ENGR 3360U Winter 2014

Unit 9
Other Choosing Techniques
Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2014-I-01

Unit 9 Other Choosing Analyses

Change Record
2014-I-01 Initial Creation
Text Chapter 9

9-2

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Course Outline
1.
2.

3.
4.
5.
6.
7.
8.
9.
1-3

Engineering Economics
General Economics
1.
Microeconomics
2.
Macroeconomics
3.
Money and the Bank of
Canada
Engineering Estimation
Interest and Equivalence
Present Worth Analysis
Annual Cash Flow
Rate of Return Analysis
Picking the Best Choice
Other Choosing Techniques
2014-I-01

10. Uncertainty and Risk

11. Income and Depreciation
12. After-tax Cash Flows
13. Replacement Analysis
14. Inflation
15. MARR Selection
16. Public Sector Issues
17. What Engineering should know
about Accounting
18. Personal Economics for the
Engineer

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Learning Objectives

9-4

9.1 Future Worth Analysis

9.2 BenefitCost Ratio
9.3Payback Period Analysis
9.4 Sensitivity Analysis
9.5 Break-even Analysis

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

In contrast to present worth analysis, one might

want to know the situation of a set of
alternatives at any point in time in the future.
Future worth analysis is very similar to present
worth analysis but the analysis exists at some
future point in time.
As in present worth analysis, the evaluation of
alternatives must be over the same time period.

9-5

This implies that the use of LCM or a specified

time period is needed.

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Example 9.1
Ron is a 20-year old UOIT student who
smokes a carton of ciggies a week. If he
stops smoking and places this money in a
savings account which earns 5%
compounded semi-annually, what is his
future worth at 65 if a carton costs $85?

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2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Answer
Semi-savings = 85x26 = 2,210
FW = (F/A, 2.5%, 90) = 2210(329.2)
= $727, 532 (at least)

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

9.2 Benefit-Cost Ratio Analysis

At a given MARR an alternative that would be
acceptable when:
PW of benefits PW of costs >= 0
or
EUAB EUAC >= 0

This makes sense as the benefits outweigh the costs for

a net positive benefit at MARR over a specified
lifetime.
This could also be stated as a ratio:
PW of benefits/PW of costs >= 1

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Called the BenefitCost Ratio

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Benefit-Cost Ratio Analysis cont.

In the public sector it is common that:

The numerator includes all consequences to the

user or public (Benefits Disbenefits).
The denominator includes the consequences to
the government or sponsor.

The ratios may differ in exact value by this

method, but, more importantly, the decision
point (> or < 1) does not.
The conclusions remain the same.
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2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Example 9-2
Two machines have a life of 5 years. A costs
$1000 and will earn $300 annually. B costs
$1350 and will earn $300, the first year,
$350 the second and so on. At 7%, which
machine should be selected?

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2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Solution
Incremental B-A
PWcosts = 1350 1000 = 350
PWbenefits = (0-0) + 50(P/G, 7%, 5) = 382
B/C = 382/350 = 1.09
Note that direct calculation gives the wrong
answer.

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2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Example 9.3
Here are 6 mutually exclusive alternatives.
They have a 20 year life. At 6%, using B/C
ratio, which would you pick?
A
B
C
D
E
F
Cost 4K 2K 6K 1K 9K 10K
PW 7.3K 4.7K 8.7K 1.3K 9K 9.5K
B/C 1.8 2.4 1.5 1.3 1.0 0.95

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2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Benefit-Cost Ratio Analysis

Graphed individual project points from Example 9-5

The slopes indicate B/C ratios of the increments between projects.

Example(s): B D slope is greater than 1.0

A C slope is less than 1.0

F is not considered (B/C ratio is less <1)

2014-I-01
Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

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Unit 9 Other Choosing Analyses

Solution
Discard F (B/C < 1)

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Solution
B-D
Cost
1K
Benefit 3.4K
B/C
3.4
1) Chose B over D
2) Chose A over B
3) Chose A over C
4) Chose A over E
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A-B
2K
2.6K
1.3

C-A
2K
1.4K
0.7

E-A
5K
1.7K
0.34

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

9.3 Payback Period

Payback period is:

The period of time required for the profit or Other
Choosing benefits of a project to equal the cost.
Note: Interest Rate is NOT considered

Four important points:

1)
2)
2)
3)

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This is an approximate calculation.

Costs/benefits/savings are included with no consideration
of timing differences.
All economic consequences beyond the payback are
ignored, including salvage!
Due to its approximate nature, it may not select the correct
alternative.

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Example 9.4
A firm is trying to decide which of 2 scales it
should buy. If both have a 6-year life, which
should be selected at 8%, using PB?
Choice
A
B

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Cost
2K
3K

UAB
450
600

Salvage
100
700

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Payback Period Example

9-18

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Solution
Ignore Salvage and interest rate
PBA = cost/UAB = 2000/450 = 4.4 years
PBB = 3000/600 = 5 years

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2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

9.4 Sensitivity Analysis

Since economic problem solving often
considers future consequences, there is
uncertainty regarding accuracy.
To better evaluate the impact of estimates,
we can compute how much an estimate can
change and the effect on a particular
decision.
This is Sensitivity Analysis.
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2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

9.5 Break-Even Analysis

Break-Even Analysis is a form of
sensitivity analysis.
Typically presented as a break-even chart.
It indicates the point at which two
alternatives are equal to each Other
Choosing.

9-21

The point of indifference

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Example 9-5
Consider a project that may be constructed to full
capacity now or may be built in 2 stages.
Assume 40 year life at 8%, no SV.
Costs
2-Stage
first stage now
100,000
2nd stage n years out
120,000
Full capacity
do it now
140,000
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2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Solution
Full Cap = 140,000
2-Stage
PW = 100000 + 120000(P/F, 8%, n)
n=05
n=10
n=20
n=40

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PW = 182,700
PW = 155,600
PW = 125,700
PW = 111,900

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Break-Even Analysis, contd.

Example 9-11

9-24

Shows present worth of building both stages now

versus building a second stage at a later date.
The point at which they are equal is when the second
stage is built in year 15.

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Summary
Future Worth Analysis

Comparisons between alternatives made based

on a future time

Benefit-Cost Ratio Analysis

9-25

Analyses the ratio of benefits to costs through

present worth or annual worth.
Incremental benefit-cost ratios are used for
multiple alternatives when neither input nor
output are fixed.
Often used in various levels of government.

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Summary, contd.
Payback Period Analysis

9-26

The period of time required for profit or Other

Choosing benefits to equal the cost of the
investment.
A poor method for ranking alternatives
because interest rate is NOT considered.
Simply measures the time it takes to recover
the investment in original dollars.

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 9 Other Choosing Analyses

Summary, contd.
Sensitivity Analysis

Used to determine how sensitive a decision is to

estimates and parameters.
Examination of the range of values to
determine their effect on a decision.

Break-Even Analysis

9-27

To locate the condition where alternatives are

equivalent.
Often uses a break-even chart.

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco