Engineering Economics and Cost Estimation
What this domain tests
Engineering Economics and Cost Estimation tests time value of money, project comparison methods, and how estimate accuracy changes with project maturity.
Core rules
- Net present value discounts all cash flows at the minimum acceptable rate of return; accept when NPV > 0.
- IRR is the rate at which NPV = 0. It misleads with non-conventional cash flows and can favour small projects.
- Payback ignores cash flows after the cut-off and ignores the time value of money inside the period.
- Annuity factor (P/A, i, n) = [(1 + i)ⁿ − 1] / [i(1 + i)ⁿ].
- Estimate classes: Class 5 order-of-magnitude (roughly −30% to +50% or wider) through Class 1 definitive (about ±10% or better).
- Contingency covers known unknowns; management reserve covers unknown unknowns.
Worked example
Capital cost 120,000; savings 50,000 per year for 4 years; MARR 10%. (P/A, 10%, 4) = 3.1699, so the present value of savings is 50,000 × 3.1699 = 158,495. NPV = 158,495 − 120,000 = 38,495, which is positive, so accept the project. Simple payback is 2.4 years, but payback alone would rank a shorter, smaller project ahead of this one even though it destroys more value.
Traps
Ranking projects on payback alone; mixing then-year and constant-year currency; presenting a Class 5 estimate as if it were definitive; forgetting salvage value, decommissioning or escalation.