3 PHC components in support of a typical transformation process

Lot Hours = SU + N × Hs (4.5)
where SU = standard setup hours for the operation, N = lot quantity for the product
category, and H S = standard hours per unit for the product category. Note: this
specification of Lot Hours is a generalization of the initial job shop meaning where
standard lot quantities were specified. Even in the chemical or powder processing
industries, standard lot quantities (55 gallon, 500 L, 100 cubic meters, 1 cubic yard,
1 ton, 1 metric ton, etc.) are specified as standard sales units or transportation units.
Once lot hours are determined, the operation cost is estimated as,
Copr = Lot Hours × PHC (4.6)
Example 4.3
A numerically controlled, vertical end mill is used to automatically mill pump
bases. The standard lot size is 200 bases. The operation has a standard setup
time of 1.8 h, standard production hours per 100 units of 5.25 h, and PHC =
$27.85. The unit material cost is $7.38. Estimate the lot hours, operation cost,
and cost per unit.
Lot Hours = SU + N HS
= 1.8 + 25.25
= 12.3 h Copr
= Lot HoursPHC
= 12.3$27.85
= $342.56 Cost per unit
= Mat l Cost + Copr/Units
= $7.38 + $342.56/200 units = $9.10
4.7 Cost Estimating Models
Cost estimating models are costing procedures that are common across private and
public sectors and have become standardized through practice. These models include:
• Per-unit Model
• Segmenting Model
• Cost Index Model
• Power-sizing Model
4.7 Cost Estimating Models 115
• Triangulation
• Learning Curve Model.
Per-unit Cost Model

Per-unit model costing uses a “per-unit” factor such as $/sq ft, cost/customer, bene-
fits/employee, vehicle cost / mile, etc. Per-unit cost is based on a strong relationship
between the unit cost and the total cost.

Ci
CU =
ni
Estimated cost = CU × Units (4.7)
Example 4.4
Agro Foods, Inc., needs to add a 10,000 square foot flash freezer warehouse.
A pre-engineered steel enclosure will cost $13.60/sqft, whereas an insulated
concrete form enclosure will cost $14.20/sqft. Spray foam insulation for the
steel building will cost $1.50 per linear foot. With a 12 ft roof, there will be 4800
linear feet of walls to cover with spray foam insulation. Additional insulation
will not be required for the insulated concrete form enclosure. Costs for the
concrete slab and roofing insulation are the same for either enclosure type.
What is the minimum total cost alternative?
Steel enclosure = $13.60/sqft 10, 000 sqft + $1.50/ft 4800 ft

= $143, 200
Insulated concrete enclosure = $14.20 10, 000 sqft = $142, 000
Segmenting Cost Model

The segmenting cost model decomposes a new product into its individual compo-
nents and assemblies, obtains or estimates the cost of each component (which typi-
cally can be obtained or estimated by suppliers), and sums the component costs into
subassembly costs and subassembly costs into product cost per unit.
Example 4.5
A yard equipment manufacturer is planning to introduce a new general-use
mini tractor with which attachments can be purchased for mowing lawns, brush
hogging, backhoeing, and grading. The Accounting department has requested
material cost estimates from the project engineer. The material cost estimate
will be combined with labor and overhead cost estimates to evaluate the poten-
tial profitability of the proposed mower. To make the product cost estimate,
the project engineer segments the component costs and estimates the total
components cost as shown below.
Unit Mat'l Unit Mat'l

Cost Item Estimate Cost Item Estimate
A. Chassis B. Power train
A.1 Deck $74.00 B.1 Engine $385.00
A.2 Front steering suspension $210.00 B.2 Starter assembly $59.00
A.3 Rear axle/differential $185.00 B.3 Transmission $145.00
A.4 Front wheels ($20 ea) $20.00 B.4 Drive disc assembly $100.00
A.5 Rear wheels ($24 ea) $48.00 B.5 Clutch linkage $51.50
A.6 Engine housing $120.00 $740.50
A.7 Rear fenders $80.00
$737.00
Unit Mat'l
Cost Item Estimate
C. Miscellaneous
C.1 Seat assembly $38.50
C.2 Instruments assembly $85.50
C.3 Brake system $74.00
C.4 Speed control $21.50
C.5 Drive control assembly $67.00
C. 6 Lighting system $74.00
$360.50
Total cost $1,838.00
Cost Index Model

Cost indexes are dimensionless multipliers that reflect relative price change from
some base year t 0 to some later year t n . Cost indexes can reflect relative price changes
in specific commodities (labor, material, electricity, water, etc.) or in bundles of
commodities (consumer price index or producer price index, combined utilities,
etc.). A cost index is computed as
Ct(n) It(n)
=
Ct(0) It(0)
or as
It(n)
Ct(n) = Ct(0) (4.8)
It(0)
where the initial cost C t(0) is historically documented and indexes I t(n) and I t(0)
are obtained from a source such as the US Department of Commerce or the US
Department of Labor.
Example 4.6
An industrial engineer needs to estimate the startup labor and material costs for
a new production line with a capacity of 1,000,000 units/year. The following
data was obtained from prior production estimates and the US Department of
Commerce and US Department of Labor.
Index 8 years prior Today Cost 8 years prior Today

Labor 124 293 $ 455,500 ?
Material 460 715 $2,575,000 ?
It(n) 293
Ct(n) = Ct(−8) = $455, 500 = $1, 076, 302
It(−8) 124
It(n) 715
Ct(n) = Ct(−8) = $2, 575, 000 = $4, 002, 446
It(−8) 460
Power-Sizing Model
The power-sizing model is used to estimate the costs of industrial plants and equip-
ment by “scaling up” or “scaling down” known costs to account for economies
of scale. The power-sizing model uses the exponent (x), called the power-sizing
exponent, to reflect economies of scale.
C A /C B = (Size A /Size B )x
or as
C A = C B (Size A /Size B )x (4.9)
where C B is the historically documented base cost. Costs C A and C B are estimated
at the same point in time (same monetary basis), and the size is in the same physical
units for A and B.
An exponent x = 1.0 indicates a linear cost-versus-size. An exponent >1.0

indicates diseconomies of scale, and an exponent <1.0 indicates economies of
scale. Exponent values may be found in Perry’s Chemical Engineer’s Handbook,
Plant Design and Economics for Chemical Engineers, or Preliminary Chemical
Engineering Plant Design.
Power-sizing models provide scaling for only the same point in time. If time
scaling must also be factored into the estimate, use the power-sizing model to scale
up or down in the prior period then use the scaled estimate in the prior period in a
cost index model.
Example 4.7
The industrial engineer in Example 4.6 has been asked to re-estimate the cost for
the new production line with a capacity of 2,500,000 units/year. She acquired
the following data.
• The prior production facility cost $50,000,000 eight years ago.
• Technological efficiency improvements indicate that the power-sizing
exponent x = 0.66.
• Production facility I t(-8) = 1200 and I t(n) = 1490.
0.66
2, 500, 000
C(2,500,000) = $50, 000, 000 = $91, 539, 985
1, 000, 000
It(n) 1490
Ct(n) = Ct(−8) = $91, 539, 985 = $113, 662, 148
It(−8) 1200
Triangulation Model
Triangulation in cost estimating uses three or more different sources of data or
different quantitative models to estimate. Triangulation is used for cost estimating
innovative new products that have no predecessors. The triangulation technique
involves acquiring cost data on three or more prior similar innovative products;
comparing similarities and differences in design parameters, parameter performance;
contrasting performance differences; and adjusting expected costs positive and nega-
tive differences to arrive at three cost estimates. The three cost estimates then provide
a minimum, middle, and maximum cost range.
Triangulation is used in the Needs Assessment and Justification Phase or early
in the Conceptual Design Phase of the product life cycle when insufficient informa-
tion exists to use more formal cost estimation techniques. Triangulation has multiple
benefits. Without prior cost data for the innovative product, triangulation provides a
means of gaining an early indication of potential cash flows and return on investment
before committing funds to a risky investment. Second, large discrepancies in the
initial cash flow estimates indicate lack of confidence in the estimates. Examina-
tion of the causes of discrepancies can provide additional adjustments toward better
estimates. Triangulation provides an initial structuring of cash flows, which can be
further refined as more information is gained later in the Conceptual Design Phase.
This allows a sequence of decision points to be incorporated into the risky investment
decision process.
Example 4.8
A software development firm is bidding on its first military contract (i.e., it
has no prior experience developing software for the military). But the firm has
written code for the following similar commercial applications (next slide),
and it knows that military contracts should be more expensive due to additional
requirements and documentation.
Application Purpose Language Size KLOC Cost/KLOC

Graphics CAD C+ 2500 $125.00
MS Office Ap Office tools Visual Basic 2000 $214.29
(max)
Acc Ledger Business C 1500 $107.00
(min)
Excel® Addin Office tools C++ 2500 $150.00
(mean)
Averages 2125 $149.07
The firm could consider bidding ~$150/KLOC expecting to write

about 2125 KLOC. To account for additional expenses, the bid might be
~$200/KLOC.
Learning Curve Model

It has long been observed that the time and effort to perform a task decreases with
repetition. The improved performance is termed “learning” and is generally modeled
by a learning curve. The learning curve is based on the following observations.
1. Human performance usually improves when a task is repeated.
2. This happens by a fixed percent each time the production doubles.
3. Percentage is called the learning rate and is modeled by a power law.
For any repetitive task, the underlying hypothesis is that the direct labor person-
hours necessary to complete a unit of product will decrease by a constant percentage
each time the production volume doubles. For example, an improvement of 10%
between doubled quantities establishes a 90% learning curve. The time required to
build the second unit will be 0.90 times that required for the first unit. The fourth unit
will require 0.90 times that required for the second unit. The eighth unit will require
0.90 time that required for the fourth unit, and so on. That is, standard learning curve
ratios are defined in terms of the time required to double output.
Tn
= = nr
T1
log
r=
log 2
Tn = T1 n r (4.10)

Total Time = T1 nr (4.11)
n
Take the log() of Eq. (4.10) allows the fitting of a simple linear regression to
estimate the learning rate r as the slope coefficient.
log Tn = log T1 + r log n
A table of decimal learning ratios to is given as follows.
Table 4.2 Decimal learning

r
ratios to
1.0 (no learning) 0
0.95 −0.074
0.90 −0.152
0.85 −0.234
0.80 −0.322
0.75 −0.415
0.70 −0.515
0.65 −0.621
0.60 −0.737
0.55 −0.861
0.50 −1.000
Example 4.9
If we have no prior learning curve data, we evaluate the % learning by the ratio
of the production hours for the unit doubling rate.
Unit No. Hours Dbl Rate Total Hrs

1 141.3 141.3
2 120.11 0.850083 261.41
3 109.21 370.62
4 102.09 0.849971 472.71
5 96.89 569.60
6 92.83 662.43
7 89.54 751.97
8 86.78 0.850034 838.75
9 84.41 923.16
10 82.35 1005.51
11 80.53 1086.04
12 78.91 1164.95
13 77.44 1242.39
14 76.11 1318.50
15 74.89 1393.39
16 73.76 0.849965 1467.15
The ratio of unit 2 to unit 1:

120.11
%Learning = = 0.85004
141.3
The ratio of unit 4 to unit 2:
102.09
%Learning = = 0.84997
120.11
Using the estimated 85% learning rate, we would estimate r and complete
the table for the project direct labor hours.
Learning curve rare 0.85

r= −0.23446
Unit No. Hours Dbl Rate Total Hrs
17 72.72 1539.87
18 71.75 1611.62
19 70.85 1682.47
20 70.00 1752.47
21 69.20 1821.67
22 68.45 1890.12
23 67.74 1957.87
24 67.07 2024.94
25 66.43 2091.37
Using the 85% learning rate, the estimate of the time to complete the 25th
unit is
T25 = T1 × n r = 141.3 × 25−0.23446 = 66.43
4.8 Summary
Definition: Cost estimating is the approximation of the probable future cost of

a product, program, or project, computed on the basis of currently available
information.
Definition: Imprecision is observed in those situations in which the potential
outcomes cannot be described by well-known probability distributions but can be
estimated by subjective probabilities.
Definition: Uncertainty is observed in those situations in which the potential
outcomes cannot be described by well-known probability distributions and cannot
be estimated by subjective probabilities.
Definition: Accuracy is the difference between an average or median estimated
cash flow at any life cycle design phase and its actual realized cash flow.
Definition: Precision is (1) the best-fit variance distribution under risk, (2)
fuzzy membership or rough set membership under imprecision, or (3) fuzzy
membership, rough set membership, or allowable greyness under uncertainty.
Definition: Model is a mathematical description of the static or dynamic func-
tional relationship between a variable, or vector of variables, of interest and
4.8 Summary 123
another variable, or vector or matrix of variables that determine the functionality

of the variable(s) of interest.
Definition: Cost estimating relationship is a model that estimates a cost or price
by using an established relationship with one or more independent variables.
Definition: Time estimating relationship is a model that estimates activity dura-
tion by connecting an established relationship with one or more independent
variables to the duration time of the activity.
Cost Estimating Process.

1. Define the Cost Estimate Scope.
2. Identify Assumptions and Constraints.
3. Develop the Cost Estimate.
4. Collect and Normalize Cash Flow Data.
5. Develop the Cost Estimating Relationships.
6. Select the Discount Cash Flow Criteria.
7. Compute the Cost Estimate.
8. Document and Present the Cost Estimate.
9. Audit Actual Life Cycle Cash Flows Versus Model Cash Flow Estimates.
10. Develop a Cost Estimation Database.
Definition: Product costing is the estimation of the cost of a unit of product (or
service delivered) through the determination or allocation of all expenses related
to the creation of the product (or service).
• A bill of materials (BOM) is a complete list of all the materials, subcompo-
nents, components, subassemblies, and assemblies and the exact quantities of
each necessary for the production of one unit of a finished product.
• An engineering bill of materials (EBOM) defines one unit of finished product as
it was originally designed.
• A manufacturing bill of materials (MBOM) specifies all the direct and indirect
materials, supplies, subcomponents, components, subassemblies, assemblies, and
packaging materials required to build a unit of shippable product.
Material cost for the next higher level in the product hierarchy.

Mhi = Q i (Mi + Hi × PHCi )
i
PHCi = unit productive hour cost (standard operation cost). The unit productive
hour cost is the sum of standard direct labor cost, standard direct equipment cost,
and allocated cost per unit of space.

PCHi = C(sdl)i j + C(sdm)ik + Cspi
j k
The product cash flow statement summarizes the value of money flowing into
and out of an organization from the production of the given product.

F p = R p − C p − D p (1 − TR) + D p
Definition: Operation costing is the estimation of the total hourly cost of labor plus the
operation hourly rate for indirect materials, tools, equipment/space, utilities, and factory
overhead to operate a transformation point in value-increasing processes over a stated time
frame.
The general process for determining operation costs is as follows.

1. Determine the future time frame over which the PHC of the operation will be
applied (determines the actual dollar value given inflation and the technology
mix).
2. Determine standard categories of product mix.
3. Determine the operation input and output boundaries and process flow.
4. For each product mix category, estimate the productive hour cost PHC.

PHC = SUM Labor, Id. Materials, Eq./Space , Utilities, Factory OH /HrPHC

= SUM Labor, Id. Materials, Eq./Space , Utilities, Factory OH /Hr
Lot hours are found using the relationship,
Lot Hours = SU + N × Hs
Once lot hours are determined, the operation cost is estimated as,
Copr = Lot Hours × PHC
Cost estimating models are costing procedures that are common across private
and public sectors and have become standardized through practice.
Per-unit model costing uses a “per-unit” factor such as $/sq ft, cost/customer,
benefits/employee, vehicle cost/mile, etc. Per-unit cost is based on a strong
relationship between the unit cost and the total cost.

CU = Ci / ni
Estimated cost = CU × Units
The segmenting cost model decomposes a new product into its individual compo-
nents and assemblies, obtains or estimates the cost of each component (which typi-
cally can be obtained or estimated by suppliers), and sums the component costs into
subassembly costs and subassembly costs into product cost per unit.
Cost indexes are dimensionless multipliers that reflect relative price change from
some base year t0 to some later year t n .
4.8 Summary 125
It(n)
Ct(n) = Ct(0)
It(0)
The power-sizing model is used to estimate the costs of industrial plants and
equipment by “scaling up” or “scaling down” known costs to account for economies
of scale. The power-sizing model uses the exponent (x), called the power-sizing
exponent, to reflect economies of scale.
C A = C B (Size A /Size B )x
Triangulation in cost estimating uses three or more different sources of data or

different quantitative models to estimate.
Learning curve model—it has long been observed that the time and effort to
perform a task decreases with repetition. The improved performance is termed
“learning” and is generally modeled by a learning curve.
Tn
= nr
T1
log
r=
log 2
Tn = T1 n r
4.9 Key Terms
• Bill of materials
• Cost estimating
• Cost estimating relationship
• Cost index model
• Detailed estimate
• Lot hours
• Learning curve model
• Operating costing
• Power-sizing model
• Product costing
• Productive hour cost
• Rough estimate
• Segmenting model
• Semi-detailed estimate
• System estimating
• Triangulation.
Problems
1. Product 8718 has the following operational times.
Operation Setup Hrs Hours per 100 units PHC

Punch holes 0.4 0.20 65.00
Deburr 0.1 0.015 35.60
Punch shape 0.4 0.20 65.00
End mill 0.8 0.50 34.75
Degrease & Clean – 0.10 22.10
Material cost per unit = $0.125. Parts are shipped in quantities of 1000 per
order.
a. Find the lot hours and cost per operation.
b. Find the total and cost per unit of manufacturing.
c. If the markup is 30%, find the price per unit.
2. The warehouse floor is worn with incomplete required OSHA markings due to
forklift traffic. The forklift traffic floor area is 14,300 sq ft. A local contractor has
bid $4.10 per square foot to resurface the forklift traffic area, $1.40 per square
foot area to apply the required OSHA markings, and $1.75 per square foot to
apply a surface finish coat. Two coats of the surface finish will be required for
the 5-year warranty. Estimate the total cost to repair the worn warehouse floor.
3. A cable television company is installing a new 2,025 square foot substation to
distribute programming to a new subdivision. The costs are as shown below.
Cost item Cost

Construction permits, legal and title fees $30,000
Driveway $56,250
Foundation $48,750
Flooring $22,500
Framing, sheathing, wallboard $45,000
Roofing $22,500
Utilities $18,750
Communications $18,750
Painting, finishing $63,750
a. What is the total cost of construction and the cost per square foot?
b. The subdivision contractor has gained approval from the city building
department to increase the size of the subdivision by 60%, and the cable
company will now need to increase the substation size proportionately.
What are the new item cost, total cost, and cost per square foot of the
substation?
4.9 Key Terms 127
4. Five years ago, the relevant cost index was 180 for an automated titration system,
and its cost was $43,000.00. The current titration system had a capacity of
processing 2250 samples per 24-h day. Today, the laboratory needs a capacity
of 6750 samples per 24-h day, and the cost index for a new automated titration
system is 450. Assuming a power-sizing exponent of 0.80 to reflect advances in
titration technology, use the power-sizing model to determine the approximate
cost (in today’s dollars) of the new automated titration system.
5. Violet is an industrial engineer at the Alest electric automobile manufacturing
facility. She has collected data on assembly of EV charging systems in a new
startup facility. She had determined that the 10th system required 175 person-
hours to assemble, and the 20th system required 140 person-hours to assemble.
Estimate the % learning rate, the r exponent, and the system number at which
the assembly will attain the 100 person-hours per system breakeven point.
Part II
Economic Analysis of Engineering
Activities and Projects
Chapter 5
Time Value of Money
Abstract Investing in productive assets requires the availability of money. From the
finance cycle in lecture two, organizations obtain financing for investment in assets
from lenders (banks and other financial institutions) or investors (stockholders). Both
sources of funds require a return on their investments that accounts for the risk of
loaning money, banks in the form of contractual interest, and investors in the form of
dividends or growth in stock value, for the time of the loan or the outstanding stock.
5.1 Interest Equivalence
From the finance cycle in chapter two, the risk-adjusted, weighted, minimum accept-
able rate of return, or hurdle rate, that must be earned on a project or investment is
termed the minimum attractive rate of return. In chapter one, the MARR was specified
as

M AR R = w Li × I Li × (1 − T C ) + w S j × RoE S j (5.1)
i j

where wLi = L i /( i L i + j S j ), wSj = S j /( i L i + j S j ), I Li = interest rate charged
on loan i, T C = the organization’s combined tax rate, and RoE Si = return on equity
interest rate for stock S j . The interest rate charged for a loan and the dividend rate
on stocks each incorporates a risk premium that accounts for the riskiness of the
investment (probably of loss). The risk premium is the interest rate in excess of the
risk-free rate of return an investment is expected to yield.
Risk Premium = Interest(Investment) − Interest(Riskfree) (5.2)
https://doi.org/10.1007/978-3-030-87767-5_5
132 5 Time Value of Money
The risk-free rate of return is the theoretical rate of return of an investment with
zero risk over a specified period. The current risk-free rate can be calculated by
subtracting the current inflation rate from the current interest rate of the US Treasury
bond matching an investment duration.
Risk Uncertainty about the future causes a decline in the value of money.
Risk increases into future times. As risk increases, the value of money
decreases.
Inflation The general price increase in an economy. As prices increase, the value
of a monetary unit decreases.
Liquidity Investors have a preference for liquidity, i.e., they prefer money today to
the promise of future money. Investments in monetary returns generating
assets are the same as a promise of future money. Investment must be
made in the assets today for future returns.
The risk premium arises from the fundamental relationship between risk and
return—the return on an investment should be proportional to the risk involved that
the rate of return, RoR, will be less than the required MARR. The fundamental
risk–return relationship is illustrated in Fig. 5.1.
In engineering economics, risk is the probability of the project’s realized return
which differs from the project’s original return estimate. Risk is a measure of
volatility. There at two components to risk volatility:
Structural difference between long run average realized return and the expected
return.
Random random error difference between realized return and realized long run
average return.
Fig. 5.1 Risk–return

relationship
5.1 Interest Equivalence 133
When we compare the cash flows from two or more projects, we must compare
them on the same basis. By definition, any set of two or more cash flows are equivalent
if they have the same economic value. More precisely, any set of two or more cash
flows are equivalent at interest rate i if we can convert one cash flow into the equivalent
value of the other(s) by using the proper interest factors.
5.2 Cash Flow Transactions with Interest
Interest elements common to all cash flow transactions include:

• Principal—the initial amount money for a loan, bond, stock offering, or asset
purchase.
• Interest rate—the proportion cost of borrowed money per period of time.
• Interest period—the time over which interest is paid.
• Number of interest periods—duration of the loan, bond, stock offering, or asset
purchase.
• Receipts or disbursements schedule—the cash flow pattern with interest over
the number of interest periods.
• Future amount of money—cumulative effect of principal and interest over the
number of interest periods.
• Present amount of money—the current value of a set of future cash flows
discounted for interest costs.
These interest elements are represented by the following variables:
An = a discrete payment or receipt of money occurring at the end of an interest
period.
i = interest rate per period.
N = number of interest periods.
P = present value or worth of a set of future cash flows discounted for interest costs.
F = single amount that is equivalent to the cumulative effect of principal and interest
over the number of interest periods.
A = an end of period payment or receipt of money in a uniform series that continue
for n periods; A1 = A2 = · · · = An .
5.3 Cash Flow Income Statement
Chapter two introduced the cash flow income statement. Differences from an accrual
income statement include:
• Credit sales and allowances are not included.

• Accounts payable amounts are not included in CoGS, selling, and G&A expenses.
• Depreciation is not included but accounted for in total taxes.
Cash flow diagram conventions were introduced in chapter three. Cash flow
diagrams represent time by a horizontal line marked with an equal number of cash
flow or interest periods. Cash receipts are represented by arrows pointed upward
in the positive direction, and cash disbursements are represented by arrows pointed
downward in the negative direction. The combination of positive and negative cash
flows at each cash flow or interest period represents the net cash flows.
Net Cash Flown = Rn − On − Mn − In − Tn (5.3)
where Rn = cash flow revenue, On = operations cash flow cost, M n = maintenance

cash flow cost, I n = interest cash flow payment, and T n = tax cash flow payment.
Each cash flow is assumed to occur at the end of each interest period to capture a
full interest payment. This is known as the end of period convention. The end of
period convention also conforms with monthly, quarterly, semi-annual, and annual
accounting statements.
Example 5.1
Given a set of cash flows, timing, and amounts, what interest rate equates the
two cash flows?
Example 5.2
Given an interest rate of 6.0% and an initial loan of $100, what are the future
two payments required to repay principal equally plus interest?
5.3 Cash Flow Income Statement 135
First year interest: $100 × 0.06 = $6.00

First year payment: $50 + $6 = $56
Second year interest: $50 × 0.06 = $3.00
Second year payment: $50 + $3 = $53
5.4 Single Payment Discrete Cash Flow Compounding
To establish the theoretical basis for single payment discrete cash flow compounding,
we will first consider simple interest. Simple interest is the interest that is computed
on only the original amount borrowed or loaned.
Total interest earned.i s = P × i × n
where is = simple interest and P, i, and n are as defined previously. For example, if
i = 8.0%, P = $100, and n = 2,
i x = $100 × 0.08/period × 2periods = $16
Under simple interest, the future amount of money due at the end of a loan is
F = P + P × i × n = P(1 + i × n)
For the example above
F = $100(1 + 0.08 × 2) = $116

Example 5.3
Given a simple interest rate of 10.0% and an initial loan of $5000, what interest
paid and the future amount to be repaid at the end of a five-year loan.
P = $5000 i = 0.10/year n = 5years F =?
Total interest earned:iS -= P × i × n = $5000 × 0.10/year × 5 year = $2500.

Future amount due:F = P(1 + i × n) = $5000(1 + 0.10/year × 5 year) =
$7500.
Two questions arise with simple interest. Would you make a loan with simple
interest terms? Would a bank? The answer is “No,” because in effect you make an
interest free loan for one year on the $8.00 interest earned at the end of the first year.
Year Beg Amt Interest End Amt

0 $100.00
1 $100.00 $8.00 $108.00
2 $108.00 $8.00 $116.00
Compound interest is computed on the unpaid debt and the unpaid interest due.
Total interest earned:i = P (1+ i)n – P
Continuing with the above example,
i = P(1 + i)n −P = $100(1 + 0.08)2 − $100 = $16.64
Year Beg Amt Interest End Amt

0 $100.00
1 $100.00 $8.00 $108.00
2 $108.00 $8.64 $116.64
Under compound interest, the future value, or amount of money due at the end of
a loan, is
F = P(1 + i)1 (1 + i)2 . . . (1 + i)n or F = P(1 + i)n

F = $100(1 + 0.08)2 = $116.64
5.4 Single Payment Discrete Cash Flow Compounding 137
Example 5.4
Re-compute the total interest and future amount due for the loan in Example
5.3 using compound interest.
P = $5000i = 0.10/year n = 5 years F = ?
Total interest earned:i = P(1 + i)n – P = $5000(1 + 0.10/year)5 − $5000.

= $3052.55
Future amount due:F = P(1 + i)n = $5000(1 + 0.10/year)5 = $8052.55.
To understand equivalence, the underlying interest formulas must be analyzed.

Assume that a present sum of money P is invested for one year at an interest rate
i. At the end of the year, we should get back the initial principal P plus the interest
earned iP, or F = P + iP = P(1 + i). If the same principal P is invested for n years,
at the end of the investment period, we should get back.
Year Beg amt Interest F ending amt

0 P
1 P iP P(1+ i)
2 P(1+ i) iP(1+ i) P(1+ i)2
3 P(1+ i)2 iP(1+ i)2 P(1+ i)3
N P(1 + i)n – 1 iP(1+ i)n – 1 P(1+ i)n
Thus, the single payment compound amount is defined as:
F = P(1 + i)n (5.3)
with functional notation
F = P(F/P, i, n) (5.4)
Values of (F/P, i, n) can be calculated in the Microsoft® Excel® Compound Interest

Calculator Spreadsheet for various values of interest rates i and periods n. Reference
Appendix A is for directions on the use of the Microsoft® Excel® Compound Interest
Calculator Spreadsheet.
Example 5.5
Assume that $500 is deposited in an account that earns 6.0% per year for three
years. Estimate its future value.
F = P(1 + i)n = $500(1 + 0.06)3 = $500(1.191) = $595.50
or from the Microsoft® Excel® Compound Interest Calculator Spreadsheet,

enter i = 6.00% and read from the Single Payment F/P column,
F = $500(F/P, 6.0%, , 3) = $500(1.191) = $595.50
Graphically, the present amount P is multiplied three times by 1.06.

If we take F = P(1 + i)n and solve for P, we get
P = F(1 + i)−n (5.5)
with functional notation
P = F(P/F, i, n) (5.6)
which is the single payment present worth amount. Values of (P/F, i, n) can be
calculated in the Microsoft® Excel® Compound Interest Calculator Spreadsheet for
various values of interest rates i and periods n.
Example 5.6
Suppose that you need $800 at the end of four years. What amount P must be
deposited now in an account that earns 5.0% per year for four years?
P = F(1 + i)−n = $800(1 + 0.05)−4 = $800(0.8227) = $658.16
or from the Microsoft® Excel® Compound Interest Calculator Spreadsheet,

enter i = 8.00% and read from the Single Payment P/F column,
P = $800(P/F, 5.0%, , 4) = $800(0.8227) = $658.16
Graphically, the future amount F is divided four times by 1.05.
Since cash flows are linear, by the superposition theorem, a net cash flow is the
algebraic sum of the individual cash flows at any given point in time. Therefore, when
there is more than one cash flow, each cash flow can be discounted or compounded
to a point in time (end of an interest period) and the cash flows summed to yield the
net cash flow. This principle is illustrated in Example 5.7.
Example 5.7
You are offered a contract in which you will loan an amount of money and will
repay $400 at the end of year 3 plus $600 at the end of year 5 both at a 12%
interest rate. What amount are you willing to loan?
P = F3 (1 + 0.12 )−3 + F5 (1 + 0.12 )−5

P = $400 (1 + 0.12 )−3 + $600 (1 + 0.12 )−5
P = $400 (P/F, 12%, 3) + $600 (P/F, 12%, 5)
P = $400 (0.7118 ) + $600 (0.5674)
P = $625.16
P(loan) = $284.70 + $340.46 = $625.16
5.5 Four Methods of Debt Repayment
Now that we have established the basis for discounted (present value) and
compounded (future value) cash flows, we can consider the four fundamental ways of
repaying a loan. To focus on the repayment methods rather than interest equivalence,
assume that a $5000 loan is to be repaid over a five-year period (interest period =
1 year) at an interest rate of 10%.
Method 1: Constant Principal Payments Plus Interest Due. Under this plan, the
borrower repays 1/n of the principal plus the interest due for each year.
Year Beg. bal Interest due Principal payment Interest payment Total payment End bal
1 $5000 $500 $1000 $500 $1500 $4000
2 $4000 $400 $1000 $400 $1400 $3000
3 $3000 $300 $1000 $300 $1300 $2000
4 $2000 $200 $1000 $200 $1200 $1000
5 $1000 $100 $1000 $100 $1100 $0
Method 2: Pay Interest Only Each Year and Principal at the End of the Loan.
Under this plan, the borrower repays all interest due for each year, and in the final
year repays the principal plus interest due for the final year. This method is used in
the repayment of a bond.
1 $5000 $500 $0 $500 $500 $5000
2 $5000 $500 $0 $500 $500 $5000
3 $5000 $500 $0 $500 $500 $5000
4 $5000 $500 $0 $500 $500 $5000
5 $5000 $500 $5,000 $500 $5500 $0
Method 3: Equal Annuity Payments Each Interest Period. Under this plan, the
borrower pays an equal payment each interest period. The payment covers declining
principal and interest amounts due each interest period such that the final payment
draws the balance due to zero. This method is used to repay house and automobile
loans.
5.5 Four Methods of Debt Repayment 143
Year Beg. bal Interest due Principal payment Interest payment Total End bal
payment
1 $5000 $500 $819 $500 $1319 $4181
2 $4181 $418 $901 $418 $1319 $3280
3 $3280 $328 $991 $328 $1319 $2289
4 $2289 $229 $1090 $229 $1319 $1199
5 $1199 $120 $1199 $120 $1319 $0
Method 4: Accumulate Interest Owed and Pay Principal Plus Accumulated

Interest at the End of the Loan. Under this plan, the borrower pays nothing in each
interest period. Interest due accumulates until the end of the loan, and the final
payment covers the principal plus accumulated interest. This method is often used
on large, fixed-price projects where the contractor receives a final fixed payment for
all or a major portion of the amount due. This repayment method is known as a
“balloon loan.”
1 $5000 $500 $0 $0 $0 $5500
2 $5500 $550 $0 $0 $0 $6050
3 $6050 $605 $0 $0 $0 $6655
4 $6655 $666 $0 $0 $0 $7321
5 $7321 $732 $5000 $3053 $8053 $0
Although the methods differ in cash flow patterns, each method is equivalent for
the principal owed at the stated interest rate. We can see this equivalence by dividing
the accumulated interest paid by the accumulated principal owed over the life of the
loan.
Year Method 1 Method 2 Method 3 Method 4

1 $5000 $5000 $5000 $5000
2 $4000 $5000 $4181 $5500
3 $3000 $5000 $3280 $6050
4 $2000 $5000 $2289 $6655
5 $1000 $5000 $1199 $7321
Acc principal $15,000 $25,000 $15,949 $30,526
Acc interest $1500 $2500 $1595 $3053
% interest 10 10 10 10
5.5.1 Payment Series Discrete Cash Flow Compounding
Method 3, equal annual payments, is widely used in commercial, industry, and private
loans. The equal annual payments method is termed “uniform payment series” and
provides nice properties when working with annuities A.
Uniform Series Compound Amount
From previous discussion, we know that the future value F of a single amount P
invested at time 0 is F = P(1 + i)n .
If we let A1 = A2 = · · · = An = P but invest Ai exactly at the end of each period,

then F is the sum of the compounded Ai amounts.
F = A1 (1 + i)n−1 + A12 (1 + i)n−2 + · · · + An−1 (1 + i)1 + An
Dropping the subscripts (A1 = A2 = · · · = An = A) and multiplying both sides

by (1 + i),
(1 + i)F = A(1 + i)n + A(1 + i)n−1 + · · · + A(1 + i)2 + A(1 + i)
Subtracting the first equation and canceling like negative intermediate terms
yields,
−(F = A1 (1 + i)n−1 + A12 (1 + i)n−2 + · · · + An−1 (1 + i)1 + An )
i F = A(1 + i)n − A

(1 + i)n − 1
F=A = A(F/A, i, n) (5.7)
i
Equation (5.7) is termed the uniform series compound amount factor.

Example 5.8
If an individual invests $1000 in a certificate of deposit paying a 4.0% annual
rate every quarter for five years and interest is paid quarterly, how much will
the individual have in certificates deposit at the end of the five years?
A = $1000/qtr n = 5 years i = 4%/year F = ?

i q = 4.0%/4 qtr/year = 1.0%/qtr
n q = 4 qtr/year × 5 years = 20 qtr

F = $1000 (1 + 0.01)20 − 1 /0.01
= $1000(22.019)
= $22, 019
F = $500(F/A, 1%, 20)
= $1000(22.019)
= $22, 019
Uniform Series Sinking Fund Amount

If we solve for A using the uniform series compound amount formula, we get

i
A=F = F(A/F, i, n) (5.8)
(1 + i)n − 1
the uniform series sinking fund factor.
Example 5.9
An engineering manager needs $10,000 at the end of the new fiscal year to
overhaul a catalytic converter in an exhaust manifold of an air scrubber. Due to
other unplanned corrective maintenance activities in this the first fiscal month
of the year, she will not have sufficient funds in her budget to cover the entire
cost and is considering investing in a uniform amount in a savings account that
pays 6.0% annually but compounded monthly. How much does she have to
deposit each month to have the $10,000 at the end of the fiscal year?
F = $10, 000n = 1 year or 12 months i = 6%/year or

i m = 6.0%/12 = 0.5%/mon A = ?

A = $10, 000 0.005/ (1 + 0.005)12 − 1
= $10, 000(0.0811)
= $810.66/month
F = $10, 000( A/F, 0.5%, 12)

= $10, 000(0.0811) .
= $811 per month
Uniform Series Capital Recovery Amount

If we substitute F = P(1 + i)n in the uniform series sinking fund factor formula, we
get

i
A = P(1 + i) n
(1 + i)n − 1

i(1 + i)n
A=P = P(A/P, i, n) (5.9)
(1 + i)n − 1
the uniform series capital recovery factor.
Example 5.10
A new more efficient IC imaging unit costs $50,000 and has a life of four years.
If the MARR for this unit is 8.0%, what must the efficiency savings be each
year to recover the unit’s cost?
P = $50, 000 n = 4 i = 8.0% A = ?

A = $50, 000 0.08 (1 + 0.08 )4 / (1 + 0.08 )4 − 1
= $50, 000 [0.30192]
= $15, 096.04
A = $50, 000 ( A/P, 0.08, 5)

= $50, 000 (0.3019) .
= $15, 095
Uniform Series Present Worth Amount

If we solve for P in the uniform series capital recovery factor, we get

(1 + i)n − 1
P=A = A(P/A, i, n) (5.10)
i(1 + i)n
the uniform series present worth factor.
Example 5.11
A bank holds a note on purchase of a backhoe-loader used by a construction
firm. The bank will receive $1,244.25 payment per month for four years at
an annual interest rate of 8.0%. How much did the bank loan the construction
company?
A = $1, 244.25 n = 4 years or 48 months

i = 9.0%/year or 0.75%/mon P = ?

P = $1, 244.25 (1 + 0.0075 )48 − 1/0.0075 (1 + 0.0075 )48
= $1, 244.25[40.1848]
= $49, 999.91
P = $1, 244.25 ( A/P, 0.08, 5)

= $1, 244.25(40.185) .
= $50, 000
Linear Interpolation of Compounding and Discounting Factors

We may apply linear interpolation to estimate factor values between interest rates for
the same number of periods and between periods for the same interest rate. Linear
interpolation is a method of estimating missing values between two known values
or of curve fitting using linear polynomials to construct new data points within the
range of a discrete set of known data points. If the two known points are given by
the coordinates (x 0 , y0 ) and (x 1 , y1 ), the unknown y given a known x is the linear
interpolant straight line between these points.
y − y0 y1 − y0
= (5.11)
x − x0 x1 − x0
Solving for y, the linear interpolation equation becomes
y1 − y0
y = y0 + (x − x0 ) (5.12)
x1 − x0
Example 5.12
A bank holds a note issued for $40,900 on a new automobile. The bank is paid
$563 payment per month for seven years plus one month. What interest rate is
the bank earning?
P = $40, 900 A = $563 n = 7 years × 12 mon/year

= 84 months i = ?
P = A(P/A, i,)
(P/A, i, 84) = P / A
(P/A, i, 84) = $40, 900 / $563
(P/A, i, 84) = 72.647
(P/A, 0.25%, 84) = 75.682 (P/A, 0.50%, 84) = 68.453
⎧ ⎫
⎨ a 0.25% 75.682 c ⎬
b i 72.647 d
⎩ ⎭
0.50% 68.453
a c
Ratio = =
b d
i − 0.25% 72.647 − 75.682
=
0.50% − 0.25% 68.453 − 75.682

72.647 − 75.682
i = 0.25% + (0.50% − 0.25%) = 0.355%
68.453 − 75.682
From the property of similar triangles or the two-point equation of a line,

the graphical solution is shown below.
Linear Interpolation to Find i

0.6
0.5
0.4
i = 0.355
0.3
0.2
72.647
0.1
68.0 69.0 70.0 71.0 72.0 73.0 74.0 75.0 76.0 77.0
Cash Flows That Do Not Match Uniform Series Patterns

To use the uniform series factors, the cash flows must have equal annual cash flows
from period one to period n with a P at time 0 or F at time n as illustrated below.
When a cash flow does not conform to these patterns, the uniform series factors
cannot be applied directly. The economic analyst has two options.
• Treat each cash flow as a single payment discrete cash flow, estimate either the
present value Pi or future value F i for each discrete cash flow, and sum the Pi ’s
or F i ’s by the superposition theorem.
• Decompose the nonconforming cash flow into conforming uniform cash flows,
estimate either the present value Pi or future value F i for each uniform cash flow,
and sum the Pi ’s or F i ’s by the superposition theorem.
If necessary, estimate the equivalent annual cash flow as A = P(A/P, i, n) or A =
F(A/F, i, n).
Example 5.13
Find F for the following cash flow pattern when i = 15%.
Method 1: Solve by setting each A = P, multiplying by (P/F, 15%, j), and

summing.
F = $1000 (1 + 0.15 )4 + $1000 (1 + 0.15 )3 + $1000 (1 + 0.15 )2

= $1000 (1.749) + $1000 (1.521) + $1000 (1.322)
= $4592.00
Method 2: Solve for F(3) and multiply by (F/P, 15%, 2).

F = $1000 (F/A, 15%, 3)(F/P, 15%, 2)

= $1000 (3.472)(1.322)
= $4590.00
Payment Series Discrete Cash Flow Compounding—Arithmetic Gradient

Often an observed cash flow increases or decreases rather than remaining at a constant
value A. The first case we will consider is when a cash flow increases in uniform
steps or by an arithmetic gradient.
An arithmetic gradient is composed of

• A uniform amount A at the end of time period one.
• A uniform increasing amount G added to A beginning at the end of time period
two.
• The same uniform increasing amount G added at the end of each subsequent time
period up to time period n.
• G = difference between each gradient cash flow amount.
Year Uniform amount A Gradient G Arithmetic gradient

0
1 $1000 $0 $1000
2 $1000 $100 $1100
3 $1000 $200 $1200
4 $1000 $300 $1300
5 $1000 $400 $1400
6 $1000 $500 $1500
7 $1000 $600 $1600
8 $1000 $700 $1700
9 $1000 $800 $1800
10 $1000 $900 $1900
The arithmetic gradient cash flow may be resolved into a uniform cash flow plus
a gradient cash flow with
P = PA + PG = A(P/A, i, n) + G(P/G, i, n)
PLUS
We already know how to solve PA given A. To find G, we can proceed as we did

in finding the uniform series compound amount factor F.
F = G(1 + i)n−2 + 2G(1 + i)n−3 + · · · + (n − 2)G(1 + i) + (n − 1)G
Multiplying both sides by (1 + i) and factoring out G:
(1 + i)F = G[(1 + i)n−1 + 2(1 + i)n−2 + · · · + (n − 2)(1 + i)2 + (n − 1)(1 + i)]
Subtracting the first equation from the second yields

i F = G (1 + i)n − 1 /i − nG

F = G (1 + i)n − 1 − in /i 2
Setting F = P(1 + i)n :

P(1 + i)n = G (1 + i)n − 1 − in /i 2

P = G (1 + i)n − 1 − in /i 2 (1 + i)n = G(P/G, i, n) (5.13)
This is the arithmetic gradient present worth amount. Setting F = A [((1 +

i)n − 1)/i]:

A (1 + i)n − 1 /i = G (1 + i)n − 1 − in /i 2

A = G (1 + i)n − 1 − in / i(1 + i)n − i = G(A/G, i, n) (5.14)
This is the arithmetic gradient uniform series amount.
Example 5.14
An engineering manager is preparing a purchase order for a new automated arc
welder with a five-year useful life. The vendor offers a five-year maintenance
contract for $8000. Records for similar model arc welder indicate that it will
cost $1200 the first year for maintenance and increase by $300 per year for
years 2–5. The arc welding process MARR is 5.0%. Should the engineering
manager purchase the maintenance contract?
A = $1200 G = $300 i = 5.0% P = ?
Uniform series present worth:
PA = A(P/A, 5%, 5) = $1200(4.329) = $5,194.80
Arithmetic gradient present worth:
PG = G(P/G, 5%, 5) = $300(8.237) = $2471.10
P = PA + PG = 7665.90. The present worth of incurring the annual main-

tenance expenses is less than the $8000 present worth of the contract cost. Do
not purchase the maintenance contract.
Example 5.15
A logistics manager just purchased a new semi-truck with a three-year main-
tenance agreement as part of the purchase price. Analysis of maintenance cost
data for similar semi-trucks indicates that year 4 maintenance cost should be
$1500 and increase each year thereafter by $500. The semi-truck has a useful
life of seven years. The MARR for trucking equipment is 10%. For budgeting
purposes, estimate the present worth and equivalent annual worth of the future
maintenance cash flows.
The cash flows are shown in the following table. Note that we set up a secondary
timeline for the maintenance cash follows with year 0 = year 3 of the budgeting
period.
Year Cash flow

0 P
1 0
2 0
3 (0) F = P3 = PU + PG
4 (1) $1500
5 (2) $2000
6 (3) $2500
7 (4) $3000
A4 = $1500 G = $500 i = 10.0% P0 = ?A = ?
Arithmetic gradient present worth, year 3:
PA = A(P/A, 10%, 4) = $1500(3.170) = $4755
PG = G(P/G, 10%, 4) = $500(4.378) = $2189
P3 = $4755 + $2189 = $6944
Present worth at time period 0:
P0 = P3 (P/F, 10%, 3) = $6944(0.7513) = $5217.03
The equivalent uniform annual worth is:
A = P0 (A/P, 10%, 7) = $5217.03(0.2054) = $1,071,58.
Payment Series Discrete Cash Flow Compounding—Geometric Gradient

Alternative to increasing in uniform steps, cash flows may also increase in a constant
proportion in each successive period. Proportional increases at discrete times is
termed as a geometric gradient series. The initial amount A1 increases at a uniform
rate g. The initial amount occurs in year 1; hence, the amount in year n is
An = A1 (1 + g)n−1
Since any An can be considered as a future value F, we can multiply any An by

(P/F, i, n) = (1 + i)–n to compute the present value.
P = A1 (1 + g)n−1 (1 + i)n
Rewriting as

P = A1 (1 + i)−1 [(1 + g)/(1 + i)]x−1
n
Expanding,
P = A1 (1 + i)−1

1 + [(1 + g)/(1 + i)] + [(1 + g)/(1 + i)]2 + · · · + [(1 + g)/(1 + i)]n−1
Let x = A1 (1 + i)−1 and y = ((1 + g)/(1 + i)),

P = x 1 + y + y 2 + y 3 + · · · + y n−1
Multiplying both sides by y:

y P = x y + y 2 + y 3 + · · · + y n−1 + y n−1
Subtracting the second equation from the first yields:

(1 − y)P = x 1 − y n

P = x 1 − y n /(1 − y)
Substitution back x = A1 (1 + i)−1 and y = ((1 + g)/(1 + i)), yields

P = A(1 + i)−1 1 − [(1 + g)/(1 + i)]n /(1 − [(1 + g)/(1 + i)])

1 − [(1 + g)/(1 + i)]n
P=
(1 + i) − [(1 + g)/(1 + i)](1 + i)
1 − ((1 + g)/(1 + i))n
P = A1 = A1 (P/A, g, i, n) (5.15)
i −g
where i = g. This is termed the geometric gradient present worth factor. In the
case of i = Eq. (5.15)becomes
P = A1 (1 + i)−1 (5.16)
Example 5.16
A quality manager is preparing a five-year budget. The cost for external calibra-
tion laboratory service was $9615.38 this year. Over the prior five-year period,
the cost for calibration services has shown a steady average annual growth of
4.0%. The MARR for calibration services is 6.0%. What is the present worth
and equivalent uniform annual cash flow cost of calibration services over the
next five-year budget planning period?
The estimated cost of the first year calibration service for the five-year
budget period is A1 = $9615.38(1.04) = $10,000. The present worth of
calibration service is
1 − ((1 + 0.04)/(1 + 0.06))5

P = $10, 000 = $45, 423.09
0.06 − 0.04
A = $45, 423.09(A/P, 6.0%, 5) = $45, 423.09(0.2374) = $10, 783, 44.
5.6 Compounding Periods and Payment Periods Differ
When the compounding and payment periods differ, we must adjust the cash flows,
so that they are in one of the standard forms. Then, we convert from one standard
form cash flow into the desired standard form cash flow.
Example 5.17
An accounting manager invests $25,000 in a money market fund that pays 3%
nominal annual interest rate compounded monthly. The accounting manager
seeks to withdraw an equal annual amount at the end of each year for five years
to cover the cost of the annual Holiday Party. How much will he be able to
withdraw each year?
First compute the equivalent monthly A for each of the 12 mon/year × 5 year
= 60 months.
i m = 3%/12 month = 0.25% per month

A = $25, 000( A / P, 0.25%, 60)
A = $25, 000(0.0179687)
A = $449.22
Now, convert from the monthly A to the end-of-year F withdrawals.
F = $449.22 (F/A, 0.25%, 12)

F = $449.22 (12.16638)
F = $5465.35
5.7 Nominal and Effective Interest Rates
In repayment methods 3 and 4 where interest is charged on interest, the stated annual
nominal interest rate is not the rate actually paid. The effective annual interest rate
is the actual interest rate charged over the life of the loan. There are three interest
rates that apply to repayment methods 3 and 4.
Nominal interest rate/year, in : the stated annual interest rate on a loan without
considering the effect of interest compounding (i.e., 12%/year).
Number of compounding subperiods, m: the number of compounding subperiods
per year (i.e., month, quarter, semi-annual).
Effective interest rate/period, i: the nominal interest rate/year divided by the number
of interest compounding periods (i.e., 12%/year/12 months/year = 1%/month)
Effective annual interest rate, ia : the annual interest rate accounting for the effect
of compounding interest over the number of interest compounding periods (i.e.,
12%/year or 1%/month has an effective annual interest rate of 12.68%/year).
Using these definitions, we can use the single payment future amount formula to
restate the nominal annual interest rate to its effective annual interest rate equivalent.
F = P(1 + i n )n

i n nm
F = P 1+
m
Using the later interest representation, the effective annual interest rate is:

i n nm
ia = 1 + −1 (5.17)
m
5.7 Nominal and Effective Interest Rates 159
Example 5.18
Depending on macroeconomic and personal factors, the typical credit card
charges a nominal annual interest rate of low of 15%, median 18%, to a high of
21%. What is the effective annual interest rate for each nominal annual interest
rate?
For in = 15.0%,
Effective interest rate/subperiod,i = 0.15/12 = 0.0125
Effective annual interest rate,ia = (1 + 0.0125)12 – 1 = 0.1608 or 16.08%
For in = 18.0%,
Effective annual interest rate,ia = (1 + 0.015)12 – 1 = 0.1956 or 19.56%.
For in = 21.0%,
Effective annual interest rate,ia = (1 + 0.0175)12 – 1 = 0.2314 or 23.14%.
Example 5.19
Example 5.17 revisited. We found that the accounting manager can withdraw
$5475.15 on $25,000 in a money market fund that pays 3% nominal annual
interest rate compounded monthly. We can use the effective annual interest rate
to verify the withdrawal rate.
Ia = (1 + 0.0025)12 − 1 = 0.030416
.
P = A (P/A, 3.0415%, 5) = $5465.35 (4.574273) = $25, 000.01
5.8 Continuous Cash Flow Compounding
Continuous compounding is the mathematical limit of compound interest if it is

calculated and re-invested into an account’s balance over a theoretically infinite
number of periods as t → 0. While compound interest has limited use in practice,
the concept of continuously compounded interest is important in finance. As an
example, an international company on the United States west coast could create a
contract with a bank in Japan (eight time zone difference) to deposit its working
cash into an continuous interest-bearing account at 5:00 PM west coast time (8:00
AM Japanese time) for 8 h. It could create a second continuous interest-bearing

account with a bank in Germany (eight time zone difference from Japan) for the
Japanese bank to transfer the cash balance plus accrued interest to the German bank
at Japan 5:00 PM (Germany 8:00 AM) time. The German bank would then transfer
cash balance plus accrued interest back into the US company’s cash account at 5:00
PM (8:00 AM US west coast time). The US west coast company earns continuous
compounding on its working cash over night when it is not in use, and each bank
adds the cash balance as a cash asset available for loans locally.
We can use the effective annual interest rate formula to develop the formula for
continuous compounding.

i n nm
1+
m
For continuous compounding, t → 0 as m → ∞

i n nm
limm→∞ 1 + = ei n (5.18)
m
limm→∞ (1 + i n ) = ein (5.19)
i a = ei n − 1 (5.20)
Single Payment Continuous Compounding and Present Worth Amounts
F = P(1 + i n )n = Pein n (5.21)
P = F(1 + i n )−n = Fe−in n (5.22)
Uniform Series Continuous Compounding

Substituting i a = ein − 1:
Continuous Compounding Sinking Fund Amount
i
i en −1
(A/F, i, n) = = (5.23)
(1 + i) − 1
n
ei n n − 1
Continuous Compounding Series Amount

in n
(1 + i)n − 1 e −1
(F/A, i, n) = = i (5.23)
i en −1
5.8 Continuous Cash Flow Compounding 161
Continuous Compounding Capital Amount

i(1 + i)n ei n n ei n − 1
(A/P, i, n) = = in (5.24)
(1 + i)n − 1 en −1
Continuous Compounding Series Present Worth Amount

in
i(1 + i)n en −1
(A/P, i, n) = = (5.25)
(1 + i)n − 1 ei n n ei n − 1
Example 5.19
A deposit of $1000 per year (end of year) is made into a retirement account that
pays a 7.0% nominal interest rate. Estimate how much is in the account at the
end of 50 years. Use both discrete compounding and continuous compounding.
Discrete compounding:
F = $1000(F/A, 7.0%, 50) = $1000(406.530) = $406,530
Continuous compounding:
in 0.07×50
en −1 e −1
F=A i = $1000 0.07 = $1000(442.922) = $442,922
e −1
n e −1
5.9 Spreadsheets for Economic Analysis
In practice, engineering departments and projects require large quantities of

economic data. It is impractical to analyze the required data manually. Spread-
sheets have become the standard for acquiring, managing, and analyzing engineering
managerial economic data. In many engineering firms, data is structured and auto-
matically analyzed in multiple interrelated workbooks of spreadsheets. Common
spreadsheet analyses include:
• Structuring tables of cash flows.
• Manually inputting data or developing scripts and macros to import data from
databases, Internet sources, or other spreadsheets.
• Structuring worksheet economic functions to automatically update and model

discounted or compound cash flows of ongoing engineering operations and
projects.
• Structuring output reports and graphics to support engineering managerial
decisions.
• Verifying and validating spreadsheet economic models.
• Revising workbook spreadsheet model structure to reflect changing organiza-
tional, process, and product economics.
Spreadsheets are used in engineering managerial economic analyses to:
• Construct operations and project cash flow.
• Calculate P, F, A, n, or i using annuity functions.
• Find the present worth or internal rate of return of cash flows using a block of
functions.
• Make graphs to support visual analysis.
• Conduct “what-if” scenario analyses to understand the ranges over which differing
decisions are optimal.
Basic Spreadsheet Operations and Arithmetic

The most basic spreadsheet operation is cell referencing. Spreadsheets use absolute,
relative, and mixed references. In cell referencing, the active cell formula points the
data value in another cell. A formula with an absolute reference points to the data in
another cell by its fixed position in the current or another worksheet. If the formula
is copied to another cell, the formula will still point to the original cell. A formula
with a relative reference points to the data in another cell by the relative number
column and row differences. If the formula is copied to another cell, the formula
will point to data in a new cell that is the same relative number column and row
differences. A formula with a mixed reference either sets an absolute reference to
a fixed column or row and leaves the other a relative reference. If the formula is
copied to another cell, the absolute column or row references will remain fixed, but
the relative column or row reference will be to a new cell the same number of relative
rows or column away. Typically, a “$” in front of the column or row designation to
make it an absolute reference. The first four rows of Table 5.1 illustrate absolute,
relative, and mixed designations of a formula that points to data in cell B3 (column
B, row 3). The basic arithmetic operations of addition, subtraction, multiplication,
division, and exponentiation are performed in an active cell’s formula as illustrated
in the last five rows of Table 5.1.
5.9 Spreadsheets for Economic Analysis 163
Table 5.1 Basic spreadsheet arithmetic operations

Operation Symbol Example Comments
Relative $ =B3 Column and row relative
Fixed column $ =$B3 Column fixed and row relative
Fixed row $ =B$3 Column relative and row fixed
Absolute $ =$B$3 Column fixed and row fixed
Addition + =A3 + B3 =SUM(A3, B3) or =SUM(A3:B3)
Subtraction − =A3 − B3 =SUM(A3, −B3)
Multiplication * =A3 * B3 =PRODUCT(A3, B3)
Division / =A3/B3 No worksheet function
Exponentiation ˆ =B3ˆ2 =POWER(B3, 2)
Table 5.2 Spreadsheet financial functions

Argument Description Function
P: present value Value of cash flows today −PV (i, n, A, F, type)
F: future value Value of cash flows at an end time −FV (i, n, A, P, type)
A: annual cash flow Equal periodic cash flows −PMT(i, n, P, F, type)
n: time periods Number of time periods in the term NPER(i, A, P, F, type)
i: interest rate Constant interest rate RATE(n, A, P, F, type)
Type Timing of cash flows 0 (default)—end of period
Financial Analysis Functions

Spreadsheet financial functions allow common business calculations without having
to construct long, complex formulas. The basic financial functions are listed in Table
5.2. Note that the financial functions accept similar arguments.
Example 5.20
A small architectural engineering firm purchases a new truck with no down
payment. The truck costs $35,732 including taxes and registration fees.
Monthly payments are $645 and the financing period is six years. What is
the monthly, nominal, and effective annual interest rate?
P = $35, 732 A = $645 n = 72 months i = ? i n = ?i a = ?

Financial Block Functions

The present value or rate of return of cash flows across multiple periods (spreadsheet
columns or rows) can be found using the NPV and IRR block functions (Table 5.3).
Table 5.3 Spreadsheet financial block functions

Argument Description Function
NPV: net present value Net Present Value NPV(i,values)
IRR: internal rate of return Internal Rate of Return RATE(n,A,P,F,type)
5.9 Spreadsheets for Economic Analysis 165
Example 5.21
A new production line will cost $500,000 to design and $7,000,000 to install.
Revenue for the first year of product sales is estimated to be $2,500,000 and
to increase by $250,000 for years 2 through 4, level at $3,250,000 for years
5 and 6, and decline by $100,000 per year for years 7 and 8. Operating and
maintenance expenses are expected to be $1,000,000 the first year, increase
by 10% in years 2 through 4, and remain steady at the year 4 level for years 5
through 8. Allocated overhead will be $250,000 each year, and the equipment
will be depreciated by straight line at $937,500. The company requires 8.0%
MARR on this type of project and pays combined 30% state and federal taxes.
Estimate the net present value and internal rate of return.
5.10 Summary
Risk Uncertainty about the future causes a decline in the value of money.
Risk increases into future times. As risk increases, the value of money
decreases.
Inflation The general price increase in an economy. As prices increase, the value
of a monetary unit decreases.
Liquidity Investors have a preference for liquidity, i.e., they prefer money today to
the promise of future money. Investments in monetary returns generating
assets are the same as a promise of future money. Investment must be
made in the assets today for future returns.
The fundamental relationship between risk and return—the return on an

investment should be proportional to the risk involved.
There are two components to risk volatility:
Structural difference between long run average realized return and the expected
return.
Random random error difference between realized return and realized long run
average return.
Equivalence of cash flows—any set of two or more cash flows are equivalent at
interest rate i if we can convert one cash flow into the equivalent value of the other(s)
by using the proper interest factors.
Principal—the initial amount money for a loan, bond, stock offering, or asset
purchase.
Interest rate—the proportion cost of borrowed money per period of time.
Interest period—the time over which interest is paid.
Number of interest periods—duration of the loan, bond, stock offering, or asset
purchase.
Receipts or disbursements schedule—the cash flow pattern with interest over the
Future amount of money—cumulative effect of principal and interest over the
Present amount of money—the current value of a set of future cash flows discounted
for interest costs.
An = a discrete payment or receipt of money occurring at the end of an interest
period.
i = interest rate per period.
N = number of interest periods.
P = present value or worth of a set of future cash flows discounted for interest costs.
F = single amount that is equivalent to the cumulative effect of principal and interest
over the number of interest periods.
A = an end of period payment or receipt of money in a uniform series that continues
for n periods; A1 = A2 = … = An
Simple interest:
Total interest earned:is = P × i × n
Future amount due:F = P + P × i × n = i(1 + i × n)
Compound interest:
5.10 Summary 167
Single payment compound amount:
F = P(1 + i)n = P(F/ P, i, n)
Single payment present worth amount:
P = F(1 + i)−n = F( P/F, i, n)
Uniform series compound amount:

(1 + i)n − 1
F=A = A(F/A, i, n)
i
Uniform series sinking fund amount:

i
A=F = F(A/F, i, n)
(1 + i)n − 1
Uniform series capital recovery amount:

i(1 + i)n
A=P = P(A/P, i, n)
(1 + i)n − 1
Uniform series present worth amount:

(1 + i)n − 1
P=A = A(P/A, i, n)
i(1 + i)n
Arithmetic gradient present worth amount:

P = G (1 + i)n − 1 − in /i 2 (1 + i)n = G(P/G, i, n)
Arithmetic gradient uniform series amount:

A = G (1 + i)n − 1 − in / i(1 + i)n − i = G(A/G, i, n)
Geometric gradient present worth amount:
1 − ((1 + g)/(1 + i))n

P = A1 = A1 (P/A, g, i, n)
i −g
where i > g.
P = A1 n(1 + i)−1
where i = g.
Nominal and Effective Interest Rates.
Nominal interest rate/year, in : the stated annual interest rate on a loan without
considering the effect of interest compounding.
Number of compounding subperiods, m: the number of compounding subperiods
per year (i.e., month, quarter, semi-annual).
Effective interest rate/period, i: the nominal interest rate/year divided by the number
of interest compounding periods.
Effective annual interest rate, ia : the annual interest rate accounting for the effect
of compounding interest over the number of interest compounding periods.

i n nm
ia = 1 + −1
m
Continuous Cash Flow Compounding

Single Payment Continuous Compound Amount
F = P(1 + i n )n = Pein n
Single Payment Present Worth Amount
P = F(1 + i n )−n = Fe−in n
Continuous Compounding Sinking Fund Amount

i
i en −1
(A/F, i, n) =
= in
(1 + i) − 1
n
en −1
Continuous Compounding Series Amount

in n
(1 + i)n − 1 e −1
(F/A, i, n) = = i
i en −1
Continuous Compounding Capital Recovery Amount

5.10 Summary 169

i(1 + i)n ei n n ei n − 1
(A/P, i, n) = = in
(1 + i)n − 1 en −1
Continuous Compounding Series Present Worth Amount

in
i(1 + i)n en −1
(A/P, i, n) = = i n i
(1 + i) − 1
n
en en −1
5.11 Key Terms
Arithmetic gradient
Cash flow
Compound interest
Compounding period
Continuous compounding
Effective interest rate
Equivalence
Geometric gradient
Interest rate per period
Internal rate of return
Nominal interest rate
Payment period
Simple interest
Spreadsheet
Uniform cash flow series.
Problems
1. A proprietor borrowed $5000 from family members to launch his organic farm.
His family members agreed to repayment at the end of three (3) years at annual
simple interest of 6%. What is the final repayment?
2. A $5000 loan was repaid at annual 5% simple interest. The amount repaid was
$6,250. How many years was the loan made?
3. How long will it take for an investment to double in value at 8.0% annual
interest rate? (a) Using simple interest. (b) Using compound interest.
4. What sum of money at the present time is equivalent to $5627.50 at the end of
two years if the interest rate is 6.0%, compounded every 6 months?
5. An engineering manager estimates that the replacement cost for a certain piece
of equipment will cost $250,000 in five years. How much should be deposited
today at 8.0% to pay for the equipment? (a) Use 8.0% annual interest rate. (b)
Use 8.0% annual interest rate compounded quarterly.
6. Suppose that $2000 is deposited into an account that earns an annual 10%
interest. (a) How much is in the account in 1, 2, 3, 4, and 5 years? (b) How
much is in the account in 1, 2, 3, 4, and 5 years if annual interest is 10%
compounded semi-annually?
7. A proprietor borrows $5000 from a bank to start his plumbing service. He is
to repay $6000 to cover the principal and interest. If he repays the loan in (a)
2 years, (b) 3 years, or (c) 5 years, what is the corresponding interest rate?
8. Quickie Loans charges its clients a mere 1.0% interest per week for cash
advance loans. What is the effective annual interest rate?
9. A local credit unit advertises that it pays 5.0% annual interest, compounded
daily, on money deposited in a savings account provided the money is left in
the account for five years. What is the effective annual interest rate? If $1,000
is deposited, how much is in the account at the end of five years?
10. A recently graduated engineer purchased a used automobile for transportation
to her new engineering position with a local manufacturing firm. She paid
$20,000 with no down payment. The loan is for three years with nominal
annual interest of 9.0% compounded monthly. What is her monthly payment?
11. Compute the present and future values of the following cash flows over a
five-year planning period. Use an annual interest rate r = 5%.
Year (a) (b) I

1 $100 $100 $150
2 $100 $100 $100
3 $100 $100 $50
4 $100 $0 $100
5 $100 $0 $150
12. A company purchases a machine for $20,500 on which it will make five equal
annual payments at an annual nominal interest rate of 6%. The loan contract
allows the company to pay off the loan at the end of any year when payment
is due without penalty. What is the company’s payoff amount for each year of
the loan contract?
13. Given (F/P, 0.015, 25) = 32.919 and (F/P, 0.18, 25) = 62.669, use linear inter-
polation to determine the multiplier for (F/P, 0.17, 25). What is the computed
value using the formula for the single payment compound amount formula?
Explain any difference in the estimates.
14. A natural gas company is installing solar powered, Wi-Fi meter readers to
replace manual reading. The readers will be installed in equal stages in the
company’s operating region over the next ten years. The readers will save
$25,000 in the first year, increasing $25,000 in each subsequent year. The
natural gas company requires 7.0% return on cost-savings projects. What is
the present worth and equivalent uniform annual worth of the project?
5.11 Key Terms 171
15. Snappy Lawn Service is considering the purchase of a new electric riding
mower. As a sales incentive, the manufacturer provides the mower with a two-
year warranty on service and parts. For this mower, online data indicates that
the annual maintenance expense for the mower in its third year of use will
be $160 and increase by $80 per year in years 4 through 7 of its useful life.
How much money should Snappy deposit in an interest-bearing account at 4%
today to pay for the mower’s maintenance expenses over its useful life? What
is Snappy’s equivalent uniform annual cost of maintenance at the 4% interest
rate?
16. A maintenance manager is considering is whether to install a new high-
efficiency electric blower motor on a roof HVAC unit. The motor cost $2000
is reports energy saving of $400 the first year of use. The motor qualifies for
an energy efficiency discount (additional savings) of 3.0% per year beginning
with the second year of life and increasing at 3.0% per year until the end of
the motor’s useful life of five years. This type of project requires a 7.0% rate
of return. Should the motor be installed?
Chapter 6
Measures of Investment Worth
Abstract Investing in productive assets requires not only the availability of money
but also sound, relevant decision criterion. Equivalence provides the basis on which
cash flows can be adjusted to account for the interest that must be paid on borrowed
or invested money to compensate for the riskiness each alternative. In this chapter,
we will explore two criteria used primarily for short-term investments and the four
primary criteria used for medium-term and long-term investments.
Short-term investment:
• Undiscounted payback.
• Discounted payback.
Medium-term and long-term investment:
• Net present worth.
• Equivalent uniform annual worth.
• Net future worth.
• Internal rate of return.
6.1 Investment Time Periods
Understanding the revenue and expense cash flows of an investment over its lifespan
is key to building a budget. This is especially true when the asset is high risk and
high value incurring higher interest and return on investment costs.
Definition: A budget period is the management equivalent of an accounting period

(i.e., month, quarter, semi-annual, year, or multi-year) tied to the product life cycle.
https://doi.org/10.1007/978-3-030-87767-5_6
174 6 Measures of Investment Worth
Budget periods correspond to specific future periods of time, such as a month, an

accounting year, product life cycle, or a natural business cycle. Typical management
budgeting periods are the zero-period budget for the current fiscal year, the life-cycle
budget, and the long-term business-cycle budget. The zero-period budget delineates
the short-term budget and sets controls for current fiscal year revenues and expenses.
A life-cycle budget is a medium-term budget greater than one year that is an estimate
of all costs to design, develop, install productive assets, market, produce revenues,
and retire a product. A life-cycle budget is tied directly to an organization’s product
life cycle and may range from two to ten or fifteen years. A business-cycle budget
is a long-term budget across multiple product life-cycle budgets that predict the
investments needed in facilities and equipment to support a chain of products.
The conventional stages of product development include embryonic, growth,
maturity, and decline. The embryonic stage covers the first four product life cycle
phases (needs assessment and justification, conceptual design, detailed design, and
production/construction) plus product introduction in the early operational phase.
Sales growth tends to be slow because of buyer unfamiliarity with the product and
the need to build product acceptance. This stage requires heavy start-up investments
in research, manufacturing, and marketing. It tends to be unprofitable and often
involves high risks and a negative cash-flows. In the growth stage, demand for the
product or service is strong with sales growing at increasing rates. As sales grow more
rapidly, the product begins to generate profits. In the maturity stage, market pene-
tration saturates resulting in demand and corresponding sales stabilizing. Inefficient
competitors are eliminated from the industry, and few, if any, entrants are attracted.
Profits and cash flow peak in the maturity stage. In the decline stage, product sales
decline as new technological competitors replace it. Management’s goal is to close
out the product with minimum loss and transition to its replacement.
The analysis period for an engineering managerial economic analysis depends
on the project situation. Some engineering economic analyses may directly support
a new product and be tied to its life cycle. Other engineering economic analyses
may be for equipment upgrade or replacement and be independent of the products
they support. Other engineering economic analyses may be for equipment required
to fulfill legal or regulatory requirements and be independent of all products. In this
chapter, we will begin with the assumption that the alternatives project lives are
equal and equal to the project life. We will then relax this assumption and evaluate
more realistic situations in which alternatives lives are not equal and not equal to the
project life.
6.2 Undiscounted Payback Period 175
6.2 Undiscounted Payback Period
Definition: Undiscounted payback period is number of time periods required to

recover the initial cost cash flow(s) of an investment from the net cash flows (profit
or other benefits) produced by that investment for an interest rate of zero.
Criterion: Select the alternative with the minimum payback period.
If CFt = cash flow (cost or benefit) in period t, the payback period is defined as
the smallest value of n that satisfies

C Ft = 0 (6.1)
n
Payback period is a popular method of selecting among investments in productive

assets, because it is simple to estimate and indicates when the asset will pay off itself
restoring lenders and stockholders to their initial financial position.
Example 6.1
An engineering manager seeks to select between two automatic labeling

devices to apply shipping labels for a one-time, special-order 4-month contract.
Both devices have a three-year technological life and will be sold at the end of
the contract. Each labeling device has the following initial cost and after-tax
net cash flow benefits. Use the undiscounted payback period to select between
the two devices.
Month A labels B labels

0 (−$1200) (−$1400)
1 $400 $400
2 $500 $400
3 $500 $500
4 $500 + $600 $600 + $1000
Payback A:

4

0 = CFt = −$1200 + $400 + $500 + f $300/$500
0
= 2.6 months Select A
Payback B:

4

0 = CFt = −$1400 + $400 + $400 + $500 + f $100/$600
0
= 3.17 months
Payback period may be visualized by the balance outstanding.
Month A Labels A Bal- B Labels B Balance

ance
0 (-$1,200) (-$1,200) (-$1,400) (-$,400)
1 $400 (-$800) $400 (-$1,000)
2 $500 (-$300) $400 (-$600)
3 $500 $200 $500 (-$100)
4 $500 + $600 $600 + $1,000 $500 + $1,000
6.3 Discounted Payback Period
Definition: Discounted payback period is the number of time periods required

to recover the initial cost cash flow(s) of an investment from the net cash flows
(profit or other benefits) produced by that investment at the MARR interest rate.
Criterion: Select the alternative with the minimum discounted payback period.
If CF t = cash flow (cost or benefit) in period t, the discounted payback period is

defined as the smallest value of n that satisfies

C F t (1 + i)−t = 0 (6.2)
n
Example 6.2
Repeat the payback period analysis of Example 6.1 using discounted payback
for MARR = 5.0%.
6.3 Discounted Payback Period 177
Month A labels B labels

0 (−$1200) (−$1400)
1 $400 $400
2 $500 $400
3 $500 $500
4 $500 + $600 $600 + $1,000
Payback A:

4

CFt = −$1200 + $400 (P/F, 5%, 1) + $500 (P/F, 5%, 2)
0

+ f $500 (P/F, 5%, 3)

4

CFt = −$1200 + $400 (0.9524) + $500 (0.9070)
0

+ f $500 (0.8638)

4

CFt = −$1200 + $381 + $454 + f $365/$432
0
f = $365/$432 = 0.85
Payback period = 2.85 months Select A.

