MEE 312 ENGINEERING ECONOMICS (2 Credit Units)

COURSE OUTLINE:

Introduction to Engineering Economics. Concepts of Engineering Economics. Interest: Simple

interest, compound formula and factors, Nominal and effective interest rates, cash flow
diagrams: Derivation of P/F, F/P, A/P P/A, F/A, and gradient series factors (P/G). Deferred
annuities: Capital recovery; continuous compounding. Basic methods of evaluating project
proposals: Present worth, annual worth, future worth, internal rate of return, pay-out period
etc. Breakeven analysis: Linear models, including dumping and production above normal
capacity; Non-linear models. Depreciation: Concept and reason for depreciation of assets;
Depreciation as an expense; Depreciation methods (straight line, sum-of-the year’s digit,
declining balance). Switching between depreciation methods. Basic replacement methods,
dynamic replacement models. After tax economic analysis: Effect of taxes on economic
analyses

1.0 Introduction
In Engineering practice there is always the need to make a choice among several alternatives
to satisfy a needed goal, the basis for such choice could be economic, non-economic, social,
technical, and aesthetic. Engineering economics gives the economic justification for selecting
among such competing alternatives either with respect to project, production processes,
investment design, etc.

Engineering economics is very essential to practicing Engineer who has to make decision on
which proposal to choose among available alternatives. In choosing among the various
alternatives, economic considerations play a very significant role.

Again the success of engineering business or projects is commonly measured in terms of

financial efficiency, i.e. the rate of Naira income to Naira spent, of which a ratio greater than
unity is most desirable in terms of financial desirability. For a project to be financially viable
it must meet the technical and the social requirements. The Engineer is the most likely person
who can provide adequate details and relevant analyses to enhance the technical, financial as
well as social and aesthetic values.

It is pertinent for the engineer in his/her daily activities to be conversant with the calculation
of simple interest and compound interest rates and solve problems using the various basic
formulae. The engineer should also be able to calculate present value, future value, etc of cash
flows series and be in position to determine discounted rate of return of cash flows. He/she
should be able to evaluate and select the best investment from two or more alternatives by
utilizing the various ranking methods.

1.1 Definition of Engineering Economics

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 1
Engineering economics can be defined as the analytical approaches to economic decision
(selection from two or more alternatives), involving engineering and technical projects. It can
also be defined as the application of economics techniques to the evaluation of design and
engineering alternatives. Engineering economics deals with the methods that enable one to take
economic decisions towards minimizing costs and/or maximizing benefits to business
organizations. The role of engineering economics is to assess the appropriateness of a given
project, estimate its value, and justify it from engineering standpoint. The analyses recognize
the fact that there is no one way of solving engineering problems. If there is only one way then
there is no problem to solve.

1.2 Engineering Economic Decision Making

The Engineer has the sole responsibilities to combine his technical and economical knowledge
to enable him in taking a good economic decision i.e. Engineering economic principles +
technical knowledge = Engineering economic decisions.

The economic decisions could be in the following specific areas:

- Equipment replacement and selection;

- New product and product expansion;
- Cost reduction
- Service improvements;
- Equipment and process selection;
- Cost effectiveness;
- Make or buy.

1.3 The Rational Decision Making Process

In making a decision as to which alternatives will be of cost effective, the following inter-
related steps are followed:

(i) Problem definition – recognizing a needed decision to make and the alternatives
available to satisfy the need. That is, identifying a problem which may hinder
the achieving of a goal.
(ii) Defining a goal or objectives
(iii) Identification of feasible alternatives. For example should we produce a certain
component or purchase it from a different manufacturer?
(iv) Collecting of cost information (data) on each alternative base on some criteria.
(v) Selecting the decision criteria – using Annual Rate of Return, Future and present
Worth, and Interest Rate, etc.
(vi) Evaluating the collated data to select the best alternative. The same criteria
should be used to avoid false decision.
(vii) Selection of the best alternative.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 2
2.0 Concepts of Engineering Economics
The concept of engineering economics is based on the principles of Time Value of Money.
Other concepts are; Interest or Rate of return, Compound Interest, Equivalence, and Interest
Period.

2.1 Time Value of Money

Time value of money is defined as the time-dependent value of money stemming both from
changes in the purchasing power of money (inflation or deflation) and from the real earning
potential of alternative investments over time. A sum of money today can multiply to worth
more in future date. This phenomenon of money being capable of earning more money over a
period of time is known as time value of money. What this means is that a unit of account today
is worth more than the same unit of account in future, and therefore N1000 today is “worth”
more than N1000 one year from today. This is attributed to the following reasons:

i. Inflation
ii. Risk
iii. Cost of money

The cost of money is most predictable to the others, and hence is an essential component of
economic analyses. Cost of money is represented by (1) money paid for the use of borrowed
money, or (2) return on investment. Cost of money is determined by interest rate.

2.2 Interest and Interest Rate (i)

Interest is the money paid (net earnings) for the use of borrowed money or return on invested
capital. Interest rate is the per unit return on invested fund within a unit interest period.

2.3 Interest Period (n)

This is the time frame over which the interest or the net return on an investment is evaluated.
This is usually a year, but it could be weekly, monthly or half yearly.

Types of Interest

(i) Simple Interest: This is the earning on invested fund or principal (P) which is
constant over a number of interest periods (n) at an interest rate (i).
(ii) Compound Interest: Here the interest earned is on both the unpaid principal and
the interest accrued at the end of each period, that is, interest is charged on earning
of the previous year which is not so in simple interest.

2.4 Equivalence

Different sums of money that have equal value over an interest period are said to be equivalent.
In engineering economics this is very essential in choosing among alternatives. This is because

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 3
the selection of a specific alternative is only meaningful if the available alternative is reduced
to an equivalent economic base for comparison.

2.5 Salvage Value

This is the price that can be obtained from the sale, removal or scrapping of a property or asset.
The implication of salvage value is that the property still has utility.

2.6 Cash- Flow

Cash flow is the stream of monetary (Naira) values – costs (inputs) and benefits (outputs) –
resulting from investment.

2.7 Cash-Flow Diagrams

It is difficult to solve problem if you cannot see it. The easiest way to approach problems in
economics analysis is to draw a picture. Therefore, cash-flow diagrams are diagrammatical
representation of cash inflows (returns, earnings or income) and cash outflows (expenses, costs
or disbursement) in respect of a project over the project period.

800
700
600
400
350

0
1 2 3 4 5
0
0 0 0 0 0

200
300 300
400
600

They are time diagrams which helps an analyst to visualize the inflow and outflow of money
and when they occur. The time is indicated on the horizontal line while the arrow above the
horizontal line represent inflow and that below it shows the outflow. Unless otherwise stated,
all cash flows occur at the end of their respective periods.

3.0 Interest and Applicable Interest Formulae

Formulae that can be used to carry out calculations of interest compounded over the interest
period to arrive at the equivalence principal are hereby presented. They are derived from the

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 4
concept of time value of money where the present worth of money invested on an item
translates to a new value called the equivalence at an interest rate over a stipulated interest
period which could be a monthly, yearly, half yearly, etc.

3.1 Notation

The following symbols will be used:

P = Present worth (sum) of money or Principal (₦);

F = Future worth (sum) of money (₦) at the end of year n;

n = Number of interest periods;

i = Interest rate per period (%). (It may be compounded monthly, quarterly, semiannually or
annually).

A = equal amount deposited at the end of every interest period

G = uniform amount which will be added/subtracted per period after period to/from the amount
of deposit A1 at the end of period 1

3.2 Simple Interest

To illustrate the basic concepts of interest, let F(n) be the future sum of money after n periods.
Then for simple interest,

𝐹(1) = 𝑃 + (𝑃)(𝑖) = 𝑃(1 + 𝑖), and,

𝐹(𝑛) = 𝑃 + (𝑛)(𝑃)(𝑖) = 𝑃(1 + 𝑛𝑖) -------------------------------------------------------- 1

For example: ₦1000 at 10% per year for 5 years yields:

𝐹(5) = 1000[1 + (5)(0.1)] = 1000(1.5) = ₦1500

However, interest is almost universally compounded to include interest on the interest.

3.3 Compound Interest

𝐹(1) = 𝑃 + (𝑃)(𝑖) = 𝑃(1 + 𝑖), is the same as simple interest,

𝐹(2) = 𝐹(1) + (𝐹(1))(𝑖), interest is applied to the new sum, i.e,

𝐹(2) = 𝐹(1)(1 + 𝑖) = 𝑃(1 + 𝑖)2

𝐹(3) = 𝐹(2)(1 + 𝑖) = 𝑃(1 + 𝑖)3

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 5
And by mathematical induction for n periods

𝐹(𝑛) = 𝑃(1 + 𝑖)𝑛 ----------------------------------------------------------------------- 2

Example: ₦1000 at 10% per year for 5 years yields:

𝐹(5) = 1000(1 + 0.1)5 = 1000(1.1)5 = 1610.50, which is over 7% greater than with
simple interest.

