Meaning, Formula, and Example of Equivalent Annual Cost

In this context, the term “equivalent annual cost” is used to refer to the

The annual cost of owning and sustaining an asset throughout the course of its lifespan is referred to as the “Equivalent Annual Cost” (or “EAC”). Simply put, it refers to the yearly average cost of owning and sustaining assets throughout the course of their useful lives. EAC is calculated by taking the present value of the purchase price, operating costs, and maintenance costs (during the asset’s whole lifespan) and dividing them by their annuity factor present value.

Capital budgeting choices are made based on the EAC idea. The cost-effectiveness of assets with various useful lives may be compared. It may also be used to assess projects with varied lifespans by a corporation, in a similar way.

EAC may also be used to determine if leasing or purchasing an asset is the most cost-effective choice for an organization. In addition, the EAC analysis aids in figuring out how much an asset will cost in terms of upkeep. It also helps in figuring out how much it would cost to maintain current equipment and how much money might be saved by purchasing a new asset.

The Importance of Costs in Dollars Per Year

Let’s take a look at an example to see how important EAC is. Suppose a corporation is weighing the pros and downsides of two software options. There are many similarities between the two programs, and they both operate in the same manner. However, the fee and the length of the license are different for each.

A $10,000 software package is assumed. It comes with a four-year license and an annual fee of $2,000 for maintenance. Software B, on the other hand, costs $8,000, has a three-year licence term and costs $3,000 per year in yearly maintenance.

Calculating net present values (NPVs) is usually all that is needed to determine which option best suits a business’s requirements. However, this strategy will not work in this example since the life spans of the two programs are different. As a result, making a choice only on the basis of net present value (NPV) is misleading.

EAC can help with this. The EAC would assist in decreasing the yearly cost of both products to a similar level. Another way to put it is that the EAC approach views the fee as a rental, which eliminates the need for separate licensing terms altogether. As a result, we chose the option with the lowest yearly cost.

The Equivalent Annual Cost formula

Simply determining the asset’s net present value is all that is needed to calculate EAC, making it simple. The net present value will be negative since there is no cash inflow. We must convert the NPV to yearly terms after obtaining the net present value (NPV). The net present value must be treated as an ordinary annuity with a duration equal to the asset’s life in order to be converted to yearly terms. Because of this, the NPV of the asset must be divided by the annuity factor’s present value (PV). As a result, the EAC formula is as follows:

(Asset Price-Discount Rate)/(1 + Discount Rate)n

To reach the final EAC, we need to include the asset’s Annual Maintenance Cost.

Calculation of Equivalent Yearly Costs

To calculate the Equivalent Annual Cost, follow these steps:

Identifying the asset’s ownership price is the first and most important step. Let’s say a business is debating between purchasing Truck A ($100,000) or Truck B ($130,000). These are the costs associated with owning an asset.

The asset’s useful life must be determined next. Assume, for the sake of argument, that Truck A lasts five years and Truck B lasts seven. That’s how many n periods there are.

We’ll need a discount rate to calculate the PV and NPV numbers as we go. It refers to the annualized cost of capital or return on capital. For the purpose of simplicity, let’s assume a discount rate of 10%.

Finally, we must determine the asset’s yearly maintenance costs. Truck A has an annual maintenance cost of $11,000, whereas Truck B has a cost of $8,000.

Finally, we’ll be ready to compute the EAC by adding all these numbers into the formula. In the above case, the computation is as follows.

Truck A’s EAC is $37,380 because $100,000 * 10% / 1 – (1 + 10%) -5 + $11,000

$8,000 = $34,702 for Truck B’s EAC, which is calculated as follows: $130,000 * 10%/ 1 – (1 + 10%) 7

Truck B should be preferred over Truck A by management since it has a lower EAC.

The EAC’s limitations

EAC has the following drawbacks:

  • EAC’s greatest shortcoming is its inability to accurately estimate the discount rate. As a result, if the estimate is off, we may get an EAC that is wrong. Consequently, experts advise using EAC analysis in conjunction with other capital budgeting methods. The risk of making a bad choice may be reduced by using alternative tools that provide more precise estimations.
  • The EAC does not take into account the effect of taxes in its study. Although tax cash flows may be included in the computations, the process is more time-consuming.
  • Assumption 1: A firm may easily swap out an existing asset for a new one at any time. Because of the rapid pace at which technology advances, it’s possible that this assumption will prove to be incorrect. As a result, an improved version of that item is more probable in the future. Additionally, the demands of customers change over time, so a firm may not always need the same things.
  • EAC analysis does not take inflation into account when calculating cash flow and capital costs.

How is it different from the total cost of ownership?

The overall cost of an asset over the course of its whole life is referred to as the “whole-life cost.” “Entire life” in this context refers to the time it takes to acquire and then sell a particular asset. The term “life-cycle cost” may also be used to describe this. When calculating total life-cycle costs, it’s important to include in everything from the initial purchase price to all subsequent expenditures, including depreciation, financing charges, and disposal fees. Whole-life costs may also take environmental and social costs into account or incorporate them.

EAC, on the other hand, is the yearly cost of owning, operating, and maintaining a resource over the course of its full useful lifetime. These charges will be less expensive than the total cost of ownership during the life of the product.

Here are the final remarks

The notion of “equivalent annual cost” is very helpful to managers since it allows them to compare many possibilities and choose the best one. Because of this, businesses may save money and increase profits. It is important for managers to make sure that they accurately estimate the cost of capital to acquire an exact figure. As a result, managers should not rely entirely on EAC to make their decisions, but should also use alternative methods.

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