CHAPTER 1

Introduction to Engineering
Economy

The purpose of Chapter 1 is to present the concepts and principles of

engineering economy.

Green Engineering in Action

E
nergy conservation comprises an important element in
environmentally-conscious (green) engineering. In a Southeas-
tern city, there are 310 traffic intersections that have been
converted from incandescent lights to light-emitting diode (LED) lights. The
study that led to this decision was conducted by the sustainability manager of
the city. The wattage used at the intersections has been reduced from 150 watts
to 15 watts at each traffic light. The resultant lighting bill has been lowered from
$440,000 annually to $44,000 annually. When engineers went to check the traffic
light meters for the first time, they were shocked by the low wattage numbers
and the associated cost. One of them said, “We thought the meters were broken
because the readings were so low.” The annual savings of $396,000 per year from
the traffic light conversion more than paid for the $150,000 cost of installing the
LED lights. Chapter 1 introduces students to the decision-making process that
accompanies “go/no go” evaluations of investments in engineering projects such
as the one described above.
1
 The best alternative may be the one you haven’t yet discovered.
—Anonymous

Icons Used in This Book

Throughout this book, these two icons will appear in connection with numerous
chapter opening materials, examples, and problems:

This icon identifies environmental (green) elements of the book. These elements
pertain to engineering economy problems involving energy conservation, materials
substitution, recycling, and other green situations.

This icon informs students of the availability of video tutorials for the examples
and problems so marked. Students are encouraged to access the tutorials at
www.pearsonhighered.com/sullivan. These icon-designated instances are
intended to reinforce the learning of engineering economy through analogy with
the marked problems and examples.

1.1 Introduction
The technological and social environments in which we live continue to change
at a rapid rate. In recent decades, advances in science and engineering have
transformed our transportation systems, revolutionized the practice of medicine,
and miniaturized electronic circuits so that a computer can be placed on a
semiconductor chip. The list of such achievements seems almost endless. In your
science and engineering courses, you will learn about some of the physical laws
that underlie these accomplishments.
The utilization of scientific and engineering knowledge for our benefit is
achieved through the design of things we use, such as furnaces for vaporizing trash
and structures for supporting magnetic railways. However, these achievements
don’t occur without a price, monetary or otherwise. Therefore, the purpose of
this book is to develop and illustrate the principles and methodology required
to answer the basic economic question of any design: Do its benefits exceed its
costs?
The Accreditation Board for Engineering and Technology states that engineer-
ing “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.”∗ In this definition, the economic aspects of engineering are
emphasized, as well as the physical aspects. Clearly, it is essential that the economic
part of engineering practice be accomplished well. Thus, engineers use knowledge
to find new ways of doing things economically.

∗ Accreditation Board of Engineering and Technology, Criteria for Accrediting Programs in Engineering in the United States
(New York; Baltimore, MD: ABET, 1998).
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 SECTION 1.2 / THE PRINCIPLES OF ENGINEERING ECONOMY 3

Engineering economy involves the systematic evaluation of the economic merits

of proposed solutions to engineering problems. To be economically acceptable
(i.e., affordable), solutions to engineering problems must demonstrate a positive
balance of long-term benefits over long-term costs, and they must also

• promote the well-being and survival of an organization,

• embody creative and innovative technology and ideas,
• permit identification and scrutiny of their estimated outcomes, and
• translate profitability to the “bottom line” through a valid and acceptable
measure of merit.

Engineering economy is the dollars-and-cents side of the decisions that

engineers make or recommend as they work to position a firm to be profitable
in a highly competitive marketplace. Inherent to these decisions are trade-offs
among different types of costs and the performance (response time, safety, weight,
reliability, etc.) provided by the proposed design or problem solution. The mission
of engineering economy is to balance these trade-offs in the most economical manner.
For instance, if an engineer at Ford Motor Company invents a new transmission
lubricant that increases fuel mileage by 10% and extends the life of the transmission
by 30,000 miles, how much can the company afford to spend to implement this
invention? Engineering economy can provide an answer.
A few more of the myriad situations in which engineering economy plays a
crucial role in the analysis of project alternative come to mind:

1. Choosing the best design for a high-efficiency gas furnace

2. Selecting the most suitable robot for a welding operation on an automotive
assembly line
3. Making a recommendation about whether jet airplanes for an overnight delivery
service should be purchased or leased
4. Determining the optimal staffing plan for a computer help desk

From these illustrations, it should be obvious that engineering economy includes

significant technical considerations. Thus, engineering economy involves technical
analysis, with emphasis on the economic aspects, and has the objective of assisting
decisions. This is true whether the decision maker is an engineer interactively
analyzing alternatives at a computer-aided design workstation or the Chief
Executive Officer (CEO) considering a new project. An engineer who is unprepared to
excel at engineering economy is not properly equipped for his or her job.