3.4 Interest Factors

Interest factors are multiplicative numbers calculated from interest formulae for given interest
rates and periods. They are used to convert cash flows occurring at different times to a common
time.

(i) Compound Amount Factor

Here, the objective is to find the single future sum (F) of the initial payment (P)
made at time 0 after n periods at an interest rate i compounded every period. In
equation (2) for finding the future value of sum of money with compound interest,
the expression (1 + 𝑖)𝑛 is known as compound amount factor, it is represented by
the format (1 + 𝑖)𝑛 = (𝐹⁄𝑃 , 𝑖%, 𝑛). Thus,
𝐹 = 𝑃(𝐹⁄𝑃 , 𝑖%, 𝑛) ---------------------------------------------------------------- 3

Where, (F/P, i%, n) is called as single-payment compound amount factor

Note: Values of the compound amount, present worth, and other factors to be discussed
can be found in tables for various interest rates, (see attached).

Example: A sum of ₦7000 was invested at 8% per annum compounded interest on

January 1, 2000. How much was accumulated by January 1, 2014?

Ans: Given P = ₦7000, i = 8% per annum, n = 14 years

The future sum in year 2014 after 14 years is:

𝐹 = 𝑃(𝐹⁄𝑃 , 𝑖%, 𝑛) = 7000(2.937) = ₦20,559.00 (see table of interest factors).

(ii) Present Worth

Here, the objective is to find the present worth amount (P) of a single future sum
(F) which will be received after n periods at an interest rate of i compounded at the
end of every interest period. The worth is the value of investment found by
discounting future cash flows to the present or base time. The inverse of
compounding is determining a present amount which will yield a specified future
sum. This process is referred to as discounting. The equation for discounting is

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 6
 found readily by using the compounding equation (2) to solve for P in terms of F
thus:

1
𝑃 = 𝐹. (1+𝑖)𝑛 ---------------------------------------------------------------------- 4a

Example: What present sum will yield ₦1000 at 10% per year for 5 years?
1 1
Ans: 𝑃 = 𝐹. (1+𝑖)𝑛 = 1000. (1+0.1)5 = ₦620.92
This result means that ₦620.92 deposited today at 10% interest rate compounded
annually will yield ₦1000 in 5 years.

Present Worth factor:

1
In the discounting equation (4a) the expression (1+𝑖)𝑛 = (𝑃⁄𝐹 , 𝑖%, 𝑛) is known as
the present worth factor.
Therefore:
1
𝑃 = 𝐹. (1+𝑖)𝑛 = 𝐹(𝑃⁄𝐹 , 𝑖%, 𝑛) --------------------------------------------------- 4b

Example: How much would an investor invest at 6% annual interest on February

14, 2013 in order to collect a sum of ₦12,000 on February 14, 2020?
Ans: Given F = ₦12,000, i = 6% per annum, n = 7 years
Then from equation (4b)
𝑃 = 𝐹(𝑃⁄𝐹 , 𝑖%, 𝑛) = 12000(𝑃⁄𝐹 , 6%, 7 = 12000(0.6651) = ₦7981.20)

Exercise: What interest rate is required to triple ₦1000 in 10 years?

3.5 Series Payments

Life would have been simpler if all financial transactions were in single lump-sum payments,
now or at some time in the future. However, most situations involve a series of regular
payments, e.g. car loans and mortgages.

(i) Series Compound Amount Factor

Given a series of regular payments, what will they be worth at some future time?
Let,
A = the amount of a regular end-of-period payment (also called annuity)
Then, each payment, A, is compounded for a period of time. The first payment will
be compounded for n-1 periods (years):
𝐹 = 𝐴(1 + 𝑖)𝑛−1
And the second payment for n-2 periods:
𝐹 = 𝐴(1 + 𝑖)𝑛−2 and so forth. Thus the total future value is

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 7
 𝐹 = 𝐴(1 + 𝑖)𝑛−1 + 𝐴(1 + 𝑖)𝑛−2 + 𝐴(1 + 𝑖)𝑛−3 + ⋯ + 𝐴(1 + 𝑖) + 𝐴 ------ 5
Equation (5) is a geometric series having a common ratio (1+i) – 1. Thus F can be
written as
(1 + 𝑖)𝑛−1 − (1 + 𝑖)−1
𝐹 = 𝐴[ ]
1 − (1 + 𝑖)−1
(1+𝑖)𝑛 −1
= 𝐴 [ 𝑖 ] = 𝐴(𝐹⁄𝐴 , 𝑖%, 𝑛) ----------------------------------------------- 6

(1+𝑖)𝑛 −1
Where, [ ] = (𝐹⁄𝐴 , 𝑖%, 𝑛), is the series compound amount factor.
𝑖

Example: Usman has decided to invest ₦700 per month from his salary for one year,
with a promise of 12% interest per month. What accumulated sum of money will he
collect at the end of the period?

Ans: Given A = ₦700, i = 12% per month, n = 12 months

Therefore, the future sum at the end of one years is:

𝐹 = 𝐴(𝐹⁄𝐴 , 𝑖%, 𝑛) = 700(𝐹⁄𝐴 , 12%, 12) = 700(24.133) = ₦16893.10

(ii) Series Sinking Fund Factor

In this type of investment mode, the objective is to find the equivalent amount (A)
that should be deposited at the end of every interest period for n interest periods to
realize a future sum (F) at the end of the nth interest period at an interest rate of i.
The process corresponding to the inverse of series compounding is referred to as a
sinking fund; that is, what size of regular series payments are necessary to acquire
a given future amount? Solving equation (6) for A,
𝑖
𝐴 = 𝐹 {[(1+𝑖)𝑛−1]} = 𝐹(𝐴⁄𝐹 , 𝑖%, 𝑛)------------------------------------------ 7
Where (𝐴⁄𝐹 , 𝑖%, 𝑛) is the series sinking fund factor

Example: Calculate the uniform yearly deposit to enable a bank customer to obtain
a sum of ₦1464.10 in 4 years at 10% annual interest.
Ans: Given F = ₦1464.10, i = 10%, n = 4
The annuity is,
𝐴 = 𝐹(𝐴⁄𝐹 , 𝑖%, 𝑛) = 1464.10(𝐴⁄𝐹 , 10%, 4) = 1464.10(0.21547) = ₦315.50

(iii) Series Present Worth Factor

The objective of this mode of investment is to find the present worth of an equal
payment made at the end of every interest period for n interest periods at an
interest rate of i compounded at the end of every interest period.The equivalent

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 8
 present sum of a uniform series payment can be obtained from equations (2) and
(6),
(1 + 𝑖)𝑛 − 1
𝐹 = 𝑃(1 + 𝑖)𝑛 ≡ 𝐴 [ ]
𝑖
Therefore,
(1+𝑖)𝑛 −1
𝑃 = 𝐴 [ 𝑖(1+𝑖)𝑛 ] = 𝐴(𝑃⁄𝐴 , 𝑖%, 𝑛) --------------------------------------------- 8
Where, (𝑃⁄𝐴 , 𝑖%, 𝑛) is the series present worth factor.

Exercise: A saving of ₦2000 is made per year on the operating expenses by the
purchase of a new machine. What is the present worth of these savings at the end
of 9 years if an interest rate of 14% is earned?

(iv) Series Capital Recovery Factor

The objective of this mode of investment is to find the annual equivalent amount
(A) which is to be recovered at the end of every interest period for n interest periods
for a loan (P) which is sanctioned now at an interest rate of i compounded at the
end of every interest period. It is also important to be able to relate regular periodic
payments to their present worth; for example, what monthly instalments will pay
for ₦600,000 car in 3years at 15%?
From equation (8),
𝑖(1 + 𝑖)𝑛
𝐴 = 𝑃[ ] = 𝑃(𝐴⁄𝑃 , 𝑖%, 𝑛)
(1 + 𝑖)𝑛 − 1
Where, (𝐴⁄𝑃 , 𝑖%, 𝑛) is the series capital recovery factor.

Exercise: How many years will it take for an annuity of ₦8000 per annum to be
paid from a present sum of ₦14000 at an annual compounding interest rate of 8%?

3.6 Gradient (Arithmetic) Series Factors

Some engineering economic problems frequently involve receipts or disbursements that

increase or decrease uniformly each period, thus leading to arithmetic series. For example,
disbursements for maintenance and repair expenses on specific (e.g. mechanical) equipment
may increase or decrease almost uniformly. If this is the same every year, then the yearly
increase or decrease is known as uniform arithmetic gradient, G.

