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Sixteenth Edition www.EngineeringBooksPdf.com 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) www.EngineeringBooksPdf.com 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 www.EngineeringBooksPdf.com Right now, in your course, there are young men and women whose engineering 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 www.EngineeringBooksPdf.com www.EngineeringBooksPdf.com ENGINEERING ECONOMY Sixteenth Edition www.EngineeringBooksPdf.com www.EngineeringBooksPdf.com 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 Dubai Madrid Hong Kong Mexico City Munich Paris Amsterdam Cape Town www.EngineeringBooksPdf.com Vice President and Editorial Director, ECS: Marcia J. Horton Executive Editor: Holly Stark Editorial Assistant: Carlin Heinle Director of Operations: Nick Sklitsis Executive Marketing Manager: Tim Galligan Marketing Assistant: Jon Bryant Senior Managing Editor: Scott Disanno Production Project Manager: Greg Dulles Operations Specialist: Linda Sager Cover Designer: Black Horse Designs Photo Researcher: Marta Samsel Image Permission Coordinator: Karen Sanatar Text Permission Coordinator: Michael Farmer Composition: Jouve India Private Limited Full-Service Project Management: Pavithra Jayapaul Printer/Binder: Courier Typeface: 10/12 Palatino Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate page within text. Copyright © 2015, 2012, 2009, 2006, 2003, 1997 by Pearson Higher Education, Inc., Upper Saddle River, NJ 07458. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright and permissions should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use materials from this work, please submit a written request to Pearson Higher Education, Permissions Department, One Lake Street, Upper Saddle River, NJ 07458. Many of the designations by manufacturers and seller to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps. 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 furnishing, performance, or use of these programs. Pearson Education Ltd., London Pearson Education Singapore, Pte. Ltd. Pearson Education Canada, Inc. Pearson Education–Japan Pearson Education Australia PTY, Limited Pearson Education North Asia, Ltd., Hong Kong Pearson Educación de Mexico, S.A. de C.V. Pearson Education Malaysia, Pte. Ltd. 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 www.EngineeringBooksPdf.com 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 www.EngineeringBooksPdf.com 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 www.EngineeringBooksPdf.com 186 187 188 189 196 197 202 213 215 218 220 222 224 236 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 www.EngineeringBooksPdf.com 368 369 370 376 381 383 385 390 393 394 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 www.EngineeringBooksPdf.com 475 476 476 483 489 493 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 www.EngineeringBooksPdf.com 575 576 576 578 578 579 579 584 592 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 www.EngineeringBooksPdf.com 598 615 619 638 642 645 648 660 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 www.EngineeringBooksPdf.com 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 www.EngineeringBooksPdf.com 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 www.EngineeringBooksPdf.com xiv www.EngineeringBooksPdf.com 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. www.EngineeringBooksPdf.com 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 www.EngineeringBooksPdf.com 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. www.EngineeringBooksPdf.com 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 www.EngineeringBooksPdf.com 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) www.EngineeringBooksPdf.com 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) www.EngineeringBooksPdf.com ENGINEERING ECONOMY Sixteenth Edition www.EngineeringBooksPdf.com www.EngineeringBooksPdf.com 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 www.EngineeringBooksPdf.com 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 www.EngineeringBooksPdf.com 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. www.EngineeringBooksPdf.com 4 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 www.EngineeringBooksPdf.com 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. www.EngineeringBooksPdf.com 6 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. www.EngineeringBooksPdf.com 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. www.EngineeringBooksPdf.com 8 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). www.EngineeringBooksPdf.com 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 www.EngineeringBooksPdf.com 10 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. www.EngineeringBooksPdf.com SECTION 1.3 / ENGINEERING ECONOMY AND THE DESIGN PROCESS 11 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. www.EngineeringBooksPdf.com 12 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 www.EngineeringBooksPdf.com SECTION 1.3 / ENGINEERING ECONOMY AND THE DESIGN PROCESS 13 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 www.EngineeringBooksPdf.com 14 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 www.EngineeringBooksPdf.com 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?” www.EngineeringBooksPdf.com 16 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. www.EngineeringBooksPdf.com 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. www.EngineeringBooksPdf.com 18 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 www.EngineeringBooksPdf.com 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) www.EngineeringBooksPdf.com 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 www.EngineeringBooksPdf.com 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. 21 www.EngineeringBooksPdf.com 22 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. www.EngineeringBooksPdf.com SECTION 2.1 / COST TERMINOLOGY 2.1.2 23 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 www.EngineeringBooksPdf.com 24 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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Oil Prices and Exchange Rate Movements
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