Sixteenth Edition
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Abbreviations and Notation Summary
CHAPTER 4
APR
annual percentage rate (nominal interest)
EOY
end of year
f̄
a geometric change from one time period to the next in cash flows
or equivalent values
i
effective interest rate per interest period
r
nominal interest rate per period (usually a year)
CHAPTER 5
AW(i%)
equivalent uniform annual worth, computed at i% interest, of one
or more cash flows
CR(i%)
equivalent annual cost of capital recovery, computed at i% interest
CW(i%)
capitalized worth (a present equivalent), computed at i% interest
FW(i%)
future equivalent worth, calculated at i% interest, of one or more
cash flows
EUAC(i%)
equivalent uniform annual cost, calculated at i% interest
IRR
internal rate of return, also designated i%
MARR
minimum attractive rate of return
N
length of the study period (usually years)
PW(i%)
present equivalent worth, computed at i% interest, of one or more
cash flows
CHAPTER 6
!(B − A)
incremental net cash flow (difference) calculated from the cash flow
of Alternative B minus the cash flow of Alternative A (read: delta B
minus A)
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CHAPTER 7
ATCF
after-tax cash flow
BTCF
before-tax cash flow
EVA
economic value added
MACRS
modified accelerated cost recovery system
NOPAT
net operating profit after taxes
WACC
tax-adjusted weighted average cost of capital
CHAPTER 8
A$
actual (current) dollars
f
general inflation rate
R$
real (constant) dollars
CHAPTER 9
EUAC
equivalent uniform annual cost
TCk
total (marginal) cost for year k
CHAPTER 12
E(X)
mean of a random variable
f (x)
probability density function of a continuous random variable
p(x)
probability mass function of a discrete random variable
SD(X)
standard deviation of a random variable
V(X)
variance of a random variable
CHAPTER 13
CAPM
capital asset pricing model
RF
risk-free rate of return
SML
security market line
Xj
binary decision variable in capital allocation problems
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achievements could revolutionize, improve, and sustain future generations.
Don’t Let Them Get Away.
Engineering Economy, 16th Edition, together with MyEngineeringLab, is a complete
solution for providing an engaging in-class experience that will inspire your students
to stay in engineering, while also giving them the practice and scaffolding they need
to keep up and be successful in the course.
Learn more at myengineeringlab.com
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ENGINEERING
ECONOMY
Sixteenth Edition
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ENGINEERING ECONOMY
SIXTEENTH EDITION
WILLIAM G. SULLIVAN
ELIN M. WICKS
C. PATRICK KOELLING
Virginia Polytechnic Institute
and State University
Wicks and Associates, L.L.P.
Virginia Polytechnic Institute
and State University
Upper Saddle River Boston Columbus San Francisco New York
Indianapolis London Toronto Sydney Singapore Tokyo Montreal
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Copyright © 2015, 2012, 2009, 2006, 2003, 1997 by Pearson Higher Education, Inc., Upper Saddle River, NJ 07458. All rights
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Many of the designations by manufacturers and seller to distinguish their products are claimed as trademarks. Where those
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The author and publisher of this book have used their best efforts in preparing this book. These efforts include the
development, research, and testing of theories and programs to determine their effectiveness. The author and publisher make
no warranty of any kind, expressed or implied, with regard to these programs or the documentation contained in this book.
The author and publisher shall not be liable in any event for incidental or consequential damages with, or arising out of, the
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Pearson Education Ltd., London
Pearson Education Singapore, Pte. Ltd.
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Pearson Education Australia PTY, Limited
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Pearson Education, Upper Saddle River, New Jersey
Library of Congress Cataloging-in-Publication Data
Sullivan, William G., 1942–
Engineering economy / William G. Sullivan, Elin M. Wicks, C. Patrick Koelling. — Sixteenth edition.
pages cm
ISBN-13: 978-0-13-343927-4
ISBN-10: 0-13-343927-5
1. Engineering economy—Textbooks. I. Wicks, Elin M. II. Koelling, C. Patrick, 1953- III. Title.
TA177.4.S85 2014
658.15—dc23
2013028782
10
9
8
7
6
5
4
3
2
1
ISBN-13: 978-0-13-343927-4
ISBN-10:
0-13-343927-5
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CONTENTS
Preface
Green Content
xi
xviii
CHAPTER 1
Introduction to Engineering Economy
1.1
1.2
1.3
1.4
1.5
1.6
Introduction
The Principles of Engineering Economy
Engineering Economy and the Design Process
Using Spreadsheets in Engineering Economic Analysis
Try Your Skills
Summary
1
2
3
7
15
15
16
CHAPTER 2
Cost Concepts and Design Economics
2.1
Cost Terminology
2.2
The General Economic Environment
2.3
Cost-Driven Design Optimization
2.4
Present Economy Studies
2.5
Case Study—The Economics of Daytime Running Lights
2.6
Try Your Skills
2.7
Summary
Appendix 2-A Accounting Fundamentals
20
21
27
38
43
49
51
52
60
CHAPTER 3
Cost-Estimation Techniques
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
Introduction
An Integrated Approach
Selected Estimating Techniques (Models)
Parametric Cost Estimating
Case Study—Demanufacturing of Computers
Electronic Spreadsheet Modeling: Learning Curve
Try Your Skills
Summary
67
68
70
78
83
94
96
98
100
v
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vi
CONTENTS
CHAPTER 4
The Time Value of Money
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
4.10
4.11
4.12
4.13
4.14
4.15
4.16
4.17
4.18
4.19
Introduction
Simple Interest
Compound Interest
The Concept of Equivalence
Notation and Cash-Flow Diagrams and Tables
Relating Present and Future Equivalent Values
of Single Cash Flows
Relating a Uniform Series (Annuity) to Its Present
and Future Equivalent Values
Summary of Interest Formulas and Relationships
for Discrete Compounding
Deferred Annuities (Uniform Series)
Equivalence Calculations Involving Multiple
Interest Formulas
Uniform (Arithmetic) Gradient of Cash Flows
Geometric Sequences of Cash Flows
Interest Rates that Vary with Time
Nominal and Effective Interest Rates
Compounding More Often than Once per Year
Interest Formulas for Continuous Compounding
and Discrete Cash Flows
Case Study—Understanding Economic “Equivalence”
Try Your Skills
Summary
107
108
109
110
110
113
117
123
133
135
137
143
148
153
155
157
160
163
166
169
CHAPTER 5
Evaluating a Single Project
5.1
5.2
Introduction
Determining the Minimum Attractive Rate
of Return (MARR)
5.3
The Present Worth Method
5.4
The Future Worth Method
5.5
The Annual Worth Method
5.6
The Internal Rate of Return Method
5.7
The External Rate of Return Method
5.8
The Payback (Payout) Period Method
5.9
Case Study—A Proposed Capital Investment
to Improve Process Yield
5.10
Electronic Spreadsheet Modeling: Payback Period Method
5.11
Try Your Skills
5.12
Summary
Appendix 5-A The Multiple Rate of Return Problem
with the IRR Method
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187
188
189
196
197
202
213
215
218
220
222
224
236
CONTENTS
vii
CHAPTER 6
Comparison and Selection among Alternatives
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
6.10
6.11
Introduction
Basic Concepts for Comparing Alternatives
The Study (Analysis) Period
Useful Lives Are Equal to the Study Period
Useful Lives Are Unequal among the Alternatives
Personal Finances
Case Study—Ned and Larry’s Ice Cream Company
Postevaluation of Results
Project Postevaluation Spreadsheet Approach
Try Your Skills
Summary
240
241
241
245
247
264
277
281
284
284
287
291
CHAPTER 7
Depreciation and Income Taxes
7.1
7.2
7.3
7.4
7.5
7.6
7.7
7.8
7.9
7.10
7.11
7.12
7.13
Introduction
Depreciation Concepts and Terminology
The Classical (Historical) Depreciation Methods
The Modified Accelerated Cost Recovery System
A Comprehensive Depreciation Example
Introduction to Income Taxes
The Effective (Marginal) Corporate Income Tax Rate
Gain (Loss) on the Disposal of an Asset
General Procedure for Making
After-Tax Economic Analyses
Illustration of Computations of ATCFs
Economic Value Added
Try Your Skills
Summary
308
309
309
312
317
326
330
333
336
337
341
353
355
356
CHAPTER 8
Price Changes and Exchange Rates
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
8.9
Introduction
Terminology and Basic Concepts
Fixed and Responsive Annuities
Differential Price Changes
Spreadsheet Application
Foreign Exchange Rates and Purchasing
Power Concepts
Case Study—Selecting Electric Motors to Power
an Assembly Line
Try Your Skills
Summary
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369
370
376
381
383
385
390
393
394
viii
CONTENTS
CHAPTER 9
Replacement Analysis
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
9.9
9.10
9.11
Introduction
Reasons for Replacement Analysis
Factors that Must Be Considered
in Replacement Studies
Typical Replacement Problems
Determining the Economic Life of a New
Asset (Challenger)
Determining the Economic Life of a Defender
Comparisons in Which the Defender’s Useful Life
Differs from that of the Challenger
Retirement without Replacement (Abandonment)
After-Tax Replacement Studies
Case Study—Replacement of a Hospital’s Emergency
Electrical Supply System
Summary
403
404
404
405
408
411
415
418
421
422
430
433
CHAPTER 10
Evaluating Projects with the Benefit−Cost Ratio Method
10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8
10.9
10.10
10.11
Introduction
Perspective and Terminology for Analyzing
Public Projects
Self-Liquidating Projects
Multiple-Purpose Projects
Difficulties in Evaluating Public-Sector Projects
What Interest Rate Should Be Used for Public Projects?