(i) Gradient to Present Worth Conversion Factor

If the uniform arithmetic gradient, G is the present sum, P of the series payment is

1 1 1 1
𝑃 = 𝐺[ ] + 2𝐺 [ ] + ⋯ + (𝑛 − 2)𝐺 [ ] + (𝑛 − 1)𝐺 [ ]
(1 + 𝑖)2 (1 + 𝑖)3 (1 + 𝑖)𝑛−1 (1 + 𝑖)𝑛

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 9
 1 (1+𝑖)𝑛 −1 𝑛
=𝐺 𝑖 [ − (1+𝑖)𝑛] = 𝐺(𝑃⁄𝐺 , 𝑖%, 𝑛) ------------------------------------------ 9
𝑖(1+𝑖)𝑛

Where, (𝑃⁄𝐺 , 𝑖%, 𝑛) is the gradient to present worth conversion factor. The
equivalent future sum, F, can be obtained from P.

(ii) Gradient to Uniform Series Conversion Factor

From equation (9), the equivalent series payments of a given uniform gradient series
can be obtained by multiplying P by (𝐴⁄𝑃 , 𝑖%, 𝑛). That is,
𝐴 = 𝑃(𝐴⁄𝑃 , 𝑖%, 𝑛) = 𝐺(𝑃⁄𝐺 , 𝑖%, 𝑛)(𝐴⁄𝑃 , 𝑖%, 𝑛)
1 (1+𝑖)𝑛 −1 𝑛 𝑖(1+𝑖)𝑛
=𝐺𝑖[ − (1+𝑖)𝑛] [(1+𝑖)𝑛−1]
𝑖(1+𝑖)𝑛
1 𝑛
=𝐺 [ 𝑖 − (1+𝑖)𝑛−1] = 𝐺(𝐴⁄𝐺 , 𝑖%, 𝑛) ------------------------------------- 10
Where, (𝐴⁄𝐺 , 𝑖%, 𝑛) is the gradient to uniform series conversion factor.

3.7 Deferred Annuities

There are some occasions when money is borrowed now but repayment does not start until
some periods later, that is, repayment is deferred. Let uniform series repayments be involved
and repayment does not start until the end of period D (or end of period D-1) marks the
reference point for the deferred payments.

F=?
P=?

0 1 2 3 ........... D+1 ...........

D -1 D n
0 0 0 0 0 0
P′ A A A
A
0 0 0
0
To calculate the present sum, P, of the deferred annuities the intermittent present sum, P′,
referred to end of period (D-1), is given by

𝑃′ = 𝐴(𝑃⁄𝐴 , 𝑖%, 𝑛 − 𝐷 + 1) ---------------------------------------------------------------- 11

Thus,

𝑃 = 𝑃′(𝑃⁄𝐹 , 𝑖%, 𝐷 − 1)

= 𝐴(𝑃⁄𝐴 , 𝑖%, 𝑛 − 𝐷 + 1) (𝑃⁄𝐹 , 𝑖%, 𝐷 − 1) -------------------------------------------- 12

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 10
3.8 Continuous Compounding (Effective Interest rate)

It is generally assumed that interest is compounded annually. However, interest may be

compounded more frequently as in banks and establishments where interest is compounded on
quarterly, monthly or, even, daily basis. Compounding monthly means that the interest is
computed at the end of every month. There are 12 interest periods in a year if the interest is
compounded monthly. Under such situations, the formula to compute the effective interest rate,
which is compounded annually, is Effective interest rate.

A special case of effective interest occurs when the number of periods per year is infinite. This
represents a situation of continuous interest also referred to as continuous compounding. Let
the nominal annual interest be compounded m times (number of subperiods per year) a year.
𝑖
Then at the end of 1 year, one unit of principal amounts to (1 + 𝑚)𝑚 . Therefore the future sum,
after n years is given by
𝑖
𝐹 = 𝑃(1 + 𝑚)𝑚𝑛 -------------------------------------------------------------------------------- 13

𝑚
If we let = 𝑘, then 𝑚 = 𝑖𝑘 ------------------------------------------------------------------ 14
𝑖

Therefore,
𝑖 1
𝐹 = 𝑃(1 + 𝑖𝑘)𝑖𝑘𝑛 = 𝑃(1 + 𝑘)𝑟𝑛 ------------------------------------------------------------- 15

1 𝑘
But from algebra, lim (1 + 𝑘) = 𝑒 (the base of natural logarithm) ---------------- 16
𝑘→∞

Hence,

𝐹 = 𝑒 𝑟𝑛 ------------------------------------------------------------------------------------- 17

Where, r = nominal annual interest rate.

Equation (17) implies that in continuous compounding the compound interest amount factor is
𝑒 𝑟𝑛 . Others are factors with their functional format are:

Continuous compounding present worth: 𝑒 −𝑟𝑛 ≡ (𝐹⁄𝑃 , 𝑟, 𝑛)

𝑒 𝑟 −1
Continuous compounding sinking fund: 𝑒 𝑟𝑛−1 ≡ (𝑃⁄𝐹 , 𝑟, 𝑛)

𝑒 𝑟𝑛 (𝑒 𝑟 −1)
Continuous compounding capital recovery: ≡ (𝐴⁄𝑃 , 𝑟, 𝑛)
𝑒 𝑟𝑛 −1

𝑒 𝑟𝑛 −1)
Continuous compounding compound amount (uniform series): ≡ (𝐹⁄𝐴 , 𝑟, 𝑛)
𝑒 𝑟 −1

Similarly, the effective interest rate is given as:

𝑟
𝑖 = (1 + 𝑚)𝑚 − 1 ----------------------------------------------------------------------------- 18

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 11
4.0 EVALUATION OF CAPITAL PROJECTS

Generally the number of proposals for capital projects far exceeds the amount of funds readily
available for their financing. Therefore, a technique or some procedure ought to be applied to
select the most appropriate investment proposals for implementation and for their continuous
appraisal.

In evaluation any investment, decision must be associated with the following criteria:

- The capital invested

- The cost of the investment outlay

- The expected value or worth of the investment accruing during the life of the project.

The capital invested is the total amount needed to finance the project. The cost of investment
outlay is the associated cost of the project other than the capital invested. The cost may be in
financial, economic, political, cultural, etc. technically a project could be a very sound
investment; however, political or cultural consideration may stifle it vice versa. The expected
value of the investment is the sum total of the benefit accruing from the investment. This is the
most difficult to predict as it involves predicting the future course of events which may not
happen.

i) Estimating the total benefits and costs (both capital invested and the cost of the
investment outlay) all measured in term of cast flows.

ii) A ranking procedure is developed to assess the cash flows associated with individual
proposals.

These two methods involve both quantitative and qualitative measures. The quantitative
approach compares the estimated cash inflows to the estimated cash outflows associated with
the project. In effect the estimated cash savings associated with the projects are calculated. The
estimated cash savings are then translated into a measure of advantage by means of a ranking
method. All projects whose rate of return exceeds the firm’s rate of return will be accepted
while whose rate of return falls below that of the firm’s be rejected.

There are many ranking methods in use, but the most sophisticated methods are by far those
which take into account the time value of money in calculating the rate of return. The
qualitative measures such as politics, culture, etc also plays significant role in taking the final
decision.

4.1 METHODS FOR RANKING INVESTMENT PROPOSAL

While there are many methods for ranking or evaluating investment proposals, the choice of
which one to use depends upon the individual circumstances and conditions. Situation may
arise where more than a single method would have to be resorted to in order to make a sound

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 12
selection. Some of the methods are either quantitative or qualitative, depending upon either
objective or subjective criteria, have either scientific or non-scientific basis. Whichever method
is adopted, it helps the engineer to decide on which investment to reject or accept; provides
ranking so that a choice can be made among the desirable alternatives; be capable of being used
to evaluate any investment proposal; and be able to give different weights to cash flows arising
from different time periods.

The traditional method of evaluating investment proposal has been the motion for urgency
surrounding the project. How urgent is the need for that project? However, since this method
has a lot of flaws, other scientific and objective methods have been adopted. The most common
ones are:

- Pay out or pay off method

- Present worth (PW) method
- Annual worth (AW) method
- Future worth (FW) method
- Internal rate of return (IRR) method
- Profitability index
A brief description of the methods will be highlighted and a comprehensive example as to their
application will be given.

4.1.1 The Pay-out or Pay-off or Pay-back Method

The method takes into account the time it takes to recover in form of cash from operation the
original amount invested in a project. It determines the number of years required to receive in
form of cash the original investment. For a project with a given useful life, the shorter the
payout period, the more desirable the project is.

