Engineering Economic Analysis

456 INFLATION AND PRICECHANGE

How to Use Price Indexes in Engineering Economic Analysis

One may question the usefulness ofhistoricaldata (as provided by price indexes) when

engineering economic analysis deals with economic effects projected to occur in thefuture.

However,both commodity-specificand composite indexesindeed are useful in many analy-

ses. Engineeringeconomic analysisis concerned with making estimates of future events:the

outcomes of yearly costs and benefits,interest rates, salvage values; and tax rates are all ex-

amples of such estimates.Associatedwith these estimatesare varyingdegreesof uncertainty.

The challenge for the engineering economist is to reduce this uncertainty for each

estimate. Historical data provide a snapshot of how the quantities of interest have behaved

in the past. Knowing this past (historical)behavior shouldprovideinsight on how to estimate

.their behavior in the future, as well as to reduce the uncertainty of that estimate. This is

where the data that price indexes provide come into play. Although it is very dangerous

to extrapolate past d~ta into the future in the short run, price index data can be useful in

making estimates (especially when considered from a long-term perspective). In this way

the engineering economist can useaverage historical percentage increases (or decreases)

from commodity-specificand composite indexes, along with data from market analyses and

other sources, to estimate how economic quantities may behave in the future.

One may wonder how both commodity-specificand composite price indexes may be

used in engineering economic analyses. The answer to that question is reasonably straight-

forward. As we have established, price indexes can be useful in making estimates of fu-

ture outcomes. The followingprinciple applies to commodity-specificand composite price

indexes and such estimates:

When the estimated quantities are items that are tracked by commodity specific indexes,

then those indexes should be used to calculate average historical percentage increases

(or decreases).

If no commodity-specificindexes are kept, one should use an appropriate composite index

to make this calculation. For example, to estimate electric usage costs for a turret lathe over

a 5-year period, one would first want to refer to a commodity-specificindex that tracks this

quantity. If such an index does not exist, one might use a specific index for a very closely

related commodity-perhaps, in this case, an index of electric usage costs of screw lathes.

In the absence of such substitute or related commodity indexes, one could use appropriate

composite indexes: there may be a composite index that tracks electric usage costs for

industrial metal-cutting machinery.Or, as before, a related composite index.could be used.

The key point is that one should try to identify and use a price index that most closely relates

to the quantity being estimated in the analysis.

CASH FLOWS THAT INFLATEATDIFFERENTRATES

Engineering economic analysis requires the estimation of various parameters. It is not

uncommon that over time, these parameters willinflateorincrease(or even decrease)

at different rates. For instance, one parameter mightincrease5% per year, another 15%

per year, and a thirddecrease3.5% per year. This phenomenon is important because of

the various items of different types that are sometimes included in engineering economic

analyses. Since we are looking at the behavior of cash flows over time, we must have a way

of handling this effect.

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