Engineering Economics

Author

Professor. Hisham Ibrahim

Engineering Economics

Summary

Engineering economics is a specialized field that applies economic principles to engineering projects for informed decision-making. It is crucial for evaluating costs and benefits, ensuring project profitability and resource management in a global marketplace. Key aspects include understanding different cost types, the time value of money, and using metrics like Net Present Value (NPV), Internal Rate of Return (IRR), and Benefit-Cost Ratio (BCR) to assess financial viability and compare alternatives. This discipline provides essential tools for engineers to integrate financial acumen into technical design and project execution.

Learning Objectives

  • Define engineering economics and its foundational importance.

  • Identify and categorize the various types of costs associated with engineering projects.

  • Explain the concept of the Time Value of Money and its implications for financial calculations.

  • Evaluate engineering project viability using key economic criteria such as NPV, IRR, and BCR.

  • Apply spreadsheet tools like Excel for performing engineering economic analyses.

Understanding Engineering Economics

What is Engineering Economics?

Engineering economics is a specialized field within economics that focuses on the economic aspects of engineering projects. It deals with the economic considerations related to the design, production, distribution, and consumption of goods and services within an engineering context. Essentially, it is about decision-making when evaluating engineering projects that involve costs and benefits. This involves understanding the costs of a product, equipment, service, or technical support. For more information, refer to References (Whitman and Terry 2012; Vajpayee and Sarder 2020; Farr and Faber 2019; Herriott 2015).

Why is Engineering Economics Important?

The study of engineering economics has become increasingly crucial for engineers and technologists in today’s global and competitive marketplace. Here’s why:

  • Globalization and Competition: The world is becoming a global village, with goods and services crossing geographic boundaries, intensifying competition. This demands that economic decisions be both precise and accurate. Engineers must contribute rationally to capital investment and other cost-related decisions.

  • Resource Management: Engineers are frequently asked to achieve more with fewer resources. Understanding economic principles helps them manage budgets, forecast, and plan for profitability.

  • Project Profitability and Viability: A primary objective of economic analysis is to determine if a project will be profitable, meaning it will provide a desirable rate of return on investment by generating revenue that offsets capital and operating costs. For sustainable technologies, feasibility analysis is key to determining if a technology is financially viable in a specific context and use.

  • Interdisciplinary Role: Modern engineers are often integrators of complex systems rather than just component-level designers. They need to be business leaders first and engineers second, possessing both business and technical savvy. This requires understanding financial motivations for project selection and being involved throughout the project life cycle.

  • Decision-Making Framework: Engineering economics provides the necessary tools for making sound decisions regarding projects. It acknowledges that final decisions are not solely based on economic evaluations but also consider financial and intangible issues like environmental, social, and political impacts.

  • Addressing Cost Implications: Engineers must understand the cost implications of their designs and decisions, as the success or failure of projects is closely tied to economic factors. This is crucial from early development phases, where decisions have the largest impact on life cycle costs.

Costs of a Project

When undertaking an engineering project, money spent is considered a cost , disbursement, expenditure, or cash outflow. Understanding and tracking these costs is fundamental to project evaluation.

Types of Costs

  • Initial Cost (Installed Cost): This is the upfront capital investment required to start a project or acquire an asset. In sustainability projects, this includes the installed cost of the technology.

  • Operating Expenses (O &M): These are recurring costs associated with running and maintaining the technology or system over its useful life. For example, an industrial embroidery machine will have operating and maintenance costs.

  • Revenues or Expenses Avoided: For sustainable technologies or efficiency projects, these represent the financial benefits, such as savings from reduced energy consumption or generation of salable output. This is considered a cash inflow, akin to earning money.

  • Salvage Value: This is the estimated value of an asset at the end of its useful life. It is typically considered a positive cash flow or benefit, as the asset can often be sold (e.g., as scrap metal).

  • Training Costs: Costs associated with training personnel to operate new systems or technologies.

  • Taxes and Tax Credits/Rebates: Legal obligations that affect a project’s cash flow. Governments may offer financial incentives like income tax credits and rebates to support sustainable technologies. The principal portion of a loan payment is paid out of after-tax funds.

Depreciation

Depreciation refers to the decrease in an asset’s value over time due to use. This loss in value is expressed as a depreciation cost or charge. Governments often allow companies to deduct depreciation costs from profits before taxes, acting as a financial incentive. Common depreciation methods include straight-line (SL), sum-of-the-years’ digits (SOYD), declining balance (DB), double-declining balance (DDB), and Modified Accelerated Cost Recovery System (MACRS), which is a government-approved method.

Time Value of Money (TVM)

The time value of money (TVM) is a fundamental concept in engineering economics, stating that money available today is worth more than the same amount in the future due to its earning capacity. This is because money can be invested and earn interest over time.

Simple vs. Compound Interest

  • Simple Interest: Interest is calculated only on the original principal amount, ignoring the effects of compounding. Simple interest is generally non-existent in today’s financial marketplace.

  • Compounded Interest: Interest is paid on both the capital and the accumulated interest (interest earns interest). This is often referred to as the “power of compounding” and benefits the lender or investor.

