UNIVERSITY OF SANTO TOMAS

Faculty of Engineering
Department of Mechanical Engineering

ENG2010 – ENGINEERING ECONOMY

COMPARING ALTERNATIVES

ROGELIO O. ALMIRA JR., PME ASEAN ENG.

 COMPARING ALTERNATIVES

In Chapter 6 (Basic Methods of Making Economy Studies), the different methods for investment of capital were discussed. In
that chapter, the problem that was resolved was justified or not. However, most engineering and business projects can be
accomplished by more than one method or alternative. This chapter will deal with these types of problems.
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 result 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, but only six patterns will be discussed.

➢ THE RATE OF RETURN ON ADDITIONAL INVESTMENT METHOD

The formula for the rate of return on additional investment is,

Rate of return on additional investment = annual net savings .

additional investment

If the rate of return on additional investment is satisfactory, then the alternative requiring a bigger investment is more
economical and should be chosen.
 COMPARING ALTERNATIVES

(7-1) A company is considering two types of equipment for its manufacturing plant. Pertinent data are as
follows:
Type A Type B
First Cost P200,000 P300,000
Annual operating Cost 32,000 24,000
Annual labor Cost 50,000 32,000
Insurance and Property Taxes 3% 3%
Payroll Taxes 4% 4%
Estimated life 10 10
If the minimum required rate of return is 15%, which equipment should be selected?
Problem (7-1)
COMPARING ALTERNATIVES
Type B
Annual costs:
Depreciation = P300,000 = P300,000 = P14,776
F/A,15%,10 20.3037
Operation = P24,000
Solution:
Labor = P32,000
By the rate of return on additional investment
Payroll Taxes = P32,000 (0.04) = P 1,280
Type A
Taxes & insurance = (P300,000) (0.03) = P 9,000
Annual costs:
Total annual cost P 81,056
Depreciation = P200,000 = P200,000 = P 9,850
F/A,15%,10 20.3037 Annual savings = P99, 850 - P81, 056 = P18,794
Operation = P32,000 Additional investment = P300, 000 – P200, 000 = P100, 000
Labor = P50,000
Rate of return on additional = annual savings .

Payroll Taxes = P50,000 (0.04) = P 2,000 investment for Type B additional investment
Taxes & insurance = (P200,000) (0.03) = P 6,000 Rate of return on additional = P 18,794 x 100% = 18.79%
investment for Type B P100,000
Total annual cost P 99,850
Since 18.79% > 15%, then Type B should be selected.
 COMPARING ALTERNATIVES

➢ THE ANNUAL COST (AC) 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. 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
for each year and a single investment of capital at the beginning of the first year of the project life.
 Problem (7-1)

COMPARING ALTERNATIVES

By annual cost method

Type A Type B
Annual costs: Annual costs:
Depreciation = P200,000 = P200,000 = P 9,850 Depreciation = P300,000 = P300,000 = P14,776
F/A,15%,10 20.3037 F/A,15%,10 20.3037
Operation = P32,000 Operation = P24,000
Labor = P50,000 Labor = P32,000
Payroll Taxes = P50,000 (0.04) = P 2,000 Payroll Taxes = P32,000 (0.04) = P 1,280
Taxes & insurance = (P200,000) (0.03) = P 6,000 Taxes & insurance = (P300,000) (0.03) = P 9,000
Interest on capital = (P200,000) (0.15) = P 30,000 Interest on capital = (P300,000) (0.15) = P 45,000
Total annual cost P129,850 Total annual cost P126,056

Since annual cost of B is less than the annual cost of A (or ACB < ACA), type B should be selected
 COMPARING ALTERNATIVES

➢ THE PRESENT WORTH COST (PWC) METHOD Problem (7-1)

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.

By the present worth cost method

Type A
Annual costs (excluding depreciation) = P32,000 + P50,000 + PWCA = P200,000 + P90,000 (P/A,15%,10)
(P50,000) (0.04) + (P200,000) (0.03) = P90,000
= P200,000 + (P90,000) (5.0188)
0 1 2 3 8 9 10 = P651, 692

P90,000 P90,000 P90,000 P90,000 P90,000 P90,000

P200,000
 COMPARING ALTERNATIVES

Type B Problem (7-1)

Annual costs (excluding depreciation) = P24,000 + P32,000

+ (P32,000) (0.04) + (P300,000) (0.03) = P66,280

0 1 2 3 8 9 10

P66,280 P66,280 P66,280 P66,280 P66,280 P66,280

P300,000

PWCB = P 300,000 + P66,280 (P/A,15%,10)

= P300,000 + (P66,280) (5.0188) = P632,646
= P632, 646

Since PWCB < PWCA for the same period of time, type B should be selected.
 COMPARING ALTERNATIVES

➢ THE EQUIVALENT UNIFORM ANNUAL COST (EUAC) METHOD

In this method, all cash flows (irregular or uniform) 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 annual cost is preferred.
When the 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 problems. The method is a modification of
the annual cost pattern.