Where cash inflow from operations is constant the payout is calculated as follows:
𝐶𝑎𝑠ℎ 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 (𝐼)
Pay out period (P)= 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤 (𝐶) --------------------------------------------------- 19

Where the cash inflow is not constant, the pay-out period is calculated by adding the yearly
cash inflows starting from year one until the amount invested is reached.

4.1.2 Internal Rate of Return (IRR) Method

The internal rate of return is defined as the discount rate or interest rate which equates the
present value of future cash inflows with the present investment out lay. Thus it is the rate of
discount which equates the sum of present positive values to the sum negative values, or the
rate at which the net present value of the investment is zero.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 13
The rate of return of a cash flow pattern is the interest rate at which the present worth of that
cash flow pattern reduces to zero. In this method of comparison, the rate of return for each
alternative is computed. Then the alternative which has the highest rate of return is selected as
the best alternative.

Alternatively, the rate is the maximum rate of interest management is prepared to pay for funds
borrowed to finance the project without loss on the project after the repayment of both the
capital sum and interest out of cash inflows generated by the project. In calculating the rate,
where annual cash inflows are even, annuity tables can be used to determine the rate. However,
where the annual cash flows are uneven the rate has to be calculated by trial and error.

Where calculation is done manually using discount table, it might not be possible to find a rate
that exactly brings the net present value to zero.

Having calculated the rate it would then be up to management to either accept or reject
depending upon a pre-determined rate approved upon. All projects with rate lower than the
acceptance rate are rejected while those with rate above or equal to pre-determined rate are
accepted for further analysis.

If Rk = net receipt for the Kth year

Dk = net disbursement for the Kth year

N = maximum number of year for study (i.e. project life)

Then
𝑃
Present worth of cash inflows = ∑𝑛𝑘=0 𝑅𝑘 (𝐹 , 𝑖%, 𝑘) ------------------------- 20

𝑃
Present worth of cash outflows = ∑𝑛𝑘=0 𝐷𝑘 (𝐹 , 𝑖%, 𝑘) ----------------------- 21

The required rate of return is that value of i that makes the two present worth equal. That is,
𝑃 𝑃
∑𝑛𝑘=0 𝑅𝑘 ( , 𝑖%, 𝑘) − ∑𝑛𝑘=0 𝐷𝑘 ( , 𝑖%, 𝑘) = 0 ----------------------------------------------- 22
𝐹 𝐹

4.1.3 Present Worth (PW) Method

This is the equivalent worth of all cash flows (relative to some base point) discount back at an
interest. If the present sum cash inflows are more than the equivalent present sum of cash
outflows at the given interest rate, then the project is economically justified, otherwise it is not.
That is net present worth is greater than zero.
𝐹
𝑃𝑊 = 𝑃0 + ∑𝑛𝑘=0 𝐹𝑘 (𝑃 , 𝑖%, 𝑘) ------------------------------------------------------------------ 23

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 14
4.1.4 Annual Worth (AW) Method

Here equivalent annual worth are calculated for cash inflows and cash outflows at a given
interest rate. The project is economically justified as long as.

Net Annual worth > 0

The equivalent annual worth is calculated converting all cash inflows and cash outflows to
present worth, from which is the annual worth can be calculated with the help of A/P factor as:
𝐴
𝐴𝑊 = 𝑃𝑊(𝑃 , 𝑖%, 𝑛) --------------------------------------------------------------------------- 24

4.1.5 Profitability Index (PI)

The profitability index method is also referred to as benefit cost ratio. The index is a ratio of
the present worth of cash inflows discounted at the desired rate of return to the initial cash
outflows of the investment.
𝑃𝑊 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
𝑃𝐼 = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠 ------------------------------------------------------------------- 25

If the ratio is greater than unity the investment is accepted since it will have a positive net
present values.

4.2 Evaluation of a Single Proposal

An example is presented here to illustrate the various methods or tools used in evaluating a
business, investment, projects, ventures etc.

Example:

The Management of Imurat Limited wishes to purchase an up-dated model of a new machine
to replace an old model which has been in use for some years now. The present useful life of
the old machine is now zero. The following additional information is given:

Present cost of new machine = ₦60,000.00

Useful life (economic life) = 6 years
Estimated salvage value of new machine = ₦4,000.00
Interest rate of return = 8%
Cash inflow associated with the new machine has been estimated as follows:

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 15
 Year Cash inflow in ₦

1 18,000
2 17,000
3 19,000
4 16,000
5 16,000
6 14,000
Total 100,000
Solution:

The cash flow diagram is shown below:

19,000
18,000
17,000
16,000 16,000
14,000

4,000
0
0 1 2 3 4 5 6
0 0 0 0 0

60,000
(i) Present Worth Method
𝑃
𝑃𝑊 = −𝑃0 + ∑6𝑖=1 𝐹𝑖 (𝐹 , 8%, 𝑖)

= −60000
𝑃 𝑃 𝑃
+ [18000 ( , 8%, 1) + 17000 ( , 8%, 2) + 19000 ( , 8%, 3)
𝐹 𝐹 𝐹
𝑃 𝑃 𝑃
+ 16000 ( , 8%, 4) + 16000 ( , 8%, 5) + 18000 ( , 8%, 6)]
𝐹 𝐹 𝐹

= −60000 + 18000(0.9259) + 17000(0.8573) + 19000(0.7938) +

16000(0.7350) + 16000(0.6806) + 18000(0.6302)

= −60000 + 80315.70

= ₦20,315.70

The net present worth is greater than zero. Hence, it is justifiable to invest on the machine.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 16
 (ii) Future Worth Method
6
𝐹
𝐹𝑊 = ∑ 𝑃𝑖 ( , 8%, 𝑖) + 𝐹
𝑃
𝑖=1

𝐹 𝐹 𝐹 𝐹
= −60000 (𝑃 , 8%, 6) + 18000 (𝑃 , 8%, 5) + 17000 (𝑃 , 8%, 4) + 19000 (𝑃 , 8%, 3) +
𝐹 𝐹
16000 (𝑃 , 8%, 2) + 16000 (𝑃 , 8%, 1) + 18000

= −60000(1.5869) + 18000(1.4693) + 17000(1.3605) + 19000(1.2597)

+ 16000(1.1664) + 16000(1.08) + 18000

= −95,214.20 + 127,454.30

= ₦32,240.10

Here as before, the net future worth is greater than zero, the sum of ₦32,240.10 is earned at the
end of 6 years, in addition to the annual interest of 8%. Hence, the machine is viable.

Also FW can be obtained from previously calculated PW as:

𝐹
𝐹𝑊 = 𝑃𝑊 ( , 8%, 6) = 20315.70(1.5869) = ₦32,239
𝑃
(iii) The Internal Rate of Return Method

Present worth of cash inflows = Present worth of cash outflows PW cash inflows.
𝑃 𝑃 𝑃
PW cash inflows = 18000 (𝐹 , 𝑖%, 1) + 17000 (𝐹 , 𝑖%, 2) + 19000 (𝐹 , 𝑖%, 3) +
𝑃 𝑃 𝑃
16000 (𝐹 , 𝑖%, 4) + 16000 (𝐹 , 𝑖%, 5) + 18000 (𝐹 , 𝑖%, 6)

PW cash outflows = 60000

The net present worth is,

𝑃 𝑃 𝑃
18000 ( , 𝑖%, 1) + 17000 ( , 𝑖%, 2) + 19000 ( , 𝑖%, 3) +
[ 𝐹 𝐹 𝐹 ] − 60,000 = 0
𝑃 𝑃 𝑃
16000 ( , 𝑖%, 4) + 16000 ( , 𝑖%, 5) + 18000 ( , 𝑖%, 6)
𝐹 𝐹 𝐹

The value of i% is to be chosen to satisfy the above equation such that the net present worth is
zero. To be able to do this values of i% are chosen such that positive and negative net values
are obtained. From which by method of interpolation the actual value of i% is obtained. This
is shown in the table below:

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 17
 i% Net Present Worth in Naira
16% 18000(0.8621) + 17000(0.7432) + 19000(0.6407) + 16000(0.5523) +
16000(0.4761) + 18000(0.4104) – 60000 = 4,167.00

20% 18000(0.8333) + 17000(0.6944) + 19000(0.5787) + 16000(0.4019) +

18000(0.3349) -60000 = - 2, 025.10

It is seen that the IRR is between 16% and 20%, the exact value is obtained by interpolation
thus:

0 − 4167
𝑖 = 16 + (20 − 16) ( )
−2025.10 − 4167

= 16 + 2.69 = 18.69%

Depending on the minimum acceptable rate of return set by the management, this value can be
accepted or rejected.

