Thursday, July 11, 2013

Using Cost Data for Decisions

In this blog, I will show how a decision can be made between the purchase of two pieces of chemical production equipment, when based on the initial and maintenance costs.  Assumptions are that the two equipment pieces provide basically the same result, but initial costs, maintenance costs per year, and length of maintenance costs are different.

Determining which equipment choice based only on the net present value (NPV) of the two choices leads to an incorrect decision.  The decision should be based not on the net present value, but based on the annuity payment (discounted payment) per year that the initial and maintenance costs represent.

For example, suppose the following (amounts in millions):

                        Initial cost         maintenance      maintenance      maintenance
                                                year 1               year 2               year 3
Equipment A      20 M                 2M                   2M                    0
Equipment B      25M                  1M                   1M                    1M

The NPV of Equipment A, with the above amounts, is 23.72M and the NPV of equipment B is 27.72M.  On the basis of NPV, Equipment A would be chosen, with the assumptions above.

This would be the wrong decision because the lengths of maintenance costs for the two pieces of equipment are different.  The NPV comparisons should not be used for projects of different lengths.  What can be used, and will show the less costly decision correctly, is determining the per year annuity (discounted) payment for each purchase.   Equipment A has an annual payment annuity of 12.76M and Equipment B 10.18M.  Equipment B is less costly on a per year basis.

I would be glad to work with you on determining your annuity costs for your situations similar to what is described above.

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