engineering economics

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engineering economics

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By

Mr. R.Siby., M.E

ASSISTANT PROFESSOR

DEPARTMENT OF MECHANICAL ENGINEERING

SASURIE COLLEGE OF ENGINEERING

VIJAYAMANGALAM 638 056

QUALITY CERTIFICATE

Subject Code

: MG 2451

Subject

Class

: IV Year Mech

Being prepared by me and it meets the knowledge requirement of the university curriculum.

Name

: R. SIBY., M.E

Designation

: ASSISTANT PROFESSOR

This is to certify that the course material being prepared by Mr. R.Siby., M.E is of adequate quality. He

has referred more than five books among them minimum one is from abroad author.

Signature of HD

Name: E.R. SIVAKUMAR., M.E

SEAL

CONTENTS

SL NO

TOPICS

PAGE NO

1.1

Introduction to economics

1.2

Flow in an economy

1.3

1.4

1.5

Engineering efficiency

1.6

Economic efficiency

1.7

1.8

Marginal cost

1.9

Marginal revenue

1.10

Sunk cost

1.11

Opportunity cost

1.12

Break-even analysis

1.13

P\V ratio

10

1.14

10

1.15

11

1.16

12

1.17

Process planning

14

2.1

18

2.2

Value engineering

18

2.3

Function

25

2.4

Aims

26

2.5

26

2.6

27

2.7

27

2.8

28

2.9

28

2.10

29

2.11

29

2.12

30

2.13

30

2.14

31

CONTENTS

UNIT III CASH FLOW

SL NO

3.1

TOPICS

PAGE NO

32

32

3.1.2.1

33

3.1.2.2

34

3.1.3.1

35

3.1.3.2

35

36

3.1.1

3.1.4

4.1

46

4.2

Types of maintenance

47

4.3

48

4.4

48

4.5

52

4.6

53

4.7

55

UNIT V DEPRECIATION

5.1

Depreciation- introduction

59

5.2.1

59

5.2.2

61

5.2.3

64

5.2.4

66

5.2.5

69

5.3

70

5.4

70

5.5

70

5.6

70

*****

6

71

Question Bank

84

92

TEXT BOOKS:

1. Panneer Selvam, R, Engineering Economics, Prentice Hall of India Ltd, New Delhi, 2001.

LT P C

3 0 0 3

OBJECTIVES:

To learn about the basics of economics and cost analysis related to engineering so as to take economically sound

decisions.

UNIT I INTRODUCTION TO ECONOMICS

8

Introduction to Economics- Flow in an economy, Law of supply and demand, Concept of Engineering Economics

Engineering efficiency, Economic efficiency, Scope of engineering economics- Element of costs, Marginal cost,

Marginal Revenue, Sunk cost, Opportunity cost, Break-even analysis- V ratio, Elementary economic Analysis

Material selection for product Design selection for a product, Process planning.

UNIT II VALUE ENGINEERING

10

Make or buy decision, Value engineering Function, aims, Value engineering procedure. Interest formulae

and their applications Time value of money, Single payment compound amount factor, Single payment present

worth factor, Equal payment series sinking fund factor, Equal payment series payment Present worth factorequal payment series capital recovery factor-Uniform gradient series annual equivalent factor, Effective interest rate,

Examples in all the methods.

UNIT III CASH FLOW

9

Methods of comparison of alternatives present worth method (Revenue dominated cash flow diagram), Future

worth method (Revenue dominated cash flow diagram, cost dominated cash flow diagram), Annual equivalent

method (Revenue dominated cash flow diagram, cost dominated cash flow diagram), rate of return method,

Examples in all the methods.

UNIT IV REPLACEMENT AND MAINTENANCE ANALYSIS

9

Replacement and Maintenance analysis Types of maintenance, types of replacement problem, determination of

economic life of an asset, Replacement of an asset with a new asset capital recovery with return and concept of

challenger and defender, Simple probabilistic model for items which fail completely.

UNIT V DEPRECIATION

9

Depreciation- Introduction, Straight line method of depreciation, declining balance method of depreciation-Sum

of the years digits method of depreciation, sinking fund method of depreciation/ Annuity method of

depreciation, service output method of depreciation-Evaluation of public alternatives- introduction, Examples,

Inflation adjusted decisions procedure to adjust inflation, Examples on comparison of alternatives and

determination of economic life of asset.

