Question

when would you deem the use of effective annual cost methodology most appropriate? ilustrate with example

Answer 1

Let us first understand what Effective Annual Cost is?

Effective Annual Cost (EAC) is the total annual cost of maintaining and operating an asset for its lifetime. In simple words, if the total cost due to an asset is, say $1M for 10 years, then the EAC is $0.1M. However, it is not this simple always to calculate EAC.

EAC is most widely used to choose between two or more assets/investments etc. that will cost minimum to the company and generate more profit. More often than not, the assets usually have different lifespans and hence their equivalent annual cost is measured.

Let us take the following example :

A company has to choose between two machines, machine A and machine B.

	Cost	Labour savings	Useful life
Machine A	8000	2000	7
Machine B	6000	1800	5

Assume investment opportunity rate is 7% (For calculation of time value of money).

Q. Which Machine is preferable?

Answer: let's analyse each machine one by one.

Machine A: Cost-8000, life = 7 yrs

let's find the annuity factor for r=7% and t=7yrs.

Annuity Factor = = 5.39

​​where:r=Cost of capital t=Number of periods​.

Therefore, the equivalent annual cost of the machine may be considered as 8000/5.39=1484.

Similarly for machine B, effective annual cost maybe calculated as 6000/4.10= 1463.

	A	B
Labour Savings	2000	1800
Effective annual cost	1484	1463
Net Savings	516	337

Therefore Machine A is preferable as Net Savings is higher.