Engineering Money E-Book

Richard Hill

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch
• Veröffentlichungsjahr: 2011

Seitenzahl: 351

Beschreibung

There are many text books about engineering design and some include project evaluation techniques. There are text books on accounting methods and yet others on business management. This book does not aim to replace these specialized texts but brings together the elements of these subjects that young engineers working in industry – particularly the construction industry and its customers – need to understand.

Most engineers learn about money the hard way: by experience in the workplace. The authors having done this themselves recognized the gap in engineers’ education and set out to bridge it. This book is based on a 1996 course George Solt pioneered for final-year engineering undergraduates. The book is written in an approachable style and gives young engineers as well as mature engineers an insight into the way engineering businesses run, the importance of capital and the problems of cash flow.

Leseprobe

Table of Contents

Cover

Table of Contents

Title page

Copyright page

Preface

Chapter 1 What’s It All About?

IT’S ALL ABOUT MONEY

ENGINEERING ACTIVITIES

ECONOMIC ENGINEERING

WHO BENEFITS?

WHERE’S THE TECHNOLOGY?

WHAT’S A PROJECT?

HOW DO WE BUILD IT?

THE CONTRACTING INDUSTRY

SUMMARY

Chapter 2 Money

WHAT IS IT?

BRIEF HISTORY OF MONEY

INFLATION

HOW MARS BAR ECONOMICS MADE SOME OF US RICH

INTEREST

WHAT IS A “REASONABLE” INTEREST RATE

THE BANKS

ISLAMIC BANKING

REAL INTEREST RATES

SUMMARY

Chapter 3 Measuring Money

WHY MEASURE IT?

FINANCIAL ACCOUNTS

PROVIDING FOR THE (UN)KNOWN

BRANDING

MANAGEMENT ACCOUNTS

SUMMARY

Chapter 4 How Things Can Go Wrong—1

SUMMARY

Chapter 5 Good Company

LIMITED LIABILITY

PRIVATE AND PUBLIC COMPANIES

WHO RUNS THINGS?

BOARD OF DIRECTORS

SENIOR MANAGEMENT TEAM

SHARE PRICE

SHAREHOLDERS

SUMMARY

Chapter 6 Capital

WHAT IS IT?

WHAT’S IT FOR?

WHERE DOES IT COME FROM?

RAISING CAPITAL BY SELLING SHARES

INCREASING THE SHARE CAPITAL

GETTING CAPITAL FROM LOANS

SUMMARY

Chapter 7 The Year’s Business Plan

HOW THE BUSINESS WORKS

PLANNING FOR PROFIT

OVERTRADING

MARGINAL SELLING

SUMMARY

Chapter 8 How Not to Go Bust

NEED FOR WORKING CAPITAL

CASE 1

CASE 2

CASE 3

SUMMARY

Chapter 9 Cash Flow

WHAT’S CASH FLOW?

WHAT DOES THIS TELL US?

PROGRESS PAYMENTS

RETENTIONS

PAYING LATE

SUMMARY

Chapter 10 What’s a Contract?

AN APOLOGY

IT’S AN AGREEMENT

HOW PROJECTS HAPPEN

TENDER DOCUMENTS

THE ACCEPTANCE

SUMMARY

Chapter 11 Conditions of Contract

WHAT’S A CONDITION?

MODEL FORMS

SUBCONTRACTS

FORCE MAJEURE

DAMAGES

DISPUTES AND SETTLEMENT

HOW TO AVOID DISPUTES

SUMMARY

Chapter 12 How Things Can Go Wrong—2

SUMMARY

Chapter 13 Cost Centers

WHAT’S A COST CENTER?

HOW DOES IT WORK?

MEASURING THE COST

MEASURING THE OUTPUT

THE ADMINISTRATION

A MONITORING SYSTEM

SUMMARY

Chapter 14 Pricing Contracts

PRICE OF THE CONTRACT

COMPETITION

MAKING UP THE PRICE

FINALIZING THE PRICE

COST OF TENDERING

SUMMARY

Chapter 15 Competitive Tendering

TENDERING

PROBLEMS

NOT SO SIMPLE

GUARANTEES

A BETTER WAY?

SUMMARY

Chapter 16 How Things Can Go Wrong—3

SUMMARY

Chapter 17 Other Types of Contracts

TRADITIONAL APPROACH

REIMBURSABLE CONTRACTS

A DIFFERENT APPROACH

PRIVATE FINANCE INITIATIVE

SUMMARY

Chapter 18 Terms of Payment

WHAT ARE TERMS OF PAYMENT?