TOTAL: 45 PERIODS

TEXT BOOKS:

1. Panneer Selvam, R, Engineering Economics, Prentice Hall of India Ltd, New Delhi,

2001.

2. Suma Damodaran, Managerial economics, Oxford university press 2006.

REFERENCES:

1. Chan S.Park, Contemporary Engineering Economics, Prentice Hall of India, 2002.

2. Donald.G. Newman, Jerome.P.Lavelle, Engineering Economics and analysis Engg.

Press, Texas, 2002

3. Degarmo, E.P., Sullivan, W.G and Canada, J.R, Engineering Economy, Macmillan,

New York, 1984

4. Grant.E.L., Ireson.W.G., and Leavenworth, R.S, Principles of Engineering

Economy, Ronald Press, New York,1976.

5. Smith, G.W., Engineering Economy, Lowa State Press, Iowa, 1973.

6. Truett & Truett, Managerial economics- Analysis, problems & cases Wiley India 8

Th edition 2004.

7. Luke M Froeb / Brian T Mccann, Managerail Economics A problem solving

approach Thomson learning 2007.

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1.1 Introduction

Efficient functioning of any business organization would enable it to provide

goods/services at a lower price.

In the process of managing organizations, the managers at different levels should take

appropriate economic decisions which will help in minimizing investment, operating and

maintenance expenditures besides increasing the revenue, savings and such other gains of the

organization.

These can be achieved through Engineering Economics which deals with the methods

that enable one to make economic decisions towards minimizing costs and/or maximizing

benefits to business organizations.

This chapter discusses the elements of economics and the interaction between its

various components.

This is followed by an analysis of the need and scope of engineering economics. Later,

elements of cost and break-even analysis are presented.

1.2 Economics - is a study of economic problems of the people concerning production,

consumption, exchange and distribution of wealth.

Economics is the science that deals with the production and consumption of goods and

services and the distribution and rendering of these for human welfare.

The following are the economic goals.

Price stability

Efficiency

An equitable distribution of income

Growth

1.3 Flow in economy The flow of goods, services, resources and money payments in a simple

economy

Households and businesses are the two major entities in a simple economy.

Business organizations use various economic resources like land, labour and capital

which are provided by households to produce consumer goods and services which

will be used by them.

Business organizations make payment of money to the households for receiving

various resources.

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receiving consumer goods and services.

This cycle shows the interdependence between the two major entities in

a simple economy.

Money payments for consumer goods and services

Consumer goods, services

Households

Businesses

1. Provide goods and services to

consumers

2. Use resources, inputs

provided by households

and services produced

by businesses and services

2. Provide productive

inputs to businesses

salaries, interest and profit

Economic Resources: Land, labour, capital

Fig.

1.3.1 Laws of supply - states that the quantity of a commodity supplied varies directly with

the price, other determinants of supply remaining constant.

If the cost of inputs increases, then naturally, the cost of the product will go up. In

such a situation, at the prevailing price of the product the profit margin per unit

will be less.

The producers will then reduce the production quantity, which in turn will affect

the supply of the product.

For instance, if the prices of fertilizers and cost of labour are increased

significantly, in agriculture, the profit margin per bag of paddy will be reduced.

So, the farmers will reduce the area of cultivation, and hence the quantity of

supply of paddy will be reduced at the prevailing prices of the paddy.

If there is an advancement in technology used in the manufacture of the product in

the long run, there will be a reduction in the production cost per unit.

This will enable the manufacturer to have a greater profit margin per unit at the

prevailing price of the product. Hence, the producer will be tempted to supply

more quantity to the market.

Weather also has a direct bearing on the supply of products. For example, demand

for woollen products will increase during winter. This means the prices of woollen

goods will be incresed in winter.

So, naturally, manufacturers will supply more volume of woollen goods during

winter.

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The shape of the supply curve is affected by the following factors:

Technology

Weather

Prices of related goods

1.3.2 Law of demand states that other things being equal demand when price falls and

contracts when price rises.

Market demand is the total quantity demanded by all the purchasers together.

responsiveness of quantity demanded to a Change in price.

An interesting aspect of the economy is that the demand and supply of a product

are interdependent and they are sensitive with respect to the price of that

product. .

From Fig. it is clear that when there is a decrease in the price of a product, the

demand for the product increases and its supply decreases.

Also, the product is more in demand and hence the demand of the product

increases.

At the same time, lowering of the price of the product makes the producers restrain

from releasing more quantities of the product in the market.