(iv) Profitability Index (PI)

The present worth of cash inflows from previous at 8% (rate of return) = ₦80,315.70
The initial cash outflows = ₦60,000.00
Therefore,
80315.70
𝑃𝐼 = = 1.339
60000
Since PI is greater than unity, the replacement of the machine is accepted as it will be have a
positive net present values.

(v) Annual Worth Method

Knowing that the PW = ₦80315.70, then using A/P factor,

𝐴
𝐴𝑊 = 𝑃𝑊 ( , 8%, 6) = 80315.70(0.2163)
𝑃

= ₦17,372.29

Using this method the machine is economically viable.

(vi) Pay-back or Pay-out Method

For the current example, we’ve as follows:

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 18
 Year Cash inflow in (₦)
1 18,000
2 17,000
3 19,000
4 16,000
Total 70,000
Here the payback period is 4 years; hence it is a viable venture.

Note: The above example has illustrated the application of the various evaluation tools for a
single proposal. However, in practice economic analyses involve several alternatives which
could have the same useful life or variable useful lives. The selection of the best one is based
on the output of the analysis carried out. The one usually chosen is the one that requires
minimum investment capital.

References

Adediran, Y. A. (2001), Introduction to Engineering Economics, FINOM Associates, Minna,

Nigeria, 1st ed.

Mbelede, C. (2006), Basic Engineering Economics, Train the Trainer Workshop organized by
Nigerian Society of Engineer, Lagos.

Watts M.J. and Chapman R.E., Engineering Eonomics

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 19
5.0 Break-even Analysis
5.1 Introduction

Break-even analysis is a technique widely used by production management and management

accountants. It is based on categorising production costs between those which are "variable"
(costs that change when the production output changes) and those that are "fixed" (costs not
directly related to the volume of production). The main objective of break-even analysis is to
find the cut-off production volume from where a firm will make profit.

Total variable and fixed costs are compared with sales revenue in order to determine the level
of sales volume, sales value or production at which the business makes neither a profit
nor a loss (the "break-even point").

5.1.1 The Break-Even Point

In economics & business, specifically cost accounting, the break-even point (BEP) is the point
at which cost or expenses and revenue are equal: there is no net loss or gain, and one has
"broken even". A profit or a loss has not been made, although opportunity costs have been
"paid", and capital has received the risk-adjusted, expected return.

For example, if a business sells fewer than 200 tables each month, it will make a loss, if it sells
more, it will be a profit. With this information, the business managers will then need to see if
they expect to be able to make and sell 200 tables per month.

If they think they cannot sell that many, to ensure viability they could:

1. Try to reduce the fixed costs (by renegotiating rent for example, or keeping better
control of telephone bills or other costs)

2. Try to reduce variable costs (the price it pays for the tables by finding a new supplier)

3. Increase the selling price of their tables.

Any of these would reduce the break-even point. In other words, the business would not need
to sell so many tables to make sure it could pay its fixed costs.

5.1.2 Areas of Application

The break-even point is one of the simplest yet least used analytical tools in management. It
helps to provide a dynamic view of the relationships between sales, costs and profits. A better
understanding of break-even, for example, is expressing break-even sales as a percentage of
actual sales—can give managers a chance to understand when to expect to break even (by
linking the percent to when in the week/month this percent of sales might occur).

Break-even analysis can be applied in the following specific areas:

(i) Product Planning – to determine what new products could be added and what old
products could be dropped in order to improve a company’s profit margin.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 20
 (ii) Product Pricing – to take advantage of elasticity of demand of a product to fix prices
in order to enhance profitability.

(iii) Profit Planning – to assist the budget-planning process in order to improve profit.

(iv) Make-or-buy – for optimal allocation of capital resources in order to determine

which components of products to buy or to internally manufacture.

(v) Equipment Selection and Replacement – to decide whether to keep an old

equipment or replace it with a new one with the aim of minimizing production cost
and, hence, increase profit.

5.2 The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various levels
of activity shown on the same chart as the variation of income (or sales, revenue) with the same
variation in activity. The point at which neither profit nor loss is made is known as the "break-
even point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase.
At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are
exactly equal to income, and hence neither profit nor loss is made. Below are other examples.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 21
5.3 Classification of Costs

Break-even analysis is traditionally based on two types of costs, fixed costs and variable costs.

5.3.1 Fixed Costs

Fixed costs are those business costs that are not directly related to the level of production or
output. In other words, even if the business has a zero output or high output, the level of fixed
costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result
of investment in production capacity (e.g. adding a new factory unit) or through the growth in
overheads required to support a larger, more complex business.

Examples of fixed costs:

- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs

5.3.2 Variable Costs

Variable costs are those costs which vary directly with the level of output. They represent
payment output-related inputs such as raw materials, direct labour, fuel and revenue-related
costs such as commission. Typical variable costs include direct labor and direct materials. The
variable cost times the number of units sold will equal the Total Variable Cost. Total Variable
costs plus Fixed costs, make up the total cost of production.

Note: A distinction is often made between "Direct" variable costs and "Indirect" variable
costs.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 22
Direct variable costs are those which can be directly attributable to the production of a
particular product or service and allocated to a particular cost centre. Raw materials and the
wages those working on the production line are good examples.

Indirect variable costs cannot be directly attributable to production but they do vary with
output. These include depreciation (where it is calculated related to output - e.g. machine
hours), maintenance and certain labour costs.

5.3.4 Semi-Variable Costs

Whilst the distinction between fixed and variable costs is a convenient way of categorising
business costs, in reality there are some costs which are fixed in nature but which increase
when output reaches certain levels. These are largely related to the overall "scale" and/or
complexity of the business. For example, when a business has relatively low levels of output
or sales, it may not require costs associated with functions such as human resource management
or a fully-resourced finance department. However, as the scale of the business grows (e.g.
output, number people employed, number and complexity of transactions) then more resources
are required. If production rises suddenly then some short-term increase in warehousing and/or
transport may be required. In these circumstances, we say that part of the cost is variable and
part fixed.

5.4 Limitations and Assumptions

 Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing
about what sales are actually likely to be for the product at these various prices.

 It assumes that fixed costs (FC) are constant. Although this is true in the short run, an
increase in the scale of production is likely to cause fixed costs to rise.

 It assumes average variable costs are constant per unit of output, at least in the range of
likely quantities of sales. (i.e. linearity)

 It assumes that the quantity of goods produced is equal to the quantity of goods sold
(i.e., there is no change in the quantity of goods held in inventory at the beginning of
the period and the quantity of goods held in inventory at the end of the period).

 In multi-product companies, it assumes that the relative proportions of each product

sold and produced are constant (i.e., the sales mix is constant).

5.5 Computation

In the linear Cost-Volume-Profit Analysis model, the break-even point can be directly
computed in terms of Total Sales Revenue (SR) and Total Costs (TC).

If F – Fixed costs;
p – Selling Price per unit;
v – Variable Cost per unit;
Q – Quantity produced (volume of output).

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 23
The total cost are given by
Total Cost (TC) = Fixed Cost + Variable Cost
𝑇𝐶 = (𝐹 + 𝑣. 𝑄) 26
Sales Revenue (SR) = Selling price per unit × Quantity
𝑆𝑅 = 𝑝. 𝑄 27
The point of intersection of Total Cost line and the sales revenue is the Break-even Point i.e.
at Break-even Point,
Total Cost (TC) = Sales Revenue (SR)
𝐹 + 𝑣. 𝑄 = 𝑝. 𝑄
𝐹 = 𝑄(𝑝 − 𝑣)
𝐹
𝑄𝐵𝐸𝑃 = (𝑝−𝑣) in units 28

5.5.1 Marginal Cost

This represents the amount at any given volume of output by which aggregate costs are changed
if the volume of output is increased or decreased by one unit. Marginal cost of a product is the
cost of producing an additional unit of that product. Marginal cost can be represented by an
equation for convenience as:

Sales Revenue – Total Variable Costs = Fixed Cost + Profit

𝑆𝑅 − 𝑉 = 𝐹 + 𝑃 29

5.5.2 Contribution

Contribution represents the difference between sales value and marginal cost sales. It provides
a fund to meet the fixed costs and also to provide the undertakings profit.

The Break-Even Point (BEP) can alternatively be computed as the point where Contribution
equals Fixed Costs since there is neither profit nor loss at this level of output, i.e.

𝑆𝑅 − 𝑉 = 𝐶 30

𝐹+𝑃 =𝐶 31

At BEP, C = F 32

The quantity (𝑆𝑅 − 𝑉) is of interest in its own right, and is called the Unit Contribution Margin
(C): it is the marginal profit per unit, or alternatively the portion of each sale that contributes
to Fixed Costs. Thus the break-even point can be more simply computed as the point where
Total Contribution = Total Fixed Cost:

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 24
 33

5.5.3 Profit Volume Ratio (ϕ)

This is the ratio between Contribution and Sales Revenue, i.e.

