System Engineering & Economy Analysis

1. System Engineering & Economy Analysis Lecturer Maha Muhaisen College ofApplied Engineering& Urban Planning

2. System Engineering & Economy Analysis Lecturer Maha Muhaisen College ofApplied Engineering& Urban Planning

3. Course outline Introduction to making economic decision Interest and equivalence Present worth analysis Cash flow analysis Rate of return Deprecation Cost benefit analysis Risk, and uncertainly Sensitivity analysis

4. Grading Research Projects & homework 30 % Midterm Exam. 30 % Final Exam. 40%

5. Resources “Engineering Economic analysis”, by Donald G. Newnan. , Ted G. Eschenbach, & J.P. Lavelle. “Civil and Environmental Systems Engineering”, Charles S. Revelle, Earl Whitlatch , Jeff Wright Class Notes and Handouts Course material will be made available through the web site

6. Introduction

7. Engineering Engineers provide answers. Ability to solve problems or take advantage of opportunities through the application of science. Must meet certain criteria. Technical feasibility/efficiency: meet or exceed specifications. Economic feasibility/efficiency: meet budgets and return.

8. Engineering Economy Every technical solution has financial consequences. Engineering economic analysis determines whether a proposed solution is financially viable. Will it pay? Is this the minimum cost solution? Will it generate an acceptable return?

9. Engineering Economic Decisions Profit Enhancing Programs: projects designed to generate revenues. New product development New product acquisition Product/service capacity expansion Improved customer service

10. Engineering Economic Decisions Cost Control Programs: projects designed to generate savings. Improving efficiency Streamlining operations Eliminating waste Reducing liabilities

11. Engineering Economic Decisions Public Improvement Programs: government entities also make capital expenditures. Increased public satisfaction Increased public safety Improved infrastructure

12. Investment Categories Expansion Products, services, capacity can expand Often requires choice of technology Replacement Technology selection Outsourcing versus in-house choice Abandonment Eliminating products, services, or capacity

13. Investment Decisions Invest Releases funds to start a project Do Not Invest Eliminates the project from further consideration Wait (Delay) Time to gather information about the future can aid in decision-making

14. Making an Economic Decision Problem or opportunity recognition and definition Generation of Solution Alternatives Development of Feasible Solution Alternative Cash Flows and Information Gathering Evaluation of Solution Alternatives Selection and Implementation of Best Alternative Post-implementation Analysis and Evaluation

15. The Role of engineering Economic analysis Engineering economic analysis is most suitable for intermediate problems and economic aspects of complex problem, they have those qualities : 1) the problem is important enough to justify our giving it serious thought and effort. 2) careful analysis requires that we recognize the problem and all various consequences, and this is just too much to be done all at once. 3) the problem has economic aspects important in reaching a decision.

16. Engineering Design Decisions Problem or opportunity recognition and definition Generation of Solution Alternatives Assess the Feasibility of Each Approach. 4 Selection of Best Alternative According to Technical and Economic Constraints 5 Detailed Design, Testing, and Analysis. If Successful, Implement, Else, Goto 2. Post-implementation Analysis and Evaluation

17. Decisions in Design The design process is generally embedded in the second step of the decision-making process. Designs = Solution Alternatives Design decisions are generally discipline specific. But the economics surrounding design decisions are for all engineers.

18. Engineering Economic Decision Analysis Importance Companies must invest to grow. Companies must invest to improve. Investments cost (lots of) money! Economic Analysis considers the economic viability of each and every investment project such that money is made, not lost.

19. Engineering Economic Decision Analysis Difficulty Investments carry risk. Money spent now for expected savings or returns in the future. As future is uncertain, so are returns or savings. Money spent can be lost. If too often, could lead to bankruptcy. While economics are paramount, many other factors influence decision.

20. Why YOU, the Engineer? Those who generate solutions are most intimate with the details and best suited to analyze them financially. To be heard, engineers must be able to speak financially: It is generally assumed that the engineering solution will work -- must justify financially. Understanding the financials will help you move up the corporate ladder. This analysis provides the link to other departments, such as accounting and finance.

21. In this course, you will learn: The fundamentals of engineering economy (time value of money, interest, economic equivalence) To perform the economic decision making process To financially evaluate engineering projects under certainty, risk, uncertainty, and multiple options Numerous methods in which to determine the best choice from a feasible set with multi-attributes To solve a variety of problems dealing with capital investments

22. Engineering economic analysis is used to answer many different questions : Which engineering projects are worthwhile ? Which engineering project should give higher priority? How should the engineering project be design? Engineering economic analysis can also used to answer questions that are personally important : How to achieve long-term financial goal. How to compare different ways to finance purchases. How to make short and long term investment decision.

