That probably depends on the software - But If you don't use mpeg2, your dvd will suck bigtime. Some authoring software will re-encode your video, so You don not want to convert from avi to mpeg1 to mpeg2 - I'll look awfull. You may be able to author avi to mpeg2 rather than rendering mpeg2 from vf.
However the vf mpeg encoder is better than most (maybe not all).
I use the MPEG2 out from VF (bought the plug in). I use ULEAD Movie Factory (love it)
Movie Factory will also accept AVI files as input for the DVD project but I have not tried if that works better than using MPEG2 as input. (See my other post on that subject)
For clarification, DVD use MPEG-2. If your input video is not MPEG-2, it will be converted into MPEG-2 by your DVD burning software (or at least it should be).
However, this conversion is not lossless in most cases. Converting from MPEG-1 to MPEG-2 will lead to a noticeable quality loss. Therefore, it is recommended that you only import MPEG-2 files or DV-AVI files.
There might be a misunderstanding here - the timeline isn't in avi. What's happening is that VF's displaying whichever bits of media you've selected for your project. Your original media haven't been changed (and wont be!) and there's no output until you "make movie" - the preview's showing what you'll get after you've rendered.