Payback B:

4

CFt = −$1400 + $400 (P/F, 5%, 1) + $400 (P/F, 5%, 2)
0

+ $500 (P/F, 5%, 3) + f $600(P/F, 5%, 4)

4

CFt = −$1400 + $400 (0.9524) + $400 (0.9070)
0

+ $500 (0.8638) + f $600(0.8227)

4

CFt t = −$1400 + $381 + $363 + $319 + f $337/$494
0
f = $337/$494 = 0.68
Payback period = 3.68 months.

Problems with Payback Period

Although undiscounted and discounted payback are simple to apply and popular,
both have significant deficiencies relative to the criteria of equivalence.
• Approximate economic analysis method.
• Prior to payback, the effect of timing is ignored when applying undiscounted
payback.
• After payback, all economic consequences are ignored. In Example 6.2, the total
cash flows for device A are (−$1,200) + $400 + $500 + $500 + ($500 + $600)
= $1,300, and the total cash flows for device B are (-$1400) + $400 + $400 +
$500 + ($600 + $1000) = $1,500 reversing the decision and favoring selection
of device B.
• Will not necessarily produce a recommended alternative consistent with equiva-
lent worth and rate of return methods.
The most serious deficiencies are:
• Undiscounted payback does not consider the time value of money.
• Neither consider the consequences of cash flows (investments or benefits) prior
to or after the payback period and the expected life of the investment.
However, organizations often apply payback to the selection of alternatives for
multi-year life-cycle and business-cycle budgeting. Given the above deficiencies,
applying payback period to multi-year alternatives will not meet criteria of equiva-
lence. Rather, payback period is applicable to small asset investments that can pay
off initial cost with net cash flows during the zero-budget period or 12–18 months.
Example 6.3
Consider the following three alternatives, each using undiscounted payback
period of three periods and MARR = 5.0%.
Month A B C
0 (-$1,500) (-$1,500) (-$1,500)
1 $600 $400 $500
2 $500 $500 $500
3 $400 $600 $500
4 $200 $1,000 $0
5 $200 $2,000 $0
6 $200 $3,000 $0
Payback 3 months 3 months 3 months
NPV @ 5% $341 $5,227 (-$138)
6.3 Discounted Payback Period 179
By undiscounted payback period, all three alternatives are equally desirable.

By NPV at MARR = 5.0%, prefer alternative B.
6.4 Net Present Worth
The net present worth criterion addresses the management question, “If we install
asset X today for $1,000,000 (or any other initial cost), what is the net worth today of
future cash revenues and expenses at the required MARR?” To answer this question,
we will use the following notation.
i = Interest rate, MARR.
C 0 = Initial cost at time 0; a negative amount.
C n = Cost or expense at the end of period n.
Rn = Revenue or income at the end of period n.
F t = Net cash flow at the end of period n. F n = Rn – C n .
N = Project life.
n = Time measured in discrete compounding periods.
The net present value or net present worth of a project, NPV or NPW, is defined
as the difference between discounted revenues and expenses at the MARR interest
rate.
N
Rn − C n N
Fn
NPW = −C 0 + = −C 0 + (6.3)
t=1
(1 + i) n
n=1
(1 + i)n
Criterion: Select the alternative that maximizes net present worth.

The procedure for applying the net present worth criterion (and equivalent uniform
annual worth) is:
1. Determine the MARR interest rate applicable to the alternative or project.
2. Estimate the required alternative life.
3. Identify and estimate expected revenue or benefit cash flows and associated
expense cash flows for each period over the required life.
4. Determine the net cash flows using Eq. (6.3).
5. Find the present worth of each net cash flow.
6. Sum the net present worth values to estimate the net present worth.
7. If the alternative or project net present worth >$0, the alternative or project is
acceptable for consideration.
8. Among alternatives with equivalent lives, select the alternative with the
maximum net present worth.
Example 6.4
A new product will cost $1,000,000 to develop and install manufacturing equip-
ment and will generate the follow revenues and expenses (×$1000) including
taxes over its five-year life. This product category must earn MARR = 10.0%.
Estimate its net present worth.
Time 0 1 2 3 4 5
Revenue, r n $0 $550 $550 $550 $550 $550
Expense, cn $1000 $125 $175 $225 $275 $325
Net, F n (−$1000) $425 $375 $325 $275 $275
Using steps 4 and 5 of the net present worth procedure:
$425 $375 $325 $275

NPW = −$1,000 + + + +
(1 + 0.1)1 (1 + 0.1)2 (1 + 0.1)3 (1 + 0.1)4
$225
+
(1 + 0.1)5
NPW = +$267.99
We can also view the net cash flows as an arithmetic gradient:
NPW = −$1000 + ($425(P/A, 10%, 5) − $50(P/G, 10%, 5))
NPW = −$1000 + ($425(3.791) − $50(6.862))
NPW = +$268.08
6.5 Equivalent Uniform Annual Worth
Equivalent uniform annual worth addresses two investment questions.

1. For lenders, will this project generate sufficient cash flows to make its loan
payments and to generate sufficient after-tax cash flows for re-investment in
future products?
6.5 Equivalent Uniform Annual Worth 181
2. For management, what are the expected annual after-tax cash flows discounted
for the MARR?
The equivalent uniform annual worth criterion provides the basis for determining
discounted equal annual cash flows. The equivalent uniform annual worth, EUAW,
of an alternative is defined as its annualized Net Present Worth.

i(1_ + i) N
EUAW = NPW = NPW(A/P, i, N ) (6.4)
(1 + i) N − 1
Criterion: Select the alternative that maximizes equivalent uniform annual worth.
The equivalent uniform annual worth of an alternative is the difference between

the equivalent uniform annual benefit and the equivalent uniform annual cost; EUAW
= EUAB – EUAC. For example, the EUAW of the project in Example 6.4 is estimated
in Example 6.5.
Example 6.5
Estimate the EUAW of the after-tax cash flows for the alternative in Example
6.4.
EUAW = +$268.08(A/P, 10%, 5) = $268.08(0.2638) = $70.72
Interpretation: A lender is assured that the alternative will be able to repay a

loan at MARR = 10% plus yield EUAW = $70,720 per year for reinvestment
in new products. Management should budget and additional EUAW = $70,720
after-tax cash flow per year from this alternative. At MARR = 10%, both the
lender and management are indifferent to the actual net cash flows F n or to the
EUAW.
6.6 Future Worth
Net present worth measures the discounted cash flow worth of an alternative at time
0. Correspondingly, equivalent uniform annual worth measures the discounted cash
flow worth of an alternative at the end of each time period t of its life. Net future worth
measures the compounded cash flows of an alternative at the end of any time period
t in the future or at the end of the alternative’s useful life t n . The net future worth is
most useful when we need to compare investments that must be made over time such
as building a new facility or adding a new production line, which each may take two
or three years. Some large-scale projects such as building a new power plant may
take seven to ten years due to the complexities of design and meeting governmental
regulations. Governmental projects such as building a new or upgrading and existing
interstate highway or an airport runway may take up to 20 years of development
engineering and construction.
The future value or future worth of a project, FV or FW, is defined as the differ-
ence between compounded revenues and expenses at the MARR interest rate at the
end of an alternative’s life.

N
FW = C0 (1 + i) N + (rn − cn )(1 + i) N −n
n=1

N
F
= C0 (F/P, i, N ) + (rn − cn ) , i, N − n (6.5)
n=1
P
Criterion: Select the alternative that maximizes future worth.
The simplest approach to estimating a future worth is to first estimate the net
present worth or equivalent uniform annual worth from an alternative’s cash flows
and us the appropriate F/P or F/A factor to estimate the compounded future worth.
F = P(F/P, i, n) (6.6)
F = A(F/A, i, n) (6.7)
Example 6.6
Estimate the FW of the after-tax cash flows for the alternative in Example 6.4.
Time 0 1 2 3 4 5
Revenue, r n $0 $550 $550 $550 $550 $550
Expense, cn $1000 $125 $175 $225 $275 $325
Net, F n (−$1,000) $425 $375 $325 $275 $275
EUAW $0 $70.72 $70.72 $70.72 $70.72 $70.72
FW = −$1000(1 + 0.1)5 + $425(1 + 0.1)4 + $375(1 + 0.1)3

+ $325(1 + 0.1)2 + $275(1 + 0.1)1 + $225 = $431.61
FW = P(F/P, i, n) = $268(F/P, 10%, 5) = $268(1.611) = $431.75

6.6 Future Worth 183
FW = A(F/A, i, n) = $268(F/A, 10%, 5) = $70.72(6.105) = $431.75
Example 6.7
A west coast robotics firm has decided to build a production facility on the
US east coast to manufacture an innovative new robot for sale there and into
the European market. The project manager has identified two options. She
has located an existing vacant building in Maryland that can be purchased for
$9,500,000 and remodeled. She has also located land in central Virginia that can
be purchased for $850,000. With production scale-up, the project will require
four years engineering and construction before full release to manufacturing.
The expected costs per year are set forth in the following table. The MARR
for this project is 12%. Estimate the time 0 initial cost at the end of year 4 for
release to manufacturing. Estimate the project present worth and equivalent
uniform annual worth to the firm
Engineering, Construction, Scale-Up:
Year Vacant building New building

0 Purchase building $9,500,000 Purchase land $850,000
1 Design engineering $3,500,000 Develop land and design $4,000,000
2 Remodel $4,500,000 Construction $21,600,000
3 Production equip. $2,500,000 Production equip. $2,000,000
4 (0) Scale-up revenue $500,000 Scale-up revenue $2,750,000
Scale-up expenses $1,900,000 Scale-up expenses $2,300,000
Operational Revenues and Expenses (including depreciation and taxes):
Vacant building New building

Year Revenue Expenses Revenue Expenses
5 (1) $10,000,000 $4,400,000 $10,000,000 $4,000,000
6 (2) $18,000,000 $11,000,000 $18,000,000 $10,000,000
7 (3) $31,000,000 $19,800,000 $31,000,000 $18,000,000
8 (4) $49,000,000 $34,100,000 $49,000,000 $31,000,000
9 (5) $47,000,000 $34,100,000 $47,000,000 $31,000,000
10 (6) $45,000,000 $34,100,000 $45,000,000 $31,000,000
Future Worth: Engineering, Construction, Scale-Up—Vacant Building

FW = $9.5(F/P, 12%, 4) + $3.5(F/P, 12%, 3)

+ $4.5(F/P, 12%, 2) + $2.5(F/P, 12%, 1) + $1.4
FW = $9.5(1.574) + $3.5(1.405) + $4.5(1.254)

+ $2.5(1.120) + $1.4 = $29,713,500
Future Worth: Engineering, Construction, Scale-Up—New Building
FW = $0.85(F/P, 12%, 4) + $4.0(F/P, 12%, 3) + $21.6(F/P, 12%, 2)

+ $2.0(F/P, 12%, 1) − $0.45
FW = $0.85s(1.574) + $4.0(1.405) + $21.6(1.254) + $2.0(1.120)

− $0.45 = $35,834,300
Present Worth: Operations − Vacant Building

NPW = (−$29.7135) + $5.6(P/F,12%,1) + $7.0(P/F,12%,2) +
$11.2(P/F,12%,3) + $14.9(P/F,12%,4) + $12.9(P/F,12%,5) +
$10.9(P/F,12%,6)
NPW = (−$29.7135) + $5.6(0.8929) + $7.0(0.7972) + $11.2(0.7118) +
$14.9(0.6355) + $12.9(0.5674) + $10.9(0.5066) = $11.14965 or $11,149,650
Present Worth: Operations − New Building
PW = ($35.8343) + $6.0(P/F,12%,1) + $8.0(P/F,12%,2) + $13.0(P/F,12%,3)
+ $18.0(P/F,12%,4) + $16.0(P/F,12%,5) + $14.0(P/F,12%,6)
PW = ($35.8343) + $6.0(0.8929) + $8.0(0.7972) + $13.0(0.7118) +
$18.0(0.6355) + $16.0(0.5674) + $14.0(0.5066) = $12.7639 or $12,763,900
6.7 Internal Rate of Return
The internal rate of return criterion addresses stockholders’ question of return on their
investment. Stockholders fundamental question is, “Will management’s proposed
portfolio of new investments yield a weighted return on investment ≥MARR?” The
internal rate of return is the interest rate at which the equivalent benefits are equal
to the equivalent costs.
6.7 Internal Rate of Return 185
PW(Benefits, i) = PW(Costs, i)
EUAB(i) = EUAC(i)
FW(Benefits, i) = FW(Costs, i)
To calculate a rate of return:

1. Convert benefits and costs into cash flows.
2. Solve the cash flows for the rate of return that equates equivalent benefits and
equivalent costs.
IRR = i ∗ −interest rate at which NPW = $0 or EUAW = $0
• PW Benefit – PW Cost = $0.

• NPW = $0.
• EUAW = EUAB – EUAC = $0.
• FW Benefit – FW Cost = $0.
Criterion: Select the alternative that maximizes IRR ≥MARR.
Example 6.8
Estimate the internal rate of tension of the after-tax cash flows for the alternative
in Example 6.4.
Example: MARR 10%. Cash flows × $1000. IRR = ?
Time 0 1 2 3 4 5
Revenue, r n $0 $550 $550 $550 $550 $550
Expense, cn $1000 $125 $175 $225 $275 $325
Net, F n (−$1000) $425 $375 $325 $275 $225
$0 = PW Benefit – PW Cost
$0 = $425(P/A, i, 5) − $50(P/G, i, 5) − $1000
Try i = 20%:
$0 = $425(P/A, 20%, 5) − $50(P/G, 20%, 5) − $1000
$0 = $425(2.991) − $50(4.906) − $1000

$0 = $25.88
Try i = 25%:
$0 = $425(P/A, 25%, 5) − $50(P/G, 25%, 5) − $1000
$0 = $425(2.689) − $50(4.204) − $1000
$0 = (−$67.38)
Linear interpolation:
⎧ ⎫
⎨ a 20% $25.88 c ⎬
IRR $0 d
⎩ ⎭
25% −$67.38
a c
Ratio = =
b d
IRR − 20% $0 − $25.88
=
25% − 20% −$67.38 − $25.88

$0 − $25.88
i = 20% + (25% − 20%) = 21.388
−$67.38 − $25.88
Example 6.9
A newly graduated engineer obtains his first engineering position and wants
to invest $5000 at the end of every year for 40 years toward his retirement. If
he desires $1,000,000 to be in the investment when he retires, what average
interest rate must the investment earn?
F = $1,000,000A = $5000 IRR = ?
EUAB = $1,000,000 (A/F, i, 40) = $5000 = EUAC
(A/F, i, 40) = $5000/$1,000,000
(A/F, i, 40) = 0.00500
From the compound interest tables
6.7 Internal Rate of Return 187
i (A/F, i, 40)
6.0% 0.00646
7.0% 0.00501
8.0% 0.00386
Linear interpolation is not needed.
6.8 Investment Worth Metrics Under Differing Project Life

Analysis Periods
In measuring interest equivalence, we must carefully consider the analysis period or

planning horizon. Differing combinations of alternatives and project lives include:
• Useful life of each alternative equals each other and the analysis period.
• Alternatives have useful lives different from each other and from the analysis
period.
– Least common multiple life analysis.
– Project life analysis.
• Special case, EUAW of a continuing requirement.
• The analysis period is infinite, n = ∞.
For the second case of unequal lives, we must also consider how end of alternative
life cash flows terminate. One of two cases may occur. Either the asset life will be
longer than the project life, or the asset life will be shorter than the project life. In
the first case, we must use the assets market value at the end of the project life. In the
second case, we must use the assets salvage value at the end of its life and re-purchase
the same asset for use until the end of the project life. At the end of the project life,
we use the market value of the replacement asset to value the asset’s cash value.
Cash flow equation for asset disposal during its useful life:

t

NPW = P0 + Net Cash Flow j (P/F, i, j) + Market Valuet (P/F, i, t)a
1
Cash flow equation for asset disposal at the end of its useful life:

n

NPW = P0 + Net Cash Flow j (P/F, i, j) + Salvage Valuen (P/F, i, n)
1
The above representations can be made equivalent to annual and future cash flows,
since EUAW = NPW(A/P, i, n) and FW = NPW(F/P, i, n).
Example 6.10
A development engineering manager must decide between two vendors for
a new automated fluorescence metallurgical microscope. The microscope is
required to examine the grain structure of a new alloy in the quality control
laboratory. The microscope will reduce false rejects of required grain size
distribution relative to specification and result decreased rework costs (uniform
annual benefit). The new alloy is expected to have a six-year technological life
before competitors can duplicate its properties. At MARR = 8.0%, which
microscope should be purchased?
Cash flow Nixon Zike

Initial cost $20,000 $30,000
Net uniform annual benefit $4500 $6000
Salvage value $1000 $7000
Useful life 6 years 6 years
Since each alternative’s useful life equal each other’s and the project life,
terminate the asset’s cash flows with its salvage value. The cash flow equation
for each alternative is,
PW = −P0 + A(P/A, 8%, 6) + S(P/F, 8%, 6)
Nixon:

PW = −$20, 000 + $4500(P/A, 8%, 6) + $1000(P/F, 8%, 6)

PW = −$20, 000 + $4500(4.623) + $1000(0.6302)
PW = $1433.70
Zike:

PW = −$30, 000 + $6000(P/A, 8%, 6) + $7000(P/F, 8%, 6)

PW = −$30, 000 + $6000(4.623) + $7000(0.6302)
PW = $2149.40
Decision: Select the Zike microscope to maximize NPW at MARR = 8.0%.
In our application of equivalence to this point, we have considered only situations

in which alternatives useful lives were equal to each other and to the project period.
There are cases where this assumption does not hold. When the useful lives of some
alternatives differ, we must select a common service period. For projects with finite
lives, two methods of common service period analyses are least common multiple
6.8 Investment Worth Metrics Under Differing Project Life Analysis Periods 189
life and project life. As a simple example, if alternative one has a useful life of three
years, alternative two a useful life of four years, and the project life is six years, the
engineering economic analyst would choose a common service period of 12 years
or two project lives. During the common analysis period, alternative one would be
purchased four times, each purchase used to its useful life of three years at which
time each would be scrapped and salvage value realized. Alternative two would be
purchased three times, each purchase used to its useful life of four years at which
time each would be scrapped and salvage value realized.
Example 6.11
A calibration provider needs to purchase a new high precision camera cali-
bration system for a new robot calibration service. Two systems are under
consideration, and their respective cash flows are given in the following table.
The robot calibration service is expected to last for 12 years and must earn
MARR = 8.0%.
Cash flow Alt 1 Alt 2

Initial cost $500,000 $750,000
Calibration service net cash flows $235,000 $255,000
Salvage value $100,000 $160,000
Use 12 years as the least common multiple life for the common service
period.
NPW(1) = −P0 + A(P/A, 8%, 12) + (S4 – P0 )(P/F, 8%, 4) + (S8 – P0 )(P/F,
8%, 8) + S4 (P/F, 8%, 12)
NPW(1) = (−$500,000) + $235,000(7.536) + (−$400,000)(0.7350) +
(−$400,000)(0.5403) + $100,000(0.3971)
NPW(1) = $800,550
NPW(2) = −P0 + A(P/A, 8%, 12) + (S6 – P0 )(P/F, 8%, 6) + S6 (P/F, 8%, 12)
NPW(2) = (−$750,000) + $255,000(7.536) + (−$590,000)(0.6302) +
$160,000(0.3971)
NPW(2) = $863,398 Select Alternative 2.
When the alternatives lives and the project life are unequal such that a reasonable
least common multiple life cannot be used, we can use the project life analysis given
that we have an estimate of the market value of each alternative in its year of disposal.
Example 6.12
Reanalyze problem 6.10 using project life analysis for the following alterna-
tives’ cash flows, useful lives, and market values.
Cash flow Alt 1 Alt 2

Initial cost $500,000 $750,000
Calibration service net cash flows $235,500 $255,000
Salvage value $100,000 $160,000
Market value in year of disposal $250,000 $180,000
NPW(1) = −P0 + (S7 – P0 )(P/F, 8%, 7) + A(P/A, 8%, 12) + M5 (P/F, 8%, 12)
NPW(1) = (−$500,000) + (−$400,000)(0.5835) + $235,000(7.536) +
$250,000(0.3971)
NPW(1) = $1,136,835
NPW(2) = −P0 + A(P/A, 8%, 12) + M12 (P/F, 8%, 12)
NPW(2) = (−$750,000) + $255,000(7.536) + $180,000(0.3971)
NPW(2) = $1,243,158 Select Alternative 2.
Example 6.13
Estimate the EUAW of Problems 6.10 and 6.11.
Problem 6.10 EUAW(1) = P(A/P, 8.0%, 12) = $800,500(0.1327) =

$106,226.35
EUAW(2) = P(A/P, 8.0%, 12) = $863,398(0.1327) = $114,572.91
Problem 6.11 EUAW(1) = P(A/P, 8.0%, 12) = $1,136,835(0.1327) =

$150,858.00
EUAW(2) = P(A/P, 8.0%, 12) = $1,243,158(0.1327) = $164,967.07
EUAW of a Continuing Requirement

One exception to the common service period is the equivalent uniform annual worth
estimate for a continuing requirement (i.e., an asset is needed for the long-term
business-cycle budget period but has a useful life much shorter than the business-
cycle budget period). A continuing requirement is an asset that is required for basic
organizational functioning regardless of the product life cycle mix. Examples include
the organizational information system, heating-ventilation-air-conditioning systems,
utilities, logistics equipment, and equipment required to meet regulatory require-
ments. In the case of a continuing requirement, we just need to estimate the one-life
EUAW of each alternative. The EUAW will not change over future common multiple
lives of the same alternative.
Example 6.14
Two network servers are being considered for purchase to support a new process
line. Whichever server is purchased, it will continue to be purchased to replace
itself over the expected 60-year facility life. MARR = 7.0%. Estimate the one-
life EUAC for each alternative server and the EUAC for each alternative for
the least common multiple life of the two servers.
Cash flow Server A Server B

Initial cost $17,000 $15,000
One-life EUAC estimate.
EUAC(A) = −P( A/P, i, n) + S( A/F, i, n)

= −$17, 000 (A/P, 7%, 12) + $1500 (A/F, 7%, 12)

= −$17, 000 (0.1259) + $1, 500 (0.0559)

= −$2, 056.45 Select server A.
EUAC(B) = −P( A/P, i, n) + S( A/F, i, n)

= −$15, 000 (A/P, 7%, 9) + $1000 (A/F, 7%, 9)

= −$15, 000 (0.1535) + $1, 000 (0.0835)

= −$2, 219.00
Least common multiple life EUAC estimate.
EUAC(A) = [−P0 + (S12 − P0 )(P/F, 7%, 12) + (S24 − P0 )(P/F, 7%, 24)
+ S(P/F, 7%, 36)](A/P, 7%, 36)

= [ −$17, 000 + $1, 500 − $17, 000 (0.4440)

+ $1, 500 − $17, 000 (0.1971) + $1500(0.0883)](0.0768)

= −$26, 804.60 (0.0768) = −$2, 058.59
$2 difference due to rounding error.
EUAC(B) = [−P0 + (S9 − P0 )(P/F, 7%, 9) + (S18 − P0 )(P/F, 7%, 18)

+ (S27 − P0 )(P/F, 7%, 27) + S(P/F, 7%, 36)](A/P, 7%, 36)

= [ −$15, 000 + $1, 000 − $15, 000 (0.5439)

+ $1, 000 − $15, 000 (0.2959)

+ $1, 000 − $15, 000 (0.1609)
+ $1, 000(0.0883)](0.0768)

= −$28, 921.50 (0.0768) = −$2, 221.17
$2 difference due to rounding error.
Infinite Analysis Period

In the governmental, utilities, and transportation sectors, some asset investments
have project lives that span multiple decades or become permanent infrastructure.
Since the compound interest values asymptotically approach their exponential limits,
these projects lives can be treated as infinite. Present worth estimates for projects
with essentially infinite lives are termed capitalized cost analysis.
Definition: Capitalized cost is the present worth of an infinite series of future cash
flows, at a stated interest rate, that represents the amount of money that needs to
be invested at time 0 to cover all future expenditures to maintain the service or
asset.
The present value of the initial investment must never decline. For any present
amount P, there can be an end of period withdrawal of A = iP at the end of each
period into the infinite future. This sets up the fundamental relationship
For n = 1 → ∞, A = iP (6.8)
Capitalized cost is the P in Equation (6.8).
For n = 1 → ∞, P = A/i (6.9)

Example 6.15
A local electric utility company needs to install power lines to a new suburb.
The initial installation will cost $12,000,000 and will have an expected life
of 100 years at which time the towers and lines will have to be replaced. The
utility company will need to keep the power service indefinitely. Assuming a
7% interest rate for this project, how much money will the utility company
have to invest at time 0 to finance the power line’s initial construction and all
future replacements? Explain the future cash flows.
From Example 6.13, the continuing requirement annual cost is,
A = P(A/P, 7%, 100)

= $12, 000, 000 (0.07000808)
= $840, 969.18
Thus, the required time 0 investment is,
P = A/i
= $840, 969.18/0.07
= $12, 013, 845.36
If the electric utility company invests a total of $12,013,845.36 ($12,000,000

initial cost plus $13,845.36 in a 7% interest-bearing account), the interest-
bearing account will grow to $13,845.36(1 + 0.07)100 = $12,013,845.36 every
100 years allowing replacement of the old power lines.
Multiple Alternatives
Multiple alternative problems are solved using the same methods as problems with
two alternatives. Analysis is determined by the cash flows.
period.
Example 6.16
A bridge contractor needs a water pump and pipe to remove water from an
excavated hole during footing installation. Engineering estimates estimate that
water seepage will be about 25 gal/min. Available matched pumps and pipe
diameter options are presented in the following table. Pipe length to the adjacent
river will be 90 ft. downstream to avoid back seepage. Work on the footing will
be completed in four months working 24-hour days. The contractor’s MARR
= 9.0% for this project.
Matching pump hp versus pipe diameter (in.)

Pump hp–self priming 1.0 1.5 2.0 2.5
Pump initial cost $400 $450 $490 $700
Pipe diameter 1 1¼ 1½ 2
Capacity (gal/min) 25 45 60 80
Pipe installed cost $450 $475 $510 $625
Pumping cost/h $1.20 $0.90 $0.70 $0.60
Interest rate/period = 9.0%/3 = 3.0% per 4-month period.

Estimate h/day pumping time.
1 hp pump w 1-in. pipe ~ (25 gal/min/25 gal/min) × 24 h = 24 h/day
1.5 hp pump w 1.5-in. pipe ~ (25 gal/min/45 gal/min) × 24 h = 13.33 h/day
2.0 hp pump w 2-in. pipe ~ (25 gal/min/60 gal/min) × 24 h = 10 h/day
2.5 hp pump w 2.5-in. pipe ~ (25 gal/min/80 gal/min) × 24 h = 7.50 h/day
Estimate pumping cost per month.
1 hp pump w 1-in. pipe ~ $1.20/h × 24 h/day × 30.5 days/mon = $878.40
1.5 hp pump w 1.5-in. pipe ~ $0.90/h × 13.33 h/day × 30.5 days/mon =
$365.91
2.0 hp pump w 2-in. pipe ~ $0.70/h × 10 h/day × 30.5 days/mon = $213.50
2.5 hp pump w 2.5-in. pipe ~ $0.60/h × 7.5 h/day × 30.5 days/mon
= $137.25
PW(a) = (−P0 (pump) – P0 (pipe)) + (pumping cost/mon)(P/A, 3.0%, 4)
Matching pump hp versus pipe diameter (in.)

1.0 1.5 2.0 2.5
Pump hp–self priming $400 $450 $490 $700
Pipe installed cost $450 $470 $510 $625
1.0|$878.40 × 3.717 $3265
1.5|$365.91 × 3.717 $1360
2.0|$213.50 × 3.717 $794
2.5|$137.25 × 3.717 $510
PW(a) $4115 $2280 $1794 $1835
Select the 2 hp pump and 1½ in. diameter pipe combination.
Example 6.17
A property management firm has an empty building that its engineering
manager indicates can leased for a retail space, food market, or fitness gymna-
sium. The engineering manager submitted the following conversion estimates.
The firm’s MARR = 12% on all lease investments. In addition to the following
alternatives, include the “Do Nothing” option in alternatives estimates.
Alternative Initial conversion cost Monthly lease revenue Salvage value end of 5
P0 A years S
Retail space $52,500 $5,400 $31,500
Food market $137,500 $17,250 $82,500
Fitness gym $99,750 $11,600 $42,750
Since property management firms are heavily dependent on monthly cash

flows to stay viable, EUAW analysis will be used. The equivalence equation
for each alternative is,
EUAW(a) = −P0 (A/P, 1%, 60) + A + S (A/F, 1%, 60)

Do nothing : EUAW = −$0(0.0222) + $0 + $0(0.0122) = $0

Retail space : EUAW = −$52, 500 (0.0222) + $1000 + $31, 500(0.0122)
= $218.80

Food market: EUAW = −$137, 500 (0.0222) + $2500 + $82, 500(0.0122)
= $454.00

Fitness gym:EUAW = −$99, 750 (0.0222) + $1700 + $42, 750(0.0122)
= $7.10
Invest in converting the empty building to a food market and seek a marketer
for a lease contract. Note that the fitness gymnasium EUAW is equivalent to
the do-nothing option and should not be pursued.
6.9 Investment Worth Metrics in Spreadsheet Analyses
In chapter five, it was noted that spreadsheets have become the standard for acquiring,
managing, and analyzing engineering managerial economic data. Many of the
primary investment worth metric estimates have been illustrated in the examples
in chapter five and this chapter. In this section, we will illustrate the use of spread-
sheets of two common investment worth estimates: (1) bond pricing and (2) building
an amortization schedule.
Bond Pricing. Governments and corporations issue bonds to raise funds for public
projects and for expansion of productive capacity. Several types of bonds are sold
in financial markets.
Treasury notes and bonds. The United States Treasury issues notes and bonds
to pay for public projects and finance the national debt.
Treasury bills. These are short-term securities, 13–52 weeks, typically sold at a
discount to par value (also known as face value). When the bill matures, its par
value is paid to the holder. The difference between the purchase price and par
value represents the interest earned.
Municipal bonds. State and local governments issue bonds to finance public
projects that cannot be funded by taxes. There are two basic types of municipal
bonds. General obligation bonds are backed by the credit worthiness of the issuing
agent. Revenue bonds are repaid from a specific income source, typically usage
fees, pledged in their contracts.
Corporate bonds. Debentures are backed by the credit worthiness of the corpo-
ration. Asset backed bonds are collateralized by a pool of assets, such as property
or equipment, loans, leases, credit card debt, royalties, or receivables.
Zero-coupon bonds. Governments and corporations sell zero-coupon bonds at a
deep discount. Interest is not paid. Rather the value of the bond increases to its
par value when it matures.
6.9 Investment Worth Metrics in Spreadsheet Analyses 197
Callable bonds. The issuer may recall and pay off the bond before its maturity
date. Organizations issue callable bonds when they believe that interest rates will
decline in the future. With callable bonds, organization issues the bonds at a
current interest rate. If the interest rate does decline, the organization will pay off
the outstanding bonds and issue new bonds at the lower rate. If the interest rate
remains the same or increases, the issuer may allow the callable bonds to remain
outstanding to full maturity. To protect the bondholders who expect the higher
interest rate, recallable bonds are typically issued with a non-callable option for
a specified period.
Floating-rate bonds. These bonds are issued with adjustable interest rates if the
general interest rate increases. This prevents investors from being “locked” into
bonds with unattractive lower interest rates.
Corporate bond prices are quoted as a percentage of the bond’s face value or in
1/8’s fraction of $10 point values. For the base 1/8th point, each fraction paid in
annual interest is $1.25. For example, a bond quoted as 96¾ is selling for $967.50.
Treasury bonds are quoted in 1/32nds, 31.25 cents, of a point.
Bonds are traded on the bond market just like stocks on the stock market
exchanges. Depending on the bond’s interest rate relative to the current market
interest rate, a bond will may sell at below or above its face value. This differ-
ential in the selling price versus the face value is the measure of yield to maturity
or the actual interest earned over its holding period. A bond’s current yield is the
annual interest earned as a percentage of its current market price.
Example 6.18
Consider purchasing a ten-year $1000 corporate bond with an annual coupon
rate of $80 paid semiannually. The current market price is $992.50. Find the
yield to maturity and current yield.
P = $992.50 Face value = $1000, i n = $80, n = 10 years

m = 2 subperiods/year
i = $80/2 = $40 or 4% per semiannual period
Periods = 2 × 10 = 20 periods
P = A(P/A, i, p) + F(P/F, i, p)
$992.50 = $40(P/A, i, 20) + $1000(P/F, i, 20)
Since the bond price $992.50 < $1000 face value, the yield to maturity
interest rate must be higher than the nominal semiannual interest rate of 4.0%.
Try, 4.5%.
$992.50 = $40(P/A, 4.5%, 20) + $1000(P/F, 4.5%, 20)

$992.50 = $40(13.008) + $1000(0.4146)
$992.50 = $934.92
Linear interpolation:
⎧ ⎫
⎨ a 4% $1,000 c ⎬
i $992.50 d
⎩ ⎭
4.5% $934.92
a c
Ratio = =
b d
i − 4% $992.50 − $1000
=
4.5% − 4% −$934.92 − $1000

$992.50 − $1000
i = 4% + (4.5% − 4%)
$934.92 − $1000
The semiannual yield to maturity = 4.0576% and the annual yield to matu-
rity = 8.1152%. The semiannual current yield = $40/$992.50 = 0.0403 or
4.03%, and the annual current yield = 8.06%.
We can set up a MS Excel® spreadsheet with the input data and use its Goal
Seek function to estimate the semiannual yield to maturity.
6.9 Investment Worth Metrics in Spreadsheet Analyses 199
Loan Amortization
Another application of spreadsheets to economic analysis is use in setting up an
amortization schedule for the repayment of a loan with a constant A period payment.
Spreadsheets assist in:
• Establishing the loan repayment amortization schedule.
• Showing the progression of principal and interest payments.
• Determining the balance due on a loan at any time in its life.
• Estimating the number of payments remaining on the loan at any time in its life.
Establishing the amortization schedule begins with calculating the annual payment
A = P(A/P, imn , mn), where i = interest rate per subperiods (quarterly, monthly,
weekly, etc.), m = subperiods per year, and n = number of years that the loan
is outstanding. The interest paid in each period is Interest($) = Pi, where P is the
remaining principal owed at the beginning of the period and i is the per period interest
rate. The amortization schedule is then estimated in tabular format as:
Period Beginning balance Payment (A) Interest Paid Principal paid Ending balance
Example 6.19
Edward purchased a house one year ago and is making monthly payments (A).
The closing price on the house was $300,000, financed for 30 years, and at
an annual interest rate of 6.0%. Estimate the monthly payment and set up the
first year’s amortization schedule. (1) What is his monthly payment (excluding
insurance and taxes)? (2) How much interest and principal did he pay on the
12th payment, and how much does he owe on the house (ending balance)
after he makes the 12th payment? (3) If he decides to pay an extra 10% of
his payment each month for the remainder of the loan, when will the loan be
repaid?
P = $300, 000.00 i n = 6.0% n = 12 × 30 = 360 months

i = 6.0%/12 = 0.5%
6.10 Spreadsheets for Alternatives with Multiple Rate-of-Returns 201
6.10 Spreadsheets for Alternatives with Multiple

Rate-of-Returns
In examples thus far, cash flows were considered to have an initial negative investment
cash flow and a sequence of net positive benefit cash flows. This single transition
in cash flow from negative to positive guaranteed a single unique rate-of-return
solution. There are other cash flows with multiple negative-to-positive and positive-
to-negative transitions for which there will be multiple rate-of-return solutions. The
most common examples are high-cost upgrade or expansions during an alternative’s
useful life or a high salvage cost in the final year of an alternative’s life. In general,
there will be a rate-of-return solution for each minus-to-plus and plus-to-minus cash
flow transitions.
To estimate the correct rate-of-return for an alternative that has multiple cash flow
sign changes, we will use the internal rate of return definition.
The internal rate of return is the interest rate at which the net present worth or
equivalent annual worth equals $0.
We can use spreadsheet financial functions to identify all multiple rate-of-return

solutions.
1. Determine the net annual cash flows for the alternative under consideration.
2. Set up a range of interest rates (e.g., −70 to +100%).
3. Estimate the net present value or equivalent uniform annual worth of the net
annual cash flows for each interest rate.
4. Perform linear interpolation for each sign change to determine the rate-of-return.
5. If there is only one positive root, it is the valid rate of return.
6. If there is only one negative root, it is the valid rate of return.
7. If there is a negative and positive root, only the positive root is considered as
the valid rate of return.
8. When multiple roots are found, there will be a negative root that can be consid-
ered as invalid and at least one positive root that can be considered as the valid
rate of return.
Example 6.20 illustrates multiple roots for an alternative with a high salvage value
at the end of its useful life. Example 6.21 illustrates multiple roots for the upgrade
or expansion during an alternative’s life.
Example 6.20
Estimate the rate of return for an alternative with an initial cost of $300,000,
annual net benefit cash flows of $80,000 for years 1 through 9, and a salvage
cost of $120,000 in year 10.
Valid IRR = 17.90%.
Example 6.21
Estimate the rate of return for an alternative with an initial cost of $200,000,
annual net benefit cash flows of $40,000 for years 1 through 5, an expansion
cost of $200,000 in year 5 with net benefit cash flows of $80,000 for years
6–10. The alternative has a salvage cost of $100,000 at the end of year 10.
Inputs: Initial cost ($200) k

Benefit 1-5 $40 k
Benefit 6-10 $80 k
Expansion ($200) k
Salvage ($100) k
Initial cost PW Estimation

Year Invest cost Benefit Salvage Cash flow i. PW
0 ($200) ($200) -40% $12,380
1 $40 $40 -30% $3,584 $14,000
2 $40 $40 -20% $1,173 $12,000
Present Worth
3 $40 $40 -10% $391 $10,000

4 $40 $40 0% $100 $8,000
$6,000
5 ($200) $40 ($160) 10% ($23)
$4,000
6 $80 $80 20% ($81)
$2,000
7 $80 $80 30% ($111)
$0
8 $80 $80 40% ($129)
0%
-40%
20%
-30%
-20%
-10%
10%
30%
40%
50%
60%
($2,000)
9 $80 $80 50% ($140)
10 $80 ($100) ($20) 60% ($148) Trial interest rate
IRR = 8.14%
Valid IRR = 7.4%.

6.11 Summary 203
6.11 Summary
Definition: A budget period is the management equivalent of an accounting period

(i.e., month, quarter, semi-annual, year, or multi-year tied to the product life cycle).
• The zero-period budget delineates the short-term budget and sets controls for
current fiscal year revenues and expenses.
• A life-cycle budget is a medium-term budget greater than one year that is
an estimate of all costs to design, develop, install productive assets, market,
produce revenues, and retire a product. A life-cycle budget is tied directly to
an organization’s product life cycle and may range from two to ten or fifteen
years.
• A business-cycle budget is a long-term budget across multiple product life-cycle
budgets that predicts the investments needed in facilities and equipment to support
a chain of products.
Undiscounted Payback Period:
Definition: Undiscounted payback period is number of time periods required to

recover the initial cost cash flow(s) of an investment from the net cash flows (profit
or other benefits) produced by that investment for an interest rate of zero.
Criterion: Select the alternative with the minimum payback period.
If CF t = cash flow (cost or benefit) in period t, the payback period is defined as

the smallest value of n that satisfies

C Ft = 0
n
Discounted Payback Period:
Definition: Discounted payback period is the number of time periods required

to recover the initial cost cash flow(s) of an investment from the net cash flows
(profit or other benefits) produced by that investment at the MARR interest rate.
Criterion: Select the alternative with the minimum discounted payback period.
If CF t = cash flow (cost or benefit) in period t, the discounted payback period is

defined as the smallest value of n that satisfies

C F t (1 + i)−t = 0
n
Net Present Worth:

The net present value or net present worth of a project, NPV or NPW, is defined
as the difference between discounted revenues and expenses at the MARR interest
rate.
N
rn − cn N
Fn
NPW = −C 0 + = −C 0 +
n=1
(1 + i) n
n=1
(1 + i)n
Criterion: Select the alternative that maximizes net present worth.
Equivalent Uniform Annual Worth:

The equivalent uniform annual worth, EUAW, of an alternative is defined as its
annualized Net Present Worth.

i(1_ + i) N
EUAW = NPW = NPW(A/P, i, N )
(1 + i) N − 1
Criterion: Select the alternative that maximizes equivalent uniform annual worth.
Future Worth:
The future value or future worth of a project, FV or FW, is defined as the differ-
ence between compounded revenues and expenses at the MARR interest rate at the
end of an alternative’s life.

N
FW = C0 (F/P, i, N ) + (rn − cn )(F/P, i, N − n)
n=1
Criterion: Select the alternative that maximizes future worth.
Internal Rate of Return:

The internal rate of return is the interest rate at which the equivalent benefits are
equal to the equivalent costs.
Criterion: Select the alternative that maximizes IRR ≥ MARR.
Differing combinations of alternatives and project lives include:

period.
6.11 Summary 205

Types of bonds:
• Treasury notes and bonds.
• Treasury bills.
• Municipal bonds.
• Corporate bonds.
• Zero-coupon bonds.
• Callable bonds.
• Floating-rate bonds.
Loan amortization:
A = P(A/P, i mn , mn)
where i = interest rate per subperiods (quarterly, monthly, weekly, etc.), m = subpe-
riods per year, and n = number of years that the loan is outstanding. The amortization
schedule is then estimated as:
Period Beginning balance Payment (A) Interest paid Principal paid Ending balance
6.12 Key Terms
Amortization schedule
Analysis period
Business-cycle budget period
Capitalized cost
Common service period
Continuing requirement
Coupon rate
Discounted payback period
Equivalent uniform annual worth criterion
Equivalent uniform annual benefit
Equivalent uniform annual cost
Face value
Future worth
Infinite analysis period
Internal rate of return
Least common multiple life analysis
Life cycle budget period
Net present worth criterion

Par value
Project life analysis
Undiscounted payback period
Zero-budget period
Problems
1. Consider four mutually exclusive alternatives for a one-year short-term product

contract in a job shop. For short-term products, the firm requires 4.0% MARR.
Cash flow Product A Product B Product C Product D

Initial cost $17,500 $15,000 $4750 $21,000
Uniform monthly net income $1900 $1400 $450 $2400
a. Estimate the undiscounted payback period for each product.

b. Estimate the discounted payback period for each product.
2. Specialty Plastics, Inc., is considering purchasing a new injection molding

machine to improve control of shrinkage of molded parts. The improvement in
shrinkage control will reduce losses by $95,000 per year. The injection molding
machine can be purchased and installed for $340,000 today. It will have a useful
life of seven years and will have a salvage value of $17,000. The new injection
molding machine will not increase operating expenses but will require an addi-
tional maintenance expenses of $15,300 per year. Specialty Plastics requires
a 12% rate of return on investments in new technology. Do you recommend
purchasing the new injection molding machine? What is the EUAW and rate of
return on the investment?
3. A new engineering graduate, who just turned 21, started her new engineering
job. Her salary is $68,000 per year, which after income taxes, health insurance,
and social security will yield take-home pay of $60,000 per year. She elects to
have $500 per month deducted into an Individual Retirement Account (IRA) for
retirement. Historically, the IRA has paid 3.0% annual nominal interest rate but
compounded monthly. (a) If she works to the required retirement age of 67, how
much will be in the IRA when she retires? (b) Currently, social security pays
$3011 per month, which after taxes for someone in the 25% tax bracket nets
$2260. If she desires to maintain her $54,000/12 = $4500 per month income
during retirement, how many months will her IRA account last?
6.12 Key Terms 207
4. For the following alternatives, which is preferred if the firms’s MARR = 7.0%?
Total revenue will be the same for both alternatives.
Parameter A B
First cost $72,500 $52,500
Annual operating expenses $5000 $6000
Annual maintenance exp’s $1800 $400
Overhaul (year 5) $15,000 NA
Useful life (years) 8 4
5. Reconsider problem 4 if alternative A’s market value is 80% of its initial cost
at the end of the two years after initial purchase, alternative B’s market value is
40% of its initial cost, and the project life is ten years.
6. A maintenance manager is considering the budget for a machine on the produc-
tion line. Over the next five years, the budget is expected to be $19,000 per year.
During years six to ten, the budget is expected to increase by $6000 per year due
to machine wear. Additionally, $9000 is budgeted in year four and year eight for
overhaul of the machine. If the relevant MARR = 8.0%, what is the equivalent
uniform annual cost for maintaining this machine?
7. Assuming the alternative A, B, and C will be needed for continued use and
MARR = 12.0%, which alternative should be selected based on annual cash
flow analysis?
A B C
Initial cost $15,000 $22,500 $30,000
Annual benefit $1500 $2650 $6325
Life ∞ 30 8
8. The state highway department is considering the construction of a new bridge.

Based on the following data, which type of construction is preferred. The
relevant interest rate is 5.0%.
Steel Concrete
Initial cost $5,000,000 $7,000,000
Annual maintenance $350,000 $250,000
Resurfacing $3,500,000 $4,500,000
Resurfacing interval 10 years 15 years
9. A process engineer for a French fry manufacturing line is considering investment

in one of three automatic slicing machines. The MARR for this investment is
6.0%. Which alternative should be selected?
A B C
Initial cost $88,400 $107,100 $113,900
Increased revenue $64,600 $52,700 $62,900
Annual O&M expense $25,500 $15,300 $20,400
Salvage value $22,100 $32,300 $37,400
Life 6 6 12
Chapter 7
Depreciation Effects on Investment
Worth
Abstract We first introduced the concept of depreciation in Chapter two with the
statement, “assets are valued at their acquisition cost and adjusted for depreciation and
improvement costs.” Likewise in chapter two, under the balance sheet category fixed
assets, depreciation was subtracted from plant and asset initial cost to arrive at net
fixed assets valuation. On the income statement, depreciation was subtracted as a part
of operating expenses to calculate earnings before interest and taxes. However, the
methods to estimate annual depreciation expenses were not discussed. This chapter
discusses historical depreciation methods, the Modified Accelerated Cost Recovery
System depreciation required under US tax code, unit-of-production depreciation,
and depletion depreciation.
7.1 Depreciation Fundamentals
Fixed assets such as buildings, equipment, computer networks, and office furniture
are acquired to directly or indirectly support production operations that generate
future cash flows from the sale of products and services. Unlike direct labor, direct
materials, and indirect materials consumed and expensed in the current budget
accounting period, fixed assets exist across multiple periods. Thus, a different
accounting method is needed to expense fixed assets initial costs across multiple
budget accounting periods. Depreciation is the method used to expense fixed assets’
initial costs.
Definition: Depreciation is a decrease in fixed asset value; that is, market value
is due to the use or value to the owner due to the aging.
Definition (financial): Depreciation is the systematic allocation of the cost of a
fixed asset over its depreciable life related to deterioration, or consumption of its
useful life.
https://doi.org/10.1007/978-3-030-87767-5_7
210 7 Depreciation Effects on Investment Worth
Fig. 7.1 Depreciation categories
As shown in Fig. 7.1, economic depreciation can be recognized as,
Economic Depreciation = Initial value (purchase price) − Market Value
From the accounting perspective, depreciation is not a cash flow in the period it
is expensed. However, depreciation affects the accounting journal value of assets,
and, as a budgeting period expense, depreciation affects the after-tax cash flow of an
alternative or project. Financial depreciation can be recognized as
Financial Depreciation = Initial value (purchase price) − Consumed Life value
Figure 7.1 also shows that depreciation must also be considered from an
accounting perspective.
Expenses: subtracted from business revenues during each accounting budget
period.
• Labor.
• Utilities.
• Materials.
• Insurance, etc.
• Depreciation—allocation of initial equipment cost plus installation costs.
At the end of each accounting budget period,
Book Value (balance sheet) = Initial value (purchase price)

− Sum(depreciation expenses)
Net Income = EBTn − Taxes = EBTn − EBTn × Tax Rate

Net Income = [Rn − (On + Mn + Dn + In)]
− [Rn − (On + Mn + Dn + In)] TR
Net Income = [Rn − (On + Mn + Dn + In)] (1 − TR)
7.1 Depreciation Fundamentals 211
From a cash flow perspective, depreciation must be added back to net income to
estimate the after-tax net cash flow.
Net Cash Flow = [Rn − (On + Mn + Dn + In )] (1 − TR) + Dn

Net Cash Flow = [Rn − (On + Mn + In )] (1 − TR) − Dn (1 − TR) + Dn
Net Cash Flow = [Rn − (On + Mn + In )] − Dn + (Dn × TR) + Dn
Net Cash Flow = [Rn − (On + Mn + In )] + (Dn × TR)
7.1.1 US Tax Code Depreciation Fundamentals
Applicable US Department of the Treasury Internal Revenue Publications for this

depreciation discussion:
• 179, Property Expense.
• 197, Intangibles.
• 551, Basis of Assets.
• 946, How to Depreciate Property.
Note: For personal business property purchased and used outside of the USA,
consult the codes of the country in which the property is used. Tax codes of foreign
governments must be observed for foreign assets.
Note: For US-headquartered companies, US IRS code still applies to depreciation
of property used in foreign countries. Hence, separate journals, ledgers, balance
sheets, income statements, statements of retrained earnings, and statements of cash
position will have to be maintained in the USA and each foreign country.
IRS Publication 551, Basis of Assets
Tangible Asset Cost Basis:
• Initial asset cost plus.
• All fees and charges allowed under the Uniform Capitalization Rules with
• Allocated expenses for the purchase of multiple assets plus.
• Allowable increases or decreases in the cost basis.
necessary to place the asset in service fit for use.
Placed-in-service date is the day on which the asset begins to provide returns to the business
by performing its intended function or by producing its intended output.
A placed-in-service date for each asset or class of assets must be recorded in

the fixed assets journal. For historical depreciation methods, the recorded placed-in-
service date specifies the remaining portion of depreciation that can be taken in the
first and last years of service.
Depreciable life or recovery period: The period over which an asset is depreciated.
• Depreciation is a non-cash cost: money does not change hands during the recovery
period.
• Depreciation is used to allocate an asset’s loss of value over time.
• Depreciation is deducted from revenue and reduces the taxable income of a
business over time.
• Depreciation affects cash flow on an after-tax basis.
An asset is depreciable if:
• The asset is used for business purposes in the production of income.
• The asset has a useful life that can be determined, and the useful life is longer
than one year. Otherwise, the asset is expensed.
• The asset decays, gets used up, wears out, becomes obsolete or loses value from
natural causes.
Types of Assets:
Tangible: can be seen, touched, and felt.
• Real: land, buildings, and things growing on, or attached to the land.
• Personal: equipment, furnishings, vehicles, office machinery, etc., are not defined
as real property.
Intangible: has value but cannot be seen or touched; examples include patents,
copyrights, and trademarks.
Note: Buildings and equipment are depreciable; land is not. Land is entered into
the fixed asset journal and shown on the balance sheet at its purchase price plus costs
and fees necessary to complete the purchase (real estate brokers, escrow fees, legal
fees). Regardless of its current market value, land is maintained on the balance sheet
at its initial purchase price until it is sold. Land value can be changed only when it
is sold, and a new market value is established by the objective sales transaction.
7.1.2 Depreciation Estimation Fundamentals
Figure 7.2 shows the relationship between allocated depreciation expenses and asset
book value. The horizontal axis is in time units of an asset’s useful life (generally
years). The vertical axis is the balance sheet book value of the asset at the end of each
accounting budget period showing the effect on book value of each d(t) depreciation
expense. In general, an asset’s book value declines linearly or at a decelerating rate as
each depreciation expense is realized. The equation for the calculation of an asset’s
book value at each d(t) is,
Book value = Asset cost − Sum( Depreciation Charges)

7.1 Depreciation Fundamentals 213
Fig. 7.2 Book value versus

time relationship

t
BV j = Asset cost − dj (7.1)
1
7.2 Historical Depreciation Methods
Prior to 1981, four methods were used to estimate period depreciation allowances:
• Straight line.
• Sum-of-years’-digits.
• Declining balance.
• Declining balance switching to straight line.
1981–1986, Accelerated Cost Recovery System (ACRS).
• Asset assigned to category of property class life.
• Estimate salvage value.
• Shorter recovery periods than historical methods.
1986–present, Modified Accelerated Cost Recovery System (MACRS).
• Expanded number of property classes.
• Annual depreciation percentages modified to include half-year convention for first
and last year.
Depreciation estimates are important for estimating after-tax cash flow effects.
We will find that US IRS tax code depreciation methods are based on variations
of historical methods. Many organizations continue to use historical depreciation
methods for financial reporting to stockholders and outside stakeholders (hence,
another reason that organizations maintain multiple journals and ledgers). Finally,
many states still require historical methods for the estimation of state taxable income.
7.2.1 Straight-Line Depreciation
Straight-line depreciation was applied to fixed assets that were consumed uniformly
over their useful lives. Straight-line depreciation expenses are an equal fraction of
the initial cost basis. The period depreciation charge is
B−S
Depreciation expense dt = (7.2)
N
B = Initial cost basis of the asset.
S = Salvage value.
N = Depreciable life in years.
For the historical methods, if an asset is placed in service during its first year, the
first-year depreciation charge is just for the period of service of the remainder of the
year.
B−S
d1 = premaining−year
N
Example 7.1
A fixed asset has a cost basis of $8600 and has a useful life of 4 years, and
a salvage value of $200. It is expected to be used uniformly each day. It is
placed in service at the end of the 5th month of the organization’s fiscal year.
What is the annual depreciation expense, and what is the first-year depreciation
expense?
$8600 − $200
dt = = $2100/year
4
premaining−year = 7/12
d1 = $2100(7/12) = $1225
The remaining $2100 – $1225 = $875 depreciation charge will be taken for
the first five months of year 4 use.
7.2 Historical Depreciation Methods 215
7.2.2 Sum-of-Years-Digits Depreciation
An asset may provide useful output that declines over time due to wear or techno-
logical obsolescence. For this asset type, we should apply an accelerated depreci-
ation method to recognize the higher consumption of useful life early in the asset’s
life cycle. One such accelerated depreciation method is the Sum-of-Years-Digits
(SYOD) depreciation. SYOD estimates higher depreciation expenses than straight-
line depreciation in an asset’s early life and smaller depreciation expenses at the end
of its depreciable life. SYOD is calculated as
N −t +1 N −t +1
Depreciation expense dt = N −1 (B − S) = (B − S) (7.3)
0 N − j N (N + 1)/2
B = Initial cost of asset.

S = Salvage value.
t = Depreciation year of asset life.
An algorithmic approach to estimating the multiplier is
Years in reverse order

Multiplier =
Sum(Years digits)
As an example, for an asset with a five-year useful life, the multiplier for each
year is
Year SYOD multiplier

1 5/15
2 4/15
3 3/15
4 2/15
5 1/15
Example 7.2
Compute the SYOD depreciation schedule for an asset with the following
expense and life information: B = $10,000, S = $1000, N = 5.
N − t + 1
dt = $10,000 − $1000
15
Year Multiplier d(t) End BV

0 $10,000
1 5/15 $3000 $7000
2 4/15 $2400 $4600
3 3/15 $1800 $2800
4 2/15 $1200 $1600
5 1/15 $600 $1000
7.2.3 Declining Balance Depreciation
The second accelerated depreciation method, declining balance allocates a fixed

fraction of the asset’s remaining book value as the annual depreciation expense.
C
Depreciation expense dt = Book Valuet−1
N
where C = constant multiplier to be selected. The most widely applied values of C

are 150% and 200% of straight-line depreciation. When C = 1.5, d t is termed 150%
declining balance. When C = 2, or the 200% rate, d t is termed double-declining
balance (DDB) and is estimated as

2 2
DDB dt = (Book Valuet−1 ) = B− dj (7.4)
N N t−1
B = Initial cost of asset.

t = Current year of life.
Note: Eq. (7.4) does not include the salvage value lower limit. Since total depreci-
ation charges cannot reduce asset value below its salvage value, the final depreciation
charge may be only the proportion of the final d t that reduces the asset worth to its
salvage value.
Example 7.3
Rework Example 7.2 using double-declining balance.
7.2 Historical Depreciation Methods 217
Year (2/N) BV d(t) End BV

0 $10,000
1 (2/5) $10,000 $4000 $6000
2 (2/5) $6000 $2400 $3600
3 (2/5) $3600 $1440 $2160
4 (2/5) $2160 $864 $1296
5 (2/5) $1166 Not $518; $296 $1000
7.3 Modified Accelerated Cost Recovery System (MACRS)
The Economic Recovery Tax Act of 1981 established the Accelerated Cost Recovery
System (ACRS). ACRS changed from straight-line depreciation to depreciating
assets to shorter depreciation schedules based on cost recovery. Accelerated depreci-
ation increased the depreciation expenses that organizations were able to claim early
in an asset’s life. The law’s proponents believed that accelerated asset depreciation
would, in turn, accelerate economic growth.
Congress modified ACRS in the United States Tax Reform Act of 1986, naming
the new system as the Modified Accelerated Cost Recovery System (MACRS).
MACRS introduced the following tax advantages over ACRS.
• “Property class lives” are less than “actual useful lives.”
• Salvage values are required to be zero.
• Tables of annual percentages simplify computations.
MACRS depreciation schedules are set forth in IRS Publication 946 How to
Depreciate Property, Section 4 Figuring Depreciation under MACRS. (Note: This
discussion presents only the fundamentals of MACRS depreciation. Actual applica-
tion is much more complex. Always consult the organization’s tax accountant when
estimating MACRS depreciation on final project estimates.)
MACRS uses the general depreciation system (GDS), which is just declining
balance with switch to straight-line depreciation. The alternative depreciation system
(ADS) provides longer recovery periods and uses straight-line depreciation. Under
US law, ADS must be used for:
• Tangible assets used outside the USA.
• Any tax-exempt asset financed by tax-exempt bonds.
• Farming assets.
Depreciation is estimated using general method (IRS FORM 4562):
1. Determine asset cost basis.
2. Determine asset property class and recovery period.