23. Decision making process, include : - Rational Decision making - Decision making for current cost - Examples Decision making process

24. Decision making process It is the choosing from alternatives, but is this enough for definition?

25. Rational Decision Making Rational decision making is a complex process that contain nine essential elements. Although those nine steps are shown sequentially it is common for decision making to repeat the steps. All those steps is required and shown in a logical order.

27. 1- Recognize the problem Recognition of the problem is obvious and immediate Many firms establish programs for total quality management (TQM) or continuous improvement that are designed to identify the problems, so that they can be solved.

28. 2- Define the Goal or objective The goal can be a grand, overall goal of a person or a firm. The presence of multiple goal is often foundation of complex problem. But the objective need not to be a grand but the overall objective may be specific and narrow. “I want to pay a load by may” So defining the objective is the act of exactly describing the task and goal

29. 3- Assemble of relevant data Good decision good information Some data are available immediately at little or no cost, but still other require survey, or consulting with specific knowledgeable people Time horizon is part of data as how long equipment, building will last? Accounting system is of important source of data Financial and cost accounting are designed to show accounting values and the flow of money (cost & benefit) What are the cost that related to specific operation , those indirect (overhead) cost, that usually allocated to operations, those may be satisfactory for cost –accounting purposes, but may be unreliable for economic analysis. To understand the meaningful analysis see the following example :

30. Example • The cost accounting records of a large company show the avg. monthly costs for the three persons printing dep. The wages of the three dep. members and benefits such as vacation, sick leave, make up the first category of the direct labor. The company’s indirect or overhead costs – such heat , electricity, …etc must be distributed to its various departments in some manner , this one uses floor space as basis for its allocations • Direct labor cost $6000 • Material and supplies consumed $7000 • Allocated overhead costs 200m2 of the floor area at $25/m2 $5000 The total $ 18000 • The printing dep. charges other dep. for its services to cover 18,000$ monthly cost. For example , the charge to run 1000 copies of an announcement is : • Direct labor 7.6 $ • Material and supplies 9.8 $ • Over head 9.05 Cost to other dep.s 26.45 $

31. Cont. The shipping dep. checks with a commercial printer which would print 1000 copies for $ 22.95 although the shipping dep. needs only about 30,000 copies printed a month, its Forman decision to stop printing dep. and have work done by outside printer. The manger has asked to study situation and recommend what should be done. Solution :

32. Cont. The firm will save $ 294 in material and may or may not save $ 228 in direct labor if printing dep. no longer does the shipping dep. work. The max. saving will be 294 + 228= $ 522 But if the shipping dep. Is permitted to obtain its printing from outside, the firm will be 688.5$ a month. The saving from not doing the shipping dep. work in printing de. Would not exceed $ 522 and it is probably would be $ 294 The result would be a net increase in cost to firm. For this reason it is not encouraged to print outside. Data cost gathering present other difficulty. One way to look at financial consequences , cost-benefit, of various alternative : Market consequences : raw material, machinery cost, ..etc. Extra market consequences : (shadow prices) as cost of employee injury,…ect. Intangible consequences : numerical analysis probably never fully describe the difference between alternative. As how does one evaluate the potential loss of worker’s job due to automation ?

33. 4. Identify feasible alternative There is no way to ensure the best alternative is listed among the alternatives considered. Sometime a group of people considering alternative in an innovative atmosphere ( brainstorming) can be helpful Any good listing of alternative will produce both practical and impractical solutions. Only feasible alternative are retained for further analysis.

34. 5. Select the criterion to determine the best alternative • To choose the best alternative , we must define what we mean by best. • Criterion or set of criteria must be judged. • Worst – Bad – Fair – Good – Better – Best • Several possible criteria are : • create the least disturbance to the environment • Improve the distribution of the wealth among people. • Minimize the expenditure • Ensure that benefit greater that losses • Minimize the time to achieve the goal • Minimize unemployment • Maximize profit • Maximize profit is normally selected in engineering decision . When it is used all problems fall into one of the three categories : • fixed output , fixed input, or neither input nor output.

35. Cont. • Fixed input : the amount of money or other input resources (like labor, material, or equipment) . The objective is no effectively utilize them. • Example : • A project engineer has a budget of 350,000$ to renovate a portion of petroleum refinery. • For ecom\nomic efficiency, the appropriate criterion is to maximize benefits or outputs. • Fixed output :there is a fixed task (or other output objectives / results) to be accomplished • Example: • Civil engineer firm has been given a job of surveying land and preparing a record of survey map. • purchasing a car without any optional equipment.

36. Cont. Neither input nor output fixed : It is the general situation, whereas the amount of money or inputs is not fixed, nor is the amount of benefits or other output. Example: A consulting eng. Firms has a lot of work, and paying for the staff for evening works to increase the amount of design work. In this category, maximize the benefit is the criterion, since the difference between input and output is simply the profit.