OWNERSHIP

DELIVERY

RETENTIONS

EXTRAS

SUMMARY

Chapter 19 How Things Can Go Wrong—4

SUMMARY

Chapter 20 Planning Contract Execution

WHAT NEXT?

THE PLAN

SUMMARY

Chapter 21 Procurement and Monitoring

MORE PLANNING

HOW (AT LEAST SOME) PROCUREMENT DEPARTMENTS WORK

COMMUNICATIONS

THE S CURVE

SUMMARY

Chapter 22 Paying and Getting Paid

WHAT’S THE PROBLEM?

THE CONTRACT

ACHIEVING THE MILESTONE

REAL AND VIRTUAL MONEY

BAD PAYERS

SUMMARY

Chapter 23 Consultants

BRIEF HISTORY OF ENGINEERING

WHAT’S A CONSULTANT?

BIG CONSULTANTS

SMALL CONSULTANTS

CONTRACTORS

SPECIFICATION

SUMMARY

Chapter 24 Using Your Judgment

CHOICES

LIFE-CYCLE COST

ENVIRONMENTAL COSTS

OPTIMIZATION

COMMON ENGINEERING EXAMPLE

CURSE OF TOM THE COMPUTER

IS IT MEASURABLE?

UTILIZATION

RELIABILITY

SUMMARY

Chapter 25 Health and Safety Aspects of Design

ENGINEERING AND RISK

ACCIDENTS WILL HAPPEN

SAFETY LAW

RISK ASSESSMENT

COST OF SAFETY

SUMMARY

Chapter 26 Green Engineering and Greenbacks

THE ENVIRONMENT

RISK

SUSTAINABILITY

SUMMARY

Chapter 27 Research and Development

CHALLENGE OF R&D

BACKING THE RIGHT RUNNER

PATENTING

HIDDEN BENEFITS OF R&D

SUMMARY

Chapter 28 The Love of Money

ETHICS

ENGINEERING AND ETHICS

MONEY AND ETHICS

BRIBERY

CONTRACTS AND OTHER GOALS

WHISTLEBLOWING

WHAT’S ETHICAL?

SUMMARY

Chapter 29 Last Words

SUMMARY

Appendix 1  Financial Accounts

BALANCE SHEET

DEPRECIATION

PROFIT AND LOSS

Appendix 2  Critical Path Analysis

WHAT’S A CRITICAL PATH?

ACTIVITY LIST

NETWORK DIAGRAM

Appendix 3  Project Evaluation Techniques

TO BE OR NOT TO BE …

PROJECT CASH FLOW

PAYBACK

AMORTIZATION

TIME VALUE OF MONEY

NET PRESENT VALUE

RATE OF RETURN

Index

Copyright © 2010 by John Wiley & Sons, Inc. All rights reserved

Published by John Wiley & Sons, Inc., Hoboken, New Jersey

Published simultaneously in Canada

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Library of Congress Cataloging-in-Publication Data:

Hill, Richard (Richard William), 1947–

 Engineering money : financial fundamentals for engineers / Richard Hill and George Solt.

p. cm.

 Includes index.

 ISBN 978-0-470-54601-7 (pbk.); ISBN 978-1-118-06308-8 (ebk.)

1. Engineering–Accounting. 2. Engineering–Finance. I. Solt, George S. II. Title.

 TA185.H55 2010

 658.15024′62—dc22

2010007985

Preface

There is a traditional gap in an engineer’s education. Most academic courses around the world do little to explain that engineering projects depend as much on financial matters as they do on technology. Without money projects don’t get built, and without profits there would be no incentive to build them.

In 1996 George Solt pioneered a course on this for senior-year civil engineering students at University College London, and Richard Hill took over the course in 2002. We now teach it to BEng, MEng, and MSc students in civil, mechanical, chemical, and biochemical engineering. When mature engineers hear about it, they all say “Gosh! I wish they’d taught me that when I was a student, I had to learn the hard way.” This book is based on that course and aims to fill this gap in engineering education for both students and young engineers in industry. We must be doing something right because, since the first version of this book, our student numbers have grown so much that even though we run two parallel version of this course every year, we’ve had to move to a bigger lecture hall!

We both graduated in chemical engineering—George in 1950 from Battersea (now the University of Surrey) and Richard in 1970 from the University of Leeds. George spent 35 years in industry, in technical and R&D roles, and a short spell in a management consultant role before becoming a full-time academic. He was also engaged as technical expert for a number of major disputes before the High Court in London.

