Introduction to Engineering Economics
Engineering economics is the application of economic techniques to the evaluation of design and engineering alternatives. It plays a critical role in decision-making by assessing the appropriateness of a project, estimating its value, and justifying it from an engineering standpoint.
Ideally, engineering decisions are not just about technical feasibility; they are about allocating limited resources to maximize value.
Key Takeaways
- The Core Mission: Engineering economy is the systematic evaluation of the economic merits of proposed solutions to engineering problems. It blends technical feasibility with economic rationality.
- Focus on Alternatives: The primary function is to help decision-makers choose the best alternative among competing options based on financial viability.
- Maximizing Value: Decisions aim to allocate scarce resources (money, time, labor, materials) efficiently to maximize long-term value for the organization or society.
Principles of Engineering Economics
The foundation of engineering economic analysis rests on seven fundamental principles. These guide the decision-making process.
Seven Fundamental Principles
- Develop the Alternatives: The choice (decision) is among alternatives. The alternatives need to be identified and then defined for subsequent analysis.
- 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.
- Use a Consistent Viewpoint: The prospective outcomes of the alternatives, economic and other, should be consistently developed from a defined viewpoint (perspective).
- 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 and comparison of alternatives.
- 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.
- 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.
- Revisit Your Decisions: Improved decision making results from an adaptive process; to the extent practical, the initial projected outcomes of the selected alternative should be subsequently compared with the actual results achieved.
Key Takeaways
- Structured Decision Making: The 7 principles mandate a consistent, rigorous approach: clearly define alternatives, focus only on differences, maintain a consistent viewpoint, and use a common monetary unit.
- Account for Uncertainty: Always explicitly recognize and account for risk and uncertainty in future estimates.
- Continuous Feedback: Revisit decisions by comparing projected outcomes with actual results to improve future estimating accuracy.
Cost Concepts and Terminology
Understanding cost terminology is crucial for accurate economic analysis. Errors in classifying costs can lead to incorrect decisions.
Direct and Indirect Costs
Checklist
- Direct Costs: Costs that can be reasonably measured and allocated to a specific output or work activity (e.g., direct materials, direct labor).
- Indirect Costs (Overhead): Costs that are difficult to attribute or allocate to a specific output or work activity (e.g., administrative salaries, rent, utilities). These are often allocated based on a formula or percentage.
Fixed, Variable, and Incremental Costs
Fixed Costs
Costs that remain constant regardless of the level of activity or output over a feasible range of operations. These are often referred to as "overhead" or "indirect costs."
- Examples: Insurance, property taxes, license fees, administrative salaries, rent.
Variable Costs
Costs that vary in total directly with the quantity of output or level of activity.
- Examples: Direct material cost, direct labor cost, fuel, power.
Marginal and Incremental Costs
Marginal Cost is the additional cost that results from increasing the output of a system by one single unit. Incremental Cost is the additional cost associated with a choice of one alternative over another, which may involve a block or batch of additional units.
Recurring and Nonrecurring Costs
Recurring Costs
Costs that are repetitive and occur when an organization produces similar goods or services on a continuing basis. These are easier to estimate.
Nonrecurring Costs
Costs that are one-time expenses, typically associated with starting a new project or capability.
- Examples: Research and development (R&D), initial construction, specialized equipment purchase.
Sunk Costs
Sunk Costs
A sunk cost is a cost that has occurred in the past and has no relevance to estimates of future costs and revenues related to an alternative course of action. It is money already spent and irretrievable.
Rule: Sunk costs should be ignored in engineering economic analysis. Decisions should be based on future cash flows, not past expenditures.
To elaborate, sunk costs represent money that has already been spent and cannot be recovered, regardless of what future action is taken. Because they remain the same across all possible future alternatives, they do not provide any differentiating value for decision-making. Allowing sunk costs to influence decisions can lead to irrational choices, a cognitive bias known as the "sunk cost fallacy."
Opportunity Costs
Opportunity Cost
Opportunity cost is the potential benefit lost by choosing one alternative over another. It represents the value of the best rejected (foregone) opportunity. It is a critical concept in decision-making when resources are limited.