The Benefit−Cost Ratio Method
Evaluating Independent Projects by B−C Ratios
Comparison of Mutually Exclusive Projects
by B−C Ratios
Case Study—Improving a Railroad Crossing
Summary
443
444
445
446
446
449
450
452
458
460
465
467
CHAPTER 11
Breakeven and Sensitivity Analysis
11.1
11.2
11.3
11.4
11.5
Introduction
Breakeven Analysis
Sensitivity Analysis
Multiple Factor Sensitivity Analysis
Summary
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476
476
483
489
493
CONTENTS
ix
CHAPTER 12
Probabilistic Risk Analysis
12.1
12.2
12.3
12.4
12.5
12.6
12.7
12.8
12.9
12.10
Introduction
Sources of Uncertainty
The Distribution of Random Variables
Evaluation of Projects with Discrete Random Variables
Evaluation of Projects with Continuous
Random Variables
Evaluation of Risk and Uncertainty
by Monte Carlo Simulation
Performing Monte Carlo Simulation
with a Computer
Decision Trees
Real Options Analysis
Summary
502
503
504
504
508
517
522
526
530
535
538
CHAPTER 13
The Capital Budgeting Process
13.1
13.2
13.3
13.4
13.5
13.6
13.7
13.8
13.9
13.10
Introduction
Debt Capital
Equity Capital
The Weighted Average Cost of Capital (WACC)
Project Selection
Postmortem Review
Budgeting of Capital Investments
and Management Perspective
Leasing Decisions
Capital Allocation
Summary
546
547
549
550
553
557
561
562
563
565
571
CHAPTER 14
Decision Making Considering Multiattributes
14.1
14.2
14.3
14.4
14.5
14.6
14.7
14.8
Introduction
Examples of Multiattribute Decisions
Choice of Attributes
Selection of a Measurement Scale
Dimensionality of the Problem
Noncompensatory Models
Compensatory Models
Summary
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576
576
578
578
579
579
584
592
x
CONTENTS
Appendix A
Appendix B
Appendix C
Appendix D
Appendix E
Appendix F
Appendix G
Using Excel to Solve Engineering Economy
Problems
Abbreviations and Notation
Interest and Annuity Tables for Discrete
Compounding
Interest and Annuity Tables for Continuous
Compounding
Standard Normal Distribution
Selected References
Solutions to Try Your Skills
Index
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615
619
638
642
645
648
660
PREFACE
We live in a sea of economic decisions.
—Anonymous
About Engineering Economy
A succinct job description for an engineer consists of two words: problem solver.
Broadly speaking, engineers use knowledge to find new ways of doing things
economically. Engineering design solutions do not exist in a vacuum but within the
context of a business opportunity. Given that every problem has multiple solutions,
the issue is, How does one rationally select the design with the most favorable
economic result? The answer to this question can also be put forth in two words:
engineering economy. Engineering economy provides a systematic framework for
evaluating the economic aspects of competing design solutions. Just as engineers
model the stress on a support column, or the thermodynamic response of a steam
turbine, they must also model the economic impact of their recommendations.
Engineering economy—what is it, and why is it important? The initial reaction
of many engineering students to these questions is, “Money matters will be handled
by someone else. They are not something I need to worry about.” In reality, any
engineering project must be not only physically realizable but also economically
affordable.
Understanding and applying economic principles to engineering have never
been more important. Engineering is more than a problem-solving activity focusing
on the development of products, systems, and processes to satisfy a need
or demand. Beyond function and performance, solutions must also be viable
economically. Design decisions affect limited resources such as time, material,
labor, capital, and natural resources, not only initially (during conceptual design)
but also through the remaining phases of the life cycle (e.g., detailed design,
manufacture and distribution, service, retirement and disposal). A great solution
can die a certain death if it is not profitable.
• MyEngineeringLab is now available with Engineering Economy, 16/e and provides a powerful homework and test manager which lets instructors create,
import, and manage online homework assignments, quizzes, and tests that are
automatically graded. You can choose from a wide range of assignment options,
xi
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xii
PREFACE
including time limits, proctoring, and maximum number of attempts allowed.
The bottom line: MyEngineeringLab means less time grading and more time
teaching.
• Algorithmic-generated homework assignments, quizzes, and tests that
directly correlate to the textbook.
• Automatic grading that tracks students’ results.
• Assignable Spreadsheet Exercises that students can complete in an Excelsimulated environment.
• Interactive “Help Me Solve This” tutorials provide opportunity for point-ofuse help and more practice.
• Learning Objectives mapped to ABET outcomes provide comprehensive
reporting tools. If adopted, access to MyEngineeringLab can be bundled with
the book or purchased separately.
What’s New to This Edition?
The basic intent behind this revision of the text is to integrate computer technology
and realistic examples to facilitate learning engineering economy. Here are the
highlights of changes to the sixteenth edition:
•
•
•
•
•
•
•
There are more integrated videos keyed to material in the text and designed to
reinforce learning through analogy with marked problems and examples.
Many new spreadsheet models have been added to the sixteenth edition
(several contributed by James A. Alloway).
This edition contains over 900 examples, solved problems and end-of-chapter
problems. These include 70 “Try Your Skills” problems in selected chapters,
with full solutions given in Appendix G.
Over 160 “green” examples and problems populate this edition as a subset
of 750 problems at the conclusion of the 14 chapters in this book. Many of
these problems incorporate energy conservation in commonly experienced
situations with which students can identify.
PowerPoint visual aids for instructors have been expanded and enhanced.
Chapter 2, dealing with choice among alternatives when the time value of
money can be ignored, has been revised for improved readability.
Optional student resources include MyEngineeringLab with Pearson e-text, a
complete on-line version of the book. It allows highlighting, note taking, and
search capabilities. This resource permits access to the Video Solutions files
which accompany this text as well as additional study materials. All end-ofchapter problems with this icon [ ] indicate the availability of some form of
Video Solutions.
Strategies of This Book
This book has two primary objectives: (1) to provide students with a sound
understanding of the principles, basic concepts, and methodology of engineering
economy; and (2) to help students develop proficiency with these methods and with
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PREFACE
xiii
the process for making rational decisions they are likely to encounter in professional
practice. Interestingly, an engineering economy course may be a student’s only college
exposure to the systematic evaluation of alternative investment opportunities. In this
regard, Engineering Economy is intended to serve as a text for classroom instruction
and as a basic reference for use by practicing engineers in all specialty areas
(e.g., chemical, civil, computer, electrical, industrial, and mechanical engineering).
The book is also useful to persons engaged in the management of technical
activities.
As a textbook, the sixteenth edition is written principally for the first formal
course in engineering economy. A three-credit-hour semester course should be
able to cover the majority of topics in this edition, and there is sufficient depth
and breadth to enable an instructor to arrange course content to suit individual
needs. Representative syllabi for a three-credit and a two-credit semester course
in engineering economy are provided in Table P-1. Moreover, because several
advanced topics are included, this book can also be used for a second course in
engineering economy.
All chapters and appendices have been revised and updated to reflect current
trends and issues. Also, numerous exercises that involve open-ended problem
statements and iterative problem-solving skills are included throughout the book.
A large number of the 750-plus end-of-chapter exercises are new, and many
solved examples representing realistic problems that arise in various engineering
disciplines are presented.
In the 21st century, America is turning over a new leaf for environmental
sustainability. We have worked hard to capture this spirit in many of our examples
and end-of-chapter problems. In fact, more than 160 “green” problems and
examples have been integrated throughout this edition. They are listed in the Green
Content section following the Preface.
Fundamentals of Engineering (FE) exam–style questions are included to
help prepare engineering students for this milestone examination, leading to
professional registration. Passing the FE exam is a first step in getting licensed
as a professional engineer (PE). Engineering students should seriously consider
becoming a PE because it opens many employment opportunities and increases
lifetime earning potential.
It is generally advisable to teach engineering economy at the upper division
level. Here, an engineering economy course incorporates the accumulated knowledge students have acquired in other areas of the curriculum and also deals with
iterative problem solving, open-ended exercises, creativity in formulating and
evaluating feasible solutions to problems, and consideration of realistic constraints
(economic, aesthetic, safety, etc.) in problem solving.
Also available to adopters of this edition is an instructor’s Solutions Manual
and other classroom resources. In addition, PowerPoint visual aids are readily
available to instructors. Visit www.pearsonhighered.com/sullivan for more
information.
Engineering Economy Portfolio
In many engineering economy courses, students are required to design, develop,
and maintain an engineering economy portfolio. The purpose of the portfolio
is to demonstrate and integrate knowledge of engineering economy beyond
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xiv
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1
2
1
2
Topic(s)
Introduction to Engineering Economy
Cost Concepts and Design
Economics
3
3
Cost-Estimation Techniques
4
4–5
The Time Value of Money
5
6
Evaluating a Single Project
6
7
Comparison and Selection
among Alternatives
8
Midterm Examination
7
9
Depreciation and Income Taxes
10
10
Evaluating Projects with the
Benefit–Cost Ratio Method
8
11
Price Changes and Exchange Rates
11
12
Breakeven and Sensitivity Analysis
9
13
Replacement Analysis
12
14
Probabilistic Risk Analysis
13–14
15
The Capital Budgeting Process,
Decision Making
Considering Multiattributes
15
Final Examination
Number of class periods: 45
Week of the
Semester
Chapter
Semester Course (Three Credit Hours)
5
1
3
2
4
1
2
5
1
1
4
1, 2, 4
3
5
6
3, 5, 6
11
7
14
All the above
Number of class periods: 30
1
4
Introduction to Engineering Economy
Cost Concepts, Single Variable
Trade-Off Analysis, and
Present Economy
The Time Value of Money
Test #1
Developing Cash Flows and
Cost-Estimation Techniques
Evaluating a Single Project
Comparison and Selection
among Alternatives
Test #2
Breakeven and Sensitivity Analysis
Depreciation and Income Taxes
Decision Making Considering
Multiattributes
Final Examination
Topic(s)
Semester Course (Two Credit Hours)
No. of Class
Periods
1
2
Chapter(s)
TABLE P-1 Typical Syllabi for Courses in Engineering Economy
PREFACE
xv
the required assignments and tests. This is usually an individual assignment.
Professional presentation, clarity, brevity, and creativity are important criteria to
be used to evaluate portfolios. Students are asked to keep the audience (i.e., the
grader) in mind when constructing their portfolios.
The portfolio should contain a variety of content. To get credit for content,
students must display their knowledge. Simply collecting articles in a folder
demonstrates very little. To get credit for collected articles, students should read
them and write a brief summary of each one. The summary could explain how
the article is relevant to engineering economy, it could critique the article, or it
could check or extend any economic calculations in the article. The portfolio should
include both the summary and the article itself. Annotating the article by writing
comments in the margin is also a good idea. Other suggestions for portfolio content
follow (note that students are encouraged to be creative):
•
•
•
•
•
•
•
Describe and set up or solve an engineering economy problem from your own
discipline (e.g., electrical engineering or building construction).
Choose a project or problem in society or at your university and apply
engineering economic analysis to one or more proposed solutions.
Develop proposed homework or test problems for engineering economy.
Include the complete solution. Additionally, state which course objective(s)
this problem demonstrates (include text section).
Reflect upon and write about your progress in the class. You might include a
self-evaluation against the course objectives.
Include a photo or graphic that illustrates some aspects of engineering economy.
