SEEM2440 Engineering Economics

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SEEM2440 Engineering Economics

Tutorial 1

Guo Weiwei

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Principles of engineering economics

Principle 1: Develop the alternatives

Principle 2: Focus on the differences

Principle 3: Use a consistent viewpoint

Principle 4: Use a common unit of measure

Principle 5: Consider all relevant criteria

Principle 6: Make uncertainty explicit

Principle 7: Revisit your decisions

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Engineering economic analysis: seven-step

procedure

Problem recognition and formulation.

Development of the feasible alternatives.

Development of the outcomes for each alternative.

Selection of criteria.

Analysis and comparison of the alternatives.

Selection of the preferred alternative.

Performance monitoring and post-evaluation of results.

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Indexes

Simple Index: Estimate of the cost in year n is

C

n

=

C

k

(

I

n

I

k

)

where

C

n

is the estimated cost of the item in year n and

C

k

is

the cost of item in reference year k.

Composite Index: we obtain an over all index by using a

weighted average approach

I

n

=

w

1

(

C

n1

/

C

k1

) +

...

+

w

m

(

C

nm

/

C

km

)

w

1

+

...

+

w

m

I

k

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Parametric Cost Estimating

Power-sizing technique

Exponential Model

X: cost capacity factor

C

A

=

C

B

(

S

A

S

B

)

X

where

S

A

is the size of Plan A and

C

A

is the cost of plan A.

Learning curve: the number of input resource unites needed to

produce output unit u is

Z

u

=

K

(

u

n

)

where K is the number of input resource unites needed to

produce the first output unit and

n

= (

logs

)

/

(

log

2) where s is

the learning curve slope parameter.

Linear regression

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Linear regression

y=a+bx

b

=

n

P

n i=1

x

i

y

i

−

(

P

n i=1

x

i

) (

P

n i=1

y

i

)

n

P

n i=1

x

2 i

−

(

P

n i=1

x

i

)

2

a

=

P

n i=1

y

i

−

b

P

n i=1

x

i

n

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Question 1(Example 1-2)

Your friend is considering investing in a two-year MBA program. Tuition costs will be $60,000 for two years while living expenses will be $25,000 per year. She has $10,000 in savings, which she can spend on her education, and will need to borrow the rest from her bank. Her annual loan repayment will be $10,500 for ten years. She currently works as an analyst and makes $60,000 a year; after she gets her degree she hopes to work as a manager for $150,000 a year. Use the seven-step procedure to answer these questions:

(a) How should your friend formulate her problem?

Solution:Your friend is debating whether or not to invest in an MBA degree. The benefit from the degree is a higher income stream for the rest of her working life, but she cannot be certain of getting her dream job. Her problem, therefore, is that of risk: she takes on a large loan of $100,000 to finance the MBA, but cannot find a job afterwards that allows her to pay it off.

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Question 1(Example 1-2)

Your friend is considering investing in a two-year MBA program. Tuition costs will be $60,000 for two years while living expenses will be $25,000 per year. She has $10,000 in savings, which she can spend on her education, and will need to borrow the rest from her bank. Her annual loan repayment will be $10,500 for ten years. She currently works as an analyst and makes $60,000 a year; after she gets her degree she hopes to work as a manager for $150,000 a year. Use the seven-step procedure to answer these questions:

(a) How should your friend formulate her problem?

Solution:Your friend is debating whether or not to invest in an MBA degree. The benefit from the degree is a higher income stream for the rest of her working life, but she cannot be certain of getting her dream job. Her problem, therefore, is that of risk: she takes on a large loan of $100,000 to finance the MBA, but cannot find a job afterwards that allows her to pay it off.

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Question 1(Example 1-2)

(b) What are her projected costs?(Identify all costs)

Solution:

Her costs include tuition and living expenses over two years of

$110,000($60,000+$25,000

×

2).

She also faces annual loan repayment of $10,500 over ten years,

generating an interest cost of $5,000($105,000-$100,000).

Finally, she also loses earning of $120,000($60,000

×

2) over two

years, because she quits her job.(Opportunity cost(Chapter 2))

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Question 1(Example 1-2)

(b) What are her projected costs?(Identify all costs)

Solution:

Her costs include tuition and living expenses over two years of

$110,000($60,000+$25,000

×

2).

She also faces annual loan repayment of $10,500 over ten years,

generating an interest cost of $5,000($105,000-$100,000).

Finally, she also loses earning of $120,000($60,000

×

2) over two

years, because she quits her job.(Opportunity cost(Chapter 2))

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Question 1(Example 1-2)

(c) Suggest alternatives to your friend to reduce the uncertainty associated with finding a high-income job to pay of her loan

Solution:

Option 1: To do a lower-cost degree, such as a part-time MBA, so that she can work at the same time. This will reduce the direct and indirect costs of the MBA program, as well as the size of the debt she will have to take on. However, her expected income after this degree is also likely to be lower. Option 2: She could postpone the MBA and save more money for it. This will reduce the size of the loan she has to take on as well as the interest costs associated with the loan. However, she will continue to earn at a lower level until she completes the MBA.