3. Use the asset’s placed-in-service date to locate MACRS depreciation percent-
ages in Tables 7.1, 7.2 and 7.3.
Once the asset class and recovery period are determined IRS 946 Tables B-1 or
B-2, consult the appropriate table in Appendix A, MACRS Percentage Table Guide
for the annual percentage depreciation charges. Table 7.3 reproduces IRS 946 Chart 1
guidance for personal business property.
Table 7.4 reproduces IRS 946 Chart 2 guidance for residential rental and
nonresidential real property.
In this text, we will restrict personal business property depreciation percentages
to IRS 946, Table A-1 shown in Table 7.5. Likewise, we will restrict real property
depreciation percentages to IRS 946, Table A-7a shown in Table 7.6.
Table 7.1 IRS 946 Table B-1: specific depreciable assets used in all business activities
Recovery periods (in years)
Asset class Description Class life GDS ADS
(in years) (MACRS)
00.11 Office furniture, fixtures, and 10 7 10
equipment
00.12 Information systems including 6 5 5
computers
00.13 Data handling equipment: 6 5 6
except computers
00.21 Airplanes (airframes and 6 5 6
engines), except commercial or
freight and all helicopters
00.22 Automobiles and taxies 3 5 5
00.23 Buses 9 5 9
00.241 Light general purpose trucks 4 5 5
00.242 Heavy general purpose trucks 6 5 6
00.25 Railroad cars and locomotives 15 7 15
not owned by railroad
transportation companies
00.26 Tractor units for use 4 3 4
over-the-road
00.27 Trailers and trailer-mounted 6 5 6
containers
00.28 Vessels, barges, tugs and 18 10 18
similar water transportation
00.3 Land improvements 20 15 20
00.4 Industrial steam and electric 22 15 22
generation and distribution
systems
7.3 Modified Accelerated Cost Recovery System (MACRS) 219
Table 7.2 IRS 946 Table B-2: depreciable assets used in the following activities
Asset class Description Class life GDS (MACRS) ADS
(years)
01.1 Agriculture 10 7 10
10.0 Mining 10 7 10
13.0 Offshore drilling 7.5 5 7.5
15.0 Construction 6 5 6
20.1 Manufacture food products 17 10 17
20.5 Manufacture food 4 3 4
products—special handling
devices
21.0 Manufacture tobacco products 15 7 15
22.1 Manufacture of 7.5 5 7.5
textiles—knitted goods
24.4 Manufacture of wood product 10 7 10
& furniture
26.1 Manufacture pulp and paper 13 7 10
27.0 Printing and publishing 11 7 11
28.0 Manufacture chemicals 9.5 5 9.5
30.1 Manufacture of rubber 14 7 14
products
30.2 Manufacture finished plastic 11 7 11
products
31.0 Manufacture leather products 11 7 11
32.1 Manufacture glass products 14 7 14
32.2 Manufacture of cement 20 15 20
32.3 Manufacture of stone/clay 15 7 15
products
33.2 Manufacture nonferrous metals 14 7 14
33.3 Manufacture foundry products 14 7 14
33.4 Manufacture of primary steel 15 7 15
mill products
34.0 Manufacture of fabricated 12 7 12
metal products
35.0 Manufacture machinery and 10 7 10
mechanical products
36.0 Manufacture of electronic 6 5 6
components
37.11 Manufacture of motor vehicles 12 7 12
(continued)
Table 7.2 (continued)

Asset class Description Class life GDS (MACRS) ADS
(years)
37.2 Manufacture of aerospace 10 7 10
products
37.31 Ship & boat building 12 7 12
machinery & equipment
37.41 – 2 Manufacture locomotives 11.5 7 11.5
(railroad cars)
39.0 Manufacture athletic, jewelry, 12 7 12
other goods
41.0, 42.0 Motor transport—passengers 8 5 8
& freight
45.0 Air transport 12 7 12
46.0 Pipeline Transportation 22 15 22
48.12 Telephone central office 18 10 18
equipment
48.14 Telephone distribution 24 15 24
48.2 Radio and television 6 5 6
broadcasting
48.31 Electric power and 19 10 19
communications
49.11 Electric utility & power 50 20 50
production—classes 49.11 to
49.5
50 Municipal water treatment 24 15 24
51 Municipal sewer 50 20 50
57.0 Distributed trades and 9 5 9
services—wholesale, retail,
personal and professional
services
57.1 Distributed trades and 20 15 20
services—billboard, service
station, and petroleum
marketing
79.0 Recreation 10 7 10
80.0 Theme and amusement park 12.5 7 12.5
Technological & research 5
equipment
Table 7.3 IRS 946 Chart 1: personal business property

MACRS Depreciation Recovery Convention Class Mon/Qtr Tables
system method period placed in
service
GDS 200% GDS/3, 5, 7, Half-Year 3, 5, 7, 10 Any A-1
10 Nonfarm
GDS 200% GDS/3, 5, 7, Mid-Quarter 3, 5, 7, 10 1st Qtr A-2
10 Nonfarm 2nd Qtr A-3
3rd Qtr A-4
4th Qtr A-5
GDS 150% GDS/3, 5, 7, Half-Year 3, 5, 7, 10 Any A-14
10
GDS 150% GDS/3, 5, 7, Mid-Quarter 3, 5, 7, 10 1st Qtr A-15
10 2nd Qtr A-16
3rd Qtr A-17
4th Qtr A-18
GDS 150% GDS/15, 20 Half-Year 15 & 20 Any A-1
GDS 150% GDS/15, 20 Mid-Quarter 15 & 20 1st Qtr A-2
2nd Qtr A-3
3rd Qtr A-4
4th Qtr A-5
GDS SL GDS Half-Year Any Any A-8
ADS ADS
GDS SL GDS Mid-Quarter Any 1st Qtr A-9
ADS ADS 2nd Qtr A-10
3rd Qtr A-11
4th Qtr A-12
ADS 150% ADS Half-Year Any Any A-14
ADS 150% ADS Mid-Quarter Any 1st Qtr A-15
2nd Qtr A-16
3rd Qtr A-17
4th Qtr A-18
Table 7.4 IRS 946 Chart 2: Residential rental and nonresidential real property
MACRS Depreciation Recovery Convention Class Mon/Qtr Table
system method period placed in
Service
GDS SL GDS/27.5 Mid-Month Residential Any A-6
Rental
GDS SL GDS/31.5 Mid-Month Nonresidential Any A-7
Real A-7a
ADS SL GDS/3, 5, Half-Year 3, 5, 7, 10 Any A-13
7, 10
SL GDS/3, 5, Mid-Quarter 3, 5, 7, 10 Any A-13a
7, 10
Table 7.5 IRS 946 Table A-1. 3-, 5-, 7-, 10-, 15-, and 20-year property; half-year convention
Applicable percentage for GDS property class
Recovery 3-year 5-year 7-year 10-year 15-year 20-year
year property property property property property property
1 33.33 20.00 14.29 10.00 5.00 3.750
2 44.45 32.00 24.49 18.00 9.50 7.219
3 14.81 19.20 17.49 14.40 8.55 6.677
4 7.41 11.52 12.49 11.52 7.70 6.177
5 11.52 8.93 9.22 6.93 5.713
6 5.76 8.92 7.37 6.23 5.285
7 8.93 6.55 5.90 4.888
8 4.46 6.55 5.90 4.522
9 6.56 5.91 4.462
10 6.55 5.90 4.461
11 3.28 5.91 4.462
12 5.90 4.461
13 5.91 4.462
14 5.90 4.461
15 5.91 4.462
16 2.95 4.461
17 4.462
18 4.461
19 4.462
20 4.461
21 2.231
Table 7.6 IRS 946 Table A-7a nonresidential real property mid-month convention-39 years
Percentage—month placed in and removed from service
Recovery year 1 2 3 4 5 6
1 2.461 2.247 2.033 1.819 1.605 1.391
2–39 (mid) 2.564 2.564 2.564 2.564 2.564 2.564
40 (last) 0.107 0.321 0.535 0.749 0.963 1.177
Recovery year 7 8 9 10 11 12
1 1.177 0.963 0.749 0.535 0.321 0.107
2–39 (mid) 2.564 2.564 2.564 2.564 2.564 2.564
40 (last) 1.391 1.605 1.819 2.033 2.247 2.461
Once the correct depreciation percentages are determined, the year-to-year

depreciation expense for the GDS asset is estimated as:
dt = B × rt (7.5)
d t = depreciation deduction in year t.

B = cost basis (initial ready-for-use cost).
r t = MACRS percentage rate in year t.
Example 7.4
A company installs a small research laboratory with $230,000 of research
equipment with an estimated salvage value of $30,000 at the end of its 7-year
technological life. Calculate the annual MACRS depreciation expenses and
annual book values.
From IRS 946 Table B-2, research equipment is GDS 5-year personal
business property. From IRS 946 Table A-1, the GDS 5-year depreciation
percentages are shown in the following table.
Year t Cost basis MACRS dt Cum d t Book value

r t (%)
0 $230,000 $230,000
1 20.00 $46,000 $46,000 $184,000
2 32.00 $73,600 $119,600 $110,400
3 19.20 $44,160 $163,760 $66,240
4 11.52* $26,496 $190,256 $39,744
5 11.52 $26,496 $216,752 $13,248
6 5.76 $13,248 $230,000 $0
The year of switch to straight-line depreciation is indicated by an "*"
Note in Table 7.5 that each GDS property class life is depreciated over n + 1 years.
This is due to the IRS 946 MCRS half-year convention. The half-year convention
requires that one-half the depreciation charge be taken in the first and last years. This
rule assumes that the asset is placed in service on average at mid-year (mid-quarter for
the mid-quarter convention) and disposed of on average at mid-year in the final year
of service. Table 7.7 gives estimation of the MACRS 5-year property percentages
with the half-year convention. To simplify the discussion, we will assume a fixed
asset with $1.00 initial cost basis. For a 5-year life, the DDB multiplier is 2/5 = 0.40.
For year 1, the depreciation expense is 0.4($1.00) = $0.40, but by the MACRS half-
year convention take only 0.5($0.40) = $0.20 depreciation expense. The straight-
line depreciation for the remaining GDS life is 1/5.5 = 0.1818 with depreciation
Table 7.7 Estimation of MACRS GDS 5-year property rates

Year Beg BV DDB SLN MACRS End BV
1 1.0000 × 4/2 = 0.20 0.1818 0.20 0.80
2 0.8000 × 4/2 = 0.32 0.1777 0.32 0.48
3 0.4800 × 4/2 = 0.192 0.1371 0.192 0.288
4 0.2880 × 4/2 = 0.1152 0.1152* 0.1152 0.1728
5 0.1728 × 4/2 = 0.06912 0.1152 0.1152 0.0576
6 0.0576 × 4/2 = 0.02304 0.0576 0.0576 0.0000
The year of switch to straight-line depreciation is indicated by an "*"
expense of 0.1818($1.00) = $0.1818. Since MACRS depreciation $0.20 > $0.1818,

use the MACRS depreciation. The book value at the end of the 1st year is $1.00 −
$0.20 = $0.80. For year 2, the MACRS depreciation expense is 0.4($0.80) = $0.32.
The straight-line depreciation for the remaining GDS life is 1/4.5 = 0.2222 with
depreciation expense of 0.2222($0.80) = $0.1717. Since MACRS depreciation $0.32
> $0.1717, use the MACRS depreciation. The book value at the end of the 2nd year
is $0.80 − $0.32 = $0.48. For year 3, MACRS depreciation is 0.4($0.48) = $0.1920,
and the straight-line depreciation is (1/3.5)($0.48) = $0.1371. Again, use MACRS
depreciation with end-of-year book value of $0.48 − $0.192 = $0.288. For year 4,
MACRS depreciation is 0.4($0.288) = $0.1152, and the straight-line depreciation is
(1/2.5)($0.288) = $0.1152. Since MACRS depreciation $0.1152 = $0.1152 straight-
line depreciation, switch to straight-line depreciation for the remaining asset life.
The book value at the end of year 4 is $0.288 − $0.1152 = $0.1728. For year 5,
the straight-line depreciation is (1/1.5)($0.1728) = $0.1152 and the ending book
value is $0.1728 − $0.1152 = $0.0576. The year 6 depreciation is $0.0576 and the
ending book value is $0.00. Double-declining balance with switch to straight-line
depreciation is used to estimate the MACRS depreciation percentages for each GDS
property class in Table 7.5.
Example 7.5
MAN property management group purchased land for $7,500,000 and
constructed a building for lease to a logistics and warehousing firm. The
building cost $120,000,000 to construct and was completed and leased to the
logistics and warehousing firm in the 4th month of MAN’s current fiscal year.
The lease is for 7 1/2 years with option for the logistics and warehousing firm
to purchase the building. If the logistics and warehousing firm does not exer-
cise the option to purchase the building, MAN will sell the land and building
to any other interest party. Using the percentages in Table 7.6, estimate the
annual MACRS depreciation expenses and book value for MAN’s 7 1/2 years
of ownership.
As previously stated, land is not depreciable. The building cost basis is

$120,000,000.
Percentage – Month Placed in and Removed from Service

Recovery
Year 1 2 3 4 5 6
1 2.461 2.247 2.033 1.819 1.605 1.391
2-39 2.564 2.564 2.564 2.564 2.564 2.564
(mid)
40 (last) 0.107 0.321 0.535 0.749 0.963 1.177
Percentage – Month Placed in and Removed from Service
Recovery
Year 7 8 9 10 11 12
1 1.177 0.963 0.749 0.535 0.321 0.107
2-39 2.564 2.564 2.564 2.564 2.564 2.564
(mid)
40 (last) 1.391 1.605 1.819 2.033 2.247 2.461
Since the building was placed in service in the 4th month of the current fiscal
year, the first-year depreciation is 1.819%. All intermediate years’ depreciation
charges are at 2.564%. The 7 1/2-year contract will terminate in the 10th month
of MAN’s fiscal year. The final year’s depreciation is 2.033%. The depreciation
schedule is shown in the following table.
Year r(t) d(t) d(t) End BV

0 $120,000,000
1 0.01819 $2,182,800 $2,182,800 $117,817,200
2 0.02534 $3,076,800 $5,259,600 $114,740,400
3 0.02534 $3,076,800 $8,336,400 $111,663,600
4 0.02534 $3,076,800 $11,413,200 $108,586,800
5 0.02534 $3,076,800 $14,490,000 $105,510,000
6 0.02534 $3,076,800 $17,566,800 $102,433,200
7 0.02534 $3,076,800 $20,643,600 $99,356,400
8 0.02033 $2,439,600 $23,083,200 $96,916,800
7.4 Depreciation at Asset Disposal
In disposing of fixed assets depreciated by MACRS, the engineering manager must

consider its value at the time of disposal. If the asset is disposed of at the end of
its or after its MACRS GDS property life, the asset has a book value of zero, and
taxes must be paid on any gains made on the salvage value of the asset. If the asset
is disposed of during its MACRS GDS property life, the manager must compare its
market value and book value.
• Depreciation recapture (ordinary gains): If the asset is sold (market value) for
more than its book value, “… any gain on the disposition generally is recaptured
(included in income) as ordinary income up to the amount of the depreciation
previously allowed or allowable for the property.” (IRS 946, section 4) Taxes must
be paid on the difference between its market value received and its book value.
• Depreciation loss (ordinary loss): If the asset’s market value (sales price) is less
than its book value, a tax credit will be realized on ordinary income.
• Capital gains: Capital gain must be realized when the asset is sold (market value)
for more than its initial cost basis. The excess over the original cost basis is the
capital gain. If the asset is held for less than one year, short-term capital gain tax
rates apply. The federal capital gains tax rate on assets held for less than one year
corresponds to ordinary corporate income tax rate of 21%. If the asset is held
for more than one year, long-term capital gains tax rates apply as set forth in the
following table.
Capital gain Fed. tax rate (%)

$0 to $53,600 0
$53,601 to $469,050 15
$469,051 + 20
Regardless of whether it is a depreciation recapture or loss, the MACRS rule for

disposal in any period during the GDS property life is to take one/half of the allowable
depreciation in the year of disposal. Additional considerations in accounting for
depreciation recapture or loss or capital gains can be found in:
• IRS section 1231 Property—defines rules for gains or losses for different asset
classes.
• IRS Publication 946, How to Depreciate Property. General Asset Accounts
(GAA)—defines rules for gains or losses for disposition of separate assets grouped
into a GAA.
7.4 Depreciation at Asset Disposal 227
Example 7.6
Estimate the depreciation recapture or loss for a fixed asset disposed of in year
2 and 3 of its GDS 3-year property life with an initial cost basis of $100,000
and market values of $84, 000 at the end of year 1, $42,000 at the end of year 2,
$21,000 at the end of year 3, and $10,000 salvage value every year thereafter.
Year r(t) d(t) Book value Market value Recapture/loss

1 0.3333 $33,333 $66,667
2 0.4445 × 0.5 $22,225 $44,442 $42,000 (−$2442) Loss
1 0.3333 $33,333 $66,667
2 0.4445 $44,450 $22,217
3 0.1481 × 0.5 $7405 $14,812 $21,000 $6188
Recapture
7.5 Unit-of-Production Depreciation
Unit-of-production depreciation method for fixed assets whose life consumption is

proportional to its use in the extraction of natural resources (minerals, gas, oil, timber,
etc.). The unit-of-production depreciation for these fixed assets is,
Unit Production Year(i)

dt = × (B − S) (7.5)
Total Number Recoverable Units
Example 7.7
Extraction and processing equipment with an initial cost basis of $1,800,000
and salvage value $300,000 is used in the extraction and processing of lime-
stone into gravel. It is estimated that the limestone volume will take 5 years
to extract. Then the pit will be shut down and reclaimed in accordance with
the US Office of Surface Mining Reclamation and Enforcement regulations.
Estimate the annual unit-of-production depreciation expenses on the extraction
and processing equipment using the unit-of-production method.
The first-year depreciation expense is:
105,000
dt = × $1,800,000 − $300,000 = $225,000
700,000
Year m3 sold Proportion dt

1 105,000 0.15 $225,000
2 140,000 0.20 $300,000
3 175,000 0.25 $375,000
4 140,000 0.20 $300,000
5 140,000 0.20 $300,000
Total 700,000
7.6 Depletion
Depreciation of natural resource, such as mineral, oil, gas, timber, etc., is estimated
by one of two depletion methods. The rules for estimating depletion expenses are set
forth in IRS Publication 535, Business Expenses, section 9 Depletion. Two methods
are set forth for estimating depletion: cost depletion and percentage depletion. The
selected method is used for estimating of annual depletion expenses and the book
value of the remaining natural resource.
7.6.1 Cost Depletion Method
Cost depletion expenses are determined by the adjusted basis of the natural resource
divided by the number of recoverable units of the natural resource multiplied number
of units sold during the given year. The adjusted basis represents the depletion
allowance and is re-estimated annually for tax reporting purposes. Re-estimating
the number of recoverable units of the natural resource is an engineering problem.
Cost depletion expense for the resource is
Adjusted Basis
dt = ×B (7.6)
7.6 Depletion 229
7.6.2 Percentage Depletion Method
Annual percentage depletion is computed based on annual income rather than the
adjusted cost basis of the resource. Under the percentage depletion method, the
annual depletion expense is estimated as
Value Production Year(i)

dt = ×B (7.7)
Value Total Number Recoverable Units
As in the cost method, the value of the total number of recoverable units must be
re-estimated annually. Note that since the percentage depletion is estimated based
on income rather than the cost basis of the property, the total depletion on asset
may exceed the cost of the property. To avoid this, the annual allowance under
the percentage method may not be more than 50% of the taxable income from the
property.
Both depletion methods are complex requiring ownership allocation, annual re-
estimates of the number of recoverable units, and carry back/forward depletion re-
estimates. Bottom line, leave depletion estimates to tax accountants.
7.7 Spreadsheets and Depreciation
Spreadsheets have functions for estimating depreciationTable 7.8.

The VDB() function is used for MACRS double-declining balance with switch
to straight-line depreciation. It includes the specification of starting and ending
periods and default switch = TRUE to straight-line depreciation. For the case of only
declining balance only, set switch = FALSE. The factor = 2 for double-declining
balance. For 150% declining balance, set factor = 1.5.
Table 7.8 Spreadsheets and depreciation

Method Personal property (non-real estate)
Straight-line SLN (cost, salvage, life)
Declining balance DDB (cost, salvage, life, period, factor)
Sum-of-years’ digits SYD (cost, salvage, life, period)
MACRS VDB (cost, salvage, GDSlife, start_period, end_period, factor, no_switch)
Example 7.8
Use the VDB() function in a spreadsheet to estimate the depreciation schedule
for the $230,000 research equipment of Example 7.4. Its estimated salvage
value was $30,000 at the end of its 7-year technological life. Recall that its
MACRS property class was 5-year.
Note that the start-period = MAX(0,$B10-1.5). For $B10 = 1, start-period

= MAX(0, −0.5) = 0 and end-period = MIN(5, 1–0.5) = 0.5 to account for
the MACRS half-year convention for year 1. For year 2, $B11 = 2 and start-
period = MAX(0, 2–1.5) = 0.5 and end-period = MIN(5, 2–0.5) = 1.5 for
one full year depreciation expense. The same one-year depreciation expense
occurs for years 3 to 5. In year 6, $B15 = 6, start-period = MAX(0, 6–1.5)
= 4.5, and end-period = MIN(5, 6–0.5) = 5 or 0.5 again accounting for the
MACRS half-year convention in the final year.
7.8 Summary
Definition: Depreciation is a decrease in fixed asset value; that is, market value
is due to the use or value to the owner due to aging.
Definition (financial): Depreciation is the systematic allocation of the cost of a
fixed asset over its depreciable life related to deterioration, or consumption of its
useful life.
IRS Publication 551, Basis of Assets

Tangible Asset Cost Basis:
7.8 Summary 231
• Initial asset cost.

• All fees and charges allowed under the Uniform Capitalization Rules.
• Allocated expenses for the purchase of multiple assets.
• Allowable increases or decreases in the cost basis.
necessary to place the asset in service fit for use.
Placed-in-service date is the day on which the asset begins to provide returns to
the business by performing its intended function or by producing its intended output.
Depreciable life or recovery period: the period over which an asset is depreciated.
– Depreciation is a non-cash cost: money does not change hands during the recovery
period.
– Depreciation is used to allocate an asset’s loss of value over time.
– Depreciation is deducted from revenue and reduces the taxable income of a
business over time.
Depreciation affects cash flow on an after-tax basis.
Types of Assets:
Tangible: can be seen, touched, and felt.
• Real: land, buildings, and things growing on, or attached to the land.
• Personal: equipment, furnishings, vehicles, office machinery, etc., are not defined
as real property.
Intangible: have value but cannot be seen or touched; examples include patents,
copyrights, and trademarks.
Book value = Asset cost − Sum( Depreciation Charges)
Straight-line Depreciation
B−S
Depreciation expense dt =
N
Sum-of-Years-Digits Depreciation
N −t +1 N −t +1
Depreciation expense dt = N −1 (B − S) = (B − S)
0 N−j N (N + 1)/2
Declining Balance Depreciation
C
Depreciation expense dt = Book Valuet−1
N
Modified Accelerated Cost Recovery System
dt = B × rt
d t = depreciation deduction in year t.

B = cost basis (initial ready-for-use cost).
r t = MACRS percentage rate in year t.
Depreciation at Asset Disposal
• Depreciation recapture (ordinary gains): If the asset is sold (market value) for
more than its book value, “… any gain on the disposition generally is recaptured
(included in income) as ordinary income up to the amount of the depreciation
previously allowed or allowable for the property.” (IRS 946, section 4) Taxes must
be paid on the difference between its market value received and its book value.
• Depreciation loss (ordinary loss): If the asset’s market value (sales price) is less
than its book value, a tax credit will be realized on ordinary income.
• Capital gains: Capital gain must be realized when the asset is sold (market value)
for more than its initial cost basis. The excess over the original cost basis is the
capital gain.
Unit-of-Production Depreciation
Unit Production Year(i)

dt = × (B − S)
Depletion—Cost Depletion Method
Adjusted Basis
dt = ×B
Depletion—Percentage Depletion Method
Value Production Year(i)

dt = ×B
Value Total Number Recoverable Units
7.9 Key Terms
Alternative depreciation system

Capital gain
Cost basis
Declining balance depreciation
Depletion
Depreciable life n
Depreciation
Depreciation loss
Depreciation recapture
Deterioration
Double-declining balance depreciation
7.9 Key Terms 233
General depreciation system

Loss on disposal
MACRS
Obsolescence
Percentage depletion
Personal property
Real property
Recovery period
Straight-line depreciation
Sum-of-years-digits depreciation
Unit-of-production depreciation
Problems
1. Develop straight-line, sum-of-years’-digits, double-declining balance, and
MACRS GDS depreciation schedules for petroleum drilling equipment with
an initial cost of $110,000 and salvage value of $10,000 at the end of its 10-year
useful life.
machine to improve control of shrinkage of molded parts. The improvement in
shrinkage control will reduce losses by $95,000 per year. The injection molding
machine can be purchased and installed for $340,000 today. It will have a useful
life of 7 years and will have a salvage value of $17,000. The new injection
molding machine will not increase operating expenses but will require addi-
tional maintenance expenses of $15,300 per year. Specialty Plastics requires
a 12% rate of return on investments in new technology. Estimate the annual
taxable net income and pre-tax cash flow for this machine using (a) straight
line, (b) sum-of-years’-digits, (c) double-declining balance, and (d) MACRS
GDS depreciation.
3. A process engineer for a French fry manufacturing line is considering investment
in one of three automatic slicing machines. The MARR for this investment
is 6.0%. Estimate the annual taxable net income and pre-tax cash flow using
MACRS GDS depreciation. Which alternative should be selected?
A B C
Initial cost $88,400 $107,100 $113,900
Increased revenue $64,600 $52,700 $62,900
Annual O&M expense $25,500 $15,300 $20,400
Salvage value $22,100 $32,300 $37,400
Life 6 6 12
4. Western Silver LLC purchased a silver mine with ore extraction and refinement
equipment valued at $25,000,000 and a salvage value of $5,000,000 at the end
of an 8-year project life. Develop the unit-of-production depreciation schedule
for the equipment.
Year Tons silver

1 5000
2 10,000
3 20,000
4 20,000
5 15,000
6 15,000
7 10,000
8 5000
Chapter 8
Tax Effects on Engineering Investments
Abstract Governments protect their citizens from outside interference, provide for
the general welfare, and provide the parameters (laws and regulations) for everyday
behavior for citizens as the basis of social order. Governments protect their citi-
zens from outside influence by investing in and maintaining standing militaries.
Governments provide for the general welfare by establishing policies promoting
and investing in health, education, commerce, physical, and safety infrastructures.
Governments provide social order by investing in governmental and social insti-
tutions and legal institutions. Governmental investments require money, and that
money is generally raised in the form of taxes and fees. Governmental taxes can be
into four major classes.
• Federal corporate and personal income taxes.

• State corporate and personal income taxes and sales taxes.
• Local property taxes.
• Federal, state, and local use taxes based on the type of use.
This discussion of the effect of taxes on engineering investments will be restricted
to federal and state corporate income taxes. Corporations are taxed at the “entity”
level. The corporation pays taxes on income earned. Partnerships, limited liability
corporations, and proprietors are “flow through” entities. The business pays no taxes.
Proprietors pay personal income taxes on gains or losses from the business. Managing
partners pay personal income taxes on their respective portions of gains or losses
generated from partnership business operations. The Internet portal for United States
IRS tax code is http://www.irs.gov/Businesses/Corporations.
In general,
• Nearly all states and some localities levy taxes on corporate income.
• The rules for determining state taxes vary widely from state to state.
• Many states compute taxable income with reference to federal taxable income,
with specific modifications.
https://doi.org/10.1007/978-3-030-87767-5_8
236 8 Tax Effects on Engineering Investments
• States do not allow a tax deduction for income taxes, whether federal or state.
• Most states deny tax exemption for interest income that is tax exempt at the federal
level.
8.1 Classification of Taxable Income
There are two general types of business expenditures:

• Capital expenses:
– Expenditures for depreciable assets. Generally, assets having a life in exceeding
one year.
– Expenditures for non-depreciable assets. Generally land, as land has no finite
life.
• Operating expenses—materials, labor, overhead, rents, leases, interest, and
equipment having a life of less than one year.
From the income statement, taxable income for business firms is computed as:
Taxable Income = Net revenue

− Operating expenditures (except capital outlays)
− Allocated fixed expenses
− Depreciation and depletion charges
− Allocated general and administrative expenses
− Operating interest expenses.
The federal corporate tax established in IRS Publication 542 Corporations. For
tax years beginning after 2017, corporations, including qualified personal service
corporations, figure their tax by multiplying taxable income by 21% (0.21).
State corporate income tax rates vary by state. Corporate income taxes are levied
in 44 states. Although the other six states advertise no corporate income taxes, they
effectively collect those taxes as commercial activity taxes or gross receipts taxes.
In general,
• Forty-four states levy a corporate income tax. Rates range from 2.5% in North
Carolina to 12% in Iowa.
• Six states—Alaska, Illinois, Iowa, Minnesota, New Jersey, and Pennsylvania—
levy top marginal corporate income tax rates of 9% or higher.
• Ten states (Arizona, Colorado, Florida, Kentucky, Mississippi, Missouri, North
Carolina, North Dakota, South Carolina, and Utah) have top rates at or below 5%.
• Nevada, Ohio, Texas, and Washington impose gross receipts taxes instead of
corporate income taxes.
8.1 Classification of Taxable Income 237
• South Dakota and Wyoming are the only states that do not levy a corporate income
or gross receipts tax. South Dakota generates the bulk of its tax revenue by levying
a general sales tax and select sales excise taxes. Wyoming relies on property tax
collections. Over 60% of these revenues come from minerals production.
Table 8.1 summarizes corporate income taxes by state.
8.2 Economic Analysis Taking Taxes into Account
From Chap. 7 discussion, depreciation must be added back to net income to estimate
the after-tax net cash flow.
Net Cash Flow = [Rn − (On + Mn + Dn + An + In )](1 − T R) + Dn (8.1)
From Chap. 2 discussion, the after-tax net cash flow may be calculated from the
accrual income state as follows.
Net Revenue
Less:
Operating Expenses
Maintenance Expenses
Depreciation
Administrative Expenses
Interest Expenses .
Taxable Income
Less: State Income Tax .
Federal Taxable Income
Less: Federal Income Tax .
Net Income
Net Cash Flow = Net Income + Depreciation
Alternatively, the after-tax net cash flow may be calculated directly from the cash
flow income statement as follows.
Table 8.1 State income tax

State Tax rate Tax brackets Number
rates (tax year 2020)
(%) Low high Brackets
Alabama 6.5 – Flat Rate– 1
Alaska 1.0–9.4 $1–$222 k 10
Arizona 4.9 – Flat Rate– 1
Arkansas 1.0–6.5 $1–$100 k 6
California 8.84 – Flat Rate– 1
Colorado 4.63 – Flat Rate– 1
Connecticut 7.5 – Flat Rate– 1
Delaware 8.7 – Flat Rate– 1
Florida 4.458 – Flat Rate– 1
Georgia 5.75 – Flat Rate– 1
Hawaii 4.4–6.4 $1–$100 k 3
Idaho 6.295 – Flat Rate– 1
Illinois 9.5 – Flat Rate– 1
Indiana 5.5 – Flat Rate– 1
Iowa 6.0–12.0 $1–$250 k 4
Kansas 4.0–7.0 $1–$50 k 2
Kentucky 5.0 – Flat Rate– 1
Louisiana 4.0–8.0 $1–$200 k 5
Maine 3.5–8.93 $1–$3.5 m 4
Maryland 8.25 – Flat Rate– 1
Massachusetts 8.0 – Flat Rate– 1
Michigan 6.0 – Flat Rate– 1
Minnesota 9.8 – Flat Rate– 1
Mississippi 3–5 $1–$10 k 3
Missouri 4.0 – Flat Rate– 1
Montana 6.75 – Flat Rate– 1
Nebraska 5.58–7.81 $1–$100 k 2
Nevada – No corp tax
New Hampshire 7.7 – Flat Rate– 1
New Jersey 6.5–10.5 $1–$1 m 4
New Mexico 4.8–5.9 $1–$500 k 2
New York 6.5 – Flat Rate– 1
North Carolina 6.9 – Flat Rate– 1
North Dakota 1.41–4.31 $1–$50 k 3
Ohio – No corp tax
Oklahoma 6.0 – Flat Rate– 1
(continued)
8.2 Economic Analysis Taking Taxes into Account 239
Table 8.1 (continued)

State Tax rate Tax brackets Number
(%) Low high Brackets
Oregon 6.6–7.6 $1–$1 m 2
Pennsylvania 9.99 – Flat Rate– 1
Rhode island 7.0 – Flat Rate– 1
South Carolina 5.0 – Flat Rate– 1
South Dakota No corp tax
Tenn 6.5 – Flat Rate– 1
Texas – Franchise Tax
Utah 4.95% – Flat Rate– 1
Vermont 6.0–8.5 $1–$25 k 3
Virginia 6.0 – Flat Rate– 1
Washington No corp tax
West Virginia 6.5 – Flat Rate– 1
Wisconsin 7.9 – Flat Rate– 1
Wyoming No corp tax
Washington DC 8.25 – Flat Rate– 1
Net Cash Income

Less:
Cash Operating Expenses
Cash Maintenance Expenses
Cash Administrative Expenses
Cash Interest Expenses .
Cash Taxable Income
Less: State Income Tax .
Cash Federal Taxable Income
Less: Federal Income Tax .
Net Cash Flow Income
Example 8.1
A corporation was formed to produce kitchen utensils. The firm purchased land
for $2,200,000, erected a factory for $9,000,000, and installed equipment for
$6,500,000. The facility began operation in the fourth month of its fiscal year.
For the first year, gross income was $5,400,000 and operating and maintenance
expense were $1,200,000. The firm uses MACRS depreciation and operates in
a state that imposes a flat 5.0% income tax. Estimate the taxable income, state
and federal taxes, after-tax net income, and after-tax cash flow income.
IRS 946 Table B-2 does not specify kitchen utensils equipment. So, the firm
must use Asset Class 39.0 7-year “other” property for equipment depreciation.
Equipment—GDS 7-year property: 1st Yr Depr = $6,500,000 × 0.1429 =
$928,850.
Building 1st Yr Depr = $9,000,000 × 0.01819 = $163,710.
Total 1st yr MACRS depreciation = $928,850 + $163,710 = $1,092,560.
Gross Income $5,400,000

Less:
Expenses ($1,200,000)
Depreciation ($1,092,560)
Taxable Income $3,107,440
State Tax @ 5.0% ($ 155,372)
Federal Taxes @ 21% ($ 619,934)
Earnings After Taxes $2,332,134
Add back depreciation +$1,092,560
After-tax Cash Flow Income $3,424,694
8.2.1 Combined Federal and State Income Taxes
As discussed in Chap. 2, organizations pay state taxes on taxable income, subtract

state taxes to arrive at federal taxable income, and pay taxes on federal taxable
income. This yields a combined tax rate of,
Combined Tax Rate = TR S + TR F (1 − TR S ) (8.2)
where TRS = state income tax rate and TRF = federal income tax rate. For Example
8.1, the combined tax rate is
Combined tax rate = 0.05 + 0.21(1− 0.05) = 0.2495
Checking, total taxes paid and earnings after tax for Example 8.1 are
Combined taxes paid = Taxable income × Combined tax rate

= $3, 107, 440 × 0.2495 = $775, 306
Earnings After Tax = $3, 107, 440 − $775, 305 = $2, 332, 135
8.2 Economic Analysis Taking Taxes into Account 241
Example 8.2
A firm is considering the acquisition of manufacturing equipment which costs
$150,000. The equipment has a useful life of 5 years. It is estimated that the
firm will realize a gross income of $120,000 per year from the new equipment
with operating expenses of $80,000 per year. The firm will use straight-line
depreciation for the equipment. At the end of its 5-year life, the equipment
will have a salvage value of $45,000. The firm has combined corporate income
taxes of 26%. Estimate the after-tax rate of return.
Time 0 1 2 3 4 5
Revenue $120,000 $120,000 $120,000 $120,000 $120,000
Expenses (−$150,000) (−$80,000) (−$80,000) (−$80,000) (−$80,000) (−$80,000)
Depr (−$21,000) (−$21,000) (−$21,000) (−$21,000) (−$21,000)
Salvage $45,000
Taxable $19,000 $19,000 $19,000 $19,000 $64,000
Inc
Tax @ (−$4,940) (−$4,940) (−$4,940) (−$4,940) (−$16,640)
26%
Net $14,060 $14,060 $14,060 $14,060 $47,360
income
Cash (−$150,000) $35,060 $35,060 $35,060 $35,060 $68,360
flow
Try i = 10%:

$0 = −$150, 000 + $35, 060 (P/A, 10%, 5) + $33, 300 (P/F, 10%, 5)

$0 = −$150, 000 + $35, 060 (3.791) + $33, 300 (0.6209)
$0 = $3, 588.43
Try i = 12%:

$0 = −$150, 000 + $35, 060 (P/A, 12%, 5) + $33, 300 (P/F, 12%, 5)

$0 = −$150, 000 + $35, 060 (3.605) + $33, 300 (0.5674)

$0 = −$4, 714.28
Linear interpolation: IRR = 10%

+ (12% − 10%) $0 − $3588.43 / −$4714.28 − $3588.43
= 10.86%.
8.3 Capital Gains and Losses for Non-depreciated Assets
When a non-depreciated capital asset is sold or exchanged, its change in value during
ownership must be recognized. If the market value selling price is greater than
the original cost basis, a capital gain must be recognized in the year of disposal.
Conversely, if the market value selling price is less than the original cost basis, a
capital loss must be recognized in the year of disposal and may be carried back to
offset prior taxes paid or forward to offset future taxes owed.
Tax treatment of corporate capital gains and losses

Corporation
Capital gain Taxed as ordinary income
Capital loss Deduct capital losses only to extent of capital gains. Excess losses in current year
can be carried back 2 years to offset prior taxes paid and, if not completely
absorbed, is then carried forward for up to 20 years to offset future taxes owed
8.4 After-Tax Cash Flows with Spreadsheets
In practice, after-tax analysis of engineering operations and projects requires spread-

sheets. Realistic cash flow analyzes with required multiple data input through
interlinking spreadsheets with summary annual cash flow and economic crite-
rion. Example 8.3 presents a more realistic analysis of an actual project summary
spreadsheet.
Example 8.3
A medium-size manufacturing business is installing a computer network to
automate data collection. In the past, data collection was by manual records,
and the firm’s industrial engineer estimates that it costs the business $32,000
per year in lost productivity for manual recording and entering the data into
spreadsheets. It is estimated that the computer network will have a 5-year
technological life with a salvage value of $20,000 at the end of year 5 at which
time it will be upgraded. Estimate the after-tax rate of return.
8.4 After-Tax Cash Flows with Spreadsheets 243
IRS Publication 946, Table B-1 lists computers as asset class 00.12 with a
GDS 5-year property life. By the MACRS half-year convention, take only ½
of the final year of ownership’s allowable depreciation amount.
D(5) = $120, 000 × 0.1152 × 0.5 = $6912− cell E17
Depreciation recapture is estimated as,

Recapture = $20, 000 − $120, 000 − $106, 176 = $6176
Include depreciation recapture in the year 5 taxable income

Taxable Income = $32, 000 + −$6912 + $6176 = $31, 264
After-tax cash flow in year 1,
CF(1) = $32, 000 − $1920 = $30, 080
or
CF(1) = After − tax Income + Depreciation

CF(1) = $6, 080 + $24, 000 = $30, 080
After-tax cash flow in year 5,
CF(5) = $32, 000 + $20, 000 − $7504 = $44, 496
As shown in the spreadsheet cell K19, the internal rate of return is 11.24%.
8.5 Summary
Governmental taxes can be into four major classes.

• Federal corporate and personal income taxes.
• State corporate and personal income taxes and sales taxes.
• Local property taxes.
• Federal, state, and local use taxes based on the type of use.
Taxable income for business firms is computed as:
Taxable Income = Net revenue

− Operating expenditures (except capital outlays)
− Allocated fixed expenses
− Depreciation and depletion charges
− Allocated general and administrative expenses
− Operating interest expenses.
Economic analysis taking taxes into account:
Net Cash Flow = [Rn − (On + Mn + Dn + In )] (1− TR) + Dn
Net Revenue
Less: Op Expenses, Depreciation, Admin Expenses, Interest
Taxable Income
Less: State Tax
Less: Federal Taxes
Net Income
Net Cash Flow = Net Income + Depreciation
Alternatively,
8.5 Summary 245
Net Cash Income

Less: Cash Op Expenses, Admin Expenses, Interest
Cash Taxable Income
Less: State Tax
Less: Federal Taxes
Net Cash Flow Income
Combined federal and state income taxes,
Combined tax rate = Sr + Fr (1 − Sr)
8.6 Key Terms
After-tax cash flow

Capital expense
Capital gain or loss
Combined tax rate
Depreciated asset
Federal tax rate
Non-depreciated asset
Operating expense
State tax rate
Taxable income.
Problems
1. A corporation operates in a state that imposes 9.6% corporate income tax. This
fiscal year the corporation had taxable income of $725,000. What is the state
income tax and federal income tax the corporation must pay? What is the total
taxes paid? What is the corporation’s after-tax net income (EAT)?
2. A fabricated metal products manufacturer is purchasing special tools for a new
contract. The tools will cost $110,000 and have a market value of $7000 at
the end of the 6-year contract. The tools will be depreciated under MACRS.
The corporation’s combined tax rate is 27.0%. The before-tax cash flows are as
follows.
Year Before-tax
cash flow
1 $33,000
2 $33,000
3 $37,500
4 $44,000
5 $15,000
6 $11,000
What is the manufacturer’s rate of return on this contract?
3. New Wave Drones, Inc., is building a new manufacturing facility on land it

already owns for production of its new artificially intelligent drone model.
The building will cost $4,125,000, and the manufacturing equipment will cost
$2,325,000 with installation cost of $202,500. Operating expenses are expected
to be $1,500,000 the first year and maintenance expenses are expected to be
$450,000 the first year. Both are expected to increase at 6% per year. New
Wave Drones depreciates with manufacturing equipment using MACRS and is
in a state with a 5% corporate income tax rate. The new manufacturing facility
is scheduled to open for production in the third month of this fiscal year and
product the new AI drone through the end of the fifth fiscal year at which time
the facility will be converted to production of the second-generation AI drone.
The market value of the building is expected to increase at the 2.5% inflation
rate, and the equipment market value is estimated at $230,250 at the end of year
five. The new AI drone is expected to have a 5-year useful life with net sales as
follows.
Year Net sales

1 $3,150,000
2 $4,800,000
3 $5,700,000
4 $6,750,000
5 $5,550,000
For this investment, New Wave Drones requires MARR = 15.0%. What is the
annual net income and cash flow for this investment? By the NPW criterion, is the
new AI drone economically viable?

machine to improve control of shrinkage of molded parts. The improvement
in shrinkage control will reduce losses by $95,000 per year. The injection
molding machine can be purchased and installed for $340,000 today. It will
have a useful life of 7 years and will have a salvage value of $17,000. The new
8.6 Key Terms 247
injection molding machine will not increase operating expenses but will require
an additional maintenance expenses of $15,300 per year. Specialty Plastics uses
MARCS depreciation and operates in a state with a 9.0% corporate income tax
rate. Estimate the annual after-tax net income and after-tax cash flow for this
machine. At the required MARR = 12.0%, should Specialty Plastics invest in
the new injection molding machine?
Chapter 9
Inflation Effects on Engineering
Investments
Abstract Historically, the economies of all countries exhibit year-to-year price

inflation. As USA examples, in 1970 the cost of:
• A gallon of gasoline was $0.36. In mid-2020, the same gallon of gasoline costs
$2.52. Note, in mid-2015, a gallon of gasoline cost about $3.50, but the inflation-
adjusted cost was $2.27. The difference was due to an international shortage
causing demand to exceed supply. By mid-2016, the price had dropped to $2.14
per gallon with an inflation-adjusted price of $2.29. The collapse in gasoline price
was a part of the collapse in worldwide petroleum prices due to (1) an increase in
shale oil production in the USA between 2014 and 2016, (2) a growing global crude
petroleum supply that was greater than that demanded by global economic growth
resulting in a supply glut, and (3) OPEC nations unable to prop up petroleum prices
with production cuts.
• A cup of coffee was $0.25. In mid-2020, the same cup of coffee cost about $2.62
with an inflation-adjusted price of $1.70. The average higher actual cost is due to
the increased demand for specialty coffees.
• A gallon of milk was $1.15. In mid-2020, the same gallon of milk cost $3.45
with an inflation-adjusted price of $7.88. The price difference is due to the USDA
subsidy purchases of dairy product through food purchase programs. Under the
current The Dairy Margin Coverage program (DMC) of 2018, USDA purchases
cover the price difference between the price farmers can get for a gallon of milk
based on demand and the price they would have to charge to cover their cost of
dairy feed.
• A dozen eggs was $0.62. In mid-2020, the same dozen eggs costs $1.54 with an
inflation-adjusted price of $4.25. The price difference is due to USDA subsidies
https://doi.org/10.1007/978-3-030-87767-5_9
250 9 Inflation Effects on Engineering Investments
for other farm products. Removing USDA subsidies would lead to price increases
in food from 1 to 67%.
• An automobile was $3,542. In mid-2020, the cost of an average mid-size family
automobile is $36,718 with an inflation-adjusted price of $24,279. The most
important factors that have influenced automobile prices have been environ-
mental standards, global market conditions, tax levels for public and private users,
consumers’ purchasing power, and within industry competition.
9.1 The Meaning and Effect of Inflation on Investment

Worth
As can be observed in the above examples, inflation is a significant component

of price increase with other factors moderating the actual price from the inflation-
adjusted price. Since all engineering managerial economic decisions involve future
cash flows, it is important that the effects of inflation on future asset prices, revenues,
and expenses be incorporated into economic analyses.
• Inflation causes a loss in purchasing power over time for a fixed amount of money.
• Inflation tends to cause goods and services to cost more over time in terms of the
same fixed amount of money.
• Because of inflation, a fixed amount of money in a given period will not have
equivalent purchasing power in prior or later periods.
• Inflation is pervasive. Many industrialized countries like to see inflation main-
tained at about 3% per year to match expected economic growth.
• All engineering managerial economic analyses need to include inflation effects.
Economists generally recognize four causal sources of inflation.
• Money supply increases: money available to consumers in the general economy
increases faster than the value of the goods available.
• Exchange rates: prices differentials reflect the comparative value of currencies
in different countries.
• Cost-push inflation: producers raise prices to cover costs.
• Demand-pull inflation: consumers bid up prices by attempting to buy more than
is available.
Any or all these causal sources may drive inflation in any given period.
9.2 Incorporating Inflation in Engineering Managerial

Economic Estimates
To incorporate inflation into annual cash flows, we apply the following definitions.
9.2 Incorporating Inflation in Engineering Managerial Economic Estimates 251
Inflation rate (f ): The proportion year-over-year annual increase in the monetary

units (number of dollars) needed to purchase the same unit of goods or services.
Real interest rate (iR ): The “real” interest rate earned on paid on a unit of money
excluding inflation. The real interest rate is also referred to as the inflation-free
interest rate.
Market interest rate (iM ): The interest rate earned or paid on a unit of money on
open market including the effect of year-over-year inflation.
Using these definitions, we can estimate the future amount of $1.00 one year from
now as.
F = $1(1 + i R ) (1 + f )
F / $1 = 1 + f + i R + (i R )( f )

F / $1 −1 = i R + f + (i R )( f )
i m = i R + f + (i R )( f ) (9.1)
Example 9.1
Given the real interest rate and inflation rate, estimate the market interest rate.
i R = 0.030 f = 2.4%i M =?
i M = i R + f + (i R )( f )
i M = 0.030 + 0.024 + (0.030 )(0.024)
i M = 0.0547 or 5.47%.
Corresponding to the real interest rate and the market interest rate, we need to
define their dollar counterparts.
• Actual dollars (A$): cash money—the kind you carry in your pocket. Sometimes
called inflated dollars (currency) because its purchasing power includes inflation
effects. Use the market interest rate (iM ) to estimate future actual dollars on an
investment.
• Real dollars (R$): constant purchasing power dollars (currency) expressed as a
base year. (e.g., 1984 CPI or 1992 PPI-based dollars or a project’s year 0 dollars).
These are inflation-free dollars. Use the real interest rate (iR ) to estimate future
real dollars on an investment.
Given these definitions, the following relationships exist among iR , R$, f , iM , and
A$.
• When using actual dollars (A$), use the market interest rate (iM ).
• When using real dollars (R$), use the real interest rate (iR ).
At any point in time t ≤ n, the inflation rate f can be substituted for iM or iR as
R$ = (1 + f )−n A$ = (P/F, f, t)A (9.2)
A$ = (1 + f )n R$ = (F/P, f, t)R (9.3)
Figure 9.1 provides a roadmap for converting among actual dollars A$ and real
dollars R$ at any point in a project’s life.
• At base year time 0, P(A$) = P(R$).
• Starting at t = n with F(A$), computing P(R$) can be accomplished in one of two
ways.
– The first approach uses F(A$) and converts it to its equivalence at t = 0.

P A$ = F A$ (1 + i M )−n
Fig. 9.1 Relationships among f , iR , R$, iA , and A$

9.2 Incorporating Inflation in Engineering Managerial Economic Estimates 253
– The second approach converts F(A$) to F(R$) and then finds the constant
dollar amount at t = 0.

F R$ = F A$ (1 + f )−n

P R$ = F R$ (1 + i R )−n
Since P(A$) = P(R$), equating the results of the two approaches gives,

F A$ (1 + i M )−n = F A$ (1 + f )−n (1 + i R )−n
i M = (1 + f )(1 + i R ) − 1 (9.4)
Solving for iR yields,
i R = [(1 + i m )/(1 + f )] − 1 (9.5)
Cross-multiplying and simplifying (9.4) yield Eq. (9.1).
i M = 1 + i R + f + ( f )(i R ) − 1
i M = i R + f + ( f )(i R )
Example 9.2
A small private university’s art center was completed 50 years ago at a total
cost of $20.5 million. At that time, a wealthy alumnus donated $20 million
to be used for future replacement. The university invested the $20 million in
bonds that pay iM = 6.0% annually, and the mean inflation has been 3.5% per
year. Administration is now considering building a new replacement art center.
a. Given iM = 6.0%, what are the bonds worth today in actual dollars.
b. What are the bonds worth today in the real dollars at the time of the
donation?
c. What is the replacement cost of a new art center?

a. F A$ = $20, 000, 000 (1 + 0.06)50
= $20, 000, 000(F/P, 6.0%, 50) = $368, 403, 086

b. R$ = F A$ (1 + 0.035)−50 = A$(P/F, 3.5%, 50)
= $368, 403, 086(1 + 0.035)−50 = $65, 963, 816

c. F A$ = $20, 000, 000 (1 + 0.035)50
= $20, 000, 000(F/P, 3.5%, 50) = $111, 689537
We can check the R$ estimate by calculating the real interest rate and using
it to estimate the future value of the $20 million donation.
i R = [(1 + i m )/(1 + f )] − 1
i R = [(1 + 0.06)/(1 + 0.035)} −1 = 0.0241546 or 2.41546%

F R$ = $20, 000, 000 (1 + 0.0241546)50 = $65, 953, 816.
9.3 Investment Analysis in Real Dollars Versus Actual

Dollars
As shown in Fig. 9.1, estimates of net present worth, equivalent uniform annual
worth, future worth, and rate of return will yield consistent investment decision if
cash flows are in either real or actual dollars. Analysis can be conducted in either
real or actual dollars and the criterion converted to the other cash flow equivalent.
The analyst just needs to distinguish cash flows as being either:
• Real dollars (currency) expressed in terms of the purchasing power of base year
dollars and discounted by the real interest rate.
• Actual dollars (currency) discounted by a market interest rate (real interest rate
combined with the inflation rate).
Cash Flow Domain Applicable Interest Rate

Real dollars R$ Real (inflation-free) rate iR
Convert between domains with inflation rate f
Actual dollars A$ Market rete iM
(includes inflation f )
9.3 Investment Analysis in Real Dollars Versus Actual Dollars 255
Example 9.3
The Surface Computer Corporation is evaluating two new proposed CPU tech-
nologies proposed by two competing chip manufacturers. Both companies
propose to deliver equivalent product performance at the end of a 4-year devel-
opment period. From the proposed chip development costs in the following
table, which company should surface choose if its market MARR = 20% and
inflation is expected to be 4.5% mean rate over the development period?
MAD Chips. Development cost will be $15,750,000 first year increasing at
7.0% per year.
Itel Inc. development cost will be $17,000,000 per year in today’s real
dollars.
i R = [(1 + i m )/(1 + f )] − 1
i R = [(1 + 0.20)/(1 + 0.045)] − 1 = 0.1483 or 14.83%
Estimate MAD Chips yearly geometric cost increase. Then convert these
yearly costs to Real$.
Year MAD Chips A$ Actual$ (P/F, 4.5%, n) Real$

1 $15.750(1.07)0 = $15.750 (1.045)-1 $15.072
2 $15.750(1.07)0 = $16.853 (1.045)-2 $15.432
3 $15.750(1.07)0 = $18.032 (1.045)-3 $15.802
4 $15.750(1.07)0 = $19.294 (1.045)-4 $16.180
Covert Itel Inc.’s Real$ into Actual$.
Year Itel Inc R$ (F/P, 4.5%, n) Real$

1 $17.000 (1.045)1 $17.765
2 $17.000 (1.045)2 $18.564
3 $17.000 (1.045)3 $19.400
4 $17.000 (1.045)4 $20.273
Finally, estimate the present worth of the Real$ cash flows at iR and the
Actual$ cash flows at iM .
The same decision is made for either Real$ or Actual$ cash flows. Select
MAD Chips to minimize the present worth of development cost.
Example 9.4
A firm is considering the acquisition of manufacturing equipment which costs
$15,000. The equipment has a useful life of 5 years. It is estimated that the firm
will realize a gross income of $12,000 R$ per year from the new equipment
with operating expenses of $8,000 R$ per year. The firm will use straight-line
depreciation for the equipment. At the end of its 5-year life, the equipment
will have a salvage value of $4500 R$. The firm operates in a state with no
corporate income taxes and is in the 21% federal tax bracket. The firm uses
MARR = 11.0% market rate including expected inflation f = 3.0% over the
5-year analysis period. Using NPW, should the firm invest in the equipment?
First convert annual R$ revenues and expenses and the year 5 salvage value
to A$.
Year Revenue A$ Expenses A$

1 $12,000(1.03)1 = $12,360 $8,000(1.03)1 = $8,240
2 $12,000(1.03)2 = $12,731 $8,000(1.03)2 = $8,487
3 $12,000(1.03)3 = $13,113 $8,000(1.03)3 = $8,742
4 $12,000(1.03)4 = $13,506 $8,000(1.03)4 = $9,004
5 $12,000(1.03)5 = $13,911 $8,000(1.03)5 = $9,274
Salvage Value(5) = $4500 (1.03)5 = $5217

9.3 Investment Analysis in Real Dollars Versus Actual Dollars 257
Given a positive NPW, the firm should invest in the equipment.
i R = [(1 + i m )/(1 + f )] − 1
i R = {(1 + 0.11) / (1 + 0.03)} −1 = 0.0777 or 7.77%
Given that IRR R$ = 11.69% > 7.77% = iR , the firm should invest in the
equipment.
9.4 Cash Flows That Inflate at Different Rates
In managing engineering organizations and projects, engineering managers often

encounter commodities or utilities that inflate at different rates. For cash flows that
inflate at different rates,
1. Use the respective individual inflation rates.
2. State the annual cash flows in actual dollars, and use the market interest rate to
estimate NPW, EUAW, or IRR.
Example 9.5
An engineering manager is preparing her 5-year operating budget. Find the
NPW estimate of the utilities for her manufacturing facility given the following
data. Market rate MARR = 15.0%.
Last year’s utility costs 5-year predicted average inflation rates

Electricity $185,000 Electricity costs increase at 2.5% per year
Water $8,000 Water costs increase at 4.3% per year
Natural gas $83,000 Natural gas costs increase at 2.8% per year
Since the engineering manager is using last year’s utilities costs, those are
considered as the base year 0 for restating them to future Actual$ in the spread-
sheet below. The annual Actual$ for utilities are summed, and the NPV() func-
tion is used to estimate the present worth of the utilities summed Actual$ cash
flows at the MARR = 15.0%. For each utility, the annual cost estimate is,
Actual$ = (Cost Year0 )(1 + f )t
9.5 Different Inflation Rates Per Period
The typical case is that general inflation changes from year to year. Figure 9.2 shows
that the US CPI inflation rate has varied from a low of −0.36% in 2009 to a high
of 13.5% in 1980 with a geometric mean of 3.91%. Likewise, inflation rates for
commodities and utilities vary from year to year. Figure 9.3 shows that the US PPI
inflation rate varied from a low of −8.8% in 2009 to a high of 9.8% in 2008 with
a geometric mean of 2.0%. For the period 1990 to 2019, there was only moderate
correlation of 0.68 between the CPI and PPI inflation rates. For cash flows that inflate
at different rates,
• Apply the inflation rates in the years in which they are expected to occur.
• State the annual cash flows in actual dollars, and use the market interest rate to
9.5 Different Inflation Rates Per Period 259
Fig. 9.2 US CPI Inflation Rate 1970 to 2020
Fig. 9.3 US PPI Inflation Rate 1990 to 2019
Example 9.6
The engineering manager in Example 9.5 has found that the utilities inflation
predictions are not constant over the 5-year budget period. New utilities infla-
tion rates are reported in the following table. Re-estimate the NPW of utilities
expenses over the 5-year budget period. Market rate MARR = 15.0%.
Now, the annual utility cost estimate is,
Actual$ = (Cost Yeart −1 )(1 + f t )t
Last year’s utility costs 5-year predicted inflation rate per year
Electricity $185,000 Electricity costs increase: 2.5, 2.4, 2.0, 1.7,
Water $8000 1.4%
Water costs increase: 5.4, 3.7, 4.7, 2.8, 4.0%
Natural gas $83,000 Natural gas costs increase: 2.8, 3.6, 5.7, 6.212.1%
9.6 Geometric Mean Inflation Rate
For inflation rates that vary per period as in Example 9.5, the geometric mean inflation
rate over the entire planning period is estimated as
n 1/n

fG = (1 + f t ) −1 (9.6)
t=1
The same formula can be applied to any sequence of rate increase or decrease to
estimate the mean rate of change. For differing interest rates per period for a sequence
of periods, the geometric mean interest rate of change is
n 1/n

iG = (1 + i t ) −1 (9.7)
t=1
9.6 Geometric Mean Inflation Rate 261
Example 9.7
Estimate the geometric mean inflation rates for the utilities of Example 9.5.
5-year predicted inflation rate per year:
Electricity costs increase: 2.5, 2.4, 2.0, 1.7, 1.4%
f G = [(1 + 0.025) (1 + 0.024) (1 + 0.020) (1 + 0.017) (1 + 0.014)]1/5 −1

= 0.01999 or 2.0%
Water costs increase: 5.4, 3.7, 4.7, 2.8, 4.0%
f G = [(1 + 0.054) (1 + 0.037) (1 + 0.047) (1 + 0.028) (1 + 0.040)]1/5 −1

= 0.0412 or 4.12%
Natural gas costs increase: 2.8, 3.6, 5.7, 6.2, 12.1%
f G = [(1 + 0.028) (1 + 0.036) (1 + 0.057) (1 + 0.062) (1 + 0.121)]1/5 −1

= 0.0603 or 6.03%
9.7 Price and Cost Change with Indexes
Price indexes are another way of measuring the relative price changes of goods and
services over a period. In the USA (as in many countries), price indexes record the
relative price changes of goods and services in the national economy.
• Indexes can be for a specific commodity or utility or a composite for a bundle of
commodities or utilities.
• Indexes can be used to measure price changes for individual items like labor and
materials of the producer price index (PPI) or general costs like consumer products
of the consumer price index (CPI).
The term “relative price change” means that price changes are relative to a selected
base year for which the price is set equal to 100. The formula for estimating a price
index is

I = ((price(n) − price(base))/price(base)) × 100 + 100 (9.8)
Simplifying,
PI = [((price(n) / price(base)) − (price(base)/ price(base))) × 100] + 100

PI = [((price(n) / price(base)) −1) × 100] + 100
PI = (price(n) / price(base)) × 100−100 + 100
PI = (price(n)/price(base)) × 100 (9.9)
where price(n) = unit price in year n and price(base) = unit price in the selected
base year. To estimate year-to-year percentage price changes,
API(n) = ((Index(n) − Index(n − t))/Index(n − t)) × 100 (9.10)
where Index(n) = Index in year n and Index(n – t) = Index in the year of interest.
Estimate the average rate of price increase as the geometric mean,
PI(avg) = (Index(n)/Index(base))1/n − 1 (9.11)
where Index(n) = Index in year n and Index(base) = Index in the base year.
Composite cost indexes measure the historical prices of groups or bundles of
assets or commodities. The US Bureau of Labor Statistics tracks the consumer price
index (CPI) and the producer price index (PPI). The CPI is a measure of the average
change over time in the prices paid by urban consumers for a market basket of
consumer goods and services. Currently, the reference base for most CPI indexes is
1982–1984 = 100. Additionally, expenditure weights are updated every two years
to keep the CPI current with changing consumer preferences. Table 9.1 presents the
CCI for 1980 to 2019.
The producer price index (PPI) program measures the average change over time
in the selling prices received by domestic producers for their output. Some sectors
Table 9.1 CPI 1980 to 2019

Year CPI Year CPI Year CPI Year CPI
1980 82.4 1990 130.7 2000 172.2 2010 218.1
1981 90.9 1991 136.2 2001 177.1 2011 224.9
1982 96.5 1992 140.3 2002 179.9 2012 229.6
1983 99.6 1993 144.5 2003 184.0 2013 233.0
1984 103.9 1994 148.2 2004 188.9 2014 236.7
1985 107.6 1995 152.4 2005 195.3 2015 237.0
1986 109.6 1996 156.9 2006 201.6 2016 240.0
1987 113.6 1997 160.5 2007 207.3 2017 245.1
1988 118.3 1998 163.0 2008 215.3 2018 251.1
1989 124.0 1999 166.6 2009 214.5 2019 255.7
9.7 Price and Cost Change with Indexes 263
covered include agriculture, construction, manufacturing, and mining. The prices

included in the PPI are from the first commercial transaction for many products and
some services. Currently, the reference base for the PPI index is 1982 = 100. The
Bureau of Labor Statistics publishes thousands of product price indexes broken into
three large categories.
• Industry Level—The industry-based classification measures the cost of production
at the industry level. It tracks the changes in prices received for an industry’s
output outside the sector itself by calculating industry net output. BLS product
price index includes over 535 industry-specific listings.
• Commodity—This classification ignores the industry of production and combines
goods and services by similarity and product make-up. More than 3.700 indexes
cover products and about 800 cover services. The indices are arranged by end-use,
product, and service.
• Commodity-Based Final Demand-Intermediate Demand (FD-ID)—The FD-ID
system groups commodity indexes for goods, services, and construction into
subproduct classes, which account for the specific buyer of the products. The
end-user or buyer is termed as either the final demand (FD) or the interme-
diate demand (ID) user. This classification considers the physical assembly and
processing required for these goods. The Bureau of Labor Statistics publishes
over 600 FD-ID targeted indexes. Some indices are adjusted for seasonality.
Example 9.8
Using the CPI indexes in Table 9.1, estimate the cost of a product in 2019 that
cost $1,000 in 2009.
CPI(2009) = 214.5 CPI(2019) = 255.7
Applying Formula (9.10),
API(n) = ((Index(n) − Index(n − t))/ Index(n − t)) × 100

API(2019) = ((255.7−214.5) /214.5) × 100 = 19.21%
Price(2019) = Price(2009) (1 + API)

Price(2019) = $1000 (1 + 0.1921) = $1192.
9.8 Inflation Effect on After-Tax Calculations
In practice, managerial engineering economic analyses require cash flows over

multiple budget periods from multiple inputs that may inflate (or deflate) at different
rates. To produce accurate cash flow and economic criterion estimates, economic
analyses must account for inflation (or deflation). In general, the tax effects of infla-
tion will reduce the rate of return on an investment or the cost of interest on a
purchase.
• Depreciation is taken in year 0 (asset’s purchase year) constant dollars (currency).
• Thus, inflation results in increased taxable income and lower after-tax rate of
return.
As an example of the lower after-tax rate of return, consider the inflation-adjusted
after-tax Actual$ rate of return versus the Real$ rate of return of Example 9.4. Using
the definition of internal rate of return, the inflation-adjusted Actual$ after-tax rate
of return was,
After-Tax IRR:
$0 = −$15, 000 + $3696(P/F, i, 1) + $3793(P/F, i, 2)

+ $3894(P/F, i, 3) + $3998(P/F, i, 4) + $8226(P/F, i, 5)
Actual$ IRR = 15.04%
The Real$ after-tax rate of return was,

After-Tax IRR:
$0 = −$15, 000 + $3696(1.03) − 1(P/F, i, 1) + $3793(1.03) − 2(P/F, i, 2)

+ $3894(1.03) − 3(P/F, i, 3) + $3998(1.03) − 4(P/F, i, 4)
+ $8226(1.03) − 5(P/F, i, 5)
Real$ IRR = 11.69%
Example 9.9 directly illustrates the effects of inflation on after-tax rate of return.
Example 9.9
A $21,000,000 investment in an automatic inventory system with no salvage
value is expected to save $5,250,000 real dollars per year in labor and fixed
costs for 6 years. The automated inventory system is MACRS asset class 00.12
information systems with depreciation GDS 5-year property life. The company
9.8 Inflation Effect on After-Tax Calculations 265
operates in a state that yields a 30% combined income tax rate. Estimate the
rate of return for (1) no inflation and (2) inflation at 7.0% per year.
Inputs
Initial investment $21,000 x 1,000

Annual benefit $5,250 x 1,000
Salvage value $0
Life (years) 6
Tax rate 30%
Inflation 7%
No Inflation
Before-tax
MACRS Taxable After-tax
Cash Flow
Year Rate Depr. Income Taxes Cash Flow
0 ($21,000) ($21,000)
1 $5,250 20.00% $4,200 $1,050 ($315) $4,935
2 $5,250 32.00% $6,720 ($1,470) $441 $5,691
3 $5,250 19.20% $4,032 $1,218 ($365) $4,885
4 $5,250 11.52% $2,419 $2,831 ($849) $4,401
5 $5,250 11.52% $2,419 $2,831 ($849) $4,401
6 $5,250 5.76% $1,210 $4,040 ($1,212) $4,038
IRR 13.0% 9.79%
Inflation at 7%
After-tax
After-tax Real$
Before-tax MACRS Taxable Actual$ Cash
Year Cash Flow Rate Depr. Income Taxes Cash Flow Flow
0 ($21,000) ($21,000) ($21,000)
1 $5,618 20.00% $4,200 $1,418 ($425) $5,192 $4,853
2 $6,011 32.00% $6,720 ($709) $213 $6,224 $5,436
3 $6,431 19.20% $4,032 $2,399 ($720) $5,712 $4,662
4 $6,882 11.52% $2,419 $4,462 ($1,339) $5,543 $4,229
5 $7,363 11.52% $2,419 $4,944 ($1,483) $5,880 $4,192
6 $7,879 5.76% $1,210 $6,669 ($2,001) $5,878 $3,917
IRR 20.9% 16.1% 8.47%
With 7% inflation, the after-tax return on investment is reduced to 8.47%

from 9.79% with real dollar analysis under no inflation.
9.9 Summary
Inflation causes a loss in purchasing power over time for a fixed amount of money.
Inflation tends to cause goods and services to cost more over time in terms of the
same fixed amount of money.
Defining f = inflation rate, iR = real interest rate, and iM = market inflation rate,
we can estimate iM as
i m = i R + f + (i R )( f )
Actual dollars (A$): cash money also called inflated dollars (currency).
Real dollars (R$): constant purchasing power dollars (currency) expressed as a
base year.
Estimate the real interest rate iR from the market rate iM using the formula,
i R = [(1 + i m )/(1 + f )] − 1
Cash flow domain Applicable interest rate

Real dollars R$ Real (inflation-free) rate iR
Convert between domains with inflation rate f
Actual dollars A$ Market rate iM
(includes inflation f)
Cash Flows that Inflate at Different Rates:

• Use the respective individual inflation rates.
Different Inflation Rates per Period:
• Apply the inflation rates in the years in which they are expected to occur.
estimate NPW, EUAW, or IRR
Geometric Mean Inflation Rate
n 1/n

fG = (1 + f t ) −1
t=1
Geometric Mean Interest Rate:

n 1/n

iG = (1 + i t ) −1
t=1
9.9 Summary 267
Price Indices

PI = ((price(n) − price(base))/price(base)) × 100 + 100
PI = (price(n)/price(base)) × 100
API(n) = ((Index(n) − Index(n − t))/Index(n − t)) × 100
PI(avg) = (Index(n)/Index(base))1/n − 1
9.10 Key Terms
Actual dollars
Base year
Composite cost index
Cost-push inflation
Deflation
Demand-pull inflation
Exchange rate
Inflation rate
Market interest rate
Money supply
Price index
Purchasing power
Real dollars
Real interest rate.
Problems
1. Inflation is expected to remain relatively constant at about 3.5% per year for the
next ten years. How much money will be required in 10 years to purchase will
an item that costs $100 today?
2. If inflation is 2.5% per year and a bank is loaning money at 6.0% annually, what
is the real interest the bank earns on it loans.
3. An investor purchased a 6% tax-free municipal bond at a face value of $1000.
The bond pays $60 per year for 10 years. At maturity, the bond returns the
original $1000. (a) What is the real rate of return on the bond? (2) If inflation
is 2.0% annually, what is the market rate of return on the bond? (c) At the real
rate of return, what is the present value of the bond? (d) At the market rate of
return, what is the present value of the bond?
4. An economist predicts that prices will increase a total of 55% by the end of next
8 years. Further, she predicts that prices will increase a total of 25% over the
subsequent 12 years. What is the annual inflation rate for the 20-year period?
5. An engineering manager examines the records for the average price of an elec-
tronic component over the last five years. Calculate the year-to-year basis of
price increase. What is the manager’s estimate of the component’s inflation rate
for next year?
Year Price Annual f

5 years ago $170.00
4 years ago $171.70
3 years ago $174.90
2 years ago $180.00
1 year ago $182.00
Last year $185.20
6. If $30,000 is deposited in a 6% savings account and inflation is 3%, what is

the actual and real dollar value of the account at the end of 20 years? If the
time value of money is 4%, what is the present worth of the account at the start
of investing?
7. Radiation monitoring equipment must be purchased to monitor low-level X-
ray leakage. Two alternative units are available that can fulfill the requirements.
The X-Detect unit costs $12,600 and has a 4-year useful life. The Monitor-X
unit costs $18,000 and has an 8-year useful life. Equipment costs are inflating
at 9% annually. Based on an 8-year project period and MARR = 15%, which
monitoring equipment should be purchased?
8. An engineering manager is evaluating the options to overhaul a piece of equip-
ment. The machine will be needed for the next 10 years. MARR = 8% for this
type of investment. A contractor has suggested three alternatives.
(1) Compete overhaul for $9600 that will yield 10 years of operation.
(2) Major overhaul for $7200 that will provide 6 years of service and a minor
overhaul for $4000 in year 6 to extend the equipment life 4 more years.
(3) A minor overhaul now, in year 4, and in year 8. Each minor overhaul
will cost $4000.
Inflation is 4% annually. Which alternative should the engineering manager
select?
9. Texas Chemicals is considering a construction project to expand its MTBE
production over the next 3 years. Current construction costs and inflation rates
are given in the following table. Texas Chemicals requires MARR = 20% for
this type of project. General price inflation is expected to be steady at 4.0%
annually for the 3-year construction project. What is the present worth of the
3-year construction project and its future worth at the completion?
9.10 Key Terms 269
10. Consider two mutually exclusive investments with cash flows stated in year 0
dollars (× $1 K). Both alternatives have a three-year life with salvage cost =
salvage value. The annual inflation rate is 3.0%. The company operates in a
state with 8.9% corporate income tax. These investments qualify for straight-
line depreciation. The organization’s after-tax MARR is 8.0%. Use rate of
return analysis to determine which alternative is preferable.
Year Invest 1 Invest 2

0 ($420) ($300)
1 $225 $175
2 $225 $175
3 $225 $175
Chapter 10
Incremental Analysis
Abstract To this point it has been assumed that an engineering manager selects
from one of multiple economically acceptable investment alternatives. In economic
terms, the investment alternatives are assumed to be mutually exclusive. Under net
present worth and equivalent uniform annual worth at a stated MARR interest rate,
the mutually exclusive project with the highest NPW or EUAW is always preferred.
This is not the case for internal rate of investment analysis. Under the IRR criterion,
the investment with the highest IRR may not be the preferred alternative. To avoid
this problem, we estimate the internal rate of return on the difference in cash flows
of pairwise alternatives. The criterion for alternative selection is now maximizing
delta-IRR.
10.1 Introduction
To understand this concept, we first need to define incremental analysis.
Definition: Incremental analysis is the examination of cash flow differences

between alternatives to determine if the difference in the increased cost of the
higher initial cost alternative is justified by the difference in increased benefits.
Incremental Cash Flow = Cash Flows(Higher initial cost alt.)

