ENGINEERING ECONOMY

MODULE 5: SELECTION AMONG ALTERNATIVES

Engineering or business projects can be accomplished by more than one method or

alternatives. The alternatives are developed from project proposals to achieve a stated
purpose. Engineering economic analysis is more than simply solving interest problems.
The decision process requires that the outcomes of feasible alternatives be arranged so
that they may be judged for economic efficiency in terms of the solution criteria.

In the real world, the majority of engineering economic analysis problems is alternative
comparisons. In these problems, two or more mutually exclusive investments compete
for limited funds. A variety of methods exists for selecting the superior alternative from
a group of proposals. Each method has its own merits and applications
The objective of chapter 7 is to evaluate correctly capital investment alternatives in
making decisions.

Making decisions means comparing alternatives. There are two basic types of
alternatives.

Investment Alternatives-Those with initial capital investment that produces positive cash
flows from increased revenue, savings through reduced costs, or both.

Cost Alternatives -Those with all negative cash flows, except for a possible positive cash
flow from disposal of assets at the end of the project’s useful life.

The fundamental principle on which alternative should be used is stated as follows:

The alternative that requires the minimum investment of capital and will produce
satisfactory functional results will always be used unless there are definite reasons why
an alternative requiring a larger investment should be adopted.

METHODS OR PATTERNS IN COMPARING ALTERNATIVES

There are several methods for comparing alternatives, such as

1. The rate of return on a additional investment (ROR)

2. The annual Worth Method (AWM)
3. The Equivalent Uniform Annual Cost Method (EUAC)
4. The Present Worth Method (PWC)
5. The Future Worth Method (FWM)
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A. THE RATE OF RETURN ON ADDITIONAL INVESTMENT (ROR)

If rate of return is used to select among two or more investments, an incremental

analysis must be performed. An incremental analysis begins by ranking the alternatives
in order of increasing initial investment. Then, the cash flows for the investment with
the lower initial cost are subtracted from the cash flows for the higher-priced alternative
on a year-by-year basis.
The formula for the rate on additional investment is,

𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠

𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚,𝑒𝑛𝑡𝑠

If the rate of return on additional investment is satisfactory, then , the alternative

requiring a bigger investment is more economical and should be chosen.

B. THE ANNUAL WORTH METHOD (AWM)

The annual worth method assumes that each alternative will be replaced by an
identical twin at the end of its useful life (i.e., infinite renewal). This method, which may
also be used to rank alternatives according to their desirability, is also called the annual
return method or capital recovery method.

To apply this method, the annual cost of the alternatives including interest on
investment is determined. The alternative with the least annual cost is chosen. This
pattern, like the rate of return on additional investment pattern, applies only to
alternatives which has a uniform cost data each year and a single investment of capital
at the beginning of the first year of the project life.

C. THE EQUIVALENT UNIFORM ANNUAL COST METHOD

The major advantage of this method is that it is not necessary to make the comparison
over the same number of years when the alternatives have different lives. The reason
for that, it is an equivalent annual cost over the life of the project.

In this method , all cash flows must be converted to an equivalent uniform annual cost,
that is, a year- end amount which is the same each year. The alternative with the least
equivalent uniform cost is preferred. When EUAC method is used, the equivalent
uniform annual cost of the alternatives must be calculated for one life cycle only. This
method is flexible and can be used for any type of alternative selection problem.
 ENGINEERING ECONOMY

D. THE PRESENT WORTH COST METHOD ( PWC)

When two or more alternatives are capable of performing the same functions, the
economically superior alternative will have the largest present worth. The present worth
method is restricted to evaluating alternatives that are mutually exclusive and that have
the same lives. This method is suitable for ranking the desirability of alternatives.

In comparing alternatives by this method, determine the present worth of the net cash
outflows for each alternative for the same period of time. The alternative with the least
present worth of cost is selected.

E. FUTURE WORTH METHOD

The future worth for economy studies is exactly comparable to the present worth
method except that all cash inflows and outflows are compounded forward to a
reference point in the future. The alternative with the least future worth cost is chosen.

Problems

1. A company is considering two types of equipment for its plant. Pertinent data are
as follows:

TYPE A TYPE B

First Cost P400,000 P600,000

Annual Operating Cost P64,000 P48,000

Annual Labor Cost P100,000 P64,000

Insurance & Property 6% 6%

Taxes

Payroll Taxes 8% 8%

Estimated Life, years 10 10

 ENGINEERING ECONOMY

If the minimum required rate of return is 15% which equipment should be

selected? (Solve by ROR, AWM, PWM, FWM, AND EUAC)

a) THE RATE OF RETURN ON ADDITIONAL INVESTMENT METHIOD (ROR)

For TYPE A For TYPE B

Operating cost= 64,000 Operating cost= 48,000

Labor cost= 100,000 Labor cost= 64,000

Insurance= (0.06x400,000) 24,000 Insurance=(0.06x600,000) 36,000

Payroll= (0.08x100,000) 8,000 Payroll= (0.08x64,000) 5120

400,000 600,000
Dep’n= 10 (0. 15) 19,700.83 Dep’n= 10 (0. 15) 29,551.24
(1+0.15) −1 (1+0.15) −1

Total = 182,671.24
Total = 215,700.825

215,700.825−182,671.24
𝑅𝑂𝑅 = 600,000−400,000
(100%) =16.51%

(WATCH THE VID LEC)

2. The following data have been estimated for two feasible investment A and B , for
which revenues as well as costs are known and which have different lives. If the
Minimum attractive rate of return is 10% show which feasible alternative is more
desirable?

A B

Investment $3,500 $5,000

Annual Revenue $1,900 $2,500

 ENGINEERING ECONOMY

Annual Cost $645 $1,383

Useful Life, years 4 8

Salvage Value 0 0