Management Theory Review

December 11, 2011

Introduction to Engineering Economics

Engineers must decide if the benefits of a project exceed its costs, and must make this comparison in a unified framework. The framework within which to make this comparison is the field of engineering economics, which strives to answer exactly these questions, and perhaps more.

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It seems peculiar and indeed very unfortunate that so many authors in their engineering books give no, or very little consideration to costs, in spite of the fact that the primary duty of the engineernig is to consider costs in order to obtain real economy- to get the most possible number of dollars and cents: to get the best financial efficiency.

O.B. Goldman, Financial Planning, John Wiley & Sons, New York, 1920.

It would be well if engineering were less generally thought of, and even defined, as the art of constructing. In a certain important sense it is rather the art of not constructing; or, to define it rudely but not ineptly, it is the art of doing that well with one dollar which any bungler can do with two after a fashion.

A.M. Wellington, The Economic Theory of the Location of Railways, John Wiley, New York, 1887

The subject confines of engineering economy were staked out in 1930 by Eugene L. Grant in his book 'Principles of Engineering Economy".

WHY DO ENGINEERS NEED TO LEARN ABOUT ECONOMICS?

Ages ago, the most significant barriers to engineers were technological. The things that engineers wanted to do, they simply did not yet know how to do, or hadn't yet developed the tools to do. There are certainly many more challenges like this which face present-day engineers.

But now, natural resources (from which we must build things) are becoming more scarce and more expensive. We are much more aware of negative side-effects of engineering innovations (such as air pollution from automobiles) than ever before.

For these reasons, engineers are asked more and more to place their project ideas within the larger framework of the environment within a specific planet, country, or region. Engineers must ask themselves if a particular project will offer some net benefit to the people who will be affected by the project, after considering its inherent benefits, plus any negative side-effects (externalities), plus the cost of consuming natural resources, both in the price that must be paid for them and the realization that once they are used for that project, they will no longer be available for any other project(s).

Simply put, engineers must decide if the benefits of a project exceed its costs, and must make this comparison in a unified framework. The framework within which to make this comparison is the field of engineering economics, which strives to answer exactly these questions, and perhaps more.

The Accreditation Board for Engineering and Technology (ABET) states that engineering "is the profession in which a knowledge of the mathematical and natural sciences gained by study, experience, and practice is applied with judgment to develop ways to utilize, economically, the materials and forces of nature for the benefit of mankind".

http://www.isr.umd.edu/~austin/ence202.d/economics.html

Further Reading

Engineering Economics - Knol Book by Narayana Rao

Engineering Economics, 4th Edition, James L. Riggs, David D. Bedworth, and Sabah U. Randhawa

McGraw Hill, New York, 1996

MIT Open Courseware

ESD.70J / 1.145J Engineering Economy Module, Fall 2008, Excel based course

http://ocw.mit.edu/OcwWeb/Engineering-Systems-Division/ESD-70JFall-2008/CourseHome/index.htm

A NEW FRAMEWORK FOR ENGINEERING ECONOMICS

Basic Engineering Economics - a PDH Online Course for Engineers

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For further explanation of the topic, visit

Engineering Economy or Engineering Economics: Economic Decision Making by Engineers

Management Knols of Narayana Rao are being consolidated in

http://nraomtr.blogspot.com/

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Article Originally posted in
http://knol.google.com/k/narayana-rao/introduction-to-engineering-economics/2utb2lsm2k7a/ 248

Related Article
http://nraomtr.blogspot.com/2011/11/engineering-economy-or-engineering.html

Time Value of Money Calculations

This topic explains the various concepts used to calculate future values or present values of a series of cash flows that result from engineering decisions to buy new equipment or replace old equipments.

Introduction

In one has money in his hand, he can invest it in a bank deposit and after one year he gets back his principal amount and in addition some interest. Therefore $1 today, deposited in a bank at 3% interest per annum will become $1.03 after one year. This is the concept of time value of money. Over time, money increases due to accumulation of interest. Compound interest formula A = P(1 +i)n represents the future value of money.
P = A (1+i)-n represents the present value of money received after n years.

This topic explains the various concepts used to calculate future values or present values of a series of cash flows that result from engineering decisions to buy new equipment or replace old equipments.

Time Value can be present value of a series of future cash flows or future value of series of future cash flows.

Single Payment Cashflow

For a single payment now made, one can calculate a future value. This is done by compounding using the formula A = P(1 +i)n

For a payment to be received in the future, one can calculate the present value. This is done by using discounting formula P = A (1+i)-n

Uniform Periodic Payments

For uniform periodic payments, one can calculate the present value or future value. The payments are assumed to be made at the end of period.

Compounding of uniform series of cash payments

S = R [(1+i)n - 1]/i

where S = Compound amount or future amount at the end of n periods
R = Periodic cash payment at the end of the period
i = rate of interest or required rate of return
n = number of periods for payments are made

Discounting of uniform series of cash payments

P = R [(1+i)n - 1]/[i 1+i)n ]

Where

P = Present Value

R = Uniform series of periodic payments

i = interest rate

n = number of periods of payments

These time value formulas are expressed in factors

A = P*Single payment future worth factor =P*Spfwf

P = A* Single payment present worth factor = A*Sppwf

S = R* Uniform series future worth factor = R*Usfwf

P = R*Unform series present worth factor = R*Uspwf

Two More Factors

Sinking Fund Deposit Factor

Sfdf = 1/Usfwf

Sinking fund is fund accumulated with periodic payments for incurring a lumpsum expenditure at the end of a long period. Sfdf gives the amount to be deposited at the end of each period for n period to accumulate one dollar at the end n periods.

Capital Recovery Factor

Crf = 1/Uspwf

Capital recovery factor gives the uniform payment to be received by you at the end period of n years to get recover back the investment you made today.

The factor tables are available and factors depend on interest rate i and term n.

Factors for a required rate of return of 10% and 5 years term.

Spfwf - 1.6105

Sppwf - .62092

Usfwf - 6.1051

Uspwf - 3.7908

Sfdf - 0.16380

Crf - 0.26380

References

Engineering Economics, 4th Edition, James L. Riggs, David D. Bedworth, and Sabah U. Randhawa, McGraw Hill, New York, 1996

Original knol http://knol.google.com/k/narayana-rao/time-value-of-money/2utb2lsm2k7a/249