Include a caption that explains the relevance of the photo or graphic.
Include completely worked out practice problems. Use a different color pen to
show these were checked against the provided answers.
Rework missed test problems, including an explanation of each mistake.
(The preceding list could reflect the relative value of the suggested items; that is,
items at the top of the list are more important than items at the bottom of the
list.)
Students should develop an introductory section that explains the purpose
and organization of the portfolio. A table of contents and clearly marked sections
or headings are highly recommended. Cite the source (i.e., a complete bibliographic
entry) of all outside material. Remember, portfolios provide evidence that students
know more about engineering economy than what is reflected in the assignments
and exams. The focus should be on quality of evidence, not quantity.
Icons Used in This Book
Throughout this book, these two icons will appear in connection with numerous
chapter opening materials, examples, and problems:
This icon identifies environmental (green) elements of the book. These elements
pertain to engineering economy problems involving energy conservation, materials
substitution, recycling, and other green situations.
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xvi
PREFACE
This icon informs students of the availability of video tutorials for the examples
and problems so marked. Students are encouraged to access the tutorials at
www.pearsonhighered.com/sullivan. These icon-designated instances are
intended to reinforce the learning of engineering economy through analogy with
the marked problems and examples.
Overview of the Book
This book is about making choices among competing engineering alternatives.
Most of the cash-flow consequences of the alternatives lie in the future, so our
attention is directed toward the future and not the past. In Chapter 2, we examine
alternatives when the time value of money is not a complicating factor in the
analysis. We then turn our attention in Chapter 3 to how future cash flows are
estimated. In Chapter 4 and subsequent chapters, we deal with alternatives where
the time value of money is a deciding factor in choosing among competing capital
investment opportunities.
Students can appreciate Chapters 2 and 3 and later chapters when they
consider alternatives in their personal lives, such as which job to accept upon
graduation, which automobile or truck to purchase, whether to buy a home or rent
a residence, and many other choices they will face. To be student friendly, we have
included many problems throughout this book that deal with personal finance.
These problems are timely and relevant to a student’s personal and professional
success, and these situations incorporate the structured problem-solving process
that students will learn from this book.
Chapter 4 concentrates on the concepts of money–time relationships and
economic equivalence. Specifically, we consider the time value of money in
evaluating the future revenues and costs associated with alternative uses of
money. Then, in Chapter 5, the methods commonly used to analyze the economic
consequences and profitability of an alternative are demonstrated. These methods,
and their proper use in the comparison of alternatives, are primary subjects of
Chapter 6, which also includes a discussion of the appropriate time period for
an analysis. Thus, Chapters 4, 5, and 6 together develop an essential part of
the methodology needed for understanding the remainder of the book and for
performing engineering economy studies on a before-tax basis.
In Chapter 7, the additional details required to accomplish engineering
economy studies on an after-tax basis are explained. In the private sector, most
engineering economy studies are done on an after-tax basis. Therefore, Chapter 7
adds to the basic methodology developed in Chapters 4, 5, and 6.
The effects of inflation (or deflation), price changes, and international
exchange rates are the topics of Chapter 8. The concepts for handling price
changes and exchange rates in an engineering economy study are discussed both
comprehensively and pragmatically from an application viewpoint.
Often, an organization must analyze whether existing assets should be
continued in service or replaced with new assets to meet current and future
operating needs. In Chapter 9, techniques for addressing this question are
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PREFACE
xvii
developed and presented. Because the replacement of assets requires significant
capital, decisions made in this area are important and demand special attention.
Chapter 10 is dedicated to the analysis of public projects with the benefit–cost
ratio method of comparison. The development of this widely used method of
evaluating alternatives was motivated by the Flood Control Act passed by the
U.S. Congress in 1936.
Concern over uncertainty and risk is a reality in engineering practice. In
Chapter 11, the impact of potential variation between the estimated economic
outcomes of an alternative and the results that may occur is considered. Breakeven
and sensitivity techniques for analyzing the consequences of risk and uncertainty
in future estimates of revenues and costs are discussed and illustrated.
In Chapter 12, probabilistic techniques for analyzing the consequences of risk
and uncertainty in future cash-flow estimates and other factors are explained.
Discrete and continuous probability concepts, as well as Monte Carlo simulation
techniques, are included in Chapter 12.
Chapter 13 is concerned with the proper identification and analysis of all
projects and other needs for capital within an organization. Accordingly, the capital
financing and capital allocation process to meet these needs is addressed. This
process is crucial to the welfare of an organization, because it affects most operating
outcomes, whether in terms of current product quality and service effectiveness or
long-term capability to compete in the world market. Finally, Chapter 14 discusses
many time-tested methods for including nonmonetary attributes (intangibles) in
engineering economy studies.
We would like to extend a heartfelt “thank you” to our colleagues and students
for their many helpful suggestions (and critiques!) for this sixteenth edition of
“Engineering Economy.” We owe an enormous debt of gratitude to numerous
individuals who have contributed to this edition: Jim Alloway, Karen Bursic,
Thomas Cassel, Linda Chattin, Robert Dryden, Jim Luxhoj, Thomas Keyser,
Samantha Marcum and Shayam Moondra. Also special thanks to our Pearson
Prentice Hall team who have made invaluable improvements to this effort: Scott
Disanno, Greg Dulles, Pavithra Jayapaul, Miguel Leonarte, Clare Romeo, and Holly
Stark.
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GREEN CONTENT
Chapter 1
p. 1 (chapter opener)
p. 14 (Example 1-3)
p. 16 (Problems 1-1 and 1-3)
p. 17 (Problems 1-5, 1-7, 1-9 to 1-12)
p. 18 (Problem 1-15)
p. 19 (Problems 1-20 and 1-21)
Chapter 2
p. 42 (Example 2-7)
p. 44 (Example 2-8)
p. 49 (Example 2-11)
p. 52 (Problems 2-3 and 2-4)
p. 53 (Problem 2-12)
p. 54 (Problems 2-16, 2-21, and 2-22)
p. 55 (Problems 2-23, 2-24, 2-28, and 2-30)
p. 56 (Problems 2-31 to 2-33 and 2-37)
p. 57 (Problems 2-38, 2-39, 2-41, and 2-42)
p. 58 (Problems 2-45 and 2-47, Spreadsheet Exercise 2-49)
Chapter 3
p. 67 (chapter opener)
p. 94 (Case Study 3.5)
p. 100 (Problems 3-1 and 3-4)
p. 101 (Problems 3-6, 3-11, and 3-12)
p. 102 (Problems 3-14 and 3-15)
p. 106 (FE Practice Problems 3-37 and 3-40)
Chapter 4
p. 107 (chapter opener)
p. 115 (Example 4-2)
p. 127 (Example 4-10)
p. 141 (Example 4-18)
p. 172 (Problems 4-33, 4-36, 4-37, and 4-40)
p. 173 (Problem 4-43)
xviii
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GREEN CONTENT
p. 174 (Problem 4-53)
p. 175 (Problems 4-65, 4-70, and 4-71)
p. 177 (Problems 4-82, 4-84, and 4-85)
p. 178 (Problem 4-88)
Chapter 5
p. 186 (chapter opener)
p. 192 (Example 5-2)
p. 197 (Example 5-7)
p. 200 (Example 5-10)
p. 217 (Example 5-19)
p. 225 (Problems 5-2, 5-6, and 5-9)
p. 227 (Problem 5-25)
p. 228 (Problems 5-28, 5-29, 5-31, 5-33, and 5-34)
p. 229 (Problems 5-35, 5-39, and 5-41)
p. 231 (Problems 5-49 to 5-51)
p. 232 (Problems 5-56 to 5-59)
p. 235 (FE Practice Problems 5-75, 5-81, and 5-83)
Chapter 6
p. 240 (chapter opener)
p. 269 (Example 6-9)
p. 281 (Case Study 6-7)
p. 292 (Problem 6-2)
p. 293 (Problem 6-6)
p. 294 (Problems 6-8 and 6-13)
p. 295 (Problems 6-16 and 6-17)
p. 296 (Problems 6-20, 6-23, and 6-24)
p. 297 (Problem 6-29)
p. 298 (Problem 6-34)
p. 299 (Problems 6-35, 6-38, and 6-41)
p. 300 (Problem 6-43)
p. 301 (Problems 6-46 and 6-49)
p. 302 (Problems 6-51 and 6-53)
p. 303 (Problems 6-57 to 6-59)
p. 304 (Problems 6-64 and 6-66)
p. 306 (FE Practice Problem 6-79)
Chapter 7
p. 308 (chapter opener)
p. 341 (Example 7-14)
p. 361 (Problems 7-37 and 7-40)
p. 365 (Problem 7-60)
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xix
xx
GREEN CONTENT
Chapter 8
p. 382 (Example 8-8)
p. 390 (Case Study 8-7)
p. 395 (Problem 8-11)
p. 396 (Problem 8-18)
p. 397 (Problems 8-21, 8-23, and 8-25)
p. 399 (Problems 8-41 and 8-42)
p. 400 (Problem 8-46)
p. 402 (Case Study Exercises 8-52 to 8-54, FE Practice Problem 8-61)
Chapter 9
p. 403 (chapter opener)
p. 436 (Problem 9-6)
p. 437 (Problem 9-12)
p. 440 (Problem 9-25)
Chapter 10
p. 468 (Problems 10-2, 10-4, and 10-5)
p. 470 (Problem 10-13)
p. 472 (Problems 10-21 and 10-24)
Chapter 11
p. 478 (Example 11-1)
p. 479 (Example 11-2)
p. 480 (Example 11-3)
p. 493 (Problems 11-2 and 11-3)
p. 494 (Problem 11-6)
p. 496 (Problems 11-16 to 11-18)
p. 497 (Problems 11-21 and 11-22)
p. 498 (Spreadsheet Exercises 11-24 and 11-25)
p. 499 (Spreadsheet Exercises 11-27 to 11-29)
p. 501 (FE Practice Problem 11-40)
Chapter 12
p. 502 (chapter opener)
p. 539 (Problems 12-4 and 12-6)
p. 540 (Problem 12-7)
Chapter 13
p. 546 (chapter opener)
Chapter 14
p. 575 (chapter opener)
p. 590 (Example 14-2)
p. 597 (Problem 14-17)
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ENGINEERING
ECONOMY
Sixteenth Edition
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CHAPTER 1
Introduction to Engineering
Economy
The purpose of Chapter 1 is to present the concepts and principles of
engineering economy.