− Cash Flows (Lower initial cost alt.)
If the rate of return on the difference in the cash flows is greater than the MARR
interest rate for a project type, then the discounted difference in benefit cash flows
https://doi.org/10.1007/978-3-030-87767-5_10
272 10 Incremental Analysis
of the higher cost alternative exceeds the initial cost differential, and the higher cost
alternative is preferred. This problem is illustrated in Example 10.1.
Example 10.1
Consider two simple alternatives each with an initial cost and a year one benefit
cash flow. Alternative 1’s initial cost is $100, and its year-1 benefit cash flow is
$150. Alternative 2’s initial cost is $200, and its year-1 benefit cash flow may
range from $250 to $300. The MARR is 10%. Over the benefit cash flow range
of Alternative 2, which alternative is preferred by the present worth criterion,
the IRR criterion, and the delta-IRR criterion?
The following spreadsheet outputs illustrate the relationship between the
present worth criterion, individual IRR criterion, and the delta-IRR criterion.
Case 1: Alternative 2 benefit = $250
By IRR, Alternative 1 is preferred with IRR = 50% versus Alternative

2 IRR(2) = 25%. Delta-IRR = 0% because the initial delta cost (-$100) is
exactly offset by the delta benefit $100. Delta-IRR = 0% < 10% = MARR
and Alternative 1 is preferred. This is consistent with maximizing net present
worth, because NPW(1) = $36.36 > $27.27 = NPW(2).
10.1 Introduction 273
By IRR, Alternative 1 is preferred with IRR = 50% versus Alternative 2

IRR(2) = 30%. Delta-IRR = 10% because the delta benefit of $110 is greater
than the initial cost (-$100). Delta-IRR = 10% = 10% = MARR and neither
alternative is preferred. This is consistent with maximizing net present worth,
because NPW(1) = $36.36 = $36.36 = NPW(2).
By IRR, Alternative 1 is preferred with IRR = 50% versus Alternative 2

IRR(2) = 40%. Delta-IRR = 30% because the delta benefit of $130 is greater
than the initial cost (-$100). Delta-IRR = 30% > 10% = MARR and Alternative
2 is preferred. This is consistent with maximizing net present worth, because
NPW(1) = $36.36 < $54.55 = NPW(2).
By IRR, neither alternative is preferred with IRR(1) = 50% = IRR(2). Delta-

IRR = 50% because the delta benefit of $150 is greater than the initial cost
(-$100). Delta-IRR = 50% > 10% = MARR and Alternative 2 is preferred. This
is consistent with maximizing net present worth, because NPW(1) = $36.36 <
$72.73 = NPW(2).
From Example 10.1, we see that maximizing delta-IRR is consistent with

maximizing the net present worth of the pairwise alternatives.
The question arises, “Why just not use NPW or EUAW for project selection?” Two
scenarios arise in application that inhibit direct use of NPW or EUAW in selecting
among alternative investments.
• The relevant MARR may not be known. This case typically arises in small to
medium size new operations. These organizations are typically still managed by
the entrepreneur–owner, and industrial engineering or cost accounting depart-
ments are usually not established with sufficient talent and data to estimate
MARRs for various investment risk categories.
• The relevant MARR may be known, but the rate of return criterion is preferable
with proposing project alternative to investors. The difference between delta-IRR
and the MARR indicates the relative gain in return for the same risk.
In the case where the MARR is not known, the graphical delta-IRR sensitivity
analysis provides the capability to perform “what-if” delta-IRR analyses to determine
the range over which an alternative is preferred relative to the other alternatives under
consideration. In the case where the MARR is known, the challenger–defender
delta-IRR analysis provides a direct relative return versus risk analysis.
10.2 Graphical Incremental Rate of Return Sensitivity

Analysis
Sensitivity analysis has been applied for decades in management science to examine
the effects of change due to uncertainty on an optimal (maximizing, minimizing,
and delta from target) solution. Sensitivity analysis allows an engineering manager
to determine the range over which an optimal solution holds.
Definition: Sensitivity analysis is a determination of the amount of variation (±)

in an estimate necessary to change the decision to select a particular alternative.
The point at which the decision changes from one alternative to another is the
point of indifference.
In managerial economic analysis, graphical differences in alternatives NPW or

EUAW represent the delta-IRR between alternatives over a given range of interest
rates. At each point of indifference, the delta-IRR between alternatives goes to zero
resulting in an IRR critical decision point.
10.2 Graphical Incremental Rate of Return Sensitivity Analysis 275
The general steps in performing a graphical incremental rate of return sensitivity

analysis are as follows:
1. Identify all acceptable alternatives that fulfill similar system outcomes—difficult
in “real-world” situations.
2. Set up a table of interest rate ranges, and for each interest rate, compute the
NPW or EUAW.
3. Construct a graph of NPW or EAUW versus interest rates for all alternatives.
4. Determine which alternative provides maximum NPW or EAUW over differing
ranges of interest rates.
5. Determine the points of indifference. They are the IRR critical decision points
of the alternatives under consideration.
6. List the NPW or EAUW maximizing interest rate ranges for each alternative.
Incremental rate of return sensitivity analysis may be performed for a range of
interest rates where the period cash flows are held constant or vary. Both analyses
will be illustrated in the next two examples.
Example 10.2
An organization must select one of three mutually exclusive alternatives. The
decision-maker needs to select the most cost-effective machine, but he is uncer-
tain as to what MARR to use. Perform a graphical DIRR sensitivity analysis
to help the decision-maker make the correct economic decision.
Parameter Alt. 1 Alt. 2 Alt. 3

Initial cost ($300) ($425) ($600)
UAB $95 $110 $120
Life in years 6 8 10
Assume “continuing requirement” for EUAW one-life analysis. The spread-

sheet analysis is provided below.
The IRR critical decision points are 3.20 and 14.55%. From 0 to 3.20%,
prefer Alternative 3 to maximize EUAW. Between 3.20% and 14.55%, prefer
Alternative 2 to maximize EUAW. Above 14.55%, prefer Alternative 1 to
maximize EUAW.
Example 10.3
Three alternatives are available for investment. There is uncertainty about
the arithmetic gradient of alternatives A and C, the interest rate at which the
company can finance the projects, and the life of the project. Nominal gradi-
ents are G(A) = −$100 and G(C) = $100. Nominal interest rate is 15%, and
nominal life is 10 years. Given the following equivalent uniform annual cash
flow (EUA_CF) equations, create graphs for sensitivity analyses to gradient,
interest rate, and project life. The respective cash flow equations are as follows:
EAU_CF(A) = −$1000 (A/P, i, n) + $1, 000 − G(A/G, i, n)

EAU_CF(B) = −$5000 (A/P, i, n) + $1, 300
EAU_CFi = −$5000 (A/P, i, n) + $1, 000 + G(A/G, i, n)
Gradient Sensitivity Analysis:

To maximize EUAW, prefer alternative A over the gradient range of $0 to

$88. From gradient $89 to $147, prefer alternative B. Greater than or equal to
$148 gradient, prefer alternative C.
Graphical delta-IRR Sensitivity Analysis:
To maximize EUAW, prefer alternative C over an interest rate range of 0–

3.6%. Prefer alternative B over and interest rate range of 3.7–16.4%. Greater
than or equal to 16.5%, prefer alternative A.
Life Sensitivity Analysis:
To maximize EUAW, prefer alternative A and a project life less than or equal
to 9 years. Prefer alternative B and a project life of 9–16 years. For a project
life greater than or equal to 16 years, prefer alternative C.
10.3 Challenger–Defender Incremental Rate of Return

Analysis
In the case where the relevant MARR is known but it is desirable to examine the
relative return versus risk analysis, we apply the challenger–defender incremental
rate of return analysis. The steps to perform a challenger–defender delta-IRR analysis
are as follows:
2. Compute rate of return for each alternative. Keep alternatives with IRR ≥
MARR.
3. Rank remaining alternatives by ascending order of initial investment.
4. Make a pairwise analysis of the contender and present selection. For investment:
5. If IRR ≥ MARR, select the contender.
6. If IRR < MARR, keep the present selection.
7. Sequentially compare preferred alternative from step 4 with next alternative in
the list from step 3.
8. Continue until all pairwise comparisons have been made.
10.3 Challenger–Defender Incremental Rate of Return Analysis 281
Example 10.4
Perform challenger–defender delta-IRR analysis for the three alternatives in
Example 10.2 for MARR = 10%.
To equalize differences in alternative lives (6 vs. 8 vs. 10 years), use the

least common multiple life of 120 years.
Estimate each alternative’s common multiple life rate of return.
Perform pairwise delta-IRR analysis ordering from smallest to largest initial

cost. MARR = 10%.
Alt1 - DoNothing DeltaIRR Alt2 - Alt1 DeltaIRR Alt3 - Alt2 DeltaIRR

($300) 22.12% ($125) 14.55% ($175) 3.20%
$95 Select Alt 1 $15 Select Alt 2 $10 Keep Alt2
$95 $15 $10
$95 $15 $10
$95 $15 $10
$95 $15 $10
($205) $315 $10
$95 $15 $10
$95 ($410) $435
$95 $15 $10
$95 $15 ($590)
$95 $15 $10
($205) $315 $10
10.3 Challenger–Defender Incremental Rate of Return Analysis 283
Note that the selection of Alternative 2 by delta-IRR at MARR = 10% is

consistent with maximizing EUAW (or NPW) in Example 10.2. Note also that
the relative difference in risk (14.55% − 3.20% = 11.35% loss) for keeping
Alternative 2 versus selecting in Alternative 3 is greater than that of selecting
Alternative 2 over keeping Alternative 1 (22.12% − 14.55% = 7.57% loss).
10.4 Observations on Incremental Rate of Return Analysis
Some final observations compare incremental rate of return analysis versus net
present worth and equivalent annual worth analyses.
1. Unless the MARR is known, neither NPW or EUAW is possible.
2. NPW and EUAW often require less computation than RoR.
3. In some situations, RoR is easier to explain (i.e., comparing a single IRR to
MARR). In other situations, NPW or EUAW may be easier to explain or more
relevant.
4. Follow the established business policy for investment analysis. Often one or two
methods are specified by standard operating procedures.
10.5 Summary
Definition: Incremental analysis is the examination of cash flow differences

between alternatives to determine if the difference in the increased cost of the
higher initial cost alternative is justified by the difference in increased benefits.
Incremental Cash Flow = Cash Flows(Higher initial cost alt.)

− Cash Flows (Lower initial cost alt.)

in an estimate necessary to change the decision to select a particular alternative.
The point at which the decision changes from one alternative to another is the
point of indifference.
The general steps in performing a graphical incremental rate of return sensitivity

analysis are as follows:
2. Set up a table of interest rate ranges, and for each interest rate, compute the
NPW or EUAW.
3. Construct a graph of NPW or EAUW versus interest rates for all alternatives.
4. Determine which alternative provides maximum NPW or EAUW over differing
ranges of interest rates.
5. Determine the points of indifference. They are the IRR critical decision points
of the alternatives under consideration.
6. List the NPW or EAUW maximizing interest rate ranges for each alternative.
The steps to perform a challenger–defender delta-IRR analysis are as follows:
2. Compute rate of return for each alternative. Keep alternatives with IRR ≥
MARR.
3. Rank remaining alternatives by ascending order of initial investment.
4. Make a pairwise analysis of the contender and present selection. For investment:
5. If IRR ≥ MARR, select the contender.
6. If IRR < MARR, keep the present selection.
7. Sequentially compare preferred alternative from step 4 with next alternative in
the list from step 3.
8. Continue until all pairwise comparisons have been made.
10.6 Key Terms
Challenger–defender delta-IRR analysis

Graphical delta-IRR sensitivity analysis
IRR critical decision point
Mutually exclusive
Point of indifference
Sensitivity analysis.
Problems
1. Consider alternatives do nothing, A, and B. Perform challenger–defender incre-
mental analysis, and set up a choice table incremental analysis. Which alternative
should be selected for MARR = 12.0%?
10.6 Key Terms 285
Year Alt A Alt B

0 (−$22,500) (−$19,000)
‘1–5 $6700 $5700
2. An organization is considering two alternatives, each with no salvage value.

Perform challenger–defender incremental analysis, and set up a choice table
incremental analysis. Which alternative should be selected for MARR = 10.0%?
Year Alt X Alt Y

0 (−$22,500) (−$19,000)
UAB $6700 $5700
Useful life (years) 4 8
3. Pakossis Construction Company is considering the purchase of trenchless auger

boring equipment to reduce subcontracting costs for water and gas line instal-
lation. Perform challenger–defender incremental analysis, and set up a choice
table incremental analysis. Which alternative should be selected for MARR =
8.0%?
Cash flow Auger tiger McAuger

Initial cost (−$100,500) (-$169,000)
Annual savings $77,000 $33,000
Annual O&M Expenses (−$45,000) (−$22,000)
Salvage value $15,000 $35,000
Useful life 5 10
4. Consider three mutually exclusive alternatives. Perform challenger–defender

incremental analysis, and set up a choice table incremental analysis. Which
alternative should be selected for MARR = 12.0%?
Year Alt X Alt Y Alt Z

0 (−$22,000) (−$24,000) (−$22,500)
1 $5500 $4000 $3500
2 $5500 $7000 $6500
3 $10,000 $11,000 $10,000
4 $10,000 $14,000 $14,000
Chapter 11
Replacement Analysis
Abstract All assets have a finite life and require replacement. The engineering
managerial economics question is when is the optimum time to replace an asset
given the physics and economics of asset use?
11.1 The Replacement Problem
There are four primary factors that must be considered in answering the asset
replacement question.
• Obsolescence: Asset’s technology is surpassed by newer technology making
the asset’s benefit/cost unacceptable relative to assets that possess the newer
technology.
• Depletion: The gradual loss of an asset’s market value due to its consumption.
• Deterioration: Loss in an asset’s value due to use or aging.
• Economic Service Life: The remaining useful economic life that results in the
minimum annual equivalent cost of ownership.
In addition to these factors, the engineering manager must consider other aspects
in planning for and logistically replacing an existing asset.
• If a unit fails, must it be removed permanently from service, or repaired?
• Are standby units available if the system fails?
• Do components or units fail independently of the failure of other components?
• Is there a budget constraint?
• If the unit can be repaired after failure, is there a constraint on the capacity of the
repair facility?
• Is only one replacement allowed over the planning horizon? Are subsequent
replacements allowed at any time during the study period?
• Is there more than one replacement unit (price and quality combination) available
at a given point in time?
• Do future replacement units differ over time? Are technological improvements
considered?
https://doi.org/10.1007/978-3-030-87767-5_11
288 11 Replacement Analysis
• Is preventative maintenance included in the model?

• Are periodic operating and maintenance costs constant or variable over time?
• Is the planning horizon finite or infinite?
• Are consequences other than economic effects considered? (i.e., environmental,
sustainability, socio-technical issues)
• Are income tax consequences considered?
• Is “inflation” considered?
• Does replacement occur simultaneously with retirement, or are there nonzero lead
times?
• Are cash flow estimates deterministic or stochastic?
In managerial economic analyses the central issue is determining an asset’s
economic service life. Fixed asset costs can be partitioned into three categories.
Capital costs are the sum of one-time fixed expenses for the design of productive
assets; fees for permits and regulatory compliance; acquisition and installation of
land, facilities, and equipment; and commissioning legal fees. Asset annual oper-
ating expenses include annual non-direct labor and non-direct materials such as the
consumption of utilities and supplies, rents, and insurance to support productive
activities. Asset annual maintenance expenses include annual expenses for mainte-
nance personnel, replacement parts, supplies, and preventive restorative labor. Fixed
asset costs must be in comparable units for the defender and challenger assets under
consideration.
Defender—the existing asset currently in service.
Challenger—the best alternative asset selected from incremental analysis available to replace
the defender asset.
11.2 Economic Service Life of an Asset
To determine an asset’s economic service life, we apply EUAW of a continuing

requirement analysis of Chap. 6.
Definition: The economic service life of an asset is the number of time

periods remaining service nESL that maximizes its EUAW of ownership or,
correspondingly, minimizes it EUAC of service.
The challenger’s cash flow economic life EUAW is
Max(EUAWESL (challenger)) = [(−P0 )

+ p [(DR p −O p −M p −I p )(P/F, i, n ESL )
+ MV p(P/F, i, n ESL )](1−TR p )(A/P, i, n ESL )] (11.1)
11.2 Economic Service Life of an Asset 289
where P0 = initial installed capital cost, Rp = difference in revenue or other benefit
cash flows over the defender revenues or benefit cash flows in year p, Op challenger
operating expenses in year p, M p = challenger maintenance expenses in year p, I p
= interest expense associated with the challenger in period p, TRp = tax rate in
period p, and MVp = challenger market value or salvage value in period p, and p
= 1, 2, …, nESL , nESL + 1, …, nMAX (maximum remaining useful life in years of
either the defender or challenger). In this case, Rp > $0 is the result of efficiency
improvements from technological advances in the challenger. Where Rp = $0, no
technological efficiency improvements, Eq. (11.1) becomes
Max(EUAWESL (challenger)) = [(−P0 )

+ p [ −O p −M p −I p (P/F, i, n E SL )

+ MV p (P/F, i, n E SL )] 1−T R p (A/P, i, n E SL ) (11.2)
The defender’s EUAWESL or EUACESL cash flow equations are the same except
that we set P0 = MV0 the defender’s market value in period 0, which is the opportunity
cost that could have been received if we had sold the defender asset in period 0 of
the analysis period. For the defender, Eqs. (11.1) and (11.2) become
Max(EUAWESL (defencer)) = [(−MV0 )

+ p [(DR p −O p −M p −I p )(P/F, i, n ESL )

+ MV p(P/F, i, n ESL )] 1−TR p (A/P, i, n ESL ) (11.3)
Max(EUAWESL (challenger)) = [(−MV0 )

+ p [ −O p −M p −I p (P/F, i, n ESL )

+ MV p(P/F, i, n ESL )] 1−TR p (A/P, i, n ESL ) (11.4)
The defender asset will be retained while its economic life EUAW is greater than
the challenger’s economic life EUAW.
• If the defender’s economic service life EUAW < challenger’s economic service
life EUAW, replace the defender with the challenger.
• Finite Horizon Project Life: If the defender’s economic life EUAW > chal-
lenger’s economic life EUAW, keep the defender. Select the combination of
remaining years ownership = finite project life n that maximizes the joint EUAW
(defender(p), challenger(n − p)).
• Infinite Horizon Project Life: If the defender’s economic life EUAW > chal-
lenger’s economic life EUAW, keep the defender. For each subsequent year,
estimate the defender’s EUAW (ESL + p), where p = 1, 2, …, n. Select the
combination remaining years ownership of the defender where EUAW(ESL +
p) > EUAW(challenger) that maximizes the joint EUAW(defender(ESL + p),
challenger(ESL)).
11.3 Tax Laws Affecting Replacement Analysis
Equations (11.1)–(11.4) specify that economic service life is estimated on an after-

tax basis. Hence, it is important to consider tax laws that may affect determination
of an asset’s economic service life. Prior to January 1, 2018, exchange US IRS
Section 1031 distinguished between retirement and replacement of an asset.
Retirement—the asset is salvaged, and the service it rendered is discontinued. Gain or loss
is realized.
Replacement—an asset is removed from service, and another asset is acquired and placed
in its place to continue service. Termed like-for-like exchange. Gain or loss is not realized.
Section 1031 defined rules for recognizing gains or losses for different classes of
personal, real, and intangible property. If an asset was retired during its useful life, a
capital gain or loss equal to the difference between its market value and book value
was realized. If the asset was retired at the end of its useful life, a capital gain or
loss equal to the difference between its market value and salvage value was realized.
Conversely, if an asset was replaced, gain or loss is not realized. If a defender asset
is replaced during its useful life,
Initial book value of the new asset = purchase price

− market value (old) + book value (old)
If the asset was replaced at the end of its useful life,
Initial book value of the new asset = purchase price

− salvage value (old) + book value(old).
Under the Tax Cuts and Jobs Act, Section 1031 now applies only to exchanges of
real property and not to exchanges of personal or intangible property. An exchange
of real property held primarily for sale still does not qualify as a like-kind exchange.
Effective January 1, 2018, exchanges of machinery, equipment, vehicles, artwork,
collectibles, patents, and other intellectual property and intangible business assets
generally do not qualify for non-recognition of gain or loss as like-kind exchanges.
Real properties generally are of like-kind, regardless of whether they are improved
or unimproved. However, real property in the USA is not like-kind to real property
outside the USA.
11.3 Tax Laws Affecting Replacement Analysis 291
Example 11.1
Retirement example: Wood Products, Inc., purchased one acre of land adjacent
to its property five years ago for $100,000, drilled a natural gas well for $5000,
and installed the well head for $32,500. The well head has been depreciated
as MACRS seven-year property. The facility is transitioning from gas-fired
production to wind turbine electricity-based production and no longer needs
the land and well head and has sold it to a neighboring production operation
for $130,000. Current well head market value is $9000. The facility operates
in a state with an 8.0% corporate tax. Estimate the after-tax gain (loss) from
the sale of the land and well head.
Notes:
1. The well is attached to the land and is not depreciable.
2. In year 5, apply the half-year convention to the well head MACRS
depreciation.
3. The sale of a business (facility and equipment) for a lump sum is governed
by IRS Publication 544, Sales and Other Dispositions of Assets. The
“residual method” must be used to allocate gain or loss to each individual
asset. Consult your tax accountant.
Example 11.2
Replacement example: Reconsider now that Wood Products, Inc., in Example
11.1 trades the land, well, and well head for the to the neighboring production
facility for land with a market value of $130,000 on which it plans to build the
wind turbine electricity generating facility. The land on which the gas well is
installed has appreciated in market value to $116,000. The well itself has no
market value.
Note: Consult IRS Publication 544.
11.4 Planning Horizon
The economic service life depends on the follow observations about asset perfor-
mance in applied operational and project cases.
• Scale-up or start-up inefficiencies occur in the first year of operation. These arise
from correcting original design deficiencies and adapting asset design to opera-
tional or project constraints. These inefficiencies result in reduced benefit cash
flows and increased engineering and operational expenses over those budgeted in
the first year of useful life.
11.4 Planning Horizon 293
Fig. 11.1 Three phases of asset operational benefit/cost performance
• After scale-up or start-up inefficiencies are resolved or mitigated, there will be

a sequence of operational periods where increased benefit cash flows or lower
operational expenses than those of the previously implemented asset.
• Nearing the end of an asset’s operational life, benefit cash flows decline due to
wear and obsolescence inefficiencies, rising operational expenses from asset wear
out, and rising maintenance expenses due to increasing asset failure.
These three general periods of any asset useful life are illustrated in Figure 11.1.
Estimation of economic service life EUAW implies a continuing requirement.
Where a continuing requirement exists (operational life is unknown or long-term >
nESL ), estimate the economic service one-life EUAW or EUAC for the defender and
challenger and select the replacement period based on EUAW(total) or EAUC(total
cost). Many asset investments, however, are for only a finite operations or project life.
Application of Eqs. (11.1) to (11.4) must be modified for finite planning horizons. By
planning horizon, the operational or project service period from the current defender
and future challengers is unknown in the infinite horizon case. In the finite horizon
case, the operational or service period has a definite duration. More formally,
Finite horizon: only a set number n of replacement cycles is needed to the end of operational
or project life.
Infinite horizon: the asset fulfills a continuing requirement for a large, or infinitely large n
→ ∞ number of replacement cycles.
Replacement cycle: the number of times the asset is replaced. For example, replacement
cycle 3 indicates that the defender asset has been replaced by three challenger assets.
Replacement time: the number of analysis periods p from project initiation to the placed-in-
service date; includes the time needed to plan, budget, manufacture, install, and scale up or
debug the replacement.
Estimation of economic service life for finite planning horizon assets requires the
analyst to consider end-of-useful-life cash flows for the required operational life for
the defender and challenger. Use the project life method of Sect. 6.6 to estimate the
respective cash flows for the defender and the challenger to the required life given
the appropriate following condition. Sequentially estimate the EUAW, or EUAC,
of retaining the defender one more year and replacing it with the challenger to the
end of required life, retaining the defender two more years and replacing it with
the challenger to the end of require life, etc. Select the combination that maximizes
EUAW(total). The following examples will illustrate finite and infinite horizon cases
for Rp = $0 and for Rp > $0.
Example 11.3
Infinite planning horizon example:
Computer server generation A, used to control a manufacturing process, was
purchased and installed four years ago for $27,500. It was estimated to have
a useful life of ten years with a salvage value of $1000. Its current market
value is $7000 with a market value of $6000 at the end of the analysis period
one, declining at $1000/period thereafter. Its annual operating expenses for
electricity is $650 per year. The facility engineering manager just re-negotiated
the electricity contract down to $500 per year for years 6 to 10. Maintenance
expenses were $10,000 in year 5, but the engineering manager just negotiated
a service contract with the server manufacturer for $8000 per year in years 6
and 7 increasing by $500 per year in years 8–10 to cover expected end-of-life
repairs. The organization operates in a state with a corporate income tax rate
= 8.9%.
The same server manufacturer now offers more technologically advanced
server generation C for $26,500 with replacement time of two months, a ten-
year useful life, and salvage value $0. Due to upgrades, server C will have
estimated annual operating expenses starting at $600 per year for electricity. If
the server is purchased with an extended warranty, the first three years mainte-
nance will be covered by the server manufacturer and year 4 to 10 maintenance
expense will be $7000 per year. Its market value will be $15,000 at the end of
its first year of operation, will decline $2500/year in years 2–5, and will decline
$1000/year in years 6–10.
All cash flows are in real dollars. The organization’s MARR = 15% real
interest rate. Perform one cycle replacement analysis, but assuming an infinite
planning horizon since manufacturing control will be required into the future.
Per IRS 946 Table B-1 (Table 7.1), computer server networks are asset class
00.12, information systems including computers with GDS property life of five
years.
Note the dual timelines, one for the original server A and the second for
server C with year 0 set equal to year 4, the year in which the replacement
decision is being considered.
Also note that the first four years, server A MACRS depreciation is grayed
to indicate past estimates not relevant to the replacement decision but necessary
for estimating book value.
Server A economic service life analysis. Server A nESL = 2 more years.
Server C economic service life analysis. Server C nESL = 3 years due to the
warranty effect.
Decision:
Since the defender’s two-year economic life EUAW = (–−$6570) > (−$6582)
= EUAW challenger three-year economic life, keep the defender.
Example 11.4
Finite planning horizon example:
Machining Specialists, Inc., is considering replacing its CNC end mill with
a newer unit, which has a higher productivity. The current CNC end mill
was purchased five years ago to fulfill a ten-year contract to manufacture
specialty aircraft parts for a new private jet for Boecraft Corporation. The
current machine cost $55,000 and had an expected useful life of ten years with
a salvage value of $5000. The current machine has a market value of $18,500.
A new, more technologically advanced CNC end mill can be purchased and
installed for $67,250 and is expected to increase throughput over the defender
as shown in the following table. The new machine has an estimated useful life of
12 years. Machining Specialists requires a 12% MARR for machining equip-
ment and operates in a state with 5.0% corporate income tax rate. Relevant
operating revenues, operating expenses, maintenance expenses, and market
values are presented in the following table. Perform finite planning horizon
replacement analysis for these two machines.
Current CNC machine

Year Revenue Opr Exp Main Exp Market value
1 $12,000 ($900) ($800) $53,000
2 $14,000 ($800) ($400) $40,750
3 $14,000 ($800) ($400) $31,500
4 $14,000 ($800) ($400) $24,000
5 (0) $14,000 ($800) ($400) $18,500
6 (1) $14,000 ($800) ($450) $14,250
7 (2) $14,000 ($800) ($450) $12,000
8 (3) $13,000 ($900) ($500) $9750
9 (4) $12,000 ($1000) ($500) $7400
10 (5) $10,000 ($1100) ($550) $5000
Challenger CNC machine

Year Revenue Opr Exp Main Exp Market value
1
2
3
4
5 (0)
6 (1) $14,000 ($1000) ($1200) $63,750
7 (2) $16,750 ($1000) ($1000) $49,000
8 (3) $19,500 ($1000) ($800) $37,750
9 (4) $19,500 ($1000) ($600) $29,000
10 (5) $19,500 ($1000) ($400) $22,500
From IRS 946 Table B-2 (Table 7.2), CNC end mills are MACRS asset class
34.0 with GDS property life of seven years.
Defender CNC end mill economic service life analysis. Defender nESL = 1
more year.
Challenger CNC end mill economic service life analysis. Challenger nESL
= 3 years. With defender nESL = 1 year and challenger nESL = 3 years < 5
years required life, Condition 4 analysis is required.
Decision:
Replace the defender with the challenger. Keep the challenger three years to its
economic life EUAW = $8698 and replace the challenger with itself and keep
it two years to the end of the project life. This will maximize the remaining
project life EUAW = $8519.
11.5 Closing Comments on Replacement Analysis
This chapter has presented only an introductory discussion of the fundamentals of

economic asset replacement analysis and just one example each of infinite and finite
planning horizon replacement analysis. Some closing comments are in order.
• Application of the economic service life concept to physical assets is adapted
from finance theory.
– A physical asset may be in optimal physical condition but may not be econom-
ically useful. Conversely, a physical asset may not be in optimum physical
condition, but the cash flows of its challenger make the defender economically
useful.
– Changes in governmental regulations may render and asset obsolete even

though it is in optimal physical condition and economically useful.
– Generally Accepted Accounting Principles (GAAP) require a reasonable esti-
mate of the required time for asset use. Economic service life estimates for
the same defender and challenger may vary based on daily, weekly, monthly,
quarterly, or yearly usage.
– Economic service life may also vary depending on the depreciation schedule
applied.
– Cash flow variations in the initial install cost of an asset, revenues, and operating
expenses associated with the asset, market value schedule, and salvage value
will affect the economic service life estimate.
• Given these variables, the generic cash flow Eqs. (11.1) to (11.4) must be modi-
fied to match the actual cash flows of the defender and challenger assets under
consideration.
• In the infinite planning horizon case, the decision criteria “if the defender’s
economic life EUAW is greater than the challenger’s economic life EUAW, retain
the defender …,” did not consider the repurchase price of the defender asset. To
normalize for defender cash flow repurchase, the defender and challenger nESL
should be estimated, respectively, through one replacement cycle cash flow each
terminating in disposal. In the finite planning horizon case, if either the defender
or challenger useful life is less than the required life, repurchase and salvage value
cash flows must be incorporated into nESL estimates.
• As illustrated in Example 11.4, a suboptimal EUAW(total) or EAUC(total cost)
economic service life may be the best solution for a finite planning horizon
required life operation. In this case, either or neither defender or challenger nESL
may be included in the best EUAW(total) or EUAC(total cost) solution.
In summary, the combinatorics of cash flow, useful life, required life, and govern-
mental regulations yield almost an infinite number of patterns. It is the engineering
manager analyst’s responsibility to accurately determine the defender and challenger
cash flows of the situation to produce accurate nESL and EUAW(total) estimates. Not
addressed in this chapter, sensitivity analyses may be required to identify ranges over
which nESL , EUAW(total), and replacement decisions hold.
11.6 Summary
Defender—the existing asset currently in service.

Challenger—the best alternative asset selected from incremental analysis available
to replace the defender asset.
11.6 Summary 301
Definition: The economic service life of an asset is the number of time

periods remaining service nESL that maximizes its EUAW of ownership or,
correspondingly, minimizes it EUAC of service.
The challenger’s cash flow economic life EUAW is
Max(EUAWESL (challenger)) = [(−P0 ) + p [(DR p

− O p − M p − I p )(P/F, i, n ESL ) + MV p(P/F, i, n ESL )]

1−TR p (A/P, i, n ESL )
The defender’s cash flow economic life EUAW is
Max(EUAWESL (defencer)) = [(−MV0 ) + p [(DR p

−O p −M p −I p ) (P/F, i, n ESL )

+ MV p (P/F, i, n ESL )] 1−TR p (A/P, i, n ESL )
US IRS Section 1031:

Retirement—the asset is salvaged, and the service it rendered is discontinued. Gain
or loss is realized.
Replacement—an asset is removed from service, and another asset is acquired and
placed in its place to continue service. Termed like-for-like exchange. Gain or loss
is not realized.
Planning horizon:
Finite horizon: only a set number n of replacement cycles is needed to the end of
operational or project life.
Infinite horizon: the asset fulfills a continuing requirement for a large, or infinitely
large n → ∞ number of replacement cycles.
Replacement cycle: the number of times the asset is replaced. For example, replace-
ment cycle 3 indicates that the defender asset has been replaced by three challenger
assets.
Replacement time: the number of analysis periods p from project initiation to the
placed-in-service date; includes the time needed to plan, budget, manufacture, install,
and scale up or debug the replacement.
11.7 Key Terms
Depletion
Deterioration
EUAC (total cost)
EUAW (total)
Economic service life nESL
Finite planning horizon
Infinite planning horizon
Obsolescence
Required life
Replacement
Replacement cycle
Replacement time
Retirement
Section 1031 property.
Problems
1. A mid-western company purchased a 5-acre tract of farmland three years ago
with the intent to build a supply warehouse for its finished products, but the
local market demand did not materialize the land cost $8000 per acre and has
appreciated in value by 6.0% per year. Consider the gain/loss or new asset
valuation for the following two scenarios.
(a) The land will be sold at its current market value.

(b) The land will be exchanged for a 5-acre tract in an east coast state where
demand for the company’s products is high. Due to population demand,
land prices per acre in the east coast state are significantly higher, and the
5-acre tract market value is $67,000.
2. A special purpose machine for the manufacture of finished plastic products is

to be purchased for $225,000. The machine is required for five-year contract
with a new customer. Annual revenues, expenses, and market/salvage real dollar
values are reported in the following table. The machine will be depreciated under
MACRS and the organization operates with a combined 27% tax rate. If MARR
= 10%, what is the machine’s economic life?
Year Revenues O&M Exp’s Mkt value

1 $120,000 ($37,500) $192,000
2 $160,000 ($48,000) $121,500
(continued)
11.7 Key Terms 303
(continued)
Year Revenues O&M Exp’s Mkt value
3 $160,000 ($79,500) $78,000
4 $140,000 ($97,000) $25,500
5 $120,000 ($117,000) $0
3. An existing research and development test instrument that costs $16,000 two
years ago has a market value of $12,000 today declining at (-$1500) per year
(arithmetic gradient) until it reaches it six-year life salvage value of $2000
at the end of its six-year useful life. The asset was purchased to fulfill a 12-
year development project. The test instrument expenses (−$4000) per year to
operate. A new test instrument is under consideration as the replacement. The
new instrument costs $18,000 but reduces annual test expenses to (−$3000) per
year. The new asset will have a market value of $8500 at the end of the first
year of use declining at (−$1500) per year (arithmetic gradient) to its salvage
value of $4000 at the end of its four-year useful life. The organization operates
in a state with a combined state and federal tax rate of 24% and uses MARR =
10% for this project. The selected asset is depreciated under MACRS. Perform
replacement analysis and determine the combination of defender or challenger
economic lives that maximizes the project EUAW.
4. Pro-Trailers, Inc., is considering the purchase of a computer numerical
controlled welding robotic system to replace the automated welding system that
required human setup and intervention. The existing automated welding system
was purchased three years ago at an initial cost of $1,650,000. The current auto-
mated welding system has a salvage value of $0 at the end of its ten-year useful
life. Its remaining market values are given in the following table. The computer
numerical controlled welding robotic system costs $1,250,000 due to advances
in technology and has a salvage value of $125,000 at the end of its ten-year
useful life. Its annual market values are given in the follow table. The computer
numerical controlled welding robotic system will save $800,000 per year due
to elimination of the human support labor. Both welding systems are depre-
ciated as MACRS GDS seven-year property. Pro-Trailers operates in a state
with a combined federal and state income tax of 30%, and Pro-Trailers requires
MARR = 10% on this type of investment. Estimate the EUAW economic life
of the defender and challenger and determine if the defender should be replaced
by the challenger.
Year Automated Computer numerical controlled

1 – $1,137,500
2 – $1,025,000
3 $1,155,000 $912,500
4 $990,000 $800,000
5 $825,000 $687,500
(continued)
(continued)
Year Automated Computer numerical controlled
6 $660,000 $575,000
7 $495,000 $462,500
8 $330,000 $350,000
9 $165,000 $237,500
10 $0 $125,000
Part III
Managing Engineering Investments
Chapter 12
Determining the Appropriate MARR
Abstract The previous chapters assumed that a stated MARR for a particular asset
investment was known. Depending on organizational maturity and accounting poli-
cies, MARR may or may not be known for every asset investment type. In small,
start-up, entrepreneurial companies with only rudimentary accounting practices, the
MARR will most likely be unknown. In more mature, medium-sized companies
with maturing management and cost accounting practices, a general MARR may be
available for all asset investments. In large corporations with mature management,
cost accounting systems, and industrial engineering, a schedule of MARRs will be
published by asset risk category. This chapter provides an introductory discussion of
how MARR is determined from risk–return analysis. The discussion is a continuation
of the finance cycle introduced in Chap. 1.
12.1 Risk–Return Fundamentals
In Chap. 2, we defined MARR as follows.
Definition: MinimumAttractive Rate of Return (MARR)—the risk adjusted,

or investments.
From Chap. 1, MARR may be measured as

MARR = w Li × I Li × (1 − Tc ) + w Si × RoE Si (12.1)
i j
https://doi.org/10.1007/978-3-030-87767-5_12
308 12 Determining the Appropriate MARR
where wLi = L i /( i L i + j S j ), wSj = S j /( i L i + j S j ), I Li = interest rate charged

on loan i, T C = the organization’s combined tax rate, and RoESi = return on equity
interest rate for stock S j .
Equation (12.1) recognizes that, ultimately, the sources of organizational
financing, lenders, and stockholders set the MARR as a function of their risk assess-
ment of organizational investment opportunities. This chapter reviews the sources and
costs of financing organizational investments. The chapter then presents fundamental
methods of determining MARR.
All cash flow estimates are inherently variable, and future estimates are often
more variable than present estimates. Minor changes in any estimate(s) may alter
the results of the economic analysis and the decision regarding the best investments.
Chapter 10 introduced the concept of sensitivity analysis to determine the range over
which a criterion may vary for the current decision to remain the best decision. The
point at which the decision changes from one alternative to another was defined as
the point of indifference or the critical decision point. It is the variability in future
cash flow estimates that is the source of risk. There is an upper critical decision point
at which an investment’s risk of loss exceeds its rate of return (MARR).
Before we can establish risk–return fundamentals, we need a working definition
of risk. In application, there are three broad categories of risk.
Risk is observed in those situations in which the potential outcomes can be
described by well-known stochastic probability distributions.
Imprecision is observed in those situations in which the potential outcomes
cannot be described by well-known stochastic probability distributions but can be
estimated by human subjective probabilities.
Uncertainty is observed in those situations in which the potential outcomes cannot
be described by well-known stochastic probability distributions and cannot be
estimated by human subjective probabilities.
This chapter will deal with only the first category, risk. In engineering managerial
economics,
Definition: Risk is the probability of earning a rate of return on an investment
that varies from the investment’s expected or predicted value.
Risk is a measure of variability.
Definition: Variability arises from random structural and residual error differences
from expected or predicted values in the criterion under consideration.
Structural—bias difference between long-run average realized return on invest-
ment and the expected or predicted rate of return.
Random—random difference between realized rate of return and the long-run
average structural rate of return.
Definition: A criterion is a principle, standard, or metric by which the desirability
of a phenomenon can be evaluated.
In engineering managerial economics, the criterion is an investment’s rate of return
or a portfolio of investments weighted average rate of return relative to the expected
or predicted rate of return ≥ MARR for that investment or portfolio of investments.
12.1 Risk–Return Fundamentals 309
Structural difference = Avg[RoR(Investment)] − E[ RoR}
Random difference = RoR[Investment] − Avg{ RoR(Investment)]
Economic risk is the probability that the RoR(investment) < MARR.
P(RoR(investment) < MARR)

= Structural difference + Random difference < MARR
Figure 12.1 illustrates the structural and random variance components of RoR
risk. The structural difference is the ± Avg[RoR(investment)—E[RoR] shown by
the horizontal arrows. RoR(investment) is the ± variation of the realized RoR under
the curve of its respective ± Avg[RoR]. The areas under the respective distribu-
tions are the P(RoR(investment) < MARR). The lower tail area for the dashed blue
curve was the planned risk of RoR < MARR. If the + Avg[RoR] distribution is real-
ized, P(RoR(investment) < MARR) is much less than planned. If the −Avg[RoR]
distribution is realized, P(RoR(investment) < MARR) is much greater than planned.
Figure 12.2 points to the fundamental relationship between risk and return—the
return on an investment should be proportional to the risk involved. R0 = the risk-free
interest rate on Treasury bonds. The Real$ risk-free rate is calculated by subtracting
the current inflation rate from the yield of the Treasury bond matching the investment
duration. As variance increases below MARR, risk increases.
Generally, however, in corporations with mature management, cost accounting,
and industrial engineering functions, RoR risk versus return will be decomposed into
multiple MARR risk classes. As examples, installation of a pump required by EPA
(low risk), installation of a fully automated production line for an existing product
(medium risk), and construction of a new facility to manufacture an innovative new
product (high risk) have increasing risk of failure to achieve the relevant MARR and
correspondingly increasing consequences of the impacts of failure. Each risk category
will have a relevant range of MARRs except the last. As some level, new investment
opportunities incur excessive risk requiring such high interest rates and high common
Fig. 12.1 RoR risk variance components

Fig. 12.2 Risk versus return

relationship
Fig. 12.3 General

risk–return categories
stock dividend rates that the organization will not be able to secure loans or be able
to sell stock. Figure 12.3 presents a general representation of risk–return categories.
Risk, however, is not just the probability of RoR variance < MARR. Risk also
involves the outcome, how much RoR variance, and the consequence to and impact
on the organization. Hence, risk has three primary dimensions.
12.1 Risk–Return Fundamentals 311
• An outcome (difference from an expected or predicted RoR value).

• A probability of occurrence of that RoR < MARR.
• Consequence of the outcome (loss or gain given the outcome).

Riakt = f Outcomet , Probabilityt Consequencet (12.1)

Outcomet , Probabilityt = f (Input Eventst , Random Variationt )
Impactt = Probabilityt × Consequencet
where t = time which facilitates changes in outcomes, their associated probabilities

and impacts, and the relationships among them. Risk also has a human perception
dimension. Generally, there is an asymmetry between downside and upside risk. This
is known as risk aversion.
Downside risk: In general, a project with a greater probability of earning low or
negative returns is considered more risky than other projects with lesser probability
of low or negative returns.
Upside risk: A project with a greater probability of higher-than-expected returns
is, in general, considered less risky than other projects with lesser probability of
similar high returns.
12.2 Sources of Financing
From Chap. 2, there are three sources of asset financing for an organization: borrowed
money, money from the sale of stock, and retained earnings.
Borrowed money is debt financing. Debt financing includes both short-term
borrowing and the sale of long-term bonds. Short-term and long-term loans refer to
the time over which a loan is paid back. Short-term loans are generally unsecured and
repaid within 30 days, a few months, or the current fiscal year. Short-term loans include
• Line-of-credit bank loans to maintain a minimum level of operating cash. A line of
credit is a flexible loan from a local bank that makes available of a defined amount
of money that an organization can access as needed and repay either immediately
or over time. Interest is charged only on the amount of money borrowed over the
time it borrowed.
• Cash advances from a local bank with repayment within a few weeks. Cash
advances are often used for unplanned emergency purchases.
• Accounts payable—money owed to suppliers of materials or services, which is
typically repaid with some percent discount if repaid in a short period or repaid
in full in 30 days. Some organizations depend on rolling accounts payable as a
source of short-term financing.
• Credit card purchases with repayment monthly. Virtually all organizations use
credit card purchases as a form of short-term financing.
Long-term loan financing is either the sale of bonds or acquisition of long-term
loans. Long-term financing is commonly used to support long-term initiatives, such
as making acquisitions, opening a new production facility, financing common stock
share repurchases, and preparing for rising interest rates.
• Bond financing represents a loan made by an investor. Organizations issue bonds
directly to investors. A bond may be secured (backed by the value of assets it
finances) or unsecured. A bond includes the terms of the loan, interest payments
that will be made, and the time (maturity date) at which the bond principal will
be repaid. The coupon interest payment is the return that bondholders earn for
loaning their funds to the issuer.
• A long-term loan represents financing from commercial or investment banks.
Long-term loans typically involve a contract for a set amount of money with
equal repayments over multiple years until the loan is repaid. Long-term loans
have a distinct advantage over equity financing (sale of stock) because loan interest
payments are considered as operational expenses paid before taxes resulting in
deductions equal to the tax rate organizations receive on interest payments.
Equity financing results from the sale of preferred on common stock to investors.
Preferred stocks are stock shares issued without ownership and voting rights. Preferred
stockholders have “preference” over common stockholders in payment of dividend
(preferred dividends must be paid before issuing common stock dividends) and in
receiving cash from assets in the event of organizational liquidation. Common stock-
holders are owners of the company and have voting rights on corporate issues, such
as the board of directors and accepting takeover bids. Common stockholders may
receive dividends out of net profit if the organization has cash available after long-term
reinvestment.
Retained earnings is money (retained net profits) generated from the operation of
the company. Retained earnings is reported in the equity section of the balance sheet
but is invested in new productive assets that are listed on the assets side of the balance
sheet. Retained net profits should be invested in new productive assets only if the rate
of return on the assets is greater than or equal to the common stock dividend rate.
12.3 Cost of Financing and Investment Opportunities
As specified in Chap. 2, the debt ratio measures the proportion of total capital derived
from borrowed funds.
Total debt
Debt ratio =
Total assets
12.3 Cost of Financing and Investment Opportunities 313
The debt ratio can range from zero to 100%. An organization’s capital structure
is not independent of the proportion of debt. Borrowing affects the riskiness of an
organization’s capital structure. The amount of risk is measured by the organization’s
risk premium.
Cost of Borrowed Money = prime interest rate + risk premium
The prime rate is the interest rate banks charge their very best corporate customers
with the strongest credit ratings. Customers with weaker credit ratings are charged
more than the prime rate. This additional interest rate is termed the risk premium. As
an organization’s debt ratio increases toward 100%, the organization is considered
to be more risky and will pay an increasingly higher risk premium.
As the debt ratio decreases toward zero, the organization is considered less risky,
but its cost of equity, dividend rate paid on preferred and common stock, increases its
cost of borrowed money. This increase occurs because stockholders expect a higher
return rate for holding stocks long term than the interest rate that they can receive
by depositing their money in bank saving accounts, certificates of deposit, or money
market accounts. The second source of equity financing is retained earnings. Rein-
vestment of retained earnings likewise increases the cost of borrowed money, because
earnings will be retained only if they can be invested in assets and products that have
rates of return higher than stock dividend rates. Otherwise, excess earnings should
be returned to stockholders in the form of dividends. Retained earnings represents
an opportunity cost to stockholders. Earnings are retained and reinvested only if they
present the opportunity for higher future returns on stocks held.
Hence, each organization has a mix of debt and equity financing that will minimize
its cost of borrowed money. The challenge for the organization’s finance manager
is to find the mixed financing, or range of mixed financing, that minimizes the
organization’s total cost of borrowed money.
12.3.1 Weighted Average Cost of Capital
The proportions of debt, equity, and retained earnings are combined into the weighted
average cost of capital (WACC).

WACC = i Liabilities PLiabilities (1 − T ) + i Equity PEquity + i Earnings PEarnings
(12.2)
where P = proportion in liabilities, equity, and retained earnings, respectively, i =

interest rate on each respective debt, stock, or retained earnings, T = combined tax
rate, and PLiabilities + PEquity + PEarnings = 1.00. Recall that interest on debt is paid
before taxes, so the after-tax cost of debt is
After tax interest rate = (Before tax interest rate)(1 − T ) (12.3)

If the firm uses a mix of borrowing and equity that maintains exactly the same
capital and risk structure in financing the project or portfolio of projects under
consideration, then
WACC ≈ MARR
Example 12.1
A medium-sized chemical distributor has the following financing mix. The
distributor operates in state with 10.0% corporate income tax rate. Estimate
the distributor’s after-tax weighted average cost of capital.
Type Amount Interest rate

Bank loan $2,000,000 5.0%
Bonds $28,000,000 8.0%
Common stock $60,000,000 12.0%
Retained earnings $30,000,000 15.0%
Total $120,000,000
Combined tax rate = Sr + Fr(1 − Sr) = 0.10 + 0.21(1 − 0.10) = 0.289 or 28.9%.
Type Amount Interest rate (%) P

Bank loan $2,000,000 5.0 0.01667
Bonds $28,000,000 8.0 0.23333
Common stock $60,000,000 12.0 0.50000
Retained earnings $30,000,000 15.0 0.25000
Total $120,000,000 1.00000
WACC = [(0.05 × 0.01667 + 0.08 × 0.23333) (1 − 0.289) + 0.12 × 0.50 + 0.15 × 0.25
WACC = 0.1114 or 11.14%
Also, we can estimate the WACC based on after-tax interest expense.
Type Amount Interest Annual interest (1 − T) After-tax

rate (%) interest
Bank loan $2,000,000 5.0 $100,000 (1 − $71,100
0.289)
Bonds $28,000,000 8.0 $2,240,000 (1 − $1,592,640
0.289)
Common stock $60,000,000 12.0 $7,200,000 NA $7,200,000
Retained earnings $30,000,000 15.0 $4,500,000 NA $4,500,000
Total $120,000,000 $13,363,740
WACC = $13, 363, 740/$120, 000, 000 = 0.1114 or 11.14%
12.3.2 Weighted Marginal Cost of Capital
The previous section presented the weighted average cost of capital as an estimate
of an organization’s MARR. However, as noted in the introduction to this section,
the exact value of the WACC depends on how the amount of new capital affects
the financing mix. Financial markets recognize that funding sources are limited.
Accordingly, banks and investors will not make funds available beyond certain risk
limits. If a firm tries to extend its financing beyond market-determined risk limits,
it will encounter an increasing weighted marginal cost of capital, WMCC. A firm
determines the marginal cost of capital from external financing for increasing risk
levels by consulting an investment banker. The banker studies the organization’s
financial and risk structures and presents a report similar to the following table.
Range of new financing ($) Weighted cost of capital (%)

$0 to $1,500,000 11.0
$1,500,001 to $3,000,000 11.5
$3,000,001 to $4,500,000 12.5
$4,500,001 to $5,500,000 13.5
≥$5,500,000 15.0+
The table indicates that the organization can obtain a mix of additional debt and
stock financing up to $1,500,000 without affecting its current WACC = 11.0%.
However, if the organization has investment opportunities beyond $1,500,000, it can
obtain the additional financing only if it pays increasing interest rates in the schedule
to compensate its debtors and stockholders for the corresponding increasing risk. For
those alternatives with RoR > weighted cost of capital (%), estimate the weighted
marginal cost of capital as
WMCC = Re-estimate(WACC + acceptable alternatives)
If an organization uses a mix of borrowing and equity that increases the weighted
marginal cost of capital due to increasing risk structure in financing the project or
portfolio of projects under consideration, then
WMCC ≈ MARR
Example 12.2
Suppose that the organization in Example 12.1 has MARR = 11.14% and
the following proposed projects ranked by IRR. Use the above WCC/new-
financing schedule to estimate the organizations weighted marginal cost of
capital.
Project IRR (%) Project cost Cum$

A 18.0 $1,500,000 $1,500,000
B 17.0 $1,250,000 $2,750,000
C 15.0 $1,500,000 $4,250,000
D 12.0 $1,750,000 $6,000,000
E 11.0 $1,000,000 $7,000,000
F 10.0 $ 500,000 $7,500,000
G 9.0 $ 500,000 $8,000,000
Plot the IRR (%) and WCC (%) for the cumulative project cost for each
project investment. The organization can select only projects A, B, and C for
a marginal cumulative investment of $4,250,000 at WMCC = 12.5%.
Analysis: Estimate the WNCC = Re-estimated(WACC) with 100% bond

financing, current debt ratio mix of bonds and stock, and 100% stock financing
for a state income tax rate of 10%. Compare the WNCC with the IRR = 15%
opportunity cost of capital.
For scenario 1, use 100% bond financing at 12.50%.
State tax rate 10%

Federal tax rate 21% Combined tax rate 28.9%
Scenario 1: 100% Bond financing

Type Amount Interest Rate P ( 1- T)
Bank Loan $2,000,000 5.00% 0.0163 71.10% 0.000579226
Bonds $28,000,000 8.00% 0.2281 71.10% 0.012974664
New Bonds $4,250,000 12.50% 0.0346 71.10% 0.003077138
Common Stock $60,000,000 12.00% 0.4888 100% 0.058655804
New Stock $0 12.00% 0.0000 100% 0
Retained Earnings $30,000,000 15.00% 0.2444 100% 0.036659878
Total $122,750,000 1.0000 WNCC 0.1119
11.19%
For scenario 2, use finance 25% with bonds and 75% with stock to maintain
current debt ratio. Note: Stock financing must pay the current 12.0% stock
dividend rate.
Scenario 2: Finance 25% with bonds and 75% with stock.

Bank Loan $2,000,000 5.00% 0.0163 71.10% 0.000579226
Bonds $28,000,000 8.00% 0.2281 71.10% 0.012974664
New Bonds $1,062,500 12.50% 0.0087 71.10% 0.000769285
Common Stock $60,000,000 12.00% 0.4888 100% 0.058655804
New Stock $3,187,500 12.00% 0.0260 100% 0.00311609
Total $122,750,000 1.0000 WNCC 0.1128
11.28%
For scenario 3, use 100% stock financing.

Scenario 3: 100% common stock financing

Bank Loan $2,000,000 5.00% 0.0163 71.10% 0.000579226
Bonds $28,000,000 8.00% 0.2281 71.10% 0.012974664
New Bonds $0 12.50% 0.0000 71.10% 0
Common Stock $60,000,000 12.00% 0.4888 100% 0.058655804
New Stock $4,250,000 12.00% 0.0346 100% 0.004154786
Total $122,750,000 1.01 WNCC 0.1130
11.30%
All three financing mix scenarios are feasible relative to the retained earnings
cost of 15%.
• 100% bond financing at 11.5% increases the WACC from 11.14% to WNCC
= 11.19%.
• Debt ratio of 25% bond and 75% stock financing increases WACC from
11.14% to WNCC = 11.28%.
• 100% stock financing increases WACC from 11.14% to WNCC = 11.30%.
• 100% bond financing should be preferred if obtainable.
12.3.3 Opportunity Cost of Capital
WACC and WMCC assume that an organization has unlimited capital and resources
to support new investments. In practice, organizational resources and capital are
always constrained. It important to understand the effect on MARR due to the cost
of capital under capital rationing. Capital rationing occurs when management places
restrictions on the amounts of new investments or projects undertaken by an orga-
nization. Capital rationing is accomplished by imposing a higher cost of capital for
investments under consideration or by setting a ceiling on specific portions of a
budget. The objective of capital rationing is to ensure that all selected projects have
a higher ROR than the best rejected internal project. Opportunity cost is the ROR
of the best rejected internal project opportunity foregone due to capital rationing.
Opportunity Cost = Rate of Return on the best rejected project (12.4)
Since new investments can be financed only from either retained earnings or
new external financing, the opportunity cost of capital represents an upper bound on
MARR.
Example 12.3
An organization is considering the independent investment projects in Example
12.2. The organization’s current MARR = 11.14%, and its stockholders require
12.0% stock dividend rate. Organizational management has set a budget of
$3,000,000 for the selected new projects. Determine which projects should be
selected under capital rationing by opportunity cost.
The opportunity cost of capital is the best rejected project C with IRR =
15.0% > 12.0% stock dividend rate of Example 12.1. Although financing is
available, the organization does not have the capacity to take on project C.
12.4 Closing Comments on Determination of MARR
As noted in the introductory discussion, there is a mix of debt and equity financing that
will minimize an organization’s cost of borrowed money (debt and stock financing).
A general ranking (as a guideline) from lowest to highest cost of financing for MARR
estimates is
1. As a general guideline, the effect of the mix of debt and equity financing on
MARR ranked from lowest to highest is:
2. Cost of debt financing (if debt interest > current MARR, then increasing risk).
3. WACC or WMCC.
4. Cost of stock financing.
5. Opportunity cost of capital; this is the upper bound because the opportunity
cost of capital for new projects should always be greater than the expected
stock dividend rate.
In selecting a new MARR, add the cost of financing for all feasible new projects
to the current financing mix and re-estimate the WACC. Select the financing mix
that minimizes WACC ≈ MARR. Also, as noted in the introductory discussion of
risk and illustrated by Fig. 12.2, well-managed organizations will further decompose
RoR risk versus return into multiple MARR risk classes.
12.5 Summary
Definition: Minimum Attractive Rate of Return (MARR)—the risk adjusted,

or investments.

MARR = w Li × I Li × (1 − Tc ) + w Si × RoE Si
i j
Risk is observed in those situations in which the potential outcomes can be

described by well-known probability distributions.
Imprecision is observed in those situations in which the potential outcomes cannot
be described by well-known probability distributions but can be estimated by
subjective probabilities.
Uncertainty is observed in those situations in which the potential outcomes cannot
be described by well-known probability distributions and cannot be estimated by
subjective probabilities.
Definition: Risk is the probability of earning a return on an investment that varies
from the investment’s expected or predicted value.
Definition: Variability arises from random structural and residual error differences
from expected or predicted values in the criterion under consideration.
Structural—difference between long-run average realized return and expected
or predicted return.
Random—random difference between realized return and the long-run average
return.
Definition: A criterion is a principle, standard, or metric by which the desirability
of a phenomenon can be evaluated.

RiskT = f outcomeT , probabilityT , consequenceT
Downside risk: In general, a project with a greater probability of earning low or

negative returns is considered more risky than other projects with lesser probability
of low or negative returns.
12.5 Summary 321
Upside risk: A project with a greater probability of higher-than-expected returns

is, in general, considered less risky than other projects with lesser probability of
similar high returns.