Richard worked for 25 years in design and proposals followed by 20 years as an independent consultant. We were both in the specialist field of water treatment plant contracting. The experience we gained and the lessons we learned are applicable to all branches of engineering, especially that of project engineering, where the interaction between money and engineering is more difficult and more important than others.

We two have worked together, first in process plant contracting and then as teachers, for so long that we can speak with one voice. When you read “I” in the text, it might be either one of us speaking, but it really makes no difference.

Our experience showed us that there is a need for teaching this subject to everyone who deals with projects. Of course, the need is greatest for engineers, all of whom will sooner or later find themselves acting as either contractor or client in some project.

There’s nothing difficult in the bits that make up this subject. So why does it have to be learned? Because in this field everything is interconnected—that’s why the book is full of cross references: The trick is to understand how the whole system works.

To make things easy, we have simplified definitions and explanations wherever we thought we could without actually misleading anyone. On the other hand, you’ll see boxes with interesting or entertaining bits that are only marginally relevant, so they’re easily skipped if you wish. We hope that they’ll help to explain why it’s so important for engineers to have a good understanding of financial matters.

Project engineering is, increasingly, an international business and, like most businesses these days it’s a 24/7 workplace. I do my consulting work from a small town near London. On a recent project the site team in Shanghai would send me questions by e-mail at 10 AM (which is 6 PM there) expecting to have an answer the following morning. So after 2 PM UK time I could talk to the plant contractors in the United States (who don’t get to work before then), and they might let me have the data I need at about 10 PM (5 PM their time) before leaving for home. I would then work through to respond to Shanghai by 1 AM UK time (that’s when they start work in the morning): 24/7 is OK provided that you don’t have to work all those hours yourself.

So we must be aware of different time zones, different customs, and different currencies. In this new edition we’ve used U.S. dollars, pounds sterling, and euros in our examples—it’s as well to get to used to it.*

George Solt

Richard Hill

Note

* Exchange rates have varied a lot in recent years, but at the time of writing, the £ and € are roughly similar in value and worth about $1½ each.

Chapter 1

What’s It All About?

IT’S ALL ABOUT MONEY

Engineers create wealth. It really is a simple as that. There’s an old American tag that an engineer is a man who can do for half a dollar what any fool can do for a dollar. We create wealth by finding cost-effective solutions to problems. Railways, airplanes, atomic bombs, agricultural machines, generation of electricity, mass production of chemicals and pharmaceuticals, computers, and water supply: Engineers have made their mark in every area of human endeavor, and they have done it by reducing costs.

Engineers work in a variety of activities including design, construction, manufacturing, production, research and development, and maintenance—each of which is, ultimately, concerned with money.

ENGINEERING ACTIVITIES

Design is about devising some way of meeting an objective while making the best use of resources—labor, materials, and energy—all of which are measured in money. We also have to think of the environment and sustainability. These, too, have associated costs, but we are still learning how to measure them. That leads to difficulties that, to be honest, we haven’t yet learned to resolve.

Construction and production are actually the ends of a wide spectrum of making things—a new airport at one end and churning out family saloon cars at the other. At the extremes, construction is a one-off, long-term endeavor that involves at least some novelty, whereas production is continuous and involves little novelty. In between, the two merge continuously into one another. Building a cruise ship is a construction project: Making motor boats is production. The difference is in the size, the novelty, the time scale, and the relationship between the buyer and the manufacturer of the product.

The importance of money matters also changes continuously along the spectrum. It is most difficult and important at the “construction” end. Money is, of course, important in production, but the engineer’s work is no more affected by it than if he were making baked beans, and the same goes for those working in maintenance. (So far I’ve said nothing about research and development, which is quite different, and there is a separate chapter on that subject.)

Construction work is classically undertaken by consultants and contractors. They are the people who are in the front line in the subject of this book—that is why much of it is addressed directly to them. However, most engineers will sooner or later be involved in building, upgrading, replacement, major refurbishment, and the like—all activities that involve consultants and contractors. Disputes can arise because clients don’t understand the money problems that contractors face, so there’s no excuse for production engineers to remain ignorant.

ECONOMIC ENGINEERING

The history of automotive engineering is littered with technological innovation. Henry Ford’s Model T, Vincenzo Lancia’s Lambda, Ferdinand Porsche’s Volkswagen Beetle, Pierre Boulanger’s Citroen 2CV, Alec Issigonis’s Mini, and many more. These innovations were driven by economics: to make an automobile that was more affordable but without sacrificing quality and design.

