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Module 1 – Lecture Module 1 – Lecture 2 2

INTRODUCTION TO INTRODUCTION TO ECONOMIC DECISION ECONOMIC DECISION

AND COSTS AND COSTS ESTIMATIONESTIMATIONDr. Sayed KasebDr. Sayed Kaseb

Grant Coordinator of the VISION Grant Coordinator of the VISION ProjectProject

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Module 1 - Lecture 2 Overview

2.1 Types of Strategic Engineering Economic Decisions2.2 Costs2.3 Cost Estimating 2.4 Sources of Capital Raising 2.5 Return to Capital

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• Equipment and process selection

• Equipment replacement

• New product and product expansion

• Cost reduction

• Service and quality improvement

2.1 TYPES OF STRATEGIC ENGINEERING ECONOMIC

DECISIONS

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Energy efficiency affects the annual expense of operating an electrical device such as a pump or motor. Typically, a more energy-efficient device requires a higher capital investment than does a less energy-efficient device, but the extra capital investment usually produces annual savings in electrical power expenses relative to a second pump or motor that is less energy efficient.

If an electric pump, for example, can deliver a given horsepower (hp) or kilo Watt (kW) rating to an industrial application, the input energy requirement is determined by dividing the given output by the energy efficiency of the device. The input requirement in hp or kW is then multiplied by the annual hours that the device operates and the unit cost of electric power.

The higher the efficiency of the pump, the lower the annual cost of operating the device is relative to another less-efficient pump.

Trade-offs in energy efficiency studies

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Two pumps capable of delivering 100 hp to an agricultural application are being evaluated in a present economy study. The selected pump will only be utilized for one year, and it will have no market value at the end of that year. Their data are summarized as follows:

Example 2.1

Pump APump APump BPump B

Purchase PricePurchase Price2900 m.u.2900 m.u.6200 m.u.6200 m.u.

Annual Annual maintenancemaintenance

170 m.u.170 m.u.510 m.u.510 m.u.

EfficiencyEfficiency80%80%90%90%

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The annual expense of electric power for the Pump A is(100 hp/0.80)(0.746 kW/hp)(0.10 m.u./kWhr)(4.000 hr/yr)= 37300 m.u.

For the Pump B, the annual expense of electric power is (100 hp/0.90) (0.746 kW/hp) ( 0.10 m.u./kWhr)(4.000 hr/yr) = 33156 m.u.

Thus, the total annual cost of owning and operating the Pump A is 40370 m.u., while the total cost of owning and operat ing the Pump B for one year is 39866m.u.

Consequently, the more energy-efficient should be selected in this case.

Solution

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Pump B should be selected to minimize total cost.

Notice the difference in annual energy expense (4144 m.u.) that results from a 90% efficient pump relative to an 80% efficient pump.

This cost reduction more than balances the extra 3300 m.u. in capital investment and 340 m.u. in annual maintenance required for the Pump B

Conclusion

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There are many classifications for Costs, following are the important ones in engineering economy analysis.

Fixed and Variable costsFixed costs are the costs that are not affected by the level of activity over a feasible range of operation. Examples for fixed costs are; Depreciation, taxation, insurance and interest.

Variable costs are the costs that vary with the operation and level of activity.Examples for variable costs are; Labor, Energy, and maintenance.

2.2 COSTS

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In connection with surfacing a new high way 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 1.15 m.u. per cubic meter per

kilometer (m3-Km) to haul the asphalt paving from the mixing plant to

the job location. Factors relating to the two mixing sites are as follows

Example 2.2

Cost FactorSite ASite B

Average hauling distance 6 Km4.3 Km

Monthly rental of site1000 m.u.5000 m.u.

Cost to set up and remove equipment

15000 m.u.25000 m.u.

Extra-Labor (flag-person)Not required96 m.u. /day

NB: Production costs at each site is the

same

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The job requires 50000 m3 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 meter of paving material

does the contractor have to deliver before starting to make a

profit if 8.05 m.u. per cubic meter delivered to the job location?

Extra-estimated data

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Cost, m.u. FixedVariableSite ASite B

RentX= 4000= 20000

Setup/removal

X= 15000= 25000

Flag-personX05(17)(96) = 8160

HaulingX6(50000)(1.15) =

3450004.3(50000)(1.15) =

247250

Total: = 364000= 300410

Solution

The fixed and variable costs for this job must analyzed.

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Total cost = Total revenue

53160 m.u.+ 4.945 x m.u.= 8.05 x m.u.

x = 17121 m3 delivered.

Therefore by using Site B, the contractors will

begin to make a profit on the job after

delivering 17121 cubic meter of material.

Solution

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Recurring costs are the costs that are repeated when an organization

produces similar goods or services on a continuing basis.

Ex. Variable costs are recurring cost, because they repeat with each

unit of output

Nonrecurring costs are those costs which are not repetitive with the

production of a good or service.

Ex. The purchase cost for real estate upon which a plant will be built

is a nonrecurring cost as is the cost of constructing the plant itself.

Recurring and Nonrecurring costs

Cost Classification

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Cash costs are the cost that involves cash payments and results in a cash flow. Book costs are costs that do not involve cash payments but it represent the recovery of past expenditures over a fixed period of time.

Ex. Depreciation charged is a book value for the use of plant and equipment, in engineering economy these costs should be considered as it affect the cash costs for example Depreciation is not a cash cost and it is important in analysis because it affects income taxes which are a cash costs.

Cash cost and Book cost

Cost Classification

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Is the cost of forgoing the chance to earn interest (or profit) on investment fun.

