Benefit-cost ratio

and other analysis techniques

Chapter 7
Supplemental Reading, Chapter 8
Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.

ENG 3000 – Engineering Economics

© Farhoud Delijani, 2023
Learning Objectives

• Learn how to use the following methods to solve

engineering economy problems:
➢Future worth analysis
➢Benefit-cost ratio
➢Payback period
➢Sensitivity analysis
Future Worth Analysis

• Need to know the situation of set of

alternatives at any or some point in time in
future
• Very similar to present worth analysis but
analysis exists at some point in time
• As in present worth analysis, evaluation must
be over same time period
 Example 1
Problem:
A firm has decided to establish a second plant. There is a factory for
sale that with extensive remodelling could be used. As an alternative,
the company could buy vacant land and have a new plant constructed
there. The timing and cost of the various cash flows is as follows:

If interest is 8%, which of the two alternatives should be selected?

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Example 1
Example 1
 Benefit-Cost Ratio Analysis
• At a given MARR, alternative would be acceptable when:
➢PW of benefits - PW of costs ≥ 0, or
➢EUAB - EUAC ≥ 0
• Could also be stated as ratio, called the Benefit-Cost
Ratio
• Alternative would be acceptable when:
➢ PW of benefits/ PW of costs ≥ 1 Invest!
▪ Otherwise don't.
• EUAB/ EUAC ≥ 1
➢ IF very close to 1: use sensitivity analysis technique
 Benefit-Cost Ratio Analysis
• In benefit-cost ratio analysis, two alternatives are compared
using incremental benefit-cost ratio (B/C)

• Calculate B/C for each alternative separately

➢ Present worth (PW) values for alternatives with equal
lives
➢ Annual worth (EUAW) values for alternatives with
unequal lives
• Discard any alternative with B/C smaller than 1
• Calculate (B/C). Increment is ordered by:

Increment = Higher initial cost alternative – Lower initial cost alternative

Benefit-Cost Ratio Analysis
• Decision is based on:
➢ If B/C >= 1 choose higher initial cost alternative
➢ Indicates that additional cost is justified
➢If B/C < 1 choose lower initial cost alternative
• Indicates that additional cost is NOT justified
• Benefit-cost ratio can be deceiving!
• Comparing B/C of each project separately is necessary
but can provide incorrect results and disagree with
present worth or annual worth analysis, this is why we
use incremental benefit-cost ratio or ∆B/∆C
• Objective is to maximize “return” not “ratio”
 Example 2
Problem:
Two machines are being considered for purchase.
Assuming 10% interest, which machine should be bought?

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Example 2
Example 2
 Example 3
Problem:
Consider the following six mutually exclusive alternatives.
They have 20 year useful lives and no salvage value. If the
minimum attractive rate of return is 6%, which alternative
should be selected?

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
 Example 3
Problem:
Consider the following six mutually exclusive alternatives.
They have 20 year useful lives and no salvage value. If the
minimum attractive rate of return is 6%, which alternative
should be selected?

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Example 3
Example 3
Payback Period

• Time required for profit or other benefits of

project to equal cost
• The rule is to minimize the payback
period
✓Note: Interest rate is NOT considered!
Payback Period

• Remember:
➢Only an approximate calculation
➢All costs/benefits/savings are included with no
consideration of time value of money
➢All economic consequences beyond payback
are ignored
➢Due to approximate nature, may not select
correct alternative
Payback Period

• If payback period calculations are approximate

and may cause the wrong alternative to be
chosen, why are they used?
➢The calculations can be made readily by
people unfamiliar with economic analysis
➢Payback period is easily understood
Payback Period

• It measures how long it will take for the cost of

the investment to be recovered from the
benefits
➢Firms are often very interested in this time
period: a rapid return of invested capital
means that it can be reused sooner for
other purposes
➢The method emphasizes the quickness with
which invested funds return to a firm
 Payback Period Example

• A firm is trying to
decide which of two
scales it should
install to check a
package-filling
operation in the
plant. If both scales
have a six-year life,
which one should be
selected (using
payback period
analysis)?
• Assume an 8%
interest rate.

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Payback Period Example

Atlas Tom Thumb

To minimize payback period, choose the Atlas scale

 Example 4
Problem:
The cash flows for two alternatives are as follows:

You may assume that the benefits occur throughout the year rather
than just at the end of the year.

On the basis of payback period, which alternative should be selected?

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Example 4
Example 4
Sensitivity Analysis

• Since economic problem solving often considers

future consequences, there is uncertainty
regarding accuracy
• To better evaluate impact of estimates, we can
compute how much an estimate can change and
its effect on a particular decision
• This is “Sensitivity Analysis”
Break-Even Analysis
• A form of sensitivity analysis
• Typically presented as break-even chart
• Indicates point at which two alternatives are equal
to each other:
➢The point of indifference
➢One application of these tools is stage construction:
• Should a facility be constructed now to meet its future full-
scale requirement, or should it be constructed in stages as
the need for the increased capacity arises?
• What is the break-even point on how soon the capacity is
needed for this decision?
 Break-Even Chart Example

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
 Example 5
Problem:
Consider a project that may be constructed to full capacity
now or may be constructed in two stages. Both alternatives
have a 40 year useful life. Assuming an 8% interest rate,
what is the sensitivity of the decision to go with second-
stage construction when “n” is 16 or more years in the
future?
• Plot “Age When Second
Stage Is Constructed”
versus “Costs for Both
Alternatives.”
• Mark the break even
point on your graph.

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Example 5
Example 5
Example 5
Solution:
• The decision about how to construct the project is sensitive to the
age at which the second stage is needed only if the range of
estimates includes 15 years.
➢ For example, if one estimated that the second-stage capacity would
be needed between five and 10 years hence, the decision would be
insensitive to that estimate. For any value within that range, the
decision would not change. But if the second-stage capacity were to
be needed some time between 12 and 18 years, the decision would
be sensitive to the estimate of when the full capacity would be
needed.
• One question posed by this example is how sensitive the decision is
to the need for the second stage at 16 years or beyond. The graph
shows that the decision is insensitive.
• In all cases for construction at or after 16 years, two-stage
construction has a lower PW of cost.
 Example 6
Problem:
Three mutually exclusive alternatives are given below, each
with a 20-year life and no salvage value. The minimum
attractive rate of return is 6%.

If B is the preferred alternative at an initial cost of $4,000,

how much higher can the initial cost be and still have B as
the preferred alternative?

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Example 6
Example 6
 Example 6
Sensitivity analysis:
• Here the rule is to
maximize NPW; as a
result, the graph shows
that B is preferred if its
initial cost is less than
$4,300.
• At an initial cost above
$4,300, C is preferred.
We have a break-even
point at $4,300.
• When B has an initial
cost of $4,300, B and C
are equally desirable.
 Benefit-cost ratio
and other analysis techniques

Chapter 7
Supplemental Reading, Chapter 8
Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.

ENG 3000 – Engineering Economics

© Farhoud Delijani, 2023