WACC = i Liabilities PLiabilities (1 − T ) + i Equity PEquity + i Earnings PEarnings
After-tax interest rate = (Before-tax interest rate)(1 − Tax Rate)
WMCC = Re-estimate(WACC + acceptable alternatives)
Opportunity Cost = Rate of Return on the best rejected project
12.6 Key Terms
Cost of capital
Debt financing
Equity financing
Impact
Imprecision
Minimum Attractive Rate of Return
Opportunity Cost of Capital
Outcome
Random risk
Risk
Risk versus return
Structural risk
Uncertainty
Weighted Average Cost of Capital
Weighted Marginal Cost of Capital.
Problems
1. A firm’s stockholders expect a 14% rate of return, and the firm has earned 16%
on its retained earnings. There is $9,000,000 in common stock and $3,000,000
in retained earnings. The firm has $3,000,000 in loans at 6.0% interest rate and
$10,000,000 in bonds that pay 5.0% per year. The firm has a combined income
tax rate of 28.0%. What is the firms WACC?
2. The firm in problem 1 has asset investment projects as shown in the first table
and available financing in the second table. What is the weighted marginal cost
of capital if the firm finances with 100% bonds, current percentage mix of
liabilities and equities, and 100% stocks?
Project First cost Ann. benefit Life (yrs)

1 $200,000 $43,000 15
2 $300,000 $59,750 10
3 $100,000 $33,400 5
4 $50,000 $12,500 10
5 $250,000 $75,000 5
6 $140,000 $28,000 15
7 $400,000 $125,000 5
Range of new financing WCC (%)

$0 to $100,000 9.0
$100,001 to $150,000 10.0
$150,000 to $200,000 12.0
$200,001 to $300,000 15.0
$300,001 to $400,000 18.0
$400,001 to $500,000 22.0
>$500,001 NA
3. What is the firm’s opportunity cost of capital for the projects listed in the
first table of problem 2? How will the available financing with respect to the
opportunity cost of capital affect financing of the selected projects?
Chapter 13
Capital Budgeting Engineering
Investments
Abstract An organization’s viability depends on its ability to develop and grow to

remain competitive. A well-managed organization expends a significant amount of
its management’s time and its resources to develop sound capital budgets to remain
viable. Major capital investments in facilities, equipment, and supporting infrastruc-
ture are made and implemented through engineering projects. Capital budget projects
fall in the medium-to-high risk–return categories.
• Replacement: maintenance of existing business—medium risk–return cate-

gory. Typical projects include replacing worn or damaged equipment or infras-
tructure used to produce existing profitable products and services necessary to
continue current operations. Usually, the profit level of existing products or
services justifies continuing production, so the decision to move forward with
a capital budget is automatic. The only decision to be made are (1) minimizing
the investment to continue profitability, (2) timing for shutdown and repairs or
upgrades, and (3) building safety inventory to maintain sales during shutdown.
• Replacement for cost reduction—medium risk–return category. This category
includes costs to replace or upgrade functional equipment with remaining useful
life. The expected outcome is a reduction in operating expenditures for direct
labor, direct materials, indirect materials, or allocated fixed operating overhead.
These capital budgeting decisions are more discretionary and require detailed
capital budget analysis.
• Expansion of existing products or markets—medium–high-risk–return cate-
gory. This category includes costs to increase output or expand the distribution of
existing products or services, These capital budgeting decisions require explicit
market analysis to determine the level of future demand for existing products and
services. The greater the variability in the future demand estimates the higher the
risk of decline in profitability or even loss.
https://doi.org/10.1007/978-3-030-87767-5_13
324 13 Capital Budgeting Engineering Investments
• Expansion into new products, services, or markets—high-risk–return cate-

gory. These capital projects include costs to install a new production line or
facility to produce a new product or service or to expand into a geographic
area not currently served. These capital budgeting decisions are strategic in that
the outcome will change the fundamental operation of the organization. These
capital budgeting decisions require incurring costs over long periods for plan-
ning, designing, installing, operating, and decommissioning the new operations.
As such, these decisions require detailed analyses.
• Safety and environmental projects—low-to-medium risk category. Note that
this category of capital budgets is not risk–return decisions, because there is
no return. As such, these capital budgeting decisions are termed non-revenue-
generating projects. This category of capital budgeting is necessary to comply
with governmental regulations or possibly insurance policy terms. How the capital
budgeting decision is made depends on whether it is a low or medium risk decision.
The major consideration is minimizing the cost necessary to attain compliance.
• Other projects—low-to-medium risk category. Again, these projects fall into the
non-revenue-generating category, because they are for supporting infrastructure
such as office buildings or a truck fleet to provide on-time delivery of raw materials
or finished products.
13.1 Capital Expenditure for Project Proposals
Up until now, we have been given an interest rate for which we selected a project’s
best mutually exclusive alternative. In doing so, we assumed an unlimited amount of
money for capital investment. In a free-market economy (purely socialist economies
are excluded because capital budgeting is government dictated and may provide no
benefit to the general economy), the mechanism of scarcity of resources promotes
the selection of economically attractive capital projects. The problem of rationing
money among competing capital projects is called capital budgeting. Conceptually,
the capital budgeting process passes through six major steps.
1. Determine the capital cost and source of funding, debt or stock.
2. Estimate expected cash flows from the project including terminating market or
salvage values.
3. Estimate the riskiness (structural and random variability) of cash flows and the
risk premium necessary to compensate lenders and stockholders.
4. Estimate the IRR of the project given the risk premium as
IRR = i project = i RiskFree + i RiskPremium
where inflation is expected to have major impact on project cash flows, the
project IRR becomes
IRR = i project = i RiskFree + i RiskPremium + f + (i RiskFree + i RiskPremium ) f

13.1 Capital Expenditure for Project Proposals 325
5. Determine the project’s rate of return and net present value to obtain an estimate
of the project’s value to the organization.
6. Decide on project implementation based on NPV ≥ 0 at the MARR or RoR ≥
MARR for budgeted funds.
13.2 Rationing Capital by Rate of Return
As noted in the capital budgeting process, one criterion for assessing the value of a
capital investment is RoR > MARR for budgeted funds. The budgeting process for
rationing capital by the rate of return is:
1. Compute rate of return (RoR) on each alternative project investment given
respective cash flow structures.
2. Rank the alternatives in order of decreasing RoR.
3. For a fixed capital budget, select the highest RoR >= MARR investment project
alternatives by rank until the allocated capital funds are allocated with the sum
of allocated fund less than or equal to the budgeted funds.
4. Estimate the weighted portfolio RoR = Si (Project Cost(i)/Sum Allocated
Budget) × ROR(i).
5. Return unallocated capital budget funds to the organization for distribution
among stockholders.
The rate of return on the best-rejected project is called the cutoff rate of return
or opportunity cost of capital.
Example 13.1
An organization is considering the following nine capital investments. The
capital budget is $1,250,000. These are medium risk–return projects requiring
MARR = 12.0%. Allocate the capital budget using rationing by rate of return.
Budget $1,250,000 MARR 12.0%

Project Cost (1k) After-tax CF (1k) Life (years) Salvage Value RoR Rank CumBudget
1 $200.00 $47.70 10 $0.00 20.0% 1 $200.00
2 $400.00 $79.70 10 $0.00 15.0% 8
3 $100.00 $38.20 4 $0.00 19.4% 3 $400.00
4 $200.00 $40.00 6 $125.00 15.8% 6 $1,150.00
5 $100.00 $20.00 10 $100.00 20.0% 2 $300.00
6 $300.00 $54.00 10 $150.00 15.6% 7 Opportunity Cost
7 $600.00 $189.28 4 $50.00 12.5% 9
8 $450.00 $88.88 10 $100.00 16.1% 5 $950.00
9 $100.00 $19.25 10 $50.00 17.0% 4 $500.00
Total $2,450.00 Portfolio Weighted RoR 17.4%
NPW
$69.52
$16.03
($98.87)
($19.19)
$19.99
($7.33)
Portfolio NPW ($19.86)
Note: In the RoR analysis, the one-life EUAW for a continuing requirement
is assumed. The common life is the longest life project, and any project with a
shorter life will replace itself until the longest life project.
• Only the first six ranked projects (in rank order 1, 5, 3, 9, 8, and 4) can be
funded at a budget of $1,150,000.
• The best-rejected project 6 RoR = 15.6% is the opportunity cost of capital.
Weighted portfolio RoR = 17.4%. The portfolio life NPW = (−$19.86)
(see example worksheet).
Since the opportunity cost of capital is 15.6% > 12.0% MARR and
depending on the weighting of low-to-medium-to-high-risk categories, the
selected capital projects will increase the organization’s WMCC but, as indi-
cated by NPW analysis, will decrease the organization’s net worth. Organi-
zational management has identified high-value capital investments that will
increase common stock dividend return.
13.3 Rationing Capital by Net Present Worth 327
13.3 Rationing Capital by Net Present Worth
Rationing capital by rate of return addresses stockholders’ question of project port-

folio rate of return versus required common stock return rate. Rationing capital by
present worth addresses management’s question of projects portfolio current cash
flow value to the organization given limited budgets. However, investment project
alternative lives are usually unequal inhibiting comparable estimates of net present
worth. To overcome this deficiency, apply the continuing requirement of Chap. 7, and
set the common project life = capital budget planning horizon. Estimate the one-life
EUAW of each investment project alternative. Since each EUAW is the net of initial
cost, uniform annual benefits, and end-of-life salvage value, EUAW incorporates
receiving salvage value and repurchasing initial cost of alternative at the end of the
specified common project life. Then, set EUAW = A and estimate the present worth
of each alternative investment as P = A(P/A, MARR, project life). The budgeting
process for rationing capital by the net present worth is:
1. For each project accepted by the rate of return ranking, compute one-life EUAW
for each alternative investment project.
2. Set budget life = budgeting planning horizon.
3. Set EUAW = A and estimate P = A(P/A, MARR, budget life) for each
alternative.
4. Rank the alternatives in order of decreasing net present worth.
5. For a fixed capital budget, prioritize project value by decreasing ranked order
of NPW.
6. Since the weighted portfolio RoR > MARR, stockholder value has been maxi-
mized, the NPW ranking indicates the importance of each project to future cash
flows.
Example 13.2
For the capital budget of $1,250,000 in Example 13.1, allocate the capital
budget by net present worth using the organization’s MARR = 12.0%. The
capital budget planning horizon is 10 years.
Inputs: Analysis:
Budget $1,250,000 MARR 12.0% Project life 10 years
Project Cost (1k) After-tax CF (1k) Life (years) Salvage Value EUAW NPW Rank CumBudget RoR
1 $200.00 $47.70 10 $0.00 $12.30 $69.52 1 $200.00 20.0%
2 $400.00 $79.70 10 $0.00 $8.91 $50.32 2 $600.00 15.0%
3 $100.00 $38.20 4 $0.00 $5.28 $29.81 4 $1,150.00 19.4%
4 $200.00 $40.00 6 $125.00 -$24.05 ($135.88)
5 $100.00 $20.00 10 $100.00 -$3.40 ($19.19)
6 $300.00 $54.00 10 $150.00 -$7.64 ($43.18)
7 $600.00 $189.28 4 $50.00 -$18.72 ($105.79)
8 $450.00 $88.88 10 $100.00 $3.54 $19.99 3 $1,050.00 16.1%
9 $100.00 $19.25 10 $50.00 -$1.30 ($7.33)
Total $2,450.00 Portfolio NPW $169.65 Portfolio Wt RoR 16.7%
By rank of decreasing NPW, project importance to future cash flows is 1,

2, 8, and 3. The organization’s portfolio NPW = $169.65, increasing organi-
zational worth, and weighted RoR = 16.7% decreasing the return to common
stockholders by 0.7%.
Since allocation by NPW is based on estimating P = A(P/A, MARR, project

life) where A = EUAW for continuing requirement, the above process for capital
budgeting by NPW ranks the set of alternative investment projects by order of current
value to the firm. Conversely, ranking by RoR orders the projects within the allo-
cated capital budget fund by future value to stockholders. The selection of the order
of ranking by RoR or NPW depends on the organization’s strategic priorities of
maximizing growth in stock value or maximizing cash flows for operational stability.
13.4 Ranking Project Proposals
Examples 13.1 and 13.2 illustrate the fundamental issue in ordering the selected set of
investment project alternatives. Prioritizing the capital budget portfolio by RoR may
not maximize future cash flows. Conversely, prioritizing the capital budget portfolio
by NPW may not maximize portfolio future value to stockholders. In Example 13.2,
the opportunity cost RoR of the best-rejected investment project alternative under
the net present worth criterion was 20.0% for project 5, clearly much greater than
the 15.6% opportunity cost of project 6 under the RoR criterion in Example 13.1.
Lorie and Savage (1955) note that management must address three questions in
rationing capital among competing investment projects.
• Given the organization’s cost of capital (MARR), what combination of projects
should be selected to maximize discounted cash flows net present worth to the
organization. Recall that maximizing IRR may not maximize net present worth
of cash flows.
• Given a fixed sum for capital investment, what combination of investment projects
should be undertaken? This question has two parts. First, what criteria should
management apply to decide on the amount of the capital budget? Second, given
the allocated capital budget, what mix of investment projects maximize net present
worth under the budget constraint? Too small a capital budget may result in
rejecting the net present-worth maximizing investment portfolio for a collection
of suboptimal investment projects that fit within the budget constraint. Too large
a capital budget may result in accepting projects with low net present worth that
downwardly weight the portfolio’s net present worth.
• How to select the best combination of investment proposals among the mutually
exclusive alternatives? Given the constraint of an optimally sized capital budget,
how does management select the combination of projects that maximize portfolio
13.4 Ranking Project Proposals 329
net present worth? The order by which investment projects are admitted can result
in suboptimizing portfolio net present worth.
These problems with portfolio selection are illustrated by comparing the invest-
ment alternative projects selected under the net present worth criterion in Example
13.2 to those selected under the rate of return criterion in Example 13.1.
Lori and Savage recommend that the NPW maximizing allocation of capital funds
by the net present worth criterion is
N P W − p × P W |initial cost| = 0 (13.1)
where 0 < p < 1.0 is a constant to be determined and NPW is that estimated based
on each alternative’s useful life. Adjust p until the maximum number of investment
alternatives are selected with total capital cost ≤ capital budget funds. The final
portfolio of investment projects is the penalized maximum NPW of all possible
combinations of projects.
Lori and Savage’s p-constant approach will select the set of alternative invest-
ment projects that maximize the penalized capital budget portfolio NPW. Next, esti-
mating project alternative NPW from the continuing requirement EUAW estimate
for a common project life reflects actual continual capital budgeting in application.
Capital budgets are set for a life-cycle budgeting period and reviewed continually
for changes. All fixed assets in the existing life-cycle budget must have a positive
NPW or be capable of being replaced by assets that will have a positive NPW at the
current MARR. Selecting alternative projects based on Lori and Savage’s p-constant
approach assures selection of the set of projects that maximize the penalized NPW
over the life-cycle budget. Using the NPW-EUAW common project life estimate.
Example 13.3
For the capital budget of $1,250,000 in Example 13.2, perform sensitivity
analysis on the projects’ net present worth using the modified Lori and Savage
p-constant.
Inputs: Analysis:
Budget $1,250,000 MARR 12.0%
Project Cost (1k) After-tax CF (1k) Life (years) Salvage Value RoR EUAW NPW
1 $200.00 $47.70 10 $0.00 20.0% $12.30 $69.52
2 $400.00 $79.70 10 $0.00 15.0% $8.91 $50.32
3 $100.00 $38.20 4 $0.00 19.4% $5.28 $29.81
4 $200.00 $40.00 6 $125.00 15.8% -$24.05 ($135.88)
5 $100.00 $20.00 10 $100.00 20.0% -$3.40 ($19.19)
6 $300.00 $54.00 10 $150.00 15.6% -$7.64 ($43.18)
7 $600.00 $189.28 4 $50.00 12.5% -$18.72 ($105.79)
8 $450.00 $88.88 10 $100.00 16.1% $3.54 $19.99
9 $100.00 $19.25 10 $50.00 17.0% -$1.30 ($7.33)
Total $2,450.00 Portfolio NPW $169.65
Trial p
0 0.0733 Rank CumBudget RoR
$69.52 $84.18 1 $200.00 20.0%
$50.32 $79.64 2 $600.00 15.0%
$29.81 $37.14 4 $1,150.00 19.4%
($135.88) ($121.22)
($19.19) ($11.86)
($43.18) ($21.19)
($105.79) ($61.81)
$19.99 $52.98 3 $1,050.00 16.1%
($7.33) ($0.00) 5 $1,250.00 17.0%
Wt NPW $253.94 Portfolio Wt RoR 16.7%
Using Formula (13.1), p-constant = 0.0733 admits projects 1, 2, 8, 3, and 9

(by rank order of portfolio life NPW) with a penalized weighted portfolio life
NPW = $253.94 and a portfolio weighted RoR = 16.7% matching the RoR of
Example 13.2.
13.5 Summary
IRR = i project = i RiskFree + i RiskPremium
IRR = i project = (i RiskFree + i RiskPremium ) + f + (i RiskFree + i RiskPremium ) f
Rationing Capital by Rate of Return.

Rationing Capital by Net Present Worth.
Lori and Savage’s Penalized Net Present Worth.
N P W − p × P W |initial cost| = 0
13.6 Key Terms
Capital budgeting
Cutoff rate of return
Lori and Savage’s p-constant
Opportunity cost of capital
Rationing capital
13.6 Key Terms 331
Problems
1. Nine capital spending proposals have been submitted for management review
for the 10-year life-cycle budget. Management has initially budgeted $2,000,000
for the capital budget. Using the rate of return criteria, which projects should
be funded, and what is the opportunity cost of capital? What is the portfolio
weighted rate of return?
Project First cost Ann. benefit Salvage Life (yrs)

A $150,000 $44,300 $0 5
B $200,000 $61,750 $0 5
C $300,000 $98,750 $30,000 5
D $250,000 $62,600 $0 6
E $400,000 $119,350 $40,000 6
F $450,000 $115,500 $0 6
G $350,000 $67,950 $0 10
H $600,000 $126,900 $60,000 10
I $750,000 $140,600 $0 10
2. The firm in problem 1 requires MARR = 12.0% on investment alternatives.

Allocate the capital budget based on net present worth.
3. Allocate the capital budget in problem 1 using Lorie and Savage’s p-criterion.
Chapter 14
Benefit–Cost Ratio Analysis
Abstract The design, implementation, and management of major service systems

(agricultural, cybersecurity, energy, health care, information networks, infrastructure,
legal, military, public services, safety, etc., as distinguished from small business
services) with long lives (10-plus or 20-plus years) and associated intangible benefits
and costs are not amenable to singular economic criterion analysis requiring accurate
and precise cash flows. Often, the intangible costs and benefits of major systems are
not fully known. Major public sector service systems, however, are foundational in
that without their existence the private industrial and small business sectors would
not be economically viable. Hence, engineering managers need a broader criterion
that more completely accounts for the tangible and intangible benefits and costs of
major service systems.
14.1 Characteristics of Major Service Systems
The primary purpose of benefit–cost analysis is to determine the true full benefits
and costs (tangible and intangible) of major service systems projects. Knowledge
gained from benefit–cost analysis can then be utilized to:
• Identify and prioritize short- and long-term benefits.
• Identify and prioritize short- and long-term cost-saving opportunities.
• Identify governmental and public sources of long-term financing needed to
implement major service systems.
• Estimate the cash flows necessary to cover the true costs of designing, imple-
menting, and delivering service benefits.
• Price systemic service or product benefits (for paying beneficiaries) at a level that
covers the true costs of providing them.
https://doi.org/10.1007/978-3-030-87767-5_14
334 14 Benefit–Cost Ratio Analysis
• Report the true costs of systemic services when claiming government reimburse-
ments.
Knowing the true benefits and costs of a major systemic service program allows
determination of the amount of revenue needed from the system to support its long-
term existence and ensure that its service is not a net consumer of resources from the
organization.
Assessment of a major service system’s benefits alignment with organizational
mission is the first step toward understanding its true costs and contribution to the
organization’s mission and overall financial health. This understanding is instru-
mental to the:
• Effective allocation of financial and human resources.
• Prioritization of core service systems that must be protected especially in
economic downturns.
• Identification and elimination of peripheral and financially unhealthy systemic
services.
• Design of effective maintenance and long-term growth strategies.
• Continual improvement of the service system’s financial health and mission
alignment with the organization’s mission.
We can understand the characteristics of major service systems by contrasting their
service products with those of manufacturing. Compared to manufacturing products:
• Services are intangible in that, in general, they do not have a physical form.
• Services cannot be inventoried. Services exist only at the point and time of demand.
• Service quality requirements are more subjective than those of physical products.
• Services are more subject to and must be customized to the client’s preferences
at the time of demand. Hence, meeting demanded that service requirements incur
greater risk due to on-demand variability.
• Service quality requires collaboration between the server and client to formulate
and communicate service requirements at the time of demand.
• Due to variability in service quality requirements, service products cannot be
standardized and mass-produced.
• Given the subjectivity and variability of service quality requirements, service
processes are labor-intensive as compared to manufactured products.
• Communications and information systems are core to multiplying the human
component of service delivery.
14.2 Economic Evaluation of Services
The strategic issues that must be addressed in designing and delivering services are:
• Who is the client and what services are demanded by the client demand?
14.2 Economic Evaluation of Services 335
• What is our service capability and capacity to meet client demand? Capability is
the types of service expertise. Service expertise is fulfilled across three dimen-
sions; (1) responsiveness—promptness, helpfulness, and timely delivery of the
demanded service; (2) professionalism—knowledge and skills of the service
provider; and (3) attentiveness—caring and personalized attention in fulfilling
client service demand. Capacity is the number and amount of services that the
organization can delivery economically.
• Location of services? Does the client travel to the service location, or does the
service travel to the client location?
• Costs associated with providing and improving services?
14.3 Selecting the Appropriate Interest Rate
In the USA, as in many capitalist economies, public sector investment generally

involves some concept of promoting the general welfare. Some baseline of public
infrastructure, services, and security must be in place to support private sector capi-
talism. These require public sector investments. Benefit–cost ratio analysis is a
decision metric used by public organizations (governments, planning commissions,
highway commissions, airport and port authorities, school districts, etc.) to select the
best alternatives among major service systems investments. In public sector economic
analysis, it is not easy to determine benefits that promote the general welfare or the
forecast accuracy of projected benefits. Factors affecting public sector economic
analysis include:
• Purpose of the investment—provision of vital goods and services that are either
impossible for the private sector to supply efficiently or that require a natural
monopoly to achieve economies of scale.
• Viewpoint for the analysis—government analyst, citizens who benefit from an
investment, or citizens who are harmed by an investment.
• Financing sources—increased taxes, service fees, usage fees, earnings from the
sale of commodities, or public bonds.
• Project duration.
• Major service system life cycle.
• System service capability and capacity versus public demand.
• Economic effects of systemic service location.
• Long-term unintended consequences.
Generally, projected benefits must consider the interests of all parties involved
and unintended consequences and costs. The viewpoint of benefit–cost analysis influ-
ences or determines the final recommendation. To avoid suboptimization, the proper
approach is to take a viewpoint at least as broad as those who pay the costs and
those who receive the benefits.
Benefit–cost analysis has three primary objectives: (1) maximize an identified set
of benefits for a fixed cost, (2) maximize net benefits with benefits and costs vary, or
(3) minimize the cost to achieve a stated level of benefits. The project interest rate
affects the decision outcome for each objective. Several factors influence interest rate
selection in the public sector.
• No Time Value of Money—Taxes (the source of public finance) are, to some
extent, guaranteed future cash flows and can be spent immediately.
• Cost of Capital—Governments often borrow money or issue bonds to finance
projects. Interest on municipal bonds is free from federal taxes. The effective
interest rate is (bond rate)/(1—tax rate). General types of municipal bonds are:
– General obligation bonds—retired through taxes.
– Revenue bonds—retired through usage fees or other revenues generated by the
project.
Theoretically, there are two approaches to determining the appropriate interest
rate for public sector investments: (1) internal rate of return and (2) opportunity cost.
14.3.1 Public Sector Internal Rate of Return
In Sect. 6.5, the internal rate of return was specified as the interest rate at which the
equivalent benefits are equal to the equivalent costs.
PW(Benefits, i) = PW(Costs, i)
EUAB(i) = EUAC(i)
FW(Benefits, i) = FW(Costs, i)
For public sector projects, this definition becomes the interest rate at which the
equivalent net user benefits are equal to the life cycle cost of the investment to attain
the public asset.
PW(Net User Benefits, i) = PW(Net Life Cycle Costs, i) (14.1)
EUAB(i) = EUAC(i)
Net user benefits are the difference in the benefit and disbenefit cash flows given
public asset implementation. Disbenefits are the negative impacts and their resultant
effects on some individuals or groups resulting from public sector investments.
PW(Net User Benefits)

= (Benefit cash flows − Disbenefit cash flows)t (P/F, i, t) (14.2)
n
14.3 Selecting the Appropriate Interest Rate 337
where time t = −m, −m + 1, …, 0, 1, 2, …, n. Some examples of benefits and

disbenefits include:
• Interstate highway construction—Benefits include improved transportation effi-
ciency, reduced fuel costs, increased property values along the new route, and new
business opportunities along the new route. Disbenefits include loss of homes and
businesses to eminent domain along the new route, loss of business, and lower
property values along old highway routes.
• New hospital construction—Benefits include improved health care in the region
surrounding the hospital, new opportunities, and revenues for supporting medical
practices, and new business opportunities and revenues for supporting information
systems and medical supply services. Disbenefits include loss of existing homes
and businesses to the hospital site and loss of access to health care in older parts
of a city far away from the new hospital.
• Wind electricity generation—Benefits include increased electricity generation
efficiency resulting in lower cost per kilowatt hour, creating of new business
and employment opportunities, increased tax revenues for local governments,
and elimination of the long-term expenses associated with coal fly ash recycling
and containment. Disbenefits include high initial cost to install wind turbines,
loss of wildlife, decreased local property values resulting from noise and visual
pollution, and loss of coal mining jobs.
On the investment sponsor side of Eq. (14.2), net life cycle costs include annual
cash flow differences for the future worth of design, development, acquisition, and
installation of the public asset, lifetime annual operating and maintenance costs net
any revenues realized from the public asset.
PW(Asset) = FW(Asset costs) p (F/P, i, p)

+ PW(O&M costs − Revenues)t (P/F, i, t) (14.3)
n
where time p = −m, −m + 1, …, 0 and time t = 0, 1, 2, …, n asset lifetime.
14.3.2 Public Sector Opportunity Cost
The internal rate of return approach does not directly account for the opportunity
cost to government and taxpayers. In chapter three, opportunity cost was defined as

Government opportunity cost arises from having to select among long-term invest-
ments in differing public assets given available tax revenues. Investment on one set
of public assets often results in long-term delayed investment in other public assets
creating long-term disbenefits to public sectors.
Government opportunity cost—Interest rate is set at the financing rate for which
funding is not available. Problem: Differing governmental units will have different
opportunities and different interest rates which will lead to overall inconsistent
funding decisions.
Money for investment in public assets ultimately comes from taxpayers in the form
of taxes or fees. This is money that, otherwise, taxpayers could have invested in
alternate revenue generating assets.
Taxpayer opportunity cost—The government interest rate paid for public assets
should be at least that which taxpayers could have received on the taxes paid to
fund the asset.
The United States Office of Management and Budget Circular OMB A94, Section 8
Discount Rate Policy (1) Base Case Analysis specifies:
Constant dollar benefit–cost analyses of proposed investments and regulations should report
net present value and other outcomes determined using a real discount rate of 7 percent. This
rate approximates the marginal pre-tax rate of return on an average investment in the private
sector in recent years.
Given the stipulated 7% real interest rate and 2.5% average inflation rate in the
US economy from 1990 to 2018, this yields an approximate market interest rate iM
= 0.07 + 0.025 + (0.07)(0.025 = 0.097 or 9.7%. As a rule, select the larger of the
government opportunity cost or taxpayer opportunity cost as the interest rate for
funding public investments. If local taxpayers affected by investment in public sector
asset earn less than 9.7%, use the 9.7% interest rate. Conversely, if local taxpayers
can earn greater than the 9.7% interest rate, the higher taxpayer interest rate should
be used.
14.4 Cost-Effectiveness Analysis
Cost-effectiveness analysis (CEA) is applied when service benefits cannot be mone-

tized. As such, cost-effectiveness analysis is an alternative to benefit–cost analysis.
CEA compares the relative costs to the outcome benefits of two or more service
designs. CEA measures costs in a common monetary value and the effectiveness of a
service design in terms of common outcome benefit. As such, CEA is a comparison
tool. CEA will not always yield a unique decision. Rather, CEA provides relative
evaluation of service design options for a common service outcome benefit.
CEA distinguishes between service direct and indirect costs. Direct costs result
from the application of physical artifacts as part of service delivery (e.g., automobile
or truck in transportation, photographic equipment, drugs and medical equipment,
tables and chairs in cafeterias, etc.). Indirect costs are costs incurred by the client
14.4 Cost-Effectiveness Analysis 339
in seeking and acquiring the service. Intangibles are unintended consequences or

adverse effects as a result of the service (time or money lost due to delivery delays,
drug or medical side effects, food allergies, or incorrect food delivery).
The cost-effectiveness ratio is simply the sum of all service delivery costs divided
by the weighted sum of service benefits.

direct costs + indirect costs
CER = (14.4)
wi Bi

where wi = value placed on benefit Bi by the client and i wi = 1.0. Hence, a
service benefit is the inner product of weighted benefit outcomes. As an example,
one medical patient may value a reduction in pain over increased mobility where
another patient may desire an equivalent reduction to increased mobility.
In service design, CERs can only be ranked relative to each other. CERs must
be related in some manner to service budgets to determine the most cost-effective
package of service delivery. Since CERs are not commensurable, their direct and
indirect costs cannot be added for a selected set of services (i.e., additivity assumes
independent services; overlap intersections among services prohibit additivity).
Accordingly, development of major system services requires managerial expertise,
experience, and judgment within the given service sector.
14.5 Cost-Utility Analysis
Cost-utility analysis is used in health care to compare the cost of alternative interven-
tions versus their respective outcomes. Cost-utility analysis estimates the incremental
cost-effectiveness ratio (ICER). ICER is calculated as the difference in the expected
cost of two proposed interventions, divided by the difference in the interventions’
estimated quality-adjusted life years (QALYs). QALYs measure healthcare inter-
vention outcomes as a combination of the duration and health-related quality of life.
ICER estimates are compared with a threshold ICER. Intervention ICER < threshold
ICER is funded. ICER comparisons indicate which is the best of identified alternative
interventions given the intervention costs. ICER comparisons may not be commensu-
rable across different healthcare areas, because (1) different currencies may be used
in measuring intervention outcomes and (2) QALY measures may be sensitive to the
quality-of-life dimension. The usefulness of cost-utility analysis is related to QALY
measures. The more accurate that a QALY measurement captures the social values of
quality of life associated with interventions, the more useful the cost-utility analysis.
Given this limitation, cost-utility analysis is an insufficient basis for deciding among
alternative intervention projects.
14.6 Benefit–Cost Ratio Analysis
Dividing both sides of Eq. (14.1) by PW(Net Life Cycle Costs, i), the worthiness of
a public investment can be expressed as the benefit–cost ratio
B PW( Net User Benefits, i) EUAB(i)

= = (14.5)
C PW( Net Life Cycle Costs, i) EUAC(i)
Equation (14.5) implies that public sector investments with B/C ≥ 1.0 should be
accepted and those with B/C < 1.0 should be rejected. Equation (14.5) is termed the
conventional B/Cratio. The conventional B/C ratio may also be expressed as
B PW(Net User Benefits, i)

= (14.6)
C PW(Initial Costs, i) + PW(Net O&M Costs, i)
The conventional B/C ratio compares the benefits to users in the numerator and
cost to the public sector agency in the denominator. Economics researchers recognize
that taxpayers and users pay the annual net operating and maintenance expenses,
rather than the sponsoring public sector agency. They argue that the PW(Net O&M
Costs, i) should be subtracted from the B/C numerator and denominator to reflect the
life cycle net worth to taxpayers and users in the numerator. This yields the modified
B/Cratio.
B PW(Net User Benefits, i) − PW(Net O&M Costs, i)
Mod = (14.7)
C PW(Initial Costs, i)
Conventional B/C ratio estimates do not equal the modified B/C ratio estimates,
but both estimates yield the same investment decisions.
Example 14.1
City council had requested its city engineering manager to perform benefit–
cost analysis for construction of a new interstate interchange and widening
of a 2-lane road to 4 lanes with exits for a proposed outlet shopping mall.
Federal funding of 50% will be required for the new interstate interchange.
Construction costs and employment to the city’s citizens and tax benefits to
the city are stated below. A conservative interest rate of 10% will be used to be
just greater than the OMB A94’s 9.7% interest rate accounting for an expected
2.5% inflation rate over the expected 30-year life before the interchange and
road will require replacement
Costs.
Land Acquisition: $5,000,000 year − 1
14.6 Benefit–Cost Ratio Analysis 341
Interstate Construction Cost: $3,600,000 year − 1

$3,600,000 year 0
Annual Maintenance: $ 156, 000/year
Road Expansion
Construction Cost: $2,600,000 year 0
Entrance Traffic Light: $ 250,000 year 0
Annual Maintenance: $ 65,000/year
Benefits Per Year
After-Tax Wages 100 Employees: $3,375,000
Sales Tax Revenues to City: $1,687,500
Future worth of land acquisition and construction costs.

Land acquisition:
FW = $5,000,000 (F/P, 10%, 2)

= $5,000,000 (1.210) = $6,050,000
Interstate interchange construction:
FW = $3,600,000 (F/P, 10%, 2) + $3,600,000 (F/P, 10%, 1)

FW = $3,600,000 (1.210) + $3,600,000 (1.100) = $8,316,000
Road expansion:
FW = $2,600,000 (F/P, 10%, 1) = $2,600,000 (1.100) = $2,860,000
Traffic light:
FW = $250,000 (F/P, 10%, 1) = $250,000 (1.100) = $275,000
Present worth estimates.

Wages and tax revenues
PW = $3,375,000 (P/A, 10%, 30) + $1,687,500 (P/A, 10%, 30)

PW = $3,375,000 (9.427) + $1,687,500 (9.427) = $47,724,188
Annual maintenance costs
PW = $156, 000 (P/A, 10%, 30) + $65, 000 (P/A, 10%, 30)
PW = $156, 000 (9.427) + $65,000 (9.427) = $2,083,367

Conventional B/C ratio = $47,724,188/ $17, 501, 000 + $2, 083, 367
= 2.437

Modified B/C ratio = $47,724,188 − $2, 083,367 /$17,501,000
= 2.608
14.7 Incremental Benefit–Cost Ratio Analysis
Chapter 10 applied incremental analysis to maximize the net present worth of the best
alternative selected from multiple mutually exclusive alternative investments. Simi-
larly, when using the B/C criteria to select from among multiple mutually exclusive
alternatives, the incremental method should be applied. The process for incremental
B/C (B/C) analysis is:
1. Identify all relevant alternatives.
2. Calculate the B/C ratio of each competing alternative in the set. Eliminate
individual alternatives with B/C ratio < 1.0.
3. Rank order the projects by increasing denominator cost. The “do-nothing”
alternative is always the first on the ordered list.
4. Identify the increment of pairwise projects under consideration.
5. Calculate the B/C ratio on the incremental cash flows.
6. Select the next higher cost project if B/C > 1.0.
7. Iterate steps 4 through 6 until all pairwise comparisons have been considered.
8. Select the highest cost project that has B/C > 1.0.
Incremental B/C analysis can be applied with the conventional and modified B/C
ratio criteria. The two methods should not be mixed in the same selection problem.
14.7 Incremental Benefit–Cost Ratio Analysis 343
Example 14.2
The City of Coastal California is considering installation of two wind turbine
electricity generators to supply its residents electricity needs and minimize the
potential for wildfires due to sparks from California Power and Light high-
power lines into the city. Four commercial wind turbine manufacturers have
submitted the following bids for installation of the wind turbines, power substa-
tion, and reconnection of existing underground power lines to the substation.
The city engineering has submitted the following cost and benefit estimates
to city council for review. The project life is 50 years, and the city uses the
interest rate of 10% as an approximation of the OMB A94’s 9.7% interest rate.
Perform conventional incremental B/C analysis.
Alternatives (×$1000)
Project costs Do nothing A B C D
Installation $0 (−$25,000) (−$16,250) (−$19,000) (−$27,500)
Annual O&M costs $0 (−$240) (−$709) (−$500) (−$237)
Project benefits
Ann utility savings $0 $1200 $1034 $1444 $2128
Overcapacity rev $0 $1,400 $813 $304 $659
Annual jobs created $0 $800 $1,100 $228 $818
Alternatives
Project Costs Do Nothing A B C D
Turbine/substation installation $0 $25,000 $16,250 $19,000 $27,500
Annual O & M expenses $0 $240 $709 $500 $237
PW Costs $0 $27,380 $23,280 $23,957 $29,850
Project Benefits
Annual Savings Utilities Payments $0 $1,200 $1,034 $1,444 $2,128
Revenue from Overcapacity $0 $1,400 $813 $304 $659
Annual Effect on Jobs Created $0 $800 $1,100 $228 $818
PW Benefits $0 $33,710 $29,214 $19,592 $35,743
Project B/C 0.00 1.23 1.25 0.82 1.20

B - DN A-B D-A
$16,250 $8,750 $2,500
$709 ($469) ($3)
$23,280 $4,100 $2,470
$1,034 $166 $928

$813 $588 ($741)
$1,100 ($300) $18
$29,214 $4,496 $2,033
1.25 1.10 0.82

Select B A A
Commercial wind turbine manufacturer C is eliminated from consideration

since its B/C ratio = 0.82 < 1.0. From incremental B/C ratio analysis, select
commercial wind turbine manufacturer A.
Example 14.3
Reconsider the wind turbine electricity generator supplier selection in Example
14.2. This time, use the modified incremental B/C analysis.
Alternatives
Project Costs Do Nothing A B C D
Plant Construction $0 $25,000 $16,250 $19,000 $27,500
Project Benefits
Annual Savings Utilities Payments $0 $1,200 $1,034 $1,444 $2,128
Revenue from Overcapacity $0 $1,400 $813 $304 $659
Annual Effect on Jobs Created $0 $800 $1,100 $228 $818
Annual O & M $0 ($240) ($709) ($500) ($237)
PW Benefits $0 $31,331 $22,184 $14,634 $33,393
Project B/C 0.00 1.25 1.37 0.77 1.21

14.7 Incremental Benefit–Cost Ratio Analysis 345
B - DN A-B D-A
$16,250 $8,750 $2,500
$1,034 $166 $928

$813 $588 ($741)
$1,100 ($300) $18
($709) $469 $3
$36,244 $9,146 $2,003
2.23 1.05 0.80

Select B A A
Commercial wind turbine manufacturer C is eliminated from consideration

since its modified B/C ratio = 0.77 < 1.0. The same pairwise comparison result
is: B—do nothing, A–B, and D–A. From incremental B/C ratio analysis,
select commercial wind turbine manufacturer A.
14.8 Factors Affecting Benefit–Cost Ratio Analysis

Decisions
Four other factors affect public sector investment B/C ratio estimates and alterna-
tive selection: investment financing, investment life cycle, quantifying benefits and
disbenefits, and public sector politics and policies.
14.8.1 Public Sector Investment Financing
The primary sources of public sector financing are taxes or municipal bonds. Govern-
ments (federal, state, and local) tend to spend tax revenues on immediate service
needs. As an example, in its 2019 fiscal year the US federal government took in
approximately $3.5 trillion in taxes from corporations and individuals.
Individual income taxes $1.700 trillion

Payroll taxes $1.200
Corporate income taxes $0.230
Excise taxes $0.099
Other sources $0.271
Total revenue $3.500 trillion
For the same fiscal year, the US federal government incurred about $4.4 trillion
in expenses.
Social security $1.000 trillion

National defense $0.676
Non-defense $0.661
Medicare $0.644
Medicaid $0.409
Interest on debt $0.375
Other expenses $0.642
Total expenses $4.407 trillion
Since 49 of the 50 states have balanced budget provisions, states tend to spend their
tax revenues on immediate service needs. Although state budgets vary, the average
state expenses are as follows:
K-12 education 26%

Medicaid & children’s health 17%
Higher education 15%
Transportation 6%
Corrections 5%
Public assistance 1%
All other 30%
Further, to prevent excessive borrowing and assure repayment, the US government

restricts local governmental debt financing.
• Local governments’ borrowing is restricted to a specified percentage of assessed
property value in the taxation district.
• Borrowed funds through the sale of bonds for new construction require local voter
approval (sometimes by 2/3 majority).
• Public debt repayment must be made in a preset period in accordance with a
specific plan.
Hence, governments must borrow money for large-scale public investments,
which means that most public infrastructure and service projects are 100% financed
with bonds.
14.8.2 Public Sector Investment Life Cycle
Public sector investment life cycles are longer than those in the private sector. Private
sector investments are tied to the finite planning horizon life cycle budget of three
14.8 Factors Affecting Benefit–Cost Ratio Analysis Decisions 347
to ten or twelve years and long-term business-cycle budget of two or three life
cycle budgets. Public sector investments tend to have 20- to 50-year life cycles and
corresponding budget horizon. The investments, likewise, have longer lives with
some that could be considered as permanent investment of infinite lives.
Unlike private sector investments (Fig. 1.5), public sector investments require
substantial funding in the needs assessment, conceptual design, and detailed design
phases of the product life cycle. Hence, it is advantageous to advocates of public
sector projects to spread initial costs of investment into the latter part of the conceptual
design phase or into the detailed design phase. Doing so reduces PW0 = FW(initial
costs, i) in the denominator of Eq. (14.5) increasing the resultant B/C ratio. Likewise,
if advocates can secure interest rates less than the OMB A94 7.0% real interest rate
in the early life cycle phases, PW0 = FW(initial costs, i) in the denominator of
Eq. (14.5) will be reduced, increasing the resultant B/C ratio.
14.8.3 Quantifying Benefits and Disbenefits
Public sector benefits and disbenefits tend to be difficult to quantify, and resultant
estimates will tend to exhibit large variances. As examples, in a flood control project,
what is the value of a lost human life? In a K-12 school investment, what is the
differential value to students in investing in a regular classroom or a computerized,
media-enabled, advanced classroom? In investing in a new airport addition or runway,
how accurately and precisely can benefit cash flows be estimated 50 years into the
future versus the accuracy and precision of current disbenefit cash flows? Hence, it is
advantageous to advocates of public sector investments to inflate early benefit cash
flows and deflate later benefit cash flows to offset current disbenefit cash flows.
14.8.4 Public Sector Politics and Policies
Politics affect all public sector investments, because these investments are large scale
affecting a large proportion of citizens and have the potential to affect supporting
private sector industries. Politics put further pressure on advocates to modify the
timing and amount (discussed above) of benefit and cost cash flows and using lower
interest rates in the early life cycle phases to yield a higher B/C ratio favoring the
investment. Further, the lengthy and complex processes required for many public
sector investments are vulnerable to political bias to favor public sector investments
at each budgeting step. As an example, the federal budgeting process for public sector
investments consists of the following major steps.
• Managers develop requirements.

– “Funded” requirements—within existing budgets.
– “Unfunded” requirements—more funds required.
• Managers submit requirements to program managers.
• Programs prioritize requirements by B/C.
• Subprograms submit to higher programs—often many steps here.
• At each step, requirements are prioritized, and program budgets are adjusted.
• The president receives all budgets and applies a final prioritization.
• Federal government sets tax rates and funding rates.
• Spent by the executive branch.
• Set by federal law:
– The president submits a budget proposal.
– Congress passes budget/appropriations bills.
– President signs or vetoes.
– Congress can override a veto.
– Highly political process.
• Federal Reserve Bank sets interest rates.
• Specific funds appropriated for specific purposes.
• Each funding type can only be used in certain ways.
• Appropriated funds.
– Research, development, testing, and evaluation.
– Procurement.
– Operations and maintenance.
– Construction.
– Military salaries/compensation.
• Non-appropriated funds.
– Agencies charge fees for services—largest: US Postal Service.
– Working capital managed and reported.
Allocated federal funds are tightly tied to the federal fiscal year.
• October 1 to September 30.
• Funds must be at least obligated (on contract) before the end of the fiscal year.
• Expired funds are “lost” to the program and go back to the general fund. Hence,
there is pressure to spend allocated funds.
Some categories of allocated funds can be extended into later years.
• Operations and maintenance—1 year only.
• RDT&E—2 years.
• Procurement—3 years.
14.8 Factors Affecting Benefit–Cost Ratio Analysis Decisions 349
• Ship construction—5 years.

• Building construction—5 years.
At some point in the budgeting cycle, there is pressure to spend allocated funds
or lose them.
14.9 Summary
Optimal budgeting in the public sector requires public employees to take a viewpoint
at least as broad as those who pay the costs and those who receive the benefits.
PW(Asset) = FW(Asset costs) p (F/P, i, p)

+ PW(O&M costs − Revenues)t (P/F, i, t)
n
Conventional B/C ratio:

B PW(Net User Benefits, i)
=
C PW(Initial Costs, i) + PW(Net O&M Costs, i)
Modified B/C ratio:

B PW(Net User Benefits, i) − PW(Net O&M Costs, i)
Mod =
C PW(Initial Costs, i)
Incremental B/C(B/C) ratio.
14.10 Key Terms
Benefits
Benefit–cost ratio analysis
Conventional B/C ratio
Cost-effectiveness analysis
Cost-utility analysis
Disbenefits
Government opportunity cost
Incremental B/C ratio analysis
Modified B/C ratio analysis
Net benefits to users
Public sector investment life cycle
Public sector investment financing
Politics
Revenue bonds
Taxpayer opportunity cost
User fees.
Problems
1. Calculate the conventional and modified benefit–cost ratios for the following
project.
Category Cash flow

Initial cost $1,875,000
Annual benefits to users $625,000
Annual disbenefits to users $43,750
Annual government maintenance cost $225,000
Project life 50
Government interest rate 5.0%
2. A city’s water treatment department has a budget of $1,080,000 for projects to

improve its treatment and distribution operations. The following improvement
projects have been proposed.
Project Initial cost Annual benefit Salvage value Life

A $180,000 $63,000 $10,000 5
B $360,000 $91,450 $60,000 10
C $450,000 $168,650 $2,000 5
D $360,000 $91,250 $12,000 8
E $180,000 $37,600 $0 12
(a) What is the city’s opportunity cost of capital? Based on the opportunity cost
of capital, which projects should be recommended?
(b) If the city uses market rate of 9.7%, which projects are recommended using
the conventional B/C ratio?
Using the B/C criteria, which alternative is preferred?
3. The regional electric cooperative needs additional electricity capacity. REC is
committed to changing to clean energy sources to reduce its long-term costs and
liability for coal fly ash storage and containment. REC’s engineering manager
has selected two plans for general management consideration. REC’s interest
rate is 5.0%, and this project has a 40-year life.
14.10 Key Terms 351
Solar cell Wind turbine

Initial cost $5,320,000 $2,660,000
10th year cost $0 $380,000
O&M, replace/year $95,000 $47,500
Avg annual pwr cost
First 10 years $0 $47,500
Next 30 years $0 $190,000
4. Evaluate the three mutually exclusive alternatives in the following table with a
25-year project life and MARR = 12.0%. Use (a) conventional B/C ratio, (b)
modified B/C ratio, and (c) net present worth.
Cash flow A B C
Initial cost $15,000 $22,200 $26,400
Annual savings $3840 $6000 $11,750
Annual costs $1200 $3300 $7680
Salvage value $7200 $5040 $16,800
Chapter 15
Introduction to Management Economic
Decision Theory and Risk Analysis
Abstract Except for the introductory discussion of risk–return fundamentals in

Sect. 12.1, discounted cash flow analyses have assumed that estimates of future
cash flows are known with certainty. This is never the case in applied engineering
economic analyses. Macroeconomic, business economic, and organizational internal
variables induce structural and random variation in future cash flow outcomes. Hence,
it is essential that the engineering manager accounts for the riskiness of structural
and random variation in future cash flow estimates and report probabilities of not
achieving required returns on organizational investments.
15.1 Elements of Engineering Managerial Economic

Decisions
Selecting the best from among competing investment alternatives is hard due to
variability in future cash flows resulting from variances in macroeconomic, busi-
ness economic, and organizational internal variables. Variances in macroeconomic
variables drive short- and long-term risk of loss. International macroeconomic vari-
ables include political, social, and economic instability, trade imbalances, trade wars,
currency instability, government regulations, and pandemics. Business economic
risk variables include changes in consumer preferences or demand, competitive per-
unit costs and price, interest rates, technology, and availability of raw materials,
components, and suppliers. Organizational internal variables include management
capability and tolerance for risk, engineering and technological capability, organi-
zational capability and knowledge, cash flows from existing products and services,
and time horizon for required returns on investment. The joint effects of variances
in macroeconomic, business economic, and organizational internal variables can be
summarized into four basic sources of decision-making difficulty.
https://doi.org/10.1007/978-3-030-87767-5_15
354 15 Introduction to Management Economic Decision Theory …
• Complexity due to interacting variances in driving variables. Given just the

macroeconomic, business economic, and organizational internal variables listed
above, there are 33,554,432 combinations of statistically significant main effect
variances plus 5.62949E+14 possible two-way interactions. Essentially, there is a
countably infinite number of variable interactions that can (and do) affect future
cash flows.
• Inherent risk in predictor variable variances. The magnitude and timing of
predictor variable future variances can never be known with certainty.
• Whether an organization is working toward a single objective or toward multiple
objectives. As previously noted in Chap. 13 on capital budgeting, an organization
can seek to maximize the present worth of future cash flows, to maximize the rate
of return to investors, or to maximize some weighted combination of the two in
mixed investment portfolios.
• Competing management perspectives of investment objectives may lead to
different future cash flow estimates and different investment decisions. Even
if a single management perspective dominates, small changes in the variances
of certain predictor variables may lead to changes in the relative ordering of
investment criterion or weighted criteria and different investment decisions.
Figure 15.1 sets forth a general engineering managerial economic investment
decision analysis process.
The most important and difficult step in the economic investment decision anal-
ysis process is the problem statement. To the degree that the problem statement is
Fig. 15.1 General economic investment decision analysis process

15.1 Elements of Engineering Managerial Economic Decisions 355
misaligned with the asset requirements and investment objectives, the asset perfor-
mance and investment outcomes will be misaligned with desired results. Stated
conversely, a decision outcome’s quality is limited to the degree that the invest-
ment problem statement yields a model that approximates required asset physical
and economic performance. Why a model? Resultant detailed asset design is only a
model (mathematical and graphical representation). Discounted cash flow equations
are likewise only mathematical models. It is only when a decision-maker selects an
investment alternative, physically implements it, and realizes actual life cycle cash
flows that the decision-maker can assess model quality in terms of variances from
designed physical and economic performance.
In the problem statement step, the asset problem must be decomposed and assessed
separately from the investment problem, but their interactive effects on each other
must be incorporated into the requirements, objectives, and criteria. Asset and invest-
ment decomposition allow the engineering manager to identify optimal asset perfor-
mance design and optimal discounted cash flows. Assessment of the interactive
effects requires the engineering manager to recognize cash flow constraints imposed
on asset performance variances from optimum and asset performance constraints
imposed on cash flows from optimum. These constraint differences become the
inputs to model variances in the second phase of the economic decision analysis
process.
In phase two, the engineering manager must consider additional constraints
imposed on asset performance and economics by organizational constraints (capac-
ities, capabilities, technologies, and social dynamics), production environment
constraints, end-use environmental constraints, and projected macroeconomic and
business economic constraints over the asset’s life cycle. These impose additional
variances from optimum performance and cash flow outcomes.
In phase three, the engineering manager uses the knowledge gained to develop
mathematical and graphical models of asset performance and cash flow. The models
must reflect realistic asset performance and cash flows within identified constraints.
The models may be assessed through sensitivity analyses to determine the ranges
over which the best asset performance and cash flows hold, or constraint variances
assessed through simulations to develop performance risk profiles and economic risk
profiles. The asset design or alternative that in some sense optimizes performance or
economic criteria relative to risk is selected as the best investment.
15.2 Probability and Statistics Concepts for Management

Economic Decisions
To assess economic risk (we will forgo performance risk assessment because that
is a development and design engineering task beyond the scope of this discussion),
we need some fundamental probability and statistics concepts. Parametric statistical
models partition structure from error. Structure is measured by some metric of central
location, and error is measured by the variance of outcomes around the central loca-
tion. Some additional statistical metrics measure the shape and sharpness of the peak
of the distribution around the central location.
Fundamental Probability Theory

Estimates of probabilities are the foundation of statistical analyses. All probabilities
must exhibit three properties.
Definition: Probability is a set function P(x ∈ A) or f (x ∈ A) that assigns to each

event x ∈ A in the sample space S a number P(x ∈ A) = a or f (x ∈ A) = a, called
the probability of event A, such that the following properties are satisfied:
Discrete distributions
= A) ≥ 0.
Property 1: P(x
Property 2: P S = A + A = 1.0
Property 3: If A1 , A2 , …, An are events Ai ∩ Aj = ∅, then
P(A1 ∪ A2 ∪ · · · ∪ An ) = P(A1 ) + P(A2 ) + · · · + P(An )
Continuous distributions
Property 1: f (X = A) > 0, A ∈ .
Property 2: f (X )dx = 1.0
Property 3: The probability of event X ∈ A is P(X ∈ A) = A f (x)dx
Probability Theorems

P(A) = 1 − P A
P(∅) = 0
For each event A, P(A) ≤ 1.0

If A and B are any two events, P(A ∪ B) = P(A) + P(B)−P(A ∩ B).
Note: If A ∩ B = ∅, P(A ∪ B) = P(A) + P(B)
If any two events A and B are independent, P(A ∩ B) = P(A) × P(B).
Conditional Probabilities
Suppose you are interested in the probability of event B given that event A also
occurs. Then,
P(B ∩ A)
P(B|A) =
P(A)
Independence—Events B and A are independent if and only if P(B|A) = P(B).

Conditional independence—Events B and A are conditionally independent if and
only if
15.2 Probability and Statistics Concepts for Management … 357
P(B|A, C) = P( A|B)P(B)
Because of the symmetry of the definition of conditional probability,
P(B|A)P( A) = P( A|B)P(B)
from which Bayes theorem can be derived.
P(A|B)P(B)
P(B|A) = .
P( A)
Expanding P(A) with the formula for total probabilities,
P(A|B)P(B)
P(B|A) =
P(A|B)P(B) + P A|B P B
Discrete Probability Distributions

When estimating proportions of individuals falling into one of two categories
(i.e., pass–fail, male–female, citizen–non-citizen, etc.) or estimating counts per unit
(customers per capita, defects per unit, species per square kilometer, etc.), we apply
probability theory to discrete units. Since X is a countable event, it is termed a
random variable.
Definition: A random variable X is a numerical function specified over some
sample space S that can take on only a countable number of values in S.
The probabilities of P(X = x) are termed a probability mass function (pmf) because
the probabilities are associated with point values.
The mean and variance are required to specify the location and spread of any
probability distribution.
Definition: Let X be a discrete random variable with probability distribution
function P(X = x). The mean or expected value of X is

μ = E[X ] = xi P(xi ) (15.1)
N
where N = number of individuals in the population. In cases where all individuals of

a population cannot be enumerated, the population mean is estimated from a random
sample by the sample mean.

xi
x= n
(15.2)
n

function P(X = x). The variance of X is

σ 2 = V [X ] = (xi − μ)2 P(xi ) (15.3)
N
where N = number of individuals in the population. In cases where all individuals

of a population cannot be enumerated, the population variance is estimated from a
random sample by the sample variance

− x)2
n (x i
s =
2
(15.4)
n−1
where n − 1 adjusts for the loss of 1 degree of freedom using x-bar to estimate
the population mean μ, because E[x-bar] = μ. The standard deviation of a random
variable is defined as
√
s = s2 (15.5)
The Bernoulli distribution is the most basic of the discrete distributions. A

Bernoulli random variable is defined as the dichotomous of a trial where X = 1
if a success occurs and X = 0 if a failure occurs. The Bernoulli pmf distribution is
p(x = 0, 1) = p x (1 − p)x (15.6)
Characteristics of a Bernoulli random variable are:

• The trial results in one of two mutually exclusive outcomes.
• The outcomes are exhaustive.
• The probabilities of the outcomes are assigned P(X = 1) = p and P(X = 0) =
1− p, 0 < p ≤ 1.
The mean and variance of a Bernoulli random variable are
E[X ] = p
σ 2 = p(1 − p)
The sum of a sequence of Bernoulli trials results in the random variable being
binomially distributed. The binomial pmf distribution is

n
P(X = x) = p x (1 − p)n−x (15.7)
x
n
where x
= combination of x out of n. Characteristics of a binomial random variable
are:
• Each trial consists of identical Bernoulli random variables.
• P(X = 1) = p remains constant from trial to trial.
• Each trail is independent.
• The binominal random variable X = 1 is the number of successes in n trials.
The mean and variance of a binomial random variable are
E[X ] = np
σ 2 = np(1 − p)
Example 15.1
A quality engineer at Vapor Phase Products, Inc., is investigating impurities
in the last two 100-batch runs of 5-L reactants. In the first 100-batch run, 5
batches were found contaminated. In the last two 100-batch runs, 2 batches
and 5 batches, respectively, were found contaminated. Estimate the probability
distribution of batch contamination.
Each batch may be classified as not contaminated, 0, or contaminated, 1.
Such 0–1 classification arises from a Bernoulli process, where 0 < p < 1 is the
expected proportion of units contaminated and n is the number of units in the
sample. For this case, the best estimate of the proportion of units contaminated
per 100-batch run is p = (5 + 2 + 5)/(100 + 100 + 100) = 0.04.
Since this is continuous process producing a sequence of 100-batch runs,
the distribution of contaminated batches X per 100-batch run is the sum of a
Bernoulli process resulting in a binomial pmf. Letting n = 100, the resultant
distribution-contaminated batches per 100-batch run are
x P(x) CumP(x)
0 0.01687 0.01687
1 0.07029 0.08716
2 0.14498 0.023214
3 0.19773 0.042948
4 0.19939 0.62886
(continued)
(continued)
x P(x) CumP(x)
5 0.15951 0.78837
6 0.10523 0.89361
7 0.05888 0.65249
8 0.02852 0.98101
9 0.01215 0.99316
10 0.00161 0.99776
11 0.00157 0.99933
12 0.00049 0.99982
The mean and variance of the contamination rate are
E[X ] = 4.0
V [X ] = 3.84
A contamination rate of just 0.04, or 4.0%, represents a threat to the reactant

product’s profit margin, because only 0.01687, or approximately one 100-batch
run out of 100 100-batch runs, will yield zero lost batches due to contamination.
If we set λ = E[X] = np, hold λ constant as n → ∞ as p → 0, and perform some

algebraic manipulations, we can derive the Poisson distribution. The Poisson pmf
distribution is
λx eλ−
P(X = x) = . (15.8)
x!
Characteristics of Poisson random variable are:
• In each trial, count the number of times a particular event X occurs over a σ 2 =
E[X ] = constant unit area, volume, weight, or any unit of measure.
• The probability that a number of events X in any unit area remain constant across
all unit areas sampled.
• The number of events X that occur in one unit area is independent of the number
that occurs in all other unit areas sampled.
The mean and variance of a Poisson random variable are
E[X ] = λ
σ2 = λ
Example 15.2
The Environmental Protection Agency (EPA) limits ethylene oxide emissions
to 10 ppm after sterilization. Suppose that the safety engineer sampling for the
last fiscal month of operation indicated an average of 4 ppm. If the ppm random
variable follows a Poisson distribution, (a) what is the standard deviation in
ppm and (b) what is the probability that an air sample will exceed 10 ppm?
Since the standard deviation is the square root of the variance and for this
Poisson random variable E[X] = σ 2 = λ = 4, the estimated standard deviation
is 2.
The Poisson pmf for λ = 4 is
x P(x) CumP(x)
0 0.01832 0.01832
1 0.07326 0.09158
2 0.14653 0.23810
3 0.19537 0.43347
4 0.19537 0.62884
5 0.15629 0.78513
6 0.10420 0.88933
7 0.05954 0.94887
8 0.02977 0.97864
(continued)
(continued)
x P(x) CumP(x)
9 0.01323 0.99187
10 0.00529 0.99716
11 0.00192 0.99908
12 0.00064 0.99973
13 0.00020 0.99992
14 0.00006 0.99998
15 0.00002 1.00000
With λ = 4, the probability that an air sample will exceed 10 ppm is P(X >
10) = 1 − P(X ≤ 10) = 1 − 0.99716 = 0.00284 or approximately 0.3%.
Continuous Probability Distributions

When a random variable can be measured on the real line, it is termed a continuous
random variable.
Definition: A continuous random variable X has the following properties.

• X takes on an uncountable infinite number of values in the interval (−∞, ∞).
• The cumulative distribution function F(X) is continuous.
• The P(X = x) = 0.
Definition: The cumulative distribution function F(x) for a random variable X is

equal to the probability
F(x) = P(X ≤ x), −∞ < x < ∞ (15.9)

Definition: If F(x) is the cumulative distribution function for a continuous random

variable X, then the density function f (x) for X is
dF(x)
f (x) = (15.10)
dx
The mean and variance of a continuous random variable are defined as follows.
Definition: Let X be a continuous random variable with density function f (x).

Then, the expected value or mean of X is
∞
μ = E[X ] = ∫ x f (x)dx (15.11)
−∞
Definition: Let X be a continuous random variable with E[X] = μ. Then, the

variance of X is
∞
σ 2 = ∫ (x − μ)2 f (x)dx (15.12)
−∞
The sample mean and variance of a continuous random variable are estimated the
same as in Eqs. (15.2) and (15.4).
Suppose a number X is randomly selected from a population such that X is a point
in the interval a ≤ X ≤ b. The density function of X is the uniform distribution
shown in Fig. 15.2.
The uniform distribution probability density function (pdf) is
1
f (x) = , a≤x ≤b
b−a
f (x) = 0 elsewhere (15.13)
Fig. 15.2 Uniform density

function
Each a ≤ X = x ≤ b has an equal probability of occurrence for the contin-

uous uniform distribution. Accordingly, the continuous uniform distribution is an
important reference distribution. It is most widely used in the generation of random
numbers in the uniform interval (0, 1). The mean and variance of the continuous
uniform distribution are
a+b
E[X ] =
2
(b − a)2
σ2 =
12
The triangular distribution is a second important reference distribution in
statistical modeling. Forms of the triangular density function are illustrated in
Fig. 15.3.
The triangular distribution probability density function (pdf) is
(x − a)2
f (x) = ,a ≤ x ≤ c (15.14)
(b − a)(c − a)
(b − x)2
f (x) = 1 − ,c ≤ x ≤ b
(b − a)(b − c)
The triangular distribution is used to model population distributions for which

there is only limited sample data or where the distributional form of a variable is
known but data is insufficient to fit a model. The standard triangular distribution
corresponds to a = 0, b = 1 with median SQRT(c/2) for c ≤ 1/2 and 1 − SQRT((1
− c)/2) for c ≥ 1/2. The mean and variance of the triangular distribution are
a+b+c
E[X ] =
3
Fig. 15.3 Triangular density

function
a 2 + b2 + c2 − ab − ac − bc
σ2 =
18
Perhaps, the normal distribution is the most widely applied of all continuous distri-
butions. The normal (Gaussian) density function describes the relative frequency
distribution of errors arising from additive processes. The normal probability density
function is
1
√ e− 2 ( σ )
1 x−μ 2
f (x) = (15.15)
σ 2π
The term Z = (x − μ)/σ in the exponent transforms any normally distributed

variate into the standard normal distribution. Visually, the standard normal prob-
ability density function is a symmetric, unimodal, bell-shaped curve illustrated in
Fig. 15.4 with associated ±1σ, ±2σ, and ±3σ probabilities. Since the ±3σ interval
covers 99.73% of the error probabilities, it is often referred to as the natural tolerance
limits of a process.
The mean and variance of a normal random variable N(μ, σ 2 ) are
E[X ] = μ
V [X ] = σ 2
Hence, a normal variate is completely described by its first two moments. The
normal distribution has many useful properties.
• The standard normal variate N(0,1) and the normal variate N(μ, σ 2 ) are related
by
Fig. 15.4 Standard normal probability density function

N (0, 1) = [N (μ, σ ) − μ]/σ
• Central Limit Theorem: If x 1 , x 2 , …, x n are identically, independently distributed

(IID) random variables from any unimodal distribution with mean μ and variance
σ 2 , and if y = x 1 + x 2 + … + x n , then the distribution of y

y − n μi
2
n σi
approaches N(0, 1) as n → ∞. Since y is the summation of x i IID variables, the

variance of the mean is
y nσ 2 σ2
V [μ] = V = 2 =
n n n
√
Taking the square root yields the√ standard error of the mean SEM = σ/ n.
√ mean of a sample of x n σ/ n from any IID random variable is distributed
Hence, the
N(μ, σ/ n) as the n → ∞. In application, √ sample sizes in the range of 12–15 are
sufficient to yield means that are N(μ, σ/ n) distributed.
• Linear combinations: If x i,j , where i = 1 to a units and j = 1 to jth variable, are
N(μ, σ 2 ) distributed, then the linear combination of
y = a1 x 1 + a2 x 2 + · · · + a j x j
is normally distributed with mean
μ y = a1 μ1 + a2 μ2 + · · · + a j μ j
and variance
σ y2 = a12 σ12 + a22 σ22 + · · · + a 2j σ j2
• Extending the linear combination rule, any fixed transformation of a normal variate
is also a normal variate. For constants b and c,
b + c(N : μ, σ ) ∼ N : b + μ, cσ
Example 15.3
A firm is considering investing in an automated weighing system to weigh
metal powders for an alloy molding process. The proposed automated weighing
system has an initial cost of N($32,000, $5002 ) and an estimated market value
of N($3000, $10002 ) at the end of the contract life of 5 years. The initial
cost variance is due to uncertainties about the costs of the system’s COTS
components. The market value uncertainty is due to uncertainty about future
inflation rates. Industrial engineering has estimated a uniform annual savings
of N($8000, $3002 ) per year. For the risk level of this investment, the firm
requires MARR = 8.0%. What is the probability that the investment will have
a negative NPW (i.e., P(NPW ≤ $0)?
Using the linear combinations of normally distributed variates, the expected
mean NPW is

E[NPW] = −$32, 000 + 1 × $8000 (P/F, 8%, 1)
+ 1 × $8000 (P/F, 8%, 2) + 1 × $8000 (P/F, 8%, 3)
+ 1 × $8000 (P/F, 8%, 4) + 1 × $8000 (P/F, 8%, 5)
+ 1 × $3000 (P/F, 8%, 5)

E[NPW] = −$32, 000 + 1 × $8000 (0.9259)
+ 1 × $8000 (0.8573) + 1 × $8000 (0.7938)
+ 1 × $8000 (0.7350) + 1 × $8000 (0.6806)
+ 1 × $3000 (0.6806)
E[NPW] = $1983
The variance estimate is
V [NPW] = 5002 + 12 × $3002 (P/F, 8%, 1) + 12 × $3002 (P/F, 8%, 2)

+ 12 × $3002 (P/F, 8%, 3) + 12 × $3002 (P/F, 8%, 4)
a + 12 × $3002 (P/F, 8%, 5) + 12 × $10002 (P/F, 8%, 5)
V [NPW] = 5002 + 12 × $3002 (0.9259) + 12 × $3002 (0.8573)

+ 12 × $3002 (0.7938) + 12 × $3002 (0.7350)
+ 12 × $3002 (0.6806) + 12 × $10002 (0.6806)
V [NPW] = $1, 289, 934
The standard deviation is
σ = $1, 289, 934 = $1, 135.75.

