Applied Software Project Management

Engineering Economics

Annual Equivalence Analysis

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Applied Software Project Management

Road Map

Chapter 6 Annual Equivalence Analysis Annual Equivalent Worth Criterion Applying Annual-Worth Analysis Comparing Mutually Exclusive Projects

Applied Software Project Management

Annual Cash Flow Analysis

Annual cash flow analysis is the method by unit costs are calculated. Annual-equivalence analysis, along with present-worth analysis, is the second major equivalence technique for translating alternatives into a common basis of comparison

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Applied Software Project Management

Annual Equivalent Worth Criterion

The annual equivalent worth (AE) criterion provides a basis for measuring investment worth by determining equal payments on an annual basis First find the net present worth of the original series and then multiply this amount by the capital-recovery factor AE(i) = PW(i) (A/P, i, N) Evaluating a Single Project: The accept-reject decision rule for a single revenue project is as follows: If AE(i) > 0, accept the investment. If AE(i) = 0. remain indifferent to the investment. If AE(i) < 0, reject the investment
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Applied Software Project Management

Annual Equivalent Worth Criterion

Comparing Multiple Alternatives: As with presentworth analysis, when you compare mutually exclusive service projects that have equivalent revenues, you may compare them on a cost-only basis. In this situation, the alternative with the least annual equivalent cost (or least negative annual equivalent worth) is selected

Applied Software Project Management

Finding Annual Equivalent Worth by Conversion from Present Worth (PW)

Singapore Airlines is planning to equip some of its Boeing 747 aircrafts with inflight e-mail and Internet service on transoceanic flights. Passengers on these flights will be able to send and receive e-mail no matter where they are in the skies. As e-mail has become a communications staple, airlines have been under increasing pressure to offer access to it. But the rollout has been slow. Because airlines are hesitant to invest in systems that could quickly become outdated. Hoping to provide added value to its passengers, Singapore Airlines has decided to offer the service through telephone modems for 10 Boeing 747s in 2004. As Boeing unveils a broadband e-mail and Internet system during 2004, Singapore Airlines will upgrade the systems on its planes similarly. If the project turns out to be a financial success, Singapore Airlines will introduce the service to the remaining 56 Boeing 747s in its fleet. The service will be free during the first year. After the promotional period, a nominal charge of about $10 will be instituted for each e-mail message sent or received. Singapore Airlines has estimated the projected cash flows (in millions of dollars) for the systems in the first 10aircraft as follows

Applied Software Project Management

Finding Annual Equivalent Worth by Conversion from Present Worth (PW)

n Year 0 1 2 3 4 An (million $) -15.0 -3.5 5.0 9.0 12.0 10.0 8.0

Determine whether this project can be justified at MARR = 15%, and calculate the annual benefit (or loss) that would be generated after installation of the systems Given: The cash flow; i = 15 5%. Find: The AE

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PW(15.5%) = -15.0 -3.5(P/F,15.5%,1) + 5.0(P/F,15.5%,2)+.. = 6.946 million AE(15.5%) = PW(i) (A/P,15.5,6)

Applied Software Project Management

Benefits of AE Analysis

AE preferred over PW: Corporations issue annual reports and develop yearly budgets more useful to present the annual cost or benefit of an ongoing project rather than its overall cost or benefit When consistency of report formats is desired When there is a need to determine unit costs or profits When project lives are unequal

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Applied Software Project Management

Capital (Ownership) Costs versus Operating Costs

Operating costs incurred by the operation of physical plants or equipment needed to provide service; Operating costs recur for as long as an asset is owned Capital recovery costs (or ownership costs) incurred by purchasing assets to be used in production and service. Capital costs are nonrecurring (i.e. one-time costs) In conducting an annual equivalent cost analysis, must translate these one-time costs into its annual equivalent over the life of the project. The annual equivalent of a capital cost: capital-recovery cost, designated CR(i)

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Applied Software Project Management

Capital (Ownership) Costs versus Operating Costs

CR(i) = I(A/P, i, N) S(A/F, i, N) CR(i) = (I-S) (A/P, i, N) + iS Chng minh????? Where: I = the equipment's initial cost S = its salvage value

i(1i)N ] P(A/P,i, N) A P[ (1i)N 1

i A F[ ] F(A/F,i,N) (1 i)N 1
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Applied Software Project Management

Annual Equivalent Worth: Capital Recovery Cost

Consider a machine that costs $20,000 and has a five-year useful life. At the end of the five years, it can be sold for $4,000 after all tax adjustments have been factored in. If the firm could earn an after-tax revenue of $4.400 per year with this machine, should it be purchased at an interest rate of 10%? (All benefits and costs associated with the machine are accounted for in these figures.) Given: I = $20,000, S = $4,000. A = $4,400, N = 5 years, and i = 10% per year. Find: AE, and determine whether the firm should or should not purchase the machine.

