1 2 04 4 Cost Analysis 4 1 Introduction 4 1 1 Historical Background Engineering economics can be defined as the art and science of getting the most for your money One of the first books on engineering economics was The Economic Theory of Railway Location by Arthur M Wellington This pioneer who published his first edition in 1877 was appalled that the railway engineers apparently disregarded the influence of their locations upon the prospective costs and revenues of their railways He complained there is no field of professional labor in which a limited amount of modest incompetence at 150 per month can set so many picks and shovels and locomotives at work to no purpose whatever This serious condemnation indicates that the planners didn t really plan They didn t plan so that operating costs would be minimized and revenues maximized Such concern finally led Wellington to state a classic definition of engineering Engineering is the art of doing well for one dollar what any bungler can do for two This rather trite definition should stimulate our thinking so that we are continually conscious of costs in any engineering design situation Nearly all engineering problems involve economic considerations and cost comparisons Wellington s classic remark was his way of emphasizing this fact In most design situations the costs which should be compared are not immediate ones but rather long range ones That is overall or life cycle costs for different approaches should be compared An analytical designer will be more immediately concerned with the initial costs of producing a machine rather than the life cycle costs However it should be kept in mind that operating costs maintenance costs product liability costs cost of capital interest lost etc as well as initial costs will in the long run decide the fiscal success of the product In our free enterprise system in the long run a design engineer s career and salary will depend on whether the engineer s company is able to realize a profit The engineer s accurate estimation of costs will help predict whether a profit is possible The engineer s sound decisions based in part on costs are vital to profitable production 4 1 2 A Basic Principle of Cost Analysis In a new design situation one has to choose the best approach from a number of alternate approaches This selection process is based upon selected design criteria which include both performance and cost factors Quite obviously the best approach from a cost viewpoint is based upon cost comparisons among the various candidate approaches To act on this simple principle is generally difficult primarily because the true best 56 1 2 04 approach may elude the designer The above comments are more pertinent to the conceptual designer than the analytical designer The analytical designer is concerned with optimizing the system after the best approach has been selected Therefore the cost studies are directed more toward the selection of components to yield an optimum system To avoid the omission of an alternate way which is really better than those considered the design engineer should make a serious study of all available literature and should establish dialogues with experts in the various areas related to the design situation 4 1 3 The Time Value of Money Economics almost always enters into engineering decisions In many cases cost is the major determining factor The time value of money cannot be neglected in determining the total cost of venturing into a new project particularly when comparing alternative methods of accomplishing the task The following example is adapted from Brown The basic problem can be illustrated by an example An existing company has decided to manufacture a new product A market study has produced estimates of sales volume prices etc However the method of manufacture has not yet been settled although all the possibilities except two have been eliminated for a variety of reasons Regardless of how the product is made its sale is expected to bring in an average of 200 000 per year Furthermore costs involved in sales distribution raw materials etc are expected to average 85 000 per year One of the methods of manufacture call it method A uses semi automatic machines The additional yearly expenses for labor maintenance power the out ofpocket expenses are 50 000 The machines will cost 250 000 to buy and install and are expected to last 10 years and be practically worthless after that time The other method method B uses an automatic machine which is more expensive to buy 400 000 initial cost and 10 year life but which cuts out of pocket expenses to 30 000 per year Suppose we analyze the two methods looking at an average year Method A Gross income from sale of product 200 000 Sales distribution material etc 85 000 Labor maintenance power etc 50 000 Depreciation 25 000 The machines cost a total of 250 000 and are used up over a 10 year period This averages to 25 000 per year 160 000 Total annual cost Profit Income Cost 40 000 57 1 2 04 Method B Gross income from sale of product 200 000 Sales distribution materials etc 85 000 Labor maintenance power etc 30 000 Depreciation one tenth of 400 000 40 000 155 000 Total annual cost Profit Income Cost 45 000 So you might conclude that if all the estimates are correct the company will make 5 000 more profit per year by adopting method B NOT SO One very important item has been overlooked To adopt method A an investment of 250 000 is required to purchase the machines to adopt B requires and investment of 400 000 This is a very much different kind of expenditure than for example wages to labor Wages are paid on a weekly basis To a major extent they are paid out of current income coming in from the sale of product But the expenditure to buy manufacturing machinery must come before any products have been made The company must already have the necessary capital Now if the company is considering method B it must have the necessary 400 000 If it adopts B the entire amount is invested and the 45 000 profit is the profit from that investment On the other hand if method A is adopted only 250 000 need be invested in machinery What will be done with the remaining 150 000 It could be left in a checking account buried in a tin can or hidden in a mattress In none of those places however will it be working and there are many places where it can be invested to earn more money Suppose the company knows a place where 8 interest on investment can be earned If method A is