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ENGR 155 – Engineering economics
Jan 17: Introduction
Chapter 1: Engineering economics overview
Fundamental principles of engineering economics
Time value of money
Simple & compound interest
Engineering is the profession in which knowledge of the
mathematical & natural sciences gained by study, experience &
practice is applied w/ judgment to develop ways to use,
economically, the forces of nature for the benefit of humankind.
(ABET)
Engineering economics overview
Topics dealt with in chapter 1
1. Rational decision-making process
2. Economic decisions
3. Predicting future
4. Role of engineers in business
5. Large-scale engineering projects
6. Types of strategic engineering economic
decisions
T1. Rational decision-making process
(what engineers do)
–
–
–
–
–
–
Recognize a decision
problem
Define the goals or
objectives
Collect all the relevant
information
Identify a set of feasible
decision alternatives
Select the decision
criterion to use
Select the best alternative
Text example: which car to lease?
Saturn vs. Honda
–
–
–
–
–
–
Recognize a decision
problem
Define the goals or
objectives
Collect all the relevant
information
Identify a set of feasible
decision alternatives
Select the decision
criterion to use
Select the best alternative
Need a car
Want mechanical
security
Gather technical as well
as financial data
Choose between Saturn
and Honda
Want minimum total
cash outlay
Select Honda
Financial data required to make an
economic decision
T2. Engineering economic decisions
Manufacturing
Planning
Profit
Investment
Marketing
T3. Predicting the future
- Estimating a required
investment
- Forecasting a product
demand
- Estimating a selling
price
- Estimating a
manufacturing cost
- Estimating a product
life
T4. Role of engineers in business
Create & design
engineering projects
Analyze
Evaluate
Evaluate
production methods
expected
profitability
impact on
financial statements
timing of
cash flows
firm’s market value
engineering safety
environmental impacts
market assessment
degree of
financial risk
stock price
Accounting vs. engineering economics
Evaluating past
performance
Accounting
Evaluating & predicting
future events
Engineering economy
past
present
future
Time & uncertainty are the defining
aspects of any engineering
economic decision
T5. A large-scale engineering project
– Requires a large sum of
investment
– Takes a long time to see
the financial outcomes
– Has uncertainty in
predicting the revenue &
cost streams
T6. Types of strategic engineering economic
decisions in manufacturing sector
– Service improvement
– Equipment & process selection
– Equipment replacement
– New product & product expansion
– Cost reduction
Fundamental principles of
engineering economics
1. A nearby dollar is worth more than a distant
dollar
2. All that counts are the differences among
alternatives
3. Marginal revenue must exceed marginal cost
4. Additional risk is not taken without the
expected additional return
Principle 1: A nearby dollar is worth
more than a distant dollar
today
6-month later
Principle 2: All that counts are the
differences among alternatives
Monthly Salvage
fuel cost mainten- outlay at payment value at
end of
signing
ance
year 3
Option Monthly Monthly Cash
Buy
$960
$550
$6,500 $350
$9,000
Lease
$960
$550
$2,400 $550
0
Irrelevant items in decision making
Principle 3: Marginal revenue must
exceed marginal cost
Marginal
cost
Manufacturing cost
Sales revenue
Ignore sunk costs
1 unit
1 unit
Marginal
revenue
Principle 4: Additional risk is not taken
without expected additional return
Investment
class
Potential
risk
Expected
return
Savings
account (cash)
Low/none
1.5%
Bond (debt)
Moderate
4.8%
Stock (equity)
High
11.5%
Summary of chapter 1
– Engineering economic decision refers to all
investment decisions relating to engineering
projects
– Five main types of engineering economic
decisions: service improvement, equipment &
process selection, equipment replacement, new
product & product expansion, cost reduction
– The factors of time & uncertainty are the defining
aspects of any investment project
Time value of money
– Money has a time value
because it can earn more
money over time (earning
power).
– Money has a time value
because its purchasing
power changes over time
(inflation).
– Time value of money is
measured in terms of
interest rate.
– Interest is the cost of
money—a cost to the
borrower & an earning to
the lender
What determines interest rate?
–
–
–
–
–
Time value of money
Risk
Overhead costs
Inflation
Supply of & demand for funds
Money supply & demand
Methods of calculating interest
Simple interest: the practice of charging
an interest rate only to an initial sum
(principal amount).
Compound interest: the practice of
charging an interest rate to an initial
sum & to any previously accumulated
interest that has not been withdrawn.
Simple interest
P = Principal amount
i = Interest rate
N = Number of interest
periods
Example:
P = $1,000
i = 8%
N = 3 years
End of
year
Beginning
balance
Interest
earned
0
Ending
balance
$1,000
1
$1,000
$80
$1,080
2
$1,080
$80
$1,160
3
$1,160
$80
$1,240
Simple interest formula
F = P + (iP)N
where
P = Principal amount
i = simple interest rate
N = number of interest periods
F = total amount accumulated at the end of period N
F = $1, 000 + (0.08)($1, 000)(3)
= $1, 240
Compound interest
Compound interest: the practice of
charging an interest rate to an initial
sum & to any previously accumulated
interest that has not been withdrawn.
Compound interest
P = Principal amount
i = Interest rate
N = Number of
interest periods
Example:
P = $1,000
i = 8%
N = 3 years
End
of
year
Beginning Interest
balance
earned
0
Ending
balance
$1,000
1
$1,000
$80
$1,080
2
$1,080
$86.40 $1,166.40
3
$1,166.40
$93.31 $1,259.71
Become rich by the age of 65
•
•
•
•
Your current age: 20 years old
Amount of savings desired: $2 million
Interest earned on your savings: 10%
Required monthly savings:
Upper 5% of U.S. income bracket
Monthly savings required
to save $2M at age 65
Starting
Age
Required Monthly Savings at Varying Interest
Rates
5%
7%
$987
$527
$190
$93
$31
30
$1,760 $1,110
$527
$311
$136
40
$3,358 $2,469 $1,507 $1,064
$617
50
$7,483 $6,310 $4,825 $4,003 $2,998
20
10%
12%
15%
Returns from various investment
classes
Average Annual
Return 19701997
Best Year
Worst year
U.S. stocks
13.0%
37.6%
(1995)
-26.5%
(1974)
International
stocks
12.7%
39.4%
(1993)
-26.2%
(1974)
Real estate
8.8%
20.5%
(1979)
-5.6% (1991)
U.S. bonds
9.3%
33.5%
(1982)
-5.6% (1994)
What’s an engineering degree worth?
Source: CNN Money, April 19, 2005
Majors
Chemical engineering
Electrical engineering
Computer engineering
Mechanical engineering
Industrial engineering
Information science
Civil engineering
Business administration
Average starting salary
$54,256
$52,009
$51,496
$51,046
$49,541
$43,732
$43,462
$39,448
For most engineering graduates, it is not difficult to set aside
$100 each month for savings.
Conclusion?
Start saving Early!