WHY DO ENGINEERS NEED TO LEARN ABOUT ECONOMICS? Ages ago, the most significant barriers to engineers were technological.

The things that engineers wanted to do, they simply did not yet know how to do, or hadn't yet developed the tools to do. There are certainly many more challenges like this which face present-day engineers. However, we have reached the point in engineering where it is no longer possible, in most cases, simply to design and build things for the sake simply of designing and building them. Natural resources (from which we must build things) are becoming scarcer and more expensive. We are much more aware of negative side-effects of engineering innovations (such as air pollution from automobiles) than ever before. For these reasons, engineers are tasked more and more to place their project ideas within the larger framework of the environment within a specific planet, country, or region. Engineers must ask themselves if a particular project will offer some net benefit to the people who will be affected by the project, after considering its inherent benefits, plus any negative side-effects (externalities), plus the cost of consuming natural resources, both in the price that must be paid for them and the realization that once they are used for that project, they will no longer be available for any other project(s). Simply put, engineers must decide if the benefits of a project exceed its costs, and must make this comparison in a unified framework. The framework within which to make this comparison is the field of engineering economics, which strives to answer exactly these questions, and perhaps more. The Accreditation Board for Engineering and Technology (ABET) states that engineering "is the profession in which a knowledge of the mathematical and natural sciences gained by study, experience, and practice is applied with judgment to develop ways to utilize, economically, the materials and forces of nature for the benefit of mankind".1 It should be clear from this discussion that consideration of economic factors is as important as regard for the physical laws and science that determine what can be accomplished with engineering. The following figure shows how engineering is composed of physical and economic components:

Figure 1 : Physical and Economic Components of an Engineering System

Figure 1 shows how engineering is composed of physical and economic components.

1. Physical Environment : Engineers produce products and services depending on physical

laws (e.g. Ohm's law; Newton's law). Physical efficiency takes the form: system output(s) Physical (efficiency ) = ------------------system input(s)
2. Economic Environment : Much less of a quantitative nature is known about economic

environments -- this is due to economics being involved with the actions of people, and the structure of organizations. Satisfaction of the physical and economic environments is linked through production and construction processes. Engineers need to manipulate systems to achieve a balance in attributes in both the physical and economic environments, and within the bounds of limited resources. Following are some examples where engineering economy plays a crucial role: 1. Choosing the best design for a high-efficiency gas furnace 2. Selecting the most suitable robot for a welding operation on an automotive assembly line 3. Making a recommendation about whether jet airplanes for an overnight delivery service should be purchased or leased 4. Considering the choice between reusable and disposable bottles for high-demand beverages With items 1 and 2 in particular, note that coursework in engineering should provide sufficient means to determine a good design for a furnace, or a suitable robot for an assembly line, but it is the economic evaluation that allows the further definition of a best design or the most suitable robot. In item 1 of the list above, what is meant by " high-efficiency"? There are two kinds of efficiency that engineers must be concerned with. The first is physical efficiency, which takes the form: System output(s) Economic (efficiency ) = ----------------System input(s)

For the furnace, the system outputs might be measured in units of heat energy, and the inputs in units of electrical energy, and if these units are consistent, then physical efficiency is measured as a ratio between zero and one. Certain laws of physics (e.g., conservation of energy) dictate that the output from a system can never exceed the input to a system, if these are measured in consistent units. All a particular system can do is change from one form of energy (e.g. electrical) to another (e.g., heat). There are losses incurred along the way, due to electrical resistance, friction, etc., which always yield efficiencies less than one. In an automobile, for example, 10-15% of the energy supplied by the fuel might be consumed simply overcoming the internal friction of the engine. A perfectly efficient system would be the theoretically impossible Perpetual Motion Machine! The other form of efficiency of interest to engineers is economic efficiency, which takes the form: system worth Economic (efficiency ) = ----------------system cost You might have heard economic efficiency referred to as "benefit-cost ratio". Both terms of this ratio are assumed to be of monetary units, such as dollars. In contrast to physical efficiency, economic efficiency can exceed unity, and in fact should, if a project is to be deemed economically feasible. The most difficult part of determining economic efficiency is accounting for all the factors which might be considered benefits or costs of a particular project, and converting these benefits or costs into a monetary equivalent. Consider for example a transportation construction project which promises to reduce everyone's travel time to work. How do we place a value on that travel time savings? This is one of the fundamental questions of engineering economics. In the final evaluation of most ventures, economic efficiency takes precedence over physical efficiency because projects cannot be approved, regardless of their physical efficiency, if there is no conceived demand for them amongst the public, if they are economically infeasible, or if they do not constitute the "wisest" use of those resources which they require. There are numerous examples of engineering systems that have physical design but little economic worth (i.e it may simply be too expensive !!). Consider a proposal to purify all of the water used by a large city by boiling it and collecting it again through condensation. This type of experiment is done in junior physical science labs every day, but at the scale required by a large city, is simply too costly. ROLE OF UNCERTAINTY IN ENGINEERING When conducting engineering economic analyses, it will be assumed at first, for simplicity, that benefits, costs, and physical quantities will be known with a high degree of confidence. This degree of confidence is sometimes called assumed certainty. In virtually all situations, however, there is some doubt as to the ultimate values of various quantities. Both risk and uncertainty in decision-making activities are caused by a lack of precise knowledge regarding future conditions, technological developments, synergies among funded projects, etc. Decisions under risk are decisions in which the analyst models the decision problem in terms of assumed possible future outcomes, or scenarios, whose probabilities of occurrence can be estimated. Of course, this type of

analysis requires an understanding of the field of probability. Decisions under uncertainty, by contrast, are decision problems characterized by several unknown futures for which probabilities of occurrence cannot be estimated. Other less objective means exist for the analysis of such problems. For the purposes of this brief tutorial, we cannot delve further into the analytical extensions required to accommodate risk or uncertainty in the decision process. We must recognize that these things exist, however, and be careful about reaching strong conclusions based on data which might be susceptible to these. Because engineering is concerned with actions to be taken in the future, an important part of the engineering process is improving the certainty of decisions with respect to satisfying the objectives of engineering applications. THE ENGINEERING PROCESS Engineering activities dealing with elements of the physical environment take place to meet human needs that arise in an economic setting. The engineering process employed from the time a particular need is recognized until it is satisfied may be divided into a number of phases: 1. Determination of Objectives This step involves finding out what people need and want that can be supplied by engineering. People's wants may arise from logical considerations, emotional drives, or a combination of the two. 2. Identification of Strategic Factors The factors that stand in the way of attaining objectives are known as limiting factors. Once the limiting factors have been identified, they are examined to locate strategic factors -those factors which can be altered to remove limitations restricting the success of an undertaking. A woman who wants to empty the water from her swimming pool might be faced with the limiting factor that she only has a bucket to do the job with, and this would require far greater time and physical exertion than she has at her disposal. A strategic factor developed in response to this limitation would be the procurement of some sort of pumping device which could do the job much more quickly, with almost no physical effort on the part of the woman. 3. Determination of means (engineering proposals) This step involves discovering what means exist to alter strategic factors in order to overcome limiting factors. In the previous example, one means was to buy (or rent) a pump. Of course, if the woman had a garden hose, she might have been able to siphon the water out of the pump. In other engineering applications, it may be necessary to fabricate the means to solve problems from scratch. 4. Evaluation of Engineering Proposals

