Engineering Economic Analysis

-.- ----- -------.

Assumptions in Solving Economic Analysis Problems 145

Viewpoint of Economic Analysis Studies

When we make economic analysis calculations,we must proceed from a point of reference.

Generally, we will want to take the point of view of a total firm when doing industrial

economic analyses. Example 1-1 vividly illustrated the problem: a firm's shipping depart-

ment decided it could save money having its printing work done outside rather than by

the in-house printing department. An analysis from the viewpoint of the shipping depar:t-

ment supported this, as it could get for $688.50 the same printing it was paying $793.50

for in house. Further analysis showed, however, that its printing department costs would

declinelessthan using the commercial printer would save. From the viewpoint of the firm,

the net result would be an increase in total cost.

From Example 1-1 we see itisimportant that the viewpoint of the study be carefully

considered. Selecting a narrow viewpoint,like that of the shipping department, may result

in a suboptimal decision from the viewpoint of the firm. For this reason, the viewpoint of

the total firm is used in industrial economic analyses.

Sunk Costs

We know that it is the differences between alternatives that are relevant in econonllc

analysis. Events that have occurred in the past really have no bearing.on what we should

do in the future.When thejudge says,"$200fineor 3 days injail,'~the eventsthat led to.

these ~nhappy alternatives really are unimportant. It is the current and future differences

between the alternatives thatareimportant. Past costs, like past events; have no beari.Iigon

deciding between alternatives unless the past costs somehow affect the present or future

costs. In general, past costs do not affect the present or the future, so we refer to them as.

sunk costsand disregard them.

Borrowed Money Viewpoint

In most economic analyses, the proposed alternativesinevitably require money to be spent,

and so it is natural to ask the source of that money. The source will vary from situation to

situation. In fact, there aretwoaspects of money to determine: one is the financing-the

obtaining of money-problem; the other is .the investment-the spending of money-

problem. Experience has shown that these two concerns should be distinguished. When

separated, the problems of obtaining money and of spending it are both logical and straight-

forward. Failure to separate them sometimesproduces confusing results and poor decision

making.

The conventionalassumptionin economicanalysisis that the money required to finance

alternatives/solutionsin problem solving is considered to be borrowed at interest ratei.

Effect of Inflation and Deflation

For the present we will assume that prices are stable. This means that a machine that costs

$5000 today can be expected to cost the same amount several years hence. Inflation and

deflation can be serious problems for after-tax analysis and for cost and revenues whose

inflation rates differ from the economy's inflation rates, but we assume stable prices for

now.

T -

--