Module 1: Introduction

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.
Outline Module 1
What is Economics?
What is Engineering Economy?
The Role of Engineering in Shaping the Economic
Environment
Project Life Cycle
Some Concepts, Definitions and Terminologies
Time Value of Money
Interest and Interest Rate
Cash Flow

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What is Economics?
The study of how limited resources are used to satisfy
unlimited human wants.
The study of how individual and societies choose to use
and utilize scarce resources
Resources:
LAND all gifts of nature that can be applied to the process
(production)
LABOR efforts, skills, expertise, knowledge of people which
can be applied to the process
CAPITAL human, tools/machineries, financial

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What is Engineering Economy?
Engineering and the Economy
Any endeavor, including engineering, will always have consequences
Engineering endeavor
Add value betterment of effectiveness, efficiency, changing conditions
Add economic value the most common comparable measurement
Example:
Economic decisions
A piece of equipment has been used for 10 years as part of important
process. Current condition indicates that service level is slightly decrease,
often breaks down. On the other hand the demand for product is in
constant increase, at least for the next 5 years.
Alternatives:
Replaced with a new one or to be repaired
Current and future technology (?)
Future demand (?)

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Engineering Economy
Deals with the concepts and techniques of analysis useful
for evaluating the worth of goods, services, system in
relation to cost
For engineers, it is used to answer questions such as:
Which engineering projects are worthwhile?
Which engineering projects should have higher priority?
How should an engineering project be designed?
The answers based on the concepts of:
Cash flows (cash in and cash out)
Interest rate and time value of money
Equivalent techniques

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The Role of Engineering in Shaping the
Economic Environment
Engineering Options
There are many (engineering) alternative solution for any
problem or challenge
What solution is best to satisfy? For now or anytime in the
future
How do we compare one to another?
Engineering Steps
1. Determine objectives
2. Identification of strategic factors
3. Determine means engineering proposals
4. Evaluation of engineering proposals cash flow of
alternatives
5. Decision making economic evaluation

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Project Life Cycle
Concept &
Definition Phase
Next Cycle
Design Phase

Construction Phase

Level of Change Operation & Maintenance Phase

scope cost

Time

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Time Value of Money
Purchasing or earning power of money
Funds borrowed for the prospects of gain are commonly
exchanged for goods, services or instruments of production,
that ultimately leads to increase earning
Time value of money
What you could buy with Rp. 1 million a year ago will not be
the same with the ones you buy today.
Rp. 1 million you invested in a bank a year ago will yield more
when you draw today.
Rp 1 million today is worth more than a year latter.
Concept of equivalence different sums of money at different
time can be equal in economic value.
Rp. 1 Mill P F Rp. 1 Mill
+ interest

0 1 2 3 n-1 n
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Interest and Interest Rate
Interest is defined as a rental amount charged by financial institution
of the use of money
Interest rate (also known as rate of capital growth) is defined as the
rate gain received from an investment measured in %
Interest rate is determined mutual agreement between the
borrower and the lender, or by market forces involving supply and
demand market value.
From lenders point of view:
Involves risk of default
Compensate for not taking other alternative (including for own use)
Cost of investigating borrower and other administrative expenses
To make up for inflation
From borrowers point of view:
Based in ones utility, for personal use
Based on expected return, for financing operation or investment

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Basic Calculation of Interest
Rp. 1 Mill P F Rp. 1 Mill
+ interest

0 1 2 3 n-1 n

Original investment present value (P)

Total accumulated amount future value (F)
Interest , I = F P
Interest rate, i = (interest accrued per unit time) /
(original amount)

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Simple Interest
Simple interest = (principal)(number of periods)(interest rate), I = P.n.i
Accumulated amount, F = P + I = P(1+ni)

i=12%
End of Amount Owed at Interest Amount Owed at Amount Paid at
Period Beginning of Period Charged End of Period End of Period
(A) (B) (C) = (B) x i (D) = (B) + (C)
1 Rp. 1.000.000,- Rp. 120.000,- Rp. 1.120.000,- Rp. 0
2 Rp. 1.120. 000,- Rp. 120.000,- Rp. 1.240.000,- Rp. 0
3 Rp. 1.240.000,- Rp. 120.000,- Rp. 1.360.000,- Rp. 0
4 Rp. 1.360.000,- Rp. 120.000,- Rp. 1.480.000,- Rp. 1.480.000,-

EXCEL

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 Compound Interest
Compound interest interest will be charged for all unpaid amount
Accumulated amount, F = P(1+i)n
End of Amount Owed at Interest Charged Amount Owed at Amount Paid at
Period Beginning of Period (C) = (B) x i End of Period End of Period
(A) (B) = (C)n-1 (D) = (B) + (C) (E)
1 Rp. 1.000.000,- Rp. 120.000,- Rp. 1.120.000,- Rp. 0,-
2 Rp. 1.120. 000,- Rp. 134.400,- Rp. 1.254.400,- Rp. 0,-
3 Rp. 1.254.400,- Rp. 150.528,- Rp. 1.404,928- Rp. 0,-
4 Rp. 1.404.928,- Rp. 168.592,- Rp. 1.573.519,- Rp. 1.573.519,-

End of Amount Owed at Interest Amount Owed at End of Period

Period Beginning of Period Charged
1 P Pi P + Pi = P (1+i)1
2 P(1+i) P(1+i) i P(1+i) 1 + P(1+i)i = P (1+i) 2
3 P(1+i) 2 P(1+i) 2i P(1+i) 2 + P(1+i) 2.i = P (1+i) 3
n P(1+i) n-1 P(1+i) n-1i P(1+i) n-1 + P(1+I) n-1i = P(1+i) n EXCEL

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Exercise for Concept of Equivalence
Loan: $ 5,000, i = 8%, n = 5
Repayment plans:
Plan 1: Simple interest, pay all at end.
Plan 2: Compound interest, pay all at end.
Plan 3: Simple interest paid annually, principal repaid at end.
Plan 4: Compound interest and portion of principal repaid
annually.
Plan 5: Equal payments of compound interest and principal
made annually.

EXCEL

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Cash Flows
Any undertaking and/or business endeavor (including
engineering projects) generally have economic consequences
that occur over an extended period of time.
Each project is described as cash received (inflow cash in) or
disbursement or expenses (outflow cash out) at different
point in time.
Cash Flow Diagram (CFD) summarizes the costs and benefits
of engineering project over time. CFD illustrates the size, sign
and timing of individual cash flows and form as the basis for
engineering economic analysis

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Cash Flows Diagram
In a CFD the end of period t is the same as the
beginning of next period t+1
The choice of time 0 is arbitrary. It can be when the
project is analyzed, when funding is approved or when
the construction begins

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Homework #1
1. What will be the accumulated amount of Rp 1.750.000,-
compounded annually for three years at the rate of 15% p.a?
2. How much do you have to save now if youd like to have
Rp. 12.500.000,- to start a new company 3 years from now at
the interest rate of 12% per year?
3. What is the rate of return of an initial investment worth Rp.
30 millions that yield Rp. 45.000.000,- after 3 years?
4. An initial investment of Rp. 50 millions is being considered.
The revenues from this investment are Rp 20 millions at the
end of first year, Rp 25 millions and Rp 15 millions at the end
of second and third years. If the alternative will give a
revenue of Rp 57,5 millions at the end of the third year, which
investment would you recommend? The interest rate is set at
10% annually.
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