Green Engineering in Action
E
nergy conservation comprises an important element in
environmentally-conscious (green) engineering. In a Southeastern city, there are 310 traffic intersections that have been
converted from incandescent lights to light-emitting diode (LED) lights. The
study that led to this decision was conducted by the sustainability manager of
the city. The wattage used at the intersections has been reduced from 150 watts
to 15 watts at each traffic light. The resultant lighting bill has been lowered from
$440,000 annually to $44,000 annually. When engineers went to check the traffic
light meters for the first time, they were shocked by the low wattage numbers
and the associated cost. One of them said, “We thought the meters were broken
because the readings were so low.” The annual savings of $396,000 per year from
the traffic light conversion more than paid for the $150,000 cost of installing the
LED lights. Chapter 1 introduces students to the decision-making process that
accompanies “go/no go” evaluations of investments in engineering projects such
as the one described above.
1
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The best alternative may be the one you haven’t yet discovered.
—Anonymous
Icons Used in This Book
Throughout this book, these two icons will appear in connection with numerous
chapter opening materials, examples, and problems:
This icon identifies environmental (green) elements of the book. These elements
pertain to engineering economy problems involving energy conservation, materials
substitution, recycling, and other green situations.
This icon informs students of the availability of video tutorials for the examples
and problems so marked. Students are encouraged to access the tutorials at
www.pearsonhighered.com/sullivan. These icon-designated instances are
intended to reinforce the learning of engineering economy through analogy with
the marked problems and examples.
1.1 Introduction
The technological and social environments in which we live continue to change
at a rapid rate. In recent decades, advances in science and engineering have
transformed our transportation systems, revolutionized the practice of medicine,
and miniaturized electronic circuits so that a computer can be placed on a
semiconductor chip. The list of such achievements seems almost endless. In your
science and engineering courses, you will learn about some of the physical laws
that underlie these accomplishments.
The utilization of scientific and engineering knowledge for our benefit is
achieved through the design of things we use, such as furnaces for vaporizing trash
and structures for supporting magnetic railways. However, these achievements
don’t occur without a price, monetary or otherwise. Therefore, 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
costs?
The Accreditation Board for Engineering and Technology states that engineering “is the profession in which a knowledge of the mathematical and natural
sciences gained by study, experience, and practice is applied with judgment to
develop ways to utilize, economically, the materials and forces of nature for the
benefit of mankind.”∗ In this definition, the economic aspects of engineering are
emphasized, as well as the physical aspects. Clearly, it is essential that the economic
part of engineering practice be accomplished well. Thus, engineers use knowledge
to find new ways of doing things economically.
∗ Accreditation Board of Engineering and Technology, Criteria for Accrediting Programs in Engineering in the United States
(New York; Baltimore, MD: ABET, 1998).
2
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SECTION 1.2 / THE PRINCIPLES OF ENGINEERING ECONOMY
3
Engineering economy involves the systematic evaluation of the economic merits
of proposed solutions to engineering problems. To be economically acceptable
(i.e., affordable), solutions to engineering problems must demonstrate a positive
balance of long-term benefits over long-term costs, and they must also
•
•
•
•
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.
Engineering economy is the dollars-and-cents side of the decisions that
engineers make or recommend as they work to position a firm to be profitable
in a highly competitive marketplace. Inherent to these decisions are trade-offs
among different types of costs and the performance (response time, safety, weight,
reliability, etc.) provided by the proposed design or problem solution. The mission
of engineering economy is to balance these trade-offs in the most economical manner.
For instance, if an engineer at Ford Motor Company invents a new transmission
lubricant that increases fuel mileage by 10% and extends the life of the transmission
by 30,000 miles, how much can the company afford to spend to implement this
invention? Engineering economy can provide an answer.
A few more of the myriad situations in which engineering economy plays a
crucial role in the analysis of project alternative come to mind:
1. Choosing the best design for a high-efficiency gas furnace
2. Selecting the most suitable robot for a welding operation on an automotive
assembly line
3. Making a recommendation about whether jet airplanes for an overnight delivery
service should be purchased or leased
4. Determining the optimal staffing plan for a computer help desk
From these illustrations, it should be obvious that engineering economy includes
significant technical considerations. Thus, engineering economy involves technical
analysis, with emphasis on the economic aspects, and has the objective of assisting
decisions. This is true whether the decision maker is an engineer interactively
analyzing alternatives at a computer-aided design workstation or the Chief
Executive Officer (CEO) considering a new project. An engineer who is unprepared to
excel at engineering economy is not properly equipped for his or her job.
1.2 The Principles of Engineering Economy
The development, study, and application of any discipline must begin with a
basic foundation. We define the foundation for engineering economy to be a set of
principles that provide a comprehensive doctrine for developing the methodology.
These principles will be mastered by students as they progress through this book.
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CHAPTER 1 / INTRODUCTION TO ENGINEERING ECONOMY
Once a problem or need has been clearly defined, the foundation of the discipline
can be discussed in terms of seven principles.
PRINCIPLE 1
Develop the Alternatives
Carefully define the problem! Then the choice (decision) is among alternatives.
The alternatives need to be identified and then defined for subsequent analysis.
A decision situation involves making a choice among two or more alternatives.
Developing and defining the alternatives for detailed evaluation is important
because of the resulting impact on the quality of the decision. Engineers and
managers should place a high priority on this responsibility. Creativity and
innovation are essential to the process.
One alternative that may be feasible in a decision situation is making no change
to the current operation or set of conditions (i.e., doing nothing). If you judge this
option feasible, make sure it is considered in the analysis. However, do not focus
on the status quo to the detriment of innovative or necessary change.
PRINCIPLE 2
Focus on the Differences
Only the differences in expected future outcomes among the alternatives are
relevant to their comparison and should be considered in the decision.
If all prospective outcomes of the feasible alternatives were exactly the same, there
would be no basis or need for comparison. We would be indifferent among the
alternatives and could make a decision using a random selection.
Obviously, only the differences in the future outcomes of the alternatives are
important. Outcomes that are common to all alternatives can be disregarded in
the comparison and decision. For example, if your feasible housing alternatives
were two residences with the same purchase (or rental) price, price would be
inconsequential to your final choice. Instead, the decision would depend on other
factors, such as location and annual operating and maintenance expenses. This
simple example illustrates Principle 2, which emphasizes the basic purpose of an
engineering economic analysis: to recommend a future course of action based on
the differences among feasible alternatives.
PRINCIPLE 3
Use a Consistent Viewpoint
The prospective outcomes of the alternatives, economic and other, should be
consistently developed from a defined viewpoint (perspective).
The perspective of the decision maker, which is often that of the owners of the
firm, would normally be used. However, it is important that the viewpoint for the
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SECTION 1.2 / THE PRINCIPLES OF ENGINEERING ECONOMY
5
particular decision be first defined and then used consistently in the description,
analysis, and comparison of the alternatives.
As an example, consider a public organization operating for the purpose of
developing a river basin, including the generation and wholesale distribution of
electricity from dams on the river system. A program is being planned to upgrade
and increase the capacity of the power generators at two sites. What perspective
should be used in defining the technical alternatives for the program? The “owners
of the firm” in this example means the segment of the public that will pay the cost
of the program, and their viewpoint should be adopted in this situation.
Now let us look at an example where the viewpoint may not be that of the
owners of the firm. Suppose that the company in this example is a private firm and
that the problem deals with providing a flexible benefits package for the employees.
Also, assume that the feasible alternatives for operating the plan all have the same
future costs to the company. The alternatives, however, have differences from
the perspective of the employees, and their satisfaction is an important decision
criterion. The viewpoint for this analysis should be that of the employees of the
company as a group, and the feasible alternatives should be defined from their
perspective.
PRINCIPLE 4
Use a Common Unit of Measure
Using a common unit of measurement to enumerate as many of the prospective
outcomes as possible will simplify the analysis of the alternatives.
It is desirable to make as many prospective outcomes as possible commensurable
(directly comparable). For economic consequences, a monetary unit such as dollars
is the common measure. You should also try to translate other outcomes (which
do not initially appear to be economic) into the monetary unit. This translation, of
course, will not be feasible with some of the outcomes, but the additional effort
toward this goal will enhance commensurability and make the subsequent analysis
of alternatives easier.
What should you do with the outcomes that are not economic (i.e., the expected
consequences that cannot be translated (and estimated) using the monetary unit)?
First, if possible, quantify the expected future results using an appropriate unit of
measurement for each outcome. If this is not feasible for one or more outcomes,
describe these consequences explicitly so that the information is useful to the
decision maker in the comparison of the alternatives.
PRINCIPLE 5
Consider All Relevant Criteria
Selection of a preferred alternative (decision making) requires the use of a
criterion (or several criteria). The decision process should consider both the
outcomes enumerated in the monetary unit and those expressed in some other
unit of measurement or made explicit in a descriptive manner.
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CHAPTER 1 / INTRODUCTION TO ENGINEERING ECONOMY
The decision maker will normally select the alternative that will best serve the
long-term interests of the owners of the organization. In engineering economic
analysis, the primary criterion relates to the long-term financial interests of the
owners. This is based on the assumption that available capital will be allocated to
provide maximum monetary return to the owners. Often, though, there are other
organizational objectives you would like to achieve with your decision, and these
should be considered and given weight in the selection of an alternative. These
nonmonetary attributes and multiple objectives become the basis for additional
criteria in the decision-making process. This is the subject of Chapter 14.
PRINCIPLE 6
Make Risk and Uncertainty Explicit
Risk and uncertainty are inherent in estimating the future outcomes of the alternatives and should be recognized in their analysis and comparison.
The analysis of the alternatives involves projecting or estimating the future
consequences associated with each of them. The magnitude and the impact of future
outcomes of any course of action are uncertain. Even if the alternative involves no
change from current operations, the probability is high that today’s estimates of,
for example, future cash receipts and expenses will not be what eventually occurs.
Thus, dealing with uncertainty is an important aspect of engineering economic
analysis and is the subject of Chapters 11 and 12.
PRINCIPLE 7
Revisit Your Decisions
Improved decision making results from an adaptive process; to the extent
practicable, the initial projected outcomes of the selected alternative should be
subsequently compared with actual results achieved.
A good decision-making process can result in a decision that has an undesirable
outcome. Other decisions, even though relatively successful, will have results
significantly different from the initial estimates of the consequences. Learning from
and adapting based on our experience are essential and are indicators of a good
organization.