In engineering economics, resources such as capital, time, and personnel are strictly limited. Committing these resources to Project A inherently means they cannot be used for Project B. The opportunity cost is therefore the hidden "cost" of the lost return that Project B would have generated. A rigorous economic analysis must always evaluate whether the chosen path offers a higher return than the best available alternative.
- Example: If a company uses its own warehouse for a project, the opportunity cost is the rent it could have earned by leasing that warehouse to another party.
Life-Cycle Cost
Life-cycle cost refers to the summation of all costs related to a product, structure, system, or service during its entire life span, from inception to disposal.
Procedure
- Acquisition Phase: Needs assessment, conceptual design, detailed design.
- Investment Phase: Construction, manufacturing, installation.
- Operation Phase: Operation, maintenance, support.
- Disposal Phase: Retirement, recycling, salvage.
Key Takeaways
- Direct vs. Indirect: Direct costs are easily traceable to a specific project; indirect costs (overhead) are shared and must be allocated.
- Fixed vs. Variable: Fixed costs remain constant over a feasible range of output; variable costs fluctuate directly with production volume.
- Sunk Costs: Past expenditures that cannot be recovered. They are completely irrelevant to future economic decisions and must be ignored.
- Opportunity Costs: The hidden cost of rejecting the next-best alternative when resources are limited. Crucial for assessing true economic viability.
- Life-Cycle Costs: The total cost of ownership from cradle to grave, encompassing acquisition, operation, maintenance, and disposal.
The General Economic Environment
Engineering projects exist within a market economy driven by supply and demand and are influenced by various market structures and behavioral laws.
Consumer and Producer Goods
Checklist
- Consumer Goods: Products or services that are directly used by people to satisfy their wants (e.g., food, clothing, cars).
- Producer Goods: Products or services used to produce consumer goods or other producer goods (e.g., machine tools, factory buildings, raw materials).
Supply and Demand
Checklist
- Law of Demand: As the price of a good increases, the quantity demanded decreases, assuming other factors remain constant (ceteris paribus).
- Law of Supply: As the price of a good increases, the quantity supplied increases.
Equilibrium
Market equilibrium occurs where the quantity demanded equals the quantity supplied. At this price point, there is no shortage or surplus.
Elasticity of Demand
Price elasticity of demand measures how responsive the quantity demanded is to a change in price.
Checklist
- Elastic Demand: A small change in price leads to a large change in quantity demanded. This usually applies to luxury goods or goods with many substitutes.
- Inelastic Demand: A change in price leads to a very small change in quantity demanded. This usually applies to necessities (like basic food or medicine).
- Unitary Elasticity: The percentage change in quantity demanded is exactly equal to the percentage change in price.
Market Structures
The economic environment is also defined by the level of competition in the market.
Types of Market Structures
- Perfect Competition: A theoretical market structure where there are many buyers and sellers, homogeneous products, perfect information, and free entry/exit. No single entity can influence the market price.
- Monopoly: A market structure characterized by a single seller, selling a unique product in the market. The seller faces no competition and has considerable control over the price.
- Oligopoly: A market structure where a small number of large firms dominate the market. Decisions of one firm significantly impact the others (e.g., the auto industry or airline industry).
- Monopolistic Competition: A market structure with many firms selling products that are similar but differentiated. Firms have some control over price but face competition from close substitutes (e.g., restaurants, clothing brands).
Law of Diminishing Returns
Law of Diminishing Returns
This principle states that if one factor of production (like labor) is increased while other factors (like capital or land) are held constant, the marginal output (the additional output gained from the extra unit of input) will eventually decrease.
In an engineering context, this means simply adding more workers to a construction site won't indefinitely speed up the project proportionally; eventually, the site becomes overcrowded and productivity drops.
Key Takeaways
- Market Dynamics: Engineering projects operate within a broader economic system dictated by the fundamental laws of supply, demand, and elasticity.
- Market Structure Influence: The competitive environment (monopoly vs. perfect competition) dictates pricing strategies and profitability.
- Diminishing Returns: Recognizing that continuous addition of variable inputs to fixed inputs eventually yields lower marginal returns is vital for optimizing production and project management.