Option 3: She could choose not to do the MBA at all and continue to work at her current income level.

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Question 1(Example 1-2)

(c) Suggest alternatives to your friend to reduce the uncertainty associated with finding a high-income job to pay of her loan

Solution:

Option 1: To do a lower-cost degree, such as a part-time MBA, so that she can work at the same time. This will reduce the direct and indirect costs of the MBA program, as well as the size of the debt she will have to take on. However, her expected income after this degree is also likely to be lower. Option 2: She could postpone the MBA and save more money for it. This will reduce the size of the loan she has to take on as well as the interest costs associated with the loan. However, she will continue to earn at a lower level until she completes the MBA.

Option 3: She could choose not to do the MBA at all and continue to work at her current income level.

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Question 1(Example 1-2)

(d) Select a criterion for discriminating among alternatives, and use it

to advise your friend on which course of action to pursue.

Solution:

One criterion could be to minimize risk, in which case you

would advise her to take on either the second or the third option,

involving less or no debt.

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Question 1(Example 1-2)

(d) Select a criterion for discriminating among alternatives, and use it

to advise your friend on which course of action to pursue.

Solution:

One criterion could be to minimize risk, in which case you

would advise her to take on either the second or the third option,

involving less or no debt.

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Question 1(Example 1-2)

(e) Attempt to analyze and compare the alternatives in view of at

least one criterion in addition to cost.

Solution:

”Credit worthiness” could be an additional criterion,

whereby she is concerned about her credit rating. In this case, taking

on any kind of debt without a guaranteed job at the end of the MBA

would be ruled out. Hence, option (3) may be her only option.

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Question 1(Example 1-2)

(e) Attempt to analyze and compare the alternatives in view of at

least one criterion in addition to cost.

Solution:

”Credit worthiness” could be an additional criterion,

whereby she is concerned about her credit rating. In this case, taking

on any kind of debt without a guaranteed job at the end of the MBA

would be ruled out. Hence, option (3) may be her only option.

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Question 1(Example 1-2)

(f) What should your friend do based on the information you and she

have generated?

Solution:

In order to reduce uncertainty regarding employment, your

friend should gather information on the state of the job market in

both the geographical area and the sector in which she wants to

work. She should find out which MBA programs are particularly

strong at driving recruitment in her chosen job sector. She could also

try to negotiate a job with a desired employer before starting the

MBA program.

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Question 1(Example 1-2)

(f) What should your friend do based on the information you and she

have generated?

Solution:

In order to reduce uncertainty regarding employment, your

friend should gather information on the state of the job market in

both the geographical area and the sector in which she wants to

work. She should find out which MBA programs are particularly

strong at driving recruitment in her chosen job sector. She could also

try to negotiate a job with a desired employer before starting the

MBA program.

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Question 2(1-4)

Tyler just wrecked his new Nissan, and the accident was his fault. The owner of the other vehicle estimated that the costs for repairing was for $803. 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 annual 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. 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.

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Solution

Tyler is facing with two alternatives: 1) Pay the owner of the other car himself 2) File the claim against his insurance company

If Tyler wants to keep his Nissan for five more years (an assumption), costs: 1) $803

2) (803−500) + 5×60 = $603

If Tyler wants to keep his Nissan for ten more years (an assumption), costs: 1) $803

2) (803−500) + 10×60 = $903

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Solution

2) (803−500) + 5×60 = $603

2) (803−500) + 10×60 = $903

Assumption: The insurance premium will never drop no matter what.

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Solution

2) (803−500) + 5×60 = $603

2) (803−500) + 10×60 = $903

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Solution

Other option for Tyler:

What we don’t know in this problem is the age and condition of

the other car. If we assume it’s an clunker, another option for

Tyler is to offer to buy the other car and fix it himself and then

sell it over the internet.

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Question 3

Prepare a composite (weighted) Index for housing construction costs

in 2008, using the following data

Type of Housing

percent

reference year

2008

Single Units

70

41

62 Duplex Units

5

38

57

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Solution

I

2008

=

70 ×

(62

/

41) + 5

×

(57

/

38) + 25

×

(53

/

33)

100 = 1

.

54

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Question 4

If 2,722 labor hours are required for the first production unit and

1000 labor hours are required for the seventh production unit,

determine the learning curve parameter s.

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Solution

K=2,722

s is unknown

n=log s/log 2

The time needed to produce 7th term is

Z

7

=

K

(7

n

) = 2

,

722 ×

7

n