Engineering Economics: Fundamentals of Economic Analysis

2. Lecture # 1 Engineering Economics (2+0) Fundamentals of Engineering Economics-2 Instructor: Prof. Dr. Attaullah Shah Department of Civil Engineering City University of Science and IT Peshawar

3. Civil Engineering- Program Educational Outcomes The graduates of Civil Engineering Program after 4-5 years of graduation will: PEO1: Successfully practice Civil Engineering at the highest professional levels to serve national, and international industries and government agencies; PEO2: Have the necessary background and technical skills to work professionally in one or more of the areasof environmental engineering, geotechnical engineering, structural engineering, transportation engineering, water resources engineering and other related fields; PEO3: Be prepared and commitment to their ethical and social responsibilities to work for the safety of society, both as individuals and in team environments; PEO4: Be motivated for, and capable of pursing continued life-long learning through further graduate education, or other training programs in engineering or related fields.

5. Engineering Economics Course Objectives/Outcomes: At the end of the semester students should be able to: • CLO1: To introduce the fundamentals of engineering economics. • CLO2: To enable students to perform economic analysis of different projects.

7. Course Outline Fundamentals of Engineering Economics: Basic concepts and principles of Economics, Micro-economics theory, the problems of financial scarcity, Basic concept of Engineering Economy, Consumer and Producer goods, Goods and services, Price-supply-demand-relationship, Equilibrium, Elasticity of demand & supply, Measures of economic worth, Non-monitory values, Theory of pricing, Theory of production and laws of return. Capital Financing and Allocation: Funding, funding agencies and planning commission, Capital Budgeting, Allocation of capital among independent projects, financing with debt capital, Financing with equity capital, Trading on equity, Financial leveraging Business Organization and Industrial Relationship: Types of ownership, types of stocks, partnership and joint companies, Banking and Specialized credit institution; Labour problems, labour organization, prevention and settlement of disputes, Markets, competition and monopoly.

8. Linear Programming: Mathematical statement of linear programming problems, Graphic solution Simplex procedure, Duality problem Depreciation and Taxes: Depreciation concept. Economic life, Methods of depreciation, Profit and returns on capital, productivity of capital, Gain (loss) on the disposal of an asset, depreciation as a tax shield election between Alternatives: Time value of money and financial rate of return, present value, future value and annuities, Rate of Return Analysis, Incremental Analysis, Cost-Benefit Analysis, Payback Period, Sensitivity and Breakeven Analysis, alternatives having different lives, making of buy decisions and replacement decisions.

9. Assessment

10. What is Economics? • Scarcity – a basic human dilemma • Limited resources vs. unlimited wants • The human condition requires making choices • Definitions of Economics • Mankiw’s definition • …is the study of how society manages its scarce resources • Hedrick’s definition • …is how society chooses to allocate its scarce resources among competing demands to improve human welfare • Alternative definitions • … what economists do. • … is the study of choice.

11. What is Economics? “A science that deals with the allocation, or use, of scarce resources for the purpose of fulfilling society’s needs and wants.” – Addison-Wesley Scarcity: A situation in which the amount of something actually available would not be sufficient to satisfy the desire for it, if it were provided free of charge.

12. The Economic Problem • What goods and services should an economy produce?– should the emphasis be on agriculture, manufacturing or services, should it be on sport and leisure or housing? • How should goods and services be produced?– labour intensive, land intensive, capital intensive? Efficiency? • Who should get the goods and services produced?– even distribution? more for the rich? for those who work hard?

13. What is Macroeconomics and Microeconomics? Macroeconomicsis the study of issues that affect the economy as a whole. Examples are the effects of inflation, and unemployment on economic growth and economic well-being. • Macroeconomicsexamines the aggregate behavior of the economy (i.e. how the actions of all the individuals and firms in the economy interact to produce a particular level of economic performance as a whole). • Ex.: Overall level of prices in the economy (how high or how low they are relative to prices last year) rather than the price of a particular good or service. • Microeconomics focuses on how decisions are made by individuals and firms and the consequences of those decisions. • Ex.: How much it would cost for a university or college to offer a new course ─ the cost of the instructor’s salary, the classroom facilities, the class materials, and so on.

14. Flow in an Economy-Simple Model Two major entities – Household and – Business organization Business Organizations need various resources like capital, labor and land etc from the households and make payments to use these resources Households make payments for the goods and services, they consume.