My colleague the keen sales director (see Chapter 7) had a Rolls Royce Phantom III (1937 model) of which he was immensely proud. It weighed 2.25 tons and got 7 miles to the gallon. People often asked whether they might look under the hood. There they would find a downsized version of the Merlin engine—the one that powered the Spitfire and other famous World War II aircraft: a 7-liter V12 engine, with 24 spark plugs and twin magneto ignition (see Chapter 24). “What a beautiful piece of engineering!” they would exclaim. But, of course, it was the exact reverse—it was a classical case of bad engineering. Ettore Bugatti (1882–1947), who knew a thing or two about motor car design, said of the Rolls Royce that it “represents the triumph of mechanics over engineers.”

Which of theses innovative automobiles is the most important is a matter of opinion, but they were all far superior, in engineer­ing terms, to contemporary Rolls Royces, which carry the same number of people in large and very expensive gas guzzlers. It’s not hard to design and build anything if you can use the most expensive materials, take as much space as you like, and pay no attention to its running and maintenance costs—in short spend unlimited amounts of money.

While these technological innovations were made for commercial reasons, they also resulted in sociological change by bringing automobiles, which had been the preserve of the wealthy, within the reach of almost everyone. Indeed, the Mini became something of an icon of the 1960s, being driven by princesses, film stars, and factory workers. Engineers often underestimate the way they affect society both for good and bad (see Chapter 28).

WHO BENEFITS?

There are many textbooks on “management.” Most, in my experience, are rubbish. I do, however, recommend Up the Organization by Robert Townsend. It was published decades ago, but it is still a classic. His answer to the question in the chapter title is “If you can’t do it excellently, don’t do it at all. Because if it’s not excellent, it won’t be profitable or fun, and if you’re not in business for fun or profit, what the hell are you doing here?”

Ultimately it’s society or “the public.” Unless there is a benefit to the general public, engineering innovations fail. Naturally, individuals and corporations make money along the way: Engineers are no more altruistic than other humans. But that is what provides the impetus for innovation. When Isambard Brunel built the pioneering Great Western Railway he did it for the benefit of the burghers of Bristol, who wanted to compete with the London docks for trans-Atlantic trade, and they paid him well for his efforts. But the benefit of lower cost travel between London and the west is still with us.

Businesses exist to make money—that is, a profit—for someone. So, ultimately, do engineers.

WHERE’S THE TECHNOLOGY?

The word engineer comes from the same Latin word as ingenious, which implies that we have to use creative skills and inventiveness to solve problems.

We create wealth by innovations in technology or its application, but good engineers are not, primarily, technologists. We create wealth by using our ingenuity to solve problems, and that usually means using technology. What engineers do is to select and adapt the best technology to get the best fit to the problem, but the most difficult problems are often those of implementing the solution.

This is where social, political, and above all economic questions get mixed up with pure technology and very often become the controlling element. In my own field of water treatment, we currently have all the necessary technology to convert domestic wastewater (sewage) into drinking water, but persuading the public that the product is safe to drink—a sociopolitical problem—can only be achieved by education and persuasion.

Technological problems usually have a simple right answer—how thick does a 200 mm wide beam have to be to support a uniformly distributed load of 30 tons over a span of 10 m? Engineering problems, on the other hand, have answers that vary depending on the conditions of time and place.

Another example from wastewater treatment is wet-air oxidation. Capable of destroying a wide range of organic contaminants in wastewater, the process was developed in the 1950s by F. J. Zimmerman, a British engineer working in Wisconsin. In spite of continuing technological development, wet-air oxidation was always too expensive, in both capital and operating costs, to be attractive for wastewater treatment. In the last decade things have changed: Alternative disposal options such as chemical treatment and landfill, have become relatively more expensive as a result of environmental legislation and taxation. So, half a century after the technology was invented, the economic climate has changed and wet-air oxidation’s time has finally arrived.

Geography also has a major influence, as the tale of L & C Steinmüller shows. The company started as a paper mill in Gummersbach, a remote village in the hills near Cologne, Germany, that took its product to the nearest railhead by oxcart. In the nineteenth century it replaced the oxen with an English steam locomotive. It had a multipass fire tube boiler. It failed miserably because, on steep uphill gradients, the boiler water drained back. The tubes at the front rose above the water level and, consequently, burned out. “Ach! We must put the water in the tubes,” said Herr S, and had the boiler converted. The water tube design was such a success that boilermaking overtook the papermill as the company’s main business. I was told this story when I visited the company works after the war and saw the original machine displayed at the front entrance. “Made in Thetford” I read. “Have any of you gentlemen ever been to Thetford? It’s in Norfolk, a completely flat part of the UK: this thing was never designed to go up and down hills!”

