Content area
Full Text
Abstract
Incremental analysis of Rate of Return or Benefit-Cost analysis is a tool that aids the user in the selection of the best project among multiple mutually exclusive alternatives. This method permits the user to identify if investment in a higher cost alternative is justified by examining the extra cost and additional benefits. Most engineering economics college textbooks focus more on "how" and "when" to use incremental analysis, and less on principles of this method. Incremental analysis is originally linked to the principles of marginal analysis, a major theoretical building block of neoclassical economics, which suggests that economic decisions are made at the margin. Marginal analysis permits the user to examine how the costs and benefits of an alternative change in response to incremental changes in actions. This topic does not receive adequate coverage in many engineering economy textbooks. Students both at the graduate and particularly the undergraduate levels struggle to conduct incremental analyses. While, incremental analysis is computation intensive, the authors believe students encounter difficulty primarily because of their insufficient knowledge of the economic principles of this method. Therefore, a comprehensive approach, incorporating classical marginal analysis, can be adopted to teach incremental analysis. In this paper, the authors will demonstrate such an instructional method.
Keywords: Engineering economics, incremental rate of return, benefit-cost analysis, marginal analysis, mutually exclusive alternatives.
1. Introduction
Incremental analysis of Rate of Return (IROR) or Benefit-Cost (IBCA) analysis is a tool that aids the user in the selection of the best project among mutually exclusive alternatives. Most college textbooks in engineering economics discuss "when" and "how" to use these methods and less on principles of this method. The majority of graduate and undergraduate student, in particular, seem to struggle to grasp and apply incremental analysis principle. The authors believe that their confusion appears to stem from their lack of understanding of marginal analysis - which is conceptually linked to incremental analysis. Instead of using IROR or IBCA, students have a tendency to select a project that has either the maximum benefit-cost ratio (B/C) or maximum rate of return (ROR) values. Interestingly, the authors also observed that many students find B/C or ROR intuitively logical.
Incremental analysis is a technique used in microeconomics and engineering economics by which small changes in...