Introduction to Engineering Economy

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Introduction to Engineering Economy
2
Introduction

• What will we learn in the class?
• Terms and techniques of economic analysis
• How to justify the purchase of equipment
• How to justify the implementation of a project

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Keys to Success

• Why is this information important?
• You will be able to
• Discuss economic problems and topics with
  financial analysts in your organization
• Justify equipment, projects and other activities
  needed to get your job done
• Make decisions with knowledge of the impact of
  taxes, interest, and other financial implications

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Keys to Success in Engineering Economy

• Work the homework problems yourself before
  seeking help
• Seek help with homework problems (from your
  classmates or your professor) if you cannot reach
  the answers
• Concentrate your effort on understanding what the
  problem is asking. The solutions in this course
  are relatively simple. The challenge is
  determining what the question is asking.
• Learning the new terms. This course contains a
  lot of new vocabulary terms that you need to
  understand before working the homework.

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Keys to Success in Engineering Economy

• The amount of effort you put in is directly
  related to your grade more effort better
  grades, work more problems better grades
• Formulas will be derived not that you will be
  deriving formulas, but deriving them will show
  you the assumptions made when using them.
• When you have a situation where the assumptions
  are not valid, then you cannot use certain
  formulas.

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Cash Flow Approach

• You will learn how to evaluate alternative
  engineering investment opportunities. This
  evaluation must begin with an estimate of the
  investments cash flow.
• What is cash flow?
• The cash flow is a listing and or diagram of the
  costs (negative cash flows) and revenues
  (positive cash flows) and when each of these cash
  flows occur.
• Example Say you buy a 2001 Mustang. Price,
  including all fees is 20,000. Then you make
  monthly payments of 395.87 for 5 years.
  Including interest, you actually pay about
  23,000 for the car.

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Cash Flow Approach

• This course will spend a lot of time determining
  what cash flows look like for different
  transactions.
• Cash Flows involve two things
• 1. How much money is being transferred
• 2. Time when the money transfers

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Cash Flow Approach

• Cash flows allow us to compare different
  projects.
• Example
• Ford is offering 6.90 interest for 5 years
• GM is offering 5.90 for 4 years
• Which is the better deal?
• We can calculate the cash flows and find out!

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The Problem Solving Process

• This is a structured approach that can be used to
  solve engineering problems.
• 1. Define the problem or project objective.
• In doing so the engineer should make every
  attempt to be specific and quantitative.
• For example an objective might be to improve
  on-time deliveries. However, a specific and
  quantitative objective might be "To improve
  on-time deliveries to 95 of all shipments and to
  accomplish this within three months."
• A lot of times engineering projects fail because
  this step was skipped or not done properly. This
  seems crazy, but it is true. People often start
  trying to solve a problem not fully understanding
  the goal

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The Problem Solving Process

• Real life problems can have many solutions
  which one is best depends on your goals
• Be specific the more specific the definition,
  the more likely you will solve the problem (to
  everyones satisfaction)
• Be quantitative In real life, problem
  definition can change constantly. Example
  Bridgets software goals constantly updated.
• If late delivery is the problem, what is the
  solution? 99 on time, 95 on time depends on
  management, customers, and others
• I strongly suggest getting the problem down in
  writing and getting management to agree to the
  written problem. Once the problem is in writing,
  management cannot change the problem unless you
  are notified.

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The Problem Solving Process

• 2. Analyze the problem.
• The step involves gaining an understanding of all
  key variables and constraints. You will have a
  lot of courses that deal with analysis.
• 3. Search for alternative solutions.
• An engineer should always strive to obtain
  multiple solutions to problems.
• You must come up with many alternatives each
  with different strengths and weaknesses
• Just like coming up with several restaurants to
  choose from when going out to eat

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The Problem Solving Process

• 4. Select the preferred alternative.
• Economic analysis is part of step 4. The
  preferred solution is generally but not always
  the investment alternative that results in the
  greatest economic benefit to your organization.
• 5. Specify the preferred solution.