It is usually possible to accomplish the same result with a variety of means. Once these means have been described fully, in the form of project proposals, economic analysis can be employed to determine which among them, if any, is the best means for solving the problem at hand. 5. Assistance in Decision Making It is commonplace for the final decision-making responsibility to fall on the head(s) of someone other than the engineer(s). The person(s) so charged, however, may not be sufficiently knowledgeable about the technical aspects of a proposal to determine its relevant worth compared to other means. The engineer can help to bridge this gap. ENGINEERING ECONOMIC STUDIES The four key steps in planning an economic study are :
1. Creative Step : People with vision and initiative adopt the premise that better opportunities

exist than are known to them. This leads to research, exploration, and investigation of potential opportunities. 2. Definition Step : System alternatives are synthesised with economic requirements and physical requirements, and enumerated with respect to inputs/outputs. 3. Conversion Step : The attributes of system alternatives are converted to a common measure so that systems can be compared. Future cash flows are assigned to each alternative, consisting of the time-value of money.
4. Decision Step : Qualitative and quantitative inputs and outputs to/from each system form

the basis for system comparison and decision making. Decisions among system alternatives should be made on the basis of their differences. For a small number of real world systems there will be complete knowledge. All facts/information and their relationships, judgements and predictive behavior become a certainty. For most systems, however, even after all of the data that can be bought to bear on it has been considered, some areas of uncertainty are likely to remain. If a decision must be made, these areas of uncertainty must be bridged by consideration of non-quantitative data/information, such as common sense, judgement and so forth. Decisions among system alternatives should be made on the basis of their differences. For a small number of real world systems there will be complete knowledge. Dll facts/information and their relationships, judgements and predictive behavior become a certainty. For most systems, however, even after all of the data that can be bought to bear on it has been considered, some areas of uncertainty are likely to remain. If a decision must be made, these areas of uncertainty must be bridged by consideration of non-quantitative data/information, such as common sense, judgement and so forth.

Examples : 1. 2. 3. 4. Infrastructure expenditure decision Replace versus repair decisions Selection of inspection method Selection of a replacement for an equipment

FUNDAMENTAL ECONOMIC CONCEPTS Economics deals with the behavior of people, and as such, economic concepts are usually qualitative in nature, and not universal in application. Marshall defined economics as "a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing. Thus it is on one side a study of wealth; and on the other, and more important side, a part of the study of man." "Economics" is usually defined as the social science concerned with analyzing and describing the production, distribution, and consumption of wealth. Robbins' Definition The study of how the forces of supply and demand allocate scarce resources. Subdivided into microeconomics, which examines the behavior of firms, consumers and the role of government; and macroeconomics, which looks at inflation, unemployment, industrial production, and the role of government. According to Adam Smith "Economics was concerned with, An Enquiry into the Nature and Causes of Wealth of Nations." UTILITY

Utility is the power of a good or service to satisfy human needs.

VALUE

Designates the worth that a person attaches to an object or service. Is a measure or appraisal of utility in some medium of exchange. Is not the same as cost or price.

CONSUMER AND PRODUCER GOODS

1. Consumer goods : Consumer goods are the goods and services that directly satisfy human

wants. For example, TV, shoes, houses.

2. Producer goods : Producer goods are the goods and services that satisfy human wants

indirectly as a part of the production or construction process. For example, factory equipment, industrial chemicals ands materials. UTILITY OF GOODS
1. Consumer goods : Basic human needs of food, clothing and shelter. In commercial

advertisements, emphasis is given to senses not reasoning. The utility in this case is considered objectively and/or subjectively. 2. Producer goods : The utility stems for their means to get to an end. The utility in this case is considered objectively. ECONOMY OF EXCHANGE 1. 2. 3. 4. Occurs when utilities are exchanged by two or more people. It is possible because consumer utilities are evaluated subjectively. Represents mutual benefit in exchange. Persuasion in exchange. Salesperson.

ECONOMY OF ORGANIZATION Through organizations, ends can be attained or attained more economically by: 1. Labor saving 2. Efficiency in manufacturing or capital use SUPPLY AND DEMAND 1. Demand curve shows the number of units people are willing to buy and cost per unit (decreasing curve). 2. Supply curve shows the number of units that vendors will offer for sale and unit price (increasing curve). 3. The intersection defines the exchange price. 4. Elasticity of demand. Price changes and their effect on demand changes. It depends on whether the consumer product is a necessity or a luxury. 5. Law of diminishing return. A process can be improved at a rate with a diminishing return. Example: cost of inspection to reduce cost of repair and lost production. INTEREST RATE Interest is a rental amount charged by financial institutions for the use of money.

1. Called also the rate of capital growth, it is the rate of gain received from an investment. 2. It is expressed on an annual basis. 3. For the lender, it consists, for convenience, of (1) risk of loss, (2) administrative expenses, and (3) profit or pure gain. 4. For the borrower, it is the cost of using a capital for immediately meeting his or her needs.

A market is defined as a group of buyers and sellers of a particular product or service. Competitive markets are markets with many buyers and sellers, so that each has a very small influence on the price. Supply and demand is the most useful model for a competitive market, and shows how buyers (citizens) and sellers (businesses) interact in that market. Quantity Demanded & Supplied The demand for a product is the amount that buyers are willing and able to purchase. Quantity demanded is the demand at a particular price, and is represented as the demand curve. The supply of a product is the amount that producers are willing and able to bring to the market for sale. Quantity supplied is the amount offered for sale at a particular price. The main determinant of supply/demand is the price of the product.

Law of Demand
The Law of Demand states that other things held constant, as the price of a good increases, the quantity demanded will fall. Other factors that can influence demand include:
1. Income - Generally, as income increases, we are able to buy more of most goods. When

demand for a good increases when incomes increase, we call that good a "normal good". When demand for a good decreases when incomes increase, then that good is called an inferior good. 2. Price of related products - Related goods come in two types, the first of which are "substitutes".Substitutes are similar products that can be used as alternatives. Examples of substitute goods are Coke/Pepsi, and butter/margarine. Usually, people substitute away to the less expensive good. Other related products are classified as "complements". Complements are products that are used in conjunction with each other. Examples of complements are pencil/eraser, left/right shoes, and coffee/sugar. 3. Tastes and preferences - Tastes are a major determinant of the demand for products, but usually does not change much in the short run. 4. Expectations - When you expect the price of a good to go up in the future, you tend to increase your demand today. This is another example of the rule of substitution, since you are substituting away from the expected relatively more expensive future consumption.