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Applied Software Project Management

Annual Equivalent Worth: Capital Recovery Cost

We will compute the capital costs in two different ways:

Method 1: calculate PW(i%) and CR(i)% PW (10%) = -20,000 + 4,400(P/A, 10%,5) + 4,000(P/F, 10%, 5) PW(10%) = -836.88
AE(10%) = -836.88(A/P, 10%, 5) = -220.76 Method 2: to separate cash flows associated with the asset acquisition and disposal from the normal operating cash flows. The operating cash flows, the $4.400 yearly income, already given in equivalent annual flows AE(i)2 convert the cash flows associated with asset acquisition and disposal into equivalent annual flows AE(i)1.

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Applied Software Project Management

Annual Equivalent Worth: Capital Recovery Cost

AE(i)1 = -CR(i) = -[(I-S)(A/P, I, N) + iS] = -[(20,000 4,000)(A/P, 10%, 5) + (0.1)4,000] = -4,620.76 AE(i) = AE(i)1 + AE(i)2 = -4,620.76 + 4,400 = -220.76

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Applied Software Project Management

Road Map

Chapter 6 Annual Equivalence Analysis Annual Equivalent Worth Criterion Applying Annual-Worth Analysis Comparing Mutually Exclusive Projects

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Applied Software Project Management

Unit-Profit or Unit-Cost Calculation

To obtain a unit profit (or cost), we may proceed as follows: Determine the number of units to be produced (or serviced) each year over the life of the asset. Identify the cash flow series associated with production or service over the life of the asset. Calculate the present worth of the project's cash flow series at a given interest rate, and then determine the equivalent annual worth. Divide the equivalent annual worth by the number of units to be produced or serviced during each year. When the number of units varies each year, you may need to convert the units into equivalent annual units.

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Applied Software Project Management

Unit-Profit or Unit-Cost Calculation

Unit Profit per Machine Hour When Annual Operating Hours Remain Constant: Consider the investment in the metal-cutting machine that three-year investment was expected to generate a PW of $3,553. Suppose that the machine will be operated for 2,000 hours per year. Compute the equivalent savings per machine hour at i = 15% compounded annually Given: PW = $3,553, N = 3 years, i = 15% per year, and there are 2,000 machine-hours per year. Find: Equivalent savings per machine-hour.

Annual equivalent saving AE(15%) = 3,553(A/P, 15%, 3) = 1,556 Savings per machine hour = 1,556/2000 = 0.78/hour

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Applied Software Project Management

Unit-Profit or Unit-Cost Calculation

Unit Profit per Machine Hour When Annual Operating Hours Fluctuate Reconsider the above example, Reconsider Example 6.3, but suppose that the metal-cutting machine will be operated according to varying hours: 1,500 hours in the first year, 2,500 hours in the second year. and 2.000 hours in third year. The total number of operating hours is still 6,000 over three years. Compute the equivalent savings per machine-hour at i = 15% compoundcd annually investment in the metal-cutting machine that three-year investment was expected to generate a PW of $3,553. Suppose that the machine will be operated for 2,000 hours per year. Compute the equivalent savings per machine hour at i = 15% compounded annually Given: PW = $3,553, N = 3 years, i = 15% compounded annually, operating hours of 1.500 hours in the first year, 2.500 hours in the second year, and 2,000 hours in the third year. Find: Equivalent savings per machine-hour
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Applied Software Project Management

Make-or-Buy Decision

Make-or-buy problems are among the most common business decisions Unit-cost comparison requires the use of annual-worth analysis. The specific procedure is as follows: Step 1: Determine the time span (planning horizon) for which the part (or product) will be needed. Step 2: Determine the annual quantity of the part (or product). Step 3: Obtain the unit cost of purchasing the part (or product) from the outside firm. Step 4: Determine the cost of the equipment. manpower. and all other resources required to make the part (or product). Step 5: Estimate the net cash flows associated with the "make" option over the planning horizon.

