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School of Sciences and Engineering

ENGR 345/3222 - Engineering Economy

Annual Worth Analysis

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- Annual worth is also known by other titles. Some are

equivalent annual worth (EAW), equivalent annual cost
(EAC), annual equivalent (AE), and equivalent uniform
annual cost (EUAC).

- When evaluating alternatives, the alternative selected

by the AW method will always be the same as that
selected by the PW method, and all other alternative
evaluation methods, provided they are performed
correctly.
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The AW Method
- Annual Worth (AW) Analysis is defined as the
equivalent uniform annual worth of all estimated
receipts (income) and disbursements (costs) during the
life cycle of a project.
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The AW Method
- In other words, AW is the economic equivalent of the
PW and FW values at the MARR for n years.
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Advantage of the AW Method

- Since the AW value is the equivalent uniform annual worth of
all estimated receipts and disbursements during the life cycle
of the project or alternative, AW is easy to understand by any
individual acquainted with annual amounts, for example,
dollars per year.

- The annual worth method offers a prime computational and

interpretation advantage because the AW value needs to be
calculated for only one life cycle. The AW value determined
over one life cycle is the AW for all future life cycles.
Therefore, it is not necessary to use the LCM of lives to
satisfy the equal-service requirement.
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As with the PW method, there are three fundamental

assumptions of the AW method that should be understood.
When alternatives being compared have different lives, the AW
method makes the assumptions that
1. The services provided are needed for at least the LCM
of the lives of the alternatives.
2. The selected alternative will be repeated for
succeeding life cycles in exactly the same manner as
for the first life cycle.
3. All cash flows will have the same estimated values in
every life cycle.
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- If any of the three assumptions in the previous slide is

not acceptable for an alternative, a study period
analysis must be used. Then the cash flow estimates
over the study period are converted to AW amounts.
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Remember this example?

The PW analysis used the LCM of 18 years.

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- We had to plot the cash flow diagram for the 18 years.

- And we had to add up 7 elements in the equation to get

the PW.
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We could compare between alternatives

using the AW method instead …

Using the AW method,

we need to analyze just
ONE Life Cycle.

Calculate the equivalent uniform

annual worth value for all cash
flows in one life cycle.

AW = − 15,000 (A|P ,15%,6)

+ 1000 (A|F ,15%,6)
− 3500
= $−7349
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We could compare between alternatives

using the AW method instead …

The we do the same to Vendor B, then we select

the Vendor that has the best AW for us.
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Benefits of AW Analysis
1. When life-cycle-cost analysis is desired. A life-cycle-cost analysis is useful
when project alternatives fulfill the same performance requirements but differ with
respect to initial costs and operating costs. Life-cycle-cost analysis enables the
analysts to make sure that the selection of a design alternative is not based solely
on the lowest initial costs but also to take into account all the future costs over the
project's useful life.
2. When there is a need to determine unit costs or profits. In many situations,
projects must be broken into unit costs (or profits) for ease of comparison with
alternatives. Outsourcing decisions such as "make-or-buy" and pricing the usage
of an asset (rental charge per hour) reimbursement analyses are key examples of
such situations and will be discussed in this chapter.
3. When project lives are unequal. As we saw in the PW analysis, comparison of
projects with unequal service lives is complicated by the need to determine the
common lifespan. For the special situation of an indefinite service period and
replacement with identical projects, we can avoid this complication by using AW
analysis. This situation will also be discussed in more detail in this chapter.
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AW Analysis – Single Project

- If Net AW > 0  accept the project (the return on
investment is higher than the MARR)

- IF Net AW < 0  reject the project (the return on

investment is lower than the MARR)

- IF Net AW = 0  the return on investment is exactly

equal to the MARR.

The AW criterion will always

be consistent with the PW criterion.
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AW Analysis – Multiple Projects

 When comparing mutually exclusive revenue
projects, we select the project with the largest AE
value.

 If comparing mutually exclusive service projects

that have equivalent revenues, we compare them on a
cost-only basis.
 In this situation, the alternative with the least
annual equivalent cost (AEC) or least
negative annual equivalent worth is selected.
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 Engineers have proposed that the boiler controls in a hospital could

be upgraded by installing variable speed drives for the boiler fans
and using the fans in conjunction with oxygen trim equipment for
combustion control.
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Solution
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When converted to
The cost of annual costs, this
purchasing then annual equivalent is
selling the equipment called Capital
Recovery (CR)

Capital (Ownership) Costs

versus

Operating Costs
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Capital Costs
- Capital costs (or ownership costs) are incurred by the purchase of
assets to be used in production and service.

- Because capital costs tend to be one-time costs (buying and

selling), when conducting an annual equivalent cost analysis, we
must translate these one-time costs into their annual equivalent
over the life of the project.

