Principles of Engineering Economics

by Jackie Lohrey; Updated September 26, 2017
dollar growth diagram

Although the term “engineering economics” might seem far removed from the business world, in reality every small-business owner is an engineering economist. For instance, any time you use a cost-value comparison to decide between two alternatives for a project, capital purchase or potential investment, you’re practicing engineering economics. It is important to understand the basics of engineering economics because no matter how sound a project, capital purchase or investment may seem, it will fail if it is not economically feasible.

What Engineering Economics Is and Isn’t

Engineering economics principles focus on the process used to make an economics-based decision, not on the decision itself. Engineering economics plays an important role for business owners because it helps identify the steps required to make well-thought out decisions such as whether to lease or purchase office space, invest in new computers or update existing ones, or provide customer service in-house or outsource the customer service department.

The Seven Principles

Each of the seven principles of engineering economics moves you a step closer toward making an economics-related decision. The first two principles -- making a list of alternatives and identifying the differences between each alternative -- set up the thought process. The next three principles focus on evaluation criteria. These include establishing consistent evaluation criteria, developing common performance measurements and considering all relevant monetary and non-monetary criteria. The final two principles focus on analysis. These include weighing risks against potential rewards and performance monitoring.

The Time Value of Money

Evaluation criteria establish measures of economic worth that make it possible to decide between two possible cost or investment alternatives. The alternative that provides the greatest return for the least cost or investment is usually the best solution. Common measures of worth include calculations based on the time value of money, a concept that uses time, interest rates and the investment amount to determine which alternative is the wisest decision. These calculations might include the rate of return, cost-benefit ratio, cost capitalization and present, future and annual worth. Their value lies in forcing you to consider long-term benefits and costs -- not just an initial purchase price or investment.

Principles in Action

The way you put the principles of engineering economics into action depends on what kind of decision you must make. For example, potential economic alternatives for an out-of-date computer network might include updating the current system or building a new system from scratch. During this process you might analyze how each alternative will affect the cost, expected performance and useful lifetime of the system to decide which alternative will provide the most value to the company. Evaluation criteria might include factors such as the purchase and installation costs, annual operating costs, maintenance costs and both principal and interest payments if you plan on using outside financing. Compare the risks of each alternative against potential economic and non-economic rewards. After making a decision, compare actual results to expectations.

About the Author

Based in Green Bay, Wisc., Jackie Lohrey has been writing professionally since 2009. In addition to writing web content and training manuals for small business clients and nonprofit organizations, including ERA Realtors and the Bay Area Humane Society, Lohrey also works as a finance data analyst for a global business outsourcing company.

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