This is illustrated by the history of power generation. You might think that designing the most efficient power station is a fairly straightforward technological pro­blem, but the developments of the last half-century show that this was not the case, and that economics, sociology, and politics all have an influence. By the 1940s, steam turbine generating sets were the main power generators in the world—coal fired in Europe and oil fired in the United States. Their technology had been refined for several decades. At the end of World War II, the nuclear research effort that had produced the atomic bomb was channeled into power generation, which promised unlimited cheap electricity. By the 1960s nuclear power stations were being built around the world.

In the 1980s, while large reservoirs of natural gas were being exploited, it became apparent that the high initial capital costs and massive decommissioning costs of nuclear power made it more expensive than the newly developed combined-cycle gas turbine technology. Moreover, high-profile nuclear accidents such as Three Mile Island and Chernobyl raised such antinuclear sentiment that governments around the world largely ceased construction of nuclear stations.

By the end of the twentieth century, wars in the Middle East raised the cost of oil, which in turn raised the cost of natural gas. In Europe, Russia’s manipulation of gas supplies added to concerns about the long-term economic security of fossil fuels. Nuclear power once more began to look cost effective. Meanwhile environmental concerns about carbon dioxide emissions, together with the threat of carbon taxes, led to a wave of enthusiasm for “renewable” power using wind, tide, and solar energy. Attractive though these technologies are, they cannot meet the ever-increasing demand for electricity. Many environmentalists, including James Lovelock the “father of the Gaia hypothesis,” concluded that nuclear power’s long-term sustainability outweighed the environmental problems of nuclear waste disposal, which had always been their main concern. Nuclear power seems to be back.

It’s like teaching musical composi‑tion. The Juilliard School, the Paris Conservatoire, or the Royal College of Music are very good at teaching composition, but they can’t turn their students into Bachs or Mozarts.

It’s not easy to teach this sort of thing. In fact, engineering courses generally just teach technology, which is comparatively easy to teach and easy to assess in exams. But engineering projects live or die by money not technology, and most university courses don’t tell you about that. That is why we pioneered this course at University College London and have written this book, which covers most of the outline of the course.

WHAT’S A PROJECT?

It seems that when they started to build the famous Sidney Opera House it couldn’t actually have been built to the original design. (Civil engineers on the whole are pretty critical of architects for occasionally landing them with this sort of situation.) It was only saved from oblivion by a radical redesign.

I’ve used the word project. The best definition I’ve come across for a project is “something that’s never been done before,” though we are here concerned only with engineering projects. Whether it’s a tunnel under the Channel, a space station in orbit, a bacteria-driven computer chip, an oil refinery, or a bridge from Denmark to Sweden, every new engineering project is different. It needs to be designed and it needs to be built. And it needs to be designed and built economically.

The fact that a project is something new means that there must be more or less uncertainty about its outcome. Can we really build it for the budget and in the time proposed? Will it be profitable? Can we afford it? Can we do it at all? There are unknown ground conditions that can affect not only the foundation but the whole approach to construction. Marc Brunel, Isambard’s father, had to invent a tunneling shield to construct the Rotherhithe tunnel under London’s River Thames. It was innovative, completely untried, and had to be developed on the job. Although it’s been updated, the same technology is still used for major tunneling projects such as the UK–France Channel Tunnel.

The last time I saw one of the shields used to dig the Channel Tunnel, it was sitting on a mound near Dover, with a placard saying “FOR SALE—ONE CAREFUL OWNER.”

HOW DO WE BUILD IT?

Most people who want something built don’t themselves have the necessary skills or resources to build it. Building something such as an oil refinery requires a multidisciplinary team of engineers—chemical, mechanical, structural, electrical, and civil—to create the design. Then a vast team of skilled builders and fabricators are needed—scaffolders, pipe fitters, riggers, electricians, and so on. An organization is also needed to coordinate their efforts, no matter how small the project.

The construction industry provides these skills and the organization. It covers every scale of construction from the local builder who constructs house extensions to the international corporations that build power stations, chemical factories, and airports. Construction companies get paid to build projects for their clients. Often either the technology or the organization of such projects, or both, need additional skills that a consultant can provide. The agreement between the client and builder is called a contract and the builder is called a contractor. A consultant works somewhere in between them, and there is quite a variety of ways in which that can be organized.

THE CONTRACTING INDUSTRY

It’s not just engineers who work in the contracting industry who need to understand its needs. Sooner or later most other engineers (e.g., working in production) will also have dealings with the contracting industry, so they too need to understand how contracting operates as a business. It’s much like any other business in its structure and management, but it has many unique characteristics, particularly in the area of finance.

