The main goal I have for this website is to help engineers and engineering organizations grow and prosper through mastery of the non-technical side of engineering: business, management, and leadership. I believe that in order for you to be sucessful you need to have skills and abilities beyond the technical stuff you learned in engineering school. Second-order differentiation is great and everything, but it won’t help you a whole lot in terms of climbing the ranks or keeping a project on track. There’s more to being an engineer than being a technical expert.
With that in mind, I think one of the most important areas an engineer can grow in is understanding how money works in a business. Today’s post will be an introduction to exactly that and will launch a month dedicated to finance and accounting for engineers.
Why should engineers learn about money?
It may seem like finance and accounting are a bit outside of what an engineer should care about. If we have accountants and financial analysts, why would an engineer ever need to worry about money?
Well, as it turns out, there are plenty of reasons why an engineer should care about money. In the last few years, it’s become more and more clear to me how valuable it is to know how money works in a business. Understanding money can help you:
- Make smarter design decisions
- Make your businesses more successful
- Make your clients happy
- Differentiate yourself from your peers and get promoted faster.
I can think quite a few examples of where I was thankful to have a solid grounding in the world of dollars and cents: project management, R&D, trade off studies, bids and project proposals, procurement, manufacturing…. Money is important to all of these areas.
If you want to move into management one day, you’ll need to know how to budget people’s time and other resources. Both come down to understanding how money gets used and flows through an organization to help it meet its goals.
Let me be clear – money is not all that is important in this world; however, it is the lifeblood of a business, and one of the most important measures of its success. When you run out of money, it’s game over. On the other hand, a profitable company is able to keep its doors open, employ people, and do some good in the world. Sweet.
Lesson 1 – the time value of money
The most important thing that you need to learn about money is that it’s value is dynamic. A dollar today does not carry the same value as a dollar tomorrow. This is referred to as the time value of money. This is probably the most important thing to know about money for an engineer, especially when it comes to evaluating something like the life cycle cost of a design. For example, does spending more on high-grade insulation for a new building today save enough money down the road to justify the initial expense? Every situation is unique, but understanding that the value of money fluctuates as a function of time is super important in making this kind of assessment.
Discount rates and interest rates
For now, I’d like to keep things simple and just say that an interest rate at which money changes value in time. Think of your savings account. It has an interest rate that tells you how fast your money will grow in the future. It’s the same idea here. There’s a lot that goes into trying to decide what the “right” interest rate is when doing certain calculations, but we won’t get into that now. If you ask your company’s accounting or finance department, they’ll be able to tell you what rate your company uses.
Also, you may have come across the term “discount rate” in the past. In reality, there’s no difference between a discount rate and an interest rate. You use the same number in the same places in financial formulas. When you look forward to see how money you have today will grow in the future, you call it an interest rate. When you look backward to see how much less a future value is in today’s dollars, we call it a discount rate (i.e. you “discount” the future value by a certain amount to determine it’s present day value.)
This will all make a bit more sense once you read through the following sections ;-)
Solving for the future value of $100
The most general formula for relating money in the future and money in the present is this:
FV = PV(1+i)^t
- PV = Present value
- FV = Future value
- i = interest rate (normally some decimal between 0 and 1)
- t = time
So, let’s say that you give me $100 today. If I invest that $100 for a year at 5% interest, what would the future value of that $100 be?
FV = 100*(1 + 0.05)^1
FV = $105
So now we can see that $105 a year from now is equivalent to $100 today. Why? If you give me $100 today, I can turn that into $105 in a year’s time. If you gave me $100 a year from now, that wouldn’t be as good for me as giving me $100 today, because I would have lost the opportunity to invest for a year and earn $5.
Solving for the current value of multiple future payments
Often, we want to know if payments we receive in the future are going to be worth some sort of investment today. In order to do that, we need to figure out when the future payments will be, and how much they will be. Then we can compare the present value of those future payments to the initial cost. If the present value of the future payments is greater than the initial cost, then the investment today is a good one. Otherwise, it’s a bad investment.
Let’s look at an example:
Say you could spend $100 today in order to save $40 in energy bills each year for the next three years. Do the savings make the initial investment worth it?
To start, we have to remember that we can’t just say $40 + $40 + $40 is $120, which is more than the initial $100 and is therefore a good investment. This approach is wrong because we haven’t accounted for the time value of money for the future savings. None of the $40 savings will be worth $40 in today’s dollars, therefore we need to transform them into today’s dollars to be able to compare the savings to the initial investment.
Let’s say we’re using an interest rate of 10%. Using the formula from above, we can calculate the present values of the three future payments independently, add them up, and see what the total savings are in terms of today’s dollars.
PV1 = 40(1 + 0.05)^-1 = $36.36
PV2 = 40(1 + 0.05)^-2 = $33.06
PV3 = 40(1 + 0.05)^-3 = $30.05
Total savings in today’s dollars = $36.36 + $33.06 + $30.05 = $99.47
So, in this case, the initial investment of $100 isn’t worth it because we will only save $99.47.
Your questions above money, finance, and accounting
Is there anything you’d like to know about how money works? Have a burning question or something that’s stumped you in the past? I’d love to hear about it in the comments section below. I already have some topics I can cover over the rest of the month, but if there are common questions from my readers, I’m more than happy to tackle those instead. Just let me know!