Transforming to a standard normal variable,
$0 − $1, 983
Z= = −1.74589
$1, 135.75
For Z = −1.74589, the cumulative probability of P(NPW ≤ $0) = 0.040374

or about 4.04%.
Many processes exhibit exponential growth or decay. An exponential process

occurs when the rate of change with respect to a variable is proportional to the quantity
of the variable itself. Examples of exponential processes include radioactivity, chain
reactions, cooling, charging and discharging, spread of information, propagation of
defects through a medium or system, population growth in biomechanical processes,
interest compounding, and departure from or arrival at a systemic equilibrium state.
If the variable of proportionality is random, then the process exhibits an exponential
probability distribution function.
f (x) = λe−λx or f (x) = λeλx (15.16)
Exponential decay occurs when λ is negative, and exponential growth occurs

when λ is positive. The mean and variance of the exponential distribution are
1
μ=
λ
1
σ2 =
λ2
In reliability engineering, the exponential distribution is used to model the random
time to failure of a component or system. In this use, λ is termed the failure rate,
which yields 1/λ = mean time to failure. As an example, suppose that a component
has a failure rate of 0.001/hour of continuous operation. That is, λ = 0.0001 and the
mean time to failure is 1/λ = 1/0.0001 = 1000 h. What is the probability that any
randomly selected component will not fail before 2000 h of operation?
∞
P(x ≥ 2000) = ∫ λe−λx dx = e−2 = 0.1353
2000
There is an important relationship between the Poisson and exponential distribu-

tions. If the Poisson probability density function is restated to model the number of
occurrences of an event in the interval (0, t], then
(λt)x e−λt
P(X = t) =
x!
For x = 0, there are no occurrences in (0, t], and P(X = 0) = P(X ≥ t) = e−λt .
Since
F(t) = P(X ≤ t) = 1 − e−λ
and applying f (x) = dF(t)/dx, we derive
f (x) = λe−λx
as the interval between successive occurrences. Therefore, if the number of occur-

rences of an event is Poisson distributed with parameter λ, then the distribution of
the intervals between each successive occurrence is exponentially distributed with
parameter λ.
Many processes are multiplicative (with no time lags or feedback loops). Examples
include (1) crushing boulders into sequentially smaller rocks, pebbles, and power;
(2) sequentially blending and purifying chemicals and pharmaceutical powders;
(3) sequentially separating and refining gases; and (4) software coding processes.
In multiplicative processes, product characteristics grow or decline exponentially
y = e±λx , where x = the sequential step. A special case occurs when the x is a
normally distributed random variable (i.e., the processing step intervals are normally
distributed rather than constant). In this case, the distribution of x is termed a
lognormal distribution with probability density function (Fig. 15.5).
2
1 −1
ln(x)−μ N
f (x) = √ e 2 σN
(15.17)
xσ N 2π
The mean and variance of the lognormal distribution are
μ = meσ N /2
2
Fig. 15.5 Standard

lognormal probability
density function

V [X ] = m 2 eσ N eσ N − 1
2 2
The parameter m = median. Equation (15.17) implies that the ln(x) of a lognor-
mally distributed variable is normally distributed. Thus, if data x is lognormally
distributed, ln(x) will be normally distributed, and the standard normal variate Z can
be used to estimate probabilities of occurrence.
Example 15.4
In cybersecurity, the “intrusion kill chain” is a model of the sequence of counter
events that must occur to effectively detect and deny, disrupt, or degrade and
contain a cyberintrusion. The intrusion kill chain for a particular SQL injection
attack is known to be lognormally distributed with μN = 3.2484 and σ N =
0.10837. A recent SQL injection kill chain required 30 h to disrupt and contain
the intrusion. What was the intrusion kill chain’s probability of containment
(i.e., 1 − P(X ≤ x))?

ln(30) − 3.2484
P(containment) = 1 − = 1 − (1.41)
0.10837
= 1 − 0.9207 = 0.0793
For this particular SQL intrusion, the kill chain was 7.93% effective.
15.3 Structuring Decision Problems
The engineering management investment decision is the selection of the portfolios of

short- and long-term productive assets that maximizes net present worth cash flows at
the current MARR and maximizes rate of return when WMCC > MARR (Fig. 15.6).
Chapter 13 introduced the capital budgeting problem. Capital budgeting is the
process of selecting the asset investment portfolio that maximizes the rate of return
on asset investments over the life cycle budget and business-cycle budget planning
periods. Capital budgeting is accomplished in six major steps:
1. Identify Potential Asset Investment Opportunities. Asset investment opportu-
nities are identified from market analysis of demand trends, gaps in existing
products’ performance, and new product opportunities. Competitive analysis
identifies existing and emerging competitors, their strategies, and their strengths
and weaknesses relative to the organizations. Identify macro-environmental
economic, technological, political, and social trends that may modify variable
15.3 Structuring Decision Problems 371
Fig. 15.6 Engineering Value Maximizing

management investment Short & Long Term
decision Asset Portfolio
Capital Working Capital

Budgeting Management
Long Term Short Term

RoR Maximizing NPW Maximizing
Assets Portfolio Assets Portfolio
Macro & Business Current Macro &

Economic Business Economic
Constraints Constraints
Available
Organizational
Financing
Constraints
Constraints
Current
Organizational
Technological
Constraints
Constraints
Available
Technological
Constraints
relationships in the market analysis. Likewise, identify organizational socio-

technical capacities, capabilities, and potential for transformation to support
successful implementation of identified opportunities. Select asset investment
opportunities with the highest probability of increasing return on investment.
2. Develop the Capital Budget Investment Portfolio. Categorize fixed asset invest-
ment opportunities according to their purpose: market expansion, new product,
replacement, upgrade, regulatory requirement, or social welfare. Within each
category, rank opportunities by estimated rate of return or net present worth.
3. Decision Making. Select those opportunities that maximize rate of return, net
present worth, or are a weighted mix to achieve a target rate of return and cash
flow.
4. Prepare the Capital Budget and Appropriations. Classify fixed asset outlays
into economic risk value categories. Higher-value outlays are approved by upper
management for long-term investment. Medium- and lower-value outlays are
approved by middle management and usually covered by blanket appropriations
for rapid implementation.
5. Implement the Capital Budget. Project teams are formed and authorized to
make the authorized outlays to acquire and implement the fixed assets.
6. Performance Review. Establish project performance reviews to track implemen-
tation outlays and performance against actual costs and performance. Correc-
tive actions are taken on negative variances to keep project implementation on
budget, schedule, and performance targets. Upon completion of each project,
perform project closeout review. Schedule annual audits to compare fixed asset
life cycle rate of return to that forecasted in the opportunity identification step.
Begin a new capital budgeting cycle.
Chapters 6–10 introduced economic concepts necessary for working capital
management. Working capital management is a business strategy designed to ensure
that a company operates efficiently by monitoring and maintaining its current
assets and current liabilities within acceptable current ratio and quick ratio ranges.
Working capital management involves balancing movements among cash, accounts
receivables, accounts payables, short-term financing, and inventories.
• Cash levels should be sufficient to cover ordinary and small, unexpected needs
but not beyond these levels.
• Credit sales (accounts receivable) should be just sufficient to balance the need
to maintain sales and healthy business relationships while limiting exposure to
customers with low creditworthiness.
• Short-term debt and accounts payable should be just sufficient to allow liquidity
for ordinary operations and unexpected needs without increasing financial risk.
• Inventories should be just sufficient to maintain current production levels and
product sales while avoiding losses due to accumulation and obsolescence.
Working capital management is operations management’s primary responsibility.
Engineering management plays a supporting role in assisting operations manage-
ment in maintaining working capital. For engineering management, working capital
management is the process of managing current fixed assets over the zero-budget
period and life-cycle budget period to maximize the net present worth of cash flows.
Influence Diagrams
An influence diagram is a graphical representation of the key elements of a deci-
sion problem: decisions, alternatives, constraints, risk, criteria, scope, outcome, and
stakeholders.
Definition: A decision is the selection of a sequence of actions designed to resolve
a problem or attain an objective.
Definition: Alternatives are two or more available actions.
Definition: Constraints—(1) Limitations or restrictions on selecting an alterna-
tive or on a selected alternative’s range of outcome values. (2) Decision constraints
are a set of rules for acceptable values of decision variables.
Definition: Criteria are acceptable values of decision variables.
Definition: An outcome of a decision is the realized value of the decision criterion

or criteria vector.
Definition: Stakeholders are all persons impacted by or with interest in the
outcome of a decision.
Influence diagrams are constructed from the outcome backward through the
variables, constraints, and decisions necessary to achieve the outcome.
Step 1. Define the problem: Capital budget management—maximize the weighted
rate of return > MARR. Working capital management—maximize the net
present worth of cash flows from current fixed assets for the required
MARR.
Step 2. Identify the outcome and the random independent variables that directly
determine its value.
2(a) Identify each stakeholder impacted by or with interest in the
outcome.
2(b) Identify the constraints on the values of each independent variable.
Step 3. Identify the decision node that determines each random independent
variable and its probability of occurrence.
Step 4. Continue decomposition for each random variable and decision node until
no variable or decision remains.
Influence diagram symbols are illustrated in Fig. 15.7.
The elementary risky decision is maximizing the net present worth of working
capital cash flows for a required MARR is investment in a single asset. For this deci-
sion, there is one decision to make; one uncertain event, the variation is actual cash
flows versus predicted cash flows; and one stakeholder, management. The influence
diagram for this decision is illustrated in Fig. 15.8.
The decision node is to invest or not invest given the net present worth of future
annual revenue and expense cash flows and net cash receipt from market value or
Fig. 15.7 Influence diagram symbols

Fig. 15.8 Single asset investment, working capital influence diagram
salvage value upon disposal of the asset at the end of the project life. Operating annual
revenue cash flows are constrained by demand for the asset’s product or service,
which, in turn, is constrained by customer preferences and demand-side business
and macroeconomic factors. Hence, annual revenue cash flows can be modeled as a
regression equation.

Revenue(t) = β R(0,t) + βC,t CustPref(t) + β R( j) BusFactor( j, t)
j

+ β R(k) MacFactor(k, t) + ε R( j,k,t)
k
This regression representation incorporates only a weighted sum of customer

preferences CustPref(t), business economic factors main effects BusFactor(t), and
macroeconomic factors main effects MacFactor(t). Possible two-factor interac-
tions are omitted. The annual revenue error term is a linear combination of the
customer preference, business economic factors, and macroeconomic factors’ vari-
2
ances ε R( j,k,t) = j,k,t Actual R ( j, k, t)−E R X j,k,t + σ R( j,k,t) . Correspond-
2
ingly, the annual operating expense cash flows are constrained by supply-side
business and macroeconomic factors and can be represented as a regression equation.

Expense(t) = β E(0,t) + β E( j) BusFactor( j, t)
j

+ β E(k) MacFactor(k, t) + ε E( j,k,t)
k
Again, only business economic factors and macroeconomic factors’ main

effects are considered. The error term is a linear combination of the busi-
ness economic factors and macroeconomic factors’ variances ε E( j,k,t) =
2
j,k,t Actual R ( j, k, t)−E E X j,k,t + σ E( j,k,t) . Investment net present worth
2
is

NPW = Revenue(t)(P/F, MARR, t)
n

+ Expenses(t)(P/F, MARR, t) + ε R( j,k,n) + ε E( j,k,n)
n
where Revenue(t) and Expenses(t) are the realized revenues and expenses, and the
sum of the variances εR(j,k,t) and εE(j,k,t) results in the linear combination of additive
variances.
15.4 Sensitivity Analyses
Section 10.1 introduced sensitivity analysis in the context of incremental analysis and
applied sensitivity analysis to determine the ranges over which alternatives cash flows
maximized NPW or EUAW. Given an influence diagram structured representation of
a decision problem, sensitivity analysis allows an engineering manager to determine
the range over which an optimal solution holds for variation in some influential
predictor variable.
in an objective function predictor variable or constraint necessary to change the
decision to select a particular alternative. The point at which the decision changes
from one alternative to another is the point of indifference.
Figure 15.8 illustrates input variables annual revenues and expenses and the market
and salvage value of a zero-budget period or life cycle budget period investment in
which the objective is to maximize cash flow (NPW). Input variables are those over
which management can exercise some level of control. The figure also illustrates
constraints. Constraints are conditions or limitations on input variables that affect
the latter’s average or variance. Management can exercise limited or no control over
constraints and must respond to their effects on input variable and the resultant
objective function (NPW in Fig. 15.8). Sensitivity analysis informs management of
the points of indifference at which the decision changes and management response
is required.
Assuming random errors are identically and independently normally distributed,
N(E[X], σ 2 ), the expected mean NPW of an investment alternative is

E[NPW] = E[Revenue(t)](P/F, MARR, t)
n

+ E Expenses(t) (P/F, MARR, t)
n
Hence, the expected NPW of an investment alternative is just its accepted predicted
value. The variance of an investment alternative’s NPW is obtained by applying the
variance operator resulting in
2
V [NPW] = Actual R ( j, k, t) − E R X j,k,t
n
2
+ Actual E ( j, k, t) − E E X j,k,t .
n
+ σ R(
2
j,k,t) + σ E( j,k,t)
2
Sensitivity analysis informs engineering management about variances from

expected NPW due to bias variances (ActualR (j,k,t) − E R [X j,k,t ])2 and (ActualE (j,k,t)
− E E [X j,k,t ])2 .
Example 15.5
Following the six-step graphical incremental rate of return sensitivity analysis
in Sect. 10.1, consider variances in competing investment alternatives. An
engineering manager is considering two alternatives for improving throughput
on a production line. Both alternatives have useful lives of 12 years to end of
the expected product life.
Alternative 1: A partial reconfiguration will cost $7,200,000 and require
annual maintenance expenses of $120,000. During construction in year one,
disruption to production is expected to cost $720,000. The reconfiguration is
predicted to save $1,480,000 annually.
Alternative 2: A complete reconfiguration will cost $9,600,000. The
completely reconfigured line will require $60,000 annual maintenance
expenses. This construction is completely disruptive shutting down the produc-
tion line at a cost of $1,730,000 the first year. Once complete, the full
reconfiguration is predicted to save $1,960,000 annually.
Although construction and disruption costs are certain due to their short-
term prediction, annual saving for each alternative could vary ±5% and annual
maintenance expenses could vary ±10%. The MARR for this investment is
12.0%. Estimate the expected NPW for each alternative, and perform sensi-
tivity analyses for the expected variances in annual savings and maintenance
expenses.
Expected NPW:
Alternative 1:

E[NPW] = −$7,200,000 + −$720,000 (P/F, 12%, 1)

+ $1,480,000 − $120,000 (P/F, 12%, 12)

E[NPW] = −$7,200,000 + −$720,000 (0.8929)

+ $1,480,000 − $120,000 (6.194)

E[NPW] = −$7,200,000 + −$642,888 + $8,423,840
15.4 Sensitivity Analyses 377
E[NPW] = $580,952
Alternative 2:

E[NPW] = −$9,600,000 + −$1,730,000 (P/F, 12%, 1)

+ $1,960,000 − $60,000 (P/F, 12%, 12)

E[NPW] = −$9,600,000 + −$1,730,000 (0.8929)

+ $1,960,000 − $60,000 (6.194)

E[NPW] = −$9,600,000 + −$1,544,717 + $11,768,600
E[NPW] = $623, 888 → Prefer Alternative 2.
Since Alternative 2 is preferred, consider the case where Alternative 2’s

annual savings decreases 5% to $1,862,000 but Alternative 1’s remains at
$1,480,000.
Alternative 2:

E[NPW] = −$9,600,000 + −$1,730,000 (P/F, 12%, 1)

+ $1,862,000 − $60,000 (P/F, 12%, 12)

E[NPW] = −$9,600,000 + −$1,730,000 (0.8929)

+ $1,862,000 − $60,000 (6.194)

E[NPW] = −$9,600,000 + −$1,544,717 + $11,161,588
E[NPW] = $16, 871 Now prefer Alternative 1 with NPW = $580, 952
Now, assume Alternative 2’s savings remains at $1,960,000 but its annual
maintenance cost increases 10% to (−$66,000).
Alternative 2:

E[NPW] = −$9,600,000 + −$1,730,000 (P/F, 12%, 1)

+ $1,960,000 − $60,000 (P/F, 12%, 12)

E[NPW] = −$9,600,000 + −$1,730,000 (0.8929)

+ $1,960,000 − $66,000 (6.194)

E[NPW] = −$9,600,000 + −$1,544,717 + $11,731,436
E[NPW] = $586,719 Prefer Alternative 2.
Now, we know that change in either alternative’s annual savings is the vari-
ance driver in the decision point of indifference. Evaluating different scenarios
in % change annual savings and maintenance expenses in Excel® yields the
following approximate points of indifference and decisions.
If NPW is replaced with RoR, Fig. 15.7 represents the generic elements of a
capital budgeting decision in which the objective is to maximize rate of return
over the business-cycle budget period. Sensitivity analysis can be performed
for the internal rate of return > MARR at NPW = EUAW = $0 on capital
budgeting projects. Investment rate of return is

IRR NPW = $0 = Revenue(t)(P/F, i, t)
n

+ Expenses(t)(P/F, i, t) + ε R( j,k,n) + ε E( j,k,n)
n
Again, assuming random errors are identically and independently normally

distributed, N(E[X], σ 2 ), the expected IRR[NPW = $0] of an investment
alternative is

IRR NPW = $0 = E[Revenue(t)](P/F, i, t)
n

+ E Expenses(t) (P/F, i, t)
n
with variance
2
V [IRR] = Actual R ( j, k, t) − E R X j,k,t
n
2
+ Actual E ( j, k, t) − E E X j,k,t
n
+ σ R(
2
j,k,t) + σ E(
2
j,k,t)
Example 15.6 illustrates rate of return sensitivity analysis for the simple
case of a portfolio of two capital projects.
Example 15.6
For the capital budget of $1,250,000 in Example 13.1, conduct sensitivity
analysis to determine the increase in rejected projects 2, 6, and 7 after-tax
benefit cash flows necessary for alternatives to achieve the 15.8% rate of return
of project 4 (last accepted project) and be admitted as acceptable alternatives.
Given that projects 2, 6, and 7 become acceptable at a 15.8% rate of return, how
would the $1,250,000 be re-allocated to maximize value to the organization?
Determine (P/A, 15.8%, 4), (P/A, 15.8%, 6), (P/A, 15.8%, 10), (P/F, 15.8%,
4), (P/F, 15.8%, 6), and (P/F, 15.8%, 10) by linear interpolation.
(P/A, 15.8%, 4) = (P/A, 15%, 4) + [(P/A, 18%, 4) − (P/A, 15%, 4)]

[(15.8% − 15%)/(18% − 15%)]
(P/A, 15.8%, 4) = 2.855 + [2.690 − 2.855][0.26666] = 2.811
(P/A, 15.8%, 6) = (P/A, 15%, 6) + [(P/A, 18%, 6)

− (P/A, 15%, 6)][0.26666]
(P/A, 15.8%, 6) = 3.784 + [3.498 − 3.784][0.26666] = 3.708
(P/A, 15.8%, 10) = (P/A, 15%, 10) + [(P/A, 18%, 10)

− (P/A, 15%, 10)][0.26666]
(P/A, 15.8%, 6) = 5.019 + [4.494 − 5.019][0.26666] = 4.879
(P/F, 15.8%, 4) = (P/F, 15%, 4)+[(P/F, 18%, 4)

− (P/F, 15%, 4)][0.26666]
(P/F, 15.8%, 4) = 0.5718 + [0.5158 − 0.5718]
[0.26666] = 0.5569
(P/F, 15.8%, 6) = (P/F, 15%, 6) + [(P/F, 18%, 6)

−(P/F, 15%, 6)][0.26666]
(P/F, 15.8%, 6) = 0.4323 + [0.3704 − 0.4323]
[0.26666] = 0.4158
(P/F, 15.8%, 10) = (P/F, 15%, 10) + [(P/F, 18%, 10)

− (P/F, 15%, 10)][0.26666]
(P/F, 15.8%, 10) = 0.2472 + [0.1911 − 0.2472]
[0.26666] = 0.2322
Manual solutions—Set projects 2, 6, and 7 cash flow equations equal to that

of project 6 and at 15.6% and solve for the unknown after-tax benefit cash flow.
For project 4, 15.8% = IRR; therefore, NPW(Project 4) = $0.
Project 2 = Project 4

−$400 + ATCF(P/A, 15.8%, 10) = −$200 + $40(P/A, 15.8%, 6)
+ $125(P/F, 15.8%, 6)

−$400 + ATCF(4.879) = −$200 + $40(3.708)

+ $125(0.4158) −$400 + ATCF(4.879) = $0
ATCF = $400/4.879 = $81.98 increase from $79.70 or delta = $2.190 K

New capital budget with project 2 replacing project 4: $1150 − $200 +
$400 = $1350.
Over the set budget = $1250. Not feasible.

−$300 + ATCF (P/A, 15.8%, 10) + $150 (P/F, 15.8%, 10) = $0

−$300 + ATCF (4.879) + $150(0.2322) = $0
ATCF = ($300 − $34.83)/4.879 = $54.349 increase from $54.00 or delta

= $0.349 K.
$300 = $1250.
On the set budget = $1250. Feasible.

NPW = −$300 + $54.35 (P/A, 12.0%, 10)
+ $150 (P/F, 12.0%, 10)

NPW = −$300 + $54.35 (5.650) + $150 (0.3220)
= $55.38 New Portfolio
NPW = $267.78 − $27.79 + $55.38
= $295.37; net increase + $27.59 K

−$600 + ATCF (P/A, 15.8%, 4) + $50 (P/F, 15.8%, 4) = $0

−$600 + ATCF (2.811) + $50 (0.5569) = $0
ATCF = ($600 − $27.845)/2.811 = $203.54 increase from $189.28 or delta

= $14.260 K
$600 = $1550.
Over the set budget = $1250. Not feasible.
15.5 Decision Analysis
Influence diagrams are excellent for representing the key elements of a decision;
however, influence diagrams do not represent the risk structure of a decision. Decision
trees are used to represent the probabilistic risk structure of decisions.
Definition: A decision tree is a static graphical representation of the probabilistic

outcomes of a decision.
A decision tree represents the sequential relationships of decision nodes, random

variables, and outcomes that make up a risky decision. A decision tree describes the
problem by starting at the decision that must be made, the root node, and adding
chance and decision nodes in the proper logic sequence. Both root and leaf nodes
contain questions or criteria to be answered. Branches are arrows connecting nodes,
showing the flow from question to answer. Each node typically has two or more
nodes extending from it. Best practices for creating a decision tree are:
• Start the decision tree—draw the root decision node near the left edge of the
drawing area. Write the question regarding the investment to be made and the
economic criteria (net present worth, equivalent annual worth, or rate of return)
to be used to make the decision.
• State the goal—above the root decision node, add a goal node with a statement
of the investment objective in terms of the economic criteria (i.e., NPW or EUAW
> 0 at MARR = 12%, RoR ≥ 14.5% opportunity cost of capital, etc.). Link the
goal node to the root decision node with an arc (solid line).
• Add branches—moving to the right in time order from each node, draw an arc
for each possible alternative path reflecting the decision logic of the investment’s
possible future cash flows. Each branch should reflect the decision sequence of
chance nodes, deterministic nodes, intermediate decision and goal nodes, and
outcomes that reflect the future cash flow outcomes of the investment.
• Mutual exclusivity and exhaustivity—all decision and chance nodes with their
associated probabilities must be mutually exclusive and exhaustive. Each decision
node must have the number of arcs emanating from it equal to the number of
possible decision routes from the node. Each chance node must have the number
of arcs emanating from it equal to the number of possible outcome nodes. Each
chance node arc must state the probability of its respective outcome, and the sum
of the probabilities across all chance node arcs must equal 1.0.
• Terminate in outcome nodes—decision logic branch must terminate in an

outcome node.
15.5 Decision Analysis 383
• Add a timeline—each chance node, deterministic node, intermediate decision

and goal node, and outcome node must be associated with its time interval of
occurrence from 0 to n periods of the investment or project life.
A rudimentary decision tree example is illustrated in Fig. 15.8.
To solve a decision tree, work backward from the outcome nodes at time n to the
decision root node.
• Add predicted cash flows at each intermediate and time n outcome node. For a
NPW criteria goal, restate each predicted future cash flow to its present worth at
the MARR. For an EUAW or a rate of return criteria goal, use the predicted future
cash flows.
• Add cash flow requirements to each intermediate decision node.
• Add mutually exclusive and exhaustive P(outcome(i)) to each branch from a
chance node. Sum(P(outcome(i)) = 1.0.
• Starting at each time n outcome node, work backward through the decision logic
structure estimating either expected present worth cash flows at each time t = 1,
2, …, n for a NPW criteria goal or expected monetary cash flows for an EUAW
or a rate of return criteria goal. For each chance node, the expected cash flow is
estimated as

E[CF] = P(statei ) × CFi
n
• Select the decision network path that maximizes the expected NPW of future
present worth cash flows at the root decision node. For and EUAW or a rate of
return goal criteria, select the decision network path that maximizes the expected
monetary value at the root decision node, and then estimate the life EUAW or
internal rate of return for the cash flows along that decision network path.
Example 15.7
Management of a building supply manufacturer is deciding on whether to open
a new warehouse outlet for local building contractors. There are two options for
the new warehouse. A warehouse building can be erected for a cost $8,750,000,
and new warehousing fixtures and equipment and office fixtures and equip-
ment can be purchased for $3,500,000. Option two is to purchase an existing
empty warehouse for $9,450,000 with the building market value $7,000,000
and equipment $2,450.000. Due to logistics of the existing warehouse location,
expected Real$ revenues will be 90% of those set forth in the following table.
Either way, the building, fixtures, and equipment will be depreciated under
MACRS beginning the first day of the next fiscal year. Forecasted annual cash
flow net revenues (revenues–operating expenses–maintenance expenses) are
set forth in the following table along with their probabilities of occurrence. If
demand meets or exceeds expectations, the outlet will remain in service indefi-
nitely. If demand falls below expectations, outlet operations will be terminated
at the end of eight years. All chase flows are in Real$, and the market MARR
for this project is 12.0%. The organization operates in a state with 6.0% corpo-
rate income tax rate. Based on expected value, which alternative should be
pursued?
Predicted annual cash flow revenue

Demand Low Expected High
P(demand) 0.3 0.6 0.1
Revenue $3,050,000 $3,660,000 $5,850,000
For each warehouse alternative, estimate:

• Building depreciation—year 1, initial cost × 0.02461; year 2, initial cost ×
0.02564.
• Equipment and fixture depreciation—initial cost × GDS 7-year property
percentages.
• Combined income tax rate = 0.06 + 0.21(1 − 0.06) = 0.2574 or 25.74%.

• Taxable income = CF Revenue − Building Depreciation − Equipment
Depreciation
• Taxes paid = Taxable income × 0.2574
• After-tax Cash Flow = CF Revenue − Taxes paid
• NPW = (Building cost + Equipment cost) + Sum(PV(After-tax Cash
Flows, 12.0%, n).
The eight-year NPW estimates are set forth from the associated Excel®
worksheet.
New Warehouse - Low Demand

Taxable Income Aer Tax
Year Building Cost Equipment CF Revenue Build Depr Eq Depr Income Tax Paid Cash Flow NPW
0 ($8,750,000) ($3,500,000) ($12,250,000) ($100,376)
1 $3,050,000 ($215,338) ($500,000) $2,334,663 ($600,942) $2,449,058
2 $3,050,000 ($224,350) ($857,143) $1,968,507 ($506,694) $2,543,306
3 $3,050,000 ($224,350) ($612,245) $2,213,405 ($569,730) $2,480,270
4 $3,050,000 ($224,350) ($437,318) $2,388,332 ($614,757) $2,435,243
5 $3,050,000 ($224,350) ($312,370) $2,513,280 ($646,918) $2,403,082
6 $3,050,000 ($224,350) ($312,370) $2,513,280 ($646,918) $2,403,082
7 $3,050,000 ($224,350) ($312,370) $2,513,280 ($646,918) $2,403,082
8 $3,050,000 ($224,350) ($156,185) $2,669,465 ($687,120) $2,362,880
New Warehouse - Expected Demand

CF Revenue Income Tax Paid Cash Flow NPW
($12,250,000) $2,149,895
$3,660,000 $2,944,663 ($757,956) $2,902,044
$3,660,000 $2,578,507 ($663,708) $2,996,292
$3,660,000 $2,823,405 ($726,744) $2,933,256
$3,660,000 $2,998,332 ($771,771) $2,888,229
$3,660,000 $3,123,280 ($803,932) $2,856,068
$3,660,000 $3,123,280 ($803,932) $2,856,068
$3,660,000 $3,123,280 ($803,932) $2,856,068
$3,660,000 $3,279,465 ($844,134) $2,815,866
New Warehouse - High Demand

($12,250,000) $10,228,738
$5,850,000 $5,134,663 ($1,321,662) $4,528,338
$5,850,000 $4,768,507 ($1,227,414) $4,622,586
$5,850,000 $5,013,405 ($1,290,450) $4,559,550
$5,850,000 $5,188,332 ($1,335,477) $4,514,523
$5,850,000 $5,313,280 ($1,367,638) $4,482,362
$5,850,000 $5,313,280 ($1,367,638) $4,482,362
$5,850,000 $5,313,280 ($1,367,638) $4,482,362
$5,850,000 $5,469,465 ($1,407,840) $4,442,160
Exisng Warehouse - Low Demand

Year Building Cost Equipment CF Revenue Build Depr Eq Depr Income Tax Paid Cash Flow NPW
0 ($7,000,000) ($2,450,000) ($9,450,000) $1,333,488
1 $2,745,000 ($172,270) ($350,000) $2,222,730 ($572,131) $2,172,869
2 $2,745,000 ($179,480) ($600,000) $1,965,520 ($505,925) $2,239,075
3 $2,745,000 ($179,480) ($428,571) $2,136,949 ($550,051) $2,194,949
4 $2,745,000 ($179,480) ($306,122) $2,259,398 ($581,569) $2,163,431
5 $2,745,000 ($179,480) ($218,659) $2,346,861 ($604,082) $2,140,918
6 $2,745,000 ($179,480) ($218,659) $2,346,861 ($604,082) $2,140,918
7 $2,745,000 ($179,480) ($218,659) $2,346,861 ($604,082) $2,140,918
8 $2,745,000 ($179,480) ($109,329) $2,456,191 ($632,223) $2,112,777
Exisng Warehouse - Expected Demand

($9,450,000) $3,358,732
$3,294,000 $2,771,730 ($713,443) $2,580,557
$3,294,000 $2,514,520 ($647,237) $2,646,763
$3,294,000 $2,685,949 ($691,363) $2,602,637
$3,294,000 $2,808,398 ($722,882) $2,571,118
$3,294,000 $2,895,861 ($745,395) $2,548,605
$3,294,000 $2,895,861 ($745,395) $2,548,605
$3,294,000 $2,895,861 ($745,395) $2,548,605
$3,294,000 $3,005,191 ($773,536) $2,520,464
Exisng Warehouse - High Demand

($12,250,000) $7,829,690
$5,265,000 $4,742,730 ($1,220,779) $4,044,221
$5,265,000 $4,485,520 ($1,154,573) $4,110,427
$5,265,000 $4,656,949 ($1,198,699) $4,066,301
$5,265,000 $4,779,398 ($1,230,217) $4,034,783
$5,265,000 $4,866,861 ($1,252,730) $4,012,270
$5,265,000 $4,866,861 ($1,252,730) $4,012,270
$5,265,000 $4,866,861 ($1,252,730) $4,012,270
$5,265,000 $4,976,191 ($1,280,871) $3,984,129
Decision Tree:

E[NPW New] = 0.3 $10, 228, 738 + 0.6 $2, 149, 895

+ 0.1 −$100, 376 = $4, 348, 521

E NPW Existing = 0.3 $7, 829, 690 + 0.6 $3, 358, 732

+ 0.1 $1, 333, 488 = $4, 497, 495
Select the existing warehouse with expected NPW = $4,497,495.
15.6 Decision Tree Risk Simulation
In application, many decision tree variables are subject to random variation. The
combinatorics of modeling even simple decision trees with random variables, as in
the prior example, would create a bush of decision paths. The goal of any decision
problem is to estimate expected outcomes (NPW, EUAW, IRR, etc.). Risk analysis
simulations allow the estimation of expected outcomes within a range of prediction
error.
A decision tree risk simulation is a mathematical model (a system of formulas)
that specifies how the structural and random components of an economic decision
change over time. Decision tree risk simulation models are used to investigate a wide
variety of “what if” questions about risky decisions.
• The long-run expected average values of variables and metrics.
• The prediction error of the expected average values.
• The points at which a decision changes from one alternative to another are due
to random variation (we examined structural points of indifference in Sect. 10.0
graphical sensitivity analysis).
• The breakeven points where NPW or EUAW ≤ 0 given a stated MARR, or the
points where IRR ≤ MARR or stockholders’ required return on equity.
• How changes in input factor or variable values affect the expected values and
prediction error of output metrics (NPW, EUAW, or RoI).
• Which input factors or variables dominate (are probabilistically important
components of) the decision.
To decide which of the alternatives is preferred, the engineering analyst assigns
random probability estimates to chance node probabilities and random cash flow
estimates (NPW, EUAW, RoI, etc.) to outcome nodes representing their structural and
random values based on the best available information. In Excel, uniform distribution
probabilities can be generated using the following functions.
=RAND() returns uniformly distributed random numbers between 0 and 1.
=RANDBETWEEN(bottom, top) returns a random integer number between the bottom
integer and the top integer numbers.
Simulation of chance node probabilities requires observing their rank order. As

an example, if a chance node has three outcomes P(low) = 0.2, P(expected) = 0.5,
and P(high) = 0.3, then the rank order of Rank(low) < Rank(high) < Rank(expected)
must not be violated in random number generation. To maintain rank order,
1. Set T () = P() × 100.
2. Beginning with lowest Rank(1), assign V (1) = RANDBETWEEN(1,
ROUND((T (2) + T (1))/2,0)).
3. For each intermediate Rank(2, …, Max − 1), assign V (2+) = RANDBE-
TWEEN(V (1+) + 1, ROUND(((T (2+) + T (3 + ))/2 − SUM(V 1+)),0)).
4. Repeat step 3 until all V (2, …, Max − 1) have been assigned. Assign V (Max)
= 1 − Sum(V 1(),V 2(), …,V (Max − 1)).
5. Assign random chance probabilities Pc(1) = V (1)/100, Pc(2) = V (2)/100, …,
P(Max) = V (Max)/100.
To generate cash flow, NPW, EUAW, or RoI random values, the specific population
probability density function form must be known or estimated from sample data. The
15.6 Decision Tree Risk Simulation 389
general form of the distribution may be approximated by plotting a histogram. If the

data is reasonably symmetric, the normal, lognormal, or triangular distribution may
provide a good distributional fit. If the data is positively skewed, the lognormal or
triangular distribution may provide a good approximation of the fit. If the data is
positively skewed with the mode at the minimum value, the exponential distribution
may provide the best fit. If the data is negatively skewed, the triangular distribution
may provide a good approximation of the fit. One of the parametric distribution fitting
methods (probability plotting with the Anderson–Darling or Kolmogorov–Smirnov
test, method of moments, maximum likelihood, etc.) will be required to determine
the parameters of the probability mass function (covered in statistics textbooks). This
discussion will assume that the probability density function is known or has been
estimated from sample data.
In Microsoft® Excel, random values may be generated for a normal distribution
using
=NORM.INV(probability, mean, standard deviation)
with RAND() used for the probability argument. Similarly, random values may be
generated for a lognormal distribution by using
=LOGNORM.INV(probability, mean, standard deviation)
where RAND() used for the probability argument, mean = AVERAGE(LN(data)),

standard deviation = STDEV(LN(data)).
Microsoft® Excel® does not have a comparable inverse function for the triangular
distribution. Random values may be generated for a triangular distribution using the
following observations about the triangular distribution. The area of the triangular
distribution may be found as the sum of the areas of two right-angle distributions.
From basic geometry for any triangle, the area = 1/2 × base × height,
A1 = 1/2 × (c−a) × handA2 = 1/2 × (b−c) × h
Now, the total area = A1 + A2 or
A = 1/2 × (c−a) × h + 1/2 × (b−c) × h

= 1/2((c−a) + (b−c))h
Setting the A = 1, we get h = 2/(b − a). Evaluating the A1 yellow triangle,

P(a < x ≤ c) = 1/2 × (c−a) × h = 1/2 × (c−a)

× 2/(b−a) = (c−a)/(b−a)
Evaluating the A2 blue triangle,
P(c < x ≤ b) = 1/2 × (b−c) × h = 1/2 × (b−c)

4 × 2/(b−a) = (b−c)/(b−a)
From the above figure of the triangular distribution and utilizing conformity of
the triangles, for a ≤ x ≤ c,
2
x −a c−a
P(X ≤ x) =
c−a b−a
Taking the derivative with respect to x,

x −a 2
f (x) =
c−a b−a
From the complement rule for the case c ≤ x ≤ b

2
b−x b−c
P(X ≤ x) = 1 −
b−c b−a
Taking the derivative with respect to x,

b−x 2
f (x) =
b−c b−a
The inverse triangle cdf of X is

√
−1 a + U (b − a)(c − a) for0 < U < F(c)
F (x) = √
b − (1 − U )(b − a)(b − c) forF(c) ≤ U < 1
where U is the standard U(0, 1) distribution. The inverse triangle cdf of X can be
incorporated into the cells of an Excel® spreadsheet as follows.
Parameter Value Assumed cell

Lower limit a A1
Most likely c A2
Upper limit B A3
U(0, 1) U A4
(continued)
(continued)
X =x x See formula below
= ROUND(IF(A4≤ (A2 − A1)/(A3 − A1), A1 + SQRT(A4 * (A3 − A1) * (A2 − A1)),
A3 − SQRT(1 − A4) * (A3 − A1) * (A3 − A2))),0)
Similarly, Microsoft® Excel® does not have a comparable inverse function for
the exponential distribution. Random values may be generated for an exponential
distribution using the following observations about the exponential distribution.
Exponential probability density function:
f (x) = λe−λ
Exponential cumulative density function:
F(x) = 1 − e−λx
The inverse exponential cdf of X is
F −1 (x) = −λLn(1 − x)
where 0 < x ≤ 1. The inverse exponential cdf of X can be incorporated into the cells
of an Excel® spreadsheet as follows.

λ Average (data) A1
U U(0, 1)
X =x x See formula below
= −A1 * LN(1-RAND())
Decision tree simulations are iterative in that the initial decision tree values are
randomly altered, outcome economic criteria (NPW, EUAW, or RoI) are recorded,
the altered decision tree becomes the decision outcomes under study, and the cycle
repeats until a sufficient number of random criteria values are recorded to permit
sensitivity analysis. Figure 15.9 presents a schematic of an economic decision tree
simulation process flow.
1. Identify the Economic Investment Problem—This was the central discussion
of the first eleven chapters of this text: new product, new process, upgraded
product or process, new facility or facility expansion, alternative investment
comparisons (incremental analysis), replacement analysis, etc.
Fig. 15.9 Decision tree simulation process flow
2. Construct the Cash Flow Model—A mathematical model that estimates the
current value of an investment based on its expected future cash flows.
3. Construct the Decision Tree—The static graphical representation of the proba-
bilistic outcomes of an investment decision.
4. Construct the Simulation Model—Translation of the graphical decision tree
structure into a discounted cash flow model that can be executed in the selected
simulation software application.
5. Simulation Runs—Determine the number of runs necessary to achieve a
required statistical prediction interval (subject of statistical or simulation text-
books) and conduct those runs. After each run, record the values of economic
criteria (NPW, EUAW, or RoI).
6. Simulation Sensitivity Analysis—Given the observed random variation in the
economic criteria, determine the statistical prediction interval and points of
indifferences in interval unions where decision changes occur.
Example 15.8
Conduct a simulation sensitivity analysis of the warehouse investment deci-
sion in Example 15.8 using the data in the following table. Revenues are
normally distributed with E[Revenue] means and Stdev[Rev] standard devi-
ations in the following table. Conduct 100 simulation runs for each of the
following scenarios: (a) P(Demand) random variation only with E[Revenue]
held constant. (b) Revenue random variation using N(E[Revenue], Stdev[Rev])
population values with P(Demand) held constant.
Predicted annual cash flow revenue

Demand Low Expected High
P(Demand) 0.3 0.6 0.1
E[Revenue] $3,050,000 $3,660,000 $5,850,000
Stdev[Rev] $122,000 $190,000 $558,000
P(Demand) simulation
Add a demand simulation matrix of cells to the worksheet, and encode the
rank order simulation functions into cells (relative to the worksheet example
below).
Cell H15: = $D$15 * 100 Cell I15: = $E$15 * 100 Cell J15: = $F$15 * 100
In rank order:
Cell J16: = RANDBETWEEN(1,ROUND(($H$15 + $J$15)/2,0))
Cell H16: = RANDBETWEEN($J$16 + 1,ROUND((($I$15 + $H$15)/2-
$J$16),0))
Cell I16: = 100-SUM($H$16,$J$16)
Cell H17: = H$16/SUM($H$16:$J$16)
Cell I17: = I$16/SUM($H$16:$J$16)
Cell J17: = J$16/SUM($H$16:$J$16).
In the decision tree, reference the P(Demand) probability cells to the random
demand cells.
Run simulation samples (100 for this example) of the variable demand by
clicking on any cell with a formula, clicking in the formula bar, repeatedly
√
clicking on the button to generate a new random sample.
Copy and paste each new simulated E[NPW] New and Existing to columns
in the spreadsheet.
Plot histogram distributions of E[NPW|New], E[NPW|Existing], and

E[NPW|Existing]—E[NPW|New], the last to test for negative differences
indicating a change in decision from the existing warehouse to the new
warehouse.
Since the NPW difference distribution is always > $0, E[NPW|Existing] >
E[NPW|New] everywhere, and no random variation in the ranked proportion
demand will change the decision from purchasing the existing warehouse to
building the new warehouse.
Revenue simulation
Since revenue cash flows are determined by the mutually exclusive demand
outcomes, conduct simulation runs for demand outcome (low, expected, and
high). For low demand, set the cash flow revenue to
New Warehouse: = NORM.INV(RAND(),$D$16,$D$17)
Existing Warehouse: = NORM.INV(RAND(),$D$16*$F$7,$D$17).
where $F$7 = 90%
Run simulation samples (100 for this example) of the variable revenue for
demand = low by clicking on any cell with a formula, clicking in the formula
√
bar, repeatedly clicking on the button to generate a new random sample.
Copy and paste each new simulated E[NPW] New and Existing to columns
in the spreadsheet.
Repeat the simulation runs for new and existing warehouse–expected
demand and new and existing warehouse–high demand.
Plot histogram distributions of
• NPW(New|Low) versus NPW(Exist|Low)
• NPW(New|Expected) versus NPW(Exist|Expected).
to assess for distribution overlaps indicating ranges of indifference (change in
decision) and possibly dominance.
For low demand with variable revenues, NPW(Existing|Low) dominates

NPW(New|Low), and the decision will be to always invest in the existing
warehouse.
For expected demand variable revenues less than about $4,756,000, invest
in the new warehouse at P(New|$4,377,500 < Exp[Rev] < $4,756,000) ~ 0.23.
Invest in the existing warehouse at P(Existing|$3,55,300 < E[Rev]) ~ 0.77.
For high demand variable revenues less than about $4,928,100, invest in
the new warehouse at P(New|$3,612,500 < E[Revenue] < $4,928,100) ~ 0.42.
Invest in the existing warehouse at P(Existing|$3,933,200 > E[Revenue]) ~
0.58.
15.7 Summary
Fundamental Probability Theory
Definition: Probability is a set function P(x ∈ A) or f (x ∈ A) that assigns to each

event x ∈ A in the sample space S a number P(x ∈ A) = a or f (x ∈ A) = a, called
the probability of event A, such that the following properties are satisfied:
Discrete distributions
Property 1: P(x = A) ≥ 0
Property 2: P(S = A + A) = 1.0
Property 3: If A1 , A2 , …, An are events Ai ∩ Aj = ∅, then
P(A1 ∪ A2 ∪ · · · ∪ An ) = P(A1 ) + P(A2 ) + · · · + P(An )

15.7 Summary 399
Continuous distributions
Property 1: f (X = A) > 0, A ∈ .
Property 2: f (X ) dx = 1.0
Property 3: The probability of event X ∈ A is P(X ∈ A) = A f (x) dx.
Probability Theorems

P(A) = 1 − P Ā
P(∅) = 0.
For each event A, P(A) ≤ 1.0

If A and B are any two events, P(A ∪ B) = P(A) + P(B)−P(A ∩ B).
Note: If A ∩ B = ∅, P(A ∪ B) = P(A) + P(B).
If any two events A and B are independent, P(A ∩ B) = P(A) × P(B).
Discrete Probability Distributions
Definition: A random variable X is a numerical function specified over some

sample space S that can take on only a countable number of values in S.
Definition: The probability distribution for a discrete random variable X is a
table, graph, or formula that gives the probability P(X = x) of each possible value
of X = x.
function P(X = x). The mean or expected value of X is

μ = E[X ] = xi P(xi )
N
where N = number of individuals in the population. In cases where all individuals of

a population cannot be enumerated, the population mean is estimated from a random
sample by the sample mean.

xi
x= n
n
function P(X = x). The variance of X is

σ 2 = V [X ] = (xi − μ)2 P(xi )
N
where N = number of individuals in the population. In cases where all individuals

of a population cannot be enumerated, the population variance is estimated from a
random sample by the sample variance

− x)2
n (x i
s =
2
n−1
where n − 1 adjusts for the loss of 1 degree of freedom using x-bar to estimate
the population mean μ, because E[x-bar] = μ. The standard deviation of a random
variable is defined as
√
s = s2
Bernoulli Distribution
p(x = 0, 1) = P x (1 − p)x
E[X ] = p
σ 2 = p(1 − p)
Binomial Distribution

n
P(X = x) = p x (1 − p)n−x
x
E[X ] = np
σ 2 = np(1 − p)
Poisson Distribution
λx e−λ
P(X = x) =
x!
E[X ] = λ
σ2 = λ
15.7 Summary 401
Continuous Probability Distributions
Definition: A continuous random variable X has the following properties.
• The cumulative distribution function F

X takes on an uncountable infinite number of values in the interval (−∞, ∞).
• (X) is continuous.
• The P(X = x) = 0.
Definition: The cumulative distribution function F(x) for a random variable X

is equal to the probability
F(x) = P(X ≤ x), −∞ < x < ∞
Definition: If F(x) is the cumulative distribution function for a continuous random

variable X, then the density function f (x) for X is
dF(x)
f (x) =
dx
Definition: Let X be a continuous random variable with density function f (x).
Then, the expected value or mean of X is
∞
μ = E[X ] = ∫ x f (x)dx
−∞
Definition: Let X be a continuous random variable with E[X] = μ, Then, the

variance of X is
∞
σ 2 = ∫ (x − μ)2 f (x)dx
−∞
Uniform Distribution
1
f (x) = ,a ≤ x ≤ b
b−a
f (x) = 0 elsewhere
a+b
E[X ] =
2
(b − a)2
σ2 =
12
Triangular Distribution
(x − a)2
f (x) = ,a ≤ x ≤ c
(b − a)(c − a)
(b − x)2
f (x) = 1 − ,c ≤ x ≤ b
(b − a)(b − c)
a+b+c
E[X ] =
3
a 2 + b2 + c2 − ab − ac − bc
σ2 =
18
Normal Distribution
1
√ e− 2 ( σ )
1 x−μ 2
f (x) =
σ 2π
E[X ] = μ
V [X ] = σ 2
The standard normal variate N(0, 1) and the normal variate N(μ, σ 2 ) are related
by
N (0, 1) = [N (μ, σ ) − μ]/σ
Central Limit Theorem: If x 1 , x 2 , …, x n are identically, independently distributed

(IID) random variables from any unimodal distribution with mean μ and variance
σ 2 , and if y = x 1 + x 2 + · · · + x n , then the distribution of y

y − n μi
2
n σi
approaches N(0, 1) as n → ∞. Since y is the summation of x i IID variables, the

variance of the mean is
15.7 Summary 403
y nσ 2 σ2
V [μ] = V = 2 =
n n n
√
Taking the square root yields the standard error of the mean SEM = σ/ n.
Linear Combinations: If x i,j , where i = 1 to a units and j = 1 to jth variable, are
N(μ, σ 2 ) distributed, then the linear combination of
y = a1 x 1 + a2 x 2 + · · · + a j x j
is normally distributed with mean
μ y = a1 μ1 + a2 μ2 + · · · + a j μ j
and variance
σ y2 = a12 σ12 + a22 σ22 + · · · + a 2j σ j2
Exponential Distribution
f (x) = λe−λx or f (x) = λeλx
1
μ=
λ
1
σ2 =
λ2
Lognormal Distribution
2
1 −1
ln(x)−μ N
f (x) = √ e 2 σN
xσ N 2π
μ = meσ N /2
2

V [X ] = m 2 eσ N eσ N − 1
2 2
Influence Diagrams
Definition: A decision is the selection of a sequence of actions designed to resolve

a problem or attain an objective.
Definition: Alternatives are two or more available actions.
Definition: Constraints—(1) Limitations or restrictions on selecting an alterna-

tive or on a selected alternative’s range of outcome values. (2) Decision constraints
are a set of rules for acceptable values of decision variables.
Definition: Criteria are acceptable values of decision variables.
Definition: An outcome of a decision is the realized value of the decision criterion
or criteria vector.
Definition: Stakeholders are all persons impacted by or with interest in the
outcome of a decision.
in an objective function predictor variable or constraint necessary to change the
decision to select a particular alternative. The point at which the decision changes
from one alternative to another is the point of indifference.
Decision Analysis
Definition: A decision tree is a static graphical representation of the probabilistic

outcomes of a decision.
Decision Tree Risk Simulation
Used to investigate a wide variety of “what if” questions about risky decisions.
• The long-run expected average values of variables and metrics.
• The prediction error of the expected average values.
• The points at which a decision changes from one alternative to another are due
to random variation (we examined structural points of indifference in Sect. 10.0
graphical sensitivity analysis).
• The breakeven points where NPW or EUAW ≤ 0 given a stated MARR, or the
points where IRR ≤ MARR or stockholders’ required return on equity.
• How changes in input factor or variable values affect the expected values and
prediction error of output metrics (NPW, EUAW, or RoI).
• Which input factors or variables dominate (are probabilistically important
components of) the decision.
Process
1. Identify the Economic Investment Problem—This was the central discussion
of the first eleven chapters of this text: new product, new process, upgraded
product or process, new facility or facility expansion, alternative investment
comparisons (incremental analysis), replacement analysis, etc.
2. Construct the Cash Flow Model—A mathematical model that estimates the
current value of an investment based on its expected future cash flows.
3. Construct the Decision Tree—The static graphical representation of the proba-
bilistic outcomes of an investment decision.
15.7 Summary 405
4. Construct the Simulation Model—Translation of the graphical decision tree

structure into a discounted cash flow model that can be executed in the selected
simulation software application.
5. Simulation Runs—Determine the number of runs necessary to achieve a
required statistical prediction interval (subject of statistical or simulation text-
books) and conduct those runs. After each run, record the values of economic
criteria (NPW, EUAW, or RoI).
6. Simulation Sensitivity Analysis—Given the observed random variation in the
economic criteria, determine the statistical prediction interval and points of
indifferences in interval unions where decision changes occur.
15.8 Key Terms
Asset criteria
Asset problem
Bernoulli distribution
Binomial distribution
Decision tree
Economic risk
Exponential distribution
Influence diagram
Investment objective
Lognormal distribution
Mean
Normal distribution
Probability
Probability distribution
Probability mass function
Poisson distribution
Population
Random variation
Requirements criteria
Risk simulation
Sensitivity analysis
Simulation
Standard deviation
Statistics
Structural variation
Triangular distribution
Uniform distribution
Variance
Problems
1. Heat recirculatory exchangers are being installed in a factory heating system to
increase heat exchange efficiency in the facility. The exchangers’ initial cost is
$96,000 with an expected life of 12 years. Since the facility is in a Midwest state
with variable year-to-year winter temperatures, the predicted annual savings in
natural gas is triangularly distributed with P(low savings|mild = $12,000) =
0.10, P(moderate savings|normal = $16,000) = 0.6, and P(high savings|severe
= $18,000) = 0.3.
(a) Estimate the expected (mean) savings.
(b) Estimate the variance and standard deviation of savings.
(c) Estimate the expected internal rate of return.
(d) If MARR = 9.0% for this type of investment, should the recirculatory
exchangers be installed?
2. For the heat recirculatory exchangers’ installation in problem 1, assume that the
distribution of annual savings can be estimated by a triangular distribution with
low(a) = $12,000, mode(c) = $16,000, and high (b) = $18,000.
(a) Estimate the expected (mean) savings.
(b) Estimate the variance and standard deviation of savings.
(c) Estimate the expected internal rate of return.
(d) If MARR = 9.0% for this type of investment, should the recirculatory
exchangers be installed?
3. A new development project has a life of 7 years and no salvage value. The orga-
nization uses MARR = 18% for risky new development projects. The project
has independent uncertain initial cost and annual net revenue as shown in the
following table.
P (Init cost) Initial cost P (Ann Rev) Annual Rev

0.2 $450,000 0.1 $176,000
0.7 $600,000 0.5 $212,000
0.3 $900,000 0.4 $240,000
(a) Since each initial cost and annual net revenue are independent, esti-
mate the joint probability distribution P(Cost ∩ Revenue) = P(Cost) ×
P(Revenue).
(b) Estimate the expected value, variance, and standard deviation of the NPW
of the joint probability distribution.
(c) Defining pessimistic as initial cost = $900,000 and annual revenue =
$176,000, most likely as initial cost = $600,000 and annual revenue =
$212,000, and most likely as optimistic as initial cost = $450,000 and
annual revenue= $240,000, estimate the pessimistic, most likely, and
optimistic NPW.
15.8 Key Terms 407
4. Construct a decision tree of the new development project in problem 3 and find
the expected NPW.
5. Using the decision tree for problem 4, by what percentage can the joint annual
revenues decrease before the decision changes to not invest? (b) By what
percentage can the joint initial costs increase (go more negative) before the
decision changes to not invest?
6. Assume that initial costs are known with a high degree of certainty. Given
the expected means and historical standard deviations of normally distributed
annual revenues, conduct a 100-trial simulation of the project (NPW) using the
decision tree from problem 4. What percentage of the outcomes will yield the
decision to not invest?
P (Init cost) Initial cost P (Ann Rev) E[Ann Rev] Std deviation
0.2 $450,000 0.1 $176,000 $19,950
0.7 $600,000 0.5 $212,000 $24,000
0.3 $900,000 0.4 $240,000 $27,200
Appendix A
Use of the Microsoft® Excel® Compound
Interest Calculator Spreadsheet
Engineering economics textbooks typically provide an appendix with multiple pages

of compound interest tables indexed by interest percentage. Before the advent of
personal computers and spreadsheet programs such as Excel® , this was the only
effective means of avoiding manual computation of the correct compound interest
formula each time it was used in a cash flow equation. Spreadsheet programs supply
built-in discrete compounding functions and provide the ability to code formulas
specifying geometric gradient and continuous compounding functions. In addition
to setting forth multiple pages of discrete payment compound amount factors for
functional notation (i.e., (P/F, i, n), (A/P, i, n), etc.) in Appendix B, this work provides
a one-spreadsheet Excel® workbook as a supplement.
The spreadsheet requires only two inputs:
• Interest rate i. This interest rate is used to update the spreadsheet factors for both
discrete and continuous compounding.
© The Editor(s) (if applicable) and The Author(s), under exclusive license 409
to Springer Nature Switzerland AG 2022
https://doi.org/10.1007/978-3-030-87767-5
410 Appendix A: Use of the Microsoft® Excel® Compound Interest Calculator Spreadsheet
• Geometric growth rate g. The combination of I and g is required to update the

geometric gradient (P/A, i, g, n) and (F/A, i, g, n) compound amount factors.
Appendix B
Discrete Payment Compound Interest Factors
Interest Rate: 0.25%
Single payment Uniform payment series

n F/P P/F A/F A/P F/A P/A
1 1.00250 0.99751 1.00000 1.00250 1.00000 0.99751
2 1.00501 0.99502 0.49938 0.50188 2.00250 1.99252
3 1.00752 0.99254 0.33250 0.33500 3.00751 2.98506
4 1.01004 0.99006 0.24906 0.25156 4.01503 3.97512
5 1.01256 0.98759 0.19900 0.20150 5.02506 4.96272
6 1.01509 0.98513 0.16563 0.16813 6.03763 5.94785
7 1.01763 0.98267 0.14179 0.14429 7.05272 6.93052
8 1.02018 0.98022 0.12391 0.12641 8.07035 7.91074
9 1.02273 0.97778 0.11000 0.11250 9.09053 8.88852
10 1.02528 0.97534 0.09888 0.10138 10.11325 9.86386
11 1.02785 0.97291 0.08978 0.09228 11.13854 10.83677
12 1.03042 0.97048 0.08219 0.08469 12.16638 11.80725
13 1.03299 0.96806 0.07578 0.07828 13.19680 12.77532
14 1.03557 0.96565 0.07028 0.07278 14.22979 13.74096
15 1.03816 0.96324 0.06551 0.06801 15.26537 14.70420
16 1.04076 0.96084 0.06134 0.06384 16.30353 15.66504
17 1.04336 0.95844 0.05766 0.06016 17.34429 16.62348
18 1.04597 0.95605 0.05438 0.05688 18.38765 17.57953
19 1.04858 0.95367 0.05146 0.05396 19.43362 18.53320
20 1.05121 0.95129 0.04882 0.05132 20.48220 19.48449
(continued)
https://doi.org/10.1007/978-3-030-87767-5
412 Appendix B: Discrete Payment Compound Interest Factors
(continued)
21 1.05383 0.94892 0.04644 0.04894 21.53341 20.43340
22 1.05647 0.94655 0.04427 0.04677 22.58724 21.37995
23 1.05911 0.94419 0.04229 0.04479 23.64371 22.32414
24 1.06176 0.94184 0.04048 0.04298 24.70282 23.26598
25 1.06441 0.93949 0.03881 0.04131 25.76457 24.20547
26 1.06707 0.93714 0.03727 0.03977 26.82899 25.14261
27 1.06974 0.93481 0.03585 0.03835 27.89606 26.07742
28 1.07241 0.93248 0.03452 0.03702 28.96580 27.00989
29 1.07510 0.93015 0.03329 0.03579 30.03821 27.94004
30 1.07778 0.92783 0.03214 0.03464 31.11331 28.86787
35 1.09132 0.91632 0.02738 0.02988 36.52924 33.47243
40 1.10503 0.90495 0.02380 0.02630 42.01320 38.01986
45 1.11892 0.89372 0.02102 0.02352 47.56606 42.51088
50 1.13297 0.88263 0.01880 0.02130 53.18868 46.94617
60 1.16162 0.86087 0.01547 0.01797 64.64671 55.65236
70 1.19099 0.83964 0.01309 0.01559 76.39444 64.14385
80 1.22110 0.81894 0.01131 0.01381 88.43918 72.42595
90 1.25197 0.79874 0.00992 0.01242 100.78845 80.50382
100 1.28362 0.77904 0.00881 0.01131 113.44996 88.38248
Interest rate: 0.25%
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.49938 0.99502
3 0.99834 2.98009
4 1.49688 5.95028
5 1.99501 9.90065
6 2.49272 14.82630
7 2.99001 20.72235
8 3.48689 27.58391
9 3.98335 35.40614
10 4.47940 44.18420
11 4.97503 53.91328
12 5.47025 64.58858
(continued)
Appendix B: Discrete Payment Compound Interest Factors 413
(continued)
Arithmetic grad
n A/G P/G
13 5.96504 76.20532
14 6.45943 88.75874
15 6.95339 102.24409
16 7.44694 116.65666
17 7.94008 131.99172
18 8.43279 148.24459
19 8.92510 165.41059
20 9.41698 183.48508
21 9.90845 202.46341
22 10.39951 222.34096
23 10.89014 243.11313
24 11.38036 264.77534
25 11.87017 287.32301
26 12.35956 310.75160
27 12.84853 335.05657
28 13.33709 360.23340
29 13.82523 386.27760
30 14.31296 413.18468
35 16.74535 560.50760
40 19.16735 728.73988
45 21.57895 917.34000
50 23.98016 1,125.77667
60 28.75142 1,600.08454
70 33.48117 2,147.61109
80 38.16942 2,764.45681
90 42.81623 3,446.86997
100 47.42163 4,191.24173

1 1.00500 0.99502 1.00000 1.00500 1.00000 0.99502
2 1.01003 0.99007 0.49875 0.50375 2.00500 1.98510
3 1.01508 0.98515 0.33167 0.33667 3.01502 2.97025
4 1.02015 0.98025 0.24813 0.25313 4.03010 3.95050
(continued)
(continued)
5 1.02525 0.97537 0.19801 0.20301 5.05025 4.92587
6 1.03038 0.97052 0.16460 0.16960 6.07550 5.89638
7 1.03553 0.96569 0.14073 0.14573 7.10588 6.86207
8 1.04071 0.96089 0.12283 0.12783 8.14141 7.82296
9 1.04591 0.95610 0.10891 0.11391 9.18212 8.77906
10 1.05114 0.95135 0.09777 0.10277 10.22803 9.73041
11 1.05640 0.94661 0.08866 0.09366 11.27917 10.67703
12 1.06168 0.94191 0.08107 0.08607 12.33556 11.61893
13 1.06699 0.93722 0.07464 0.07964 13.39724 12.55615
14 1.07232 0.93256 0.06914 0.07414 14.46423 13.48871
15 1.07768 0.92792 0.06436 0.06936 15.53655 14.41662
16 1.08307 0.92330 0.06019 0.06519 16.61423 15.33993
17 1.08849 0.91871 0.05651 0.06151 17.69730 16.25863
18 1.09393 0.91414 0.05323 0.05823 18.78579 17.17277
19 1.09940 0.90959 0.05030 0.05530 19.87972 18.08236
20 1.10490 0.90506 0.04767 0.05267 20.97912 18.98742
21 1.11042 0.90056 0.04528 0.05028 22.08401 19.88798
22 1.11597 0.89608 0.04311 0.04811 23.19443 20.78406
23 1.12155 0.89162 0.04113 0.04613 24.31040 21.67568
24 1.12716 0.88719 0.03932 0.04432 25.43196 22.56287
25 1.13280 0.88277 0.03765 0.04265 26.55912 23.44564
26 1.13846 0.87838 0.03611 0.04111 27.69191 24.32402
27 1.14415 0.87401 0.03469 0.03969 28.83037 25.19803
28 1.14987 0.86966 0.03336 0.03836 29.97452 26.06769
29 1.15562 0.86533 0.03213 0.03713 31.12439 26.93302
30 1.16140 0.86103 0.03098 0.03598 32.28002 27.79405
35 1.19073 0.83982 0.02622 0.03122 38.14538 32.03537
40 1.22079 0.81914 0.02265 0.02765 44.15885 36.17223
45 1.25162 0.79896 0.01987 0.02487 50.32416 40.20720
50 1.28323 0.77929 0.01765 0.02265 56.64516 44.14279
60 1.34885 0.74137 0.01433 0.01933 69.77003 51.72556
70 1.41783 0.70530 0.01197 0.01697 83.56611 58.93942
80 1.49034 0.67099 0.01020 0.01520 98.06771 65.80231
90 1.56655 0.63834 0.00883 0.01383 113.31094 72.33130
100 1.64667 0.60729 0.00773 0.01273 129.33370 78.54264
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.49875 0.99007
3 0.99667 2.96037
4 1.49377 5.90111
5 1.99003 9.80260
6 2.48545 14.65519
7 2.98005 20.44933
8 3.47382 27.17552
9 3.96675 34.82436
10 4.45885 43.38649
11 4.95013 52.85264
12 5.44057 63.21360
13 5.93018 74.46023
14 6.41896 86.58346
15 6.90691 99.57430
16 7.39403 113.42380
17 7.88031 128.12311
18 8.36577 143.66343
19 8.85040 160.03602
20 9.33419 177.23221
21 9.81716 195.24341
22 10.29929 214.06109
23 10.78060 233.67676
24 11.26107 254.08203
25 11.74072 275.26856
26 12.21953 297.22805
27 12.69751 319.95231
28 13.17467 343.43317
29 13.65099 367.66255
30 14.12649 392.63241
35 16.49153 528.31226
40 18.83585 681.33469
45 21.15947 850.76312
50 23.46242 1,035.69659
60 28.00638 1,448.64580
70 32.46796 1,913.64274
(continued)
(continued)
Arithmetic grad
n A/G P/G
80 36.84742 2,424.64551
90 41.14508 2,976.07688
100 45.36126 3,562.79343

