The Economics of Engineering Project Management

By Neil G. Siegel

The Economics of Engineering Project Management is a practical, step-by-step guide to understanding and managing the financial and economic aspects of an engineering project.

This is a companion book to the same author's Engineering Project Management textbook. Both books are based on many years of research, and decades of actual, hands-on experience in successfully managing complex engineering projects.

This book starts by introducing just those aspects of the field of economics that an engineering project manager needs to know. It then lists and explains all of the actual financial and economic metrics that your company and your management will expect to you collect, assess, and report. It also provides detailed guidance about how to avoid common errors of validity in the collection and analysis of these data.

Neil G. Siegel, Ph.D., spent many years managing engineering projects, large and small. After retiring as sector Vice-President & Chief Technology officer of the Northrop Grumman Corporation, he is at present the IBM Professor of Engineering Management at the University of Southern California.

• Language: English
• Publisher: BookBaby
• Release date: Jul 15, 2022
• ISBN: 9781667852720

Book preview

The concepts underlying the economics of engineering project management

The economics of engineering projects are a mixture of reporting current financial status (such as inception-to-date financial performance), and projecting / predicting future financial performance.  We use both types of information in order to make decisions about potential courses-of-action on our project, and we will do this literally every single day for the duration of the project.  For example:

We now predict that the battery for our spacecraft will weigh 29 pounds more than we thought. 

As the manager of an engineering project, you face situations like this every day.  In response, you will have your team create and analyze data, to create candidate alternative courses of action.  You will then use those data to make decisions. 

Perhaps the team has determined that there is an alternative chemistry for the battery that will weigh less, but it costs a lot more than the battery chemistry we had planned to use.

As you can see from this last example, even when we think we are dealing with a purely technical issue, the economic factors are actually deeply involved.  In this example, we found a path to solve the technical issue (the battery is now predicted to weigh too much), but this new technical solution has economic implications (it is going to make the battery for our satellite cost more).

This type of decision-making process is always fraught with risk and uncertainty, because we are combining reasonably certain information (such as inception-to-date financial performance) with information that is highly uncertain (such as future financial performance).  Many people seem not to notice that the range of uncertainty about those metrics which are predictions is inevitably far larger than for the inception-to-date financial performance.

Before we talk about the specific financial measures that we use in engineering project management (chapter 3), let’s talk about the nature of financial measures, whether those measures be of actual current financial status, or predictions about future financial performance. 

The significance of all of the financial measures that we use in engineering project management is strongly conditioned by three basic financial concepts: (a) the time-value-of-money, the highly-related topic of (b) interest and compound interest, and (c) inflation and deflation.  Nothing about the financial measures used for our engineering projects makes the slightest sense without understanding these three basic concepts.  So, we start our discussion by explaining these three concepts.

Here, in a nutshell, is the key insight: receiving $1 today is worth more than receiving $1 at some point in the future.  In fact, receiving $1 now is probably even worth more than receiving $2 at some point in the future. We call this phenomenon the time-value-of-money.  Think of the value of that dollar at some point in the future as the sum of the $1 and all of the interest that you could earn on that dollar between now and that particular point in the future.

Note that interest is a type of income, and therefore, your company (and you personally, when you receive interest on your own personal savings) will have to pay taxes on that interest (and likely also will incur some administrative expenses). We will defer the discussion of the effect of such taxes until later.

Note also that an effect called inflation may decrease the actual buying power of a given amount of money, and an effect called deflation may increase it; historically, inflation has been much more common than deflation.  We will also defer the discussion of the effect of such inflation or deflation until later.

Similarly to receiving $1 today, if you were to spend $1 today, that imposes a cost of more than $1 as measured at some future date, due to this same time-value-of-money.

This concept of the time-value-of-money is vitally important, because on a large engineering project, it almost always has an effect that is significant in size.  We cannot ignore it.

Let’s illustrate the time-value-of-money with a simple example, that of buying a house.

Figure 1.

