Description and role in decision making process

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 officials 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 definition,

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 economy 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 flows

§  Interest rates for time value of money

§  Measure of economic worth for selecting an alternative

Since the estimates of cash flow amounts and timing are about the future, they will be somewhat 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 estimates, 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.

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?

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 recommended.

§  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 specific set of estimates is called a measure of worth. The measures developed and used in this text are:

§  Present worth (PW)

§  Future worth (FW)

§  Annual worth (AW)

§  Rate of return (ROR)

§  Benefit/cost (B/C)

§  Capitalized cost (CC)

§  Payback period (PP)

§  Economic value added (EVA)

§  Cost Effectiveness (CE)

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.

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 specific criterion (measure of worth) was attained.