Cash Flow Diagrams (CFD) and Tables

To comprehend and solve engineering economics problems, it is crucial to track cash flows and their timings properly.

  • Cash Flow Table: A two-column table where the first column lists time periods (e.g., years) and the second lists corresponding cash flow amounts. Cash outflows (costs) are typically shown with a negative sign, while cash inflows (benefits) are positive.

  • Cash Flow Diagram (CFD): A graphical representation using vectors to show the magnitude and direction of cash flows over time. Downward arrows usually indicate cash outflows (expenses), and upward arrows indicate cash inflows (revenue). CFDs help visualize the problem and can lead to error-free solutions.

Key Economic Criteria for Project Evaluation

Several criteria are used to evaluate the economic viability of engineering projects and to compare alternatives.

Minimum Acceptable Rate of Return (MARR)

The Minimum Acceptable Rate of Return (MARR) is the lowest interest rate a company is willing to accept for an investment to be considered successful or acceptable. For engineers performing economic evaluations, the MARR is typically provided by upper management. It should be at least equal to the interest the capital could earn in the financial marketplace, with additional consideration for risk.

Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the discount rate at which the Net Present Value (NPV) of all cash flows from a project equals zero. It is a widely used and popular method for analyzing engineering economics problems. If the calculated IRR is greater than or equal to the MARR, the project is generally considered acceptable. Software and PCs have significantly eased the complexity of IRR analysis, making it more popular.

Net Present Value (NPV)

The Net Present Value (NPV) (sometimes called Net Present Worth, NPW) is a project evaluation method where all future cash flows are discounted to their present value and then summed up, along with the initial investment. A positive NPV indicates that a project is financially attractive and normally funded. The NPV function in spreadsheet software can calculate the present value of a series of payments.

Annual Equivalent Worth (AEW)

The Annual Equivalent Worth (AEW) (also referred to as Equivalent Uniform Annual Cost - EUAC, or Net Annual Value - NAV) is a uniform flow of benefits minus costs over the project’s life cycle, providing an annualized measure of net return. It is an easy-to-understand method for reporting cash flows per time period and allows for direct comparison of projects with unequal time periods. The project with the larger NPV will always have a larger AEW.

How to Conduct Cost-Benefit Analysis (CBA)

Cost-Benefit Analysis (CBA) is a process that provides decision-makers with the facts, data, and analysis needed to make informed decisions by presenting an accurate and complete picture of both project costs and derived benefits. CBA is commonly used in the economic analysis of government projects , which often aim to benefit as many people as possible.

The Benefit-Cost Ratio (BCR) is a key metric in CBA, representing the time-valued benefit per unit of initial investment. For a project to be considered investment-worthy, its time-valued benefits must exceed its costs, meaning the BCR must be greater than one. For projects with only one candidate, a higher BCR indicates a more favorable project.

The BCR can be simplified as: \[\[\begin{equation} \text{BCR} = \frac{\text{Net Benefit}}{\text{Initial Cost}} \end{equation}\]\]

Comparing Alternatives Based on Present Value (PW)

When faced with multiple project alternatives, the goal is to select the best economic choice. The Present Worth (PW) method is a suitable criterion for capital investment projects where the aim is to invest in a resource now for generating profits later.

Present Worth Method

The PW method involves determining the present worth of costs and the present worth of benefits for a project or alternative. A project’s PW accounts for the net effect of benefits over costs. A positive PW means the project is financially attractive. When comparing multiple alternatives, the one with the largest positive PW is generally preferred.

Input-Output Concept

The input-output concept facilitates problem comprehension in engineering economics. A project can be modeled as a decision box where:

  • Inputs: Represent all costs, including project-associated efforts quantifiable in monetary terms.

  • Outputs: Represent all benefits derived from the project.

Perpetual-Life Projects and Capitalized Cost

For facilities or projects expected to provide service forever (e.g., highways, dams), their economic analysis covers a perpetual or infinite period. The capitalized cost concept applies here, representing the initial lump sum whose interest income can perpetually cover operation and maintenance costs.

Using Excel for Economic Analysis

Spreadsheet software like Excel is an essential tool for feasibility analysis and engineering economic calculations. It allows for setting up data, performing essential calculations, and conducting sensitivity analysis.

  • Built-in Functions: Excel includes financial functions like RATE(nper, pmt, pv) to calculate interest rates, NPV(rate, value1, [value2], ...) to calculate net present value, and CUMPRINC(rate,nper,pv,start_period,end_period,type) for cumulative principal payment.

  • Sensitivity Analysis: Excel allows users to easily change numerical values and observe the impact on results, which is crucial for understanding how input variables affect profitability and for performing “what-if” scenarios.

  • Data Management: It provides a flexible platform for organizing data in rows and columns, making it user-friendly for economic analysis.

Detailed Examples of Cost-Benefit Analysis

Example 1: Financial Viability of a Wind Power System

This example illustrates how to determine the financial viability of a wind power system using break-even analysis and interest rate calculations, similar to problems an engineer-economic analyst would face.

