Engineering economics

Engineering economics

Engineering economics, previously known as engineering economy, is a subset of economics for application to engineering projects. Engineers seek solutions to problems, and the economic viability of each potential solution is normally considered along with the technical aspects.

In the U.S. undergraduate engineering curricula, engineering economics is often a required course. It is a topic on the Fundamentals of Engineering examination, and questions might also be asked on the Principles and Practice of Engineering examination; both are part of the Professional Engineering registration process.

Considering the time value of money is central to most engineering economic analyses. Cash flows are "discounted" using an interest rate, i, except in the most basic economic studies.

For each problem, there are usually many possible "alternatives". One option that must be considered in each analysis, and is often the "choice", is the "do nothing alternative". The "opportunity cost" of making one choice over another must also be considered. There are also noneconomic factors to be considered, like color, style, public image, etc., and are called "attributes". ["Engineering Economy", 11th Ed., Sullivan, Bontadelli, and Wicks, Prentice-Hall, New York, 2000]

"Costs" as well as "revenues" are considered, for each alternative, for an "analysis period" that is either a fixed number of years or the estimated life of the project. The "salvage value" is often forgotten, but is important, and is either the net cost or revenue for decommissioning the project.

Some other topics that may be addressed in engineering economics are inflation, uncertainty, replacements, depreciation, resource depletion, taxes, tax credits, accounting, cost estimations, or capital financing. All these topics are primary skills and knowledge areas in the field of cost engineering.

Since engineering is an important part of the manufacturing sector of the economy, engineering industrial economics is an important part of industrial or business economics. Major topics in engineering industrial economics are:

* the economics of the management, operation, and growth and profitability of engineering firms;

* macro-level engineering economic trends and issues;

* engineering product markets and demand influences; and

* the development, marketing, and financing of new engineering technologies and products. ["Engineering Firms: A Survey Of Factors Affecting Their Growth & Performance", Industrial Systems Research Publications, Manchester (UK), 2nd. Revised edition 2003, page 1. ISBN 978-0-906321-28-7] []

Typical analyses

* Simple payback (SPB)
* Discounted payback (DPB)
* Present worth (PW)
* Annual worth (AW)
* Future worth (FW)
* Capitalized worth (CW)
* Internal rate of return (IRR)
* External rate of return (ERR)
* Minimum attractive rate of return (MARR)
* Life cycle cost (LCC)
* Life cycle savings (LCS)
* Benefit to cost ratio (B/C)WHY ENGINEERING ECONOMY IS IMPORTANT TO ENGINEERS (and other professionals) Decisions made by engineers, managers, corporation presidents, and individuals are commonly the result of choosing one alternative over another. Decisions often reflect a person's educated choice of how to best invest funds, also called capital. The amount of capital is usually restricted, just as the cash available to an individual is usually limited. The decision of how to invest capital will in¬variably change the future, hopefully for the better; that is, it will be value adding. Engineers play a major role in capital investment decisions based on their analysis, synthesis, and design efforts. The factors considered in making the decision are a combination of economic and non economic factors. Additional factors may be intangible, such as convenience, goodwill, friendship, and others.Fundamentally, engineering economy involves formulating, estimating, and evaluating the economic outcomes when alternatives to accomplish a defined purpose are available. Another way to define engineering econ¬omy is as a collection of mathematical techniques that simplify economic comparison Knowing how to correctly apply these techniques is especially important to en¬gineers, since virtually any project will affect costs and/or revenues.Some of the typical questions that can be addressed using the material in this book are posed below.

For Engineering Activities• Should a new bonding technique be incorporated into the manufacture of au¬tomobile brake pads?• If a computer-vision system replaces the human inspector in performing qual¬ity tests on an automobile welding line, will operating costs decrease over a time horizon of 5 years?• Is it an economically wise decision to upgrade the composite material pro¬duction center of an airplane factory in order to reduce costs by 20%?• Should a highway bypass be constructed around a city of 25,000 people, or• Should the current roadway through the city be expanded?• Will we make the required rate of return if we install the newly offered technology onto our medical laser manufacturing line?For Public Sector Projects and Government Agencies• How much new tax revenue does the city need to generate to pay for an upgrade to the electric distribution system?• Do the benefits outweigh the costs of a bridge over the intracoastal waterway• at this point?.• Is it cost-effective for the state to cost-share with a contractor to construct a new toll road?• Should the state university contract with a local community college to teach foundation-level undergraduate courses or have university faculty teach them?

For Individuals • Should I payoff my credit card balance with borrowed money?• What are graduate studies worth financially over my professional career?• Are federal income tax deductions for my home mortgage a good deal, or• Should I accelerate my mortgage payments?• Should I buy or lease my next car, or keep the one I have now and payoff the• Loan?

Example Two lead engineers with a mechanical design company and a structural analysis firm work together often. They have decided that, due to their joint and frequent commercial airline travel around the region, they should evaluate the purchase of a plane-co-owned by the two companies. What are some of the economics-based questions the engineers should answer as they evaluate the alternatives to (I) co-own a plane or (2) continue to fly commercially?