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒−𝑇𝑜𝑡𝑎𝑙 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡
∅ = 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = 34
𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

(𝑝.𝑄−𝑣.𝑄) 𝑄(𝑝−𝑣) 𝐹
∅= = = 𝑝.𝑄 35
𝑝.𝑄 𝑝.𝑄

Therefore,
𝐹
∅ = 𝑝.𝑄 36

So BEP can also be given by

𝐹
𝑄𝐵𝐸𝑃 = ∅ 37

𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡
Similarly, sales at BEP (units) = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 38

5.5.4 Margin of Safety

Margin of safety represents the strength of the business. It enables a business to know what
exact amount it has gained or lost and whether they are over or below the break-even point.

Margin of safety = (current output - breakeven output)

Margin of safety% = (current output - breakeven output)/current output × 100

When dealing with budgets you would instead replace "Current output" with "Budgeted
output".

In practice, it is clearly desirable for budgeted income to exceed break-even income by as large
as possible. Working at or near the break-even point is difficult as the ability to accept changes
is small. The margin of safety gives the measure of this ability.

5.5.5 Graphical Solution of Break Even Analysis

To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC
in the diagram) which shows the total cost associated with each possible level of output, the
fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the
total revenue line which show the total amount of revenue received at each output level, given
the price you will be charging.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 25
The break even points (BEP) is the point of intersection between the total cost curve (TC) and
a total revenue curve. The break even quantity at each selling price can be read off the
horizontal axis and the break-even price at each selling price can be read off the vertical axis.
The total cost, total revenue, and fixed cost curves can each be constructed with simple
formulae. For example, the total revenue curve is simply the product of selling price times
quantity for each output quantity.

Example:

A manufacturing company has an output of 5,000 items per month with a fixed cost of ₦2000
each month. The variable cost is 20k per item and a selling price of 40k per item. At what level
of production will the company break even after five months? What will be the total loss at a
production level of 5000 items? Solve both graphically and by formula.

Solution:

Output 5000 10000 15000 20000 2500

Fixed Cost 2000 2000 2000 2000 2000
Variable Cost 1000 2000 3000 4000 5000
Total Cost 3000 4000 5000 6000 7000
Total Sales 2000 4000 6000 8000 10000

Fixed Cost Total Cost Total sales

SALES AND COSTS
12000

11000

10000

9000

8000

7000

6000

5000
Margin of Safety
4000 BE
3000

2000

1000

0
0 5000 10000 15000 20000 25000
OUTPUTS (UNITS)

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 26
From the above chart, the break-even point at the output level of 10,000 units and sales of
₦4,000. This is at the point of intersection between the sales line and the cost line.

The loss at 5,000 units output = 3000 – 2000 = ₦1,000.

By Formula:
𝐹 2,000
𝑄𝐵𝐸𝑃 = (𝑝−𝑣) = 0.4−0.2 = 10,000 𝑢𝑛𝑖𝑡𝑠

And sales value is 10000 × 0.4 = ₦4,000.

Exercises:

1. The owner of a shop is contemplating adding a new product, which will require additional
monthly payment of ₦6,000.00 Variable costs would be ₦2.00 per new product, and its selling
price is ₦7.00 each.

(a) How many new products must be sold in order to break-even?

(b) What would the profit (loss) be if 1,000 units were sold in a month?

(c) How many units must be sold to realize a profit of ₦4,000.00?

2. Process X has fixed costs of ₦20,000.00 per year and variable costs of ₦12.00 per unit,
whereas process Y has fixed costs of ₦8,000.00 per year and variable costs of ₦22.00 per unit.
At what production quantity (Q) are the total costs of X and Y equal?

3. A fertilizer company produces the NPK fertilizer which has a variable cost structure as
follows:

Material ₦350.00

Labour ₦200.00

Overhead is 65% of Labour.

Each bag of the fertilizer is sold at 125% of the variable cost per bag. During the current year
2012, the sales are expected to be ₦2,252,500.00 and fixed overhead of ₦175,000.00. Under a
wage agreement an increase of 25% is payable to all direct labour from the beginning of the
forthcoming year, whilst material costs are expected to decrease by 8 ½ %. Calculate:

(a) The new selling price in the forthcoming year if the current contribution/sales ratio is
to be maintained.

(b) The quantity to be sold at Breakeven.

(c) The quantity to be sold during the year 2013 to yield the same profit.

(d) The margin of safety in the forthcoming year 2013.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 27
6.0 Depreciation and Depreciation Accounting
Depreciation is the loss in value of a piece of equipment over time, generally caused by wear
and tear from use, deterioration, obsolescence, or reduce need. Any equipment which is
purchased today will not work for ever. This may be due to wear and tear of the equipment or
obsolescence of technology.

 Hence, it is to be replaced at the proper time for continuance of any business.

 The replacement of the equipment at the end of its life involves money. This
must be internally generated from the earnings of the equipment.

 The recovery of money from the earnings of an equipment for its replacement
purpose is called depreciation fund since we make an assumption that the
value of the equipment decreases with the passage of time.

 Thus the word “depreciation” means decrease in value of any physical asset
with the passage of time.

There are two different kind of depreciation an investor must grapple with when analyzing
financial statements. They are depreciation expense and accumulated depreciation.

6.1 Depreciation as an Expense

Depreciation recording is the process by which a company gradually records the loss in value
of a fixed asset. The purpose of recording depreciation as an expense over a period is to spread
the initial purchase price of the fixed asset over its useful life. Each time a company prepare its
financial statements, it records a depreciation expense to allocate the loss in value of the
machines, equipment’s or cars it has purchased. However, unlike other expenses, depreciation
expenses is a “non-cash” charge. This simply means that no money is actually paid at the time
in which the expense is inquired.

An example of depreciation expense

A cotton company earns #10,000 profit a year. In the middle of 2019, the business purchased
a #7,500 cotton candy machine that it expected to last for five years. If an investor examined
the financial statements, they might be discouraged to see that the business only made #2,500
at the end of 2019 (#10, 000 profit - #7,500 expense for purchasing the new machinery). The
investor would wonder why the profit had fallen so much during the year.

Fortunately, the company’s accountants come to her rescue and tell her that the #7,500 must
be allocated over the entire period it will benefit the company. Since the cotton candy machine
is expected to last five years, the company can take the cost of the cotton candy machine and
divide it by five (#7,500 / 5 years = #1,500 per year). Instead of realizing a one-time expense,
the company can subtract #1,500 each year for the next five years, reporting earnings of #8,500.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 28
This allows investors to get a more accurate picture of how the company’s earning power. The
practice of spreading-out the cost of the asset over its useful life is depreciation expense.
When you see a line for depreciation expense on an income statement, this is what it references.

This present an interesting dilemma. Although the company reported earnings of #8,500 in the
first year, it was still forced to write a #7,500 check, effectively leaving it with #2,500 in the
bank at the end of the year (#10,000 profit - #7,500 cost of machine = #2,500 remaining).

The result is that the cash flow of the company is different from what it is reporting earning.
The case flow is very important to investors because they need to be ensured that the business
can pay its bills on time. The first year, the company would report earnings of #8,500 but only
have #2,500 in the bank. Each subsequent year, it would still report earnings of #8,500, but
have #10,000 in the bank because, in reality, the business paid for the machinery up-front in a
lump-sum. This is vital because if an investor knew that the company had had a #3,000 loan
payment due to the bank in the first year, he may incorrectly assume that the company would
be able to cover it since reported earnings of #8,500. In reality, the business would be #500
short. * There have been cases of companies going bankrupt even though they were reporting
substantial profit.

Depreciation is a very real expense. Depreciation attempt to match up profit with the expense
it took to generate that profit. This provides the most accurate pictures of a company’s earning
power. An investor who ignores the economic reality of depreciation expense will be apt to
overvalue a business and find his or her returns lacking. As one famous investor quipped the
tooth fairy doesn’t pay for a company’s capital expenditure needs. Whether you own a
motorcycle shop or a construction business, you have to pay for your machine and tools to
pretend like you don’t is delusional.

6.2 Accumulated Depreciation

If you purchase a new car for #50,000 and resold it three years later for #30,000, you would
have experienced a #20,000 loss on the value of your asset. As you just learned in the last
section, a business would write a portion of this loss of value off each year, even though it
require no cash outlay, reducing reporting profits.