Demand Curves and Schedules Demand curves isolate the relationship between quantity demanded and the price of the product, while holding all other influences constant (in latin: ceteris paribus). These curves show how many of a product will be purchased at different prices. Note that demand is represented by the entire curve, not just one point on the curve, and represents all the possible price-quantity choices given the ceteris paribus assumptions. When the price of the product changes, quantity demanded changes, but demand does not change. Price changes involve a movement along the existing demand curve. Market demand is the summation of all the individual demand curves of those in the market. It is the horizontal sum of individual curves and add up all the quantities demanded at each price. The main interest is in market demand curves, because they are averages of individual behaviour tend to be well-behaved. When any influence other than the price of the product changes, such as income or tastes, demand changes, and the entire demand curve will shift (either upward or downward). A shift to the right (and up) is called an increase in demand, while a shift to the left (and down) is called a decrease in demand. In example, there are two ways to discourage smoking: raise the price through taxes or; make the taste less desirable.

Law of Supply
As the price of a product rises, ceteris paribus, suppliers will offer more for sale. This implies that price and quantity supplied are positively related. The major factor that influences supply is the "cost of production", and includes:
1. Input prices - As the prices of inputs such as labour, raw materials, and capital increase,

production tends to be less profitable, and less will be produced. This leads to a decrease in supply. 2. Technology - Technology relates to methods of transforming inputs into outputs. Improvements in technology will reduce the costs of production and make sales more profitable so it tends to increase the supply. 3. Expectations - If firms expect prices to rise in the future, may try to product less now and more later. Supply Curves and Schedules The relationship between the price of a product and the quantity supplied, holding all other things constant is generally sloping upwards. Supply is represented by the entire curve and not just one point on the curve. When the price of the product changes, the quantity supplied changes, but supply does not change. When cost of production changes, supply changes, and the entire supply curve will shift. Market Supply is the summation of all the individual supply curves, and is the horizontal sum of individual supply curves. It is influenced by the factors that determine individual supply curves,

such as cost of production, plus the number of suppliers in the market. In general, the more firms producing a product, the greater the market supply. When quantity supplied at a given price decreases, the whole curve shifts to the left as there is a decrease in supply. This is generally caused by an increase in the cost of production or decrease in the number of sellers. An increase in wages, cost of raw materials, cost of capital, ceteris paribus, will decrease supply. Sometimes weather may also affect supply, if the raw materials are perishable or unattainable due to transportation problems. Reaching Equilibrium We can analyze how markets behave by matching (or combining) the supply and demand curves. Equilibrium is defined as the intersection of supply and demand curves. The equilibrium price is the price where the quantity demanded matches the quantity supplied. The equilibrium quantity is the quantity where price has adjusted so that QD = QS. At the equilibrium price, the quantity that buyers are willing to purchase exactly equals the quantity the producers are willing to sell. Actions of buyers and sellers naturally tend to move a market towards the equilibrium. Excess Supply/Demand Excess Supply is where Quantity supplied > Quantity demanded, and results in surpluses at the current price. A large surplus is known as a "glut". In cases of excess supply:

price is too high to be at equilibrium suppliers find that inventories increase suppliers react by lowering prices this continues until price falls to equilibrium

Excess Demand occurs when Quantity demanded > Quantity supplied, and results in shortages at current prices. In cases of excess demand:

buyers cannot buy all they want at the going price sellers find that their inventories are decreasing sellers can raise prices without losing sales prices increase until market reaches equilibrium

Law of Supply and Demand

In free markets, surpluses and/or shortages tend to be temporary and obey the law of supply and demand, since actions of buyers and sellers tend to match prices back toward their equilibrium levels Elasticity In addition to understanding how equilibrium prices and quantities change as demand and supply change, economists are also interested in understanding how demand and supply change in

response to changes in prices and incomes. The responsiveness of demand or supply to changes in prices or incomes is measured by the elasticity of demand or supply. Price elasticity of demand and supply. The price elasticity of demand is given by the formula:

The price elasticity of supply is given by a similar formula:

If the percentage change in quantity demanded is greater than the percentage change in price, demand is said to be price elastic, or very responsive to price changes. If the percentage change in quantity demanded is less than the percentage change in price, demand is said to be price inelastic, or not very responsive to price changes. Similarly, supply is price elastic when the percentage change in quantity supplied is greater than the percentage change in price, and supply is price inelastic when the percentage change in quantity supplied is less than the percentage change in price. The price elasticity of demand or supply will differ among goods. For example, consider a 50 percent increase in the price of two goodscandy bars and prescription medicines. While the demand for both candy bars and prescription medicines should decline in response to the price increases, the percentage change in the quantity demanded of candy bars is likely to be much greater than the percentage change in the quantity demanded of prescription medicines because candy bars are less of a necessity than prescription medicines. You could summarize this finding by stating that the demand for candy bars is more price elastic than the demand for prescription medicines. Alternatively, you might state that the demand for prescription medicines is more price inelastic than the demand for candy bars. Two extreme cases. There are two cases where the price elasticity of demand or supply can take on extreme values. One is the case of perfectly price elasticdemand or supply. Demand is perfectly price elastic if for any percentage decreasein price, no matter how small, the percentage change in

quantity demanded is infinitely largedemanders demand all that they can. Supply is perfectly price elastic if for any percentage increase in price, no matter how small, the percentage change in quantity supplied is also infinitely largesuppliers supply all that they can. The other extreme case occurs when the percentage change in quantity demanded or supplied is always equal to 0, regardless of the percentage change in price. In this case, demand or supply is said to be perfectly price inelastic, or completely nonresponsive to change in prices. The two extreme cases are illustrated in Figure 1 . The demand curve D1 in Figure 1(a) illustrates the case of perfectly price elastic demand, while the supply curve S1 in Figure 1 (b) illustrates the case of perfectly price elastic supply. The demand curveD2 in Figure 1 (a) illustrates the case of perfectly price inelastic demand, and the supply curve S2 in Figure 1 (b) illustrates the case of perfectly price inelastic supply.