15. Law of Supply and Demand • Law of Demand: The demand of a product increases with the decrease of its price and vice versa, provided that other things remain the same. Demand is affected by: • Income of the people: • Prices of related goods ( Substitute and Complimentary) • Tastes and Habits of consumers: • Law of Supply: The supply of a products/goods increases with the increase of its price and vice versa, provided that other things remain the same. Supply is affected by: • Cost of the inputs: With increase of prices of inputs the cost of production and supply will reduce. • Technology: The improvement in technology leads to reduced production cost and more supply. • Weather: Demand of woolen products will increase in winter • Prices of related goods: The decreases in LCD sets would lead to reduction in the TV prices.

16. Elasticity of Demand • If price rises by 10% - what happens to demand? • We know demand will fall • By more than 10%? • By less than 10%? • Elasticity measures the extent to which demand will change • 4 basic types used: • Price elasticity of demand • Price elasticity of supply • Income elasticity of demand • Cross elasticity

17. Elasticity of demand • Price Elasticity of Demand • The responsiveness of demand to changes in price • Where % change in demand is greater than % change in price – elastic • Where % change in demand is less than % change in price – inelastic

18. Elasticity The Formula: % Change in Quantity Demanded ___________________________ Ped = % Change in Price If answer is between 0 and -1: the relationship is inelastic If the answer is between -1 and infinity: the relationship is elastic Note: Ped has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

19. Income Elasticity of Demand: • The responsiveness of demand to changes in incomes • Normal Good – demand rises as income rises and vice versa • Inferior Good – demand falls as income rises and vice versa • Cross Elasticity: • The responsiveness of demand of one good to changes in the price of a related good – either a substitute or a complement • Goods which are complements: • Cross Elasticity will have negative sign (inverse relationship between the two) • Goods which are complements: • Cross Elasticity will have negative sign (inverse relationship • Goods which are substitutes: • Cross Elasticity will have a positive sign (positive relationship)

20. Elasticity • Price Elasticity of Supply: • The responsiveness of supply to changes in price • If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price • If Pes is elastic – supply can react quickly to changes in price % Δ Quantity Supplied ____________________ Pes = % Δ Price

21. Determinants of Elasticity • Time period – the longer the time under consideration the more elastic a good is likely to be • Number and closeness of substitutes – the greater the number of substitutes, the more elastic • The proportion of income taken up by the product – the smaller the proportion the more inelastic • Luxury or Necessity - for example, addictive drugs, diabetic drugs

22. Importance of Elasticity • Relationship between changes in price and total revenue • Importance in determining what goods to tax (tax revenue) • Importance in analysing time lags in production • Influences the behaviour of a firm

23. Types of Efficiency • Efficiency is simply the ratio of output to the input, also called Technical efficiency. • Technical efficiency (%) =(Output/ Input) x 100 • Technical efficiency (%) = (Heat equivalent of mechanical energy produced/ Heat equivalent of fuel used) x 100 • Economic efficiency (%)= (Output/Input)x100 = (Worth/Cost)x100 • Economic efficiency is also called ‘productivity’. • There are several ways of improving productivity. • Increased output for the same input • Decreased input for the same output • By a proportionate increase in the output which is more than the proportionate increase in the input • By a proportionate decrease in the input which is more than the proportionate decrease in the output • Through simultaneous increase in the output with decrease in the input.

24. Elements of Cost • Two major components: Variable cost and overhead cost • Variable Cost would depend on the volume of production and can be further divided into direct material cost, direct labor and direct expenses • Direct Material Cost: Costs of materials • Direct Labor; Direct Cost of labor • Direct expenses: Other direct expenses on production than material and labor • Overhead Cost: It is fixed irrespective of the production. It can be further divided into Indirect material cost, Indirect labor cost and Indirect expenses. • Overheads such as Administrative, selling and distribution overheads

25. Selling Price of a product a) Direct material costs + Direct labor costs + Direct expenses = Prime cost (b) Prime cost + Factory overhead = Factory cost (c) Factory cost + Office and administrative overhead = Costs of Production (d) Cost of production + Opening finished stock – Closing finished stock = Cost of goods sold e) Cost of goods sold + Selling and distribution overhead = Cost of sales (f) Cost of sales + Profit = Sales (g) Sales/Quantity sold = Selling price per unit

26. OTHER COSTS/REVENUES Marginal cost: The cost of producing an additional unit of that product. Marginal revenue: Marginal revenue of a product is the incremental revenue of selling an additional unit of that product. Sunk cost: This is known as the past cost of an equipment/asset. The sunk cost should not be considered for any analysis done from now onwards. Opportunity cost Opportunity cost of an alternative is the return that will be foregone by not investing the same money in another alternative.