The accounting entry has to be put somewhere on the financial statements. It is kelp in a special
type of account (known as a contra account) on the balance sheet known as accumulated
depreciation. Frankly, you don’t need to worry about that. You just need to know that your
balance sheet is going to look like this:

Car Asset - #50,000 value

Accumulated Depreciation – Car – (#20,000 value)

Net Asset Value – Car: #30,000

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 29
As it can be seen, the purpose of the accumulated depreciation account is to reduce the carrying
value of an asset to reflect the loss of value due to wear, tear, and usage. Companies purchase
assets such as computers, copy machine, building, and furniture, all of which lose value each
day. This depreciation loss must be accounted for in the company’s financial statement in order
to give shareholders the most accurate portrayal of the economic reality of the business.

6.2.1 Accumulated Depreciation – Net

When you look at a balance sheet, you aren’t going to see the individual assets and many
businesses don’t even bother to show you the accumulated depreciation account at all. Instead,
they show a single line called “Property, Plant, and Equipment – net” it is referring to the fact
that the company has deducted accumulated depreciation from the purchase price of the
company’s assets. To see the amount of those depreciation charges, you will probably have to
delve into the annual report.

Once the asset has become worthless or is sold, both it and the matching accumulated
depreciation account are removed from the balance sheet. Any gain or loss above the book
value, or carry value, is recorded according to specific accounting rules depending on the
situation. If, for instance, the car discussed above sold for #27,000 despite having a carrying
value of #30,000, a business would record a #3,000 loss, adjusted for the income tax saving
that would result.

6.3 Depreciation accounting

Depreciation accounting is the systematic allocation of the cost of a capital investment over
some specific number of year. Reasons for calculating the depreciation accounting value
(usually termed book value) of a piece of equipment:

1. To provide the construction and project manager with an easily calculated estimate of
the current market value of the equipment.

2. To provide a systematic method of allocating and depreciation portion of equipment

ownership costs over a period of time and to a specific productivity rate.

3. To allocate the depreciation portion of ownership cost in such a manner that the greatest
tax benefits will accrue.

6.3.1 Information needed for depreciation accounting:

1. The purchase price and pieces of equipment, P

2. The optimum period of time to keep the equipment or the recovery period of income
tax purposes, N

3. The estimate resale value at the close of the minimum period of time, F

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 30
6.4 Depreciation Calculating Methods

There are several methods of accounting depreciation fund. These are as follows:
1. Straight line (SL) method of depreciation
2. Declining balance (DB) method of depreciation
3. Sum of the years-digits (SOY) method of depreciation
4. Sinking-fund method of depreciation
5. Service output method of depreciation

1. Straight-line (SL) Method

2. Sum-of-the-years (SOY) Method

3. Declining-balance (DB) Method

6.4.1 Straight-line (SL) Method

In this method of depreciation, a fixed sum is charged as the depreciation amount throughout
the lifetime of an asset such that the accumulated sum at the end of the life of the asset is exactly
equal to the purchase value of the asset.

The simplest and most commonly used depreciation method, straight line depreciation is
calculated by taking the purchase or acquisition price of an asset subtracted by the salvage
value divided by the total productive years the asset can be reasonable expected to benefit the
company (called “useful life” in accounting jargon).

The annual amount of depreciation Dm, for any year m, is a constant value, and thus the book
value BVm decreases at a uniform rate over the useful life of the equipment. P = first cost of the
asset, F = salvage value of the asset
1
Depreciation rate: 𝑅𝑚 = 𝑁

(𝑃−𝐹)
Annual depreciation amount: 𝐷𝑚 = 𝑅𝑚 (𝑃 − 𝐹) = 𝑁

Book value at year, m: 𝐵𝑉𝑚 = 𝑝 − 𝑚𝐷𝑚

Note: The value (P - F) is often referred to as the depreciation value of the investment.

Example 1

A piece of equipment is available for purchase for #12,000, has an estimate useful life of 5
years, and has an estimate salvage value of #2,000. Determine the depreciation and the book
value for each 5 years using the SL method.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 31
Solution:
1
Depreciation Rate: 𝑅𝑚 = 5 = 0.2

Annual depreciation amount: 𝐷𝑚 = 0.2(12,000 − 2,000) = #2,000 per year

The table of values is:

Year (m) BVm-1 Dm BVm

0 #0 #0 #12,000

1 12,000 2,000 10,000

2 10,000 2,000 8,000

3 8,000 2,000 6,000

4 6,000 2,000 4,000

5 4,000 2,000 2,000

If the equipment is expected to be used about 1,400 hours per year the its estimated hourly
depreciation portion of the ownership cost is #2,000/1,400 = #1.428 = #1.43 per hour

6.4.2 Sum-of-the-Years (SOY) Digits Method

In this method of depreciation also, it is assumed that the book value of the asset decreases at
a decreasing rate. To calculate depreciation charges using the sum of the year’s digits method,
take the expected life of an asset (in years) count back to one and add the figures together.
SOY is an accelerated depreciation method (fat write-off), which is a term applied to
accounting method which permit rates of depreciation faster than the straight line.

The rate of depreciation is a factor Rm (depreciation rate) times the depreciation value (P – F)

𝐷𝑚 = 𝑅𝑚 (𝑃 − 𝐹)

𝑁(𝑁 + 1)
𝑆𝑂𝑌 =
2
(𝑁 − 𝑚 + 1)
𝑅𝑚 =
𝑆𝑂𝑌
The annual depreciation Dm for m th year (at any age m) is:

(𝑁 − 𝑚 + 1)
𝐷𝑚 = { } (𝑃 − 𝐹)
𝑆𝑂𝑌

The book value at the end of year m is:

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 32
 𝑚
(𝑁 − 2 + 0.5)
𝐵𝑉𝑚 = 𝑃 − (𝑃 − 𝐹) [𝑚 ]
𝑆𝑂𝑌

Example 2

Using the same values as given in example 1, calculate the allowable depreciation and the book
value for each of the 5 years using the SOY method.

𝑆𝑂𝑌 = 1 + 2 + 3 + 4 + 5 = 15

6
𝑜𝑟 5 ( ) = 15
2
(𝑁 − 𝑚 + 1) (5 − 𝑚 + 1)
𝑅𝑚 = =
𝑆𝑂𝑌 15
(𝑁 − 𝑚 + 1) (5 − 𝑚 + 1)
𝐷𝑚 = { } (𝑃 − 𝐹) = (10,000)
𝑆𝑂𝑌 15

Year Rm Dm BVm
0 $0 $12,000
1 5/15 3,333 8667
2 4/15 2,667 6000
3 3/15 2,000 4,000
4 2/15 1,333 2,667
5 1/15 667 2,000

6.4.3 Declining-balance (DB) Method

Declining-balance (DB) methods also are accelerated depreciation methods that provide for
even larger portions of the cost of a piece of equipment to be written off in the early years.
 In this method of depreciation, a constant percentage of the book value of
the previous period of the asset will be charged as the depreciation amount
for the current period.
 This approach is a more realistic approach, since the depreciation charge
decreases with the life of the asset which matches with the earning
potential of the asset.
 The book value at the end of the life of the asset may not be exactly equal
to the salvage value of the asset. This is a major limitation of this approach.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 33
Declining method range from 1.25 times the current book value divided by the life to 2.00
times the current book value divided by the life. If the rate R used is limited to at the most
2/n., then the corresponding approach is called the double declining balance method of
depreciation.

Note: Although the estimated salvage value F is not included in the calculation, the book value
cannot go below the salvage value.

Declining-balance (DB) Method

The following equations are necessary to use the declining-balance methods.
The symbol R is used for the depreciation rate for the declining-balance method of
depreciation:
1. For 1.25 declining-balance (1.25DB) method, R= 1.25/N
For 1.50 declining-balance (1.50DB) method, R= 1.50/N
For 1.75 declining-balance (1.75DB) method, R= 1.75/N
For double-declining-balance (DDB) method, R= 2.00/N

2. The allowable depreciation Dm, for any year m and any depreciation rate R is:
𝑫𝒎 = 𝑹𝑷(𝟏 − 𝑹)𝒎 − 𝟏 𝒐𝒓 𝑫𝒎 = (𝑩𝑽𝒎−𝟏 )𝑹
3. The book value for any year m is:

𝑩𝑽𝒎 = 𝑷(𝟏 − 𝑹)𝒎 𝒐𝒓 𝑩𝑽𝒎 = 𝑩𝑽𝒎−𝟏 − 𝑩𝑽𝒎 , provided that 𝑩𝑽𝒎 > 𝑭

Example 3
For the same piece of equipment described in Example 2, calculate the allowable depreciation
and the book value for each of the 5 years of its life.
𝟐.𝟎 𝟐
𝑹= = 𝟓 = 𝟎. 𝟒
𝑵

𝑫𝒎 = (𝑩𝑽𝒎−𝟏 )𝑹 = 𝟎. 𝟒(𝑩𝑽𝒎−𝟏 )