Figure 1

Perfectly price elastic and perfectly price inelastic demand and supply curves

Income elasticity of demand. The income elasticity of demand is given by the formula:

If the percentage change in the quantity demanded is greater than the percentage change in income,

then demand is said to be income elastic, or very responsive to changes in demanders' incomes. If the percentage change in the quantity demanded is less than the percentage change in income, then demand is said to be income inelastic, or not very responsive to changes in demanders' incomes. Notice from the definition of income elasticity that if the income elasticity of demand is positive, the good must be a normal good, and if the income elasticity of demand isnegative, the good must be an inferior good. Cross-price elasticity of demand. The cross-price elasticity of demand is the ratio of the percentage change in the quantity demanded of some good X to a percentage change in the price of some other good Y. The cross-price elasticity of demand is given by the formula:

If the percentage change in the quantity demanded of good X is greater than the percentage change in the price of good Y, the demand for good X is cross-price elastic with respect to good Y, or very responsive to changes in the price of goodY. If the percentage change in the quantity demanded of good X is less than the percentage change in the price of good Y, the demand for good X, is crossprice inelastic with respect to good Y, or not very responsive to changes in the price of good Y. From the definition of cross-price elasticity, one may also conclude that if the cross-price elasticity of demand is positive, the goods X and Y must besubstitutes, and if the cross-price elasticity of demand is negative, the goods Xand Y must be complements.

BEP ANALYSIS
Break-even analysis is a technique widely used by production management and management accountants. It is based on categorising production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production). Definition of the break-even point (BE point): (1) the amount of sales at which the net profit is zero; or (2) the point where total cost equals total revenue. Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point").

Applications:

The break-even point is one of the simplest yet least used analytical tools in management. It helps to provide a dynamic view of the relationships between sales, costs and profits. A better understanding of break-even, for example, is expressing break-even sales as a percentage of actual salescan give managers a chance to understand when to expect to break even (by linking the percent to when in the week/month this percent of sales might occur). The break-even point is a special case of Target Income Sales, where Target Income is 0 (breaking even). This is very important for financial analysis. Limitations Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices. It assumes that fixed costs (FC) are constant. Although this is true in the short run, an increase in the scale of production is likely to cause fixed costs to rise. It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. (i.e. linearity) It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period). In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant).

The Break-Even Chart In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is

known as the "break-even point" and is represented on the chart below by the intersection

of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made. Fixed Costs Fixed costs are those business costs that are not directly related to the level of production or output. In other words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business. Examples of fixed costs: - Rent and rates - Depreciation - Research and development - Marketing costs (non- revenue related) - Administration costs Variable Costs Variable costs are those costs which vary directly with the level of output. They represent payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs such as commission. A distinction is often made between "Direct" variable costs and "Indirect" variable costs. Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those working on the production line are good examples.

Indirect variable costs cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output - e.g. machine hours), maintenance and certain labour costs. Semi-Variable Costs Whilst the distinction between fixed and variable costs is a convenient way of categorising business costs, in reality there are some costs which are fixed in nature but which increase when output reaches certain levels. These are largely related to the overall "scale" and/or complexity of the business. For example, when a business has relatively low levels of output or sales, it may not require costs associated with functions such as human resource management or a fully-resourced finance department. However, as the scale of the business grows (e.g. output, number people employed, number and complexity of transactions) then more resources are required. If production rises suddenly then some short-term increase in warehousing and/or transport may be required. In these circumstances, we say that part of the cost is variable and part fixed. The formula used to calculate the number of units for break even:

Pricing policies
Activities aimed at finding a products optimum price, typically including overall marketing objectives, consumer demand, product attributes, competitors' pricing, and market and economic trends. The policy by which a company determines the wholesale and retail prices for its products or services. See also pricing strategy.

Objectives of the Price Policy;

1. Profit maximization in the short term 2. 2. Profit optimization in the long run 3. 3. Price Stabilization 4. 4. Facing competitive situation 5. 5. Maintenance of market share 6. 6. Capturing the Market

7. 7. Entry into new markets 8. 9. Achieving a target return 9. 11. Long run welfare of the firm 10. 13. Ethical Pricing

Pricing Factors to Consider;

Determine primary and secondary market segments. This helps you better understand the offering's value to consumers. Segments are important for positioning and merchandising the offering to ensure maximized sales at the established price point.

Assess the product's availability and near substitutes. Underpricing hurts your product as much as overpricing does. If the price is too low, potential customers will think it can't be that good. This is particularly true for high-end, prestige brands. One client underpriced its subscription product, yielding depressed response and lower sales. The firm underestimated the uniqueness of its offering, the number of close substitutes, and the strength of the consumer's bond with the product. As a result, the client could increase the price with only limited risk to its customer base. In fact, the initial increase resulted in more subscribers as the new price was more in line with its consumer-perceived value.

Survey the market for competitive and similar products. Consider whether new products, new uses for existing products, or new technologies can compete with or, worse, leapfrog your offering. Examine all possible ways consumers can acquire your product. I've worked with companies that only take into account direct competitors selling through identical channels. Don't limit your analysis to online distribution channels.

Competitors may define your price range. In this case, you can price higher if consumers perceive your product and/or brand is significantly better; price on parity if your product has better features; or price lower if your product has relatively similar features to existing products. An information client faced this situation with a premium product. Its direct competitors established the price for a similar offering. As the third player in this segment, its choices were price parity with an enhanced offering or a lower price with similar features. Examine market pricing and economics. A paid, ad-free site should generate more revenue than a free ad-supported one, for example. In considering this option, remember to incorporate the cost of forgone revenue, especially as advertisers find paying customers more attractive.

To gain additional insight from this analysis, observe consumers interacting with your product to better understand their connection to it. This can yield insights into how to package and promote the offering that can affect on pricing, features, and incentives. Calculate the internal cost structure and understand how pricing interacts with the offering.I recommended a content client promote its advertising-supported free e-zines to incent readers to register. The client believed the e-zines had no value as the content was repurposed

from another product, so it didn't advertise them. Yet the repurposed content was exactly what readers viewed as a benefit. By undervaluing its offering, the client missed an opportunity to increase registrations and, hence, advertising revenues with a product that effectively had no development costs. Test different price points if possible. This is important if you enter a new or untapped market, or enhance an offering with consumer-oriented benefits. To determine price, MarketingExperiments.com tested three different price points for a book. It found the highest price yielded the greatest product revenue. Interestingly, the middle price yielded greater revenue over time, as it generated more customers to whom other related products could be marketed.

Monitor the market and your competition continually to reassess pricing. Market dynamics and new products can influence and change consumer needs.

