ES301 – ENGINEERING ECONOMICS

LESSON 1
THE ECONOMIC ENVIRONMENT

THE BASICS OF ENGINEERING ECONOMY

Engineering is the profession in which a knowledge of the mathematical and natural

science gained by study, experience and practice is applied with judgement to
develop ways to utilize, economically the materials and forces of nature for the
benefit of mankind. In this definition, the economic aspects of engineering are
emphasized, as well as the physical aspects. Clearly, it is essential that the economic
part of engineering be accomplished well.

In manufacturing, engineering is involved in every detail of a product’s production,

from the conceptual design to the shipping. In fact, engineering decisions account for
the majority of product costs. Engineers must consider the effective use of capital
assets such as building and machinery. One of the engineer’s primary tasks is to plan
for the acquisition of equipment (capital expenditure) that will enable the firm to
design and produce products economically.

Engineering economy is the discipline concerned with the economic aspect of

engineering. It involves the systematic evaluation with the economic merits of
proposed solutions to the engineering problems. To be economically acceptable (i.e.,
affordable), solutions to engineering problem must demonstrate a positive balance of
long-term benefits over long term cost.

Engineering economics is the application of economic techniques to the evaluation of

design and engineering alternatives. The role of engineering economics is to assess
the appropriateness of a given project, estimate its value, and justify it from an
engineering standpoint.

ENGINEERING ECONOMIC CONCEPTS

• Value is the worth that a person attaches to a product or service. It is relative

concept.
• Utility is the power to satisfy needs.
• Goods are objects with utility.

2 Types of Goods
➢ Consumer good
➢ Producer goods
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Why Engineering Economy is Important to Engineers?
• Engineers design and create
• Designing involves economic decisions
• Engineers must be able to incorporate economic analysis into their creative
efforts
• Often engineers must select and implement from multiple alternatives •
Understanding and applying time value of money, economic equivalence, and
cost estimation are vital for engineers
• A proper economic analysis for selection and execution is a fundamental task of
engineering

THE GENERAL ECONOMIC ENVIRONMENT

There are numerous general economic concepts that must be taken into account in
engineering studies.
• Consumer goods and services are those products or services that are directly
used by people to satisfy their wants. Examples are foods, clothing, homes, cars,
haircuts and medical services.

• Producer goods and services are used to produce consumer goods and services
and other producer goods. Examples are machine tools, factory buildings, buses
and farm machinery.

• Price of goods and services is defined to be the present amount of money or its
equivalent which is given in exchange for it.

• Demand is a quantity of certain commodity that is bought at a certain price at a

given place and time.

• Supply is a quantity of a certain commodity that is offered for sale at a certain price
at a given place and time.

• Perfect competition occurs in a situation in which any given product is supplied by

a large number of vendors and there is no restriction in additional suppliers
entering the market.

• Perfect monopoly exists when a unique product or service is available from a

single supplier and that vendor can prevent the entry of all others into the market.

• Oligopoly occurs when there are few suppliers and any action taken by anyone of
 them will definitely after the course of action of the others.

• Total Revenue is the product of the selling price per unit and the number of units
sold.

• Total Cost is the sum of the fixed costs and the variable costs. • Profit/

Loss is the difference between total revenue and the total costs.

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COST TERMINOLOGIES
Cost considerations and comparisons are fundamental aspects of engineering
practice. Before the study of various engineering economic decisions problems, the
concept of various costs must be understood. At the level of plant operations,
engineers must make decisions involving materials, plant facilities and the in-house
capabilities of company level.

• Fixed costs are those unaffected by changes in activity level over a feasible range
of operations for the capacity or capability available. Examples are insurance and
taxes on facilities, general management and administrative salaries, license fees,
and interest costs on borrowed capital.

• Variable costs are those associated with an operation that vary in total with the
quantity of output or other measures of activity level. Examples are the costs of
material and labor used in a product or service.

• Incremental cost is the additional cost (or revenue) that results from increasing the
output of the system by one or more units.