37. Cont.

38. 6. Constructing the model Putting various elements together (objective, relevant data, feasible alternatives, and selection criteria) Relationship between the elements called model building or constructing model. To an engineer, the model is a mathematical equations.

39. 7. Predicting the outcomes for each alternative. Each alternative might produce a variety of outcomes. Studying each alternative and outcomes for everyone.

40. 8. Choose the best alternative The selection of the feasible alternative may be key item, with the rest of the analysis a methodical process leading to predictable decision.

41. 9. Audit the results It the comparison of what happened against predication. Do the results of decision agree with its predications? The audit help ensure that projected operating advantages are ultimately obtained. On other hand, the economic decision may be unjustifiably optimistic.

42. Example A concrete aggregate mix is required to contain at least 31% sand by volume for proper batching. One source of material, which has 25% sand and 75% coarse aggregate, sells for $3 per cubic meter (m3). Another source, which has 40% sand and 60% coarse aggregate, sells for $4.40/m3. Determine the least cost per cubic meter of blended aggregates. Solution : The least cost of blended aggregates will result from maximum use of the lower-cost material. The higher-cost material will be used to increase the proportion of sand up to the minimum level (3 1%) specified. Let x = Portion of blended aggregates from $3.00/m3 source 1 - x = Portion of blended aggregates from $4.40hi3 source Sand Balance X(0.25) + (1 -x)(0.40) = 0.31 0.25x + 0.4-0.4x = 0.31 0.31 – 0.4 = -0.09 =0.6 0.25 - .04 -0.15 Thus the blended aggregates will contain : 60% of $3.0m3 material, 40% of $4.40/m3 material The least cost per cubic meterof blended aggregates is: 0.6($3.00)+ 0.4($4.4) = 1.8+1.76 = $3.56 / m3

43. Summary • Classifying to solve. Others problems : • Many problems are simple and thus easy to solve, others are of intermediate difficulty and need considerable thought / calculation to properly evaluate. There intermediate problems tends to have a substantial economic component, hence, are good candidates for economic analysis. Complex problems, on other hand, often contain people elements along with political and economic components. • Economic analysis is still very important but the best alternative must be selected considering all criteria not just the economic.

44. Cont. • The Rational decision making process : • Rational Decision – Making Process uses a logical method to select the best alternative from among the feasible alternatives. The following nine steps can be followed sequentially, but decision makers often repeat some steps undertake some simultaneously, and skip others altogether. 1- recognize the problem 2- define goal or objective. What is the task? 3- assemble relevant data: What are the facts? Are more data needed, and is it worth more than the cost to obtain it ?4- Define feasible alternative. 5- Select the criterion for choosing the best alternative, possible criteria include political, economic, environmental, and humanitarian. The single criterion may be a composite or several criteria.

45. Cont. 6 - Mathematically model the various interrelations. 7- Predict the outcomes for each alternative. 8- choose best alternative. 9- audit the alternative. Engineering DM refers to solving substantial engineering problems in which economic aspects dominate and economic efficiency is the criteria for choosing from among possible alternatives. It is particular case of general decision making process, some of unusual aspects of engineering decision making are as follows : 1- cost – accounting systems, while an important source of cost data, contain allocations of indirect costs that may be incorporate for use in economic analysis. 2- the various consequences – costs & benefits- of an alternative may be of three types : • Market consequences – there are established market prices. • Extra – market consequences – there are no direct market process, but prices can be assigned by indirect costs. • Intangiable consequences – valued by judgment , not by monetary prices.

46. Cont. 3- the economic criteria for judging alternatives can be reduced to three cases : • For fixed input : maximize the benefits or other outputs. • For fixed output : minimize the costs or other outputs. • When neither input or output is fixed, maximize the differences between benefits, and costs or more simply stated, maximize profit. The third case states the general rule from which both first and second cases may derived. 4- to choose among the alternatives, the market consequences and extra market consequences are organized into a cash flow diagram, we will see in the next chapter, that engineering economic calculation can be used to compare differing cash flows.. These outcomes are compared against the selection criteria. From this comparison plus the consequences not included in Monterey analysis, the best alternative is selected. 5- an essential part of engineering decision making is post audit of results. This step helps to ensure that projected benefits are obtained and to encourage realistic estimates in analysis.

47. Principles of Engineering Economy

48. Cash Flows

49. Cash flow • Cash flow diagram (CFD) summarized the cost and benefit of the project occur over time. • CFD is created by first drawing a segmented time – based horizontal line, divided onto appropriate time units. • At each time at which cash flow will occur a vertical arrow is added. Pointing down for cost , pointing up for revenues or benefit.

50. Key Concepts • Cash Flow Diagram: the financial description (visual) of a project • Time Value of Money: the value of money changes with time • Money provides utility (value) when spent • Value of money grows if invested • Value of money decreases due to inflation • Interest: used to move money through time for comparisons