Unit 2: Engineering Economics Estimating and Costing
1. Elements of Business
The essentials of starting a business called elements of the business. Some of the elements are
discussed below:
a. Business idea: Every business starts with an idea. The idea needs to be justified in respect
of its practicability and lucrativeness.
b. Entrepreneurship: The birth of business requires some sort of entrepreneurship. It is
equally applicable irrespective of the nature and size of the enterprise.
c. Forecasting: A business plan is a written description of the expected future of the business.
Forecasting helps in preparing a business plan.
d. Organization: Land, labour, and capital are the scattered means of production which are
arranged, correlated, and coordinated by the entrepreneur to turn the idea into reality.
e. Uncertainty: In the free-market economy, uncertainty is inevitable since there exits the
competition in the field of production as well as in distribution.
f. Legality: The production and distribution, i.e., the business, need to be legalized. To do so,
it has to go through a legal framework.
g. Profit-seeking motive: All activities of the business, such as procurement, production, or
creation of utilities, distribution, etc. are guided by the profit-seeking motive, i.e., a surplus
of income over expenditure.
h. Financing: Whether large or small, every business requires two types of capital – fixed
capital and working capital. Thus, the business requires ensuring finance at the lowest cost.
i. Research and Development (R&D): To be ahead and increase the market share, R&D
remains the only alternative for the business enterprise.
j. Customer Satisfaction: The business organization ensures customer satisfaction through
the creation of utilities.
2. Cost and Cost Control
Cost control refers to the process of monitoring and managing expenses within an organization
to maintain financial stability and achieve profitability. This process involves identifying and
analysing various cost factors, such as operational expenses, production costs, and overheads,
and implementing measures to reduce or optimize them.
It aims to strike a balance between minimizing costs without compromising the quality of
products or services. By effectively controlling costs, businesses can enhance their
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competitiveness, improve operational efficiency, and generate higher profits, ultimately
leading to long-term growth and success.
4.1 Benefits of cost control management
Cost control management offers numerous benefits to any organizations.
Here are the list of its key advantages:
a. Cost savings: Effective cost control management helps identify areas of excessive
spending, inefficiencies, and waste. By implementing cost-saving measures, businesses
can reduce expenses, optimize resource allocation, and improve their financial position.
b. Improved profitability: By reducing costs and increasing efficiency, cost control
management directly contributes to improved profitability. It enables businesses to
generate higher revenues, enhance profit margins, and achieve sustainable financial
growth.
c. Enhanced cash flow: Proper cost control management ensures that cash flow remains
healthy and stable. By minimizing unnecessary expenses and managing payment cycles
effectively, organizations can maintain a steady flow of funds, meet financial obligations,
and invest in growth initiatives.
d. Competitive advantage: Cost control management allows organizations to offer
competitive prices while maintaining the highest level of quality. This pricing strategy
helps attract customers, retain market share, and gain an edge over competitors in the
marketplace.
e. Resource optimization: It helps ensure that resources, including materials, labor, and
equipment, are utilized efficiently, eliminating any instances of underutilization or excess
capacity.
f. Strategic decision-making: Cost control management provides decision makers with
valuable insights and data that helps immensely in the strategic decision-making processes.
With accurate cost information, organizations can make informed choices regarding
pricing strategies, product development, market expansion, and investment decisions.
g. Operational efficiency: Effective cost control management streamlines processes and
improves overall operational efficiency. What’s more, it helps identify bottlenecks,
implement process improvements, and optimize workflow, resulting in higher productivity
and smoother operations.
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h. Risk management: Organizations can mitigate financial risks by actively monitoring and
controlling costs. It helps identify potential cost overruns, budget deviations, or unforeseen
expenses, allowing proactive measures to be taken to prevent or minimize such risks.
i. Improved financial stability: It’s no secret that maintaining a strong financial position is
vital for business sustainability. Cost control management helps in financial stability by
reducing unnecessary expenses, avoiding inessential debt, and enabling organizations to
weather economic uncertainties or market fluctuations.
j. Long-term growth: By optimizing costs and improving profitability, cost control
management frees up financial resources that can be reinvested in growth initiatives. This
capital can be utilized for research and development, marketing campaigns, talent
acquisition, technological advancements, or market expansion, fostering long-term growth
and success.
