IE2324 L14 C8 Incremental Analysis

IE2324 $
Engineering Economy€
¥£
€ SUBJECT MATTER:
Incremental Rate of
£ Return Evaluation
¥
$
Notes:
Department of Industrial Engineering
Mario G. Beruvides, Ph. D., P.E.
1
©© Mario
Mario G.G. Beruvides
Beruvides
$€
Information Updates
¥£
Remember:
 Quiz #5 Today
 Exam #2 next Thursday
Notes: 2
© Mario G. Beruvides
IE3301 Engineering Economic Analysis Thought Diagram
$€
¥£
Introduction
Principles and
Philosophy
Economics & the Decision Making Process
Money / Time Relationship: Equivalence & Compound Interest
Present Rate of
Techniques
Worth Replacement
Return
Analysis Annual Analysis
Analysis Incremental Other
Cash Flow
Analysis Analysis Techniques
Decision Making
Effects on
Economic
Taxation
Depreciation & Depletion Income Taxes
Inflation & Deflation
Operational
Operationalizing
Economics
Economics
Estimation of Future Selection of

Events MARR
Concepts of Optimization
Notes: of Capital 3
© Mario G. Beruvides Engineering
EngineeringEconomics
Economics
$€
Incremental Analysis ¥£
 Incremental analysis can be defined
as the examination of the differences
between alternatives.
 By emphasizing alternatives, we are
really deciding whether or not
differential costs are justified by
differential benefits.
Notes: 4
$€
Incremental Analysis ¥£
 We did incremental analysis by the rate of return
evaluation of the differences between two alternatives.
We recognized that the two alternatives could be related
as follows:
Higher-cost Lower-cost Differences between
= +
alternative alternative them
 Two approaches can be used to solve these types of

problems.
a.Graphical solution
b.Numerical solution
Notes: 5
$€
Steps ¥£
 The procedure for conducting an incremental
investment analysis is as follows:
1.Order the alternatives so that the one with the

larger initial investment is in the last column
(increasing magnitude).
2.Prepare the cash-flow tabulation using the least

common multiple of years.
Notes: 6
$€
Steps (Cont…) ¥£
3.Draw a net cash-flow diagram.
4.Set up and find the incremental return using

the ROR equation for the net cash flow.
[Check for sign changes in the net cash-flow
sequence which indicate the possible presence
of multiple rates of return].
5.If < MARR, select lowest cost alternative. If

> MARR, select highest cost alternative.
Notes: 7
Example #1 $€
Graphical Solution ¥£
 There were two mutually exclusive
alternatives:
Year Alt. 1 Alt. 2
0 -$10 -$20
1 +15 +28
 If 6% interest is assumed, which

alternative should be selected?
Notes: 8
Example #1 (Cont..) $€
 For this problem, we will plot the
two alternatives on a PW of benefits
vs. PW of cost graph.
 Alternative 1:
PW of cost  $10
PW of benefit  $15(P/F,6% ,1)
 15(0.9434)
 $14.15
Notes: 9
Alternative 2:
PW of cost  $20
PW of benefit  $28(P/F,6% ,1)
 28(0.9434)
 $26.42
Notes: 10
 The alternatives are plotted in Figure 1, which looks
very simple yet tells us a great deal about the situation.
 Figure 1. PW of benefits vs. PW of cost graph

Notes: 11
Benefit - Cost Graph ¥£
Figure 2. Benefit
- cost graph for
Example 1 with a
one year analysis
period
Notes: 12
Benefit - Cost Graph ¥£
Figure 3. Benefit-
cost graph for
Alternatives 1 and
2 with a one-year
analysis period.
Notes: 13
Analysis of Multiple $€
Alternatives (2+) ¥£
Figure 4. Solving
multiple-
alternative
problems by
successive two-
alternative
analyses.
Notes: 14
$€
Example #2 ¥£
 Consider the three mutually exclusive
alternatives below.
A B C
Initial Cost $2000 $4000 $5000
Uniform annual benefit 410 639 700
 Each alternative has a twenty-year life and