The evaluation of results versus the initial estimate of outcomes for the selected
alternative is often considered impracticable or not worth the effort. Too often,
no feedback to the decision-making process occurs. Organizational discipline is
needed to ensure that implemented decisions are routinely postevaluated and that
the results are used to improve future analyses and the quality of decision making.
For example, a common mistake made in the comparison of alternatives is the
failure to examine adequately the impact of uncertainty in the estimates for selected
factors on the decision. Only postevaluations will highlight this type of weakness
in the engineering economy studies being done in an organization.
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SECTION 1.3 / ENGINEERING ECONOMY AND THE DESIGN PROCESS
7
1.3 Engineering Economy and the Design Process
An engineering economy study is accomplished using a structured procedure
and mathematical modeling techniques. The economic results are then used in
a decision situation that normally includes other engineering knowledge and
input.
A sound engineering economic analysis procedure incorporates the basic principles
discussed in Section 1.2 and involves several steps. We represent the procedure
in terms of the seven steps listed in the left-hand column of Table 1-1. There are
several feedback loops (not shown) within the procedure. For example, within
Step 1, information developed in evaluating the problem will be used as feedback
to refine the problem definition. As another example, information from the analysis
of alternatives (Step 5) may indicate the need to change one or more of them or to
develop additional alternatives.
The seven-step procedure is also used to assist decision making within the
engineering design process, shown as the right-hand column in Table 1-1. In this
case, activities in the design process contribute information to related steps in the
economic analysis procedure. The general relationship between the activities in
the design process and the steps of the economic analysis procedure is indicated
in Table 1-1.
The engineering design process may be repeated in phases to accomplish a
total design effort. For example, in the first phase, a full cycle of the process may
be undertaken to select a conceptual or preliminary design alternative. Then, in
the second phase, the activities are repeated to develop the preferred detailed
design based on the selected preliminary design. The seven-step economic analysis
TABLE 1-1
The General Relationship between the Engineering Economic Analysis
Procedure and the Engineering Design Process
Engineering Design Process
(see Figure P1-15 on p. 18)
Engineering Economic Analysis Procedure
Step
1.
2.
3.
4.
5.
6.
7.
Activity
1. Problem/need definition.
Problem recognition, definition, and
evaluation.
Development of the feasible alternatives.
Development of the outcomes and
cash flows for each alternative.
Selection of a criterion (or criteria).
Analysis and comparison of the
alternatives.
Selection of the preferred alternative.
Performance monitoring and postevaluation of results.
⎫
⎪
⎪
⎪
⎪
⎬
⎪
⎪
⎪
⎪
⎭
2.
3.
Problem/need formulation and evaluation.
Synthesis of possible solutions (alternatives).
4.
Analysis, optimization, and evaluation.
5.
6.
Specification of preferred alternative.
Communication.
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CHAPTER 1 / INTRODUCTION TO ENGINEERING ECONOMY
procedure would be repeated as required to assist decision making in each phase
of the total design effort. This procedure is discussed next.
1.3.1
Problem Definition
The first step of the engineering economic analysis procedure (problem definition)
is particularly important, since it provides the basis for the rest of the analysis. A
problem must be well understood and stated in an explicit form before the project
team proceeds with the rest of the analysis.
The term problem is used here generically. It includes all decision situations for
which an engineering economy analysis is required. Recognition of the problem is
normally stimulated by internal or external organizational needs or requirements.
An operating problem within a company (internal need) or a customer expectation
about a product or service (external requirement) are examples.
Once the problem is recognized, its formulation should be viewed from a
systems perspective. That is, the boundary or extent of the situation needs to
be carefully defined, thus establishing the elements of the problem and what
constitutes its environment.
Evaluation of the problem includes refinement of needs and requirements, and
information from the evaluation phase may change the original formulation of the
problem. In fact, redefining the problem until a consensus is reached may be the
most important part of the problem-solving process!
1.3.2
Development of Alternatives∗
The two primary actions in Step 2 of the procedure are (1) searching for potential
alternatives and (2) screening them to select a smaller group of feasible alternatives
for detailed analysis. The term feasible here means that each alternative selected for
further analysis is judged, based on preliminary evaluation, to meet or exceed the
requirements established for the situation.
1.3.2.1 Searching for Superior Alternatives In the discussion of Principle 1 (Section 1.2), creativity and resourcefulness were emphasized as being
absolutely essential to the development of potential alternatives. The difference
between good alternatives and great alternatives depends largely on an individual’s or group’s problem-solving efficiency. Such efficiency can be increased in
the following ways:
1.
2.
3.
4.
Concentrate on redefining one problem at a time in Step 1.
Develop many redefinitions for the problem.
Avoid making judgments as new problem definitions are created.
Attempt to redefine a problem in terms that are dramatically different from the
original Step 1 problem definition.
∗ This is sometimes called option development. This important step is described in detail in A. B. Van Gundy, Techniques
of Structured Problem Solving, 2nd ed. (New York: Van Nostrand Reinhold Co., 1988). For additional reading, see
E. Lumsdaine and M. Lumsdaine, Creative Problem Solving—An Introductory Course for Engineering Students (New York:
McGraw-Hill Book Co., 1990) and J. L. Adams, Conceptual Blockbusting—A Guide to Better Ideas (Reading, MA: AddisonWesley Publishing Co., 1986).
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SECTION 1.3 / ENGINEERING ECONOMY AND THE DESIGN PROCESS
9
5. Make sure that the true problem is well researched and understood.
In searching for superior alternatives or identifying the true problem, several
limitations invariably exist, including (1) lack of time and money, (2) preconceptions of what will and what will not work, and (3) lack of knowledge. Consequently,
the engineer or project team will be working with less-than-perfect problem
solutions in the practice of engineering.
EXAMPLE 1-1
Defining the Problem and Developing Alternatives
The management team of a small furniture-manufacturing company is under
pressure to increase profitability to get a much-needed loan from the bank to
purchase a more modern pattern-cutting machine. One proposed solution is to
sell waste wood chips and shavings to a local charcoal manufacturer instead of
using them to fuel space heaters for the company’s office and factory areas.
(a) Define the company’s problem. Next, reformulate the problem in a variety
of creative ways.
(b) Develop at least one potential alternative for your reformulated problems
in Part (a). (Don’t concern yourself with feasibility at this point.)
Solution
(a) The company’s problem appears to be that revenues are not sufficiently
covering costs. Several reformulations can be posed:
1. The problem is to increase revenues while reducing costs.
2. The problem is to maintain revenues while reducing costs.
3. The problem is an accounting system that provides distorted cost
information.
4. The problem is that the new machine is really not needed (and hence
there is no need for a bank loan).
(b) Based only on reformulation 1, an alternative is to sell wood chips and
shavings as long as increased revenue exceeds extra expenses that may
be required to heat the buildings. Another alternative is to discontinue
the manufacture of specialty items and concentrate on standardized, highvolume products. Yet another alternative is to pool purchasing, accounting,
engineering, and other white-collar support services with other small firms
in the area by contracting with a local company involved in providing these
services.
1.3.2.2 Developing Investment Alternatives “It takes money to make
money,” as the old saying goes. Did you know that in the United States the average
firm spends over $250,000 in capital on each of its employees? So, to make money,
each firm must invest capital to support its important human resources—but
in what else should an individual firm invest? There are usually hundreds of
opportunities for a company to make money. Engineers are at the very heart of
creating value for a firm by turning innovative and creative ideas into new or
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CHAPTER 1 / INTRODUCTION TO ENGINEERING ECONOMY
reengineered commercial products and services. Most of these ideas require investment of money, and only a few of all feasible ideas can be developed, due to lack
of time, knowledge, or resources.
Consequently, most investment alternatives created by good engineering ideas
are drawn from a larger population of equally good problem solutions. But how
can this larger set of equally good solutions be tapped into? Interestingly, studies
have concluded that designers and problem solvers tend to pursue a few ideas that
involve “patching and repairing” an old idea.∗ Truly new ideas are often excluded
from consideration! This section outlines two approaches that have found wide
acceptance in industry for developing sound investment alternatives by removing
some of the barriers to creative thinking: (1) classical brainstorming and (2) the
Nominal Group Technique (NGT).
(1) Classical Brainstorming. Classical brainstorming is the most well-known
and often-used technique for idea generation. It is based on the fundamental
principles of deferment of judgment and that quantity breeds quality. There are four
rules for successful brainstorming:
1.
2.
3.
4.
Criticism is ruled out.
Freewheeling is welcomed.
Quantity is wanted.
Combination and improvement are sought.
A. F. Osborn lays out a detailed procedure for successful brainstorming.† A classical
brainstorming session has the following basic steps:
1. Preparation. The participants are selected, and a preliminary statement of the
problem is circulated.
2. Brainstorming. A warm-up session with simple unrelated problems is
conducted, the relevant problem and the four rules of brainstorming are
presented, and ideas are generated and recorded using checklists and other
techniques if necessary.
3. Evaluation. The ideas are evaluated relative to the problem.
Generally, a brainstorming group should consist of four to seven people, although
some suggest larger groups.
(2) Nominal Group Technique. The NGT, developed by Andre P. Delbecq
and Andrew H. Van de Ven,‡ involves a structured group meeting designed to
incorporate individual ideas and judgments into a group consensus. By correctly
applying the NGT, it is possible for groups of people (preferably, 5 to 10) to generate
investment alternatives or other ideas for improving the competitiveness of the
∗ S. Finger and J. R. Dixon, “A Review of Research in Mechanical Engineering Design. Part I: Descriptive, Prescriptive,
and Computer-Based Models of Design Processes,” in Research in Engineering Design (New York: Springer-Verlag, 1990).
† A. F. Osborn, Applied Imagination, 3rd ed. (New York: Charles Scribner’s Sons, 1963). Also refer to P. R. Scholtes,
B. L. Joiner, and B. J. Streibel, The Team Handbook, 2nd ed. (Madison, WI: Oriel Inc., 1996).
‡ A. Van de Ven and A. Delbecq, “The Effectiveness of Nominal, Delphi, and Interactive Group Decision Making
Processes,” Academy of Management Journal 17, no. 4 (December 1974): 605–21.
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firm. Indeed, the technique can be used to obtain group thinking (consensus) on a
wide range of topics. For example, a question that might be given to the group is,
“What are the most important problems or opportunities for improvement of . . .?”
The technique, when properly applied, draws on the creativity of the individual
participants, while reducing two undesirable effects of most group meetings: (1) the
dominance of one or more participants and (2) the suppression of conflicting ideas.