4.2 Types of Costs
a. Direct Costs: Direct costs are related to producing a good or service. A direct cost includes
raw materials, labour, and expense or distribution costs associated with producing a
product. The cost can easily be traced to a product, department, or project. For example,
Ford Motor Company (F) manufactures cars and trucks. A plant worker spends eight hours
building a car. The direct costs associated with the car are the wages paid to the worker
and the cost of the parts used to build the car.
b. Indirect Costs: Indirect costs, on the other hand, are expenses unrelated to producing a
good or service. An indirect cost cannot be easily traced to a product, department, activity,
or project. For example, with Ford, the direct costs associated with each vehicle include
tires and steel. However, the electricity used to power the plant is considered an indirect
cost because the electricity is used for all the products made in the plant. No one product
can be traced back to the electric bill.
c. Fixed Costs: Fixed costs do not vary with the number of goods or services a company
produces over the short term. For example, suppose a company leases a machine for
production for two years. The company has to pay Rs. 2,000 per month to cover the cost
of the lease, no matter how many products that machine is used to make. The lease payment
is considered a fixed cost as it remains unchanged.
d. Variable Costs: Variable costs fluctuate as the level of production output changes, contrary
to a fixed cost. This type of cost varies depending on the number of products a company
produces. A variable cost increases as the production volume increases, and it falls as the
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production volume decreases. For example, a toy manufacturer must package its toys
before shipping products out to stores. This is considered a type of variable cost because,
as the manufacturer produces more toys, its packaging costs increase, however, if the toy
manufacturer's production level is decreasing, the variable cost associated with the
packaging decreases.
e. Operating Costs: Operating costs are expenses associated with day-to-day business
activities but are not traced back to one product. Operating costs can be variable or fixed.
Examples of operating costs, which are more commonly called operating expenses, include
rent and utilities for a manufacturing plant. Operating costs are day-to-day expenses, but
are classified separately from indirect costs – i.e., costs tied to actual production. Investors
can calculate a company's operating expense ratio, which shows how efficient a company
is in using its costs to generate sales.
f. Opportunity Costs: Opportunity cost is the benefits of an alternative given up when one
decision is made over another. This cost is, therefore, most relevant for two mutually
exclusive events. In investing, it's the difference in return between a chosen investment
and one that is passed up. For companies, opportunity costs do not show up in the financial
statements but are useful in planning by management. For example, a company decides to
buy a new piece of manufacturing equipment rather than lease it. The opportunity cost
would be the difference between the cost of the cash outlay for the equipment and the
improved productivity versus how much money could have been saved in interest expense
had the money been used to pay down debt.
g. Sunk Costs: Sunk costs are historical costs that have already been incurred and will not
make any difference in the current decisions by management. Sunk costs are those costs
that a company has committed to and are unavoidable or unrecoverable costs. Sunk costs
are excluded from future business decisions.
h. Controllable Costs: Controllable costs are expenses managers have control over and have
the power to increase or decrease. Controllable costs are considered when the decision of
taking on the cost is made by one individual. Common examples of controllable costs are
office supplies, advertising expenses, employee bonuses, and charitable donations.
Controllable costs are categorized as short-term costs as they can be adjusted quickly.
4.3 Life Cycle Costs
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Life cycle costing is the process of estimating how much money you will spend on an asset
over the course of its useful life. Whole-life costing covers an asset’s costs from the time you
purchase it to the time you get rid of it.
Buying an asset is a cost commitment that extends beyond its price tag. For example, think of
a car. The car’s price tag is only part of the car’s overall life cycle cost. You also need to
consider expenses for car insurance, interest, fuel, oil changes, and any other necessary
maintenance to keep the car running. Not planning for these additional costs can set you back.
The cost to buy, use, and maintain a business asset adds up. Whether you’re purchasing a car,
a copier, a computer, or inventory, you should consider and budget for the asset’s future costs.
Conducting a life cycle cost assessment helps you better predict how much your business will
pay when you acquire a new asset.
To calculate an asset’s life cycle cost, estimate the following expenses:
a. Purchase
b. Installation
c. Operating
d. Maintenance
e. Financing (e.g., interest)
f. Depreciation
g. Disposal
Add up the expenses for each stage of the life cycle to find your total.
Life cycle costing assessment example: Let’s say you want to buy a new copier for your
business.
a. Purchase: The purchase price is $2,500.
b. Installation: You spend an additional $75 for setup and delivery.
c. Operating: You need to buy ink cartridges and paper for it, so you estimate you will
spend $1,000 on these supplies over the course of its useful life. And, you expect the
total electricity the copier will use to be $300.
d. Maintenance: If the copier breaks, you estimate repairs will total $450.
e. Financing: You purchase the copier with your store credit card, which has an interest
rate of 3.5% per month. You pay off the printer the next month, meaning you owe
$87.50 in interest ($2,500 X 3.5%).
f. Depreciation: You predict the copier will lose value by $150 each year.