no salvage value. If the MARR is 6%,
which alternative should be selected?
Notes: 15
Example #2 $€
Solution ¥£
 At 6%, (PW of benefits) = (Uniform
annual benefit) x (Series present
worth factor).
PW of benefits  (Uniform annual benefit) (P/A,6%,20)
PW of benefits for :
Alt. A  $410(11.47 0)  $4703
Alt. B  $639(11.47 0)  $7329
Alt. C  $700(11.47 0)  $8029
Notes: 16
Example #2 $€
Solution (Cont...) ¥£
 So, by graphical methods (see Figure 5) we
select Alternative B.
Figure 5. Benefit-cost
graph for Example 8-3
Notes: 17
Example 3 - Numerical Method $ €
(Incremental ROR Analysis) ¥£
 The following information is provided for five mutually
exclusive alternatives that have twenty-year useful lives.
If the minimum attractive rate of return is 6%, which
alternative should be selected?
A B C D E
Cost $400 $200 $600 $1000 $900
0 0 0 0
Uniform annual benefit 639 410 761 117 785
PW of benefit* 7330 4700 8730 1340 9000
Rate of return 15% 20% 11% 10% 6%
* PW of benefit  (Uniform annual benefit) (P/A,6%,20)  11.47 (Uniform annual benefit).
 These values will be used later to plot a PW of cost vs. PW of

benefit curve.
Notes: 18
Example #3 $€
Solution ¥£
 We see that the rate of return for each
alternative equals or exceeds the MARR,
therefore, no alternatives are rejected at this
point.
 Next, we rearrange the alternatives to put
them in order of increasing cost:
D B A C E
Cost $1000 $2000 $4000 $6000 $9000
Uniform annual benefit 117 410 639 761 785
Rate of return 10% 20% 15% 11% 6%
Notes: 19
Example #3 $€
Solution (Cont…) ¥£
Increment Increment Increment
B-D A-B C-A
∆Cost $1000 $2000 $2000
∆Annual benefit 293 229 122
∆Rate of return 29% 10% 2%
 Beginning with the analysis of Increment B-D, we compute a
∆ROR of 29%. Alternative B is thus preferred to Alt. D and
D may be discarded at this point.
 The ∆ROR for A-B is also satisfactory, so A is retained and B
is now discarded.
 The C-A increment has a rate of return less than the MARR.
 Therefore, C is discarded and A continues to be retained.
Notes: 20
Example #3 $€
Increment Increment Increment
B-D A-B C-A
∆Cost $1000 $2000 $2000
∆Annual benefit 293 229 122
∆Rate of return 29% 10% 2%
 At this point, we have examined four alternatives - D, B, A,
C - and retained A after discarding the other three.
 Now we must decide whether A or E is the superior
alternative.
 The increment we will examine is E-A.
(Note: Increment E-C would have no particular meaning for

we have already discarded C.)
Notes: 21
Example #3 $€
Increment E-A
∆Cost $5000
∆Annual benefit 246
 Over the twenty-year useful life, the total benefits

(20 x 146 = $2,920) are less than the cost.
 There is no rate of return on this increment (or one
might say the ∆ROR < 0%).
 This is an unsatisfactory increment, so E is
discarded.
 Alternative A is the best of the five alternatives.
Notes: 22
Example #3 $€
Figure 6.
Benefit-cost
graph for
Example 3 data.
Notes: 23
Elements in Incremental $€
ROR Analysis ¥£
1.Be sure all the alternatives are identified.
2.(Optional) Compute the rate of return for each

alternate.
3.Arrange the remaining alternatives in ascending

order of investment.
4.Make a two-alternative analysis of the first two

alternatives.
Notes: 24
Elements in Incremental $€
ROR Analysis ¥£
5.Take the preferred alternative from Step
4, and the next alternative from the list
created in Step 3. Proceed with another
two-alternative comparison.
6.Continue until all alternatives have been