𝑩𝑽𝒎 = 𝑩𝑽𝒎−𝟏 − 𝑫𝒎
Year Dm BVm
0 0 12,000
1 0.4×12,000 = 4,800 7,200
2 0.4 ×7,200 = 2,880 4,320
3 0.4×4,320 = 1,728 2,592
4 0.4×2,592 = 592 2,000
5 0 2,000

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 34
7.0 REPLACEMENT AND MAINTENANCE
7.1 Introduction
Organizations providing goods/services use several facilities like equipment and
machinery which are directly required in their operations. In addition to these facilities,
there are several other items which are necessary to facilitate the functioning of
organizations.
All such facilities should be continuously monitored for their efficient functioning;
otherwise, the quality of service will be poor. Besides the quality of service of the
facilities, the cost of their operation and maintenance would increase with the passage of
time.
Hence, it is an absolute necessity to maintain the equipment in good operating conditions
with economical cost. Thus, we need an integrated approach to minimize the cost of
maintenance. In certain cases, the equipment will be obsolete over a period of time.
If a firm wants to be in the same business competitively, it has to take decision on whether
to replace the old equipment or to retain it by taking the cost of maintenance and
operation into account.
There are two basic reasons for considering the replacement of an equipment physical
impairment of the various parts or obsolescence of the equipment.
Physical impairment refers only to changes in the physical condition of the machine
itself. This would lead to a decline in the value of the service rendered, increased
operating cost, increased maintenance cost or a combination of these.
Obsolescence is due to improvement of the tools of production, mainly improvement in
technology.
So, it would be uneconomical to continue production with the same machine under any
of the above situations. Hence, the machines are to be periodically replaced.
Sometimes, the capacity of existing facilities may be inadequate to meet the current
demand. Under such situation, the following alternatives will be considered.
i) Replacement of the existing equipment with a new one.
ii) Augmenting the existing one with an additional equipment.

7.2 Types of Maintenance

Maintenance activity can be classified into two types:

(i) Preventive maintenance and
(ii) Breakdown maintenance.

Preventive maintenance (PM) is the periodical inspection and service activities which
are aimed to detect potential failures and perform minor adjustments or repairs which
will prevent major operating problems in future.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 35
Breakdown maintenance is the repair which is generally done after the equipment has
attained down state. It is often of an emergency nature which will have associated
penalty in terms of expediting cost of maintenance and down time cost of equipment.

Preventive maintenance will reduce such cost up to a point. Beyond that point, the cost
of preventive maintenance will be more when compared to the breakdown maintenance
cost.

The total cost, which is the sum of the preventive maintenance cost and the breakdown
maintenance cost, will go on decreasing with an increase in the level of maintenance up
to a point.

Beyond that point, the total cost will start increasing. The level of maintenance
corresponding to the minimum total cost is the optimal level of maintenance. The
concepts are demonstrated in Fig.

Fig. Maintenance costs

7.3 Types of Replacement Problem

Replacement study can be classified into two categories:

(a) Replacement of assets that deteriorate with time (Replacement due to gradual
failure, or wear and tear of the components of the machines).

This can be further classified into the following types:

i. Determination of economic life of an asset.

ii Replacement of an existing asset with a new asset.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 36
(b) Simple probabilistic model for assets which fail completely (replacement due to
sudden failure).

7.4 Determination of Economic Life of an Asset

Any asset will have the following cost components:

Capital recovery cost (average first cost), computed from the first cost (purchase price) of the
machine.
Average operating and maintenance cost (O & M cost)
Total cost which is the sum of capital recovery cost (average first cost) and average
maintenance cost.
A typical shape of each of the above costs with respect to life of the machine is shown in Fig.

Fig. Chart showing economic life.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 37
 EXAMPLE
A firm is considering replacement of an equipment, whose first cost is #4,000
and the scrap value is negligible at the end of any year. Based on experience,
it was found that the maintenance cost is zero during the first year and it
increases by #200 every year thereafter.

(a) When should the equipment be replaced if i = 0%?

(b) When should the equipment be replaced if i = 12%?

(a) When i = 0%. In this problem

(i) First cost = #4,000

(ii) Maintenance cost is #0 during the first year and it increases by #200
every year thereafter.
This is summarized in column B of Table

End of Maintenance Summation of Average cost of Average first Average total

year cost at end of maintenance maintenance through cost if replaced cost through
(n) year costs year given at year end given year given
B C/A 4,000/A D+E
A B (#) C (#) D (#) E (#) F(#)
1 0 0 0 4,000.00 4,000.00
2 200 200 100 2,000.00 2,100.00
3 400 600 200 1,333.33 1,533.33
4 600 1,200 300 1,000.00 1,300.00
5 800 2,000 400 800.00 1,200.00
6 1,000 3,000 500 666.67 1,166.67b
7 1,200 4,200 600 571.43 1,171.43
b
Economic life of machine = 6 years

Column C summarizes the summation of maintenance costs for each replacement period.
The value corresponding to any end of year in this column represents the total
maintenance cost of using the equipment till the end of that particular year.

First cost (FC) + Summation of maintenance cost

Average total cost =
Replacement period

Average first cost for the given period + Average maintenance cost for the given period
=
n
Column F = Column E + Column D

The value corresponding to any end of year (n) in Column F represents the average
total cost of using the equipment till the end of that particular year.

For this problem, the average total cost decreases till the end of year 6 and then it
increases. Therefore, the optimal replacement period is six years, i.e. economic life of
the equipment is six years.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 38
(b) When interest rate, i = 12%.
When the interest rate is more than 0%, the steps to be taken for getting the economic
life are summarized with reference to Table

Table: Calculations to Determine Economic Life (First cost = #4,000, Interest = 12%)

7.5 REPLACEMENT OF EXISTING ASSET WITH A NEW ASSET

In this section, the concept of comparison of replacement of an existing asset with a new
asset is presented. In this analysis, the annual equivalent cost of each alternative should
be computed first.

Then the alternative which has the least cost should be selected as the best alternative.
Before discussing details, some preliminary concepts which are essential for this type of
replacement analysis are presented.

7.5.1 Capital Recovery with Return

Consider the following data of a machine.

Let
P = purchase price of the machine,
F = salvage value of the machine at the end of machine life,
n = life of the machine in years, and

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 39
 i = interest rate, compounded annually

The corresponding cash flow diagram is shown in Fig

The equation for the annual equivalent amount for the above cash flow
diagram is

AE (i) = (P – F ) (A/P, i, n) + Fi

This equation represents the capital recovery with return.

7.5.2 Concept of Challenger and Defender

If an existing equipment is considered for replacement with a new equipment, then the existing
equipment is known as the defender and the new equipment is known as challenger.
Assume that an equipment has been purchased about three years back for #500,000 and it is
considered for replacement with a new equipment. The supplier of the new equipment will take
the old one for some money, say, #300,000.
This should be treated as the present value of the existing equipment and it should be considered
for all further economic analysis.
The purchase value of the existing equipment before three years is now known as sunk cost,
and it should not be considered for further analysis.

EXAMPLE
Two years ago, a machine was purchased at a cost of #200,000 to be useful for eight years. Its
salvage value at the end of its life is #25,000. The annual maintenance cost is #25,000.
The market value of the present machine is #120,000. Now, a new machine to cater to the need
of the present machine is available at #150,000 to be useful for six years. Its annual
maintenance cost is #14,000. The salvage value of the new machine is #20,000.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 40
Using an interest rate of 12%, find whether it is worth replacing the present machine with the
new machine.
Solution
Alternative 1:
Present machine
Purchase price = #200,000
Present value (P) = #120,000
Salvage value (F) = #25,000
Annual maintenance cost (A) = #25,000
Remaining life = 6 years
Interest rate = 12%

The cash flow diagram of the present machine is illustrated in Fig.

Annual maintenance cost for the preceding periods are not shown in
this figure. The annual equivalent cost is computed as

AE (12%) = (P – F) (A/P, 12%, 6) + Fi + A

= (120,000 – 25,000) (0.2432) + 25,000 × 0.12 + 25,000
= #51,104

Alternative 2:

New machine
Purchase price (P) = #150,000 Salvage
value (F) = #20,000
Annual maintenance cost (A) = #14,000
Life = 6 years
Interest rate = 12%

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 41
The cash flow diagram of the new machine is depicted in Fig.

The formula for the annual equivalent cost is

AE (12%) = (P – F) (A/P, 12%, 6) + Fi + A

= (150,000 – 20,000) (0.2432) + 20,000 × 0.12 + 14,000

= #48,016

Since the annual equivalent cost of the new machine is less than that of the present
machine, it is suggested that the present machine be replaced with the new machine.

Engineering Economics Lecture Notes Series Prepared By Engr. Prof. K.C. Bala, Mech. Engrg Dept. F.U.T. Minna Page 42