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The Problem Solving Process

• 6. Sell the solution to decision makers
• You must be able to sell your ideas
• Engineers sell projects by making sure the
  analysis is thorough and correct
• Answer questions of managers
• Must be able to reduce risk by doing a lot of
  analysis. Managers do not like risk.
• Demonstrate that you understand the problem and
  have examined several alternatives
• Document all results and conclusions
• Oral presentations can be brutal if you have not
  done your homework

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Decision Making

• 3.1 Multiple Criteria This course will focus
  on the criteria of economic value. However, real
  decisions are made by simultaneously considering
  many criteria.
• Five observations about decision making are
  listed on page 9 of your textbook.
• Example a new machine must be safe,
  environmentally friendly, under budget, delivered
  on time, works with other machines currently in
  operation, ect
• Some objectives will conflict, Example best
  quality machine may not be under budget

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Decision Making

• 3.2 Selling the Investment Alternative
  Engineers must do a technical analysis and design
  of all alternatives under consideration. Then
  these alternatives are analyzed from an economic
  standpoint using the techniques learned in
  chapters 2 6.
• Finally, the best alternative must be sold to
  management. Decision makers must be convinced
  that your technical and economic analyses are
  through and based on good data and sound judgment
  or they will not take the risk of approving the
  project (investment).
• Selling involves backing good technical work with
  a good verbal presentation and / or written
  report.

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Decision Making

• Solutions are time dependent Make decisions
  with the information you have within the time
  constraints
• Aspiration level what do the decision makers
  want to achieve?
• Example what is your aspiration level in this
  course? Am A, a B, or a C the highest A
  or just a A
• Individuals are rational but companies sometimes
  are not (usually due to some rules to avoid
  abusing the system or taking advantage of the
  company)

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Time value of money

• What is the time value of money?
• The time value of money concept simply recognizes
  that a given dollar amount has different values
  at different times.
• In order to adjust these different values to a
  common reference point on the time scale, an
  interest rate is used to make the adjustment.

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Time value of money

• Why is it important to consider the time value of
  money?
• Investment projects that have a life cycle of
  several years will almost invariably have
  associated revenues (or savings) and expenses
  that occur periodically over the life cycle.
• This series of cash flows constitute a particular
  cash flow pattern, and alternative projects can
  have different cash flow patterns over their
  respective life cycles.
• In order to compare such alternative projects at
  a common point in time by an economic measure of
  effectiveness, the time value of money must be
  considered.

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Selling the Investment Alternative

• When selling an idea to management, what is more
  important the content of your presentation or
  the method you use to sell it?
• The sales technique of the individual who
  presents the alternative to management.
• It is not unusual for management to adopt a
  weaker alternative because of the persuasive
  power of the person who presented the investment
  alternative.
• What is said to support an investment
  justification and how it is said influence the
  ultimate decision regarding the investment.
• The strengths and weaknesses of the communication
  often outweigh the technical aspects of the
  investment alternative.

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Selling the Investment Alternative

• How well you communicate with the decision makers
  often will determine whether or not the
  alternative is funded.
•  
• How do you increase your chances of getting your
  idea approved?
• To maximize your chance of success, it is
  important to speak the language of the listeners,
  to understand what motivates them, to see the
  world as they see it, and to understand what
  rules and criteria they use.
• Your proposal must be structured in such a way
  that it communicates to them the message you want
  to deliver.
• Dr. Liles Example Be direct and to the point.
  Must be in terms of dollars cost and benefit

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Lessons for Engineers

• Engineers tend to become enamored of the
  technical aspects of the solution they have
  developed or designed and fail to understand that
  management often speaks financial language, not
  the language of technology.
• In most cases, when you are presenting an idea,
  many others are being considered you are
  competing for limited funds.