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g. Disposal: You estimate it will cost $100 to hire an independent contractor to remove
the copier from your business.
Although the purchase price of the copier is $2,500, the life cycle cost of the copier could end
up costing your business over $4,500.
4.6 Break-Even Analysis
Break-even analysis is the effort of comparing income from sales to the fixed costs of doing
business. The analysis seeks to identify how much in sales will be required to cover all fixed
costs so that the business can begin generating a profit.
This activity also leads to calculating and examining the margin of safety for an entity based
on the revenues collected and associated costs. A demand-side analysis would give a seller
significant insight into selling capabilities.
4.6.1 Importance of Break-Even Analysis
a. Manages the size of units to be sold: With the help of break-even analysis, the company or
the owner comes to know how many units need to be sold to cover the cost. The variable
cost and the selling price of an individual product and the total cost are required to evaluate
the break-even analysis.
b. Budgeting and setting targets: Since the company or the owner knows at which point a
company can break-even, it is easy for them to fix a goal and set a budget for the firm
accordingly. This analysis can also be practised in establishing a realistic target for a
company.
c. Manage the margin of safety: In a financial breakdown, the sales of a company tend to
decrease. The break-even analysis helps the company to decide the least number of sales
required to make profits. With the margin of safety reports, the management can execute a
high business decision.
d. Monitors and controls cost: Companies’ profit margin can be affected by the fixed and
variable cost. Therefore, with break-even analysis, the management can detect if any
effects are changing the cost.
e. Helps to design pricing strategy: The break-even point can be affected if there is any
change in the pricing of a product. For example, if the selling price is raised, then the
quantity of the product to be sold to break-even will be reduced. Similarly, if the selling
price is reduced, then a company needs to sell extra to break-even.
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6. Investment Analysis
6.1 NPV
Net present value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows over a period of time. NPV is used in capital budgeting and
investment planning to analyse the profitability of a projected investment or project.
NPV is the result of calculations that find the current value of a future stream of payments using
the proper discount rate. In general, projects with a positive NPV are worth undertaking, while
those with a negative NPV are not.
Net present value (NPV) is used to calculate the current value of a future stream of payments
from a company, project, or investment.
To calculate NPV, you need to estimate the timing and amount of future cash flows and pick a
discount rate equal to the minimum acceptable rate of return.
The discount rate may reflect your cost of capital or the returns available on alternative
investments of comparable risk.
If the NPV of a project or investment is positive, it means its rate of return will be above the
discount rate.
If there’s one cash flow from a project that will be paid one year from now, then the calculation
for the NPV of the project is as follows:
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
𝑁𝑃𝑉 = − 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
(1 + 𝑖)𝑡
where:
i = Required return or discount rate; t = Number of time periods
6.2 ROI
Return on investment (ROI) is a performance measure used to evaluate the efficiency or
profitability of an investment or compare the efficiency of a number of different investments.
ROI tries to directly measure the amount of return on a particular investment, relative to the
investment’s cost.
To calculate ROI, the benefit (or return) of an investment is divided by the cost of the
investment. The result is expressed as a percentage or a ratio.
Return on Investment (ROI) is a popular profitability metric used to evaluate how well an
investment has performed.
ROI is expressed as a percentage and is calculated by dividing an investment's net profit (or
loss) by its initial cost or outlay.
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ROI can be used to make apples-to-apples comparisons and rank investments in different
projects or assets.
ROI does not take into account the holding period or passage of time, and so it can miss
opportunity costs of investing elsewhere.
Whether or not something delivers a good ROI should be compared relative to other available
opportunities.
The return on investment (ROI) formula is as follows:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑅𝑂𝐼 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
6.3 IRR
The internal rate of return (IRR) is a metric used in financial analysis to estimate the
profitability of potential investments. IRR is a discount rate that makes the net present value
(NPV) of all cash flows equal to zero in a discounted cash flow analysis.
IRR calculations rely on the same formula as NPV does. Keep in mind that IRR is not the actual
value of the project. It is the annual return that makes the NPV equal to zero.
Generally, the higher an internal rate of return, the more desirable an investment is to undertake.
IRR is uniform for investments of varying types and, as such, can be used to rank multiple
prospective investments or projects on a relatively even basis. In general, when comparing
investment options with other similar characteristics, the investment with the highest IRR
probably would be considered the best.