Models of pricing
Cost-plus pricing Cost-plus pricing is the simplest pricing method. The firm calculates the cost of producing the product and adds on a percentage (profit) to that price to give the selling price. This method although simple has two flaws; it takes no account of demand and there is no way of determining if potential customers will purchase the product at the calculated price. This appears in two forms, Full cost pricing which takes into consideration both variable and fixed costs and adds a % markup. The other is Direct cost pricing which is variable costs plus a % markup, the latter is only used in periods of high competition as this method usually leads to a loss in the long run. Creaming or skimming In market skimming, goods are sold at higher prices so that fewer sales are needed to break even. Selling a product at a high price, sacrificing high sales to gain a high profit is therefore "skimming" the market. Skimming is usually employed to reimburse the cost of investment of the original research into the product: commonly used in electronic markets when a new range, such as players, are firstly dispatched into the market at a high price. This strategy is often used to target "early adopters" of a product or service. These early adopters are relatively less pricesensitive because either their need for the product is more than the need to economise or they understand the value of the product better than others. This strategy is employed only for a limited duration to recover most of investment made to build the product. To gain further market share, a seller must use other pricing tactics such as economy or penetration. This method can have some setbacks as it could leave the product at a high price against the competition. Limit pricing A limit price is the price set by a monopolist to discourage economic entry into a market, and is illegal in many countries. The limit price is the price that the entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average

cost of production or just low enough to make entering not profitable. The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger than would be optimal for a monopolist, but might still produce higher economic profits than would be earned under perfect competition. The problem with limit pricing as a strategy is that once the entrant has entered the market, the quantity used as a threat to deter entry is no longer the incumbent firm's best response. This means that for limit pricing to be an effective deterrent to entry, the threat must in some way be made credible. A way to achieve this is for the incumbent firm to constrain itself to produce a certain quantity whether entry occurs or not. An example of this would be if the firm signed a union contract to employ a certain (high) level of labor for a long period of time. Loss leader A loss leader or leader is a product sold at a low price (ie at cost or below cost) to stimulate other profitable sales. Market-oriented pricing Setting a price based upon analysis and research compiled from the target market. This means that marketers will set prices depending on the results from the research. For instance if the competitors are pricing their products at a lower price, then it's up to them to either price their goods at an above price or below, depending on what the company wants to achieve. Penetration pricing 1) Penetration pricing Setting the price low in order to attract customers and gain market share. The price will be raised later once this market share is gained. Price discrimination Setting a different price for the same product in different segments to the market. For example, this can be for different ages, such as classes, or for different opening times, such as cinema tickets. Premium pricing Premium pricing is the practice of keeping the price of a product or service artificially high in order to encourage favorable perceptions among buyers, based solely on the price. The practice is intended to exploit the (not necessarily justifiable) tendency for buyers to assume that expensive items enjoy an exceptional reputation, are more reliable or desirable, or represent exceptional quality and distinction. Predatory pricing Aggressive pricing (also known as "undercutting") intended to drive out competitors from a market. It is illegal in some countries. Contribution margin-based pricing Contribution margin-based pricing maximizes the profit derived from an individual product, based on the difference between the product's price and variable costs (the product's contribution margin per unit), and on ones assumptions regarding the relationship between the products price and the number of units that can be sold at that price. The product's contribution to total firm profit (i.e. to

operating income) is maximized when a price is chosen that maximizes the following: (contribution margin per unit) X (number of units sold).. Psychological pricing Pricing designed to have a positive psychological impact. For example, selling a product at $3.95 or $3.99, rather than $4.00. Dynamic pricing A flexible pricing mechanism made possible by advances in information technology, and employed mostly by Internet based companies. By responding to market fluctuations or large amounts of data gathered from customers - ranging from where they live to what they buy to how much they have spent on past purchases - dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customers willingness to pay. The airline industry is often cited as a dynamic pricing success story. In fact, it employs the technique so artfully that most of the passengers on any given airplane have paid different ticket prices for the same flight.Price leadership 2) Price leadership An observation made of oligopolistic business behavior in which one company, usually the dominant competitor among several, leads the way in determining prices, the others soon following. The context is a state of limited competition, in which a market is shared by a small number of producers or sellers. Target pricing Pricing method whereby the selling price of a product is calculated to produce a particular rate of return on investment for a specific volume of production. The target pricing method is used most often by public utilities, like electric and gas companies, and companies whose capital investment is high, like automobile manufacturers. Target pricing is not useful for companies whose capital investment is low because, according to this formula, the selling price will be understated. Also the target pricing method is not keyed to the demand for the product, and if the entire volume is not sold, a company might sustain an overall budgetary loss on the product. Absorption pricing Method of pricing in which all costs are recovered. The price of the product includes the variable cost of each item plus a proportionate amount of the fixed costs and is a form of cost-plus pricing

COST DETERMINATION
A key objective in engineering applications is the satisfaction of human needs, which will nearly always imply a cost.
The Meaning of Classification of Cost.

Cost classification is the process of grouping costs according to their common characteristics. A suitable classification of costs is of vital importance in order to identify the cost with cost centres or cost units. Cost may be classified accounting to their nature, i.e., material, labor and expenses and a number of other characteristics. The same cost figures are classified according to different ways of costing depending upon the purpose to be achieved and requirements of particular concern. The important ways of classification are:

1. On the basis of Identity: According to this classification, the costs are divided into there
categories i.e., Materials, Labor and Expenses. There can be further sub-classification of each element; for example, material into raw material components, and spare parts, consumable stores, packing material etc. This classification is important as it helps to find total cost, how such total cost is constituted and valuation of work-in-progress. 2. On the basis of Function: Production, Administration, Selling & Distribution are three important functions of a business concern. Taking these functions into consideration, costs have been classified by: 3. (a) Production or Manufacturing Cost: Manufacturing costs are those costs which are incurred in the course of manufacture. It includes cost of raw material, cost of labour, other direct cost and factory indirect cost. Example of production or manufacturing costs may be power, lighting, heating, rent, depreciation etc. 4. (b) Office and Administration Cost: These costs are incurred for the general administration of the enterprise. It includes office costs as well as administration cost. For example, salary of office staff, rent of office building, electricity charges, audit fee, printing and stationeries etc. 5. (c) Selling and Distribution Cost: It includes both selling cost as well as distribution cost. Selling costs are those costs which are incurred in connection with the selling of goods and services Distribution costs are those costs which are incurred on despatch of finished goods to the consumers. Example of selling and distribution costs are: sales men salary, packing charges, carriage, out ward, advertisement, ware house charges etc.

6. On the basis of Variability: The behavior of cost varies from one another as production
increases, some cost remains constant or varies in direct proportion to the volume of out put, or others may vary partially. Thus on the basis of variability, costs can be classified into the following three categories. 7. (a) Fixed Cost / Period Cost: Fixed costs are those costs which remain fixed irrespective of the change in volume of out put. As production increases cost per unit of the fixed cost decreases and as production decreases fixed costs are, rent of the factory building depreciation, salary of the office manager etc. 8. (b) Variable Cost / Product Cost: Variable costs are those costs which very in direct proportion to the volume of out put. As production increases total cost increases but also per

unit remains constant. As production decreases total cost decreases and cost per unit also decreases. Example of variable costs are, cost of raw materials labor etc. 9. (c) Semi-Variable Cost / Semi-Fixed cost: These costs are partly fixed and partly variable. Examples of variable costs are telephone rent. It includes partly fixed charge up to a certain level and then varies according to the calls.