SolutionSome questions (and what is needed to respond) for each alternative are as follows:• How much will it cost each year? (Cost estimates are needed.)• How do we pay for it? (A financing plan is needed.)• Are there tax advantages? (Tax law and tax rates are needed.)• What is the basis for selecting an alternative? (A selection criterion is needed.• What is the expected rate of return? (Equations are needed.)• What happens if we fly more or less than we estimate now? (Sensitivity analysis is needed.)


People make decisions; computers, mathematics, and other tools do not. The techniques and models of engineering economy assist people in making deci¬sions. Since decisions affect what will be done, the time frame of engineering economy is primarily the future. Therefore, numbers used in an engineering eco¬nomic analysis are best estimates of what is expected to occur. These estimates often involve the three essential elements mentioned earlier: cash flows, time of occurrence, and interest rates. These estimates are about the future, and will be somewhat different than what actually occurs, primarily because of changing cir¬cumstances and unplanned-for events. In other words, the stochastic nature of estimates will likely make the observed value in the future differ from the esti¬mate made now.Commonly, sensitivity analysis is performed during the engineering economic study to determine how the decision might change based on varying estimates,especially those that may vary widely. For example, an engineer who expects ini¬tial software development costs to vary as much as :!::20% from an estimated $250,000 should perform the economic analysis for first-cost estimates of $200,000, $250,000, and $300,000. Other uncertain estimates about the project can be "tweaked" using sensitivity analysis. (Sensitivity analysis is quite easy to perform using electronic spreadsheets. Tabular and graphical displays make analysis possible by simply changing the estimated values. The power of spread¬sheets is used to advantage throughout this text and on the supporting website.)Engineering economy can be used equally well to analyze outcomes of the past. Observed data are evaluated to determine if the outcomes have met or not met a specified criterion, such as a rate of return requirement. For example, sup¬pose those 5 years ago, a United States-based engineering design company initi¬ated a detailed-design service in Asia for automobile chassis. Now, the company president wants to know if the actual return on the investment has exceeded 15% per year.There is an important procedure used to address the development and selec¬tion of alternatives. Commonly referred to as the problem-solving approach or the decision-making process, the steps in the approach follow.1. Understand the problem and define the objective.2. Collect relevant information.3. Define the feasible alternative solutions and make realistic estimates.4. Identify the criteria for decision making using one or more attributes.5. Evaluate each alternative, using sensitivity analysis to enhance the evaluation.6. Select the best alternative7. Implement the solution and monitor the results.Engineering economy has a major role in all steps and is primary to steps 2 through 6. Steps 2 and 3 establish the alternatives and make the estimates for each one. Step 4 requires the analyst to identify attributes for alternative selec¬tion. This sets the stage for the technique to apply. Step 5 utilizes engineering economy models to complete the evaluation and perform any sensitivity analysis upon which a decision is based (step 6).

annual sales revenue, and income tax deductions. For alternative 2 (fly com¬mercial) estimate commercial transportation costs, number of trips, annual sales rev¬enue, and other relevant data.Step 4: The selection criteriol1 is a numericl4ly valued attribute called a measure of worth Some measures of worth areFuture worth (FW) Rate of return (ROR) Capitalized cost (CC)Payback period Economic value addedPresent worth (PW) Annual worth (AW)Benefit/cost ratio (B/C)Example 2Reconsider the questions presented for the engineers in the previous example about Co-owning an airplane. State some ways in which engineering economy contributes to decision making between the tow alternatives.Solution Assume that the objective is same for each engineer -, available, reliable, refillable transportation that minimize total cost. Use the steps above. Step 2 and 3: the frame work for an engineering economy study assists in identifying what should be estimated or collected .For alternatives 1 (buy the plane) Estimate the purchase, financing method, interest rate, annual operating costs, and possible increase in annual sales revenue, and income tax deductions. For alternative 2 (fly com¬mercial) estimate commercial transportation costs, number of trips, annual sales rev¬enue, and other relevant data.Step 4: The selection criteriol1 is a numerically valued attribute called a measure of worth some measures of worth are

Present worth (PW) Future worth (FW) Rate Payback period Economic Annual worth (AW) of return (ROR) Economic value addedBenefit/cost ratio (B/C) Capitalized cost (CC)

When determining a measure of worth, the fact that money today is worth a different amount in the future is considered; that is, the time value of money is accounted for.There are many non economic attributes-social, environmental, legal, political, personal, to name a few. This multiple-attribute environment may result in less reliance placed on the economic results in step 6. But this is exactly why the decision maker must have adequate information for all factors-economic and non economic-to make an informed selection. In our case, the economic analysis may favor the co-owned plane (alternative I), but because of non economic factors, one or both engineers may select alternative 2.Steps 5 and 6: The actual computations, sensitivity analysis, and alternative selec¬tion are accomplished here.The concept of the time value of money was mentioned above. It is often said that money makes money. The statement is indeed true, for if we elect to invest money today, we inherently expect to have more money in the future. If a per¬son or company borrows money today, by tomorrow more than the original loan principal will be owed. This fact is also explained by the time value of money.

The change in the amount of money over a given time period is called the time value of money; it is the most important concept in engineering economy

Other fundamental engineering topics

* Analysis of resistive circuits
* Dynamics
** Thermodynamics
** Fluid dynamics
* Heat transfer
* Materials science
** Strength of materials
* Statics


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