Engineering Economy

1. Engineering Economy Chapter 1: Introduction to Engineering Economy

2. The purpose of this book is to develop and illustrate the principles and methodology required to answer the basic economic question of any design: Do its benefits exceed its cost?

3. Engineering economy… involves the systematic evaluation of the economic merits of proposed solutions to engineering problems.

4. Solutions to engineering problems must promote the well-being and survival of an organization, embody creative and innovative technology and ideas, permit identification and scrutiny of their estimated outcomes, and translate profitability to the “bottom line” through a valid and acceptable measure of merit.

5. Engineering economic analysis can play a role in many types of situations. Choosing the best design for a high-efficiency gas furnace. Selecting the most suitable robot for a welding operation on an automotive assembly line. Making a recommendation about whether jet airplanes for an overnight delivery service should be purchased or leased. Determining the optimal staffing plan for a computer help desk.

6. There are seven fundamental principles of engineering economy. Develop the alternatives Focus on the differences Use a consistent viewpoint Use a common unit of measure Consider all relevant criteria Make uncertainty explicit Revisit your decisions

7. Engineering economic analysis procedure Problem definition Development of alternatives Development of prospective outcomes Selection of a decision criterion Analysis and comparison of alternatives. Selection of the preferred alternative. Performance monitoring and postevaluation of results.

8. Electronic spreadsheets are a powerful addition to the analysis arsenal. Most engineering economy problems can be formulated and solved using a spreadsheet. Large problems can be quickly solved. Proper formulation allows key parameters to be changed. Graphical output is easily generated.

9. Engineering Economy Chapter 2: Cost Concepts and Design Economics

10. The objective of Chapter 2 is to analyze short-term alternatives when the time value of money is not a factor.

11. Costs can be categorized in several different ways. Fixed cost: unaffected by changes in activity level Variable cost: vary in total with the quantity of output (or similar measure of activity) Incremental cost: additional cost resulting from increasing output of a system by one (or more) units

12. More ways to categorize costs Direct: can be measured and allocated to a specific work activity Indirect: difficult to attribute or allocate to a specific output or work activity (also overhead or burden) Standard cost: cost per unit of output, established in advance of production or service delivery

13. Some useful cost terminology Cash cost: a cost that involves a payment of cash. Book cost: a cost that does not involve a cash transaction but is reflected in the accounting system. Sunk cost: a cost that has occurred in the past and has no relevance to estimates of future costs and revenues related to an alternative course of action.

14. More useful cost terminology Opportunity cost: the monetary advantage foregone due to limited resources. The cost of the best rejected opportunity. Life-cycle cost: the summation of all costs related to a product, structure, system, or service during its life span.

15. The general price-demand relationship The demand for a product or service is directly related to its price according to p=a-bD where p is price, D is demand, and a and b are constants that depend on the particular product or service.

16. Total revenue depends on price and demand. Total revenue is the product of the selling price per unit, p, and the number of units sold, D.

17. Calculus can help determine the demand that maximizes revenue. Solving, the optimal demand is

18. We can also find maximum profit… Profit is revenue minus cost, so for Differentiating, we can find the value of D that maximizes profit.

19. And we can find revenue/cost breakeven. Breakeven is found when total revenue = total cost. Solving, we find the demand at which this occurs.

20. Engineers must consider cost in the design of products, processes and services. “Cost-driven design optimization” is critical in today’s competitive business environment. In our brief examination we examine discrete and continuous problems that consider a single primary cost driver.

21. Two main tasks are involved in cost-driven design optimization. Determine the optimal value for a certain alternative’s design variable. Select the best alternative, each with its own unique value for the design variable. Cost models are developed around the design variable, X.

22. Optimizing a design with respect to cost is a four-step process. Identify the design variable that is the primary cost driver. Express the cost model in terms of the design variable. For continuous cost functions, differentiate to find the optimal value. For discrete functions, calculate cost over a range of values of the design variable. Solve the equation in step 3 for a continuous function. For discrete, the optimum value has the minimum cost value found in step 3.

23. Here is a simplified cost function. where, a is a parameter that represents the directly varying cost(s), b is a parameter that represents the indirectly varying cost(s), k is a parameter that represents the fixed cost(s), and X represents the design variable in question.

24. “Present economy studies” can ignore the time value of money. Alternatives are being compared over one year or less. When revenues and other economic benefits vary among alternatives, choose the alternative that maximizes overall profitability of defect-free output. When revenues and other economic benefits are not present or are constant among alternatives, choose the alternative that minimizes total cost per defect-free unit.

25. Engineering Economy Chapter 3: Cost Estimation Techniques

26. The objective of Chapter 3 is to present various methods for estimating important factors in an engineering economy study.

27. Estimating the future cash flows for feasible alternatives is a critical step in engineering economy studies. Estimating costs, revenues, useful lives, residual values, and other pertinent data can be the most difficult, expensive, and time-consuming part of the study.

