Every day, I hear reports on the radio and television of stock market reports, the Dow Jones level, and of actions taken by the Federal Reserve (the central bank in the United States). Often, I ignore these reports, hoping the announcer will just get on with the scores of my favorite local sports team. However, all these economic measures impact my pocketbook in significant ways, like affecting the purchasing power of a dollar and in influencing a decision of when to buy a house, go back to school, or retire.
Economic and financial theory and practice are covered in the Engineering Management Body of Knowledge (EMBOK), Domain 4: Financial Resource Management. This domain covers the typical financial data and information engineering managers should understand. Moreover, much of the content in Domain 4 actually bridges the gap between engineering and management. Senior executives typically make decisions based on money more than how cool the science is.
Accounting and Finance
All engineers should be exposed to the basics of bookkeeping and accounting. The most typical system of bookkeeping is a “double-entry” in which debits (left-hand side of a worksheet) must be in balance with credits (the right-hand side of the worksheet). For chemical engineers, this is much like a material balance for money. (Please see “Talking to Your Bo$$” at AIChE’s ChEnected website).
Thus, for every transaction, the debits and credits must remain in balance. If we spend $1 to acquire a pencil, we would credit, or subtract from, the cash account while we debit, or add to, our materials account. Debits and credits stay in balance always.
Financial people will prepare reports called balance sheets on a periodic basis to demonstrate that assets are in balance with liabilities and owner’s equity. Owner’s equity is the value held in a company after all the liabilities have been paid off. If we had $2 cash and only spent $1 to acquire the aforementioned pencil, we would still have $1 in savings (also known as owner’s equity). If we had $0.50 of debt to pay off first, then there would only be $0.50 of owner’s equity. Companies often make investment and stock buyback decisions based on the value of owner’s equity. Banks will examine the balance sheet in order to make loan decisions, as well.
As described in Section 4.1.4 of the EMBOK (4th ed.), profit is measured by the difference (in a given transaction) between the sales price of a good and the cost to produce and sell it. Production costs have two components: fixed costs which do not change regardless of the quantity of goods produced and variable costs that scale with production. Rent, for example, is a fixed cost because it doesn’t change regardless how many widgets are produced in a factory. Raw materials, on the other hand, are variable costs because as the number of widgets produced increases, we need more raw materials to manufacture them.
Profit, then, is the difference between sales price and the cost of production (fixed and variable).
On the radio and television, we also hear a lot about government agencies (national, state, and local) setting budgets. You might also have a personal budget so that your expenses don’t exceed your income. Engineering organizations also must establish annual budgets so that expenditures don’t exceed inputs. Further, the Board of Directors and CEO are tasked with maintaining the long-term financial health of the company.
The most common way for a business to set a budget is zero-based budgeting. In the zero-based budgeting method, we build expected revenues (inputs) and costs (expenses) from a blank sheet of paper each year. In this way, the management team (or family) will examine the validity of each expense and the assumptions leading to revenue generation. (Note that the US Congress does not use zero-based budgeting and generally assumes an added percentage to each budget item in each year, tending toward less examination of each line item.) Budgets are designed to help engineering managers invest in appropriate growth projects while maintaining profitability in existing operations.
As a part of any budget process, we must assume and calculate information regarding inflation and the time value of money. In essence, the time value of money means that $1 today is worth more than $1 tomorrow. For example, in the US, the Federal Reserve has determined that a 2-3% inflation rate is ideal. Let’s call it 2.5%. This means, that next year, the $100 bill in your pocket will only have the purchasing power of $97.56.
As engineering managers plan, design, and construct projects with long lead times, the time value of money becomes an important consideration. The present value of a project will be more heavily influenced by revenues and expenses that happen in the near-term. When cash flows are further into the future, the impact to present value will be lessened.. Similarly, foreign exchange rates for international projects and income tax rates can both influence the profitability of a capital project. Engineering managers must be fluent in both the science and the economics of projects they are involved in..
Making Money Work for You
Successful engineering managers can bridge the gap between the technical and the financial fields. Some engineers pursue expensive MBAs to learn about finance and economics. However, ASEM members are presented with a mini-MBA in Domain 4 of the EMBOK, building on the information presented earlier on Strategy (Domain 3, http://asem.org/blog/6133262) and Management Theory (Domain 2, http://asem.org/blog/6004937. To be successful, engineers must learn to speak “accounting” to gain support for projects and programs. CPEM and CAEM (http://asem.org/EM-Professional-Cert-Program) certification requires that an engineering manager be familiar with basic accounting so that s/he is skilled in the financial nuances of any engineering decision. After all, companies are in business to make money.
Get your copy of the EMBOK here. There are also great tools on economics and finance in the EM handbook here. Past articles in this series include:
The Business Savvy Engineer - http://asem.org/blog/5704908
The Business-Savvy Engineer’s Introduction to Engineering Management - http://asem.org/blog/5880804
Leadership & Organizational Management for the Business Savvy Engineer - http://asem.org/blog/6004937
About the Author
Teresa Jurgens-Kowal, PE, CPEM, PMP®, NPDP, is a passionate lifelong learner. She enjoys helping individuals and companies improve their innovation programs and loves scrapbooking. You can learn more about Teresa and innovation by connecting on LinkedIn.