By the equivalent uniform annual cost method

Type A
0 1 2 3 8 9 10 0 1 2 3 8 9 10

P90,000 P90,000 P90,000 P90,000 P90,000 P90,000 EUACA EUACA EUACA EUACA EUACA EUACA

P200,000 EUACA = P200,000(A/P,15%,10) + P90,000

= (P200,000) (0.1993) + P90,000 = P129,860
 COMPARING ALTERNATIVES

Type B
0 1 2 3 8 9 10 0 1 2 3 8 9 10

P66,280 P66,280 P66,280 P66,280 P66,280 P66,280 EUACB EUACB EUACB EUACB EUACB EUACB

P300,000 EUACB = P300,000(A/P,15%,10) + P66,280

= (P300,000) (0.1993) + P66,280 = P126,070
Since EUACB < EUACA type B is more economical.

➢ PAYBACK (PAYOUT) PERIOD METHOD

To use this method, the payback period of each alternative is computed. The alternative with the shortest payback
period is adopted. This method is seldom used.

Payout period (years) = investment – salvage value

net annual cash flow
 COMPARING ALTERNATIVES

(7-2) Choose from the two machines which is more economical.

Machine A Machine B
First Cost P8,000 P14,000
Salvage value 0 2,000
Annual operation 3,000 2,400
Annual maintenance 1,200 1,000
Taxes and insurance 3% 3%
Life, years 10 15
Money is worth at least 16%
Problem (7-2)
COMPARING ALTERNATIVES

Machine B
Annual costs:
Depreciation = P14,000 – P2,000 = P12,000 = P 232
F/A,16%,15 51.6595
Solution:
Operation = P 2,400
By the rate of return on additional investment
Maintenance = P 1,000
Machine A Taxes & insurance = (P14,000) (0.03) =P 420
Annual costs: Total annual cost P 4,052
Depreciation = P8,000 = P8,000 = P 375
F/A,16%,10 21.3215 Annual savings = P4,815 – P4,052 = P763
Operation = P3,000 Additional investment = P14,000 – P8,000 = P6,000
Maintenance = P1,200
Rate of return on additional = annual savings .

Taxes & insurance = (P8,000) (0.03) =P 240 investment for Machine B additional investment
Total annual cost P 4,815 Rate of return on additional = P 763 x 100% = 12.72%
investment for Type B P6,000
Since 12.72% < 15%, then Machine A is more economical.
 Problem (7-2)

COMPARING ALTERNATIVES

By annual cost method

Machine A Machine B
Annual costs: Annual costs:
Depreciation = P8,000 = P8,000 = P 375 Depreciation = P12,000 = P12,000 = P 232
F/A,16%,10 21.3215 F/A,16%,15 51.6595
Operation = P3,000 Operation = P2,400
Maintenance = P1,200 Maintenance = P1,000

Taxes & insurance = (P8,000) (0.03) = P 240 Taxes & insurance = (P14,000) (0.03) = P 420

Interest on capital = (P8,000) (0.16) = P1,280 Interest on capital = (P14,000) (0.16) = P2,240
Total annual cost P6,095 Total annual cost P6,292

Since ACA < ACB, Machine A is more economical.

 COMPARING ALTERNATIVES

By the present cost method

Use 30-year study period, which is the least common multiple of 10 and 15.
Machine A
Annual costs (excluding depreciation) = P3,000 + P1,200 + (P8,000) (0.03) = P4,440

0 1 2 10 11 20 21 29 30

P4,400 P4,400 P4,400 P4,400 P4,400 P4,400 P4,400 P4,400

P8,000
P8,000 P8,000

PWCA = P8,000 + P4,400 (P/A,16%,30) + P8,000 (P/F,16%,10) + P8,000 (P/F,16%,20) = P37,652

 COMPARING ALTERNATIVES

Machine B
Annual costs (excluding depreciation) = P2,400 + P1,000 + (P14,000) (0.03) = P3,820
P2,000 P2,000

0 1 2 3 14 15 16 28 29 30

P3,820 P3,820 P3,820 P3,820 P3,820 P3,820 P3,820 P3,820

P14,000
P14,000

PWCB = P14,000 + P3,820 (P/A,16%, 30) + P12,000 (P/F,16%, 15) - P2,000 (P/F,16%, 30) = P38,869

Machine A should be chosen, since PWCA < PWCB.