1 1.00750 0.99256 1.00000 1.00750 1.00000 0.99256
2 1.01506 0.98517 0.49813 0.50563 2.00750 1.97772
3 1.02267 0.97783 0.33085 0.33835 3.02256 2.95556
4 1.03034 0.97055 0.24721 0.25471 4.04523 3.92611
5 1.03807 0.96333 0.19702 0.20452 5.07556 4.88944
6 1.04585 0.95616 0.16357 0.17107 6.11363 5.84560
7 1.05370 0.94904 0.13967 0.14717 7.15948 6.79464
8 1.06160 0.94198 0.12176 0.12926 8.21318 7.73661
9 1.06956 0.93496 0.10782 0.11532 9.27478 8.67158
10 1.07758 0.92800 0.09667 0.10417 10.34434 9.59958
11 1.08566 0.92109 0.08755 0.09505 11.42192 10.52067
12 1.09381 0.91424 0.07995 0.08745 12.50759 11.43491
13 1.10201 0.90743 0.07352 0.08102 13.60139 12.34235
14 1.11028 0.90068 0.06801 0.07551 14.70340 13.24302
15 1.11860 0.89397 0.06324 0.07074 15.81368 14.13699
16 1.12699 0.88732 0.05906 0.06656 16.93228 15.02431
17 1.13544 0.88071 0.05537 0.06287 18.05927 15.90502
18 1.14396 0.87416 0.05210 0.05960 19.19472 16.77918
19 1.15254 0.86765 0.04917 0.05667 20.33868 17.64683
20 1.16118 0.86119 0.04653 0.05403 21.49122 18.50802
21 1.16989 0.85478 0.04415 0.05165 22.65240 19.36280
22 1.17867 0.84842 0.04198 0.04948 23.82230 20.21121
23 1.18751 0.84210 0.04000 0.04750 25.00096 21.05331
24 1.19641 0.83583 0.03818 0.04568 26.18847 21.88915
25 1.20539 0.82961 0.03652 0.04402 27.38488 22.71876
26 1.21443 0.82343 0.03498 0.04248 28.59027 23.54219
27 1.22354 0.81730 0.03355 0.04105 29.80470 24.35949
28 1.23271 0.81122 0.03223 0.03973 31.02823 25.17071
(continued)
(continued)
29 1.24196 0.80518 0.03100 0.03850 32.26094 25.97589
30 1.25127 0.79919 0.02985 0.03735 33.50290 26.77508
35 1.29890 0.76988 0.02509 0.03259 39.85381 30.68266
40 1.34835 0.74165 0.02153 0.02903 46.44648 34.44694
45 1.39968 0.71445 0.01877 0.02627 53.29011 38.07318
50 1.45296 0.68825 0.01656 0.02406 60.39426 41.56645
60 1.56568 0.63870 0.01326 0.02076 75.42414 48.17337
70 1.68715 0.59272 0.01091 0.01841 91.62007 54.30462
80 1.81804 0.55004 0.00917 0.01667 109.07253 59.99444
90 1.95909 0.51044 0.00782 0.01532 127.87899 65.27461
100 2.11108 0.47369 0.00675 0.01425 148.14451 70.17462
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.49813 0.98517
3 0.99502 2.94083
4 1.49066 5.85250
5 1.98506 9.70581
6 2.47821 14.48660
7 2.97011 20.18084
8 3.46077 26.77467
9 3.95019 34.25438
10 4.43836 42.60641
11 4.92529 51.81736
12 5.41097 61.87398
13 5.89541 72.76316
14 6.37860 84.47197
15 6.86055 96.98758
16 7.34126 110.29735
17 7.82072 124.38875
18 8.29894 139.24940
19 8.77592 154.86708
20 9.25165 171.22969
(continued)
(continued)
Arithmetic grad
n A/G P/G
21 9.72614 188.32527
22 10.19939 206.14200
23 10.67139 224.66820
24 11.14216 243.89233
25 11.61168 263.80295
26 12.07996 284.38879
27 12.54701 305.63869
28 13.01281 327.54162
29 13.47737 350.08668
30 13.94069 373.26310
35 16.23872 498.24714
40 18.50583 637.46933
45 20.74209 789.71734
50 22.94756 953.84863
60 27.26649 1,313.51888
70 31.46337 1,708.60649
80 35.53908 2,132.14723
90 39.49462 2,577.99605
100 43.33112 3,040.74530

1 1.01000 0.99010 1.00000 1.01000 1.00000 0.99010
2 1.02010 0.98030 0.49751 0.50751 2.01000 1.97040
3 1.03030 0.97059 0.33002 0.34002 3.03010 2.94099
4 1.04060 0.96098 0.24628 0.25628 4.06040 3.90197
5 1.05101 0.95147 0.19604 0.20604 5.10101 4.85343
6 1.06152 0.94205 0.16255 0.17255 6.15202 5.79548
7 1.07214 0.93272 0.13863 0.14863 7.21354 6.72819
8 1.08286 0.92348 0.12069 0.13069 8.28567 7.65168
9 1.09369 0.91434 0.10674 0.11674 9.36853 8.56602
10 1.10462 0.90529 0.09558 0.10558 10.46221 9.47130
11 1.11567 0.89632 0.08645 0.09645 11.56683 10.36763
12 1.12683 0.88745 0.07885 0.08885 12.68250 11.25508
(continued)
(continued)
13 1.13809 0.87866 0.07241 0.08241 13.80933 12.13374
14 1.14947 0.86996 0.06690 0.07690 14.94742 13.00370
15 1.16097 0.86135 0.06212 0.07212 16.09690 13.86505
16 1.17258 0.85282 0.05794 0.06794 17.25786 14.71787
17 1.18430 0.84438 0.05426 0.06426 18.43044 15.56225
18 1.19615 0.83602 0.05098 0.06098 19.61475 16.39827
19 1.20811 0.82774 0.04805 0.05805 20.81090 17.22601
20 1.22019 0.81954 0.04542 0.05542 22.01900 18.04555
21 1.23239 0.81143 0.04303 0.05303 23.23919 18.85698
22 1.24472 0.80340 0.04086 0.05086 24.47159 19.66038
23 1.25716 0.79544 0.03889 0.04889 25.71630 20.45582
24 1.26973 0.78757 0.03707 0.04707 26.97346 21.24339
25 1.28243 0.77977 0.03541 0.04541 28.24320 22.02316
26 1.29526 0.77205 0.03387 0.04387 29.52563 22.79520
27 1.30821 0.76440 0.03245 0.04245 30.82089 23.55961
28 1.32129 0.75684 0.03112 0.04112 32.12910 24.31644
29 1.33450 0.74934 0.02990 0.03990 33.45039 25.06579
30 1.34785 0.74192 0.02875 0.03875 34.78489 25.80771
35 1.41660 0.70591 0.02400 0.03400 41.66028 29.40858
40 1.48886 0.67165 0.02046 0.03046 48.88637 32.83469
45 1.56481 0.63905 0.01771 0.02771 56.48107 36.09451
50 1.64463 0.60804 0.01551 0.02551 64.46318 39.19612
60 1.81670 0.55045 0.01224 0.02224 81.66967 44.95504
70 2.00676 0.49831 0.00993 0.01993 100.67634 50.16851
80 2.21672 0.45112 0.00822 0.01822 121.67152 54.88821
90 2.44863 0.40839 0.00690 0.01690 144.86327 59.16088
100 2.70481 0.36971 0.00587 0.01587 170.48138 63.02888
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.49751 0.98030
3 0.99337 2.92148
4 1.48756 5.80442
(continued)
(continued)
Arithmetic grad
n A/G P/G
5 1.98010 9.61028
6 2.47098 14.32051
7 2.96020 19.91681
8 3.44777 26.38120
9 3.93367 33.69592
10 4.41792 41.84350
11 4.90052 50.80674
12 5.38145 60.56868
13 5.86073 71.11263
14 6.33836 82.42215
15 6.81433 94.48104
16 7.28865 107.27336
17 7.76131 120.78340
18 8.23231 134.99569
19 8.70167 149.89501
20 9.16937 165.46636
21 9.63542 181.69496
22 10.09982 198.56628
23 10.56257 216.06600
24 11.02367 234.18002
25 11.48312 252.89446
26 11.94092 272.19566
27 12.39707 292.07016
28 12.85158 312.50472
29 13.30444 333.48630
30 13.75566 355.00207
35 15.98711 470.15831
40 18.17761 596.85606
45 20.32730 733.70372
50 22.43635 879.41763
60 26.53331 1,192.80614
70 30.47026 1,528.64744
80 34.24920 1,879.87710
90 37.87245 2,240.56748
100 41.34257 2,605.77575

1 1.01250 0.98765 1.00000 1.01250 1.00000 0.98765
2 1.02516 0.97546 0.49689 0.50939 2.01250 1.96312
3 1.03797 0.96342 0.32920 0.34170 3.03766 2.92653
4 1.05095 0.95152 0.24536 0.25786 4.07563 3.87806
5 1.06408 0.93978 0.19506 0.20756 5.12657 4.81784
6 1.07738 0.92817 0.16153 0.17403 6.19065 5.74601
7 1.09085 0.91672 0.13759 0.15009 7.26804 6.66273
8 1.10449 0.90540 0.11963 0.13213 8.35889 7.56812
9 1.11829 0.89422 0.10567 0.11817 9.46337 8.46234
10 1.13227 0.88318 0.09450 0.10700 10.58167 9.34553
11 1.14642 0.87228 0.08537 0.09787 11.71394 10.21780
12 1.16075 0.86151 0.07776 0.09026 12.86036 11.07931
13 1.17526 0.85087 0.07132 0.08382 14.02112 11.93018
14 1.18995 0.84037 0.06581 0.07831 15.19638 12.77055
15 1.20483 0.82999 0.06103 0.07353 16.38633 13.60055
16 1.21989 0.81975 0.05685 0.06935 17.59116 14.42029
17 1.23514 0.80963 0.05316 0.06566 18.81105 15.22992
18 1.25058 0.79963 0.04988 0.06238 20.04619 16.02955
19 1.26621 0.78976 0.04696 0.05946 21.29677 16.81931
20 1.28204 0.78001 0.04432 0.05682 22.56298 17.59932
21 1.29806 0.77038 0.04194 0.05444 23.84502 18.36969
22 1.31429 0.76087 0.03977 0.05227 25.14308 19.13056
23 1.33072 0.75147 0.03780 0.05030 26.45737 19.88204
24 1.34735 0.74220 0.03599 0.04849 27.78808 20.62423
25 1.36419 0.73303 0.03432 0.04682 29.13544 21.35727
26 1.38125 0.72398 0.03279 0.04529 30.49963 22.08125
27 1.39851 0.71505 0.03137 0.04387 31.88087 22.79630
28 1.41599 0.70622 0.03005 0.04255 33.27938 23.50252
29 1.43369 0.69750 0.02882 0.04132 34.69538 24.20002
30 1.45161 0.68889 0.02768 0.04018 36.12907 24.88891
35 1.54464 0.64740 0.02295 0.03545 43.57087 28.20786
40 1.64362 0.60841 0.01942 0.03192 51.48956 31.32693
45 1.74895 0.57177 0.01669 0.02919 59.91569 34.25817
50 1.86102 0.53734 0.01452 0.02702 68.88179 37.01288
60 2.10718 0.47457 0.01129 0.02379 88.57451 42.03459
70 2.38590 0.41913 0.00902 0.02152 110.87200 46.46968
(continued)
(continued)
80 2.70148 0.37017 0.00735 0.01985 136.11880 50.38666
90 3.05881 0.32692 0.00607 0.01857 164.70501 53.84606
100 3.46340 0.28873 0.00507 0.01757 197.07234 56.90134
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.49689 0.97546
3 0.99172 2.90230
4 1.48447 5.75687
5 1.97516 9.51598
6 2.46377 14.15685
7 2.95032 19.65715
8 3.43479 25.99494
9 3.91720 33.14870
10 4.39754 41.09733
11 4.87581 49.82011
12 5.35202 59.29670
13 5.82616 69.50717
14 6.29824 80.43196
15 6.76825 92.05186
16 7.23620 104.34806
17 7.70208 117.30207
18 8.16591 130.89580
19 8.62767 145.11145
20 9.08738 159.93161
21 9.54502 175.33919
22 10.00062 191.31742
23 10.45415 207.84986
24 10.90564 224.92039
25 11.35507 242.51321
26 11.80245 260.61282
27 12.24778 279.20402
28 12.69106 298.27192
(continued)
(continued)
Arithmetic grad
n A/G P/G
29 13.13230 317.80191
30 13.57150 337.77969
35 15.73688 443.90369
40 17.85148 559.23198
45 19.91557 682.27103
50 21.92950 811.67385
60 25.80834 1,084.84285
70 29.49130 1,370.45134
80 32.98225 1,661.86513
90 36.28548 1,953.83026
100 39.40577 2,242.24109

1 1.01500 0.98522 1.00000 1.01500 1.00000 0.98522
2 1.03023 0.97066 0.49628 0.51128 2.01500 1.95588
3 1.04568 0.95632 0.32838 0.34338 3.04522 2.91220
4 1.06136 0.94218 0.24444 0.25944 4.09090 3.85438
5 1.07728 0.92826 0.19409 0.20909 5.15227 4.78264
6 1.09344 0.91454 0.16053 0.17553 6.22955 5.69719
7 1.10984 0.90103 0.13656 0.15156 7.32299 6.59821
8 1.12649 0.88771 0.11858 0.13358 8.43284 7.48593
9 1.14339 0.87459 0.10461 0.11961 9.55933 8.36052
10 1.16054 0.86167 0.09343 0.10843 10.70272 9.22218
11 1.17795 0.84893 0.08429 0.09929 11.86326 10.07112
12 1.19562 0.83639 0.07668 0.09168 13.04121 10.90751
13 1.21355 0.82403 0.07024 0.08524 14.23683 11.73153
14 1.23176 0.81185 0.06472 0.07972 15.45038 12.54338
15 1.25023 0.79985 0.05994 0.07494 16.68214 13.34323
16 1.26899 0.78803 0.05577 0.07077 17.93237 14.13126
17 1.28802 0.77639 0.05208 0.06708 19.20136 14.90765
18 1.30734 0.76491 0.04881 0.06381 20.48938 15.67256
19 1.32695 0.75361 0.04588 0.06088 21.79672 16.42617
20 1.34686 0.74247 0.04325 0.05825 23.12367 17.16864
(continued)
(continued)
21 1.36706 0.73150 0.04087 0.05587 24.47052 17.90014
22 1.38756 0.72069 0.03870 0.05370 25.83758 18.62082
23 1.40838 0.71004 0.03673 0.05173 27.22514 19.33086
24 1.42950 0.69954 0.03492 0.04992 28.63352 20.03041
25 1.45095 0.68921 0.03326 0.04826 30.06302 20.71961
26 1.47271 0.67902 0.03173 0.04673 31.51397 21.39863
27 1.49480 0.66899 0.03032 0.04532 32.98668 22.06762
28 1.51722 0.65910 0.02900 0.04400 34.48148 22.72672
29 1.53998 0.64936 0.02778 0.04278 35.99870 23.37608
30 1.56308 0.63976 0.02664 0.04164 37.53868 24.01584
35 1.68388 0.59387 0.02193 0.03693 45.59209 27.07559
40 1.81402 0.55126 0.01843 0.03343 54.26789 29.91585
45 1.95421 0.51171 0.01572 0.03072 63.61420 32.55234
50 2.10524 0.47500 0.01357 0.02857 73.68283 34.99969
60 2.44322 0.40930 0.01039 0.02539 96.21465 39.38027
70 2.83546 0.35268 0.00817 0.02317 122.36375 43.15487
80 3.29066 0.30389 0.00655 0.02155 152.71085 46.40732
90 3.81895 0.26185 0.00532 0.02032 187.92990 49.20985
100 4.43205 0.22563 0.00437 0.01937 228.80304 51.62470
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.49628 0.97066
3 0.99007 2.88330
4 1.48139 5.70985
5 1.97023 9.42289
6 2.45658 13.99560
7 2.94046 19.40176
8 3.42185 25.61574
9 3.90077 32.61248
10 4.37721 40.36748
11 4.85118 48.85681
12 5.32267 58.05708
(continued)
(continued)
Arithmetic grad
n A/G P/G
13 5.79169 67.94540
14 6.25824 78.49944
15 6.72231 89.69736
16 7.18392 101.51783
17 7.64306 113.93999
18 8.09973 126.94349
19 8.55394 140.50842
20 9.00569 154.61536
21 9.45497 169.24532
22 9.90180 184.37976
23 10.34618 200.00058
24 10.78810 216.09009
25 11.22758 232.63103
26 11.66460 249.60654
27 12.09918 267.00017
28 12.53132 284.79585
29 12.96102 302.97790
30 13.38829 321.53101
35 15.48820 419.35212
40 17.52773 524.35682
45 19.50739 635.01098
50 21.42772 749.96361
60 25.09296 988.16739
70 28.52901 1,231.16582
80 31.74228 1,473.07411
90 34.73987 1,709.54387
100 37.52953 1,937.45061

1 1.01750 0.98280 1.00000 1.01750 1.00000 0.98280
2 1.03531 0.96590 0.49566 0.51316 2.01750 1.94870
3 1.05342 0.94929 0.32757 0.34507 3.05281 2.89798
4 1.07186 0.93296 0.24353 0.26103 4.10623 3.83094
(continued)
(continued)
5 1.09062 0.91691 0.19312 0.21062 5.17809 4.74786
6 1.10970 0.90114 0.15952 0.17702 6.26871 5.64900
7 1.12912 0.88564 0.13553 0.15303 7.37841 6.53464
8 1.14888 0.87041 0.11754 0.13504 8.50753 7.40505
9 1.16899 0.85544 0.10356 0.12106 9.65641 8.26049
10 1.18944 0.84073 0.09238 0.10988 10.82540 9.10122
11 1.21026 0.82627 0.08323 0.10073 12.01484 9.92749
12 1.23144 0.81206 0.07561 0.09311 13.22510 10.73955
13 1.25299 0.79809 0.06917 0.08667 14.45654 11.53764
14 1.27492 0.78436 0.06366 0.08116 15.70953 12.32201
15 1.29723 0.77087 0.05888 0.07638 16.98445 13.09288
16 1.31993 0.75762 0.05470 0.07220 18.28168 13.85050
17 1.34303 0.74459 0.05102 0.06852 19.60161 14.59508
18 1.36653 0.73178 0.04774 0.06524 20.94463 15.32686
19 1.39045 0.71919 0.04482 0.06232 22.31117 16.04606
20 1.41478 0.70682 0.04219 0.05969 23.70161 16.75288
21 1.43954 0.69467 0.03981 0.05731 25.11639 17.44755
22 1.46473 0.68272 0.03766 0.05516 26.55593 18.13027
23 1.49036 0.67098 0.03569 0.05319 28.02065 18.80125
24 1.51644 0.65944 0.03389 0.05139 29.51102 19.46069
25 1.54298 0.64810 0.03223 0.04973 31.02746 20.10878
26 1.56998 0.63695 0.03070 0.04820 32.57044 20.74573
27 1.59746 0.62599 0.02929 0.04679 34.14042 21.37173
28 1.62541 0.61523 0.02798 0.04548 35.73788 21.98695
29 1.65386 0.60465 0.02676 0.04426 37.36329 22.59160
30 1.68280 0.59425 0.02563 0.04313 39.01715 23.18585
35 1.83529 0.54487 0.02095 0.03845 47.73084 26.00725
40 2.00160 0.49960 0.01747 0.03497 57.23413 28.59423
45 2.18298 0.45809 0.01479 0.03229 67.59858 30.96626
50 2.38079 0.42003 0.01267 0.03017 78.90222 33.14121
60 2.83182 0.35313 0.00955 0.02705 104.67522 36.96399
70 3.36829 0.29689 0.00739 0.02489 135.33076 40.17790
80 4.00639 0.24960 0.00582 0.02332 171.79382 42.87993
90 4.76538 0.20985 0.00465 0.02215 215.16462 45.15161
100 5.66816 0.17642 0.00375 0.02125 266.75177 47.06147
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.49566 0.96590
3 0.98843 2.86447
4 1.47832 5.66334
5 1.96531 9.33099
6 2.44941 13.83671
7 2.93062 19.15057
8 3.40895 25.24345
9 3.88439 32.08698
10 4.35695 39.65354
11 4.82662 47.91623
12 5.29341 56.84886
13 5.75733 66.42596
14 6.21836 76.62270
15 6.67653 87.41495
16 7.13182 98.77919
17 7.58424 110.69257
18 8.03379 123.13283
19 8.48048 136.07832
20 8.92431 149.50799
21 9.36529 163.40134
22 9.80341 177.73847
23 10.23868 192.49999
24 10.67111 207.66706
25 11.10069 223.22138
26 11.52744 239.14512
27 11.95135 255.42098
28 12.37243 272.03215
29 12.79069 288.96226
30 13.20613 306.19544
35 15.24123 396.38241
40 17.20665 492.01087
45 19.10318 591.55397
50 20.93167 693.70101
60 24.38848 901.49545
70 27.58564 1,108.33334
(continued)
(continued)
Arithmetic grad
n A/G P/G
80 30.53289 1,309.24819
90 33.24089 1,500.87981
100 35.72112 1,681.08862 lePara>

1 1.02000 0.98039 1.00000 1.02000 1.00000 0.98039
2 1.04040 0.96117 0.49505 0.51505 2.02000 1.94156
3 1.06121 0.94232 0.32675 0.34675 3.06040 2.88388
4 1.08243 0.92385 0.24262 0.26262 4.12161 3.80773
5 1.10408 0.90573 0.19216 0.21216 5.20404 4.71346
6 1.12616 0.88797 0.15853 0.17853 6.30812 5.60143
7 1.14869 0.87056 0.13451 0.15451 7.43428 6.47199
8 1.17166 0.85349 0.11651 0.13651 8.58297 7.32548
9 1.19509 0.83676 0.10252 0.12252 9.75463 8.16224
10 1.21899 0.82035 0.09133 0.11133 10.94972 8.98259
11 1.24337 0.80426 0.08218 0.10218 12.16872 9.78685
12 1.26824 0.78849 0.07456 0.09456 13.41209 10.57534
13 1.29361 0.77303 0.06812 0.08812 14.68033 11.34837
14 1.31948 0.75788 0.06260 0.08260 15.97394 12.10625
15 1.34587 0.74301 0.05783 0.07783 17.29342 12.84926
16 1.37279 0.72845 0.05365 0.07365 18.63929 13.57771
17 1.40024 0.71416 0.04997 0.06997 20.01207 14.29187
18 1.42825 0.70016 0.04670 0.06670 21.41231 14.99203
19 1.45681 0.68643 0.04378 0.06378 22.84056 15.67846
20 1.48595 0.67297 0.04116 0.06116 24.29737 16.35143
21 1.51567 0.65978 0.03878 0.05878 25.78332 17.01121
22 1.54598 0.64684 0.03663 0.05663 27.29898 17.65805
23 1.57690 0.63416 0.03467 0.05467 28.84496 18.29220
24 1.60844 0.62172 0.03287 0.05287 30.42186 18.91393
25 1.64061 0.60953 0.03122 0.05122 32.03030 19.52346
26 1.67342 0.59758 0.02970 0.04970 33.67091 20.12104
27 1.70689 0.58586 0.02829 0.04829 35.34432 20.70690
28 1.74102 0.57437 0.02699 0.04699 37.05121 21.28127
(continued)
(continued)
29 1.77584 0.56311 0.02578 0.04578 38.79223 21.84438
30 1.81136 0.55207 0.02465 0.04465 40.56808 22.39646
35 1.99989 0.50003 0.02000 0.04000 49.99448 24.99862
40 2.20804 0.45289 0.01656 0.03656 60.40198 27.35548
45 2.43785 0.41020 0.01391 0.03391 71.89271 29.49016
50 2.69159 0.37153 0.01182 0.03182 84.57940 31.42361
60 3.28103 0.30478 0.00877 0.02877 114.05154 34.76089
70 3.99956 0.25003 0.00667 0.02667 149.97791 37.49862
80 4.87544 0.20511 0.00516 0.02516 193.77196 39.74451
90 5.94313 0.16826 0.00405 0.02405 247.15666 41.58693
100 7.24465 0.13803 0.00320 0.02320 312.23231 43.09835
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.49505 0.96117
3 0.98680 2.84581
4 1.47525 5.61735
5 1.96040 9.24027
6 2.44226 13.68013
7 2.92082 18.90349
8 3.39608 24.87792
9 3.86805 31.57197
10 4.33674 38.95510
11 4.80213 46.99773
12 5.26424 55.67116
13 5.72307 64.94755
14 6.17862 74.79992
15 6.63090 85.20213
16 7.07990 96.12881
17 7.52564 107.55542
18 7.96811 119.45813
19 8.40732 131.81388
20 8.84328 144.60033
(continued)
(continued)
Arithmetic grad
n A/G P/G
21 9.27599 157.79585
22 9.70546 171.37947
23 10.13169 185.33090
24 10.55468 199.63049
25 10.97445 214.25924
26 11.39100 229.19872
27 11.80433 244.43113
28 12.21446 259.93924
29 12.62138 275.70639
30 13.02512 291.71644
35 14.99613 374.88264
40 16.88850 461.99313
45 18.70336 551.56519
50 20.44198 642.36059
60 23.69610 823.69753
70 26.66323 999.83432
80 29.35718 1,166.78677
90 31.79292 1,322.17008
100 33.98628 1,464.75275

1 1.02500 0.97561 1.00000 1.02500 1.00000 0.97561
2 1.05063 0.95181 0.49383 0.51883 2.02500 1.92742
3 1.07689 0.92860 0.32514 0.35014 3.07563 2.85602
4 1.10381 0.90595 0.24082 0.26582 4.15252 3.76197
5 1.13141 0.88385 0.19025 0.21525 5.25633 4.64583
6 1.15969 0.86230 0.15655 0.18155 6.38774 5.50813
7 1.18869 0.84127 0.13250 0.15750 7.54743 6.34939
8 1.21840 0.82075 0.11447 0.13947 8.73612 7.17014
9 1.24886 0.80073 0.10046 0.12546 9.95452 7.97087
10 1.28008 0.78120 0.08926 0.11426 11.20338 8.75206
11 1.31209 0.76214 0.08011 0.10511 12.48347 9.51421
12 1.34489 0.74356 0.07249 0.09749 13.79555 10.25776
(continued)
(continued)
13 1.37851 0.72542 0.06605 0.09105 15.14044 10.98318
14 1.41297 0.70773 0.06054 0.08554 16.51895 11.69091
15 1.44830 0.69047 0.05577 0.08077 17.93193 12.38138
16 1.48451 0.67362 0.05160 0.07660 19.38022 13.05500
17 1.52162 0.65720 0.04793 0.07293 20.86473 13.71220
18 1.55966 0.64117 0.04467 0.06967 22.38635 14.35336
19 1.59865 0.62553 0.04176 0.06676 23.94601 14.97889
20 1.63862 0.61027 0.03915 0.06415 25.54466 15.58916
21 1.67958 0.59539 0.03679 0.06179 27.18327 16.18455
22 1.72157 0.58086 0.03465 0.05965 28.86286 16.76541
23 1.76461 0.56670 0.03270 0.05770 30.58443 17.33211
24 1.80873 0.55288 0.03091 0.05591 32.34904 17.88499
25 1.85394 0.53939 0.02928 0.05428 34.15776 18.42438
26 1.90029 0.52623 0.02777 0.05277 36.01171 18.95061
27 1.94780 0.51340 0.02638 0.05138 37.91200 19.46401
28 1.99650 0.50088 0.02509 0.05009 39.85980 19.96489
29 2.04641 0.48866 0.02389 0.04889 41.85630 20.45355
30 2.09757 0.47674 0.02278 0.04778 43.90270 20.93029
35 2.37321 0.42137 0.01821 0.04321 54.92821 23.14516
40 2.68506 0.37243 0.01484 0.03984 67.40255 25.10278
45 3.03790 0.32917 0.01227 0.03727 81.51613 26.83302
50 3.43711 0.29094 0.01026 0.03526 97.48435 28.36231
60 4.39979 0.22728 0.00735 0.03235 135.99159 30.90866
70 5.63210 0.17755 0.00540 0.03040 185.28411 32.89786
80 7.20957 0.13870 0.00403 0.02903 248.38271 34.45182
90 9.22886 0.10836 0.00304 0.02804 329.15425 35.66577
100 11.81372 0.08465 0.00231 0.02731 432.54865 36.61411
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.49383 0.95181
3 0.98354 2.80901
4 1.46914 5.52687
(continued)
(continued)
Arithmetic grad
n A/G P/G
5 1.95063 9.06228
6 2.42801 13.37377
7 2.90128 18.42136
8 3.37045 24.16658
9 3.83552 30.57241
10 4.29649 37.60320
11 4.75338 45.22464
12 5.20618 53.40376
13 5.65490 62.10880
14 6.09955 71.30926
15 6.54013 80.97577
16 6.97665 91.08015
17 7.40912 101.59527
18 7.83754 112.49509
19 8.26193 123.75459
20 8.68230 135.34974
21 9.09865 147.25746
22 9.51099 159.45562
23 9.91933 171.92296
24 10.32369 184.63909
25 10.72408 197.58447
26 11.12050 210.74034
27 11.51298 224.08873
28 11.90152 237.61243
29 12.28613 251.29494
30 12.66683 265.12048
35 14.51218 335.88680
40 16.26203 408.22200
45 17.91848 480.80703
50 19.48389 552.60805
60 22.35185 690.86565
70 24.88807 818.76427
80 27.11666 934.21807
90 29.06288 1,036.54990
100 30.75249 1,125.97474

1 1.03000 0.97087 1.00000 1.03000 1.00000 0.97087
2 1.06090 0.94260 0.49261 0.52261 2.03000 1.91347
3 1.09273 0.91514 0.32353 0.35353 3.09090 2.82861
4 1.12551 0.88849 0.23903 0.26903 4.18363 3.71710
5 1.15927 0.86261 0.18835 0.21835 5.30914 4.57971
6 1.19405 0.83748 0.15460 0.18460 6.46841 5.41719
7 1.22987 0.81309 0.13051 0.16051 7.66246 6.23028
8 1.26677 0.78941 0.11246 0.14246 8.89234 7.01969
9 1.30477 0.76642 0.09843 0.12843 10.15911 7.78611
10 1.34392 0.74409 0.08723 0.11723 11.46388 8.53020
11 1.38423 0.72242 0.07808 0.10808 12.80780 9.25262
12 1.42576 0.70138 0.07046 0.10046 14.19203 9.95400
13 1.46853 0.68095 0.06403 0.09403 15.61779 10.63496
14 1.51259 0.66112 0.05853 0.08853 17.08632 11.29607
15 1.55797 0.64186 0.05377 0.08377 18.59891 11.93794
16 1.60471 0.62317 0.04961 0.07961 20.15688 12.56110
17 1.65285 0.60502 0.04595 0.07595 21.76159 13.16612
18 1.70243 0.58739 0.04271 0.07271 23.41444 13.75351
19 1.75351 0.57029 0.03981 0.06981 25.11687 14.32380
20 1.80611 0.55368 0.03722 0.06722 26.87037 14.87747
21 1.86029 0.53755 0.03487 0.06487 28.67649 15.41502
22 1.91610 0.52189 0.03275 0.06275 30.53678 15.93692
23 1.97359 0.50669 0.03081 0.06081 32.45288 16.44361
24 2.03279 0.49193 0.02905 0.05905 34.42647 16.93554
25 2.09378 0.47761 0.02743 0.05743 36.45926 17.41315
26 2.15659 0.46369 0.02594 0.05594 38.55304 17.87684
27 2.22129 0.45019 0.02456 0.05456 40.70963 18.32703
28 2.28793 0.43708 0.02329 0.05329 42.93092 18.76411
29 2.35657 0.42435 0.02211 0.05211 45.21885 19.18845
30 2.42726 0.41199 0.02102 0.05102 47.57542 19.60044
35 2.81386 0.35538 0.01654 0.04654 60.46208 21.48722
40 3.26204 0.30656 0.01326 0.04326 75.40126 23.11477
45 3.78160 0.26444 0.01079 0.04079 92.71986 24.51871
50 4.38391 0.22811 0.00887 0.03887 112.79687 25.72976
60 5.89160 0.16973 0.00613 0.03613 163.05344 27.67556
70 7.91782 0.12630 0.00434 0.03434 230.59406 29.12342
(continued)
(continued)
80 10.64089 0.09398 0.00311 0.03311 321.36302 30.20076
90 14.30047 0.06993 0.00226 0.03226 443.34890 31.00241
100 19.21863 0.05203 0.00165 0.03165 607.28773 31.59891
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.49261 0.94260
3 0.98030 2.77288
4 1.46306 5.43834
5 1.94090 8.88878
6 2.41383 13.07620
7 2.88185 17.95475
8 3.34496 23.48061
9 3.80318 29.61194
10 4.25650 36.30879
11 4.70494 43.53300
12 5.14850 51.24818
13 5.58720 59.41960
14 6.02104 68.01413
15 6.45004 77.00020
16 6.87421 86.34770
17 7.29357 96.02796
18 7.70812 106.01367
19 8.11788 116.27882
20 8.52286 126.79866
21 8.92309 137.54964
22 9.31858 148.50939
23 9.70934 159.65661
24 10.09540 170.97108
25 10.47677 182.43362
26 10.85348 194.02598
27 11.22554 205.73090
28 11.59298 217.53197
(continued)
(continued)
Arithmetic grad
n A/G P/G
29 11.95582 229.41367
30 12.31407 241.36129
35 14.03749 301.62670
40 15.65016 361.74994
45 17.15557 420.63248
50 18.55751 477.48033
60 21.06742 583.05261
70 23.21454 676.08687
80 25.03534 756.08652
90 26.56665 823.63021
100 27.84445 879.85405

1 1.04000 0.96154 1.00000 1.04000 1.00000 0.96154
2 1.08160 0.92456 0.49020 0.53020 2.04000 1.88609
3 1.12486 0.88900 0.32035 0.36035 3.12160 2.77509
4 1.16986 0.85480 0.23549 0.27549 4.24646 3.62990
5 1.21665 0.82193 0.18463 0.22463 5.41632 4.45182
6 1.26532 0.79031 0.15076 0.19076 6.63298 5.24214
7 1.31593 0.75992 0.12661 0.16661 7.89829 6.00205
8 1.36857 0.73069 0.10853 0.14853 9.21423 6.73274
9 1.42331 0.70259 0.09449 0.13449 10.58280 7.43533
10 1.48024 0.67556 0.08329 0.12329 12.00611 8.11090
11 1.53945 0.64958 0.07415 0.11415 13.48635 8.76048
12 1.60103 0.62460 0.06655 0.10655 15.02581 9.38507
13 1.66507 0.60057 0.06014 0.10014 16.62684 9.98565
14 1.73168 0.57748 0.05467 0.09467 18.29191 10.56312
15 1.80094 0.55526 0.04994 0.08994 20.02359 11.11839
16 1.87298 0.53391 0.04582 0.08582 21.82453 11.65230
17 1.94790 0.51337 0.04220 0.08220 23.69751 12.16567
18 2.02582 0.49363 0.03899 0.07899 25.64541 12.65930
19 2.10685 0.47464 0.03614 0.07614 27.67123 13.13394
20 2.19112 0.45639 0.03358 0.07358 29.77808 13.59033
(continued)
(continued)
21 2.27877 0.43883 0.03128 0.07128 31.96920 14.02916
22 2.36992 0.42196 0.02920 0.06920 34.24797 14.45112
23 2.46472 0.40573 0.02731 0.06731 36.61789 14.85684
24 2.56330 0.39012 0.02559 0.06559 39.08260 15.24696
25 2.66584 0.37512 0.02401 0.06401 41.64591 15.62208
26 2.77247 0.36069 0.02257 0.06257 44.31174 15.98277
27 2.88337 0.34682 0.02124 0.06124 47.08421 16.32959
28 2.99870 0.33348 0.02001 0.06001 49.96758 16.66306
29 3.11865 0.32065 0.01888 0.05888 52.96629 16.98371
30 3.24340 0.30832 0.01783 0.05783 56.08494 17.29203
35 3.94609 0.25342 0.01358 0.05358 73.65222 18.66461
40 4.80102 0.20829 0.01052 0.05052 95.02552 19.79277
45 5.84118 0.17120 0.00826 0.04826 121.02939 20.72004
50 7.10668 0.14071 0.00655 0.04655 152.66708 21.48218
60 10.51963 0.09506 0.00420 0.04420 237.99069 22.62349
70 15.57162 0.06422 0.00275 0.04275 364.29046 23.39451
80 23.04980 0.04338 0.00181 0.04181 551.24498 23.91539
90 34.11933 0.02931 0.00121 0.04121 827.98333 24.26728
100 50.50495 0.01980 0.00081 0.04081 1,237.62370 24.50500
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.49020 0.92456
3 0.97386 2.70255
4 1.45100 5.26696
5 1.92161 8.55467
6 2.38571 12.50624
7 2.84332 17.06575
8 3.29443 22.18058
9 3.73908 27.80127
10 4.17726 33.88135
11 4.60901 40.37716
12 5.03435 47.24773
(continued)
(continued)
Arithmetic grad
n A/G P/G
13 5.45329 54.45462
14 5.86586 61.96179
15 6.27209 69.73550
16 6.67200 77.74412
17 7.06563 85.95809
18 7.45300 94.34977
19 7.83416 102.89333
20 8.20912 111.56469
21 8.57794 120.34136
22 8.94065 129.20242
23 9.29729 138.12840
24 9.64790 147.10119
25 9.99252 156.10400
26 10.33120 165.12123
27 10.66399 174.13846
28 10.99092 183.14235
29 11.31205 192.12059
30 11.62743 201.06183
35 13.11984 244.87679
40 14.47651 286.53030
45 15.70474 325.40278
50 16.81225 361.16385
60 18.69723 422.99665
70 20.19614 472.47892
80 21.37185 511.11614
90 22.28255 540.73692
100 22.98000 563.12487

1 1.05000 0.95238 1.00000 1.05000 1.00000 0.95238
2 1.10250 0.90703 0.48780 0.53780 2.05000 1.85941
3 1.15763 0.86384 0.31721 0.36721 3.15250 2.72325
4 1.21551 0.82270 0.23201 0.28201 4.31013 3.54595
(continued)
(continued)
5 1.27628 0.78353 0.18097 0.23097 5.52563 4.32948
6 1.34010 0.74622 0.14702 0.19702 6.80191 5.07569
7 1.40710 0.71068 0.12282 0.17282 8.14201 5.78637
8 1.47746 0.67684 0.10472 0.15472 9.54911 6.46321
9 1.55133 0.64461 0.09069 0.14069 11.02656 7.10782
10 1.62889 0.61391 0.07950 0.12950 12.57789 7.72173
11 1.71034 0.58468 0.07039 0.12039 14.20679 8.30641
12 1.79586 0.55684 0.06283 0.11283 15.91713 8.86325
13 1.88565 0.53032 0.05646 0.10646 17.71298 9.39357
14 1.97993 0.50507 0.05102 0.10102 19.59863 9.89864
15 2.07893 0.48102 0.04634 0.09634 21.57856 10.37966
16 2.18287 0.45811 0.04227 0.09227 23.65749 10.83777
17 2.29202 0.43630 0.03870 0.08870 25.84037 11.27407
18 2.40662 0.41552 0.03555 0.08555 28.13238 11.68959
19 2.52695 0.39573 0.03275 0.08275 30.53900 12.08532
20 2.65330 0.37689 0.03024 0.08024 33.06595 12.46221
21 2.78596 0.35894 0.02800 0.07800 35.71925 12.82115
22 2.92526 0.34185 0.02597 0.07597 38.50521 13.16300
23 3.07152 0.32557 0.02414 0.07414 41.43048 13.48857
24 3.22510 0.31007 0.02247 0.07247 44.50200 13.79864
25 3.38635 0.29530 0.02095 0.07095 47.72710 14.09394
26 3.55567 0.28124 0.01956 0.06956 51.11345 14.37519
27 3.73346 0.26785 0.01829 0.06829 54.66913 14.64303
28 3.92013 0.25509 0.01712 0.06712 58.40258 14.89813
29 4.11614 0.24295 0.01605 0.06605 62.32271 15.14107
30 4.32194 0.23138 0.01505 0.06505 66.43885 15.37245
35 5.51602 0.18129 0.01107 0.06107 90.32031 16.37419
40 7.03999 0.14205 0.00828 0.05828 120.79977 17.15909
45 8.98501 0.11130 0.00626 0.05626 159.70016 17.77407
50 11.46740 0.08720 0.00478 0.05478 209.34800 18.25593
60 18.67919 0.05354 0.00283 0.05283 353.58372 18.92929
70 30.42643 0.03287 0.00170 0.05170 588.52851 19.34268
80 49.56144 0.02018 0.00103 0.05103 971.22882 19.59646
90 80.73037 0.01239 0.00063 0.05063 1,594.60730 19.75226
100 131.50126 0.00760 0.00038 0.05038 2,610.02516 19.84791
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.48780 0.90703
3 0.96749 2.63470
4 1.43905 5.10281
5 1.90252 8.23692
6 2.35790 11.96799
7 2.80523 16.23208
8 3.24451 20.96996
9 3.67579 26.12683
10 4.09909 31.65205
11 4.51444 37.49884
12 4.92190 43.62405
13 5.32150 49.98791
14 5.71329 56.55379
15 6.09731 63.28803
16 6.47363 70.15970
17 6.84229 77.14045
18 7.20336 84.20430
19 7.55690 91.32751
20 7.90297 98.48841
21 8.24164 105.66726
22 8.57298 112.84611
23 8.89706 120.00868
24 9.21397 127.14024
25 9.52377 134.22751
26 9.82655 141.25852
27 10.12240 148.22258
28 10.41138 155.11011
29 10.69360 161.91261
30 10.96914 168.62255
35 12.24980 200.58069
40 13.37747 229.54518
45 14.36444 255.31454
50 15.22326 277.91478
60 16.60618 314.34316
70 17.62119 340.84090
(continued)
(continued)
Arithmetic grad
n A/G P/G
80 18.35260 359.64605
90 18.87120 372.74879
100 19.23372 381.74922

1 1.06000 0.94340 1.00000 1.06000 1.00000 0.94340
2 1.12360 0.89000 0.48544 0.54544 2.06000 1.83339
3 1.19102 0.83962 0.31411 0.37411 3.18360 2.67301
4 1.26248 0.79209 0.22859 0.28859 4.37462 3.46511
5 1.33823 0.74726 0.17740 0.23740 5.63709 4.21236
6 1.41852 0.70496 0.14336 0.20336 6.97532 4.91732
7 1.50363 0.66506 0.11914 0.17914 8.39384 5.58238
8 1.59385 0.62741 0.10104 0.16104 9.89747 6.20979
9 1.68948 0.59190 0.08702 0.14702 11.49132 6.80169
10 1.79085 0.55839 0.07587 0.13587 13.18079 7.36009
11 1.89830 0.52679 0.06679 0.12679 14.97164 7.88687
12 2.01220 0.49697 0.05928 0.11928 16.86994 8.38384
13 2.13293 0.46884 0.05296 0.11296 18.88214 8.85268
14 2.26090 0.44230 0.04758 0.10758 21.01507 9.29498
15 2.39656 0.41727 0.04296 0.10296 23.27597 9.71225
16 2.54035 0.39365 0.03895 0.09895 25.67253 10.10590
17 2.69277 0.37136 0.03544 0.09544 28.21288 10.47726
18 2.85434 0.35034 0.03236 0.09236 30.90565 10.82760
19 3.02560 0.33051 0.02962 0.08962 33.75999 11.15812
20 3.20714 0.31180 0.02718 0.08718 36.78559 11.46992
21 3.39956 0.29416 0.02500 0.08500 39.99273 11.76408
22 3.60354 0.27751 0.02305 0.08305 43.39229 12.04158
23 3.81975 0.26180 0.02128 0.08128 46.99583 12.30338
24 4.04893 0.24698 0.01968 0.07968 50.81558 12.55036
25 4.29187 0.23300 0.01823 0.07823 54.86451 12.78336
26 4.54938 0.21981 0.01690 0.07690 59.15638 13.00317
27 4.82235 0.20737 0.01570 0.07570 63.70577 13.21053
28 5.11169 0.19563 0.01459 0.07459 68.52811 13.40616
(continued)
(continued)
29 5.41839 0.18456 0.01358 0.07358 73.63980 13.59072
30 5.74349 0.17411 0.01265 0.07265 79.05819 13.76483
35 7.68609 0.13011 0.00897 0.06897 111.43478 14.49825
40 10.28572 0.09722 0.00646 0.06646 154.76197 15.04630
45 13.76461 0.07265 0.00470 0.06470 212.74351 15.45583
50 18.42015 0.05429 0.00344 0.06344 290.33590 15.76186
60 32.98769 0.03031 0.00188 0.06188 533.12818 16.16143
70 59.07593 0.01693 0.00103 0.06103 967.93217 16.38454
80 105.79599 0.00945 0.00057 0.06057 1,746.59989 16.50913
90 189.46451 0.00528 0.00032 0.06032 3,141.07519 16.57870
100 339.30208 0.00295 0.00018 0.06018 5,638.36806 16.61755
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.48544 0.89000
3 0.96118 2.56924
4 1.42723 4.94552
5 1.88363 7.93455
6 2.33040 11.45935
7 2.76758 15.44969
8 3.19521 19.84158
9 3.61333 24.57677
10 4.02201 29.60232
11 4.42129 34.87020
12 4.81126 40.33686
13 5.19198 45.96293
14 5.56352 51.71284
15 5.92598 57.55455
16 6.27943 63.45925
17 6.62397 69.40108
18 6.95970 75.35692
19 7.28673 81.30615
20 7.60515 87.23044
(continued)
(continued)
Arithmetic grad
n A/G P/G
21 7.91508 93.11355
22 8.21662 98.94116
23 8.50991 104.70070
24 8.79506 110.38121
25 9.07220 115.97317
26 9.34145 121.46842
27 9.60294 126.85999
28 9.85681 132.14200
29 10.10319 137.30959
30 10.34221 142.35879
35 11.43192 165.74273
40 12.35898 185.95682
45 13.14129 203.10965
50 13.79643 217.45738
60 14.79095 239.04279
70 15.46135 253.32714
80 15.90328 262.54931
90 16.18912 268.39461
100 16.37107 272.04706

1 1.07000 0.93458 1.00000 1.07000 1.00000 0.93458
2 1.14490 0.87344 0.48309 0.55309 2.07000 1.80802
3 1.22504 0.81630 0.31105 0.38105 3.21490 2.62432
4 1.31080 0.76290 0.22523 0.29523 4.43994 3.38721
5 1.40255 0.71299 0.17389 0.24389 5.75074 4.10020
6 1.50073 0.66634 0.13980 0.20980 7.15329 4.76654
7 1.60578 0.62275 0.11555 0.18555 8.65402 5.38929
8 1.71819 0.58201 0.09747 0.16747 10.25980 5.97130
9 1.83846 0.54393 0.08349 0.15349 11.97799 6.51523
10 1.96715 0.50835 0.07238 0.14238 13.81645 7.02358
11 2.10485 0.47509 0.06336 0.13336 15.78360 7.49867
12 2.25219 0.44401 0.05590 0.12590 17.88845 7.94269
(continued)
(continued)
13 2.40985 0.41496 0.04965 0.11965 20.14064 8.35765
14 2.57853 0.38782 0.04434 0.11434 22.55049 8.74547
15 2.75903 0.36245 0.03979 0.10979 25.12902 9.10791
16 2.95216 0.33873 0.03586 0.10586 27.88805 9.44665
17 3.15882 0.31657 0.03243 0.10243 30.84022 9.76322
18 3.37993 0.29586 0.02941 0.09941 33.99903 10.05909
19 3.61653 0.27651 0.02675 0.09675 37.37896 10.33560
20 3.86968 0.25842 0.02439 0.09439 40.99549 10.59401
21 4.14056 0.24151 0.02229 0.09229 44.86518 10.83553
22 4.43040 0.22571 0.02041 0.09041 49.00574 11.06124
23 4.74053 0.21095 0.01871 0.08871 53.43614 11.27219
24 5.07237 0.19715 0.01719 0.08719 58.17667 11.46933
25 5.42743 0.18425 0.01581 0.08581 63.24904 11.65358
26 5.80735 0.17220 0.01456 0.08456 68.67647 11.82578
27 6.21387 0.16093 0.01343 0.08343 74.48382 11.98671
28 6.64884 0.15040 0.01239 0.08239 80.69769 12.13711
29 7.11426 0.14056 0.01145 0.08145 87.34653 12.27767
30 7.61226 0.13137 0.01059 0.08059 94.46079 12.40904
35 10.67658 0.09366 0.00723 0.07723 138.23688 12.94767
40 14.97446 0.06678 0.00501 0.07501 199.63511 13.33171
45 21.00245 0.04761 0.00350 0.07350 285.74931 13.60552
50 29.45703 0.03395 0.00246 0.07246 406.52893 13.80075
60 57.94643 0.01726 0.00123 0.07123 813.52038 14.03918
70 113.98939 0.00877 0.00062 0.07062 1,614.13417 14.16039
80 224.23439 0.00446 0.00031 0.07031 3,189.06268 14.22201
90 441.10298 0.00227 0.00016 0.07016 6,287.18543 14.25333
100 867.71633 0.00115 0.00008 0.07008 12,381.66179 14.26925
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.48309 0.87344
3 0.95493 2.50603
4 1.41554 4.79472
(continued)
(continued)
Arithmetic grad
n A/G P/G
5 1.86495 7.64666
6 2.30322 10.97838
7 2.73039 14.71487
8 3.14654 18.78894
9 3.55174 23.14041
10 3.94607 27.71555
11 4.32963 32.46648
12 4.70252 37.35061
13 5.06484 42.33018
14 5.41673 47.37181
15 5.75829 52.44605
16 6.08968 57.52707
17 6.41102 62.59226
18 6.72247 67.62195
19 7.02418 72.59910
20 7.31631 77.50906
21 7.59901 82.33932
22 7.87247 87.07930
23 8.13685 91.72013
24 8.39234 96.25450
25 8.63910 100.67648
26 8.87733 104.98137
27 9.10722 109.16556
28 9.32894 113.22642
29 9.54270 117.16218
30 9.74868 120.97182
35 10.66873 138.13528
40 11.42335 152.29277
45 12.03599 163.75592
50 12.52868 172.90512
60 13.23209 185.76774
70 13.66619 193.51853
80 13.92735 198.07480
90 14.08122 200.70420
100 14.17034 202.20008

1 1.08000 0.92593 1.00000 1.08000 1.00000 0.92593
2 1.16640 0.85734 0.48077 0.56077 2.08000 1.78326
3 1.25971 0.79383 0.30803 0.38803 3.24640 2.57710
4 1.36049 0.73503 0.22192 0.30192 4.50611 3.31213
5 1.46933 0.68058 0.17046 0.25046 5.86660 3.99271
6 1.58687 0.63017 0.13632 0.21632 7.33593 4.62288
7 1.71382 0.58349 0.11207 0.19207 8.92280 5.20637
8 1.85093 0.54027 0.09401 0.17401 10.63663 5.74664
9 1.99900 0.50025 0.08008 0.16008 12.48756 6.24689
10 2.15892 0.46319 0.06903 0.14903 14.48656 6.71008
11 2.33164 0.42888 0.06008 0.14008 16.64549 7.13896
12 2.51817 0.39711 0.05270 0.13270 18.97713 7.53608
13 2.71962 0.36770 0.04652 0.12652 21.49530 7.90378
14 2.93719 0.34046 0.04130 0.12130 24.21492 8.24424
15 3.17217 0.31524 0.03683 0.11683 27.15211 8.55948
16 3.42594 0.29189 0.03298 0.11298 30.32428 8.85137
17 3.70002 0.27027 0.02963 0.10963 33.75023 9.12164
18 3.99602 0.25025 0.02670 0.10670 37.45024 9.37189
19 4.31570 0.23171 0.02413 0.10413 41.44626 9.60360
20 4.66096 0.21455 0.02185 0.10185 45.76196 9.81815
21 5.03383 0.19866 0.01983 0.09983 50.42292 10.01680
22 5.43654 0.18394 0.01803 0.09803 55.45676 10.20074
23 5.87146 0.17032 0.01642 0.09642 60.89330 10.37106
24 6.34118 0.15770 0.01498 0.09498 66.76476 10.52876
25 6.84848 0.14602 0.01368 0.09368 73.10594 10.67478
26 7.39635 0.13520 0.01251 0.09251 79.95442 10.80998
27 7.98806 0.12519 0.01145 0.09145 87.35077 10.93516
28 8.62711 0.11591 0.01049 0.09049 95.33883 11.05108
29 9.31727 0.10733 0.00962 0.08962 103.96594 11.15841
30 10.06266 0.09938 0.00883 0.08883 113.28321 11.25778
35 14.78534 0.06763 0.00580 0.08580 172.31680 11.65457
40 21.72452 0.04603 0.00386 0.08386 259.05652 11.92461
45 31.92045 0.03133 0.00259 0.08259 386.50562 12.10840
50 46.90161 0.02132 0.00174 0.08174 573.77016 12.23348
60 101.25706 0.00988 0.00080 0.08080 1,253.21330 12.37655
70 218.60641 0.00457 0.00037 0.08037 2,720.08007 12.44282
(continued)
(continued)
80 471.95483 0.00212 0.00017 0.08017 5,886.93543 12.47351
90 1,018.91509 0.00098 0.00008 0.08008 12,723.93862 12.48773
100 2,199.76126 0.00045 0.00004 0.08004 27,484.51570 12.49432
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.48077 0.85734
3 0.94874 2.44500
4 1.40396 4.65009
5 1.84647 7.37243
6 2.27635 10.52327
7 2.69366 14.02422
8 3.09852 17.80610
9 3.49103 21.80809
10 3.87131 25.97683
11 4.23950 30.26566
12 4.59575 34.63391
13 4.94021 39.04629
14 5.27305 43.47228
15 5.59446 47.88566
16 5.90463 52.26402
17 6.20375 56.58832
18 6.49203 60.84256
19 6.76969 65.01337
20 7.03695 69.08979
21 7.29403 73.06291
22 7.54118 76.92566
23 7.77863 80.67259
24 8.00661 84.29968
25 8.22538 87.80411
26 8.43518 91.18415
27 8.63627 94.43901
28 8.82888 97.56868
(continued)
(continued)
Arithmetic grad
n A/G P/G
29 9.01328 100.57385
30 9.18971 103.45579
35 9.96107 116.09199
40 10.56992 126.04220
45 11.04465 133.73309
50 11.41071 139.59279
60 11.90154 147.30001
70 12.17832 151.53262
80 12.33013 153.80008
90 12.41158 154.99254
100 12.45452 155.61073

1 1.09000 0.91743 1.00000 1.09000 1.00000 0.91743
2 1.18810 0.84168 0.47847 0.56847 2.09000 1.75911
3 1.29503 0.77218 0.30505 0.39505 3.27810 2.53129
4 1.41158 0.70843 0.21867 0.30867 4.57313 3.23972
5 1.53862 0.64993 0.16709 0.25709 5.98471 3.88965
6 1.67710 0.59627 0.13292 0.22292 7.52333 4.48592
7 1.82804 0.54703 0.10869 0.19869 9.20043 5.03295
8 1.99256 0.50187 0.09067 0.18067 11.02847 5.53482
9 2.17189 0.46043 0.07680 0.16680 13.02104 5.99525
10 2.36736 0.42241 0.06582 0.15582 15.19293 6.41766
11 2.58043 0.38753 0.05695 0.14695 17.56029 6.80519
12 2.81266 0.35553 0.04965 0.13965 20.14072 7.16073
13 3.06580 0.32618 0.04357 0.13357 22.95338 7.48690
14 3.34173 0.29925 0.03843 0.12843 26.01919 7.78615
15 3.64248 0.27454 0.03406 0.12406 29.36092 8.06069
16 3.97031 0.25187 0.03030 0.12030 33.00340 8.31256
17 4.32763 0.23107 0.02705 0.11705 36.97370 8.54363
18 4.71712 0.21199 0.02421 0.11421 41.30134 8.75563
19 5.14166 0.19449 0.02173 0.11173 46.01846 8.95011
20 5.60441 0.17843 0.01955 0.10955 51.16012 9.12855
(continued)
(continued)
21 6.10881 0.16370 0.01762 0.10762 56.76453 9.29224
22 6.65860 0.15018 0.01590 0.10590 62.87334 9.44243
23 7.25787 0.13778 0.01438 0.10438 69.53194 9.58021
24 7.91108 0.12640 0.01302 0.10302 76.78981 9.70661
25 8.62308 0.11597 0.01181 0.10181 84.70090 9.82258
26 9.39916 0.10639 0.01072 0.10072 93.32398 9.92897
27 10.24508 0.09761 0.00973 0.09973 102.72313 10.02658
28 11.16714 0.08955 0.00885 0.09885 112.96822 10.11613
29 12.17218 0.08215 0.00806 0.09806 124.13536 10.19828
30 13.26768 0.07537 0.00734 0.09734 136.30754 10.27365
35 20.41397 0.04899 0.00464 0.09464 215.71075 10.56682
40 31.40942 0.03184 0.00296 0.09296 337.88245 10.75736
45 48.32729 0.02069 0.00190 0.09190 525.85873 10.88120
50 74.35752 0.01345 0.00123 0.09123 815.08356 10.96168
60 176.03129 0.00568 0.00051 0.09051 1,944.79213 11.04799
70 416.73009 0.00240 0.00022 0.09022 4,619.22318 11.08445
80 986.55167 0.00101 0.00009 0.09009 10,950.57409 11.09985
90 2,335.52658 0.00043 0.00004 0.09004 25,939.18425 11.10635
100 5,529.04079 0.00018 0.00002 0.09002 61,422.67546 11.10910
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.47847 0.84168
3 0.94262 2.38605
4 1.39250 4.51132
5 1.82820 7.11105
6 2.24979 10.09238
7 2.65740 13.37459
8 3.05117 16.88765
9 3.43123 20.57108
10 3.79777 24.37277
11 4.15096 28.24810
12 4.49102 32.15898
(continued)
(continued)
Arithmetic grad
n A/G P/G
13 4.81816 36.07313
14 5.13262 39.96333
15 5.43463 43.80686
16 5.72446 47.58491
17 6.00238 51.28208
18 6.26865 54.88598
19 6.52358 58.38679
20 6.76745 61.77698
21 7.00056 65.05094
22 7.22322 68.20475
23 7.43574 71.23594
24 7.63843 74.14326
25 7.83160 76.92649
26 8.01556 79.58630
27 8.19064 82.12410
28 8.35714 84.54191
29 8.51538 86.84224
30 8.66566 89.02800
35 9.30829 98.35899
40 9.79573 105.37619
45 10.16029 110.55607
50 10.42952 114.32507
60 10.76832 118.96825
70 10.94273 121.29416
80 11.02994 122.43064
90 11.07256 122.97576
100 11.09302 123.23350

1 1.10000 0.90909 1.00000 1.10000 1.00000 0.90909
2 1.21000 0.82645 0.47619 0.57619 2.10000 1.73554
3 1.33100 0.75131 0.30211 0.40211 3.31000 2.48685
4 1.46410 0.68301 0.21547 0.31547 4.64100 3.16987
(continued)
(continued)
5 1.61051 0.62092 0.16380 0.26380 6.10510 3.79079
6 1.77156 0.56447 0.12961 0.22961 7.71561 4.35526
7 1.94872 0.51316 0.10541 0.20541 9.48717 4.86842
8 2.14359 0.46651 0.08744 0.18744 11.43589 5.33493
9 2.35795 0.42410 0.07364 0.17364 13.57948 5.75902
10 2.59374 0.38554 0.06275 0.16275 15.93742 6.14457
11 2.85312 0.35049 0.05396 0.15396 18.53117 6.49506
12 3.13843 0.31863 0.04676 0.14676 21.38428 6.81369
13 3.45227 0.28966 0.04078 0.14078 24.52271 7.10336
14 3.79750 0.26333 0.03575 0.13575 27.97498 7.36669
15 4.17725 0.23939 0.03147 0.13147 31.77248 7.60608
16 4.59497 0.21763 0.02782 0.12782 35.94973 7.82371
17 5.05447 0.19784 0.02466 0.12466 40.54470 8.02155
18 5.55992 0.17986 0.02193 0.12193 45.59917 8.20141
19 6.11591 0.16351 0.01955 0.11955 51.15909 8.36492
20 6.72750 0.14864 0.01746 0.11746 57.27500 8.51356
21 7.40025 0.13513 0.01562 0.11562 64.00250 8.64869
22 8.14027 0.12285 0.01401 0.11401 71.40275 8.77154
23 8.95430 0.11168 0.01257 0.11257 79.54302 8.88322
24 9.84973 0.10153 0.01130 0.11130 88.49733 8.98474
25 10.83471 0.09230 0.01017 0.11017 98.34706 9.07704
26 11.91818 0.08391 0.00916 0.10916 109.18177 9.16095
27 13.10999 0.07628 0.00826 0.10826 121.09994 9.23722
28 14.42099 0.06934 0.00745 0.10745 134.20994 9.30657
29 15.86309 0.06304 0.00673 0.10673 148.63093 9.36961
30 17.44940 0.05731 0.00608 0.10608 164.49402 9.42691
35 28.10244 0.03558 0.00369 0.10369 271.02437 9.64416
40 45.25926 0.02209 0.00226 0.10226 442.59256 9.77905
45 72.89048 0.01372 0.00139 0.10139 718.90484 9.86281
50 117.39085 0.00852 0.00086 0.10086 1,163.90853 9.91481
60 304.48164 0.00328 0.00033 0.10033 3,034.81640 9.96716
70 789.74696 0.00127 0.00013 0.10013 7,887.46957 9.98734
80 2,048.40021 0.00049 0.00005 0.10005 20,474.00215 9.99512
90 5,313.02261 0.00019 0.00002 0.10002 53,120.22612 9.99812
100 13,780.6123 0.00007 0.00001 0.10001 137,796.12340 9.99927
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.47619 0.82645
3 0.93656 2.32908
4 1.38117 4.37812
5 1.81013 6.86180
6 2.22356 9.68417
7 2.62162 12.76312
8 3.00448 16.02867
9 3.37235 19.42145
10 3.72546 22.89134
11 4.06405 26.39628
12 4.38840 29.90122
13 4.69879 33.37719
14 4.99553 36.80050
15 5.27893 40.15199
16 5.54934 43.41642
17 5.80710 46.58194
18 6.05256 49.63954
19 6.28610 52.58268
20 6.50808 55.40691
21 6.71888 58.10952
22 6.91889 60.68929
23 7.10848 63.14621
24 7.28805 65.48130
25 7.45798 67.69640
26 7.61865 69.79404
27 7.77044 71.77726
28 7.91372 73.64953
29 8.04886 75.41463
30 8.17623 77.07658
35 8.70860 83.98715
40 9.09623 88.95254
45 9.37405 92.45443
50 9.57041 94.88887
60 9.80229 97.70101
70 9.91125 98.98702
(continued)
(continued)
Arithmetic grad
n A/G P/G
80 9.96093 99.56063
90 9.98306 99.81178
100 9.99274 99.92018

