Performing an Engineering Economy Study
An engineering economy study involves many elements: problem identification, definition of the objective, cash flow estimation, financial analysis, and decision making. Implementing a structured procedure is the best approach to select the best solution to the problem.
The steps in an engineering economy study are as follows:
1- Identify and understand the problem; identify the objective of the project.
2- Collect relevant, available data and define viable solution alternatives.
3- Make realistic cash flow estimates.
4- Identify an economic measure of worth criterion for decision making.
5- Evaluate each alternative; consider noneconomic factors; use sensitivity analysis as needed.
6- Select the best alternative.
7- Implement the solution and monitor the results.
Technically, the last step is not part of the economy study, but it is, of course, a step needed to meet the project objective. There may be occasions when the best economic alternative
requires more capital funds than are available, or significant noneconomic factors preclude the most economic alternative from being chosen. Accordingly, steps 5 and 6 may result in selection of an alternative different from the economically best one. Also, sometimes more than one project may be selected and implemented. This occurs when projects are independent of one another. In this case, steps 5 through 7 vary from those above. Figure (1-1) illustrates the steps above for one alternative. Descriptions of several of the elements in the steps are important to understand.
Problem Description and Objective Statement: A succinct statement of the problem and primary objective(s) is very important to the formation of an alternative solution. As an illustration, assume the problem is that a coal-fueled power plant must be shut down by 2030 due to the production of excessive sulfur dioxide. The objectives may be to generate the forecasted electricity needed for 2030 and beyond, plus to not exceed all the projected emission allowances in these future years.
Alternatives: These are stand-alone descriptions of viable solutions to problems that can meet the objectives. Words, pictures, graphs, equipment and service descriptions, simulations, etc. define each alternative. The best estimates for parameters are also part of the alternative. Some parameters include equipment first cost, expected life, salvage value (estimated trade-in, resale, or market value), and annual operating cost (AOC), which can also be termed maintenance and operating (M&O) cost, and subcontract cost for specific services. If changes in income (revenue) may occur, this parameter must be estimated.
Cash Flows: All cash flows are estimated for each alternative. Since these are future expenditures and revenues, the results of step 3 usually prove to be inaccurate when an alternative is actually in place and operating. When cash flow estimates for specific parameters are expected to vary significantly from a point estimate made now, risk and sensitivity analyses (step 5) are needed to improve the chances of selecting the best alternative. Sizable variation is usually expected in estimates of revenues, AOC, salvage values, and subcontractor costs.
Engineering Economy Analysis: The techniques and computations that you will learn and use throughout this text utilize the cash flow estimates, time value of money, and a selected measure of worth. The result of the analysis will be one or more numerical values; this can be in one of several terms, such as money, an interest rate, number of years, or a probability. In the end, a selected measure of worth mentioned in the previous section will be used to select the best alternative.
Before an economic analysis technique is applied to the cash flows, some decisions about what to include in the analysis must be made. Two important possibilities are taxes and inflation. Federal, state or provincial, county, and city taxes will impact the costs of every alternative. An after-tax analysis includes some additional estimates and methods compared to a before-tax analysis. If taxes and inflation are expected to impact all alternatives equally, they may be disregarded in the analysis. However, if the size of these projected costs is important, taxes and inflation should be considered. Also, if the impact of inflation over time is important to the decision, an additional
Figure (1-1): Steps in an engineering economy study
Selection of the Best Alternative: The measure of worth is a primary basis for selecting the best economic alternative. For example, if alternative A has a rate of return (ROR) of 15.2% per year and alternative B will result in an ROR of 16.9% per year, B is better economically. However, there can always be noneconomic or intangible factors that must be considered and that may alter the decision. There are many possible noneconomic factors; some typical ones are:
§ Market pressures, such as need for an increased international presence
§ Availability of certain resources, e.g., skilled labor force, water, power, tax incentives
§ Government laws that dictate safety, environmental, legal, or other aspects
§ Corporate management’s or the board of director’s interest in a particular alternative
§ Goodwill offered by an alternative toward a group: employees, union, county, etc.
As indicated in Figure (1-1), once all the economic, noneconomic, and risk factors have been evaluated, a final decision of the “best” alternative is made. At times, only one viable alternative is identified. In this case, the do-nothing (DN) alternative may be chosen provided the measure of worth and other factors result in the alternative being a poor choice. The do-nothing alternative maintains the status quo.