As we’ll see later, the contracting industry is very competitive. Only a few large contracts in any particular sector are placed every year, and it is important for a contracting company to win enough of them to survive. This means that profit margins on turnover are low—typically 1.5–5%—although the return on capital invested is quite good (see Chapter 5).

I worked for a specialist process plant contracting company, and we had sold a water purification system to a large pharmaceutical company. The contract was successful, although there were several disputes during its execution. The following year I was approached by the pharmaceutical company’s project manager to see if we would bid for another water purification system at another factory because they were very pleased with the plant we had built. However, he told me that if we were to be given the opportunity to bid we’d have to nominate another contract manager!

The successful execution of an engineering contract depends greatly on technology and finance; but it also depends on the relationship between the project manager and the contract manager. The first is the purchaser’s representative, who has to get the project completed and pays the contractor, and the second is the contractor’s representative and manages the contract. We will see later how important this relationship is, but first we need to understand a bit more about money.

SUMMARY

Engineering is about money.Project engineering is about risk.Finance for routine production is similar to that for any other routine business.The time scale and novelty of project engineering creates different problems.Every engineer needs to understand about money.

Chapter 2

Money

WHAT IS IT?

I think of money as the stuff we haven’t got enough of—a good oversimplification for a start! Economists probably hate this definition, but it makes an important point: The engineer’s job is to meet some demand by the most efficient use of scarce resources—labor, power, materials. Our common measure for all these is money—it’s a perfectly awful measure but the only one we have.

BRIEF HISTORY OF MONEY

This overview will help to understand where we are now. For thousands of years, people traded by barter—wheat for oil, peacocks for sandalwood, and so on. In time they found that ingots of metal had three properties that made them particularly useful for trading, and so they became the basis for money. Compared with other useful goods, metal was

A valuable and scarce resourceCompact and easily transportedNot perishable.

The Chinese tael was a silver ingot with a standard weight of about 37 g, whose value varied with the price of silver at the time.

In 1941 the Abyssinian currency was still the Maria Theresa dollar. It was originally an Austrian silver coin (28 g) that was minted all over the world until after World War II. Its value was in its weight of silver and mostly was used in northeast Africa. The British army, which invaded the Italian-held country from Kenya, paid their auxilliaries in Maria Theresa dollars and needed great mule trains, their saddle bags weighed down with silver coins, to transport them.

At first, the shape of the bits of metal used for trading was unimportant, their value being set by their weight. It became what we now call money when they stamped metal into standard sizes, with some mark to indicate a value—but in the beginning that value was still their weight of gold, silver, or copper.

When the value of coins became fixed rather than dependent on their weight, some crafty people found they could snip silver or gold from their edges and melt the snippings down. Milled edges (introduced by Isaac Newton when he was warden of the Royal Mint) prevent that, and our higher denomination coins still have them—even though today’s coins are made of cheap alloys.

If customers lose confidence in their bank, they may all try to withdraw their deposits at the same time. This is known as a “run on the bank.” As more customers withdraw their cash, so panic spreads. It can result in the bank collapsing. The financial crisis of 2007 resulted in the first run on a UK bank (Northern Rock) since 1866 when Overend Gurney failed.

Carrying precious metal about may be less troublesome than wheat or peacocks, but it is still a cumbersome business and invites robbery. To overcome these two problems, banks (initially in Italy) began to write personal letters promising payment. A merchant going from Milan to Antwerp to buy English wool would pay cash into the bank in Milan and take with him such a note addressed to the Antwerp branch. He could then travel light and in safety because the bit of paper he was carrying was of no use to anyone else. The Italian bank’s agents in Antwerp would pay him in cash when he actually needed to pay for the wool.

In 1695 the Bank of England issued the first bank notes, which could be cashed by anyone. These notes were an undertaking by the Bank of England to pay the specified amount in gold or silver. Other banks followed suit. They claimed to have enough in their vaults to cover the total value of all the notes they issued, but quite soon that stopped being true. Everyone really knew that was so, but the notes still represented silver and gold and they were “as good as gold”—just as long as there wasn’t a run on the bank. Today’s UK £10 bank notes still say “I promise to pay the bearer on demand the sum of Ten Pounds” signed by the chief cashier of the Bank of England. It is a meaningless promise. What can the poor man actually do if anyone tries to enforce it?

From 1450 until 1931 the UK currency included a little £1 gold coin called a “sovereign”. It weighs 8 g and is no longer currency, but it is still minted and traded widely for its gold value which (in 2010) is about £150. Assuming the value of gold is constant (it isn’t, but it doesn’t vary enormously), that represents an inflation rate of 6.5% per annum over the last 80 years.