1 1.12000 0.89286 1.00000 1.12000 1.00000 0.89286
2 1.25440 0.79719 0.47170 0.59170 2.12000 1.69005
3 1.40493 0.71178 0.29635 0.41635 3.37440 2.40183
4 1.57352 0.63552 0.20923 0.32923 4.77933 3.03735
5 1.76234 0.56743 0.15741 0.27741 6.35285 3.60478
6 1.97382 0.50663 0.12323 0.24323 8.11519 4.11141
7 2.21068 0.45235 0.09912 0.21912 10.08901 4.56376
8 2.47596 0.40388 0.08130 0.20130 12.29969 4.96764
9 2.77308 0.36061 0.06768 0.18768 14.77566 5.32825
10 3.10585 0.32197 0.05698 0.17698 17.54874 5.65022
11 3.47855 0.28748 0.04842 0.16842 20.65458 5.93770
12 3.89598 0.25668 0.04144 0.16144 24.13313 6.19437
13 4.36349 0.22917 0.03568 0.15568 28.02911 6.42355
14 4.88711 0.20462 0.03087 0.15087 32.39260 6.62817
15 5.47357 0.18270 0.02682 0.14682 37.27971 6.81086
16 6.13039 0.16312 0.02339 0.14339 42.75328 6.97399
17 6.86604 0.14564 0.02046 0.14046 48.88367 7.11963
18 7.68997 0.13004 0.01794 0.13794 55.74971 7.24967
19 8.61276 0.11611 0.01576 0.13576 63.43968 7.36578
20 9.64629 0.10367 0.01388 0.13388 72.05244 7.46944
21 10.80385 0.09256 0.01224 0.13224 81.69874 7.56200
22 12.10031 0.08264 0.01081 0.13081 92.50258 7.64465
23 13.55235 0.07379 0.00956 0.12956 104.60289 7.71843
24 15.17863 0.06588 0.00846 0.12846 118.15524 7.78432
25 17.00006 0.05882 0.00750 0.12750 133.33387 7.84314
26 19.04007 0.05252 0.00665 0.12665 150.33393 7.89566
27 21.32488 0.04689 0.00590 0.12590 169.37401 7.94255
28 23.88387 0.04187 0.00524 0.12524 190.69889 7.98442
(continued)
(continued)
29 26.74993 0.03738 0.00466 0.12466 214.58275 8.02181
30 29.95992 0.03338 0.00414 0.12414 241.33268 8.05518
35 52.79962 0.01894 0.00232 0.12232 431.66350 8.17550
40 93.05097 0.01075 0.00130 0.12130 767.09142 8.24378
45 163.98760 0.00610 0.00074 0.12074 1,358.23003 8.28252
50 289.00219 0.00346 0.00042 0.12042 2,400.01825 8.30450
60 897.59693 0.00111 0.00013 0.12013 7,471.64111 8.32405
70 2,787.79983 0.00036 0.00004 0.12004 23,223.33190 8.33034
80 8,658.48310 0.00012 0.00001 0.12001 72,145.69250 8.33237
90 26,891.9342 0.00004 0.00000 0.12000 224,091.11853 8.33302
100 83,522.2657 0.00001 0.00000 0.12000 696,010.54772 8.33323
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.47170 0.79719
3 0.92461 2.22075
4 1.35885 4.12731
5 1.77459 6.39702
6 2.17205 8.93017
7 2.55147 11.64427
8 2.91314 14.47145
9 3.25742 17.35633
10 3.58465 20.25409
11 3.89525 23.12885
12 4.18965 25.95228
13 4.46830 28.70237
14 4.73169 31.36242
15 4.98030 33.92017
16 5.21466 36.36700
17 5.43530 38.69731
18 5.64274 40.90798
19 5.83752 42.99790
20 6.02020 44.96757
(continued)
(continued)
Arithmetic grad
n A/G P/G
21 6.19132 46.81876
22 6.35141 48.55425
23 6.50101 50.17759
24 6.64064 51.69288
25 6.77084 53.10464
26 6.89210 54.41766
27 7.00491 55.63689
28 7.10976 56.76736
29 7.20712 57.81409
30 7.29742 58.78205
35 7.65765 62.60517
40 7.89879 65.11587
45 8.05724 66.73421
50 8.15972 67.76241
60 8.26641 68.81003
70 8.30821 69.21029
80 8.32409 69.35943
90 8.32999 69.41397
100 8.33214 69.43364

1 1.15000 0.86957 1.00000 1.15000 1.00000 0.86957
2 1.32250 0.75614 0.46512 0.61512 2.15000 1.62571
3 1.52088 0.65752 0.28798 0.43798 3.47250 2.28323
4 1.74901 0.57175 0.20027 0.35027 4.99338 2.85498
5 2.01136 0.49718 0.14832 0.29832 6.74238 3.35216
6 2.31306 0.43233 0.11424 0.26424 8.75374 3.78448
7 2.66002 0.37594 0.09036 0.24036 11.06680 4.16042
8 3.05902 0.32690 0.07285 0.22285 13.72682 4.48732
9 3.51788 0.28426 0.05957 0.20957 16.78584 4.77158
10 4.04556 0.24718 0.04925 0.19925 20.30372 5.01877
11 4.65239 0.21494 0.04107 0.19107 24.34928 5.23371
12 5.35025 0.18691 0.03448 0.18448 29.00167 5.42062
(continued)
(continued)
13 6.15279 0.16253 0.02911 0.17911 34.35192 5.58315
14 7.07571 0.14133 0.02469 0.17469 40.50471 5.72448
15 8.13706 0.12289 0.02102 0.17102 47.58041 5.84737
16 9.35762 0.10686 0.01795 0.16795 55.71747 5.95423
17 10.76126 0.09293 0.01537 0.16537 65.07509 6.04716
18 12.37545 0.08081 0.01319 0.16319 75.83636 6.12797
19 14.23177 0.07027 0.01134 0.16134 88.21181 6.19823
20 16.36654 0.06110 0.00976 0.15976 102.44358 6.25933
21 18.82152 0.05313 0.00842 0.15842 118.81012 6.31246
22 21.64475 0.04620 0.00727 0.15727 137.63164 6.35866
23 24.89146 0.04017 0.00628 0.15628 159.27638 6.39884
24 28.62518 0.03493 0.00543 0.15543 184.16784 6.43377
25 32.91895 0.03038 0.00470 0.15470 212.79302 6.46415
26 37.85680 0.02642 0.00407 0.15407 245.71197 6.49056
27 43.53531 0.02297 0.00353 0.15353 283.56877 6.51353
28 50.06561 0.01997 0.00306 0.15306 327.10408 6.53351
29 57.57545 0.01737 0.00265 0.15265 377.16969 6.55088
30 66.21177 0.01510 0.00230 0.15230 434.74515 6.56598
35 133.17552 0.00751 0.00113 0.15113 881.17016 6.61661
40 267.86355 0.00373 0.00056 0.15056 1,779.09031 6.64178
45 538.76927 0.00186 0.00028 0.15028 3,585.12846 6.65429
50 1,083.65744 0.00092 0.00014 0.15014 7,217.71628 6.66051
60 4,383.99875 0.00023 0.00003 0.15003 29,219.99164 6.66515
70 17,735.7200 0.00006 0.00001 0.15001 118,231.46693 6.66629
80 71,750.8794 0.00001 0.00000 0.15000 478,332.52934 6.66657
90 290,272.325 0.0000 0.0000 0.15000 1,935,142.168 6.6666
100 1,174,313.4 0.0000 0.0000 0.1500 7,828,749.671 6.6666
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.46512 0.75614
3 0.90713 2.07118
4 1.32626 3.78644
(continued)
(continued)
Arithmetic grad
n A/G P/G
5 1.72281 5.77514
6 2.09719 7.93678
7 2.44985 10.19240
8 2.78133 12.48072
9 3.09223 14.75481
10 3.38320 16.97948
11 3.65494 19.12891
12 3.90820 21.18489
13 4.14376 23.13522
14 4.36241 24.97250
15 4.56496 26.69302
16 4.75225 28.29599
17 4.92509 29.78280
18 5.08431 31.15649
19 5.23073 32.42127
20 5.36514 33.58217
21 5.48832 34.64479
22 5.60102 35.61500
23 5.70398 36.49884
24 5.79789 37.30232
25 5.88343 38.03139
26 5.96123 38.69177
27 6.03190 39.28899
28 6.09600 39.82828
29 6.15408 40.31460
30 6.20663 40.75259
35 6.40187 42.35864
40 6.51678 43.28299
45 6.58299 43.80513
50 6.62048 44.09583
60 6.65298 44.34307
70 6.66272 44.41563
80 6.66555 44.43639
90 6.66636 44.44222
100 6.66658 44.44384

1 1.18000 0.84746 1.00000 1.18000 1.00000 0.84746
2 1.39240 0.71818 0.45872 0.63872 2.18000 1.56564
3 1.64303 0.60863 0.27992 0.45992 3.57240 2.17427
4 1.93878 0.51579 0.19174 0.37174 5.21543 2.69006
5 2.28776 0.43711 0.13978 0.31978 7.15421 3.12717
6 2.69955 0.37043 0.10591 0.28591 9.44197 3.49760
7 3.18547 0.31393 0.08236 0.26236 12.14152 3.81153
8 3.75886 0.26604 0.06524 0.24524 15.32700 4.07757
9 4.43545 0.22546 0.05239 0.23239 19.08585 4.30302
10 5.23384 0.19106 0.04251 0.22251 23.52131 4.49409
11 6.17593 0.16192 0.03478 0.21478 28.75514 4.65601
12 7.28759 0.13722 0.02863 0.20863 34.93107 4.79322
13 8.59936 0.11629 0.02369 0.20369 42.21866 4.90951
14 10.14724 0.09855 0.01968 0.19968 50.81802 5.00806
15 11.97375 0.08352 0.01640 0.19640 60.96527 5.09158
16 14.12902 0.07078 0.01371 0.19371 72.93901 5.16235
17 16.67225 0.05998 0.01149 0.19149 87.06804 5.22233
18 19.67325 0.05083 0.00964 0.18964 103.74028 5.27316
19 23.21444 0.04308 0.00810 0.18810 123.41353 5.31624
20 27.39303 0.03651 0.00682 0.18682 146.62797 5.35275
21 32.32378 0.03094 0.00575 0.18575 174.02100 5.38368
22 38.14206 0.02622 0.00485 0.18485 206.34479 5.40990
23 45.00763 0.02222 0.00409 0.18409 244.48685 5.43212
24 53.10901 0.01883 0.00345 0.18345 289.49448 5.45095
25 62.66863 0.01596 0.00292 0.18292 342.60349 5.46691
26 73.94898 0.01352 0.00247 0.18247 405.27211 5.48043
27 87.25980 0.01146 0.00209 0.18209 479.22109 5.49189
28 102.96656 0.00971 0.00177 0.18177 566.48089 5.50160
29 121.50054 0.00823 0.00149 0.18149 669.44745 5.50983
30 143.37064 0.00697 0.00126 0.18126 790.94799 5.51681
35 327.99729 0.00305 0.00055 0.18055 1,816.65161 5.53862
40 750.37834 0.00133 0.00024 0.18024 4,163.21303 5.54815
45 1,716.68388 0.00058 0.00010 0.18010 9,531.57711 5.55232
50 3,927.35686 0.00025 0.00005 0.18005 21,813.09367 5.55414
60 20,555.1399 0.00005 0.00001 0.18001 114,189.66648 5.55529
70 107,582.222 0.0000 0.0000 0.1800 597,673.4576 5.5555
(continued)
(continued)
80 563,067.660 0.0000 0.0000 0.1800 3,128,148.113 5.5555
90 2,947,003.5 0.0000 0.0000 0.1800 16,372,236.33 5.5555
100 15,424,131 0.0000 0.0000 0.1800 85,689,616.14 5.5555
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.45872 0.71818
3 0.89016 1.93545
4 1.29470 3.48281
5 1.67284 5.23125
6 2.02522 7.08341
7 2.35259 8.96696
8 2.65581 10.82922
9 2.93581 12.63287
10 3.19363 14.35245
11 3.43033 15.97164
12 3.64703 17.48106
13 3.84489 18.87651
14 4.02504 20.15765
15 4.18866 21.32687
16 4.33688 22.38852
17 4.47084 23.34820
18 4.59161 24.21231
19 4.70026 24.98769
20 4.79778 25.68130
21 4.88514 26.30004
22 4.96324 26.85061
23 5.03292 27.33942
24 5.09498 27.77249
25 5.15016 28.15546
26 5.19914 28.49353
27 5.24255 28.79149
28 5.28096 29.05371
(continued)
(continued)
Arithmetic grad
n A/G P/G
29 5.31489 29.28416
30 5.34484 29.48643
35 5.44852 30.17728
40 5.50218 30.52692
45 5.52933 30.70059
50 5.54282 30.78561
60 5.55264 30.84648
70 5.55490 30.86030
80 5.55541 30.86335
90 5.55553 30.86402
100 5.55555 30.86416

1 1.20000 0.83333 1.00000 1.20000 1.00000 0.83333
2 1.44000 0.69444 0.45455 0.65455 2.20000 1.52778
3 1.72800 0.57870 0.27473 0.47473 3.64000 2.10648
4 2.07360 0.48225 0.18629 0.38629 5.36800 2.58873
5 2.48832 0.40188 0.13438 0.33438 7.44160 2.99061
6 2.98598 0.33490 0.10071 0.30071 9.92992 3.32551
7 3.58318 0.27908 0.07742 0.27742 12.91590 3.60459
8 4.29982 0.23257 0.06061 0.26061 16.49908 3.83716
9 5.15978 0.19381 0.04808 0.24808 20.79890 4.03097
10 6.19174 0.16151 0.03852 0.23852 25.95868 4.19247
11 7.43008 0.13459 0.03110 0.23110 32.15042 4.32706
12 8.91610 0.11216 0.02526 0.22526 39.58050 4.43922
13 10.69932 0.09346 0.02062 0.22062 48.49660 4.53268
14 12.83918 0.07789 0.01689 0.21689 59.19592 4.61057
15 15.40702 0.06491 0.01388 0.21388 72.03511 4.67547
16 18.48843 0.05409 0.01144 0.21144 87.44213 4.72956
17 22.18611 0.04507 0.00944 0.20944 105.93056 4.77463
18 26.62333 0.03756 0.00781 0.20781 128.11667 4.81219
19 31.94800 0.03130 0.00646 0.20646 154.74000 4.84350
20 38.33760 0.02608 0.00536 0.20536 186.68800 4.86958
(continued)
(continued)
21 46.00512 0.02174 0.00444 0.20444 225.02560 4.89132
22 55.20614 0.01811 0.00369 0.20369 271.03072 4.90943
23 66.24737 0.01509 0.00307 0.20307 326.23686 4.92453
24 79.49685 0.01258 0.00255 0.20255 392.48424 4.93710
25 95.39622 0.01048 0.00212 0.20212 471.98108 4.94759
26 114.47546 0.00874 0.00176 0.20176 567.37730 4.95632
27 137.37055 0.00728 0.00147 0.20147 681.85276 4.96360
28 164.84466 0.00607 0.00122 0.20122 819.22331 4.96967
29 197.81359 0.00506 0.00102 0.20102 984.06797 4.97472
30 237.37631 0.00421 0.00085 0.20085 1,181.88157 4.97894
35 590.66823 0.00169 0.00034 0.20034 2,948.34115 4.99154
40 1,469.77157 0.00068 0.00014 0.20014 7,343.85784 4.99660
45 3,657.26199 0.00027 0.00005 0.20005 18,281.30994 4.99863
50 9,100.43815 0.00011 0.00002 0.20002 45,497.19075 4.99945
60 56,347.51435 0.00002 0.00000 0.20000 281,732.5717 4.9999
70 348,888.956 0.0000 0.0000 0.2000 1,744,439.78 4.9999
80 2,160,228.4 0.0000 0.0000 0.2000 10,801,137.3 5.0000
90 13,375,565.2 0.0000 0.0000 0.2000 66,877,821.2 5.0000
100 82,817,974.5 0.0000 0.0000 0.2000 414,089,867 5.0000
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.45455 0.69444
3 0.87912 1.85185
4 1.27422 3.29861
5 1.64051 4.90612
6 1.97883 6.58061
7 2.29016 8.25510
8 2.57562 9.88308
9 2.83642 11.43353
10 3.07386 12.88708
11 3.28929 14.23296
12 3.48410 15.46668
(continued)
(continued)
Arithmetic grad
n A/G P/G
13 3.65970 16.58825
14 3.81749 17.60078
15 3.95884 18.50945
16 4.08511 19.32077
17 4.19759 20.04194
18 4.29752 20.68048
19 4.38607 21.24390
20 4.46435 21.73949
21 4.53339 22.17423
22 4.59414 22.55462
23 4.64750 22.88671
24 4.69426 23.17603
25 4.73516 23.42761
26 4.77088 23.64600
27 4.80201 23.83527
28 4.82911 23.99906
29 4.85265 24.14061
30 4.87308 24.26277
35 4.94064 24.66140
40 4.97277 24.84691
45 4.98769 24.93164
50 4.99451 24.96978
60 4.99894 24.99423
70 4.99980 24.99893
80 4.99996 24.99980
90 4.99999 24.99996
100 5.00000 24.99999

1 1.25000 0.80000 1.00000 1.25000 1.00000 0.80000
2 1.56250 0.64000 0.44444 0.69444 2.25000 1.44000
3 1.95313 0.51200 0.26230 0.51230 3.81250 1.95200
4 2.44141 0.40960 0.17344 0.42344 5.76563 2.36160
(continued)
(continued)
5 3.05176 0.32768 0.12185 0.37185 8.20703 2.68928
6 3.81470 0.26214 0.08882 0.33882 11.25879 2.95142
7 4.76837 0.20972 0.06634 0.31634 15.07349 3.16114
8 5.96046 0.16777 0.05040 0.30040 19.84186 3.32891
9 7.45058 0.13422 0.03876 0.28876 25.80232 3.46313
10 9.31323 0.10737 0.03007 0.28007 33.25290 3.57050
11 11.64153 0.08590 0.02349 0.27349 42.56613 3.65640
12 14.55192 0.06872 0.01845 0.26845 54.20766 3.72512
13 18.18989 0.05498 0.01454 0.26454 68.75958 3.78010
14 22.73737 0.04398 0.01150 0.26150 86.94947 3.82408
15 28.42171 0.03518 0.00912 0.25912 109.68684 3.85926
16 35.52714 0.02815 0.00724 0.25724 138.10855 3.88741
17 44.40892 0.02252 0.00576 0.25576 173.63568 3.90993
18 55.51115 0.01801 0.00459 0.25459 218.04460 3.92794
19 69.38894 0.01441 0.00366 0.25366 273.55576 3.94235
20 86.73617 0.01153 0.00292 0.25292 342.94470 3.95388
21 108.42022 0.00922 0.00233 0.25233 429.68087 3.96311
22 135.52527 0.00738 0.00186 0.25186 538.10109 3.97049
23 169.40659 0.00590 0.00148 0.25148 673.62636 3.97639
24 211.75824 0.00472 0.00119 0.25119 843.03295 3.98111
25 264.69780 0.00378 0.00095 0.25095 1,054.79118 3.98489
26 330.87225 0.00302 0.00076 0.25076 1,319.48898 3.98791
27 413.59031 0.00242 0.00061 0.25061 1,650.36123 3.99033
28 516.98788 0.00193 0.00048 0.25048 2,063.95153 3.99226
29 646.23485 0.00155 0.00039 0.25039 2,580.93941 3.99381
30 807.79357 0.00124 0.00031 0.25031 3,227.17427 3.99505
35 2,465.19033 0.00041 0.00010 0.25010 9,856.76132 3.99838
40 7,523.16385 0.00013 0.00003 0.25003 30,088.65538 3.99947
45 22,958.87404 0.00004 0.00001 0.25001 91,831.49616 3.99983
50 70,064.9232 0.0000 0.0000 0.2500 280,255.6928 3.99994
60 652,530.4468 0.0000 0.0000 0.2500 2,610,117.78 3.9999
70 6,077,163.35 0.0000 0.0000 0.2500 24,308,649.4 4.0000
80 56,597,994.2 0.0000 0.0000 0.2500 226,391,972 4.0000
90 527,109,897 0.000 0.000 0.250 2,108,439,58 4.000
Arithmetic grad
n A/G P/G
1 0.00000 0.00000
2 0.44444 0.64000
3 0.85246 1.66400
4 1.22493 2.89280
5 1.56307 4.20352
6 1.86833 5.51424
7 2.14243 6.77253
8 2.38725 7.94694
9 2.60478 9.02068
10 2.79710 9.98705
11 2.96631 10.84604
12 3.11452 11.60195
13 3.24374 12.26166
14 3.35595 12.83341
15 3.45299 13.32599
16 3.53660 13.74820
17 3.60838 14.10849
18 3.66979 14.41473
19 3.72218 14.67414
20 3.76673 14.89320
21 3.80451 15.07766
22 3.83646 15.23262
23 3.86343 15.36248
24 3.88613 15.47109
25 3.90519 15.56176
26 3.92118 15.63732
27 3.93456 15.70019
28 3.94574 15.75241
29 3.95506 15.79574
30 3.96282 15.83164
35 3.98580 15.93672
40 3.99468 15.97661
45 3.99804 15.99146
50 3.99929 15.99692
60 3.99991 15.99961
70 3.99999 15.99995
(continued)
(continued)
Arithmetic grad
n A/G P/G
80 4.00000 15.99999
90 4.00000 16.00000
Appendix C
Selected Discrete Payment Compound Interest
Factors with Geometric Gradient Percentages
Interest rate: 1.0%; gradient rates: 0.25%, 0.50%
Single payment Single payment

n P/A, i, 0.25% F/A, i, 0.25% P/A, i, 0.50% F/A, i, 0.50%
1 0.99010 1.00000 0.99010 1.00000
2 1.97285 2.01250 1.97530 2.01500
3 2.94829 3.03763 2.95562 3.04518
4 3.91650 4.07553 3.93108 4.09070
5 4.87752 5.12632 4.90172 5.15176
6 5.83140 6.19015 5.86756 6.22853
7 6.77819 7.26714 6.82861 7.32119
8 7.71796 8.35744 7.78490 8.42993
9 8.65075 9.46119 8.73646 9.55494
10 9.57661 10.57853 9.68331 10.69640
11 10.49559 11.70960 10.62547 11.85450
12 11.40775 12.85454 11.56297 13.02944
13 12.31314 14.01350 12.49583 14.22142
14 13.21181 15.18663 13.42406 15.43062
15 14.10380 16.37407 14.34771 16.65724
16 14.98917 17.57598 15.26678 17.90150
17 15.86796 18.79250 16.18130 19.16358
18 16.74023 20.02378 17.09129 20.44371
19 17.60602 21.26999 17.99678 21.74207
20 18.46538 22.53127 18.89779 23.05889
21 19.31836 23.80779 19.79433 24.39438
(continued)
https://doi.org/10.1007/978-3-030-87767-5
466 Appendix C: Selected Discrete Payment Compound Interest Factors with Geometric …
(continued)
n P/A, i, 0.25% F/A, i, 0.25% P/A, i, 0.50% F/A, i, 0.50%
22 20.16500 25.09970 20.68644 25.74874
23 21.00536 26.40717 21.57413 27.12220
24 21.83948 27.73035 22.45743 28.51497
25 22.66741 29.06941 23.33635 29.92728
26 23.48918 30.42451 24.21092 31.35935
27 24.30486 31.79583 25.08117 32.81141
28 25.11448 33.18353 25.94710 34.28367
29 25.91808 34.58778 26.80875 35.77638
30 26.71572 36.00875 27.66613 37.28977
35 30.61594 43.37062 31.88980 45.17517
40 34.37348 51.17743 36.00994 53.61390
45 37.99357 59.45274 40.02911 62.63799
50 41.48123 68.22135 43.94978 72.28120
60 48.07847 87.34399 51.50519 93.56931
70 54.20186 108.77030 58.69480 117.78657
80 59.88544 132.74897 65.53631 145.27533
90 65.16080 159.55487 72.04658 176.41560
100 70.05726 189.49186 78.24164 211.62907

n P/A, i, 0.50% F/A, i, 0.50% P/A, i, 1.25% F/A, i, 1.25%
1 0.98039 1.00000 0.98039 1.00000
2 1.94637 2.02500 1.95358 2.03250
3 2.89814 3.07553 2.91960 3.09831
4 3.83591 4.15211 3.87853 4.19824
5 4.75989 5.25530 4.83040 5.33315
6 5.67028 6.38566 5.77528 6.50390
7 6.56729 7.54375 6.71320 7.71136
8 7.45110 8.73016 7.64423 8.95644
9 8.32192 9.94547 8.56842 10.24005
10 9.17993 11.19029 9.48581 11.56315
11 10.02533 12.46523 10.39645 12.92668
12 10.85829 13.77093 11.30040 14.33164
13 11.67900 15.10803 12.19770 15.77902
(continued)
Appendix C: Selected Discrete Payment Compound Interest Factors with Geometric … 467
(continued)
n P/A, i, 0.50% F/A, i, 0.50% P/A, i, 1.25% F/A, i, 1.25%
14 12.48764 16.47718 13.08840 17.26987
15 13.28439 17.87904 13.97256 18.80522
16 14.06942 19.31430 14.85021 20.38615
17 14.84291 20.78366 15.72141 22.01377
18 15.60503 22.28782 16.58620 23.68918
19 16.35593 23.82751 17.44464 25.41354
20 17.09580 25.40345 18.29676 27.18802
21 17.82478 27.01642 19.14262 29.01382
22 18.54304 28.66717 19.98225 30.89216
23 19.25074 30.35648 20.81572 32.82429
24 19.94804 32.08516 21.64305 34.81149
25 20.63508 33.85403 22.46431 36.85507
26 21.31201 35.66390 23.27952 38.95637
27 21.97899 37.51564 24.08874 41.11674
28 22.63616 39.41011 24.89201 43.33759
29 23.28367 41.34818 25.68937 45.62033
30 23.92165 43.33077 26.48087 47.96643
35 26.97358 53.94418 30.35192 60.70049
40 29.80760 65.81636 34.08273 75.25603
45 32.43928 79.08223 37.67838 91.85441
50 34.88306 93.89081 41.14377 110.74209
60 39.25963 128.81204 47.70247 156.51326
70 43.03355 172.11518 53.79455 215.15443
80 46.28780 225.67337 59.45322 289.86056
90 49.09395 291.77190 64.70931 384.57607
100 51.51370 373.19851 69.59147 504.16558

n P/A, i, 1.00% F/A, i, 1.00% P/A, i, 2.00% F/A, i, 2.00%
1 0.97087 1.00000 0.97087 1.00000
2 1.92290 2.04000 1.93232 2.05000
3 2.85643 3.12130 2.88443 3.15190
4 3.77184 4.24524 3.82730 4.30766
5 4.66947 5.41320 4.76102 5.51933
(continued)
(continued)
n P/A, i, 1.00% F/A, i, 1.00% P/A, i, 2.00% F/A, i, 2.00%
6 5.54968 6.62661 5.68567 6.78899
7 6.41279 7.88693 6.60134 8.11882
8 7.25915 9.19567 7.50813 9.51107
9 8.08907 10.55440 8.40611 10.96806
10 8.90287 11.96471 9.29537 12.49220
11 9.70087 13.42828 10.17599 14.08596
12 10.48338 14.94679 11.04807 15.75191
13 11.25069 16.52202 11.91168 17.49271
14 12.00311 18.15578 12.76691 19.31110
15 12.74091 19.84992 13.61383 21.20991
16 13.46439 21.60639 14.45253 23.19207
17 14.17382 23.42716 15.28309 25.26062
18 14.86947 25.31428 16.10559 27.41868
19 15.55162 27.26986 16.92009 29.66949
20 16.22052 29.29606 17.72670 32.01638
21 16.87643 31.39513 18.52547 34.46282
22 17.51961 33.56938 19.31648 37.01237
23 18.15029 35.82117 20.09982 39.66872
24 18.76873 38.15297 20.87555 42.43569
25 19.37517 40.56730 21.64374 45.31719
26 19.96982 43.06675 22.40448 48.31732
27 20.55293 45.65401 23.15784 51.44025
28 21.12472 48.33184 23.90388 54.69035
29 21.68541 51.10308 24.64268 58.07208
30 22.23520 53.97068 25.37430 61.59009
35 24.82814 69.86298 28.92725 81.39729
40 27.17893 88.65870 32.31103 105.39981
45 29.31018 110.83925 35.53372 134.37416
50 31.24239 136.96371 38.60297 169.23180
60 34.58232 203.74532 44.31005 261.05723
70 37.32755 295.55293 49.48664 391.82637
80 39.58398 421.20877 54.18204 576.54514
90 41.43863 592.59172 58.44099 835.73340
100 42.96304 825.69091 62.30405 1,197.39859

n P/A, i, 2.00% F/A, i, 2.00% P/A, i , 4.00% F/A, i, 4.00%
1 0.95238 1.00000 0.95238 1.00000
2 1.87755 2.07000 1.89569 2.09000
3 2.77629 3.21390 2.83002 3.27610
4 3.64935 4.43580 3.75545 4.56477
5 4.49746 5.74003 4.67206 5.96287
6 5.32134 7.13111 5.57995 7.47766
7 6.12168 8.61383 6.47919 9.11686
8 6.89916 10.19320 7.36986 10.88864
9 7.65442 11.87452 8.25205 12.80164
10 8.38811 13.66334 9.12584 14.86503
11 9.10083 15.56550 9.99131 17.08853
12 9.79318 17.58715 10.84854 19.48241
13 10.46576 19.73475 11.69760 22.05756
14 11.11912 22.01509 12.53857 24.82552
15 11.75381 24.43533 13.37154 27.79847
16 12.37037 27.00296 14.19657 30.98933
17 12.96931 29.72590 15.01375 34.41178
18 13.55114 32.61243 15.82314 38.08027
19 14.11635 35.67130 16.62482 42.01010
20 14.66540 38.91168 17.41887 46.21746
21 15.19877 42.34321 18.20536 50.71945
22 15.71690 45.97603 18.98436 55.53419
23 16.22023 49.82082 19.75593 60.68082
24 16.70917 53.88876 20.52016 66.17958
25 17.18415 58.19163 21.27711 72.05186
26 17.64556 62.74182 22.02686 78.32029
27 18.09378 67.55233 22.76946 85.00877
28 18.52919 72.63683 23.50499 92.14258
29 18.95217 78.00970 24.23351 99.74841
30 19.36306 83.68603 24.95510 107.85449
35 21.24798 117.20419 28.46124 156.99264
40 22.87858 161.06497 31.80357 223.89681
45 24.28918 218.23845 34.98975 314.38321
50 25.50945 292.52706 38.02707 436.07164
60 27.47828 513.27184 43.68262 815.95585
(continued)
(continued)
n P/A, i, 2.00% F/A, i, 2.00% P/A, i , 4.00% F/A, i, 4.00%
70 28.95166 880.89558 48.82206 1,485.48072
80 30.05428 1,489.53340 53.49248 2,651.16420
90 30.87943 2,492.90773 57.73668 4,661.10317
100 31.49694 4,141.88706 61.59356 8,099.63097

n P/A, i, 3.00% F/A, i, 3.00% P/A, i, 5.00% F/A, i, 5.00%
1 0.93458 1.00000 0.93458 1.00000
2 1.83422 2.10000 1.85169 2.12000
3 2.70023 3.30790 2.75166 3.37090
4 3.53387 4.63218 3.63481 4.76449
5 4.33634 6.08194 4.50144 6.31351
6 5.10881 7.66695 5.35188 8.03174
7 5.85241 9.39769 6.18643 9.93405
8 6.56821 11.28540 7.00537 12.03654
9 7.25725 13.34215 7.80901 14.35655
10 7.92053 15.58087 8.59763 16.91284
11 8.55901 18.01545 9.37150 19.72563
12 9.17363 20.66077 10.13092 22.81676
13 9.76527 23.53278 10.87613 26.20979
14 10.33479 26.64861 11.60742 29.93013
15 10.88302 30.02660 12.32504 34.00517
16 11.41076 33.68643 13.02924 38.46446
17 11.91877 37.64919 13.72028 43.33984
18 12.40779 41.93748 14.39841 48.66565
19 12.87852 46.57554 15.06386 54.47887
20 13.33166 51.58933 15.71687 60.81934
21 13.76786 57.00670 16.35768 67.72999
22 14.18776 62.85746 16.98651 75.25705
23 14.59195 69.17358 17.60358 83.45031
24 14.98104 75.98932 18.20912 92.36335
25 15.35558 83.34137 18.80334 102.05388
26 15.71612 91.26904 19.38646 112.58401
27 16.06318 99.81447 19.95868 124.02057
(continued)
(continued)
n P/A, i, 3.00% F/A, i, 3.00% P/A, i, 5.00% F/A, i, 5.00%
28 16.39727 109.02277 20.52020 136.43546
29 16.71886 118.94229 21.07122 149.90607
30 17.02844 129.62481 21.61194 164.51563
35 18.41113 196.56798 24.16769 258.02831
40 19.55400 292.81050 26.49334 396.72346
45 20.49863 430.52140 28.60962 600.87220
50 21.27941 626.82798 30.53537 899.48126
60 22.45817 1,301.37059 33.88237 1,963.36205
70 23.26347 2,651.78926 36.65383 4,178.14833
80 23.81364 5,339.83743 38.94874 8,733.64733
90 24.18951 10,670.06282 40.84903 18,018.63074
100 24.44629 21,212.44234 42.42257 36,810.75339

n P/A, i, 4.00% F/A, i, 4.00% P/A, i, 8.00% F/A, i, 8.00%
1 0.90909 1.00000 0.90909 1.00000
2 1.76860 2.14000 1.80165 2.18000
3 2.58122 3.43560 2.67799 3.56440
4 3.34951 4.90402 3.53839 5.18055
5 4.07590 6.56428 4.38314 7.05910
6 4.76267 8.43737 5.21254 9.23433
7 5.41198 10.54642 6.02686 11.74464
8 6.02587 12.91700 6.82637 14.63293
9 6.60628 15.57726 7.61134 17.94715
10 7.15503 18.55830 8.38205 21.74087
11 7.67385 21.89438 9.13874 26.07389
12 8.16436 25.62327 9.88167 31.01291
13 8.62813 29.78663 10.61109 36.63237
14 9.06659 34.43036 11.32726 43.01524
15 9.48114 39.60508 12.03040 50.25395
16 9.87308 45.36653 12.72075 58.45152
17 10.24364 51.77616 13.39856 67.72261
18 10.59398 58.90168 14.06404 78.19489
19 10.92522 66.81766 14.71742 90.01040
(continued)
(continued)
n P/A, i, 4.00% F/A, i, 4.00% P/A, i, 8.00% F/A, i, 8.00%
20 11.23839 75.60628 15.35892 103.32714
21 11.53448 85.35803 15.98876 118.32081
22 11.81442 96.17260 16.60715 135.18673
23 12.07909 108.15978 17.21429 154.14194
24 12.32932 121.44048 17.81039 175.42760
25 12.56590 136.14783 18.39566 199.31154
26 12.78958 152.42845 18.97028 226.09117
27 13.00106 170.44376 19.53446 256.09664
28 13.20100 190.37150 20.08838 289.69436
29 13.39003 212.40736 20.63223 327.29090
30 13.56876 236.76675 21.16618 369.33727
35 14.32637 402.60580 23.69384 665.85463
40 14.89870 674.30392 25.99991 1,176.73670
45 15.33106 1,117.48847 28.10383 2,048.50171
50 15.65769 1,838.06949 30.02331 3,524.46202
60 16.09085 4,899.36687 33.37222 10,161.22879
70 16.33805 12,902.92231 36.15972 28,557.02754
80 16.47912 33,755.84026 38.47992 78,822.26902
90 16.55964 87,981.72131 40.41115 214,705.37613
100 16.60558 228,835.12319 42.01864 579,042.55417
Appendix D
Cumulative Standard Normal Distribution
Z 0.00 0.01 0.02 0.03 0.04

−3.9 0.00005 0.00005 0.00004 0.00004 0.00004
−3.8 0.00007 0.00007 0.00007 0.00006 0.00006
−3.7 0.00011 0.00010 0.00010 0.00010 0.00009
−3.6 0.00016 0.00015 0.00015 0.00014 0.00014
−3.5 0.00023 0.00022 0.00022 0.00021 0.00020
−3.4 0.00034 0.00032 0.00031 0.00030 0.00029
−3.3 0.00048 0.00047 0.00045 0.00043 0.00042
−3.2 0.00069 0.00066 0.00064 0.00062 0.00060
−3.1 0.00097 0.00094 0.00090 0.00087 0.00084
−3.0 0.00135 0.00131 0.00126 0.00122 0.00118
−2.9 0.00187 0.00181 0.00175 0.00169 0.00164
−2.8 0.00256 0.00248 0.00240 0.00233 0.00226
−2.7 0.00347 0.00336 0.00326 0.00317 0.00307
−2.6 0.00466 0.00453 0.00440 0.00427 0.00415
−2.5 0.00621 0.00604 0.00587 0.00570 0.00554
−2.4 0.00820 0.00798 0.00776 0.00755 0.00734
−2.3 0.01072 0.01044 0.01017 0.00990 0.00964
−2.2 0.01390 0.01355 0.01321 0.01287 0.01255
−2.1 0.01786 0.01743 0.01700 0.01659 0.01618
−2.0 0.02275 0.02222 0.02169 0.02118 0.02068
−1.9 0.02872 0.02807 0.02743 0.02680 0.02619
−1.8 0.03593 0.03515 0.03438 0.03362 0.03288
(continued)
https://doi.org/10.1007/978-3-030-87767-5
474 Appendix D: Cumulative Standard Normal Distribution
(continued)
Z 0.00 0.01 0.02 0.03 0.04
−1.7 0.04457 0.04363 0.04272 0.04182 0.04093
−1.6 0.05480 0.05370 0.05262 0.05155 0.05050
−1.5 0.06681 0.06552 0.06426 0.06301 0.06178
−1.4 0.08076 0.07927 0.07780 0.07636 0.07493
−1.3 0.09680 0.09510 0.09342 0.09176 0.09012
−1.2 0.11507 0.11314 0.11123 0.10935 0.10749
−1.1 0.13567 0.13350 0.13136 0.12924 0.12714
−1.0 0.15866 0.15625 0.15386 0.15151 0.14917
−0.9 0.18406 0.18141 0.17879 0.17619 0.17361
−0.8 0.21186 0.20897 0.20611 0.20327 0.20045
−0.7 0.24196 0.23885 0.23576 0.23270 0.22965
−0.6 0.27425 0.27093 0.26763 0.26435 0.26109
−0.5 0.30854 0.30503 0.30153 0.29806 0.29460
−0.4 0.34458 0.34090 0.33724 0.33360 0.32997
−0.3 0.38209 0.37828 0.37448 0.37070 0.36693
−0.2 0.42074 0.41683 0.41294 0.40905 0.40517
−0.1 0.46017 0.45620 0.45224 0.44828 0.44433
0.0 0.50000 0.50399 0.50798 0.51197 0.51595
Z 0.05 0.06 0.07 0.08 0.09

−3.9 0.00004 0.00004 0.00004 0.00003 0.00003
−3.8 0.00006 0.00006 0.00005 0.00005 0.00005
−3.7 0.00009 0.00008 0.00008 0.00008 0.00008
−3.6 0.00013 0.00013 0.00012 0.00012 0.00011
−3.5 0.00019 0.00019 0.00018 0.00017 0.00017
−3.4 0.00028 0.00027 0.00026 0.00025 0.00024
−3.3 0.00040 0.00039 0.00038 0.00036 0.00035
−3.2 0.00058 0.00056 0.00054 0.00052 0.00050
−3.1 0.00082 0.00079 0.00076 0.00074 0.00071
−3.0 0.00114 0.00111 0.00107 0.00104 0.00100
−2.9 0.00159 0.00154 0.00149 0.00144 0.00139
−2.8 0.00219 0.00212 0.00205 0.00199 0.00193
−2.7 0.00298 0.00289 0.00280 0.00272 0.00264
−2.6 0.00402 0.00391 0.00379 0.00368 0.00357
−2.5 0.00539 0.00523 0.00508 0.00494 0.00480
(continued)
Appendix D: Cumulative Standard Normal Distribution 475
(continued)
Z 0.05 0.06 0.07 0.08 0.09
−2.4 0.00714 0.00695 0.00676 0.00657 0.00639
−2.3 0.00939 0.00914 0.00889 0.00866 0.00842
−2.2 0.01222 0.01191 0.01160 0.01130 0.01101
−2.1 0.01578 0.01539 0.01500 0.01463 0.01426
−2.0 0.02018 0.01970 0.01923 0.01876 0.01831
−1.9 0.02559 0.02500 0.02442 0.02385 0.02330
−1.8 0.03216 0.03144 0.03074 0.03005 0.02938
−1.7 0.04006 0.03920 0.03836 0.03754 0.03673
−1.6 0.04947 0.04846 0.04746 0.04648 0.04551
−1.5 0.06057 0.05938 0.05821 0.05705 0.05592
−1.4 0.07353 0.07215 0.07078 0.06944 0.06811
−1.3 0.08851 0.08691 0.08534 0.08379 0.08226
−1.2 0.10565 0.10383 0.10204 0.10027 0.09853
−1.1 0.12507 0.12302 0.12100 0.11900 0.11702
−1.0 0.14686 0.14457 0.14231 0.14007 0.13786
−0.9 0.17106 0.16853 0.16602 0.16354 0.16109
−0.8 0.19766 0.19489 0.19215 0.18943 0.18673
−0.7 0.22663 0.22363 0.22065 0.21770 0.21476
−0.6 0.25785 0.25463 0.25143 0.24825 0.24510
−0.5 0.29116 0.28774 0.28434 0.28096 0.27760
−0.4 0.32636 0.32276 0.31918 0.31561 0.31207
−0.3 0.36317 0.35942 0.35569 0.35197 0.34827
−0.2 0.40129 0.39743 0.39358 0.38974 0.38591
−0.1 0.44038 0.43644 0.43251 0.42858 0.42465
0.0 0.51994 0.52392 0.52790 0.53188 0.53586
Z 0.00 0.01 0.02 0.03 0.04

0.0 0.50000 0.50399 0.50798 0.51197 0.51595
0.1 0.53983 0.54380 0.54776 0.55172 0.55567
0.2 0.57926 0.58317 0.58706 0.59095 0.59483
0.3 0.61791 0.62172 0.62552 0.62930 0.63307
0.4 0.65542 0.65910 0.66276 0.66640 0.67003
0.5 0.69146 0.69497 0.69847 0.70194 0.70540
0.6 0.72575 0.72907 0.73237 0.73565 0.73891
0.7 0.75804 0.76115 0.76424 0.76730 0.77035
(continued)
(continued)
Z 0.00 0.01 0.02 0.03 0.04
0.8 0.78814 0.79103 0.79389 0.79673 0.79955
0.9 0.81594 0.81859 0.82121 0.82381 0.82639
1.0 0.84134 0.84375 0.84614 0.84849 0.85083
1.1 0.86433 0.86650 0.86864 0.87076 0.87286
1.2 0.88493 0.88686 0.88877 0.89065 0.89251
1.3 0.90320 0.90490 0.90658 0.90824 0.90988
1.4 0.91924 0.92073 0.92220 0.92364 0.92507
1.5 0.93319 0.93448 0.93574 0.93699 0.93822
1.6 0.94520 0.94630 0.94738 0.94845 0.94950
1.7 0.95543 0.95637 0.95728 0.95818 0.95907
1.8 0.96407 0.96485 0.96562 0.96638 0.96712
1.9 0.97128 0.97193 0.97257 0.97320 0.97381
2.0 0.97725 0.97778 0.97831 0.97882 0.97932
2.1 0.98214 0.98257 0.98300 0.98341 0.98382
2.2 0.98610 0.98645 0.98679 0.98713 0.98745
2.3 0.98928 0.98956 0.98983 0.99010 0.99036
2.4 0.99180 0.99202 0.99224 0.99245 0.99266
2.5 0.99379 0.99396 0.99413 0.99430 0.99446
2.6 0.99534 0.99547 0.99560 0.99573 0.99585
2.7 0.99653 0.99664 0.99674 0.99683 0.99693
2.8 0.99744 0.99752 0.99760 0.99767 0.99774
2.9 0.99813 0.99819 0.99825 0.99831 0.99836
3.0 0.99865 0.99869 0.99874 0.99878 0.99882
3.1 0.99903 0.99906 0.99910 0.99913 0.99916
3.2 0.99931 0.99934 0.99936 0.99938 0.99940
3.3 0.99952 0.99953 0.99955 0.99957 0.99958
3.4 0.99966 0.99968 0.99969 0.99970 0.99971
3.5 0.99977 0.99978 0.99978 0.99979 0.99980
3.6 0.99984 0.99985 0.99985 0.99986 0.99986
3.7 0.99989 0.99990 0.99990 0.99990 0.99991
3.8 0.99993 0.99993 0.99993 0.99994 0.99994
3.9 0.99995 0.99995 0.99996 0.99996 0.99996
Z 0.05 0.06 0.07 0.08 0.09

0.0 0.51994 0.52392 0.52790 0.53188 0.53586
(continued)
Appendix D: Cumulative Standard Normal Distribution 477
(continued)
Z 0.05 0.06 0.07 0.08 0.09
0.1 0.55962 0.56356 0.56749 0.57142 0.57535
0.2 0.59871 0.60257 0.60642 0.61026 0.61409
0.3 0.63683 0.64058 0.64431 0.64803 0.65173
0.4 0.67364 0.67724 0.68082 0.68439 0.68793
0.5 0.70884 0.71226 0.71566 0.71904 0.72240
0.6 0.74215 0.74537 0.74857 0.75175 0.75490
0.7 0.77337 0.77637 0.77935 0.78230 0.78524
0.8 0.80234 0.80511 0.80785 0.81057 0.81327
0.9 0.82894 0.83147 0.83398 0.83646 0.83891
1.0 0.85314 0.85543 0.85769 0.85993 0.86214
1.1 0.87493 0.87698 0.87900 0.88100 0.88298
1.2 0.89435 0.89617 0.89796 0.89973 0.90147
1.3 0.91149 0.91309 0.91466 0.91621 0.91774
1.4 0.92647 0.92785 0.92922 0.93056 0.93189
1.5 0.93943 0.94062 0.94179 0.94295 0.94408
1.6 0.95053 0.95154 0.95254 0.95352 0.95449
1.7 0.95994 0.96080 0.96164 0.96246 0.96327
1.8 0.96784 0.96856 0.96926 0.96995 0.97062
1.9 0.97441 0.97500 0.97558 0.97615 0.97670
2.0 0.97982 0.98030 0.98077 0.98124 0.98169
2.1 0.98422 0.98461 0.98500 0.98537 0.98574
2.2 0.98778 0.98809 0.98840 0.98870 0.98899
2.3 0.99061 0.99086 0.99111 0.99134 0.99158
2.4 0.99286 0.99305 0.99324 0.99343 0.99361
2.5 0.99461 0.99477 0.99492 0.99506 0.99520
2.6 0.99598 0.99609 0.99621 0.99632 0.99643
2.7 0.99702 0.99711 0.99720 0.99728 0.99736
2.8 0.99781 0.99788 0.99795 0.99801 0.99807
2.9 0.99841 0.99846 0.99851 0.99856 0.99861
3.0 0.99886 0.99889 0.99893 0.99896 0.99900
3.1 0.99918 0.99921 0.99924 0.99926 0.99929
3.2 0.99942 0.99944 0.99946 0.99948 0.99950
3.3 0.99960 0.99961 0.99962 0.99964 0.99965
3.4 0.99972 0.99973 0.99974 0.99975 0.99976
3.5 0.99981 0.99981 0.99982 0.99983 0.99983
3.6 0.99987 0.99987 0.99988 0.99988 0.99989
3.7 0.99991 0.99992 0.99992 0.99992 0.99992
(continued)
(continued)
Z 0.05 0.06 0.07 0.08 0.09
3.8 0.99994 0.99994 0.99995 0.99995 0.99995
3.9 0.99996 0.99996 0.99996 0.99997 0.99997
Appendix E
Fundamentals of Engineering (FE) Examination
Example Questions
1. A product has the following annual manufacturing expenses.
Direct labor $187,000

Direct materials $220,000
Fixed overhead $ 70,000
G&A and sale overhead $ 60,000
Annual demand 20,000 units
The manufacturing firm adds 20% profit margin to its product cost to the retailer.
On average, retailers add 10% profit margin to their carrying cost to the final
customer. How much will it cost for retailers to purchase the product in 100-unit
shipments?
a. $4907
b. $3183
c. $3222
d. $5570
2. For the product in problem 1, what is the per-unit cost to the final customer?
a. $35.45
b. $53.98
c. $61.27
d. $35.01
3. An organization has total annual fixed costs of $500,000 and variable cost of
$5.10 per unit produced. The organization prices its products at $10.60 per
unit. What is the breakeven production quantity?
a. 54,535
b. 98,530
c. 132,223
https://doi.org/10.1007/978-3-030-87767-5
480 Appendix E: Fundamentals of Engineering (FE) Examination Example Questions
d. 90,909
4. A one-metric-ton/hour fluid bed jet mill costs $270,000 installed 10 years ago.
What will a two-metric-ton/hour fluid bed jet mill cost today if the power sizing
index exponent is 0.40 and the cost index for fluid bed jet mills increased from
108 to 116 over the last 10 years?
a. $355,545
b. $382,657
c. $322,238
d. 390,428
5. If 370 labor hours were required to produce the first unit in the production
run and 112 labor hours were required to produce the 16th unit, what is the
learning curve rate for this product?
a. 66%
b. 81%
c. 74%
d. 79%
6. An organization’s balance sheet shows the following account information
Cash $405,970 Accounts payable $831,000
Accounts receivable $762,590 Wages payable $200,000
Inventory $387,530 Salaries payable $20,000
Dividend payable (short term) $73,000
What are the organization’s current ratio and acid-test ratios?

a. Current = 1.26; acid-test = 1.08
b. Current = 1.31; acid-test = 1.09
c. Current = 1.15; acid-test = 0.99
d. Current = 1.38; acid-test = 1.04
7. An organization’s accrual income statement shows the following account
information
Sales $12,000,000
Returns and allowances $350,000
Cost of goods sold $8,780,000
Depreciation $329,250
Selling expenses $658,500
G&A expenses $1,566,650
If the organization’s combined federal and state income taxes were $94,680,
what was the organization’s net profit.
a. $220,920
b. $331,100
c. $215,990
Appendix E: Fundamentals of Engineering (FE) Examination Example Questions 481
d. $268,100
8. If $1000 is invested at an annual interest rate of 6% per year, its future worth
at the end of 20 years will be:
a. $2,920
b. $3,310
c. $3,156
d. $3,207
9. A maintenance manager needs $37,200 in 5 years to pay for an upgrade to
some equipment. If a fund earns 9% annually, how much must he invest today
for the amount to grow to the required $37,200?
a. $23,290
b. $24,827
c. $23,651
d. $20,730
10. An account pays 6.0% nominal interest compounded monthly. If $5,000 was
deposited at the beginning of the current year, how much will be in the account
at the end of four years?
a. $6208
b. $5872
c. $6512
d. $6352
11. The loan shark credit card only charges 2.5% per month interest. What is the
effective annual interest rate?
a. 26.08%
b. 28.27%
c. 34.48%
d. 36.23%
12. A machine must be replaced at a cost of $47,000. A local bank will finance the
cost of replacement with a loan that charges 9% nominal annual interest rate
with monthly payments for three years. What is the uniform monthly payment?
a. $1680
b. $2082
c. $1844
d. $1495
13. An engineer deposits $1000 into a retirement account today and deposits $100
at the end of every month starting with the first month. The account earns
a guaranteed 0.25% per month if the account remains open and active. How
much will the engineering have in the retirement account at the end of the
engineer’s 40-year career?
a. $91,887
b. $95,922
c. $101,484
d. $94,195
14. An asset returns the following annual cash flows: year 1—$73,000, year 2—
$78,000, year 3—$83,000, year 4—$88,000, year 5—$93,000, and year 6—
$98,000. Given MARR = 12%, what is the asset’s present worth?
a. $419,787
b. $359,292
c. $344,753
d. $299,451
15. A project has an initial cost of $90,200, generates $60,200 additional revenues
per year, requires $36,000 annual operating and maintenance expenses, and
has a salvage value of $24,000 at the end of its 4-year life. If the organization’s
MARR = 10% for this project, what is its net present worth?
a. $2906
b. $2290
c. $3443
d. $2995
16. What is the equivalent uniform annual cash flow for the project in question
15?
a. $962
b. $892
c. $1034
d. $917
17. An investment costed $50,000 and provided positive net annual cash flows of
$7790. What was the investment’s internal rate of return?
a. 9.0%
b. 8.0%
c. 10.0%
d. 7.0%
18. Consider the following two mutually exclusive investment choices. What is
the incremental rate of return?
Year Alternative 1 Alternative 2

0 ($20,000) ($30,000)
1–10 $7500 $9492
a. 15.0%
Appendix E: Fundamentals of Engineering (FE) Examination Example Questions 483
b. 18.0%
c. 12.0%
d. 8.0%
19. A MACRS GDS 5-year property asset was purchased and installed for
$100,000 and has a salvage value of $15,000 at the end of its 10-year useful
life. The asset’s MACRS depreciation charge for years 1 and 2 of service is:
a. $33,330 and $44,450
b. $17,490 and $12,490
c. $20,000 and $32,000
d. $10,000 and $18,000
20. A one-metric-ton unit of raw material cost $1000 6 years ago. If the raw
material prices have inflated at 3.0% per year for the last 6 years, what is the
per-metric-ton cost this year?
a. $1194
b. $1160
c. $1229
d. $116
21. An investor is considering purchasing $10,000 stock in a new risky venture but
only if he can double his money in one year and sell the stock. Based on his
research of other similar risky ventures, he believes the following probabilities
of return apply. What is his expected return in dollars?
Return Probability
$25,000 0.1
$20,000 0.2
$15,000 0.2
$10,000 0.3
$5000 0.1
$0 0.1
a. $9000
b. $13,000
c. $18,000
d. $20,000
22. During the next year, the cost of a commodity is expected to vary as a uniform
distribution U($3.20, $4.00) per unit. What is the commodity’s expected cost
and standard deviation?
a. $3.40 and 0.038
b. $3.60 and $0.053
c. $3.70 and 0.068

d. $3.80 and 0.079
23. Construction time for an addition to a manufacturing facility depends on the
weather. The time distribution can be described by a triangular distribution
with minimum = 5 months, mode = 6 months, and maximum = 10 months.
What is the expected completion time in months?
a. 8 months
b. 6.5 months
c. 7 months
d. 7.5 months
24. What is the standard deviation in months of construction time in problem 22?
a. 1.08 month
b. 2.55 months
c. 0.73 month
d. 1.75 month
25. Compute the sample mean and standard deviation of the following data: 90,
96, 102, 104, 108.
a. 100 and 6.32
b. 99.3 and 5.98
c. 101.2 and 6.48
d. 102.0 and 7.08.
Bibliography
1. Baasel W (1974) Preliminary chemical engineering plant design. Elsevier, New York
2. Bussey L (1978) The economic analysis of industrial projects. Prentice Hall, Englewood Cliffs,
NJ
3. Fabrycky W, Blanchard B (1991) Life-cycle cost and economic analysis. Prentice Hall,
Englewood Cliffs, NJ
4. Hodson W (ed) (2001) Maynard’s industrial engineering handbook. McGraw-Hill, New York
5. Killough L, Leininger W (1987) Cost accounting: concepts and techniques for management.
West Publishing Company, St. Paul, MN
6. Lori J, Savage L (1955) Three problems in rationing capital. J Bus 229–239
7. Meyers F (1999) Motion and time study for lean manufacturing. Prentice Hall, Englewood
Cliffs, NJ
8. NATO (2007) Methods and models for life cycle costing. RTO Technical Report TR-SAS-054
9. Newman D, Eschenbach T, Lavelle J, Lewis N (2019) Engineering economic analysis. Oxford
University Press, New York
10. Ostwald P (1992) Engineering cost estimating. Prentice Hall, Englewood Cliffs, NJ
11. Park C, Sharp-Bette G (1990) Advanced engineering economics. Wiley, New York
12. Park C (2007) Contemporary engineering economics. Pearson, Upper Saddle River, NJ
13. Perry R (ed) (1997) Perry’s chemical engineering handbook. McGraw-Hill, New York
14. Peters M, Timmerhaus K (1991) Plant design and economics for chemical engineers. McGraw-
Hill, New York
15. Thuesen G, Fabrycky W (2000) Engineering economy. Pearson, Upper Saddle River, NJ
16. Zandin K (1990) MOST work measurement systems. Marcel Dekker, New York
https://doi.org/10.1007/978-3-030-87767-5
Index
A Capital gain or loss, 226

Accounting, 8, 10, 31, 33, 37, 38 Capitalized cost, 192
Accrual income statement, 45–50, 59 Cash cost, 65
Accrued cost, 65, 90 Cash flow, 133, 134
Acid-test ratio, 52, 54, 60 Cash flow income statement, 49–51
Actual cost, 64, 66, 90, 91 Challenger-defender delta-IRR, 274, 280,
Actual dollars, 251 281, 284
After-tax cash flow, 74, 242 Combined tax rate, 240
Alternative depreciation system, 217 Composite cost index, 262
Amortization schedule, 199 Compounding period, 157, 158
Analysis period, 174, 187, 193 Compound interest, 136, 159
Arithmetic gradient series, 151, 155 Continuing requirement, 191
Asset, 10 Continuous compounding, 159, 161
Average cost, 69 Controllable costs, 65
Conventional B/C ratio, 340
Conversion costs, 68
B Corporation, 8
Balance sheet, 42 Cost basis, 140
Base year, 251 Cost center, 28
Benefit-cost ratio, 340 Cost-effectiveness analysis, 338, 339
Benefits, 333, 349 Cost estimating, 99
Bernoulli distribution, 358 Cost estimating relationship, 105
Bill of materials, 75 Cost index model, 116, 117
Binomial distribution, 358, 359 Cost of capital, 313, 318
Book cost, 90 Cost-push inflation, 250
Breakeven, 72 Cost-utility analysis, 339
Budget and budget cycle, 28, 29 Coupon rate, 197
Burden vehicle, 85, 89 Criterion, 308
Business-cycle budget period, 174, 178 Current ratio, 52
Cutoff rate of return, 325
C
Capital budgeting, 325, 330 D
Capital expenditure, 3, 10, 28, 31 Debt financing, 54, 55, 311, 319
Capital expense, 71 Decision tree, 381, 383
https://doi.org/10.1007/978-3-030-87767-5
488 Index
Declining balance depreciation, 216 G

Deflation, 264 General depreciation system, 217
Demand-pull inflation, 250 Geometric gradient series, 155, 156
Depletion, 228, 229 Government cost, 64
Depreciable life, 211 Government opportunity cost, 338
Depreciation, 209 Graphical delta-IRR sensitivity analysis,
Depreciation loss, 226 274
Depreciation recapture, 226
Detailed estimate, 102
Deterioration, 209 H
Direct component cost, 67–69, 73, 90 Historical cost, 71
Direct costs, 65
Direct labor, 67–69
I
Direct material cost, 67–69, 74–77
Impact, 309, 311
Direct variable costing, 91 Imprecision, 308
Disbenefits, 336 Incremental B/C ratio, 342
Discounted payback period, 176, 177 Incremental cost, 69
Double declining balance, 216 Indirect costs, 64, 65
Infinite analysis period, 196–197
Infinite planning horizon, 294
E Inflation rate, 251
Economic risk, 309 Influence diagram, 372, 375
Economic service life, 287–289, 301 Interest rate per period, 133
Internal rate of return, 184, 185
Effective annual interest rate, 158
Investment criteria, 16
Engineering, 4, 7
Investment objective, 354, 382
Engineering management, 4, 7
Investors, 38
Engineering managerial economics, 4
IRR critical decision point, 274
Equity, 42, 43
Equity financing, 312
Equivalence, 131 J
Equivalent uniform annual benefit, 157, 180 Joint costs, 71
Equivalent uniform annual cost, 157, 180,
181
Equivalent uniform annual worth, 157, 180, L
181 Learning curve model, 119, 120
EUAC(total cost), 300 Least common multiple life, 189
EUAW(total), 300 Lender, 38
Exchange rate, 250 Liabilities, 42, 43
Exponential distribution, 370 Life-cycle budget period, 346
Life cycle cost and costing, 16, 17
Lognormal distribution, 369, 370
Lori and Savage’s p-constant, 328, 329
F Loss on disposal, 226
Face value, 196, 197 Loss region, 72
Federal tax rate, 236 Lot hours, 113
Finance, 19
Financial ratios, 52–57
Finite planning horizon, 293, 294 M
First cost, 71 Maintenance expense, 46, 71
Fiscal year, 10 Management, 3
Fixed cost, 67 Manufacturing expense, 64
Full absorption costing, 91 Marginal costing, 64
Index 489
Market interest rate, 251 Profit margin, 53

Market value, 71 Profit region, 72
Mean, 357 Project life analysis, 187, 189
Minimum attractive rate of return, 19, 38, Proprietorship, 7
307 Public sector investment financing, 242,
Modified Accelerated Cost Recovery 243, 345, 346
System (MACRS), 209, 213, 217, Public sector investment life cycle, 346, 347
223 Purchasing power, 250
Modified B/C, 340
Money supply, 250
Mutually exclusive, 271 Q
Quick ratio, 52
N
Net benefits, 335 R
Net present worth criterion, 179 Random risk components, 388
Nominal interest rate, 158 Random variation, 353, 388
Noncontrollable cost, 65 Rationing capital, 325
Non-depreciated asset, 242 Real dollars, 251
Normal distribution, 365 Real interest rate, 251
Real property, 212
Recovery period, 211
O Replacement, 287, 288
Obsolescence, 10, 12, 14, 215, 287 Replacement cycle, 293
Operating expense, 65 Replacement time, 293
Opportunity cost, 58 Required life, 294, 300
Opportunity cost of capital, 318, 319 Requirements, 7, 8, 12, 13, 16, 20, 22, 25,
Outcome, 308 26, 106, 107
Overhead cost, 67 Retained earnings statement, 48, 49
Retirement, 301
Revenue bonds, 196
P Risk, 308
Partnership, 8 Risk simulation, 387, 404
Par value, 196 Risk versus return, 309, 310
Payment period, 157, 158 Rough estimate, 102
Percentage depletion, 229
Period cost, 65
Personal property, 229 S
Point of indifference, 274 Salvage value, 72
Poisson distribution, 360 Section 1031 property, 302
Population, 357, 400 Segmenting cost model, 115
Power-sizing model, 117 Semi-detailed estimate, 102
Predetermined time standard, 78, 79 Sensitivity analysis, 274, 275, 277–279,
Price index, 116, 261, 262 283
Prime costs, 68 Service, 3, 22
Probability, 356 Service cost, 12
Probability density function, 363, 370 Simple interest, 135
Probability distribution, 357, 362 Simulation, 387, 392
Probability mass function, 357 Single payment compound amount, 137
Product, 16 Single payment present worth, 139
Product costing, 123 Spreadsheet, 161, 163
Production, 5 Standard cost, 63, 64
Productive hour cost, 123 Standard deviation, 358
Product life cycle, 10 State tax rate, 236, 239, 240
490 Index
Statistics, 358, 370 Uniform distribution, 365

Stock, 3, 9, 11, 15, 17–19 Uniform series capital recovery amount,
Stockholders, 19 146
Straight-line depreciation, 214 Uniform series compound amount, 144
Structural risk components, 388, 404 Uniform series present worth amount, 147
Sum-of-years-digits depreciation, 215 Uniform series sinking fund amount, 145
Sunk cost, 70, 71 Unit-of-production depreciation, 227
System estimating, 101, 102
V
T Variable cost, 67
Taxable income, 236 Variance, 358
Taxpayer opportunity cost, 338
Time standard, 78
Total cost, 67
Triangular distribution, 364, 365 W
Triangulation, 118, 119 Weighted average cost of capital, 313
Weighted marginal cost of capital, 315
Work sampling, 81–88
U
Uncertainty, 308
Undiscounted payback period, 175 Z
Uniform cash flow series, 144, 152 Zero-budget period, 178

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Topics in Safety, Risk, Reliability and Quality

Teddy Steven Cotter

ISSN 1566-0443 ISSN 2215-0285 (electronic)

Features of This Book

Key design features of this book include:

• Inflation-adjusted cash flows, indexes, and inflationary effects on before and

hardcopy or electronic book. In the blended online-classroom setting, the instructor

Norfolk, VA, USA Teddy Steven Cotter, Ph.D.

Part I Economic Context of Engineering Management Decision

Part II Economic Analysis of Engineering Activities and Projects

6.6 Future Worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

9.8 Inflation Effect on After-Tax Calculations . . . . . . . . . . . . . . . . . . . 264

Part III Managing Engineering Investments

14.3.2 Public Sector Opportunity Cost . . . . . . . . . . . . . . . . . . . . 337

Appendix A: Use of the Microsoft® Excel® Compound Interest

All engineering activities and projects must be executed within an organizational

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 3

1.2 Engineering and Engineering Management

Definition: Engineeringmanagerial economics is the body of knowledge and

1.3 Types of Business Organizations

Proprietorships have three distinguishing characteristics. First, a proprietorship is

A group of shareholder owners create a corporation to pursue a common objective.

1.4 Engineering Economic Decisions

As can be seen in the Engineering and Engineering Management section above,

In the implementation and maintenance phases, engineers’ primary task is cost

• Involve costs in the $10,000s or $100,000s.

Intermediate Long Range

Fiscal Year Budget Budget Cycle Forecasted Budget

Current Expenses Product Life Cycle Future Products

Intermediate Eng. Long Term Eng.

In each of these timescales, engineering economic analysis is used to determine

5. Quality and reliability optimization. Quality is conformance of the totality of

4. Continuous processes are nonadditive processes that produce gases, liquids,

1.5 Engineering Economic Principles

Engineering economics is based on fundamental principles that, if followed, assure

6. Only differences are relevant. Prospective consequences that are common to

1.6 Engineering Life Cycle Costs

Combining these definitions, products may be defined as:

Key characteristics of products include:

Three fundamental exchanges must take place for an organization to produce a

Fig. 1.3 Organizational annual budgeting finance cycle

Fig. 1.4 Typical product, process, service, or system life cycle

2. Conceptual design—(a) Impact analysis of each feasible alternative to measure

1.7 Engineering Life Cycle Cost Management

• Basic Research—research devoted to attaining fuller knowledge of the natural

• Laboratory, shop, and office facilities.

Planning and organizing for design engineering activities includes:

Product Engineering Management

Product engineering usually entails activities dealing with issues of cost,

There are three fundamental types of process engineering:

In the twenty-first-century organization, information engineering supports all

• Staffing for the required engineering and technical skills.

In the twenty-first-century organization, facilities engineering is essential for

Fig. 1.7 Systems

1.8 Budgeting for Engineering Operations and Projects

Budget—a quantitative expression of planned sales volumes, revenues, resource quantities,

effectiveness of planning, communication, and coordination within the organiza-

Fig. 1.8 Four-phase Budget Cycle

Fig. 1.9 Engineering operations budget template

This chapter established the context of engineering managerial decision making