The internal rate of return (IRR) is the annual rate of growth that an investment is expected to
generate.
IRR is calculated using the same concept as net present value (NPV), except it sets the NPV
equal to zero.
The ultimate goal of IRR is to identify the rate of discount, which makes the present value of
the sum of annual nominal cash inflows equal to the initial net cash outlay for the investment.
IRR is ideal for analysing capital budgeting projects to understand and compare potential rates
of annual return over time.
In addition to being used by companies to determine which capital projects to use, IRR can
help investors determine the investment return of various assets.
6.4 Payback Period
The term payback period refers to the amount of time it takes to recover the cost of an
investment. Simply put, it is the length of time an investment reaches a breakeven point.
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People and corporations mainly invest their money to get paid back, which is why the payback
period is so important. In essence, the shorter payback an investment has, the more attractive
it becomes. Determining the payback period is useful for anyone and can be done by dividing
the initial investment by the average cash flows.
The payback period is the length of time it takes to recover the cost of an investment or the
length of time an investor needs to reach a breakeven point.
Shorter paybacks mean more attractive investments, while longer payback periods are less
desirable.
The payback period is calculated by dividing the amount of the investment by the annual cash
flow.
Account and fund managers use the payback period to determine whether to go through with
an investment.
One of the downsides of the payback period is that it disregards the time value of money.
6.5 Depreciation
Depreciation is an accounting practice used to spread the cost of a tangible or physical asset
over its useful life. Depreciation represents how much of the asset's value has been used up in
any given time period. Companies depreciate assets for both tax and accounting purposes and
have several different methods to choose from.
Depreciation allows businesses to spread the cost of physical assets (such as a piece of
machinery or a fleet of cars) over a period of years for accounting and tax purposes.
There are several different depreciation methods, including straight-line and various forms of
accelerated depreciation.
Some methods of accounting for depreciation require that the business estimate the "salvage
value" of the asset at the end of its useful life.
6.6 Time value of money (present and future value or worth of cash flows)
The time value of money (TVM) is the concept that a sum of money is worth more now than
the same sum will be at a future date due to its earnings potential in the interim. The time value
of money is a core principle of finance. A sum of money in the hand has greater value than the
same sum to be paid in the future. The time value of money is also referred to as the present
discounted value.
The time value of money means that a sum of money is worth more now than the same sum of
money in the future.
The principle of the time value of money means that it can grow only through investing, so a
delayed investment is a lost opportunity.
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Unit 2: Engineering Economics Estimating and Costing
The formula for computing the time value of money considers the amount of money, its future
value, the amount it can earn, and the time frame.
For savings accounts, the number of compounding periods is an important determinant as well.
Inflation has a negative impact on the time value of money because your purchasing power
decreases as prices rise.
6.6.1 Present value (PV) is the current value of a future sum of money or stream of cash flows
given a specified rate of return. Future cash flows are discounted at the discount rate, and the
higher the discount rate, the lower the present value of the future cash flows.
Determining the appropriate discount rate is the key to properly valuing future cash flows,
whether they be earnings or debt obligations.
Present value states that an amount of money today is worth more than the same amount in the
future.
In other words, present value shows that money received in the future is not worth as much as
an equal amount received today.
Unspent money today could lose value in the future by an implied annual rate due to inflation
or the rate of return if the money were invested.
Calculating present value involves assuming that a rate of return could be earned on the funds
over the period.
Present value is calculated by taking the expected cash flows of an investment and discounting
them to the present day.
𝐹𝑉
𝑃𝑉 =
(1 + 𝑟)𝑛
Where, FV = Future Value; r = Rate of return; n = Number of periods
6.6.2 Future Value (FV)
Future value (FV) is the value of a current asset at a future date based on an assumed rate of
growth. The future value is important to investors and financial planners, as they use it to
estimate how much an investment made today will be worth in the future.
Knowing the future value enables investors to make sound investment decisions based on their
anticipated needs. However, external economic factors, such as inflation, can adversely affect
the future value of the asset by eroding its value.
Future value can be contrasted with present value (PV).
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Future value (FV) is the value of a current asset at some point in the future based on an assumed
growth rate.
Investors are able to reasonably assume an investment’s profit using the FV calculation.
Determining the FV of a market investment can be challenging because of market volatility
and uncertainty about future investment conditions.
There are two ways of calculating the FV of an asset: FV using simple interest, and FV using
compound interest.