1.2 The Principles of Engineering Economy

The development, study, and application of any discipline must begin with a
basic foundation. We define the foundation for engineering economy to be a set of
principles that provide a comprehensive doctrine for developing the methodology.
These principles will be mastered by students as they progress through this book.
4 CHAPTER 1 / INTRODUCTION TO ENGINEERING ECONOMY

Once a problem or need has been clearly defined, the foundation of the discipline
can be discussed in terms of seven principles.

PRINCIPLE 1 Develop the Alternatives

Carefully define the problem! Then the choice (decision) is among alternatives.
The alternatives need to be identified and then defined for subsequent analysis.

A decision situation involves making a choice among two or more alternatives.

Developing and defining the alternatives for detailed evaluation is important
because of the resulting impact on the quality of the decision. Engineers and
managers should place a high priority on this responsibility. Creativity and
innovation are essential to the process.
One alternative that may be feasible in a decision situation is making no change
to the current operation or set of conditions (i.e., doing nothing). If you judge this
option feasible, make sure it is considered in the analysis. However, do not focus
on the status quo to the detriment of innovative or necessary change.

PRINCIPLE 2 Focus on the Differences

Only the differences in expected future outcomes among the alternatives are
relevant to their comparison and should be considered in the decision.

If all prospective outcomes of the feasible alternatives were exactly the same, there
would be no basis or need for comparison. We would be indifferent among the
alternatives and could make a decision using a random selection.
Obviously, only the differences in the future outcomes of the alternatives are
important. Outcomes that are common to all alternatives can be disregarded in
the comparison and decision. For example, if your feasible housing alternatives
were two residences with the same purchase (or rental) price, price would be
inconsequential to your final choice. Instead, the decision would depend on other
factors, such as location and annual operating and maintenance expenses. This
simple example illustrates Principle 2, which emphasizes the basic purpose of an
engineering economic analysis: to recommend a future course of action based on
the differences among feasible alternatives.

PRINCIPLE 3 Use a Consistent Viewpoint

The prospective outcomes of the alternatives, economic and other, should be
consistently developed from a defined viewpoint (perspective).

The perspective of the decision maker, which is often that of the owners of the
firm, would normally be used. However, it is important that the viewpoint for the
 SECTION 1.2 / THE PRINCIPLES OF ENGINEERING ECONOMY 5

particular decision be first defined and then used consistently in the description,
analysis, and comparison of the alternatives.
As an example, consider a public organization operating for the purpose of
developing a river basin, including the generation and wholesale distribution of
electricity from dams on the river system. A program is being planned to upgrade
and increase the capacity of the power generators at two sites. What perspective
should be used in defining the technical alternatives for the program? The “owners
of the firm” in this example means the segment of the public that will pay the cost
of the program, and their viewpoint should be adopted in this situation.
Now let us look at an example where the viewpoint may not be that of the
owners of the firm. Suppose that the company in this example is a private firm and
that the problem deals with providing a flexible benefits package for the employees.
Also, assume that the feasible alternatives for operating the plan all have the same
future costs to the company. The alternatives, however, have differences from
the perspective of the employees, and their satisfaction is an important decision
criterion. The viewpoint for this analysis should be that of the employees of the
company as a group, and the feasible alternatives should be defined from their
perspective.

PRINCIPLE 4 Use a Common Unit of Measure

Using a common unit of measurement to enumerate as many of the prospective
outcomes as possible will simplify the analysis of the alternatives.

It is desirable to make as many prospective outcomes as possible commensurable

(directly comparable). For economic consequences, a monetary unit such as dollars
is the common measure. You should also try to translate other outcomes (which
do not initially appear to be economic) into the monetary unit. This translation, of
course, will not be feasible with some of the outcomes, but the additional effort
toward this goal will enhance commensurability and make the subsequent analysis
of alternatives easier.
What should you do with the outcomes that are not economic (i.e., the expected
consequences that cannot be translated (and estimated) using the monetary unit)?
First, if possible, quantify the expected future results using an appropriate unit of
measurement for each outcome. If this is not feasible for one or more outcomes,
describe these consequences explicitly so that the information is useful to the
decision maker in the comparison of the alternatives.