28. Results of cost estimating are used for a variety of purposes. Setting selling prices for quoting, bidding, or evaluating contracts. Determining if a proposed product can be made and distributed at a profit. Evaluating how much capital can be justified for changes and improvements. Setting benchmarks for productivity improvement programs.

29. The two fundamental approaches are “top-down” and “bottom-up.” Top-down uses historical data from similar projects. It is best used when alternatives are still being developed and refined. Bottom-up is more detailed and works best when the detail concerning the desired output (product or service) has been defined and clarified.

30. The integrated cost estimation approach has three major components. Work breakdown structure (WBS) Cost and revenue structure (classification) Estimating techniques (models)

32. Work Breakdown Structure (WBS) A basic tool in project management A framework for defining all project work elements and their relationships, collecting and organizing information, developing relevant cost and revenue data, and management activities. Each level of a WBS divides the work elements into increasing detail.

34. A WBS has other characteristics. Both functional and physical work elements are included. The content and resource requirements for a work element are the sum of the activities and resources of related subelements below it. A project WBS usually includes recurring and nonrecurring work elements.

35. Cost and Revenue Structure Used to identify and categorize the costs and revenues that need to be included in the analysis. The life-cycle concept and WBS are important aids in developing the cost and revenue structure for a project. Perhaps the most serious source of errors in developing cash flows is overlooking important categories of costs and revenues.

36. Estimating Techniques REMEMBER! The purpose of estimating is to develop cash-flow projections—not to produce exact data about the future, which is virtually impossible. Cost and revenue estimates can be classified according to detail, accuracy, and their intended use. Order-of-magnitude estimates (±30%) Semidetailed, or budget, estimates (±15%) Definitive (detailed) estimates (±5%)

37. The level of detail and accuracy of estimates depends on time and effort available as justified by the importance of the study, difficulty of estimating the items in question, methods or techniques employed, qualifications of the estimator(s), and sensitivity of study results to particular factor estimates.

38. A variety of sources exist for cost and revenue estimation. Accounting records: good for historical data, but limited for engineering economic analysis. Other sources inside the firm: e.g., sales, engineering, production, purchasing. Sources outside the firm: U.S. government data, industry surveys, trade journals, and personal contacts. Research and development: e.g., pilot plant, test marketing program, surveys.

39. These models can be used in many types of estimates. Indexes Unit technique Factor technique

40. Indexes, I, provide a means for developing present and future cost and price estimates from historical data. k = reference year for which cost or price is known. n = year for which cost or price is to be estimated (n>k). Cn = estimated cost or price of item in year n. Ck = cost or price of item in reference year k. Indexes can be created for a single item or for multiple items.

41. The unit technique is one that is widely known and understood. A “per unit factor” is used, along with the appropriate number of units, to find the total estimate of cost. An often used example is the cost of a particular house. Using a per unit factor of, say, $120 per square foot, and applying that to a house with 3,000 square feet, results in an estimated cost of $120 x 3,000 = $360,000. This techniques is useful in preliminary estimates, but using average costs can be very misleading.

42. The factor technique is an extension of the unit technique where the products of several quantities are summed and then added to components estimated directly. C = cost being estimated Cd = cost of the selected component d estimated directly fm = cost per unit of component m Um = number of units of component m

43. Parametric cost estimating is the use of historical cost data and statistical techniques (e.g., linear regression) to predict future costs. Parametric models are used in the early design stages to get an idea of how much the product (or project) will cost, on the basis of a few physical attributes (such as weight, volume, and power).

44. The power-sizing technique (or exponential model) is frequently used for developing capital investment estimates for industrial plants and equipment. (both in $ as of the point in time for which the estimate is desired) (both in the same physical units)

45. A learning curve reflects increased efficiency and performance with repetitive production of a good or service. The concept is that some input resources decrease, on a per-output-unit basis, as the number of units produced increases.

46. Most learning curves assume a constant percentage reduction occurs as the number of units produced is doubled.

47. Learning curve example: Assume the first unit of production required 3 hours time for assembly. The learning rate is 75%. Find (a) the time to assemble the 8th unit, and (b) the time needed to assemble the first 6 units.

48. A cost estimating relationship (CER) describes the cost of a project as a function of design variables. There are four basic steps in developing a CER. • Problem definition • Data collection and normalization • CER equation development • Model validation and documentation

49. “Bottom-up” cost estimating is commonly used to make decisions about what to produce and how to price products. Major types of costs to estimate are • tooling costs, • manufacturing labor costs, • material costs, • supervision, • factory overhead, and • general and administrative costs.

50. “Top-down,” or target costing, focuses on “what should the product cost” instead of “what does the product cost,” with the aim of designing costs out of products before they enter the manufacturing process. Costs are viewed as an input to the design process. or