27. Opportunity Cost • Definition – the cost expressed in terms of the next best alternative sacrificed • Helps us view the true cost of decision making • Implies valuing different choices

28. General Steps for Decision Making Processes • Understand the problem – define objectives • Collect relevant information • Define the set of feasible alternatives • Identify the criteria for decision making • Evaluate the alternatives and apply sensitivity analysis • Select the “best” alternative • Implement the alternative and monitor results

29. Making Economic Decisions The most desirable of the options you pass up is called the Opportunity Cost Rank sleep, studying, and playing video games 1st, 2nd, and 3rd on a list for what you value the most

30. Making Economic Decisions

31. Making Economic Decisions There is a point at which you are paying the same increase in cost, but seeing lower benefits You must make the decision as to whether the cost is worth it This same process is used by businesses and consumers to make decisions

32. next.. • 2. If a person who wants to buy a compact disc (CD) has just enough money to buy one, and chooses CD A instead of CD B, then CD B is the • a. trade-off • b. opportunity cost • c. decision at the margin • d. opportunity at the margin

33. Elements of Cost • Two basic components: • Fixed Cost( Capital Expenditures-Capex) • One time cost- factory cost, building cost, machinery cost etc. • Variable cost: • Direct material cost, Direct labor cost, and direct expenses. • Break Even Analysis (BEA): • The main objective of break-even analysis is to find the cut-off production volume from where a firm will make profit. • s = selling price per unit, v = variable cost per unit • FC = fixed cost per period, Q = volume of production • The total sales revenue (S) of the firm is given by • S = s Q • The total cost of the firm =TC = Total variable cost + Fixed cost • = v Q + FC • At Break even point Total Cost = Total Revenue • sQ = vQ+FC or Q = FC/ (s-v)

34. The contribution is the difference between the sales and the variable costs. • Margin of Safety: Sales over and above the break-even sales. • The formulae to compute these values are • Contribution = Sales – Variable costs • Contribution/unit = (Selling price/unit – Variable cost)/unit • M.S. = Actual sales – Break-even sales = Profit / Contribution x sales • M.S. as a per cent of sales = (M.S./Sales) x 100

35. Break Even Analysis • Alpha Associates: • Fixed cost = Rs. 20,00,000 Variable cost per unit = Rs. 100 • Selling price per unit = Rs. 200 • Find • (a) The break-even sales quantity, • (b) The break-even sales • (ii) margin of safety by all methods. • Solution: Fixed cost (FC) = Rs. 20,00,000 , ariablecost per unit (v) = Rs. 100 • Selling price per unit (s) = Rs. 200 • Breakeven Quantity = FC/ (s-v) = 20,00,000/ (200-100) = 20,000 units • Break-even sales = [FC/ (s - v)] s (Rs.) = [20 00 000/200-100] x 200 = 40,00,000 • Contribution = Sales – Variable cost = s*Q – v*Q = 200 (60,000) – 100 (60,000) = 60,00,000 • Margin of Safety: M.S. = Sales – Break-even sales = 60,000 x 200 – 40,00,000 • = 1,20,00,000 – 40,00,000 = Rs. 80,00,000 • M.S. as a per cent of sales = 80,00,000/1,20,00,000 x 100 = 67%

36. PROFIT/VOLUME RATIO (P/V RATIO) P/V ratio is a valid ratio which is useful for further analysis. The different formulae for the P/V ratio are as follows: P/V ratio = Contribution/Sales= (Sales - Variable costs) /Sales The relationship between BEP and P/V ratio is as follows: BEP = Fixed cost / P/V ratio The following formula helps us find the M.S. using the P/V ratio: M.S. = Profit/ PV ratio

37. Example EXAMPLE 1.2 Consider the following data of a company for the year 1997: Sales = Rs. 1,20,000, Fixed cost = Rs. 25,000, Variable cost = Rs. 45,000 Find the following: (a) Contribution, (b) Profit, (c) BEP, (d) M.S. Solution: Contribution = Sales – Variable costs =Rs. 1,20,000 – Rs. 45,000 = Rs. 75,000 (b) Profit = Contribution – Fixed cost = Rs. 75,000 – Rs. 25,000 = Rs. 50,000 (c) BEP P/V ratio = Contribution/ Sales = (75,000/ 1,20,000) x 100 = 62.50%

38. Four Factors of Production • Natural Resources (also referred to as “land”) • Labor – effort of a person for which they are paid • Capital – human-made resources used to create other goods • Entrepreneurship – person who takes a risk in combining the other 3 factors to create a new good

39. Group Assignments G1: Explain the subject matter of Economics and its various fields. G.2: What is meant by Time Value of Money? Explain with examples from Engineering point of view G3: Explain Break Even Analysis and its use. G4: Describe role of Engineering Economics in decision making G5: Explain the concept of efficiency in Economics with examples. G6: Explain the factors which influence Demand and Supply G7: How efficiency can be improved for Engineering processes? G8: Explain Decision Making Process.