Engineering Economics
Engineering economics tests whether you can compare alternatives on a consistent time basis and choose using the criterion the organisation actually specifies.
Core rules
- Money has a time value; compare alternatives at the same point in time using present worth, annual worth or future worth at the MARR.
- NPV = sum of discounted cash flows. Accept an independent project when NPV > 0 at the MARR. IRR is the discount rate giving NPV = 0; accept when IRR > MARR. IRR can fail with multiple sign changes in the cash flow.
- Capital recovery factor converts a present sum to an equivalent annual amount; the sinking fund factor does the reverse for future sums.
- Payback period ignores the time value of money and cash flows beyond the payback point, so it is a screening tool, not a decision criterion.
- Depreciation (straight line or MACRS) reduces taxable income but is not a cash flow. Sunk costs are excluded; only incremental future costs matter.
- Break-even volume = fixed cost / (unit price − unit variable cost).
Worked example
A 150,000 investment returns 50,000 per year for 5 years with no salvage. At MARR 10%, the annuity factor is ((1.1)⁵ − 1)/(0.1 × (1.1)⁵) = 0.61051/0.161051 = 3.791. Present worth of returns = 50,000 × 3.791 = 189,550. NPV = 189,550 − 150,000 = +39,550, so accept. The IRR exceeds 10%, consistent with the positive NPV.
Traps that cost marks
Comparing alternatives with different lives without an annual-worth or replacement-cycle approach. Using simple payback (3.0 years here) as the decision rule. Including sunk costs. Mixing nominal cash flows with a real discount rate.