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Engineering Economics

Engineering Economics. John Ayers September 17, 2004. Engineering Economics. Why is it important? Value and Interest Cash Flow Diagrams and Patterns Equivalence of Cash Flow Patterns Evaluating Alternatives Break-Even Analysis Income Tax and Depreciation Inflation Conclusion.

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Engineering Economics

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  1. Engineering Economics John Ayers September 17, 2004 .

  2. Engineering Economics • Why is it important? • Value and Interest • Cash Flow Diagrams and Patterns • Equivalence of Cash Flow Patterns • Evaluating Alternatives • Break-Even Analysis • Income Tax and Depreciation • Inflation • Conclusion

  3. Why do we care about Engineering Economics? • Engineering designs are intended to produce good results. • They are accompanied by undesirables (costs). • If outcomes are evaluated in dollars, and “good” is defined as profit, then decisions will be guided by engineering economics. • This process maximizes goodness only if all outcomes are anticipated and can be monetized. $

  4. $1000 1 2 $1166 Value and Interest • The “value” of money depends on the amount and when it is received or spent. Example: What amount must be paid to settle a current debt of $1000 in two years at an interest rate of 8% ? Solution: $1000 (1 + 0.08) (1 + 0.08) = $1166

  5. “present” P-Pattern 1 2 3 n “future” F-Pattern 1 2 3 n “annual” A-Pattern 1 2 3 n “gradient” G-Pattern 1 2 3 n Cash Flow Diagrams

  6. Equivalence of Cash Flow Patterns

  7. 50k 50k 50k 50k 50k 50k 50k 1 2 3 4 5 6 7 P Example: A new circuit board component insertion tool will save $50,000 in production costs each year and will have a life of seven years. What is the highest price that can be justified for the tool using a 12% interest rate? Solution:

  8. Evaluating Alternatives • Annual Equivalent Cost Comparisons • Present Equivalent Cost Comparisons • Incremental Approach • Rate of Return Comparisons • Benefit/Cost Comparisons Minimum Attractive Rate of Return (MARR): The lowest rate of return that the organization will accept.

  9. Annual Equivalent Cost Comparison • Incomes are converted to an A-pattern. • Costs are converted to an A-pattern. • The costs are subtracted from the incomes to determine the ANEV. • Mutually Exclusive Alternatives – choose the one with highest ANEV • Independent Alternatives – choose all with positive ANEV ANEV: Annual Net Equivalent Value

  10. Example: A new circuit board component insertion tool is needed. Which should you buy? Solution: The ANEV is calculated for each: JACO: Cheepo: JACO

  11. Present Equivalent Cost Comparison • Incomes and costs are converted to P-patterns. • The costs are subtracted from the incomes to determine the PNEV. • Mutually Exclusive Alternatives – choose the one with highest PNEV • Independent Alternatives – choose all with positive PNEV PNEV: Present Net Equivalent Value, also called “life cycle cost,” “present worth,” “capital cost,” and “venture worth.”

  12. Incremental Approach • For a set of mutually exclusive alternatives, only the differences in amounts need to be considered. JACO- Cheepo: JACO

  13. Rate of Return Method • ANEV or PNEV is formulated • From this, we solve for the interest rate that will give zero ANEV or PNEV • This interest rate is the ROR of the alternative • For mutually exclusive alternatives, the one with the highest ROR is chosen • For independent alternatives, all with a ROR greater than MARR are accepted ROR: Rate of Return on Investment

  14. Benefit/Cost Comparisons • The benefit/cost ratio is determined from • For mutually exclusive alternatives, the one with the highest B/C is chosen. • For independent alternatives, all with B/C > 1 are accepted. The MARR is used to determine the numerator (benefits).

  15. Break-Even Analysis • Break-even point: the value of an independent variable such that two alternatives are equally attractive. • For values above the break-even point, one alternative is preferred. • For values below the break-even point, the other is preferred. • Break-even analysis is useful when dealing with a changing variable (such as MARR).

  16. Income Tax and Depreciation • Businesses pay the IRS a tax: • Depreciation: method of charging the initial cost of an asset against more than one year. • An asset is depreciable if : • It is used to produce income, • Has a life greater than one year, but • Decays, wears out, becomes obsolete, or gets used up. ACRS: Accelerated Cost Recovery System, used by IRS since 1980.

  17. Inflation • The buying power of money changes with time. • Inflation, if anticipated, can be put to good use by fixing costs and allowing income to rise by • Entering long-term contracts for materials or wages • Purchasing materials long before they are needed • Stockpiling product for sale later.

  18. Conclusion • For-profit enterprises exist to make money. • Non-profit entities also make decisions to maximize the goodness of outcomes by assigning dollar values. • Your engineering decisions will be shaped by economics. $

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