Question: “Is it in my best interest to keep my home because it is all paid for?

I’m a retired person living with my son, and I have rented my former home,

valued at about 185000 m.u., for 400 m.u. per month”.

Answer: There is little reason to continue owning your former home as a

rental. To see this, consider the opportunity cost, i.e., the return you are giving

up, of ownership. The same 185000 m.u. invested in secure bonds at 7% will

provide almost 13000 m.u. in yearly income. This is many times what is

obtained from continual rental.

Opportunity Costs

Cost Classification

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Sunk costs are the unrecoverable past costs and are not relevant for decision making purposes.

Suppose the heating, ventilating and air conditioning (HVAC) system in your home has just experienced a major failure. You immediately call the Air Comfort Company for an estimate to replace your system.

Their price is 4200 m.u. and you gladly sign a contract and write a check for the required 1000 m.u. down payment. At this point the weather warms and the urgency for replacement of your defunct system eases somewhat.

You then get a second estimate for a new HVAC system. It is 3000 m.u.. You call Air Comfort back and they inform you that the 1000 m.u. down payment is not refundable!

Sunk Costs

Cost Classification

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LCC are a summation of all the costs (and some revenues) over the entire life span of a structure, or system. All amounts are expressed in monetary unit that are time-equivalent

Life Cycle Costs (LLC)

General Formula:LCC = Investment Costs + Non-Fuel O & M and Repair Costs + Replacement Costs + Energy Costs + Disposal Costs - Salvage Value (if any)

Cost Classification

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It is the process by which the present and future cost consequences of engineering design are forecast. Accurate past data can be used in estimating costs and benefits directly.

For major capital investment cost estimation process involves beside engineers active participation of many departments such as accounting, finance, marketing, sates, engineering, design, manufacturing, production, field services, and computer services.

The accuracy of estimates is largely dependent upon the experiences of the person making the estimate with similar situations.

2.3 COST ESTIMATING

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Cost Estimation Classifications

Order of magnitude, 30% ErrorOrder of magnitude, 30% ErrorSemi-detailed (budget), 15% ErrorSemi-detailed (budget), 15% ErrorDefinitive (detailed), 5% ErrorDefinitive (detailed), 5% Error

Time, Effort, Estimation Methods Time, Effort, Estimation Methods and Expertsand Experts

Sensitivity analysis is Sensitivity analysis is essentialessential

to some important itemsto some important items

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Cost Estimation Methods

Accounting RecordsAccounting Records Research and Development (R&D)Research and Development (R&D) Unit TechniqueUnit Technique Learning and ImprovementLearning and Improvement Power-Sizing MethodPower-Sizing Method

It is used for equipment and industrial plant It is used for equipment and industrial plant applying the concept “Economy of Scale”:applying the concept “Economy of Scale”:

CostCostb b = Cost= Costaa ( Size ( Sizeb b / Size/ Sizeaa)^x)^x

x may equal 0.68 …. 0.79x may equal 0.68 …. 0.79

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Cost estimation results are used for

1. Providing information used in setting a selling price for quoting, bidding, or evaluating contracts

2. Determining whether a proposal product can be made and distributed at a profit (Price = Cost + Profit).

3. Evaluating how much capital can be justified for the process changes or other improvements

4. Estimating benchmark for productivity improvement programs

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•First cost of assets. •Engineering design costs. •Operating costs (annual and incremental). •Periodic maintenance and rebuild costs.•Loan interest and principal payments.•Major expected/unexpected upgrade costs.•Income taxes.•Expenditure of corporate capital funds.

Samples of Cash Outflow Estimates

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Cost EstimationCost EstimationYour Graduation Cost can be Your Graduation Cost can be

estimated easily, you are our expert:estimated easily, you are our expert:

Secondary school (with high score)Secondary school (with high score)FECU (Prep, 1, 2, 3 and 4)FECU (Prep, 1, 2, 3 and 4)Military trainingMilitary trainingSummer technical trainingSummer technical trainingComputer and language skillsComputer and language skillsManagement, communication, thinking Management, communication, thinking and research skillsand research skillsEconomical skillsEconomical skillsWorks and hobbiesWorks and hobbies..

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2.4 SOURCES OF CAPITAL RAISING

Debt Capital1 .Bank or government

loan.2. Selling of bonds. Bonds could be classified to:Corporate bondsMunicipal bondsTreasury bondsTreasury billsZero coupon bondsRepayable on demands bondsFloating bonds

Equity CapitalPersonal funds of project owner(s).

Selling of stocks.

The stockholder shares in management, profit, and loss of the business.

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2.5 RETURN TO CAPITAL

Return to capital is an important question. This is the only way the capital supplier can judge how well was his or her capital invested. This can be a primary evaluation method for engineering projects.

Considering the return to capital a very essential part of engineering economy studies, providers and investors could think about the return to capital as interest and profit because of the following:1.Interest and profit pay the suppliers the price of using their capital during the time the capital is being used.2.Interest and profit are payments for the rise of the risk the investors takes in permitting another person or an organisation to use their capital.

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Engineering Engineering Economy Economy Module 1: Module 1:

Lectures 1-8Lectures 1-8 Dr. Mohamed F. El-RefaieDr. Mohamed F. El-Refaie

(Sunday and Tuesday, L3,L4,L5 and (Sunday and Tuesday, L3,L4,L5 and L6)L6)

Dr. Sayed KasebDr. Sayed Kaseb (Saturday and Wednesday, L1,L2,L7 (Saturday and Wednesday, L1,L2,L7

and L8)and L8)

Module 1 T

eaching T

eam

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