examined and the best of the multiple
alternatives has been identified.
Notes: 25
$€
Example #4 ¥£
 Four machines can be used for a certain stamping
operation.
 The costs for each machine are shown in the table
listed below.
 Determine which machine should be selected if the
company's MARR is 13.5% per year.
Four Mutually Exclusive Alternatives
Machine
1 2 3 4
First cost $-5,000 $-6,500 $-10,000 $-15,000
Annual operating cost -3,500 -3,200 -3,000 -1,400
Salvage value +500 +900 +700 +1,000
Life,years 8 8 8 8
Notes: 26
Example #4 $€
Solution ¥£
 The machines are already ordered
according to increasing initial investment
cost and since no incomes are involved,
incremental comparisons must be made
beginning with the first two alternatives.
 Thus, as per step 4 of the incremental rate-
of-return procedure, compare machine 2
(challenger) with machine 1 (defender) on
an incremental basis to obtain:
0  - 1500  300(P/A, i%,8)  400(P/F, i%,8)
Notes: 27
Example #4 $€
 Solution of the equation yields i = 14.6%.
 Therefore, eliminate machine 1 from
further consideration. (If you have trouble
obtaining the rate-of-return equation above,
prepare a tabulation of cash flow for machines 1
and 2).
 The remaining calculations are
summarized in the table below.
Notes: 28
Example #4 $€
 Comparison using incremental rate of return
Notes: 29
Example #4 $€
 When machine 3 is compared with machine 2,
the rate of return on the increment is less than
0%; therefore, machine 3 is eliminated.
 The comparison of machine 4 with machine 2
shows that the rate of return on the increment
is greater than the MARR, favoring machine 4.
 Since no additional alternatives are available,

machine 4 represents the best selection.
Notes: 30
Example #4 $€
Comment ¥£
 You should remember that when no incomes are present
in the analysis, it is implied that one of the machines
must be selected.
 This situation could arise when the alternatives under
consideration are part of a larger project which has
already been shown to be economical regardless of which
alternative is selected.
 You could calculate the present worth and equivalent
uniform annual worth of each machine to satisfy yourself
that machine 4 would be selected by all of the evaluation
methods.
Notes: 31
Incremental Analysis - $€
Unlimited Alternatives ¥£
Figure 7.
Benefit-cost
graph for
unlimited
alternatives
Notes: 32
$€
Information Updates
¥£
Remember:
 Review Quiz #5 Next Class

 Exam #2 next Thursday
Notes: 33
IE3301 Engineering Economic Analysis Thought Diagram
$€
¥£
Introduction
Principles and
Philosophy
Economics & the Decision Making Process
Money / Time Relationship: Equivalence & Compound Interest
Present Rate of
Techniques
Worth Replacement
Return
Analysis Annual Analysis
Analysis Incremental Other
Cash Flow
Analysis Analysis Techniques
Decision Making
Effects on
Economic
Taxation
Depreciation & Depletion Income Taxes
Inflation & Deflation
Operational
Operationalizing
Economics
Economics
Estimation of Future Selection of

Events MARR
Concepts of Optimization
Notes: of Capital 34
© Mario G. Beruvides Engineering
EngineeringEconomics
Economics

IE2324 L14 C8 Incremental Analysis

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IE2324 $

Economics & the Decision Making Process

Money / Time Relationship: Equivalence & Compound Interest

Estimation of Future Selection of

 Two approaches can be used to solve these types of

1.Order the alternatives so that the one with the

2.Prepare the cash-flow tabulation using the least

4.Set up and find the incremental return using

5.If < MARR, select lowest cost alternative. If

 If 6% interest is assumed, which

 Figure 1. PW of benefits vs. PW of cost graph

 Each alternative has a twenty-year life and

 These values will be used later to plot a PW of cost vs. PW of

(Note: Increment E-C would have no particular meaning for

 Over the twenty-year useful life, the total benefits

2.(Optional) Compute the rate of return for each

3.Arrange the remaining alternatives in ascending

4.Make a two-alternative analysis of the first two

6.Continue until all alternatives have been

 Since no additional alternatives are available,

 Review Quiz #5 Next Class

Economics & the Decision Making Process

Money / Time Relationship: Equivalence & Compound Interest

Estimation of Future Selection of

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