This paper provides an overview of engineering economy, a discipline that equips engineers and analysts with financial tools to evaluate projects, compare alternatives, and make sound investment decisions. Beginning with a foundational definition of engineering economy, the paper introduces the time value of money — including present value, future value, and discounting — as the discipline's core concept. It then examines capital budgeting and project classification, followed by four key project selection methods: the payback period, net present value (NPV), internal rate of return (IRR), and modified internal rate of return. The paper concludes by acknowledging both the practical advantages and strategic limitations of quantitative engineering economy methods.
The paper demonstrates strong use of conceptual scaffolding — each new term or method is introduced only after the prerequisite concept has been explained. For example, discounting is introduced after present and future value are established, and NPV is explained before IRR is defined in relation to it. This layered structure helps readers follow a technically dense subject without losing context.
The paper opens with a definitional introduction to engineering economy, transitions into its foundational mathematical concept (time value of money), expands to organizational decision-making (capital budgeting and project classification), and then surveys four project evaluation methods in order of complexity. A brief critical conclusion weighs the strengths and weaknesses of quantitative approaches. The structure mirrors a textbook chapter, moving from theory to application to evaluation.
Among the many theoretical frameworks developed to support best financial management practices, engineering economy provides "analysts and engineers with the tools to determine which course of action results in the lowest cost, greatest profit, or other aspects, often using comparative cost studies." Engineering economy is frequently used to evaluate projects in terms of their costs and future value, and in this sense it can also be considered a decision-making tool.
A proper definition of engineering economy should begin with the two words forming the term. Economy is generally defined as "thrifty and efficient use of resources." In this sense, engineering economy answers the question: "Is it in the best interest of the enterprise to invest its limited resources in a proposed technical endeavor, or would the same investment produce a higher return elsewhere?" Engineering economy operates with such concepts as the time value of money, inflation, depreciation, decision making among alternatives, evaluating replacement alternatives, and optimization — all of which are addressed in this paper. Perhaps the best single definition of the term describes engineering economy as "the formulation, estimation, and evaluation of economic outcomes when alternatives to accomplish a defined purpose are available" (Tockey).
Following this definition, we can conclude that engineering economy deals with making the best selection among a set of alternatives by evaluating the different outcomes that each alternative implies.
When faced with an engineering project, there are generally two main considerations: how much the project costs, and how much benefit the project will bring. The difficulty is that benefits are most often realized in the future, while costs are incurred in the present. To compare future benefits with present costs, we calculate future benefits in terms of their present equivalents. This introduces the concept of the time value of money — perhaps the most important concept in engineering economy.
The time value of money rests on two general principles: future value and present value. The first concept is grounded in the idea that a dollar available today is more valuable than one received at some point in the future. The reason is straightforward: a dollar held in the present can be invested to produce an amount greater than a dollar. We therefore need a way to evaluate how much the present dollar will be worth in the future, given that it is invested at a certain rate.
The calculation is fairly simple. Let PV denote present value, FV denote future value, and k denote the annual interest rate. Then:
FV = PV + k × PV = PV × (1 + k)
That is, the future value of a dollar equals the present value plus the gain from the investment, which is found by multiplying the present value by the rate of return — in this case, the interest rate. Extending this calculation over several years yields the generalized formula:
FVn = PV × (1 + k)n
The present value of money is essentially the reverse concept. Suppose we have the opportunity to invest in a project that would return $130 after a five-year period. We need to calculate the present value of this future revenue and compare it to the actual cost of the project. If the cost exceeds the present value, the investment is not economically efficient. This process of finding the present value of a future cash flow is called discounting, and the formula used is the reverse of the one above:
PV = FV / (1 + k)n
The concepts of present and future value form the foundation of engineering economy. From here, we can move to more applied concepts involving project selection, including capital budgeting.
One of the basic principles of economics is that resources are limited while needs are not. Every company eventually faces the question: "Which of these projects is it best for us to pursue?" This question arises in a context of constrained budgets. Capital budgeting refers precisely to this challenge — analyzing all existing project proposals and determining which ones should be carried out. It is arguably the most important process within a company, because it determines how well the company will operate in the future. Choosing projects that cost too much, or that fail to deliver the expected return, can prove fatal to the enterprise.
When considering a list of proposed projects, some will be mutually exclusive. These represent alternative possibilities for investment: if one project in the group is accepted, all others in the group are excluded. An example would be acquiring two items that serve the same basic function. Other projects may be interdependent, meaning that accepting one project requires accepting all others in the group as well.
According to Halpern, there are six steps involved in the project selection process:
1. Determining the cost of the project.
2. Estimating the future cash flows of the project — which relates directly to the time value of money concepts described above.
3. Evaluating the project's risk — since projects are typically assessed in an environment of uncertainty, with estimated cash flows and projected revenues, it is necessary to evaluate how probable these outcomes actually are.
4. Estimating the cost of capital.
5. Discounting the future cash flows to obtain their present value.
6. Comparing the present value of future cash flows to the necessary costs. If the present value is greater than the cost of the project, the project should be accepted.
Halpern, Paul. Canadian Managerial Finance. Harcourt Brace & Company, Canada, 1994.
Tockey, Steve. "Engineering Economy, a Required Component of Software Engineering." Position paper presented at EDSER-1.
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