Engineering economics

What Is Engineering Economics?

Engineering economics is a specialized field of Applied Economics focused on the systematic evaluation of economic merits of engineering alternatives. It involves applying economic principles and quantitative techniques to compare and analyze different technical solutions for projects, systems, or products, with the objective of making informed decisions regarding the efficient Resource Allocation²⁵. This discipline helps engineers and decision-makers assess the financial consequences of their designs and proposals, ensuring that technical viability is coupled with economic justification²⁴. The core aim of engineering economics is to maximize value while considering the constraints of scarcity, focusing on profitability and cost-effectiveness over a project's lifecycle²³.

History and Origin

The foundational concepts of engineering economics can be traced back to the late 19th century, notably with the work of Arthur M. Wellington. His seminal 1887 book, The Economic Theory of the Location of Railways, is often cited as a pioneering effort to systematically analyze the economic implications of engineering decisions, particularly in railway construction²¹, ²². Wellington emphasized that technical decisions in engineering must always consider their economic consequences, advocating for a scientific analysis of costs and benefits¹⁹, ²⁰.

The formal development of engineering economics as a distinct academic discipline gained momentum in the early 20th century. Engineering faculty recognized the need to integrate economic analysis into engineering curricula¹⁸. This led to the formation of committees and, eventually, the establishment of the Engineering Economy Division within the American Society for Engineering Education (ASEE), playing a critical role in standardizing and disseminating knowledge in the field¹⁷. The founding of The Engineering Economist journal in 1955 further solidified engineering economics as a recognized area of study and research¹⁶.

Key Takeaways

• Engineering economics evaluates the economic viability of engineering projects and design alternatives.
• It utilizes quantitative methods to compare costs and benefits over time, integrating financial principles with technical considerations.
• Key concepts include the Time Value of Money, Cash Flow analysis, and various investment criteria.
• The discipline aids in making rational decisions for Resource Allocation in both private and public sectors.
• It is crucial for ensuring that technically sound projects are also economically justified and sustainable.

Formula and Calculation

Engineering economics employs various formulas to evaluate alternatives, often incorporating the Time Value of Money. These formulas convert present and future cash flows into comparable terms. Key formulas include those for Net Present Value (NPV), Future Worth (FW), and Annual Worth (AW), which are all derived from fundamental interest factors.

One of the most common applications involves calculating the Present Value (P) of a Future Value (F) given an Interest Rate (i) per period and a number of periods (n):

$P = F(1+i)^{-n}$

Alternatively, the Future Value (F) of a Present Value (P) can be calculated as:

$F = P(1+i)^{n}$

Where:

• (P) = Present Value
• (F) = Future Value
• (i) = Discount Rate (interest rate per period)
• (n) = Number of periods

Other common formulas address series of equal payments (annuities) or gradient series to account for varying cash flows over time. Tools like spreadsheets are frequently used to perform these calculations efficiently, especially for complex projects with numerous Cash Flow components¹⁴, ¹⁵.

Interpreting Engineering Economics

Interpreting the results of an engineering economics analysis involves understanding the financial implications of different engineering choices and how they align with organizational goals. For instance, a positive Net Present Value (NPV) typically indicates that a project is expected to generate more value than its costs over its lifetime, after accounting for the Time Value of Money. Conversely, a negative NPV suggests the project may not be economically viable.

Beyond simple profitability metrics, engineering economics considers factors like sensitivity to changing conditions, risk, and the ability to meet strategic objectives¹³. The interpretation also involves considering non-monetary criteria, such as environmental impact, safety, or social benefits, which may influence the final decision even if a project does not yield the highest Return on Investment¹². The goal is to select alternatives that are not only technically sound but also offer the most favorable economic outcome from a consistent viewpoint¹¹.

Hypothetical Example

Consider a manufacturing company deciding between two new machinery investments to increase production efficiency.

Machine A:

• Initial Cost: $100,000
• Annual Savings (due to efficiency): $30,000
• Useful Life: 5 years
• Salvage Value (at end of 5 years): $10,000

Machine B:

• Initial Cost: $150,000
• Annual Savings: $40,000
• Useful Life: 5 years
• Salvage Value: $20,000

The company's required rate of return (or Discount Rate) is 10%. To determine which machine is more economically attractive, the company can use Net Present Value (NPV) analysis.