 COMPARING ALTERNATIVES

By the equivalent uniform annual cost method

Machine A
0 1 2 8 9 10 0 1 2 8 9 10

P4,400 P4,400 P4,400 P4,400 P4,400 EUACA EUACA EUACA EUACA EUACA

EUACA = P8,000 (A/P,16%,10) + P4,400 = P6,095

P8,000
P2,000

Machine B
0 1 2 13 14 15 0 1 2 13 14 15

P3,820 P3,820 P3,820 P3,820 P3,820 EUACA EUACA EUACA EUACA EUACA

P14,000 EUACB = P14,000 (A/P,16%,15) + P3,820 – P2,000 (A/F,16%,15) = P6,292

Machine A should be chosen, since EUACA < EUACB

 COMPARING ALTERNATIVES

(7-3) A company is going to buy new machine for manufacturing its product. Four different machines are
available. Cost, operation and other expenses are as follows:
A B C D
First cost P24,000 P30,000 P49,600 P52,000
Power per year 1,300 1,360 2,400 2,020
Labor per year 11,600 9,320 4,200 2,000
Maintenance per year 2,800 1,900 1,300 700
Taxes and insurance 3% 3% 3% 3%
Life, years 5 5 5 5

Money is worth 17% before taxes to the company. Which machine should be chosen?
 COMPARING ALTERNATIVES

Solution:
Comparative Total Annual Cost for Four Machines
By the annual cost method
Depreciation:
Machine A = P24,000 = P24,000
F/A,17%,5 7.0144
= P3,422

Machine B = P30,000 = P4,277

7.0144

Machine C = P49,600 = P7,071

7.0144
Machine D = P52,000 = P7,413 The economic criterion is to choose that alternative with the
7.0144
minimum annual cost, which is machine D. However, it should be
noted that machine B is very close, showing a total annual cost of
only P22,857-P22,533 = P324 more than machine D.
 COMPARING ALTERNATIVES

Solution:
By the rate of return on additional investment method ➢ Comparing Machine B with Machine C.

ROR on additional investment on C = P17,757 – 16,459

P49,000 – P30,000
= 6.62% < 17%
Machine B is economical than Machine C

➢ Comparing Machine B with Machine D.

ROR on additional investment on D = P17,757 – 13,693

➢ Comparing Machine A with Machine B. P52,000 – P30,000
= 18.47% > 17%
ROR on additional investment on B = P19,482 – P17,757
P30,000 – P24,000
Machine D is economical than Machine B, choose
= 34.75% > 17% Machine D.
Machine B is economical than Machine A
 COMPARING ALTERNATIVES

(7-4) An untreated electric wooden pole that will last 10 years under certain soil condition costs P20,000. If a treated pole will
last for 20 years, what is the maximum justifiable amount that can be paid for the treated pole, if the maximum return
on investment is 20%. Consider annual taxes and insurance amount to be 1% of first cost.

Solution: By annual cost method

Untreated Pole: Treated Pole Let C = maximum amount that can be
invested on the treated pole
Annual costs: Annual costs:
Depreciation = P20,000 = P20,000 = P 770 Depreciation = C = C = 0.005356C
F/A,20%,10 25.9587 F/A,20%,20 186.688
Taxes & insurance = (P20,000) (0.01) = P 200 Taxes & insurance = (C) (0.01) = 0.01C
Interest on capital = (P20,000) (0.20) = P 4,000 Interest on capital = (C) (0.2) = 0.20C
Total annual cost = P4,970 Total annual cost P0.215356C

Equating annual costs,

P0.215356C = P4,970 The maximum justifiable amount that can be paid for the pole is P23,078. More
than P23,078, the untreated pole will more economical, however if less than
C = P23,078
P23,078, then treated pole will more economical.
 COMPARING ALTERNATIVES

(7-4) An untreated electric wooden pole that will last 10 years under certain soil condition costs P20,000. If a treated pole will
last for 20 years, what is the maximum justifiable amount that can be paid for the treated pole, if the maximum return
on investment is 20%. Consider annual taxes and insurance amount to be 1% of first cost.

