University of Palestine

College of Engineering & Urban Planning

Engineering Economy

Chapter 9
Other Analysis Techniques

Lecture 11

1st Semester 2020/2021

Instructor: Eng. Abdallah Adwan

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College of Engineering & Urban Planning

Other Analysis Techniques

:Chapter 9 examines four topics
Future worth analysis •
Benefit–cost ratio or present worth index analysis •
Payback period •
.Sensitivity, breakeven, and what-if analysis •

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Payback Period
Payback period is the period of time required for the project’s profit or other benefits
to equal the project’s cost.
Warning
1. Payback period is an approximate, rather than an exact, analysis calculation. 
2. All costs and all profits, or savings of the investment prior to payback, are included
without considering differences in their timing.
3. Payback period may or may not select the same alternative as an exact economic
analysis method.

Payback period is used because

4. the concept can be readily understood,
5. the calculations can be readily made and understood by people unfamiliar with the
use of the time value of money.

It’s “better than nothing.” Use it as a last resort to communicate.

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Payback Period
Example
A firm is buying production equipment for a new plant.
Tempo Dura
Two alternative machines are being considered. Year
machine machine
0 $30,000- $35,000-

1 12,000 1,000

2 9,000 4,000

3 6,000 7,000

4 3,000 10,000

5 0 13,000

6 0 16,000

7 0 19,000

8 0 22,000
PBP analysis would choose Tempo (PBP = 4 yrs.) instead of Dura
(PBP = 5 yrs.).
However, with IRR analysis we can see that Tempo is not a very  0 57,000

attractive investment.
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Although, Tempo does return its investment more quickly than Dura.
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Payback Period
EXAMPLE 9–8
The cash flows for two alternatives are as follows:

You may assume the benefits occur throughout the year rather than just at the end of the year.
Based on payback period, which alternative should be selected?

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Payback Period

SOLUTION
Alternative A
Payback period is how long it takes for the profit or other benefits to equal the cost of the
investment. In the first 2 years, only $400 of the $1000 cost is recovered. The remaining
$600 cost is recovered in the first half of Year 3. Thus the payback period for Alt. A is 2.5
years.

Alternative B
Since the annual benefits are uniform, the payback period is simply
$2783/$1200 per year = 2.3 years
To minimize the payback period, choose Alt. B.

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Payback Period
EXAMPLE 9–9 (Example 5-4 revisited)
A firm is trying to decide which of two weighing scales it should install to check a
package-filling operation in the plant. If both scales have a 6-year life, which one should
be selected? Assume an 8% interest rate.

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Payback Period

8 To minimize payback period, select the Atlas scale.

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Payback Period Summary

Final Conclusions about PBP Analysis
• This analysis provides a measure of the speed of the return of the investment.  
• PBP analysis should not be confused with careful economic analysis.
• PBP analysis does not always mean the investment is economically desirable.

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Payback Period Summary

1. Payback period is an approximate, rather than an exact, analysis calculation.

2. All costs and all profits, or savings of the investment prior to payback, are included
without considering differences in their timing.

3. All the economic consequences beyond the payback period are completely ignored.

4. Payback period may or may not select the same alternative as an exact economic
analysis method.

5. Payback period is used because the concept can be readily understood, the
calculations can be readily made and understood by people unfamiliar with the use
of the time value of money.

10 6. PBP analysis is “better than nothing.” Use it as a last resort to communicate.

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College of Engineering & Urban Planning

Sensitivity and Breakeven Analysis

 Since many data gathered in solving a problem represent projections of future
consequences, there may be considerable uncertainty regarding the data’s accuracy.
Since the goal is to make good decisions, an appropriate question is: To what extent
do variations in the data affect my decision? When small variations in a particular
estimate would change which alternative is selected, the decision is said to be
sensitive to the estimate. To better evaluate the impact of any particular estimate, we
compute “how much a particular estimate would need to change in order to change a
particular decision.” This is called sensitivity analysis.

 An analysis of the sensitivity of a problem’s decision to its various parameters highlights

the important aspects of that problem. For example, estimated annual maintenance and
salvage values may vary substantially. Sensitivity analysis might indicate that a certain
decision is insensitive to the salvage-value estimate over the full range of possible values.
But, at the same time, we might find that the decision is sensitive to changes in the annual
maintenance estimate. Under these circumstances, one should place greater emphasis on
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improving the annual maintenance estimate and less on the salvage-value estimate.
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Sensitivity and Breakeven Analysis

 As indicated at the beginning of this chapter, breakeven analysis is a form of sensitivity
analysis that is often presented as a breakeven chart. Another nomenclature that is
sometimes used for the breakeven point is point of indifference. One application of
these tools is staged 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 breakeven point on how soon the capacity is
needed for this decision? Three examples are:
• Should we install a cable with 400 circuits now or a 200-circuit cable now and another
200-circuit cable later?
• A 10-cm water main is needed to serve a new area of homes. Should it be installed now,
or should a 15-cm main be installed to ensure an adequate water supply to adjoining
areas later, when other homes have been built?
• An industrial firm needs a new warehouse now and estimates that it will need to
doubleitssizein 4 years. The firm could have a warehouse built now and later enlarged, or
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have the warehouse with capacity for expanded operations built right away.
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Sensitivity and Breakeven Analysis

EXAMPLE 9–11
Consider a project that may be constructed to full capacity now or may be constructed in two stages.

