CHAPTER 1

Introduction to Engineering Economy

1.1 WHAT IS ENGINEERING ECONOMY?
Before we begin to develop the fundamental concepts upon which engineering
economy is based, it would be appropriate to define what is meant by engineering
economy. In the simplest of terms, engineering economy is a collection of tech-
niques that simplify comparisons of alternatives on an economic basis. In defining
what engineering economy is, it might also be helpful to define what it is not. Engi-
neering economy is not a method or process for determining what the alternatives
are. On the contrary, engineering economy begins only after the alternatives have
been identified. If the best alternative is actually one that the engineer has not even
recognized as an alternative, then all of the engineering economic analysis tools in
this book will not result in its selection.
While economics will be the sole criterion for selecting the best alternatives in
this book, real-world decisions usually include many other factors in the decision-
making process. For example, in determining whether to build a nuclear-powered,
gas-fired, or coal-fired power plant, factors such as safety, air pollution, public accept-
ance, water demand, waste disposal, global warming, and many others would be
considered in identifying the best alternative. The inclusion of other factors (besides
economics) in the decision-marking process is called multiple attribute analysis. This
topic is introduced in Appendix C.

1.2 Basic Terminology and Fundamental Concepts in Engineering Economy

In order to apply economic analysis techniques, it is necessary to understand the
basic terminology and fundamental concepts that form the foundation for engineering-
economy studies. Some of these terms and concepts are described below.

1.2.1 Alternatives
An alternative is a stand-alone solution for a given situation. We are faced with alter-
natives in virtually everything we do, from selecting the method of transportation we
use to get to work every day to deciding between buying a house or renting one.
Similarly, in engineering practice, there are always several ways of accomplishing a
given task, and it is necessary to be able to compare them in a rational manner so
that the most economical alternative can be selected. The alternatives in engineering
considerations usually involve such items as purchase cost (first cost), anticipated
useful life, yearly costs of maintaining assets (annual maintenance and operating
costs), anticipated resale value (salvage value), and the interest rate. After the facts
and all the relevant estimates have been collected, an engineering economy analysis
can be conducted to determine which is best from an economic point of view.

1.2.2 Cash Flows

The estimated inflows (revenues) and outflows (costs) of money are called cash
flows. These estimates are truly the heart of an engineering economic analysis.
They also represent the weakest part of the analysis, because most of the numbers
are judgments about what is going to happen in the future. After all, who can accu-
rately predict the price of oil next week, much less next month, next year, or next
decade? Thus, no matter how sophisticated the analysis technique, the end result
is only as reliable as the data that it is based on.

1.2.3 Alternative Selection

Every situation has at least two alternatives. In addition to the one or more formu-
lated alternatives, there is always the alternative of inaction, called the do-nothing
(DN) alternative. This is the as-is or status quo condition. In any situation, when
one consciously or subconsciously does not take any action, he or she is actually
selecting the DN alternative. Of course, if the status quo alternative is selected, the
decision-making process should indicate that doing nothing is the most favorable
economic outcome at the time the evaluation is made. The procedures developed
in this book will enable you to consciously identify the alternative(s) that is (are)
economically the best.

1.2.4 Evaluation Criteria

Whether we are aware of it or not, we use criteria every day to choose between
alternatives. For example, when you drive to campus, you decide to take the “best”
route. But how did you define best? Was the best route the safest, shortest, fastest,
cheapest, most scenic, or what? Obviously, depending upon which criterion or com-
bination of criteria is used to identify the best, a different route might be selected
each time. In economic analysis, financial units (dollars or other currency) are gen-
erally used as the tangible basis for evaluation. Thus, when there are several ways
of accomplishing a stated objective, the alternative with the lowest overall cost or
highest overall net income is selected.

1.2.5 Intangible Factors

In many cases, alternatives have noneconomic or intangible factors that are diffi-
cult to quantify. When the alternatives under consideration are hard to distinguish
economically, intangible factors may tilt the decision in the direction of one of the
alternatives. A few examples of noneconomic factors are goodwill, convenience,
friendship, and morale.
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1 economy study
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Figure 1–1
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