For Machine A:

• Present Value of Annual Savings: ( $30,000 \times (\frac{1 - (1 + 0.10)^{-5}}{0.10}) = $30,000 \times 3.7908 = $113,724 )
• Present Value of Salvage Value: ( $10,000 \times (1 + 0.10)^{-5} = $10,000 \times 0.6209 = $6,209 )
• NPV of Machine A: ( -$100,000 + $113,724 + $6,209 = $19,933 )

For Machine B:

• Present Value of Annual Savings: ( $40,000 \times (\frac{1 - (1 + 0.10)^{-5}}{0.10}) = $40,000 \times 3.7908 = $151,632 )
• Present Value of Salvage Value: ( $20,000 \times (1 + 0.10)^{-5} = $20,000 \times 0.6209 = $12,418 )
• NPV of Machine B: ( -$150,000 + $151,632 + $12,418 = $14,050 )

Based on this engineering economics evaluation, Machine A has a higher Net Present Value ($19,933) compared to Machine B ($14,050). This suggests Machine A is the more financially favorable investment, indicating a better utilization of Capital Budgeting resources.

Practical Applications

Engineering economics is widely applied across various sectors where technical decisions have significant financial implications. It forms the bedrock for Financial Feasibility studies in large-scale infrastructure projects, such as the construction of roads, bridges, and power plants, assisting civil engineers in making optimal investment choices for public and private capital¹⁰. For example, the American Society of Civil Engineers (ASCE) has highlighted how continued federal infrastructure investments, evaluated through economic studies, can significantly boost the U.S. economy and save jobs⁹.

In the private sector, engineering economics is essential for Capital Budgeting decisions, guiding companies in allocating funds to projects that promise the highest Return on Investment. This includes decisions related to purchasing new equipment, expanding production facilities, or investing in research and development. It helps assess the economic impact of technological innovations and process improvements within manufacturing, energy, and telecommunications industries⁸. Furthermore, it's used in Project Management for evaluating cost-efficiency, scheduling, and resource optimization throughout the project lifecycle. Areas like Depreciation analysis and tax implications are also integral to these practical applications.

Limitations and Criticisms

While engineering economics provides a robust framework for decision-making, it has certain limitations. One common critique is that it often simplifies complex economic realities, such as market dynamics, price determination, competition, and intricate supply and demand relationships, treating them as fixed inputs rather than variables to be analyzed within the scope of the project. This simplification can lead to an incomplete picture of a project's overall economic landscape.

Another limitation arises from the inherent uncertainty in future projections. Engineering economic analyses rely heavily on forecasting future costs, benefits, and market conditions, which are subject to considerable variability and risk⁷. Over-reliance on precise quantitative outputs without adequately addressing the probabilistic nature of these inputs can lead to misleading conclusions. Furthermore, the focus on quantifiable monetary aspects might sometimes overshadow critical qualitative factors, such as social impact, environmental sustainability, or ethical considerations, which are difficult to monetize but can be crucial for a project's long-term success or societal acceptance⁶. Challenges in teaching engineering economics also highlight the difficulty in conveying its practical application given diverse student backgrounds and the complexity of real-world data⁵.

Engineering Economics vs. Cost-Benefit Analysis

Engineering economics and Cost-Benefit Analysis are closely related, with the latter often serving as a tool within the former.

While engineering economics uses tools like Cost-Benefit Analysis to compare alternatives, it also integrates other specialized methods like sensitivity analysis, Depreciation calculations, and consideration of tax implications, all tailored to engineering decisions. Cost-Benefit Analysis is a technique that can be universally applied, whereas engineering economics specifically tailors economic principles to the unique problems faced by engineers in project design, implementation, and management⁴. The confusion often arises because both aim to make economically sound decisions, but engineering economics provides a more comprehensive framework within the engineering domain.

FAQs

What is the main objective of engineering economics?

The main objective of engineering economics is to help engineers and decision-makers make informed choices among technically feasible alternatives by systematically evaluating their economic consequences. It aims to maximize the economic value or minimize costs over a project's life cycle³.

How does the Time Value of Money relate to engineering economics?

The Time Value of Money (TVM) is a central concept in engineering economics, acknowledging that a sum of money today is worth more than the same sum in the future due to its potential earning capacity². All calculations, such as Net Present Value and Internal Rate of Return, are based on this principle, allowing for the comparison of costs and benefits occurring at different points in time.

Is engineering economics only for large-scale projects?

No, engineering economics applies to projects of all scales. While it is crucial for large infrastructure developments and industrial investments, its principles can also be used for smaller decisions, such as evaluating equipment upgrades, process improvements, or selecting materials for a product. The core principles of comparing alternatives and optimizing Resource Allocation remain relevant regardless of project size.

What are common financial metrics used in engineering economics?

Common financial metrics include Net Present Value (NPV), Internal Rate of Return (IRR), Annual Worth (AW), Future Worth (FW), and Benefit-Cost Ratio¹. These metrics help convert Cash Flow streams into comparable values to facilitate economic decision-making.