Rational Decision Making Process in Engineering Economics

1. CE 203Chapter 1Economics in Engineering Decisions

3. The Significance of Numbers • 23 - 3 • 9/11 • 911

4. Personal Finance • How much to save each month for an annual trip • Is graduate school a good investment in my future? Will the loss in income be regained by additional earnings? • Is a higher salary better than stock options? • Can you believe an ad for a car of 15y old and having done only 500 miles?

5. Photo of car in front of the house

6. Decisions: Classifying by Complexity • Simple • Should I buy a new mechanical pencil? • Should I buy cash or use credit card? • Intermediate • Which backhoe make/model should we buy? • Shall sub out the concrete work? • Shall we do our own wastewater treatment? • Complex (social, political, economic elements) • Shall we build a new lock and dam at…?

7. Could the World Trade Center have withstood the 9/11 attacks? • Towers did not collapse immediately • Fires brought them down • Better fire prevention measures? • Sturdier fireproofing adds weight and cost • How much should be spend on new high-rise buildings to prevent this?

8. Decisions: Classifying by Type • Technical • What strength steel is required? • How large a settling tank is required? • Economic • Which backhoe make/model should we buy? • What type of foundation is most cost-effective? • Societal • Is the wetland in the public’s best interest?

9. Problems emphasized in CE 203 Intermediate complexity, primarily economic • Important enough to require analysis • Difficult enough to require organized, rational approach • Decided largely or entirely on the basis of costs versus benefits (the single criterion of economics)

10. Problems beyond CE 203 Complex, a mixture of economic, social, and political elements • Economic aspects of such problems will be discussed in CE 203 • Classic economic theory assumes that the whole economy is in equilibrium (steady state)

11. Rational Decision Making (9 steps) (1) Recognize the problem (State A) • Is there a problem that is solvable? • How can the problem be defined? (2) Define the goal or objective (State B) • What do we want (or want to know)? • What change do we desire?

12. Rational Decision Making (9 steps) (3) Identify/develop alternatives • Use/modify existing solutions • Brainstorm (and other techniques) to expand solution space • Do nothing (does not imply no change)

13. Rational Decision Making (9 steps) (4) Assemble data – in 203, primarily economic • Costs • Materials and supplies • Direct labor • Overhead (facilities, support labor, utilities, etc.) • Extra-market (e.g., employee injuries) • Benefits • Sales (of products/services) • Extra-market (social, psychological, …)

14. Rational Decision Making (9 steps) (5) “Real life” definitions for costs and benefits may get complicated • Initial cost per unit? • “Life cycle cost” per unit? • Total cost of satisfying mission requirements? • “Spread the work around” cost (DOD work by congress)? • “Accomplish mission regardless” cost?

15. Rational Decision Making (9 steps) (6) Construct the model(s) • Physical (various kinds) • Virtual (3-D computer model) • Mathematical (typical for economic and many other types of problems) (7) Analyze the alternatives • Data processed using model • Results stated in comparable way

16. Rational Decision Making (9 steps) (8) Select the best alternative • Select highest B:C alternative for economic problems • Include extra-market and “intangible” consequences at this point • Present at least two “well-engineered” solutions for complex problems • Be careful in eliminating alternatives

17. Rational Decision Making (9 steps) (9) Audit the process and the results • Were assumptions reasonable? • Were projections accurate? • Are changes in process called for?

18. CE 203 Chapter 2 EEAEngineering Costs

19. Costs: what to keep in mind • Actual costs may not be known – may mean they must be estimated • Estimating may be difficult but is often critical – good analysis with bad data is worthless if not disastrous • Costs tend to be underestimated (60% low to 30% high) • Benefits tend to be overestimated (50% high to 20% low)

20. Costs: some definitions • Fixed cost • Constant, unaffected by volume: rent, insurance, property taxes, interest on borrowed capital, variety of overhead costs • Variable cost • Changes as a function of output: direct utilities, direct labor, materials, sales commissions, shipping costs, etc.

21. Costs: some definitions (cont’d) • Average cost • Per unit cost = (Total cost) / (number of units) • Marginal cost • Variable cost for one more unit

22. Costs: some definitions (cont’d) • Sunk cost • Already spent due to past decision • Immaterial to future decisions (though sometimes this is hard to accept) • (Lost) Opportunity cost • Benefit foregone because resources (time, money, equipment, etc.) are being used for something else

23. Costs: some definitions (cont’d) • Recurring cost • Known, occurring at regular intervals (and therefore easy to plan for); e.g., rent, utility bill, full-time labor, etc. • Non-recurring cost • One-of-a-kind, irregular, often unanticipated (and then difficult to plan for); e.g., start-up costs, unfavorable court verdict, damage due to natural disaster, etc.

24. Costs: some definitions (cont’d) • Incremental cost • Differences between the costs of two alternatives --- these differences should be the focus of the comparison of the two alternatives

25. Costs: some definitions (cont’d) • Cash cost • Actual transfer of money (“out-of-pocket”) • Basis for engineering economic analysis • Book cost • No transfer of money (usually) • Common example is asset depreciation (“written off” by the accounting department)

26. Costs: some definitions (cont’d) • Life-cycle cost • Sum of all costs associated with the life-cycle of a product or service conception, design, production, testing and quality assurance, maintenance, effects on the environment, disposal, etc.) • Two concepts: • The later the design change, the higher the cost • The earlier the design decision, the more later costs are “locked in.”

27. Cash Flow Diagram (CFD) Graphic tool showing size, sign, and timing of cash flows – helpful for engineering economic analysis (very important initially) • Horizontal line indicating uniform units of time (days or months or years or …) • Each cash flow “in” (revenue or benefit) is shown as an arrow up (positive) from time line • Each cash flow “out” (cost) is shown as an arrow down (negative) from time line

28. Cash Flow Diagram (CFD) sample $3000 $2000 $2000 $1500 $1500 Money in (+) 0 1 2 3 4 5 6 Money out (-) End of period 3 is also beginning of period 4 Time “0” or Today (usually) $3000 $4000

29. Some Cash Flow Categories • First Cost • Costs of “getting started” • Operations and Maintenance (O&M) • Annual expense (though not necessarily constant) for fuel, labor, minor repair, etc.) • Salvage value • Revenue received for sale or transfer of property at end of “project” or useful life

30. Some Cash Flow Categories • Revenue • “Sale” price of goods/services • Overhaul • Major repair or refurbishing during life of asset

31. In-class example (CFD) Company A purchased a backhoe for $33,500. The company paid $12,000 immediately and agreed to pay four additional payments of $6,000 each at the end of one, two, three, and four years. Maintenance for the backhoe is expected to be $500 at the end of the first year and $1,000 at the end of each subsequent year. They expect to sell the backhoe for $16,000 at the end of the fifth year (after paying for the needed maintenance). Draw the cash flow diagram