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Applied Software Project Management

Make-or-Buy Decision

Step 5: Estimate the net cash flows associated with the "make" option over the planning horizon. Step 6: Compute the annual equivalent cost of producing the part (or product 1. Step 7: Compute the unit cost of making the part (or product) by dividing the annual equivalent cost by the required annual quantity. Step 8: Choose the option with the smallest unit cost.

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Applied Software Project Management

Unit Cost: Make or Buy

Ampex Corporation currently produces both videocassette cases (bodies) and metal-particle magnetic tape for commercial use. An increased demand for metal-particle videotapes is projected, and Ampex is deciding between increasing the internal production of both empty cassette cases and magnetic tape or purchasing empty cassette cases from an outside vendor. If Ampex purchases the cases from a vendor, the company must also buy specialized equipment to load the magnetic tape into the empty cases, since its current loading machine is not compatible with the cassette cases produced by the vendor under consideration. The projected production rate of cassettes is 79,815 units per week for 48 weeks of operation per year. The planning horizon is seven years. After considering the effects of income taxes, the accounting department has itemized the costs associated with each option as follows:

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Applied Software Project Management

Unit Cost: Make or Buy

Annual Costs: Labor $1.445.633 Materials $2,048.511 Incremental overhead $1,088,110 Total annual cost $4.582.254

"Make" Option:

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Applied Software Project Management

Unit Cost: Make or Buy

"Buy" Option: Capital Expenditure: Acquisition of a new loading machine Salvage value at end of seven years

$405,000 $45,000

Annual Operating Costs: Labor $ 251,956 Purchase of empty cassette cases ($0.85/unit) $3256,452 Incremental overhead $822,719 Total annual operating costs $4,331.127 Given: Cash flows for both options; i = 14%. Find: Unit cost for each option and which option is preferred.

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Applied Software Project Management

Unit Cost: Make or Buy

The required annual production volume: 79,815 units/week X 48 weeks = 3,831,120 units per year The annual equivalent cost under each option: Make Option: AE(14%)Make = $4,582.254

Buy Option: capital cost and operating cost -Capital cost: CR(14%) = ($405,000 - $45,00O)(A/P, 14%,7) + (0.14)($45.000) = $90,249 Annual equivalent cost: AE1(14%) = CR(14%) = $90,249

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Applied Software Project Management

Unit Cost: Make or Buy

-Operating cost: AE2(14%) = 4,331.127 The total annual equivalent cost AE1(14%) = AE1(14%) + AE2(14%) = 4421.376 Make option: unit cost = 4,582.254/3,831,120 = 1.20/unit Buy option: unit cost = 4421.376 /3,831,120 = 1.15/unit

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Applied Software Project Management

Analysis Period Equals Project Lives

Birmingham Steel, Inc., is considering replacing 20 conventional 25-HP, 230-V, 60-Hz, 1800-rpm induction motors in its plant with modern premium-efficiency (PE) motors. Both types of motors have power outputs of 18.650 kW per motor (25 HP = 0.746 kW/HP). Conventional motors have a published efficiency of 89.5%, while the PE motors are 93% efficient. The initial cost of the conventional motors is $13,000, while the initial cost of the proposed PE motors is $15,600. The motors are operated 12 hours per day, 5 days per week, 52 weeks per year, with a local utility cost of $0.07 per kilowatthour (kwh). The motors are to be operated at 75% load, and the life cycle of both the conventional motor and the PE motor is 20 years, with no appreciable salvage value.

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Applied Software Project Management

Analysis Period Equals Project Lives

(a) At an interest rate of 13% compounded annually, what is the amount of savings per kwh gained by switching from the conventional motors to the PE motors? (b) At what operating hours are the two types of motors equally economical? Given: Types of motors = (standard, PE). I = ($13,000, $15,000), S = (0, 0), N = (20 years, 20 years), rated power output = (18.65 kW, 28.65 kW), efficiency rating = (89.j0h, 93%), i = 13%, utility rate = $0.07/kWh, operating hours = 3,120 hours per year, and number of motors required = 20. Find: (a) The amount saved per kwh by operating the PE motor and (b) the break-even number of operating hours for the PE motor.

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Applied Software Project Management

Tutorial

Do end chapter problems:

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