Solution: By ROR on additional method

Untreated Pole: Treated Pole Let C = maximum amount that can be
invested on the treated pole
Annual costs: Annual costs:
Depreciation = P20,000 = P20,000 = P 770 Depreciation = C = C = 0.005356C
F/A,20%,10 25.9587 F/A,20%,20 186.688
Taxes & insurance = (P20,000) (0.01) = P 200 Taxes & insurance = (C) (0.01) = 0.01C
Total annual cost = P 970 Total annual cost P0.015356C

To determine the maximum justifiable amount let ROR

on additional investment on treated pole equal to 20%

ROR on additional investment = 0.20 = 970 – 0.015356C C = P23,078

treated pole C – P20,000
 COMPARING ALTERNATIVES

(7-5) A company manufacturing acids, upon inspection of Second option

the roofing of the plant, found out that it is badly corroded
from the acids fumes and would need to be replaced. To 0 1 2 5 0 1 2 5
try to get some more life out of the roofing, the company
consulted a roofing coating contractor who presented the
EUACB EUACB EUACB
company with two options. The first option is a coating that P30,000
will cost P20,000 which would extend the life of the roofing
for 3 years from date of application, and the second option EUACB = P30,000 (A/P, i%, 5)
will cost P30,000 and which would extend the life of the
roofing for 5 years from the date of application. At what For the two alternative to be equally economical,
rate of return are the two investments equal?
EUACA = EUACB.
Solution: By Equivalent uniform annual cost
P20,000 (A/P,i%,3) = P30,000 (A/P,i%,5)
First option
A/P,i%,5 = P20,000
0 1 2 3 0 1 2 3
A/P,i%,3 P30,000

EUACA EUACA EUACA

P20,000
EUACA = P20,000 (A/P, i%, 3)
 COMPARING ALTERNATIVES

A/P,i%,5 = P20,000 0.6663 12% 2nd option:

A/P,i%,3 P30,000 0.6667 i% Annual costs:
13% Depreciation = P30,000 = P4,714.79
i . 0.6713 F/A,12.08%,5
1 – (1 + i)–5
= 0.6667 i – 12 = 0.6667– 0.6663 Int. on cap. = (P30,000) (0.1208) = P 3,624.00
i . 13 – 12 0.6713 – 0.6663 Total annual cost = P8,338.79
1 – (1 + i)–3
Rate of return = 12.08%.
1 – (1 + i)–3 = 0.6667
1 – (1 + i)–5 ➢ Check the answer by Annual cost method
First option:
Solving i by trial and error and
interpolation: Annual costs:
Depreciation = P20,000 = P5,922.43
Try i = 12% 0.6663 F/A,12.08%,3
Try i = 13% 0.6713 Int. on cap. = (P20,000) (0.1208) = P2,416.00
Total annual cost = P8,338.43
 COMPARING ALTERNATIVES

(7-6) The engineer of a medium scale industry was instructed to prepare at least two plans which is to be considered by
management for the improvement of their operations. Plan “A” calls for an initial investment of P200,000 now with a
prospective salvage value of 20% of the first cost of 20 years hence. The operation and maintenance disbursements are
estimated to be P15,000 a year and taxes will be 2% of first cost.
Plan “B” calls for an immediate investment of P140,000 and a second investment of P160,000 eight years later. The
operation and maintenance disbursements will be P9,000 a year for the initial installation, and P8,000 a year for the second
installation. At the end of 20 years the salvage value shall be 20% of the investments. Taxes will be 2% of the first cost.
If money is worth 12%, which plan would you recommend?
P40,000
Solution: By present worth method
Plan A: 0 1 2 3 19 20
Annual costs = P15,000 + (P200,000)(0.02) = P19,000
Salvage value = (P200,000)(0.20) = P40,000
P19,000 P19,000 P19,000 P19,000 P19,000

P200,000

PWCA = P200,000 +(P19,000)(P/A,12%,20) – (P40,000)(P/F,12%,20)

PWCA = P337,771
 COMPARING ALTERNATIVES

Plan B:
Annual costs = P9,000 + (P140,000)(0.02) = P11,800
Additional annual costs after 8 years = P8,000 + (P160,000) (0.02) = P11,200
Salvage value = (P140,000 + P160,000) (0.20) = P60,000
P60,000

0 1 2 8 9 19 20

P11,800 P11,800 P11,800 P11,800 P11,800 P11,800

P140,000
P11,200 P11,200 P11,200 Plan B is more economical.
P160,000

PWCB = P140,000 + P11,800(P/A,12%,20) + P160,000(P/F,12%,8) + P11,200(P/A,12%,12)(P/F,12%,8) – 60,000(P/F,12%,20)

PWCB = P314,564
 COMPARING ALTERNATIVES

By the equivalent annual cost method

EUACA = P200,000 (A/P,12%,20) + P19,000 EUACB = P140,000 (A/P,12%,20) + P11,800

– P40,000 (A/F,12%,20) = P45,224 + P160,000 (P/F,12%,8) (A/P,12%,20)
+ P11,200(F/A,12%,12) (A/F,12%,20)
– P60,000 (A/F,12%,20) = P34,019

Plan B is more economical.