PRINCIPLE 5 Consider All Relevant Criteria

Selection of a preferred alternative (decision making) requires the use of a
criterion (or several criteria). The decision process should consider both the
outcomes enumerated in the monetary unit and those expressed in some other
unit of measurement or made explicit in a descriptive manner.
6 CHAPTER 1 / INTRODUCTION TO ENGINEERING ECONOMY

The decision maker will normally select the alternative that will best serve the
long-term interests of the owners of the organization. In engineering economic
analysis, the primary criterion relates to the long-term financial interests of the
owners. This is based on the assumption that available capital will be allocated to
provide maximum monetary return to the owners. Often, though, there are other
organizational objectives you would like to achieve with your decision, and these
should be considered and given weight in the selection of an alternative. These
nonmonetary attributes and multiple objectives become the basis for additional
criteria in the decision-making process. This is the subject of Chapter 14.

PRINCIPLE 6 Make Risk and Uncertainty Explicit

Risk and uncertainty are inherent in estimating the future outcomes of the alter-
natives and should be recognized in their analysis and comparison.

The analysis of the alternatives involves projecting or estimating the future

consequences associated with each of them. The magnitude and the impact of future
outcomes of any course of action are uncertain. Even if the alternative involves no
change from current operations, the probability is high that today’s estimates of,
for example, future cash receipts and expenses will not be what eventually occurs.
Thus, dealing with uncertainty is an important aspect of engineering economic
analysis and is the subject of Chapters 11 and 12.

PRINCIPLE 7 Revisit Your Decisions

Improved decision making results from an adaptive process; to the extent
practicable, the initial projected outcomes of the selected alternative should be
subsequently compared with actual results achieved.

A good decision-making process can result in a decision that has an undesirable

outcome. Other decisions, even though relatively successful, will have results
significantly different from the initial estimates of the consequences. Learning from
and adapting based on our experience are essential and are indicators of a good
organization.
The evaluation of results versus the initial estimate of outcomes for the selected
alternative is often considered impracticable or not worth the effort. Too often,
no feedback to the decision-making process occurs. Organizational discipline is
needed to ensure that implemented decisions are routinely postevaluated and that
the results are used to improve future analyses and the quality of decision making.
For example, a common mistake made in the comparison of alternatives is the
failure to examine adequately the impact of uncertainty in the estimates for selected
factors on the decision. Only postevaluations will highlight this type of weakness
in the engineering economy studies being done in an organization.
 SECTION 1.3 / ENGINEERING ECONOMY AND THE DESIGN PROCESS 7

1.3 Engineering Economy and the Design Process

An engineering economy study is accomplished using a structured procedure

and mathematical modeling techniques. The economic results are then used in
a decision situation that normally includes other engineering knowledge and
input.

A sound engineering economic analysis procedure incorporates the basic principles

discussed in Section 1.2 and involves several steps. We represent the procedure
in terms of the seven steps listed in the left-hand column of Table 1-1. There are
several feedback loops (not shown) within the procedure. For example, within
Step 1, information developed in evaluating the problem will be used as feedback
to refine the problem definition. As another example, information from the analysis
of alternatives (Step 5) may indicate the need to change one or more of them or to
develop additional alternatives.
The seven-step procedure is also used to assist decision making within the
engineering design process, shown as the right-hand column in Table 1-1. In this
case, activities in the design process contribute information to related steps in the
economic analysis procedure. The general relationship between the activities in
the design process and the steps of the economic analysis procedure is indicated
in Table 1-1.
The engineering design process may be repeated in phases to accomplish a
total design effort. For example, in the first phase, a full cycle of the process may
be undertaken to select a conceptual or preliminary design alternative. Then, in
the second phase, the activities are repeated to develop the preferred detailed
design based on the selected preliminary design. The seven-step economic analysis

TABLE 1-1 The General Relationship between the Engineering Economic Analysis
Procedure and the Engineering Design Process
Engineering Design Process
Engineering Economic Analysis Procedure (see Figure P1-15 on p. 18)
Step Activity
1. Problem recognition, definition, and 1. Problem/need definition.
evaluation.
2. Problem/need formulation and evaluation.
2. Development of the feasible alter- 3. Synthesis of possible solutions (alternatives).
natives. 
3. Development of the outcomes and 



cash flows for each alternative. 
4. Selection of a criterion (or criteria). 4. Analysis, optimization, and evaluation.


5. Analysis and comparison of the 


alternatives.
6. Selection of the preferred alternative. 5. Specification of preferred alternative.
7. Performance monitoring and post- 6. Communication.
evaluation of results.
8 CHAPTER 1 / INTRODUCTION TO ENGINEERING ECONOMY

procedure would be repeated as required to assist decision making in each phase

of the total design effort. This procedure is discussed next.

