2 Introduction and Motivation Discussion TopicsRational decision-making processThe role of engineers in businessWhat makes engineering economics decisions difficult?Strategic decisionsThe fundamental principles in engineering economics
4 A Little Google History 1995Developed in dorm room by Larry Page and Sergey Brin, graduate students at Stanford UniversityNicknamed BackRub (reflecting great taste… )1998Raised $25 million to set up Google, Inc.Ran 100,000 queries a day out of a garage in Menlo Park2005Over 4,000 employees worldwideOver 8 billion pages indexedEstimated market value over $100 billionAs of today, the value of Google is likely to be in the hundreds of billions range
5 Rational Decision-Making Process Recognize the decision problemCollect all needed (relevant) informationIdentify the set of feasible decision alternativesDefine the key objectivesand constraintsSelect the best possible and implementable decision alternative
6 A Simple Illustrative Example: Car to Lease – Saturn or Honda? Recognize the decision problemCollect all needed (relevant) informationIdentify the set of feasible decision alternativesDefine the key objectivesand constraintsSelect the best possible and implementable decision alternativeNeed to lease a carGather technical andfinancial dataSelect cars to considerWanted: small cash outlay, safety, good performance, aesthetics,…Choice between Saturn and Honda (or others)Select Honda
7 Engineering Economic Decisions Needed e.g. in the following (connected) areas:Profit! Then continueat the next stage…ManufacturingDesignFinancialplanningInvestmentand loanMarketing
8 What Makes Engineering Economic Decisions Difficult What Makes Engineering Economic Decisions Difficult? Predicting the FutureEstimating the required investmentsEstimating product manufacturing costsForecasting the demand for a brand new productEstimating a “good” selling priceEstimating product life and the profitability of continuing production
9 The Role of Engineers in Business Create & DesignEngineering ProjectsAnalyzeProduction MethodsEngineering SafetyEnvironmental ImpactsMarket AssessmentEvaluateExpectedProfitabilityTiming ofCash FlowsDegree ofFinancial RiskEvaluateImpact on Financial StatementsFirm’s Market ValueStock Price
10 Accounting vs. Engineering Economy Evaluating past performanceEvaluating and predicting future eventsAccountingEngineering EconomyPastFuturePresent
11 Key Factors in Selecting Good Engineering Economic Decisions Objectives, available resources, time and uncertaintyare the key defining aspects of allengineering economic decisions
12 Large-Scale Engineering Projects These typicallyrequire a large sum of investmentcan be very riskytake a long time to see the financial outcomeslead to revenue and cost streams that are difficult to predictAll the above aspects (and some others not listed here) point towards the importance of EEA
13 Types of Strategic Engineering Economic Decisions in the Manufacturing Sector Service ImprovementEquipment and Process SelectionEquipment ReplacementNew Product and Product ExpansionN.B. Cost reduction or profit maximization can be seen as generic (common, eventual) objectivesIn the most general sense, we have to make decisions under resource constraints, and in presence of uncertainty – not only in the EEA context
14 Example 1: Healthcare Service Improvement 1 Traditional Plan: Patients visit the service providers2 New Strategy: Service providers visit the patientsWhich one of the two plansis more economical? Theanswer typically depends onthe type of patients and theservices offered. Examples?12service providerspatients
15 Example 2: Equipment and Process Selection How do you choose between using alternative materials for an auto body panel?The choice of material will dictate the manufacturing process and the associated manufacturing costs
16 Example 3: Equipment Replacement Problem Key question:When is the right time to replace an old machine or equipment?
17 Example 4: New Product and Product Expansion Shall we build or acquire a new facility to meet the increased (increasing forecasted) demand?Is it worth spending money to market a new product?
18 Example 5: MACH 3 Project R&D investment: $750 million(!) Product promotion through advertising: $300 million(!)Priced to sell at 35% higher than the preceding Sensor Excel model (i.e., about $1.50 extra per razor)Question 1: Would consumers pay $1.50 extra for a shave with greater smoothness and less irritation?Question 2: What happens if the blade consumption drops more than 10% – due to the longer blade life of the new razor?...
19 Example 6: Cost Reduction Should a company buy new equipment to perform an operation that is now done manually?Should we spend money now, in order to save more money later?The answer obviously depends on a number of factors; can you name some of these?
20 Further Areas of Strategic Engineering Economic Decisions in the Service Sector Commercial TransportationLogistics and DistributionHealthcare IndustryElectronic Markets and AuctionsFinancial Engineering and BankingRetailHospitality and EntertainmentCustomer Service and Maintenance
21 U.S. Gross Domestic Product (GDP) Distribution by Sector Manufacturing 14%Healthcare 14%Agriculture 2%Total 30%Service sector 70%
22 The Four Fundamental Principles of Engineering Economics 1: An instant dollar is worth more than a distant dollar…2: Only the relative (pair-wise) difference among the considered alternatives counts…3: Marginal revenue must exceed marginal cost, in order to carry out a profitable increase of operations4: Additional risk is not taken without an expected additional return of suitable magnitudeBackground and explanatory notes will follow later on
23 Principle 1 An instant dollar is worth more than a distant dollar… Today6 months later
24 Principle 2 Only the cost (resource) difference among alternatives counts OptionMonthly Fuel CostMonthly MaintenanceCash paid at signing(cash outlay )Monthly paymentSalvage Value at end of year 3Buy$960$550$6,500$350$9,000Lease$2,400The data shown in the green fields are irrelevant items for decisionmaking, since their financial impact is identical in both cases
25 Principle 3 Marginal (unit) revenue has to exceed marginal cost, in order to increase production Manufacturing cost1 unitMarginalrevenueSales revenue1 unit
26 Principle 4 Additional risk is not taken without a suitable expected additional return Investment ClassPotentialRiskExpectedReturnSavings account (cash)Lowest1.5%Bond (debt)Moderate4.8%Stock (equity)Highest11.5%A simple illustrative example. Note that all investments implysome risk: portfolio management is a key issue in finances
27 SummaryThe term engineering economic decision refers to any investment or other decision related to an engineering projectThe five main types of engineering economic decisions are (1) service improvement, (2) equipment and process selection, (3) equipment replacement, (4) new product and product expansion, and (5) cost reductionThe factors of time, resource limitations and uncertainty are key defining aspects of any investment projectNotice that all listed decision types can be seen and modeled as a constrained decision (optimization) problemQuestion: are you familiar with the basic optimization concepts? If not, then a brief introduction will be presented (soon)