 COMPARING ALTERNATIVES

(7-7) The National Government is planning to construct a bridge. At present a 4-lane bridge will be built, but it is expected
that at a later date a second 4-lane bridge will be added.
If an 8-lane bridge is built now, it will cost P8,100,000. A single 4-lane bridge can be built now for P5,500,000. It is
estimated that a second 4-lane bridge at a later date will cost P8,000,000. Annual upkeep on each 4-lane bridge would be
P91,500, and for the 8-lane bridge would be P115,000. Monet to built the bridge will cost 12%.
Assume a 50-year functional life for the project and determine the earliest time at which the additional 4 lanes would be
required to make it equally economical to build the 8-lane bridge immediately.
Solution: By present worth method
8-lane bridge:
0 1 2 49 50

P115,000 P115,000 P115,000 P115,000

P8,100,000

PWC8 = P8,100,000 + P115,000 (P/A,12%,50) = P9,055,000

 BASIC METHODS OF MAKING ECONOMY STUDIES

4-lane bridge:

0 1 2 n n+1 49 50
Solving i by trial and error and
interpolation:
P91,500 P91,500 P91,500
Try n = 9 9,417,068
P5,500,000 P183,000 P183,000 P183,000
Try n = 11 8,776,232
8,000,000
9 9,417,068
PWC4 = P5,500,000 + P91,500 (P/A,12%,n) + P8,000,000 (P/F,12%,n) + n 9,055,000
P183,000 [P/A,12%,(50-n)] (P/F,12%,n)
11 8,776,232
For the two alternative to be equally economical,
n – 9 = 9,055,000 – 9,417,068
PWC8 = PWC4 = P9,055,000 11 – 9 8,776,232 – 9,417,068

n = 10.13 years, say 10 years

 COMPARING ALTERNATIVES

PROBLEM SET NO. 5

3. It is proposed to place a cable on an existing pole line along the 6. A utility company is considering the following plans to provide a
shore of a lake to connect two points on opposite sides. certain service required by present demand and the prospective
growth of demand for the incoming 18 years.
Land Route Submarine Route Plan R requires an immediate investment of P500,000 in
Length, miles 10 5 property that has an estimated life value of 18 years and 20%
First cost of cable per mile P40,000 P68,000 terminal salvage value. Annual disbursements for operation and
Annual maintenance per mile 950 3,500 maintenance will be P50,000. Annual property taxes will be 2% of
Interest in investment 18% 18% first costs.
Taxes 3% 3% Plan S requires an immediate investment of P300,000 in
Net salvage value per mile 12,000 22,000 property that has an estimated life of 18 years with 20% terminal
Life, years 15 15 salvage value. Annual disbursements for its operation and
maintenance during the first 6 years will be P40,000. After 6 years, an
Which is more economical? additional investment of P400,000 will be required in property having
an estimated life of 12 years with 40% terminal salvage value. After
Ans. The submarine cable is more economical the rate of return on this additional property is installed, annual disbursements for
additional investment is only 8.97% operation and maintenance of the combined property will be P60,000.
Annual property taxes will be 2% of the first cost of property in
service at any time. Money is worth 12%. What would you
recommend?
Ans. Plant S
 COMPARING ALTERNATIVES

(7-8) A plant to provide the company’s present needs can be constructed for P2,800,000 with annual operating
disbursements of P600,000. It is expected that at the end of 5 years the production requirements could be
doubled, which will necessitate the addition of an extension costing P2,400,000. The disbursement after 5 years
will likewise double. A plan to provide the entire expected capacity can be constructed for P4,000,000 and its
operating disbursements will be P640,000 when operating on half capacity (for the first 5 years) and P900,000
on full capacity. The plants are predicted to have indeterminately long life. The required rate of return is 20%.
What would you recommended?

Solution: By capitalized cost (CaCo)

END