Other Factors
1. All facilities will last for 40 years regardless of when they are installed; after 40 years, they will
have zero salvage value.
2. The annual cost of operation and maintenance is the same for both two-stage construction and
full-capacity construction.
3. Assume an 8% interest rate. Plot “age when second stage is constructed” versus “costs for both
alternatives.” Mark the breakeven point on your graph. What is the sensitivity of the decision to
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second-stage construction 16 or more years in the future?
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Sensitivity and Breakeven Analysis

SOLUTION
Since we are dealing with a common analysis period, the calculations may be either annual
cost or present worth. Present worth calculations appear simpler and are used here.

Construct Full Capacity Now

PW of cost = $140,000

Two-Stage Construction
If the first stage is to be constructed now and the second stage n years hence, compute the
PW of cost for several values of n (years).
PW of cost = 100,000 + 120,000(P/F, 8%, n)
n =5 PW= 100,000 + 120,000(0.6806) = $181,700
n = 10 PW = 100,000 + 120,000(0.4632) = 155,600
n = 20 PW = 100,000 + 120,000(0.2145) = 125,700
n = 30 PW = 100,000 + 120,000(0.0994) = 111,900
These data are plotted in the form of a breakeven chart in Figure 9-4.

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Sensitivity and Breakeven Analysis

FIGURE 9–4 Breakeven chart for • In Figure 9-4 we see that the PW of cost for two-stage
.Example 9-11
construction naturally decreases as the second stage is
deferred. The one-stage construction (full capacity now)
is unaffected by the x-axis variable and, hence, is a
horizontal line.
• The breakeven point on the graph is where both
alternatives have the same PW. We see that if the second
stage is deferred for 15 years, then the PW of cost of
two-stage construction is equal to one-stage
construction; Year 15 is the breakeven point. The graph
also shows that if the second stage were to be needed
prior to Year 15, then one-stage construction, with its
smaller PW of cost, would be preferred. On the other
hand, if the second stage would not be required until
after 15 years, two-stage construction is preferred.

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Sensitivity and Breakeven Analysis

This breakeven point can also be calculated by setting the two alternatives equal to each other.
PW = 140,000 = 100,000+ 120,000(P/F, 8%, n)

From the tables

n = 14 + (15 − 14)(0.3405 − 0.3333)/(0.3405 − 0.3152)
n = 14.3 years
From Excel’s NPER function or GOAL SEEK, or using a TVM calculator,
n = n(i, A, P, F) = n(8%, 0,−40000, 120000) = 14.27 years
The decision on 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 5 and 10 years hence, the decision is insensitive to that estimate.
For any value within that range, the decision does not change. But, if the second stage capacity were
to be needed sometime between, say, 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 on
16 or after 16 years, two-stage construction has a lower PW of cost.
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Sensitivity and Breakeven Analysis

EXAMPLE 9–12
Example 8-3 posed the following situation. Three mutually exclusive alternatives are
given, each with a 20-year life and no salvage value. The minimum attractive rate of
return is 6%.

In Example 8-3 we found that Alt. B was the preferred alternative at 6%. Here we
would like to know how sensitive the decision is to our estimate of the initial cost of
B. If B is preferred at an initial cost of $4000, it will continue to be preferred at any
smaller initial cost. But how much higher than $4000 can the initial cost be and still
have B the preferred alternative? With neither input nor output fixed, maximizing
net present worth is a suitable criterion.

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Sensitivity and Breakeven Analysis

EXAMPLE 9–12
Alternative A
NPWA = 410(P/A, 6%, 20)− 2000
= 410(11.47) – 2000 = $2703
Alternative B
Let x = initial cost of B.
NPWB = 639(P/A, 6%, 20)− x
= 639(11.470)− x
= 7329 − x
Alternative C
NPWC = 700(P/A, 6%, 20) − 5000
= 700(11.470) − 5000 = $3029
For the three alternatives, we see that B will only maximize NPW as long as its NPW is
greater than 3029.
3029 = 7329 − x
18 x = 7329 − 3029 = $4300
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Sensitivity and Breakeven Analysis

EXAMPLE 9–12
Therefore, B is the preferred alternative
if its initial cost does not exceed $4300.
Figure 9-5 is a breakeven chart for the
three alternatives. Here the criterion is to
maximize NPW; as a result, the graph
shows that B is preferred if its initial cost
is less than $4300. At an initial cost
above $4300, C is preferred. We have a
breakeven point at $4300. When B has
an initial cost of $4300, B and C are
equally desirable.
FIGURE 9–5 Breakeven chart
for
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Example 9-12.