1.3.1 Problem Definition

The first step of the engineering economic analysis procedure (problem definition)
is particularly important, since it provides the basis for the rest of the analysis. A
problem must be well understood and stated in an explicit form before the project
team proceeds with the rest of the analysis.
The term problem is used here generically. It includes all decision situations for
which an engineering economy analysis is required. Recognition of the problem is
normally stimulated by internal or external organizational needs or requirements.
An operating problem within a company (internal need) or a customer expectation
about a product or service (external requirement) are examples.
Once the problem is recognized, its formulation should be viewed from a
systems perspective. That is, the boundary or extent of the situation needs to
be carefully defined, thus establishing the elements of the problem and what
constitutes its environment.
Evaluation of the problem includes refinement of needs and requirements, and
information from the evaluation phase may change the original formulation of the
problem. In fact, redefining the problem until a consensus is reached may be the
most important part of the problem-solving process!

1.3.2 Development of Alternatives∗

The two primary actions in Step 2 of the procedure are (1) searching for potential
alternatives and (2) screening them to select a smaller group of feasible alternatives
for detailed analysis. The term feasible here means that each alternative selected for
further analysis is judged, based on preliminary evaluation, to meet or exceed the
requirements established for the situation.

1.3.2.1 Searching for Superior Alternatives In the discussion of Prin-

ciple 1 (Section 1.2), creativity and resourcefulness were emphasized as being
absolutely essential to the development of potential alternatives. The difference
between good alternatives and great alternatives depends largely on an indi-
vidual’s or group’s problem-solving efficiency. Such efficiency can be increased in
the following ways:

1. Concentrate on redefining one problem at a time in Step 1.

2. Develop many redefinitions for the problem.
3. Avoid making judgments as new problem definitions are created.
4. Attempt to redefine a problem in terms that are dramatically different from the
original Step 1 problem definition.

∗ This is sometimes called option development. This important step is described in detail in A. B. Van Gundy, Techniques
of Structured Problem Solving, 2nd ed. (New York: Van Nostrand Reinhold Co., 1988). For additional reading, see
E. Lumsdaine and M. Lumsdaine, Creative Problem Solving—An Introductory Course for Engineering Students (New York:
McGraw-Hill Book Co., 1990) and J. L. Adams, Conceptual Blockbusting—A Guide to Better Ideas (Reading, MA: Addison-
Wesley Publishing Co., 1986).
 SECTION 1.3 / ENGINEERING ECONOMY AND THE DESIGN PROCESS 9

5. Make sure that the true problem is well researched and understood.

In searching for superior alternatives or identifying the true problem, several

limitations invariably exist, including (1) lack of time and money, (2) preconcep-
tions of what will and what will not work, and (3) lack of knowledge. Consequently,
the engineer or project team will be working with less-than-perfect problem
solutions in the practice of engineering.

EXAMPLE 1-1 Defining the Problem and Developing Alternatives

The management team of a small furniture-manufacturing company is under
pressure to increase profitability to get a much-needed loan from the bank to
purchase a more modern pattern-cutting machine. One proposed solution is to
sell waste wood chips and shavings to a local charcoal manufacturer instead of
using them to fuel space heaters for the company’s office and factory areas.

(a) Define the company’s problem. Next, reformulate the problem in a variety
of creative ways.
(b) Develop at least one potential alternative for your reformulated problems
in Part (a). (Don’t concern yourself with feasibility at this point.)

Solution
(a) The company’s problem appears to be that revenues are not sufficiently
covering costs. Several reformulations can be posed:
1. The problem is to increase revenues while reducing costs.
2. The problem is to maintain revenues while reducing costs.
3. The problem is an accounting system that provides distorted cost
information.
4. The problem is that the new machine is really not needed (and hence
there is no need for a bank loan).
(b) Based only on reformulation 1, an alternative is to sell wood chips and
shavings as long as increased revenue exceeds extra expenses that may
be required to heat the buildings. Another alternative is to discontinue
the manufacture of specialty items and concentrate on standardized, high-
volume products. Yet another alternative is to pool purchasing, accounting,
engineering, and other white-collar support services with other small firms
in the area by contracting with a local company involved in providing these
services.

1.3.2.2 Developing Investment Alternatives “It takes money to make

money,” as the old saying goes. Did you know that in the United States the average
firm spends over $250,000 in capital on each of its employees? So, to make money,
each firm must invest capital to support its important human resources—but
in what else should an individual firm invest? There are usually hundreds of
opportunities for a company to make money. Engineers are at the very heart of
creating value for a firm by turning innovative and creative ideas into new or