- Suppose you purchased an equipment costing $10,000. If you

keep the asset for 5 years, your cost of owning the asset should
include the opportunity cost of $10,000. So, the capital cost is
defined as the net cost of purchasing (after any salvage value
adjustment) plus the interest cost over the life of the ownership.
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Capital Costs  Capital Recovery

 The annual equivalent of a capital cost is
given a special name: capital-recovery
cost, designated CR(i).
 Two general monetary transactions are
associated with the purchase and eventual
retirement of a capital asset:
1. the asset's initial cost (I) and
2. its salvage value (S).
 Taking these amounts into account, we
calculate the capital-recovery cost as
follows:
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Capital Costs  Capital Recovery

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Operating Costs
- Once you place an asset in service, operating costs will incur by
the operation of physical plants or equipment needed to provide
service; examples include the costs of items such as labor and raw
materials.

- Because operating costs recur over the life of a project, they tend
to be estimated on an annual basis; so, for the purposes of
annual-equivalent cost analysis, no special calculation is required
unless the annual amount keeps changing.

Normally, capital costs are nonrecurring (i.e.,

one-time costs) whereas operating costs recur
for as long as an asset is being utilized
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Evaluating a Single Project

A Company is considering an investment in CAD equipment. The

equipment will cost $110,000 and will have a five-year useful
economic life. It has a salvage value of $10,000. The expected
annual operating costs for the equipment would be $20,000 for the
first two years and $25,000 for the remaining three years. Assuming
the company’s desired return on its investment (MARR) is 15%,
what is required annual savings to make the investment
worthwhile?
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Solution

We dissect the problem and separate the operating costs from the
capital costs.

capital costs

operating costs
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Solution

Capital Costs:
CR (15%) = 110,000 (A|P,15%,5) – 10,000 (A|F,15%,5)
= $31,332 per year

Operating Costs:

per year
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Solution

Annual Equivalent Cost:

per year

Conclusion:
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Comparing between Multiple Projects

Michele is the general manager of a restaurant, and she

wishes to choose between two manufacturers of
temperature retention units that are mobile and easy to
sterilize after each use. Use the cost estimates below to
select the more economic unit at a MARR of 8% per year.
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Solution
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Confused about the signs?

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Unit Profit (or unit cost) Calculations

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Unit Profit (or unit cost) Calculations

To obtain a unit profit (or cost), we may proceed as follows:

1. Determine the number of units to be produced (or serviced)

each year over the life of the asset.

2. Identify the cash flow series associated with production or

service over the life of the asset.

3. Calculate the PW of the project and then determine the

equivalent AW.

4. Divide the AW by the number of units to be produced or

serviced during each year.

- When the number of units varies each year, you may need to
convert the units into equivalent annual units.
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Using AW Analysis for Unit Profit (or Cost) Calculations

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Solution

Solution
A) Annual operating
hours remain
constant: First
compute the annual
equivalent savings,
and then calculate the
equivalent savings per
machine-hour
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Solution
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Solution
B) Annual operating
hours fluctuate:
Calculate the
equivalent
annual savings as a
function C

Part A of the question

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Example Using AW Analysis for Unit Profit (or Cost) Calculations

Consider the purchasing of a business airplane for

domestic travels. Key financial data are as follows
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Solution
832,000
A1 for variable cost = (200)($272) = $54,400
A1 for fixed cost = (200)($302.95) = $60,590

0 1 2 3 4 5

54,400

60,590
1,282,035
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Solution A1 for variable cost = (200)($272) = $54,400

832,000

A1 for fixed cost = (200)($302.95) = $60,590

0 1 2 3 4 5

54,400

60,590
1,282,035
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Make-or-Buy (outsource) Decision

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Make-or-Buy Decisions
- Make-or-buy problems are common business decisions.

- If the "make" alternative requires the acquisition of

machinery or equipment besides the item itself, then the
problem becomes an investment decision.

- Since the cost of the "buy" alternative is usually quoted in

terms of dollars per unit, it is easier to compare the two
alternatives if the differential costs of the "make" alternative
are also given in dollars per unit.

- Hence, we use of AW analysis.

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AW Procedure for Make-or-Buy Decision

1. Determine the time span (planning horizon) for which the part (or product)
will be needed.
2. Determine the required annual quantity of the part.
3. Obtain the unit cost of purchasing “buying” the part (or product) from the
outside firm.
4. Determine the cost of the equipment, manpower, and all other resources
required to make the part.
5. Estimate the net cash flows associated with the "make" option over the
planning horizon.
6. Compute the annual equivalent cost of making the part.
7. Compute the unit cost of making the part by dividing the annual equivalent
cost by the required annual quantity.
8. Choose the option with the smallest unit cost.
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Using AW Analysis for Make-or-Buy Decisions

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Solution
Buy Option Make Option
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Solution