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Lessons for Engineers

• Even if you do a superb job of analyzing,
  documenting, and presenting your investment
  recommendation, the ultimate decision will be
  influenced by how your investment fits
• The firm's overall investment portfolio
• The firm's investment strategy
• The firm's goals and objectives
• The level risk or uncertainty relative to your
  and other investment alternatives
• The impact of the investment on the various
  organizational units within the firm will be a
  factor in the final decision
• The magnitude of the request in terms of
  resources
• The scope of the projected impact on the firm
• How good the competing investments are.

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Lessons for Engineers

• What do managers want in a solution?
• High quality products and services
• Low costs
• Short delivery times
• Your challenge as an engineer?
• To convince management that
• Your investment alternative will deliver value
  beyond that delivered by competing alternatives
  and beyond the cost of capital to the firm
• Your project is technically sound and
  economically justified,
• Your project has noneconomic benefits

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Lessons for Engineers

• Why should you include noneconomic benefits?
• To improve the probability of management
  approving your idea.
• What noneconomic areas should you include?
• Strategic
• Culture
• Process
• Technology
• Why should your proposal include an executive
  summary?
• Management will not likely read a long report if
  the first page does not catch their attention.
• Management does not have time to read long
  proposals.

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Present Economy Examples
 In what conditions is the time value of money
not considered? The time value of money did not
have to be considered when one or more of the
following conditions held (1) no investment of
capital and only out-of-pocket costs were
involved (2) after paying any first cost (capital
investment), the long- term costs would be the
same for all alternatives or would be
proportional to the first cost (3) the
alternatives would have essentially identical
results regardless of the capital investment
involved. What are examples of typical present
economy studies? The choice among alternative
designs, materials, or methods.
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Problem 1.8

• The process engineer in a medium-sized machine
  shop has the choice of machining a particular
  part on either of two machines. Orders for this
  part are received regularly, but on a recurring
  basis. The order size varies. When the order is
  processed on Machine A, four setup operations of
  1 hour each are required. Once set up, the per
  unit machining time on Machine A is .5 hours.
• When the order is processed on Machine B, eight
  set-up operations of .75 hour each are required.
  Once set-up, the per unit machining time on
  Machine B is .55 hours. The hourly wage rates for
  the machine operators are 10 and 9 for Machine
  A and B, respectively. The hourly overhead rates
  (including setup time) are 15 and 13.5 for
  Machine A and B, respectively.
• A) Which machine is preferred if the order size
  is 100 units? 500 units?
• B) What is the break-even order size?

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Problem 1.8

• A 4 hrs (setup) .5 hr/unit ( units)
• 10/hr Labor 15/hr Overhead
• B 6 hrs (setup) .55 hr/unit ( units)
• 9/hr Labor 13.50/hr Overhead
• So far, A does not look good, but we have to
  consider labor rates and overhead.

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Problem 1.8

• Total Cost (A) 4 hr(10/hr 15/hr) .5
  hr/unit (x units)(10/hr 15/hr)
• Total Cost (B) 6 hr(9/hr 13.50/hr) .55
  hr/unit (x units)(9/hr 13.50/hr)
• Note how the units cancel to produce an answer in
  dollars.

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Problem 1.8

• A) Total Cost (A) 4 hr(10/hr 15/hr) .5
  hr/unit (100 units)(10/hr 15/hr) 1350
• Total Cost (B) 6 hr(9/hr 13.50/hr) .55
  hr/unit (100 units)(9/hr 13.50/hr) 1372.5
• Thus A is cheaper for 100 units, for 500 units
• Total Cost (A) 6350
• Total Cost (B) 6322.5
• Thus B is cheaper for 500 units

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Problem 1.8
B) Set each equation equal to each other to
determine the break even order size TCA 4
hr(25/hr) .5 hr/unit (X units)(25/hr) TCB 6
hr(22.5/hr) .55 hr/unit (X units)(22.5/hr) TCA
TCB 4 hr(25/hr) .5 hr/unit (X
units)(25/hr) 6 hr(22.5/hr) .55 hr/unit (X
units)(22.5/hr) 100 12.5 (X units) 132
12.375 (X units) .125 (X units) 32 (X units)
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