10. On the basis of controllability: From the point of view of controllability, the cost has been
classified in to two categories as controllable cost and uncontrollable cost. 11. (a) Controllable Cost: These costs are regulated or controlled by specified member of an organisation. Most of the variable costs are controllable. Generally direct material, direct labor and direct expenses are controlled by the lower level of the management. 12. (b) Uncontrollable Cost: These costs can not be regulated or controlled by specified member of an undertaking. Most of the fixed costs are uncontrollable. Example of uncontrollable costs are, factory rent, managers salary etc.

13. On the basis of normality: On this basis the costs have been classified in to two categories
as. 14. (a) Normal cost: It is the cost which is normally incurred at a given level of out put. These costs are part of cost production. 15. (b) Abnormal cost: It is the cost which is not normally incurred at a given level of out put. These costs are not charged to the cost of production. It is transferred to the costing profit and loss account.

16. On the basis of Time: On this basis the costs have been classified as
17. (a) Historical Cost: These costs are ascertained after they have been incurred such costs are available only when the production of a particular thing has already been done. 18. (b) Pre-determined Cost: Pre-determined costs are estimated costs which are set in advance on a scientific way. It becomes standard cost and compared with the actual for adopting controlling measures.

Economic analyses may be based on the elements of cost:

1. First (or initial) Cost: Cost to get activity started such as property improvement,

transportation, installation, and initial expenditures. 2. Operation and Maintenance Cost : They are experienced continually over the useful life of the activity. 3. Fixed Cost: A fixed cost arises from making preparations for the future, and includes costs associated with ongoing activities throughout the operational life-time of that concern.

4. 5.

6. 7.

Fixed costs are relatively constant; they are decoupled from the system input/output, for example. Variable Cost: Variable costs are related to the level of operational activity (e.g. the cost of fuel for construction equipment will be a function of the number of days of use). Incremental or Marginal Cost : Incremental (or marginal) cost is the additional expense that will be incurred from increased output in one or more system units (i.e. production increase). It is determined from the variable cost. Sunk Cost : It cannot be recovered or altered by future actions. Usually this cost is not a part of engineering economic analysis. Life-Cycle Cost : This is cost for the entire life-cycle of a product, and includes feasibility, design, construction, operation and disposal costs.

Determinants Of Cost
The determinants of cost varies so much from firm to firm and from problem to problem that no general set is applicable to all. Nevertheless, there are a few determinants which are important enough in modern manufacturing enterprises so as to deserve special mention. They are: (1) Rate of output (i.e., utilization of fixed plant) (2) Size of plant (3) Prices of input factors (materials and labour) (4) Technology (5) Size of lot (6) Stability of output (7) Efficiency (of management as well as labour) The word cost that we are using has different meanings in different settings. The kind of cost concepts to be used in a particular situation depends upon the business decision to be made. Hence an understanding of the meaning of various concepts is essential for clear business thinking. One way of getting clear-cut distinctions among different notions of cost is to set up several alternative bases of classifying costs and show the relevance of each for different kinds of problems. Although there are difficulties, workable approximations can be made if these concepts of cost can be developed by having (1) a clear understanding of the management problem and of the concept of cost that is relevant for it; (2) familiarity with the business and its records (2) familiarity with the business and its records an (2=3) ingenuity and boldness. These special cost

estimates are based mainly on the accounting and statistical records of the company, though sometimes they need to be supplemented by collection of special data.

TIME VALUE OF MONEY

The time-value of money is the relationship between interest and time. i.e.

Figure 2 : Time-Value of Money Money has time-value because the purchasing power of a dollar changes with time. EARNING POWER OF MONEY The earning power of money represents funds borrowed for the prospect of gain. Often these funds will be exchanges for goods, services, or production tools, which in turn can be employed to generate and economic gain. PURCHASING POWER OF MONEY The prices of goods and services can go upward or downward, and therefore, the purchasing power of money can change with time.
1. Price Reductions : Caused by increases in productivity and availability of goods. 2. Price Increases : Caused by government policies, price support schemes, and deficit

financing.

Balance sheet
A balance sheet is a statement of the total assets and liabilities of an organisation at a particular date - usually the last date of an accounting period. A quantitative summary of a company's financial condition at a specific point in time, including assets, liabilities and net worth. DEFINITION

TheWord Balance Sheet is defined as a Statement which sets out the Assets and Liabilities of a business firm and which serves to ascertain the financial position of the same onany particular date. On the left hand side of this statement, the liabilities and capital are shown. On the right hand side, all the assets are shown. Therefore the two sides of the Balance sheet must always beequal. Capital arrives Assets exceeds the liabilities. OBJECTIVES OF BALANCE SHEET
1. It shows accurate financial position of a firm.2. 2. It is a gist of various transactions at a given period.3. 3. It clearly indicates, whether the firm has sufficient assents to repay its liabilities.4. 4. The accuracy of final accounts is verified by this statement5.

5. It shows the profit or Loss arrived through Profit & Loss A/c IN GENERAL ASSETS AND LIABILITIES ARE CLASSIFIED AS FOLLOWS ASSETS: Assets represent everything which a business owns and has money value. Assets are alwaysshown as debit balance in the ledger are classified as follows.1. 1. Tangible Assets: Assets which can be seen and felt by touch are called Tangible Assets. Tangible Assets are classified into two: Fixed Assets: Assets which are durable in nature and used in business over and again are known as Fixed Assets.e.g. land and Building, Machinery, Trucks, etc.b. Floating Assets or Current Assets: Current Assets are unmeant to be converted into cash, ii. Meant for resale, iii. Likely to undergo change e.g. Cash, Balance, stock, Sundry Debtors 2. Intangible Assets: Assets which cannot be seen and has no fixed shape. E.g., goodwill, Patent. 3. Fictitious assets: Assets which have no real value and will appear on the Assets side of B/S. are known as Fictitious assets:E.g. Preliminary expenses, Discount or creditors. LIABILITIES: All that the business owes to others are called Liabilities. It also includes Proprietors Capital. They are known as credit balances in ledger. Classification of Liabilities: 1. Long Term Liabilities: Liabilities will be redeemed after a long period of time 10 to 15 years E.g. Capital, Long Term Loans 2. Current Liabilities: Liabilities, which are redeemed within a year, are called Current Liabilities or short term liabilities E.g. Trade creditors, B/P, Bank Loan. 3. Contingent Liabilities: Liabilities, which have the following features, are called contingent liabilities. They are: a.Not actual liability at present Might become a liability in future on condition that the contemplated event occurs.E.g. Liability in respect of pending suit.