In our first example (Figure 1, above), let’s assume the house has a list price of $1,000,000; you pay this at the time of purchase to the seller through a combination of a down-payment (cash out of your pocket) and a loan (cash that you borrow from a bank, or some other source).  You must not only pay the amount borrowed (called the loan principal) back to the bank through a series of payments, but you must also pay the bank an additional amount (interest); it is this interest that accounts for the time-value-of-money.

In the example above, if you borrowed $1,000,000, and paid it back as 360 equal monthly payments (e.g., the 30 years shown in the example), with no consideration for interest or the time-value-of-money, you would expect that each monthly payment would be $2,777.78 (e.g., $1,000,000 / 360).  But as you can see in Figure 1, above, you actually would have to pay a much larger amount each month: $4,774.15.  That means that you will be paying nearly $2,000 per month additional, every month for 30 years, to account for the time-value-of-money.  The time-value-of-money is not just some sort of abstract content; it imposes actual and material costs.

Now, what does the house actually cost?  It had a list price when you bought it of $1,000,000.  But by the time you pay off the loan 30 years later, you have actually paid nearly twice as much ($1,718,695.06). The apparent cost of the transaction to purchase the house is different, depending on the point in time at which we measure it. This illustrates the key impact of the time-value-of-money: in order to have a valid basis to compare that candidate course of action to any other candidate course of action, we must bring every one of those cost estimates to the same specific point in time.

If we have four potential courses of action that we are considering in response to a problem we have encountered on our engineering project, it is not enough to estimate the cost of implementing each; we must estimate the cost of each course of action brought to the same point in time.  We will say more about this later.

Of course, if the interest rate is higher, the numbers might change significantly.  Figure 2 (below) presents the same transaction, but with the interest rate at 7.75%2:

Figure 2.

You would now be paying about $1,579.084 in interest over the 30-year term, about twice as much interest as for the case when the interest rate was 4%, and your total cost at the end of the 30-year period would be $2,579,084.08, rather than the $1,718,695.06 that we saw for the 4% version of this candidate transaction. This is another example of the time-value-of-money in action.

Now, consider a 15-year / 4% example, below, and compare it to the 30-year / 4% example that we saw above.  Both are depicted here (Figure 3):

Figure 3.

As you can see in Figure 3, if the term is 15 years (the bottom portion of Figure 3), you would pay more each month than if the term were 30 years (the top portion of Figure 3).  That makes sense, as you are re-paying that $1,000,000 in half the time.  But by the time you have paid off the loan in 15 years, you would have paid only $331,000 in interest, less than half of the $718,000 in interest you would have paid on the 30-year loan.  Here is another illustration of the time-value-of-money.

So, what is the cost of the house?  For the 30-year loan example, the cost appears to be $1,000,000 at the beginning, but $1,718,695.06 by the time we have paid off the loan.  There are, of course, other costs, too: property tax, insurance, and so forth.  Clearly, to get an unambiguous answer, we must specify both the exact set of costs to be included in our definition of cost, and also specify the exact point in time at which we are going to measure that cost.

It is clear that if I include property taxes and insurance in my cost analysis, but you do not, our two analyses are not comparable, and it would be invalid and misleading to try to so compare them, or to try to make any sort of a decision based on those incomparable data.  We must compare the exact same set of costs.

It is more subtle error if we fail to bring the cost of each candidate course of action to the same point in time; if we fail to do so, the two courses of action are simply not comparable.  We must do both: (a) specify the exact set of costs to be included in our definition of cost, and (b) also specify the exact point in time at which we are going to measure that cost.

The key principle that we must learn about the time-value-of-money is this: because of the existence of the time-value-of-money, and the accompanying fact that the actual value of a given amount of money changes over time, whenever we compare the projected costs of two or more courses of action, we must always (a) ensure that we are using the same definition of cost for all of the transactions being compared, and (b) we must bring the transactions to the same point in time.

What drives this time-value-of-money phenomenon?  It is something called interest: that extra amount that money can earn over time.

As an example, let’s assume that government-insured savings accounts are paying 5% annual interest3.  When you place money into that savings account, you are in