All other coins were of copper or silver, but then silver coins were withdrawn and replaced by cupro-nickel so that by 1950 there were only a few still in circulation. In 1971, the traditional system of pounds, shillings and pence (£ s d) was changed to metric currency, and all coins were replaced by new ones. We needed that because the big old penny coins (some of which had been in circulation for a century) were now worth more than a penny as scrap. copper. The Royal Mint was having to mint new ones at a loss.

Inflation has soldiered on since then. If the new little “copper” coins were made of copper, they would now be worth melting down, but they’re a cheap alloy, not copper.

The system collapsed after World War I. First the Austrian and German currencies became worthless, and then around 1930 both Britain and America “came off the gold standard”—that is, they stopped pretending that their paper money was convertible into gold. For the first time the link between money and a scarce resource had been broken.

After that there was no obvious limit to how much money could be printed. Some people, however, were surprised to find that the more money was printed, the less it was worth. Inflation had arrived.

INFLATION

Engineering depends on accurate measurements for which we have units such as grams and kilowatts. Money, our only way of measuring the value of scarce resources, is not only notoriously inaccurate, it is also highly variable. For example, when a book says a ton of sulfuric acid costs $100 it doesn’t mean a thing. You need to know when the book was published and how much inflation has increased since then.

Inflation is good news for borrowers because the real value of their debt goes down, so governments, who are the biggest borrowers of all, love inflation. Naturally enough, they aim at the highest level of inflation, which doesn’t annoy the voters—the present (2010) UK government has set a target of 2% per annum. The actual rate has recently been a bit lower. For the first time ever, there have actually been complaints that inflation is too low!

Unless the world finds a more sensible means of measuring the value of scarce resources, we can expect that inflation will always be with us. It is now universal, but greater for some currencies than others. There is always the chance that it may get out of control in some places, as it did in Britain in the 1980s when it rose to 16% per annum: It is hard to budget for the cost of a project if you don’t know by how much prices will have risen by the time it is finished.

Governments make up a “basket” of household commodities and regularly measure how much that costs. The basket represents constant value, so this makes quite a good system for measuring inflation. However, it doesn’t provide us with a unit to use in everyday calculations—which is where the Mars bar came in.

Even then, 16% inflation is chicken feed compared with Germany and Austria in the 1920s, when a postage stamp could cost millions or even billions of marks or crowns, or Zimbabwe in recent years when the price of a loaf of bread would rise during the day.

Measuring the rate of inflation needs some measure of “constant” value. Gold and silver used to serve in the past, but what are we to use now? Some years ago an ingenious journalist claimed that the Mars bar hadn’t changed in decades (he was wrong there, actually!) and could be used as a measure of constant value. His examples in terms of Mars bar economics showed how borrowers profit from inflation—which naturally means that lenders lose from it. I myself think the kilowatt-hour (kWh) is a more likely measure of constant value—it seems more plausible, at least.

HOW MARS BAR ECONOMICS MADE SOME OF US RICH

When inflation was up to 16%, it was still possible to borrow money at much lower rates—an incentive to borrow as much as possible. Here’s a highly simplified example.

Suppose in 1975 I bought a house for $160,000, paying $40,000 in cash and the rest by borrowing $120,000 to be repaid after 15 years, at 6% per annum interest—that’s $7200 per annum, which would come to a total of $108,000 in 15 years.

Suppose inflation between 1975 and 1990 averaged 10% per annum. In 1975 a kWh cost 3¢. Assuming that it has a constant value, its cost in 1990 would then be about 12¢, and the average cost of a kWh during those 15 years 7.5¢.

In 1975 $160,000 was equivalent to 5333 megawatt-hours (MWh), and we’ll assume that this is the true value of the house, and that it will remain constant.

In 1990 I sold the house for its true value, which at 12¢/kWh brought me $640,000, so the whole deal works out as shown in Table 2.1.

Table 2.1 Buying and Selling a House

 Dollars ($)Megawatt-hours (MWh)Money going out   Cash (1975)40,0001333 Interest (1975–1990)108,0001440 Repayment (1990)120,0001000 Total Cost268,0003773Money coming in   Sold (1990) for640,0005333Profit   Profit372,0001560

So I lived rent free for 15 years and made a cash profit of 1560 MWh (=$188,000 in 1990)—which is almost a third of the real value of the house. Table 2.1 is realistic—it represents pretty well how I got a great windfall without doing a hand’s turn for it. The next generation is not going to be so lucky.