Equation of Balance Sheet:

Capital = Assets Liabilities Liabilities = Assets Capital Assets = Liabilities + Capital

Classification of Assets:
The properties and possessions of a business are called assets and they are classified into the following classes: Fixed assets: Fixed assets are assets which are acquired not for sale but for permanent use in the business e.g., land and buildings, plant and machinery, furniture etc. These assets help the business to be carried on. Current Assets Or Circulating Assets or Floating Assets: Current assets denote those assets which are held for sale or to be converted into cash after some time e.g., sundry debtors. bills receivables, stock of goods etc. Liquid Assets: Liquid assets are those assets which are with us in cash or easily converted into cash e.g., cash in hand, cash at bank, investments etc. Wasting Assets: The assets that depreciate through "wear and tear", whose values expire with lapse of time or that become exhausted through working are known as wasting assets. This is a sub-class of fixed assets e.g., plant machinery, mines etc. Intangible or Fictitious Assets: There are assets which have no physical existence. Which can neither be seen with eyes not touched with hands. These are called intangible assets or fictitious assets. They do not represent any thing valuable. They include debit balance of profit and loss account, goodwill etc. Contingent Assets: A contingent asset is one which comes into existence upon the happening of a certain event. If that event happens the asset becomes available, otherwise not. For example uncalled capital of a limited company. Outstanding Assets:

Expenses paid in advance i.e., prepaid expenses, and income earned but not received are known as outstanding assets.

Classification of Liabilities:
The liabilities of a business are classified as follows: Fixed Liabilities: These are the liabilities which are payable immediately or in the near future. These liabilities are payable after a long period. Long term loans, capital of the proprietor are the examples of such kind of liabilities. Current Liabilities: These are the liabilities which are payable immediately or in the near future, such as creditors, bank loans etc. Contingent Liabilities: Contingent liabilities are those liabilities which arise only on the happening of some event. The event may or may not happen. Thus a contingent liability may or may not involve the payment of money. Examples of contingent liabilities are: 1. Liabilities on bills discounted: In case the bill is dishonored by the acceptor, the holder may be called upon to pay the amount to the discounter. 2. Liability under guarantee: In case the debtor fails to fulfill his obligation, the man who has given a guarantee or surety have to make good the loss to the creditor. 3. Liability in respect of a pending suit: A suit pending against a person in a court is a contingent liability because if the decision of the court goes against him, he may thereby become liable to pay compensation. Contingent liabilities are not recorded in the books not they are included in the balance sheet. They are simply referred to by way of foot notes on the balance sheet. Outstanding Liabilities: Outstanding expenses and unearned income are examples of outstanding liabilities.

The function of the correctly prepared balance sheet is to exhibit the true and correct view of the state of affairs of any concern. In a balance sheet as the assets and liabilities are shown in details after being properly valued, a trader can judge the position of his business from it 1. The Order of Liquidity or Realizability:

According to this method assets are entered up in the balance sheet following the order in which they can be converted into cash and the liabilities in the order in which they can be paid off. The following is a format of a balance sheet based on this order: Balance Sheet as at .......... Liabilities Bills Payable Loans Trade Creditors Capital Rs. Assets Cash in hand Cash at Bank Investments Bills Receivables Debtors Stock (Closing) Stores Furniture & Fixtures Plant & Machinery Land & Buildings Rs.

2. The Order of Permanence: This method is the reverse of the first method. Under this method the assets are stated according to their permanency i.e., permanent assets are shown first and less permanent are shown one after another. Similarly the fixed liabilities are stated first and the floating liabilities follow. The following is a specimen of a balance sheet based on this order: Balance Sheet as at .......... Liabilities Capital Trade Creditors Loans Bills Payable Rs. Assets Land & Buildings Plant & Machinery Furniture & Fixtures Stores Stock (Closing) Debtors Bills Receivables Investments Cash at Bank Cash in hand Rs.

DEPRECIATION

Depreciation refers to two very different but related concepts:

1. 2.

the decrease in value of assets (fair value depreciation), and

the allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle). Depreciation is a non-cash expense that reduces the value of an asset over time. Assets depreciate for two reasons:

Wear and tear. For example, an auto will decrease in value because of the mileage, wear on tires, and other factors related to the use of the vehicle. Obsolescence. Assets also decrease in value as they are replaced by newer models. Last year's car model is less valuable because there is a newer model in the marketplace.

Definition of 'Appreciation' An increase in the value of an asset over time. The increase can occur for a number of reasons including increased demand or weakening supply, or as a result of changes in inflation or interest rates. This is the opposite of depreciation, which is a decrease over time. This term can be used to refer to an increase in any type of asset such as a stock, bond, currency or real estate. For example, the term capital appreciation refers to an increase in the value of financial assets such as stocks, which can occur for reasons such as improved financial performance of the company.

When to depreciate? when it meets the following criteria. 1. 1. Must be used for business purposes. 2. 2. Determine life longer than a year 3. 3. Decaying, wearing out, or losing value to the owner

Depreciation Rules
1. 1. Almost all tangible property can be depreciated 2. 2. Land is not depreciated 3. 3. Do not depreciate; factory inventory, leased assets, and equipment used to make capitol improvements. 4. 4. Be careful mixing business and personal.

Depreciation is calculated as follows:

The original cost of the asset, including costs of acquiring the asset, transporting it, and setting it up

Less the salvage value (the "scrap" value) Divided over the years of useful life of the asset.

Characteristics of depreciation:
a) It is related to fixed assets only. b) It is a fall in the book value of an asset. c) The fall in the book value of an asset s due to the use of the asset in business operations, effluxion of time, obsolescence, expiration of legal rights or any other cause. d) It is a permanent decrease in the book value of an asset. e) It is a continuous decrease in the book value of an asset.

Causes of depreciation:
The main causes of depreciation include the following: a) Physical wear and tear When the fixed assets are put to use, the value of such assets may decrease. Such decrease in the value of assets is said to be due to physical wear and tear. b) With the passage of time When the assets are exposed to the forces of nature like weather, winds, rains, etc. the value of such assets may decrease even if they are not put to any use.. c) Changes in economic environment The value of an asset may decrease due to decrease in the demand of the asset. The demand of the asset may decrease due to technological changes, changes in the habits of consumers etc. d) Expiration of legal rights When the use of an asset (e.g. patents, leases) is governed by the time bound arrangement, the value of such assets may decrease with the passage of time. In our introduction to the methods available to calculate depreciation, we suggested that there are two main methods that can be used:

What method of Depresciation should be use and what is involved:

There are two main methods of calculating depreciation: "Prime cost," straight line or fixed instalment method. "Diminishing value or" reducing balance method. It is a matter of choice which of the two methods is selected. "Prime cost" gives a constant charge from year to year, whilst "Diminishing Value" decreases from year to year so that the earlier years bear a larger allocation of the asset's cost. The latter method is equal to one and-a-half times the prime cost depreciation rate. Once a method has been chosen, it should not be varied but rates should be subject to an annual review to reflect useful life, usage, obsolescence and net amount anticipated on disposal.

