🏭Intro to Industrial Engineering Unit 12 – Engineering Economics & Cost Analysis

Key Concepts and Terminology

• Engineering economics focuses on the economic aspects of engineering decisions and projects
• Cost estimation techniques include bottom-up, top-down, and parametric methods
• Break-even analysis determines the point at which total revenue equals total costs
  • Fixed costs remain constant regardless of production volume (rent, salaries)
  • Variable costs change with production volume (materials, labor)
• Depreciation is the decrease in value of an asset over time due to wear and tear or obsolescence
• Net present value (NPV) is the difference between the present value of cash inflows and outflows over a period of time
• Internal rate of return (IRR) is the discount rate that makes the NPV of a project equal to zero
• Sensitivity analysis assesses the impact of changes in key variables on project outcomes
• Monte Carlo simulation is a technique for modeling the probability of different outcomes in a process that cannot easily be predicted

Time Value of Money

• Time value of money (TVM) is the concept that money available now is worth more than an identical sum in the future due to its potential earning capacity
• Present value (PV) is the current value of a future sum of money or stream of cash flows given a specified rate of return
  • Calculated using the formula: $PV = FV / (1 + r)^n$, where FV is future value, r is the discount rate, and n is the number of periods
• Future value (FV) is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today
  • Calculated using the formula: $FV = PV * (1 + r)^n$
• Annuities are a series of equal payments or receipts that occur at evenly spaced intervals over a fixed period of time
• Perpetuities are a type of annuity that continues forever, with no end date
• Compounding is the process of generating earnings on an asset's reinvested earnings
  • Compound interest is calculated on the initial principal and the accumulated interest from previous periods
• Discounting is the process of determining the present value of a payment or a stream of payments that is to be received in the future

Cost Classification and Estimation

• Direct costs are expenses that can be directly attributed to the production of a specific product or service (raw materials, labor)
• Indirect costs are expenses that cannot be directly attributed to a specific product or service (overhead, administration)
• Fixed costs remain constant regardless of changes in production volume (rent, insurance)
• Variable costs change in proportion to the volume of production (materials, labor)
• Semi-variable costs have both fixed and variable components (utilities, maintenance)
• Opportunity cost is the potential benefit that is missed or given up when choosing one alternative over another
• Sunk costs are expenses that have already been incurred and cannot be recovered
• Incremental costs are the additional costs incurred when making a decision or taking an action
  • Relevant for decision-making, as they represent the difference in costs between alternatives

Break-Even Analysis

• Break-even analysis determines the point at which total revenue equals total costs
• Break-even point (BEP) is the level of production at which total revenue equals total costs
  • Calculated using the formula: $BEP = Fixed Costs / (Price - Variable Cost per Unit)$
• Contribution margin is the difference between the selling price and the variable cost per unit
  • Represents the amount available to cover fixed costs and generate profit
• Operating leverage is the degree to which a company or project relies on fixed costs in its cost structure
  • Higher operating leverage means greater sensitivity to changes in sales volume
• Margin of safety is the difference between actual sales and break-even sales
  • Represents the amount by which sales can decrease before the company starts incurring losses
• Target profit analysis determines the level of sales needed to achieve a desired profit
• Cost-volume-profit (CVP) analysis is a method for analyzing the relationship between costs, volume, and profit

Depreciation Methods

• Straight-line depreciation allocates an equal amount of depreciation expense over each year of an asset's useful life
  • Calculated using the formula: $(Cost - Salvage Value) / Useful Life$
• Declining balance depreciation allocates a higher depreciation expense in the early years of an asset's life and less in later years
  • Calculated using the formula: $Book Value * Depreciation Rate$, where the depreciation rate is a multiple of the straight-line rate
• Sum-of-the-years' digits (SOYD) depreciation allocates a decreasing depreciation expense over the asset's useful life based on a fraction of the asset's remaining life
  • Calculated using the formula: $(Cost - Salvage Value) * (Remaining Life / SOYD)$, where SOYD is the sum of the digits of the asset's useful life
• Units of production depreciation allocates depreciation expense based on the actual usage or output of an asset
  • Calculated using the formula: $(Cost - Salvage Value) * (Units Produced / Total Estimated Units)$
• Modified Accelerated Cost Recovery System (MACRS) is a depreciation method used for tax purposes in the United States
  • Assigns assets to specific recovery periods and uses a combination of declining balance and straight-line methods

Project Evaluation Techniques

• Net present value (NPV) is the difference between the present value of cash inflows and outflows over a period of time
  • A positive NPV indicates a profitable project, while a negative NPV suggests an unprofitable one
• Internal rate of return (IRR) is the discount rate that makes the NPV of a project equal to zero
  • A higher IRR indicates a more desirable project
• Payback period is the length of time required to recover the initial investment in a project
  • Calculated by dividing the initial investment by the annual cash inflow
• Discounted payback period is the length of time required to recover the initial investment, considering the time value of money
• Benefit-cost ratio (BCR) is the ratio of the present value of benefits to the present value of costs
  • A BCR greater than 1 indicates a profitable project
• Profitability index (PI) is the ratio of the present value of future cash flows to the initial investment
  • A PI greater than 1 suggests a profitable project
• Equivalent annual cost (EAC) is the annualized cost of owning and operating an asset over its entire lifespan
  • Useful for comparing projects with different lifespans or costs

Decision Making Under Uncertainty

• Uncertainty refers to situations where the outcomes of a decision are not known with certainty
• Expected value is the weighted average of all possible outcomes, where each outcome is multiplied by its probability
  • Calculated using the formula: $\sum (Outcome * Probability)$
• Decision trees are graphical representations of decisions and their possible consequences
  • Used to analyze decisions under uncertainty by mapping out different scenarios and their probabilities
• Sensitivity analysis assesses the impact of changes in key variables on project outcomes
  • Helps identify the most critical variables and the range of values for which a project remains viable
• Scenario analysis evaluates the potential outcomes of a project under different sets of assumptions or scenarios
  • Typically considers best-case, worst-case, and most likely scenarios
• Monte Carlo simulation is a technique for modeling the probability of different outcomes in a process that cannot easily be predicted
  • Involves running multiple simulations with randomly generated input values to estimate the range of possible outcomes
• Risk analysis is the process of identifying, assessing, and prioritizing risks associated with a project or decision
  • Helps develop strategies to mitigate or manage potential risks

Applications in Industrial Engineering

• Facility location and layout decisions involve determining the optimal location and arrangement of facilities to minimize costs and maximize efficiency
• Production planning and scheduling aims to optimize resource allocation and minimize production time while meeting demand
  • Involves balancing production capacity, inventory levels, and customer service
• Inventory management focuses on determining the optimal level of inventory to minimize costs while ensuring adequate supply
  • Considers factors such as demand variability, lead times, and holding costs
• Supply chain management involves coordinating the flow of goods, services, and information from raw materials to end customers
  • Aims to minimize costs, improve efficiency, and enhance customer satisfaction
• Project management applies engineering economic principles to plan, execute, and control projects within time, cost, and quality constraints
• Cost-benefit analysis is used to evaluate the economic feasibility of investments in new technologies, processes, or products
  • Compares the expected benefits to the estimated costs to determine if a project is worthwhile
• Maintenance and replacement decisions involve determining the optimal timing and strategy for maintaining or replacing equipment
  • Considers factors such as maintenance costs, downtime, and the cost of new equipment
• Quality control and improvement initiatives aim to reduce defects, improve product quality, and minimize quality-related costs
  • Utilizes tools such as statistical process control, Six Sigma, and Lean manufacturing principles