Future value is opposed by present value (PV); the former calculates what something will be
worth at a future date, while the other calculates what something at a future date is worth today.
𝐹𝑉 = 𝐼 × (1 + 𝑅)𝑇
where:
I = Investment amount; R = Interest rate; T = Number of years
For example, assume a Rs. 1,000 investment is held for five years in a savings account with
10% compounding interest paid annually would have an FV = 1,000 × (1 + 0.10)5 = Rs.
1,610.51.
Example for practice: Find the FV of Rs. 6,000.00 after 12 years at an interest rate of 6% per
annum. Consider compounding interest.
13. Organized and Unorganized Sectors
Primary, secondary, and tertiary sectors of the economy are the most common divisions. These
are further divided into organised and unorganised sectors based on employment conditions.
The organised sector is made up of businesses where the terms of employment are set and
predictable. As a result, people are assured of employment. Small and dispersed units that the
government does not control make up the unorganised sector; as a result, there are rules and
regulations in place, but they are not obeyed.
Differences Between Organized Sector and Unorganized Sector
Organised sector Unorganised sector
It is a sector where the employment terms The unorganised sector is characterised by
are fixed and regular, and the employees small and scattered units, which are largely
get assured work. outside the control of the government.
The job is regular and has fixed working Jobs are low-paid and often not regular.
hours. If people work more, they get paid
for the overtime by the employer.
Workers enjoy the security of employment. Employment is not secure. People can be
asked to leave without any reason.
Employes will get medical and several No benefits are available for the workers.
other benefits.
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Job security is advantageous to employee There is no such assurance of employment.
Examples: Government employees, Examples: Shopkeeping, Farming, Domestic
registered industrial workers, etc. works, etc.
14. Public and Private Sector
14.1 Public Sector
The Public Sector consists of businesses that are owned and controlled by the government of a
country. The ownership and control of the central or state governments in these organisations
are either complete or partial. But it still holds a majority stake and makes every single decision
regarding running the entity. These organisations include government agencies, state-owned
enterprises, municipalities, local government authorities and other public service institutions.
Some of them can be non-profit organisations while others participate in commercial activities
as well. It generally focuses on providing goods and services to the general public at relatively
cheaper rates than private companies. Its main aim is to ensure the welfare of the general public
within a country.
14.2 Private Sector
The Private Sector enterprises are owned, controlled and managed either by individuals or
business entities. It can be small-scale, medium-scale or even large-scale organisations. These
get formed to earn a profit from their business operations, and they can raise funding from
individuals, groups, and the general public.
The different entities within the private sector include sole proprietorship, partnership,
cooperative societies, companies and multinational corporations. They also focus on taking
care of the needs of their customers to survive in the long run. Ever since the introduction of
the New Economic Policy in 1991 by the Government of India, almost every industry in the
country has opened up to the private sector. It has led to a phenomenal increase in the size of
the Indian economy and its growth rates.
Differences between Public and Private Sector
Public Sector Private Sector
Public sector organisations are owned, Private sector organisations are owned,
controlled and managed by the government controlled and managed by individuals,
or other state-run bodies. groups or business entities.
The ownership of the public sector units can The ownership of private sector units is by
be by central, state or local government individuals or entities with zero interference
from the government.
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bodies, and this ownership is either full or
partial.
The main motive of public sector The main motive of the private sector is to
organisations is to engage in activities that earn profits from their business operations.
serve the general public.
The capital for public sector undertakings The capital for private sector entities comes
comes from tax collections, excise and either from its owners or through loans,
other duties, bonds, treasury bills etc. issuing shares and debentures, etc.
Public sector units provide several Private sector units offer benefits like higher
employment benefits like job security, salary packages, better chances of promotion
housing facilities, allowances and and recognition, competitive environment and
retirement benefits. greater incentives in terms of bonus and other
benefits.
Jobs within the public sector are very stable Jobs within the private sector are not very
since the chances of getting sacked due to secure since non-performance can lead to
non-performance are very low. sacking. Companies can also fire people in
case of cost cutting or scaling down of
operations.
The criteria for promotion in the public The criteria for promotion in the private sector
sector units is generally based on the units is generally based on the merit and job
seniority of the employee. performance of the employee.
Some of the main areas that come under the Some of the main areas that come under the
public sector are police, military, mining, private sector are information technology,
manufacturing, healthcare, education, finance, fast moving consumer goods,
transport, banking, etc. construction, hospitality, pharmaceuticals,
etc.
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