The basic format of an NGT session is as follows:
1. Individual silent generation of ideas
2. Individual round-robin feedback and recording of ideas
3. Group clarification of each idea
4. Individual voting and ranking to prioritize ideas
5. Discussion of group consensus results
The NGT session begins with an explanation of the procedure and a statement
of question(s), preferably written by the facilitator.∗ The group members are
then asked to prepare individual listings of alternatives, such as investment
ideas or issues that they feel are crucial for the survival and health of the
organization. This is known as the silent-generation phase. After this phase has
been completed, the facilitator calls on each participant, in round-robin fashion,
to present one idea from his or her list (or further thoughts as the round-robin
session is proceeding). Each idea (or opportunity) is then identified in turn and
recorded on a flip chart or board by the NGT facilitator, leaving ample space
between ideas for comments or clarification. This process continues until all the
opportunities have been recorded, clarified, and displayed for all to see. At this
point, a voting procedure is used to prioritize the ideas or opportunities. Finally,
voting results lead to the development of group consensus on the topic being
addressed.
1.3.3
Development of Prospective Outcomes
Step 3 of the engineering economic analysis procedure incorporates Principles 2, 3,
and 4 from Section 1.2 and uses the basic cash-flow approach employed in engineering
economy. A cash flow occurs when money is transferred from one organization
or individual to another. Thus, a cash flow represents the economic effects of an
alternative in terms of money spent and received.
Consider the concept of an organization having only one “window” to its
external environment through which all monetary transactions occur—receipts
of revenues and payments to suppliers, creditors, and employees. The key to
developing the related cash flows for an alternative is estimating what would
happen to the revenues and costs, as seen at this window, if the particular
alternative were implemented. The net cash flow for an alternative is the difference
between all cash inflows (receipts or savings) and cash outflows (costs or expenses)
during each time period.
∗ A good example of the NGT is given in D. S. Sink, “Using the Nominal Group Technique Effectively,” National
Productivity Review, 2 (Spring 1983): 173–84.
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CHAPTER 1 / INTRODUCTION TO ENGINEERING ECONOMY
In addition to the economic aspects of decision making, nonmonetary factors
(attributes) often play a significant role in the final recommendation. Examples
of objectives other than profit maximization or cost minimization that can be
important to an organization include the following:
1. Meeting or exceeding customer expectations
2. Safety to employees and to the public
3. Improving employee satisfaction
4. Maintaining production flexibility to meet changing demands
5. Meeting or exceeding all environmental requirements
6. Achieving good public relations or being an exemplary member of the
community
1.3.4
Selection of a Decision Criterion
The selection of a decision criterion (Step 4 of the analysis procedure) incorporates
Principle 5 (consider all relevant criteria). The decision maker will normally select
the alternative that will best serve the long-term interests of the owners of the
organization. It is also true that the economic decision criterion should reflect
a consistent and proper viewpoint (Principle 3) to be maintained throughout an
engineering economy study.
1.3.5
Analysis and Comparison of Alternatives
Analysis of the economic aspects of an engineering problem (Step 5) is largely
based on cash-flow estimates for the feasible alternatives selected for detailed study.
A substantial effort is normally required to obtain reasonably accurate forecasts of
cash flows and other factors in view of, for example, inflationary (or deflationary)
pressures, exchange rate movements, and regulatory (legal) mandates that often
occur. Clearly, the consideration of future uncertainties (Principle 6) is an essential
part of an engineering economy study. When cash flow and other required estimates
are eventually determined, alternatives can be compared based on their differences
as called for by Principle 2. Usually, these differences will be quantified in terms of
a monetary unit such as dollars.
1.3.6
Selection of the Preferred Alternative
When the first five steps of the engineering economic analysis procedure have been
done properly, the preferred alternative (Step 6) is simply a result of the total effort.
Thus, the soundness of the technical-economic modeling and analysis techniques
dictates the quality of the results obtained and the recommended course of action.
Step 6 is included in Activity 5 of the engineering design process (specification of
the preferred alternative) when done as part of a design effort.
1.3.7
Performance Monitoring and Postevaluation of Results
This final step implements Principle 7 and is accomplished during and after the
time that the results achieved from the selected alternative are collected. Monitoring
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project performance during its operational phase improves the achievement of
related goals and objectives and reduces the variability in desired results. Step 7 is
also the follow-up step to a previous analysis, comparing actual results achieved
with the previously estimated outcomes. The aim is to learn how to do better
analyses, and the feedback from postimplementation evaluation is important to
the continuing improvement of operations in any organization. Unfortunately, like
Step 1, this final step is often not done consistently or well in engineering practice;
therefore, it needs particular attention to ensure feedback for use in ongoing and
subsequent studies.
EXAMPLE 1-2
Application of the Engineering Economic Analysis Procedure
A friend of yours bought a small apartment building for $100,000 in a college
town. She spent $10,000 of her own money for the building and obtained a
mortgage from a local bank for the remaining $90,000. The annual mortgage
payment to the bank is $10,500. Your friend also expects that annual maintenance
on the building and grounds will be $15,000. There are four apartments (two
bedrooms each) in the building that can each be rented for $360 per month.
Refer to the seven-step procedure in Table 1-1 (left-hand side) to answer
these questions:
(a) Does your friend have a problem? If so, what is it?
(b) What are her alternatives? (Identify at least three.)
(c) Estimate the economic consequences and other required data for the
alternatives in Part (b).
(d) Select a criterion for discriminating among alternatives, and use it to advise
your friend on which course of action to pursue.
(e) Attempt to analyze and compare the alternatives in view of at least one
criterion in addition to cost.
(f) What should your friend do based on the information you and she have
generated?
Solution
(a) A quick set of calculations shows that your friend does indeed have a
problem. Alot more money is being spent by your friend each year ($10,500 +
$15,000 = $25,500) than is being received (4 × $360 × 12 = $17,280). The
problem could be that the monthly rent is too low. She’s losing $8,220 per
year. (Now, that’s a problem!)
(b) Option (1). Raise the rent. (Will the market bear an increase?)
Option (2). Lower maintenance expenses (but not so far as to cause safety
problems).
Option (3). Sell the apartment building. (What about a loss?)
Option (4). Abandon the building (bad for your friend’s reputation).
(c) Option (1). Raise total monthly rent to $1,440 + $R for the four apartments to
cover monthly expenses of $2,125. Note that the minimum increase in rent
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CHAPTER 1 / INTRODUCTION TO ENGINEERING ECONOMY
would be ($2,125 − $1,440)/4 = $171.25 per apartment per month (almost a
50% increase!).
Option (2). Lower monthly expenses to $2,125 − $C so that these expenses
are covered by the monthly revenue of $1,440 per month. This would have
to be accomplished primarily by lowering the maintenance cost. (There’s
not much to be done about the annual mortgage cost unless a favorable
refinancing opportunity presents itself.) Monthly maintenance expenses
would have to be reduced to ($1,440 − $10,500/12) = $565. This represents
more than a 50% decrease in maintenance expenses.
Option (3). Try to sell the apartment building for $X, which recovers the
original $10,000 investment and (ideally) recovers the $685 per month loss
($8,220 ÷ 12) on the venture during the time it was owned.
Option (4). Walk away from the venture and kiss your investment good-bye.
The bank would likely assume possession through foreclosure and may try
to collect fees from your friend. This option would also be very bad for your
friend’s credit rating.
(d) One criterion could be to minimize the expected loss of money. In this case,
you might advise your friend to pursue Option (1) or (3).
(e) For example, let’s use “credit worthiness” as an additional criterion. Option
(4) is immediately ruled out. Exercising Option (3) could also harm your
friend’s credit rating. Thus, Options (1) and (2) may be her only realistic and
acceptable alternatives.
(f) Your friend should probably do a market analysis of comparable housing
in the area to see if the rent could be raised (Option 1). Maybe a fresh coat
of paint and new carpeting would make the apartments more appealing
to prospective renters. If so, the rent can probably be raised while keeping
100% occupancy of the four apartments.
A tip to the wise—as an aside to Example 1-2, your friend would need a good credit
report to get her mortgage approved. In this regard, there are three major credit
bureaus in the United States: Equifax, Experian, and TransUnion. It’s a good idea to
regularly review your own credit report for unauthorized activity. You are entitled
to a free copy of your report once per year from each bureau. Consider getting a
report every four months from www.annualcreditreport.com.
EXAMPLE 1-3
Get Rid of the Old Clunker?
Engineering economy is all about deciding among competing alternatives. When
the time value of money is NOT a key ingredient in a problem, Chapter 2 should
be referenced. If the time value of money (e.g., an interest rate) is integral to an
engineering problem, Chapter 4 (and beyond) provides an explanation of how
to analyze these problems.
Consider this situation: Linda and Jerry are faced with a car replacement
opportunity where an interest rate can be ignored. Jerry’s old clunker that
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SECTION 1.5 / TRY YOUR SKILLS
15
averages 10 miles per gallon (mpg) of gasoline can be traded in toward a vehicle
that gets 15 mpg. Or, as an alternative, Linda’s 25 mpg car can be traded in
toward a new hybrid vehicle that averages 50 mpg. If they drive both cars 12,000
miles per year and their goal is to minimize annual gas consumption, which car
should be replaced—Jerry’s or Linda’s? They can only afford to upgrade one
car at this time.
Solution
Jerry’s trade-in will save (12,000 miles/year)/10 mpg − (12,000 miles/year)/
15 mpg = 1,200 gallons/year − 800 gallons/year = 400 gallons/year.
Linda’s trade-in will save (12,000 miles/year)/25 mpg − (12,000 miles/
year)/50 mpg = 480 gallons/year − 240 gallons/year = 240 gallons/year.
Therefore, Jerry should trade in his vehicle to save more gasoline.
1.4 Using Spreadsheets in Engineering Economic Analysis
Spreadsheets are a useful tool for solving engineering economy problems. Most
engineering economy problems are amenable to spreadsheet solution for the
following reasons:
1. They consist of structured, repetitive calculations that can be expressed as
formulas that rely on a few functional relationships.
2. The parameters of the problem are subject to change.
3. The results and the underlying calculations must be documented.
4. Graphical output is often required, as well as control over the format of the
graphs.
Spreadsheets allow the analyst to develop an application rapidly, without being
inundated by the housekeeping details of programming languages. They relieve
the analyst of the drudgery of number crunching but still focus on problem
formulation. Computer spreadsheets created in Excel are integrated throughout all
chapters in this book. More on spreadsheet modeling can be found in Appendix A.
1.5 Try Your Skills
The number in parentheses that follows each problem refers to the section
from which the problem is taken. Solutions to these problems can be found in
Appendix G.