On the other hand, when my wife’s mother was married in 1904, her parents gave £6000 worth of 4% government stock. The idea was that if her husband died, the annual interest income of £240 from it was enough to keep a lady in modest comfort (including employing a maid). Now it will just cover 2 months’ worth of the local tax on my little house.

INTEREST

If I offer to give you either a $25,000 car or a check for $25,000, you will be sensible to take the check. You can buy anything you really want with it, including the car. This flexibility makes money more useful than an item of the same value. Rather than buying a car you could hire one, and that means paying rental. But actually cash is more useful than a car, so it seems reasonable that hiring money means you should pay rent for it—it’s called interest.

The Old Testament forbids lending money at interest. By the time the New Testament was written, moneylenders were clearly flourishing, so it seems no one had taken too much notice of the prohibition. Another 500 years later, and the Koran forbids it again.

Why has interest had such a bad press ever since money was invented? Because people who are desperate for money are obviously a “bad risk,” and banks won’t lend to them. Then they have no choice but to borrow from those who charge unreasonably high interest (we’ll discuss reasonable interest in a moment). This is called usury and becomes a kind of extortion. Usury often wrecks people’s lives, which is why it is rightly considered wicked. But usury is no different from charging unreasonably high rent to people who are desperate for somewhere to live. None of the Good Books mentions that nor the distinction between charging reasonable interest and usury.

WHAT IS A “REASONABLE” INTEREST RATE

The important question is therefore: What is a reasonable rate of interest? As with other goods and services, that depends on supply and demand. Historically, however, it is roughly between 1 and 3% per annum for an absolutely cast-iron safe loan. Absolutely cast-iron safe loans hardly exist, so in all real cases we have to think how other influences affect the reasonable interest rate.

Suppose I lend $120 for 10 years to each of 100 people: What interest should I reasonably charge?

The first problem comes from inflation. Suppose a kWh now costs 12¢, so that my $120 is now worth 1 MWh. After 10 years at 2% inflation, the $120 repayments I expect to receive will only buy 0.8 MWh each, so I must charge 2% interest just to offset that loss.

Then there is the risk that some of my debtors will die, go bankrupt, or run off with my money. If I reckon that each year I may lose 2 out of the 100 debtors, I must stick another 2% on the interest to break even.

I’ll have to keep records and then chase up my 100 debtors to get paid the annual interest and to get the loans repaid at the end—the cost of the necessary administrative cost east for that might come to, say, another 1%.

So far we have:

Inflation2%Risk2%Administration1%

Borrowing rates are sometimes quoted as APR (annual percentage rate), which usually means the effective APR, that is, the compound interest rate.

A simple interest rate of 24% per annum means that you pay annual interest of $24 on a $100 loan. Credit cards often quote rates per month and you might think that a rate of 2% per month is the same as a nominal APR of 24% per annum. In fact at 2% per month the effective APR is 27% per annum, and you’d pay annual interest of $27 on your loan.

On that basis 5% interest would only just break even. If I am content with a modest return of 2%, the actual interest rate comes to 7%. It sounds like a lot, but (on the above assumptions) it’s reasonable. Credit cards have high administrative costs and quite a lot of defaulters, so their interest rates are normally around 15–20% (which, to be honest, I think is verging on usury).

So the variables that govern a reasonable interest rate are inflation, risk, administration costs, and real return.

THE BANKS

As we shall see shortly, loans are a major factor in sizable engineering ventures, so that making loans available is an essential service to them. The many entitles what which perform that duty go under several that names, but I shall call them all “banks.” They exist by borrowing money at one interest rate and lending it at a higher one. The Bank of England is the UK government’s bank: its “base rate” (“prime rate” in the US) is (more or less) the interest rate at which other banks in the UK can borrow money. One of the Bank of England’s main duties is to control the UK economy, for which the level of the base rate is a major tool, and the bank reviews it every 4 weeks.

Every currency system in the world has a central bank of its own that sets a base rate, such as the “Federal Reserve, the Fed, in the United States, and the Central European Bank in Frankfurt.

Why did the great medieval cathedrals take decades and sometimes centuries to build? Maybe the bishopric might have engaged more stonemasons to speed up the work, but often it couldn’t. If the work was paid out of the income that the bishopric could raise every year, it probably couldn’t raise the money any faster and that limited the speed at which the work could go on.

Projects depend on finance being available when needed. In developing countries you see a lot of half-finished buildings, and the usual reason is that the money ran out, so work had to stop until cash could be found to go on with the work.