• Recurring costs are those that are repetitive and occur when an organization
produces similar goods or services on a continuing basis.

• Nonrecurring costs are those which are not repetitive even though the total
expenditure may become cumulative over a relatively short period of time.

• Direct costs are costs that can be reasonably measured and allocated to a specific
output or work activity. Examples are labor and material costs.

• Indirect costs are those that are difficult to attribute or allocate to a specific output
or work activity. Examples are the costs of common tools, general supplies, and
equipment maintenance.

• Overhead cost consists of plant operating costs that are not direct labor or direct
material costs. Examples are electricity, general repairs, property taxes and
supervision.

• Standard costs are representative costs per unit of output that are established in
advance of actual production or service delivery.
• Cash costs are that involves payment of cash.

• Noncash costs (book costs) are costs that does not involve a cash payment, but
rather represent the recovery of past expenditures over a fixed period of time.
Example is the depreciation charged.

• Sunk cost is one that has occurred in the past and has no relevance to estimates
of future costs and revenues related to an alternative course of action.

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• Opportunity cost is incurred because of the use of limited resources such that the
opportunity to use those resources to monetary advantage in an alternative use is
foregone.

• Life-cycle cost refers to a summation of all the costs, both recurring and
nonrecurring, related to product, structure system, or services during its life span.

• Investment cost is the capital required for most of the activities in the acquisition
phase.

• Working capital refers to the funds required for current assets that are needed for
the startup and support of operational activities.

• Operational and Maintenance cost includes many of the recurring annual

expense items associated with the operation phase of the life cycle.

• Disposal cost includes those nonrecurring costs of shutting down the operation
and the retirement and disposal of assets at the end of the life cycle. These costs
will be offset in some instances by receipts from the sale of assets with remaining
value.

• Economic life coincides with the period of time extending from the date of
acquisition to the date of abandonment, demotion in use, or replacement from the
primary intended service.

• Ownership life is the period between the date of acquisition and the date of
disposal by a specific owner.

• Physical life is the period between original acquisition and final disposal of an
asset over the succession of owner.

• Useful life is the time period that an asset is kept in productive service (either
primary or backup). It is an estimate of how long an asset is expected to be used
in a trade or business to produce income.
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THE ECONOMIC ENVIRONMENT

Engineering economy is the analysis and the evaluation of the factors that will affect
the economic success of engineering projects to the end that a recommendation can
be made which will insure the best use of capital.

CONSUMER AND PRODUCER GOODS AND SERVICES

Consumer goods and services are those products or services that are directly used
by people to satisfy their wants

Producer goods and services are used to produce consumer goods and services or
other producer goods.

NECESSITIES AND LUXURIES

Necessities are those products or services that are required to support human life
and activities that will be purchased in somewhat the same quantity even though the
price varies considerably.

Luxuries are those products or services that are desired by humans will be purchased
if money is available after the required to support human life and activities that will be
purchased in somewhat the same quantity even though the price varies considerably.

DEMAND

Demand is the quantity of a certain commodity that is bought at a certain price at a

given place and time.

Elastic demand occurs when a decrease in selling price result in a greater than
proportionate increase in sales.

Inelastic demand occurs when a decrease in selling price produces a less than
proportionate increase in sales.

Unitary elasticity of demand occurs when the mathematical product of volume and
price is constant.

SUPPLY

Supply is the quantity of a certain commodity that is offered for sale at ascertain price
at a given place and time

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Competition, Monopoly, and Oligopoly

Perfect competition occurs in a situation where a commodity or service is supplied by

a number of vendors and there is nothing to prevent additional vendors entering the
market.

Monopoly is the opposite of perfect competition. A perfect monopoly exists when a

unique product or service available from a single vendor and that vendor can prevent
the entry of all others into the market.

Oligopoly exists when there are so few suppliers of a product or service that action by
one will almost inevitably result in similar action by the others.

The Law of Supply and Demand

The law of demand says that at higher prices, buyers will demand less of an
economic good.

The law of supply says that at higher prices, sellers will supply more of an economic
good.
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