1-A. For every penny that the price of gasoline goes up, the U.S. Postal Service
(USPS) experiences a monthly fuel cost increase of $8 million. State what
assumptions you need to make to answer this question: “How many mail
delivery vehicles does the USPS have in the United States?”
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CHAPTER 1 / INTRODUCTION TO ENGINEERING ECONOMY
1-B. Assume that your employer is a manufacturing firm that produces several
different electronic consumer products. What are five nonmonetary factors
(attributes) that may be important when a significant change is considered in
the design of the current bestselling product? (1.2, 1.3)
1.6 Summary
In this chapter, we defined engineering economy and presented the fundamental
concepts in terms of seven basic principles (see pp. 3–6). Experience has shown
that most errors in engineering economic analyses can be traced to some violation
of these principles. We will continue to stress these principles in the chapters that
follow.
The seven-step engineering economic analysis procedure described in this
chapter (see p. 7) has direct ties to the engineering design process. Following this
systematic approach will assist engineers in designing products and systems and
in providing technical services that promote the economic welfare of the company
they work for. This same approach will also help you as an individual make sound
financial decisions in your personal life.
In summary, engineering economy is a collection of problem-solving tools and
techniques that are applied to engineering, business, and environmental issues.
Common, yet often complex, problems involving money are easier to understand
and solve when you have a good grasp on the engineering economy approach to
problem solving and decision making. The problem-solving focus of this text will
enable you to master the theoretical and applied principles of engineering economy.
Problems
The number in parentheses that follows each problem
refers to the section from which the problem is taken.
1-1. Stan Moneymaker needs 15 gallons of
gasoline to top off his automobile’s gas tank. If
he drives an extra eight miles (round trip) to a gas
station on the outskirts of town, Stan can save $0.10
per gallon on the price of gasoline. Suppose gasoline
costs $3.90 per gallon and Stan’s car gets 25 mpg for
in-town driving. Should Stan make the trip to get less
expensive gasoline? Each mile that Stan drives creates
one pound of carbon dioxide. Each pound of CO2 has
a cost impact of $0.02 on the environment. What other
factors (cost and otherwise) should Stan consider in his
decision making? (1.2)
1-2. The decision was made by NASA to abandon
rocket-launched payloads into orbit around the earth.
We must now rely on the Russians for this capability.
Use the principles of engineering economy to examine
this decision. (1.2)
1-3. A typical discounted price of a AAA battery
is $0.75. It is designed to provide 1.5 volts and
1.0 amps for about an hour. Now we multiply volts and
amps to obtain power of 1.5 watts from the battery. Thus,
it costs $0.75 for 1.5 Watt-hours of energy. How much
would it cost to deliver one kilo Watt-hour? How does
this compare with the cost of energy from your local
electric utility at $0.10 per kilo Watt-hour? (1.2, 1.3)
1-4. Tyler just wrecked his new Nissan, and the accident was his fault. The owner of the other vehicle got
two estimates for the repairs: one was for $803 and
the other was for $852. Tyler is thinking of keeping
the insurance companies out of the incident to keep
his driving record “clean.” Tyler’s deductible on his
comprehensive coverage insurance is $500, and he
does not want his premium to increase because of the
accident. In this regard, Tyler estimates that his semiannual premium will rise by $60 if he files a claim
against his insurance company. In view of the above
information, Tyler’s initial decision is to write a personal
check for $803 payable to the owner of the other vehicle.
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PROBLEMS
Did Tyler make the most economical decision? What
other options should Tyler have explored? In your
answer, be sure to state your assumptions and quantify
your thinking. (1.3)
1-5. Henry Ford’s Model T was originally
designed and built to run on ethanol. Today,
ethanol (190-proof alcohol) can be produced with
domestic stills for about $0.85 per gallon. When
blended with gasoline costing $4.00 per gallon, a
20% ethanol and 80% gasoline mixture costs $3.37 per
gallon. Assume fuel consumption at 25 mpg and engine
performance in general are not adversely affected with
this 20–80 blend (called E20). (1.3)
a. How much money can be saved for 15,000 miles of
driving per year?
b. How much gasoline per year is being converted if
one million people use the E20 fuel?
1-6. The Russian air force is being called on this year
to intercept storms advancing on Moscow and to seed
them with dry ice and silver iodine particles. The
idea is to make the snow drop on villages in the
countryside instead of piling up in Moscow. The cost of
this initiative will be 180 million rubles, and the savings
in snow removal will be in the neighborhood of 300
million rubles. The exchange rate is 30 rubles per dollar.
Comment on the hidden costs and benefits of such a
plan from the viewpoint of the villagers in terms of
dollars. (1.2)
1-7. A large electric utility company has
proposed building an $820 million combined
cycle, gas-powered plant to replace the electric
generation capacity at one of its coal-fired facilities.
Develop three other alternatives for replacing this
electric generation capacity.
1-8. Studies have concluded that a college degree is a
very good investment. Suppose that a college graduate
earns about 75% more money per hour than a highschool graduate. If the lifetime earnings of a high-school
graduate average $1,200,000, what is the expected value
of earning a college degree? (1.3)
1-9. Automobile repair shops typically recommend that their customers change their oil and oil
filter every 3,000 miles. Your automobile user’s manual
suggests changing your oil every 5,000–7,000 miles. If
you drive your car 15,000 miles each year and an oil
and filter change costs $30, how much money would
17
you save each year if you had this service performed
every 5,000 miles? (1.3)
1-10. Often it makes a lot of sense to spend some
money now so you can save more money in the
future. Consider filtered water. A high-tech water filter
cost about $60 and can filter 7,200 ounces of water. This
will save you purchasing two 20-ounce bottle of filtered
water every day, each costing $1.15. The filter will need
replacing every 6 months. How much will this filter save
you in a year’s time?
1-11. The manufacturer of Brand A automobile
tires claims that its tire can save 110 gallons of
fuel over 55,000 miles of driving, as compared to a
popular competitor (Brand B). If gasoline costs $4.00 per
gallon, how much per mile driven does this tire save the
customer (Brand A versus Brand B)?
1-12. During your first month as an employee at
Greenfield Industries (a large drill-bit manufacturer), you are asked to evaluate alternatives for
producing a newly designed drill bit on a turning
machine. Your boss’ memorandum to you has
practically no information about what the alternatives
are and what criteria should be used. The same task
was posed to a previous employee who could not
finish the analysis, but she has given you the following
information: An old turning machine valued at $350,000
exists (in the warehouse) that can be modified for the
new drill bit. The in-house technicians have given
an estimate of $40,000 to modify this machine, and
they assure you that they will have the machine ready
before the projected start date (although they have
never done any modifications of this type). It is hoped
that the old turning machine will be able to meet
production requirements at full capacity. An outside
company, McDonald Inc., made the machine seven
years ago and can easily do the same modifications
for $60,000. The cooling system used for this machine
is not environmentally safe and would require some
disposal costs. McDonald Inc. has offered to build a new
turning machine with more environmental safeguards
and higher capacity for a price of $450,000. McDonald
Inc. has promised this machine before the startup date
and is willing to pay any late costs. Your company has
$100,000 set aside for the start-up of the new product
line of drill bits. For this situation,
a. Define the problem.
b. List key assumptions.
c. List alternatives facing Greenfield Industries.
d. Select a criterion for evaluation of alternatives.
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CHAPTER 1 / INTRODUCTION TO ENGINEERING ECONOMY
e. Introduce risk into this situation.
f. Discuss how nonmonetary considerations may
impact the selection.
g. Describe how a postaudit could be performed.
1-13. The Almost-Graduating Senior Problem. Consider
this situation faced by a first-semester senior in civil
engineering who is exhausted from extensive job
interviewing and penniless from excessive partying.
Mary’s impulse is to accept immediately a highly
attractive job offer to work in her brother’s successful
manufacturing company. She would then be able to
relax for a year or two, save some money, and then
return to college to complete her senior year and
graduate. Mary is cautious about this impulsive desire,
because it may lead to no college degree at all!
a. Develop at least two formulations for Mary’s
problem.
b. Identify feasible solutions for each problem
formulation in Part (a). Be creative!
1-14. While studying for the engineering economy final
exam, you and two friends find yourselves craving a
fresh pizza. You can’t spare the time to pick up the pizza
and must have it delivered. “Pick-Up-Sticks” offers a
1-1/4-inch-thick (including toppings), 20-inch square
pizza with your choice of two toppings for $15 plus 5%
sales tax and a $1.50 delivery charge (no sales tax on
Recognition of
a problem to
be solved
delivery charge). “Fred’s” offers the round, deep-dish
Sasquatch, which is 20 inches in diameter. It is 1-3/4
inches thick, includes two toppings, and costs $17.25
plus 5% sales tax and free delivery.
a. What is the problem in this situation? Please state it
in an explicit and precise manner.
b. Systematically apply the seven principles of
engineering economy (pp. 3–6) to the problem you
have defined in Part (a).
c. Assuming that your common unit of measure is
dollars (i.e., cost), what is the better value for getting
a pizza based on the criterion of minimizing cost per
unit of volume?
d. What other criteria might be used to select which
pizza to purchase?
1-15. Storm doors have been installed on 50%
of all homes in Anytown, USA. The remaining
50% of homeowners without storm doors think they
may have a problem that a storm door could solve,
but they’re not sure. Use Activities 1, 2, and 3
in the engineering design process (Table 1-1) to help
these homeowners systematically think through the
definition of their need (Activity 1), a formal statement
of their problem (Activity 2), and the generation of
alternatives (Activity 3).
Needs definition
Problem formulation
The
design
process
Possible solutions
Analysis
Specification
(preferred alternative)
Communication
Completely
specified
solution
Figure P1-15 Figure for Problem 1-15
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PROBLEMS
The design process begins in Figure P1-15 with a
statement of need and terminates with the specifications
for a means of fulfilling that need.
1-16. Extended Learning Exercise.
Bad news: You have just wrecked your car! You need
another car immediately because you have decided
that walking, riding a bike, and taking a bus are
not acceptable. An automobile wholesaler offers you
$2,000 for your wrecked car “as is.” Also, your
insurance company’s claims adjuster estimates that
there is $2,000 in damages to your car. Because you
have collision insurance with a $1,000 deductibility
provision, the insurance company mails you a check
for $1,000. The odometer reading on your wrecked car
is 58,000 miles.
What should you do? Use the seven-step procedure
from Table 1-1 to analyze your situation. Also, identify
which principles accompany each step.