Scenario: A 50 kW wind power system is considered.

  1. Determine the annualized fixed cost for break-even at a 35% capacity factor. If the annualized fixed cost is found to be $16,863 per year to achieve break-even at a 35% capacity factor, this is the target annual payment needed.

  2. Calculate the interest rate on a $200,000 loan over 20 years that results in this annual payment. We can use Excel’s RATE function for this.

    • nper (number of periods) = 20 years

    • pmt (annualized fixed cost/payment) = -$16,863 (negative to conform to Excel’s sign convention)

    • pv (present value/initial investment) = $200,000

Typing =RATE(20, -16863, 200000) into Excel will return approximately 5.59%. This indicates that a government-subsidized loan with an interest rate as low as 5.59% would be required for the wind power system to be financially viable.

  1. Interpret the break-even price of the wind power output (e.g., per kWh). Assume the annual electricity output is 153,300 kWh. To cover an annual cost of $21,909, the price (P) per kWh must satisfy the equation: $153,300 = $21,909 Solving for P: = $21,909 / $153,300 = $0.143 per kWh (or 14.3 cents per kilowatt-hour). This break-even price is higher than an assumed $0.11 per kWh.

    • If the wind generator sells its output to the regional transmission grid (commercial operation), $0.143/kWh would be a wholesale price, which is typically lower than retail prices.

    • If a 50 kW turbine serves a local community, farm, or factory directly, this selling price represents the savings to the recipients (per kWh), equivalent to the retail price of electric energy they would otherwise pay a public utility.

This analysis shows how engineering-economic principles are used to assess financial viability based on technical capacity, costs, and market context.

Example 2: Municipal Waste Recycling Plant (Benefit-Cost Ratio Analysis)

This example demonstrates calculating the Benefit-Cost Ratio (BCR) for a public project, typical where CBA is frequently applied.

Scenario: The twin cities of Laurel and Hattiesburg plan to build a municipal waste recycling plant.

  • Initial cost: $16 million

  • Life: 25 years

  • Major overhauls: $300,000 every 5 years

  • Annual savings: $75 per household for 20,000 households

  • Interest rate: 6% per year

Steps to determine the project BCR:

  1. Calculate Total Annual Benefits (Cash Inflow):

$75 / , = $1.5 /year

  1. Calculate the Present Worth of Costs (Investment):

    • Initial Cost (at Year 0) = $16,000,000

    • Present Worth of Overhaul Costs: Overhauls occur at years 5, 10, 15, 20. Each overhaul is $300,000. The present worth of these future costs can be calculated using the Present Worth Factor (\(P/F, i, n\)) for each occurrence or by converting the uniform series of overhauls to a present worth.

Using \(P/F\) for each overhaul: PW(Overhauls) = $300,000

(Note: Specific \(P/F\) values would be looked up in interest tables or calculated, for instance, in Excel as \(1/(1+i)^n\))

Approximate values: \(P/F, 6%, 5\) \(\) 0.7473

\(P/F, 6%, 10\) \(\) 0.5584

\(P/F, 6%, 15\) \(\) 0.4173

\(P/F, 6%, 20\) \(\) 0.3118

PW(Overhauls) = $300,000 (0.7473 + 0.5584 + 0.4173 + 0.3118) PW(Overhauls) = $300,000 = $610,440

 * Total Present Worth of Costs = Initial Cost + PW(Overhauls) Total PW(Costs) = $16,000,000 + $610,440 = **$16,610,440**
  1. Calculate the Present Worth of Benefits: Annual benefits = $1,500,000 per year for 25 years. Use the Present Worth Factor for a Uniform Series (\(P/A, i, n\)):

PW(Benefits) = $1,500,000 (P/A, 6%, 25)

(Note: \(P/A, 6%, 25\) \(\) 12.7834 from interest tables)

PW(Benefits) = $1,500,000 = $19,175,100

  1. Calculate the Benefit-Cost Ratio (BCR): BCR = PW(Benefits) / Total PW(Costs) BCR = $19,175,100 / $16,610,440 = 1.154

Conclusion: Since the BCR (1.154) is greater than 1, the project is considered economically justifiable and desirable based on the benefit-cost ratio criterion.

References

Farr, John Vail, and Isaac Faber. 2019. Engineering Economics of Life Cycle Cost Analysis. Boca Raton, FL: CRC Press, Taylor & Francis Group.

Herriott, Scott R. 2015. Feasibility Analysis for Sustainable Technologies: An Engineering-Economic Perspective. Edited by Chris Laszlo and Robert Sroufe. Environmental and Social Sustainability for Business Advantage Collection. Business Expert Press, LLC.

Vajpayee, S. Kant, and MD Sarder. 2020. Fundamentals of Economics for Applied Engineering. Second. Boca Raton, FL: CRC Press, Taylor & Francis Group.

Whitman, David L., and Ronald E. Terry. 2012. Fundamentals of Engineering Economics and Decision Analysis. Edited by Steven F. Barrett. Synthesis Lectures on Engineering. San Rafael, CA: Morgan & Claypool Publishers.