Engineering Economics: Description and Role in Decision Making

Decisions are made routinely to choose one alternative over another by individuals in everyday life; by engineers on the job; by managers who supervise the activities of others; by corporate  presidents who operate a business; and by government offi cials who work for the public good.  Most decisions involve money, called   capital  or   capital funds , which is usually limited in  amount. The decision of where and how to invest this limited capital is motivated by a primary goal of   adding value  as future, anticipated results of the selected alternative are realized.

Engineers play a vital role in capital investment decisions based upon their ability and experience  to design, analyze, and synthesize. The factors upon which a decision is based are commonly a  combination of economic and noneconomic elements. Engineering economy deals with the economic factors. By defi  nition,
 
Engineering economy involves formulating, estimating, and evaluating the expected economic  outcomes of alternatives designed to accomplish a defi ned purpose. Mathematical techniques  simplify the economic evaluation of alternatives. 

Because the formulas and techniques used in engineering economics are applicable to all  types of money matters, they are equally useful in business and government, as well as for  individuals.   Therefore, besides applications to projects in your future jobs, what you learn  from this book and in this course may well offer you an economic analysis tool for making  personal decisions such as car purchases, house purchases, major purchases on credit, e.g.,  furniture, appliances, and electronics.

Other terms that mean the same as engineering economy  are   engineering economic analysis,  capital allocation study, economic analysis, and similar descriptors.

People make decisions; computers, mathematics, concepts, and guidelines assist people in  their decision-making process. Since most decisions affect what will be done, the time frame of  engineering economy is primarily the   future . Therefore, the numbers used in engineering econ- omy are   best estimates of what is expected to occur . The estimates and the decision usually  involve four essential elements:

  Cash flows 
  Times of occurrence of cash fl  ows
  Interest rates for time value of money
  Measure of economic worth for selecting an alternative

Since the estimates of cash fl ow amounts and timing are about the future, they will be some-what different than what is actually observed, due to changing circumstances and unplanned  events. In short, the variation between an amount or time estimated now and that observed  in the future is caused by the stochastic (random) nature of all economic events.   Sensitivity  analysis  is utilized to determine how a decision might change according to varying esti- mates, especially those expected to vary widely. Example 1.1 illustrates the fundamental  nature of variation in estimates and how this variation may be included in the analysis at a  very basic level.

EXAMPLE 1.1

An engineer is performing an analysis of warranty costs for drive train repairs within the first  year of ownership of luxury cars purchased in the United States. He found the average cost (to  the nearest dollar) to be $570 per repair from data taken over a 5-year period.

What range of repair costs should the engineer use to ensure that the analysis is sensitive to changing warranty costs?

Solution

At  first glance the range should be approximately –25% to +15% of the $570 average cost to  include the low of $430 and high of $650. However, the last 3 years of costs are higher and  more consistent with an average of $631. The observed values are approximately ±3% of this  more recent average.

If the analysis is to use the most recent data and trends, a range of, say, ±5% of $630 is recom- mended. If, however, the analysis is to be more inclusive of historical data and trends, a range  of, say, ±20% or ±25% of $570 is recommended.

The criterion used to select an alternative in engineering economy for a specifi c set of estimates  is called a   measure of worth . The measures developed and used in this text are

All these measures of worth account for the fact that money makes money over time. This is the  concept of the   time value of money.  

It is a well-known fact that money   makes  money. The time value of money explains the change  in the amount of money   over time  for funds that are owned (invested) or owed (borrowed). This is the most important concept in engineering economy.
       
The time value of money is very obvious in the world of economics. If we decide to invest  capital (money) in a project today, we inherently expect to have more money in the future than  we invested. If we borrow money today, in one form or another, we expect to return the original  amount plus some additional amount of money.
 
Engineering economics is equally well suited for the future and for the   analysis of past cash
flows  in order to determine if a specifi c criterion (measure of worth) was attained. For example,  assume you invested $4975 exactly 3 years ago in 53 shares of IBM stock as traded on the New  York Stock Exchange (NYSE) at $93.86 per share. You expect to make 8% per year appreciation,  not considering any dividends that IBM may declare. A quick check of the share value shows it  is currently worth $127.25 per share for a total of $6744.25. This increase in value represents a  rate of return of 10.67% per year. (These type of calculations are explained later.) This past  investment has well exceeded the 8% per year criterion over the last 3 years.