1-17. “What you do at work is your boss’ business” is
a timely warning for all employees to heed. Last year,
your company installed a new computer surveillance
program in an effort to improve office productivity.
As a courtesy, all employees were informed of this
change. The license for the software costs $30,000
per year. After a year of use, productivity has risen 10%,
which translates into a savings of $30,000. Discuss other
factors, in addition to productivity, that could have been
used to justify the surveillance software.
1-18. Owing to the rising cost of copper, in 1982 the
U.S. Mint changed the composition of pennies from 95%
copper (and 5% zinc) to 2.5% copper (and 97.5% zinc) to
save money. Your favorite aunt has a collection of 5,000
19
pennies minted before 1982, and she intends on gifting
the collection to you.
a. What is the collection’s value based on metal content
alone? Copper sells for $3.50 per pound and zinc for
$1 per pound. It takes approximately 130 pre-1982
pennies to add up to one pound of total weight.
b. If it cost the U.S. Mint $0.017 to produce a penny in
2012, is it time to eliminate pennies and round off all
financial transactions to the nearest 5 cents (nickel)?
As a matter of interest, it cost the government almost
10 cents to produce a nickel in 2012.
1-19. A home mortgage is “under water” when the
amount of money owed on it is much greater than
(say, twice) the market value of the home. Discuss the
economic and ethical issues of walking away from (i.e.,
defaulting on) an underwater loan. Assume you have
$10,000 equity in the home and your monthly payments
are $938. (1.3)
1-20. A deep-water oil rig has just collapsed
into the Gulf of Mexico. Its blowout-preventer
system has failed, so thousands of barrels of crude
oil each day are gushing into the ocean. List some
alternatives for stopping the unchecked flow of oil into
the Gulf. (1.3)
1-21. Energy can be conserved when your home
heating/cooling system works less during the
heating and cooling seasons. In fact a one degree
Fahrenheit difference in your thermostat setting can
reduce energy consumption by up to 5%. Identify the
assumptions necessary to make this statement valid for
heating and cooling a 2,000 square foot home. (1.3)
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CHAPTER 2
Cost Concepts and Design
Economics
The objective of Chapter 2 is to analyze short-term alternatives when the
time value of money is not a factor. We accomplish this with three types of
problems: 1) economic breakeven analysis; 2) cost-driven design
optimization; and 3) present economy studies.
The A380 Superjumbo’s Breakeven Point
W
hen Europe’s Airbus Company approved the A380 program in 2000,
it was estimated that only 250 of the giant, 555-seat aircraft needed to
be sold to break even. The program was initially based on expected
deliveries of 751 aircraft over its life cycle. Long delays and mounting costs,
however, have dramatically changed the original breakeven figure. In 2005, this
figure was updated to 270 aircraft. According to an article in the Financial Times
(October 20, 2006, p. 18), Airbus would have to sell 420 aircraft to break even—
a 68% increase over the original estimate. To date, only 262 firm orders for the
aircraft have been received. The topic of breakeven analysis is an integral part of
this chapter.
20
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The correct solution to any problem depends primarily on a true
understanding of what the problem really is.
—Arthur M. Wellington (1887)
2.1 Cost Terminology
There are a variety of costs to be considered in an engineering economic analysis.∗
These costs differ in their frequency of occurrence, relative magnitude, and degree
of impact on the study. In this section, we define a number of cost categories and
illustrate how they should be treated in an engineering economic analysis.
2.1.1
Fixed, Variable, and Incremental Costs
Fixed costs are those unaffected by changes in activity level over a feasible range
of operations for the capacity or capability available. Typical fixed costs include
insurance and taxes on facilities, general management and administrative salaries,
license fees, and interest costs on borrowed capital.
Of course, any cost is subject to change, but fixed costs tend to remain constant
over a specific range of operating conditions. When larger changes in usage of
resources occur, or when plant expansion or shutdown is involved, fixed costs can
be affected.
Variable costs are those associated with an operation that varies in total with
the quantity of output or other measures of activity level. For example, the costs
of material and labor used in a product or service are variable costs, because they
vary in total with the number of output units, even though the costs per unit stay
the same.
An incremental cost (or incremental revenue) is the additional cost (or revenue)
that results from increasing the output of a system by one (or more) units.
Incremental cost is often associated with “go–no go” decisions that involve a limited
change in output or activity level. For instance, the incremental cost per mile for
driving an automobile may be $0.49, but this cost depends on considerations such
as total mileage driven during the year (normal operating range), mileage expected
for the next major trip, and the age of the automobile. Also, it is common to read
about the “incremental cost of producing a barrel of oil” and “incremental cost to
the state for educating a student.” As these examples indicate, the incremental cost
(or revenue) is often quite difficult to determine in practice.
EXAMPLE 2-1
Fixed and Variable Costs
In connection with surfacing a new highway, a contractor has a choice of two sites
on which to set up the asphalt-mixing plant equipment. The contractor estimates
that it will cost $2.75 per cubic yard mile (yd3 -mile) to haul the asphalt-paving
material from the mixing plant to the job location. Factors relating to the two
mixing sites are as follows (production costs at each site are the same):
∗ For the purposes of this book, the words cost and expense are used interchangeably.
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CHAPTER 2 / COST CONCEPTS AND DESIGN ECONOMICS
Cost Factor
Average hauling distance
Monthly rental of site
Cost to set up and remove equipment
Hauling expense
Flagperson
Site A
Site B
4 miles
$2,000
$15,000
$2.75/yd3 -mile
Not required
3 miles
$7,000
$50,000
$2.75/yd3 -mile
$150/day
The job requires 50,000 cubic yards of mixed-asphalt-paving material. It is
estimated that four months (17 weeks of five working days per week) will be
required for the job. Compare the two sites in terms of their fixed, variable, and
total costs. Assume that the cost of the return trip is negligible. Which is the
better site? For the selected site, how many cubic yards of paving material does
the contractor have to deliver before starting to make a profit if paid $12 per
cubic yard delivered to the job location?
Solution
The fixed and variable costs for this job are indicated in the table shown next. Site
rental, setup, and removal costs (and the cost of the flagperson at Site B) would
be constant for the total job, but the hauling cost would vary in total amount
with the distance and thus with the total output quantity of yd3 -miles (x).
Cost
Rent
Setup/removal
Flagperson
Hauling
Fixed
√
√
√
Variable
√
Site A
Site B
= $8,000
= 15,000
=
0
4(50,000)($2.75) = 550,000
Total:
= $28,000
= 50,000
5(17)($150) = 12,750
3(50,000)($2.75) = 412,500
$573,000
$503,250
Site B, which has the larger fixed costs, has the smaller total cost for the
job. Note that the extra fixed costs of Site B are being “traded off” for reduced
variable costs at this site.
The contractor will begin to make a profit at the point where total revenue
equals total cost as a function of the cubic yards of asphalt pavement mix
delivered. Based on Site B, we have
3($2.75) = $8.25 in variable cost per yd3 delivered
Total cost = total revenue
$90,750 + $8.25x = $12x
x = 24,200 yd3 delivered.
Therefore, by using Site B, the contractor will begin to make a profit on the
job after delivering 24,200 cubic yards of material.
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SECTION 2.1 / COST TERMINOLOGY
2.1.2
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Direct, Indirect, and Standard Costs
These frequently encountered cost terms involve most of the cost elements that
also fit into the previous overlapping categories of fixed and variable costs. Direct
costs are costs that can be reasonably measured and allocated to a specific output
or work activity. The labor and material costs directly associated with a product,
service, or construction activity are direct costs. For example, the materials needed
to make a pair of scissors would be a direct cost.
Indirect costs are costs that are difficult to allocate to a specific output or work
activity. Normally, they are costs allocated through a selected formula (such as
proportional to direct labor hours, direct labor dollars, or direct material dollars)
to the outputs or work activities. For example, the costs of common tools, general
supplies, and equipment maintenance in a plant are treated as indirect costs.
Overhead consists of plant operating costs that are not direct labor or direct
material costs. In this book, the terms indirect costs, overhead, and burden are
used interchangeably. Examples of overhead include electricity, general repairs,
property taxes, and supervision. Administrative and selling expenses are usually
added to direct costs and overhead costs to arrive at a unit selling price for a product
or service. (Appendix 2-A provides a more detailed discussion of cost accounting
principles.)
Standard costs are planned costs per unit of output that are established in
advance of actual production or service delivery. They are developed from
anticipated direct labor hours, materials, and overhead categories (with their
established costs per unit). Because total overhead costs are associated with a certain
level of production, this is an important condition that should be remembered when
dealing with standard cost data (for example, see Section 2.4.2). Standard costs play
an important role in cost control and other management functions. Some typical
uses are the following:
1. Estimating future manufacturing costs
2. Measuring operating performance by comparing actual cost per unit with the
standard unit cost
3. Preparing bids on products or services requested by customers
4. Establishing the value of work in process and finished inventories
2.1.3
Cash Cost versus Book Cost
A cost that involves payment of cash is called a cash cost (and results in a cash flow)
to distinguish it from one that does not involve a cash transaction and is reflected
in the accounting system as a noncash cost. This noncash cost is often referred to as a
book cost. Cash costs are estimated from the perspective established for the analysis
(Principle 3, Section 1.2) and are the future expenses incurred for the alternatives
being analyzed. Book costs are costs that do not involve cash payments but rather
represent the recovery of past expenditures over a fixed period of time. The most
common example of book cost is the depreciation charged for the use of assets such
as plant and equipment. In engineering economic analysis, only those costs that
are cash flows or potential cash flows from the defined perspective for the analysis
need to be considered. Depreciation, for example, is not a cash flow and is important in
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CHAPTER 2 / COST CONCEPTS AND DESIGN ECONOMICS
an analysis only because it affects income taxes, which are cash flows. We discuss
the topics of depreciation and income taxes in Chapter 7.
2.1.4
Sunk Cost
A sunk cost is one that has occurred in the past and has no relevance to estimates of
future costs and revenues related to an alternative course of action. Thus, a sunk
cost is common to all alternatives, is not part of the future (prospective) cash flows,
and can be disregarded in an engineering economic analysis. For instance, sunk
costs are nonrefundable cash outlays, such as earnest money on a house or money
spent on a passport.
The concept of sunk cost is illustrated in the next simple example. Suppose
that Joe College finds a motorcycle he likes and pays $40 as a down payment,
which will be applied to the $1,300 purchase price, but which must be forfeited if
he decides not to take the cycle. Over the weekend, Joe finds another motorcycle
he considers equally desirable fo...
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