In either case an agreed percentage (see below) is deducted from the value of the asset each year. The difference between the two methods is the figure upon which the calculation is made. "For example:" For most general items of plant and equipment. In our introduction to the methods available to calculate depreciation, we suggested that there are two main methods that can be used: - Straight- line depreciation - Reducing balance method We emphasised the point that these two methods simply provide an alternative way of allocating the total depreciation charge over several accounting periods. The total depreciation charge using either method will be the same over the total useful economic life of the asset. To illustrate the straight line depreciation method, we have calculated the depreciation charge for the following asset: Data A business purchases a new machine for 75,000 on 1 January 2003. It is estimated that the machine will have a residual value of 10,000 and a useful economic life of five years. The business has an accounting year end of 31 December. Straight line depreciation method Using the straight line depreciation method, the calculation of the annual depreciation charge is as follows: Dpn = (C- R)/ N where: Dpn = Annual straight-line depreciation charge C = Cost of the asset R = Residual value of the asset N = Useful economic life of the asset (years) So the calculation is: Dpn = (75,000 - 10,000) / 5 Dpn = 13,000 in the accounts of the business a depreciation charge of 13,000 will be expensed in the profit and loss account for each of the five years of the asset's useful economic life.

In the annual balance sheet, the machine would be shown at its original cost less the total accumulated depreciation for the asset to date

COST - BENEFIT ANALYSIS

What is cost benefit analysis? Cost benefit analysis (COBA) is a technique for assessing the monetary social costs and benefits of a capital investment project over a given time period. The principles of cost-benefit analysis (CBA) are simple:
1. Appraisal of a project: It is an economic technique for project appraisal, widely used in

business as well as government spending projects (for example should a business invest in a new information system) 2. Incorporates externalities into the equation: It can, if required, include wider social/environmental impacts as well as private economic costs and benefits so that externalities are incorporated into the decision process. In this way, COBA can be used to estimate the social welfare effects of an investment 3. Time matters! COBA can take account of the economics of time known as discounting. This is important when looking at environmental impacts of a project in the years ahead

Uses of COBA
COBA has traditionally been applied to big public sector projects such as new motorways, bypasses, dams, tunnels, bridges, flood relief schemes and new power stations. Our example later considers some of the social costs and benefits of the new Terminal 5 for Heathrow airport. The basic principles of COBA can be applied to many other projects or programmes. For example, -public health programmes (e.g. the mass immunization of children using new drugs), an investment in a new rail safety systems, or opening a new railway line. Another example might be to use COBA in assessing the costs and benefits of introducing congestion charges for motorists in London. Or the costs and benefits of the New Deal programme designed to reduce long-term unemployment. Cost benefit analysis was also used during the recent inquiry into genetically modified foods. Increasingly the principles of cost benefit analysis are being used to evaluate the returns from investment in environmental projects such as wind farms and the development of other sources of renewable energy, an area where the UK continues to lag behind. Because financial resources are scarce, COBA allows different projects to be ranked according to those that provide the highest expected net gains in social welfare - this is particularly important given the limitations of government spending.

The Main Stages in the Cost Benefit Analysis Approach

At the heart of any investment appraisal decision is this basic question does a planned project lead to a net increase in social welfare?

o o

o o

Stage 1(a) Calculation of social costs & social benefits. This would include calculation of: o Tangible Benefits and Costs (i.e. direct costs and benefits) o Intangible Benefits and Costs (i.e. indirect costs and benefits externalities) This process is very important it involves trying to identify all of the significant costs & benefits Stage 1(b) - Sensitivity analysis of events occurring this relates to an important question If you estimate that a possible benefit (or cost) is x million, how likely is that outcome? If you are reasonably sure that a benefit or cost will occur what is the scale of uncertainty about the actual values of the costs and benefits? Stage 2: - Discounting the future value of benefits - costs and benefits accrue over time. Individuals normally prefer to enjoy the benefits now rather than later so the value of future benefits has to be discounted Stage 3: - Comparing the costs and benefits to determine the net social rate of return Stage 4: - Comparing net rate of return from different projects the government may have limited funds at its disposal and therefore faces a choice about which projects should be given the go-ahead

Evaluation: Criticisms of COBA

There are several objections to the use of CBA for environmental impact assessment:
1. Problems in attaching valuations to costs and benefits: Some costs are easy to value such as

the running costs (e.g. staff costs) + capital costs (new equipment). Other costs are more difficult not least when a project has a significant impact on the environment. The value attached to the destruction of a habitat is to some priceless and to others worthless. Costs are also subject to change over time I.e. the construction costs of a new bridge over a river or the introduction of electronic road pricing 2. The CBA may not cover everyone affected (i.e. all third parties) inevitably with major construction projects such as a new airport or a new road, there are a huge number of potential stakeholders who stand to be affected (positively or negatively) by the decision. COBA cannot hope to include all stakeholders there is a risk that some groups might be left out of the decision process a. Future generations are they included in the analysis? b. What of non-human stakeholders?
1. Distributional consequences: Costs and benefits mean different things to different income

groups - benefits to the poor are usually worth more (or are they?). Those receiving benefits and those burdened with the costs of a project may not be the same. Are the losers to be compensated? To many economists, the equity issue is as important as the efficiency argument. 2. Social welfare is not the same as individual welfare - What we want individually may not be what we want collectively. Do we attach a different value to those who feel passionately about something (for example the building of new housing on greenfield sites) contrasted with those who are more ambivalent?

3. Valuing the environment: How are we to place a value on public goods such as the

environment where there is no market established for the valuation of property rights over environmental resources? How does one value nuisance and aesthetic values? 4. Valuing human life: Some measurements of benefits require the valuation of human life many people are intrinsically opposed to any attempt to do this. This objection can be partly overcome if we focus instead on the probability of a project reducing the risk of death and there are insurance markets in existence which tell us something about how much people value their health and life when they take out insurance policies. 5. Attitudes to risk e.g. a cost benefit analysis of the effects of genetically modified foods
a. Precautionary Principle: Assume toxicity until proven safe

1. If in doubt, then regulate

b. Free Market Principle: Assume it is safe until a hazard is identified

1. If in doubt, do not regulate.

Example Cost Benefit Analysis

As Despite these problems, most economists argue that CBA is better than other ways of including the environment in project appraisal. the Production Manager, you are proposing the purchase of a $1 Million stamping machine to increase output. Before you can present the proposal to the Vice President, you know you need some facts to support your suggestion, so you decide to run the numbers and do a cost benefit analysis. Example: A sales director is deciding whether to implement a new computer-based contact management and sales processing system. His department has only a few computers, and his salespeople are not computer literate. He is aware that computerized sales forces are able to contact more customers and give a higher quality of reliability and service to those customers. They are more able to meet commitments, and can work more efficiently with fulfillment and delivery staff.