Hence, the supply of the product is decreased. The point of intersection of the

supply curve and the demand curve is known as the equilibrium point.

At the price corresponding to this point, the quantity of supply is equal to the

quantity of demand. Hence, this point is called the equilibrium point.

Price

Supply

Demand

Quantity

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The shape of the demand curve is influenced by the following factors:

Prices of related goods

Tastes of consumers

Science is a field of study where the basic principles of different physical

systems are formulated and tested.

Engineering is the application of science. It establishes varied application

systems based on different scientific principles.

From the discussions in the previous section, it is clear that price has a major role

in deciding the demand and supply of a product.

Hence, from the organizations point of view, efficient and effective functioning of

the organization would certainly help it to provide goods/services at a lower cost

which in turn will enable it to fix a lower price for its goods or services.

The following section discusses the different types of efficiency and their impact

on the operation of businesses and the definition and scope of engineering

economics.

.

1.5 Types of Efficiency

Efficiency of a system is generally defined as the ratio of its output to input. The

efficiency can be classified into technical efficiency and economic efficiency.

1. Technical efficiency

It is the ratio of the output to input of a physical system. The physical

system may be a diesel engine, a machine working in a shop floor, a furnace,

etc.

Output

Technical efficiency (%) =

100

Input

The technical efficiency of a diesel engine is as follows:

Heat equivalent of mechanical

energy produced

Technical efficiency (%) =

Heat equivalent of fuel used

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100

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This is mainly due to frictional loss and incomplete combustion of fuel, which

are considered to be unavoidable phenomena in the working of a diesel engine.

2. Economic efficiency

Economic efficiency is the ratio of output to input of a business system.

Economic efficiency (%) =

Output

Input

Worth

100 =

100

Cost

and cost is the total annual expenses incurred in carrying out the business.

For the survival and growth of any business, the economic efficiency

should be more than 100%.

Economic efficiency is also called productivity. There are several ways

of improving productivity.

more than the proportionate increase in the input

By a proportionate decrease in the input which is

more than the proportionate decrease in the output

Through simultaneous increase in the output with decrease in the

input.

As stated earlier, efficient functioning of any business organization would

enable it to provide goods/services at a lower price.

In the process of managing organizations, the managers at different levels

should take appropriate economic decisions which will help in minimizing

investment, operating and maintenance expenditures besides increasing the

revenue, savings and other related gains of the organization.

1.6.1 Definition

Engineering economics deals with the methods that enable one to take

economic decisions towards minimizing costs and/or maximizing benefits to

business organizations.

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1.6.2 Scope

The issues that are covered in this book are elementary economic analysis,

interest formulae, bases for comparing alternatives, present worth method, future

worth method, annual equivalent method, rate of return method, replacement

analysis, depreciation, evaluation of public alternatives, inflation adjusted

investment decisions, make or buy decisions, inventory control, project

management, value engineering, and linear programming.

1.7 Elements Of Costs

Cost can be broadly classified into variable cost and overhead cost.

Variable cost varies with the volume of production while overhead cost is fixed,

irrespective of the production volume.

Variable cost can be further classified into direct material cost, direct labour

cost, and direct expenses. The overhead cost can be classified into factory

overhead, administration overhead, selling overhead, and distribution

overhead.

Direct material costs are those costs of materials that are used to produce

the product. Direct labour cost is the amount of wages paid to the direct labour

involved in the production activities.

Direct expenses are those expenses that vary in relation to the production

volume, other than the direct material costs and direct labour costs.

Overhead cost is the aggregate of indirect material costs, indirect labour

costs and indirect expenses. Administration overhead includes all the costs that are

incurred in administering the business.

Selling overhead is the total expense that is incurred in the promotional

activities and the expenses relating to sales force. Distribution overhead is the total

cost of shipping the items from the factory site to the customer sites.

The selling price of a product is derived as shown below:

(a) Direct material costs + Direct labour costs + Direct

expenses = Prime cost

(b) Prime cost + Factory overhead = Factory cost

(c) Factory cost + Office and administrative overhead

= Costs of production

(d) Cost of production + Opening finished stock Closing finished

stock

= Cost of goods sold

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sales

(f) Cost of sales + Profit = Sales

(g) Sales/Quantity sold = Selling price per unit

In the above calculations, if the opening finished stock is equal to the closing

finished stock, then the cost of production is equal to the cost of goods sold.

1..8 Other Costs/Revenues

The following are the costs/revenues other than the costs which are presented in the

previous section:

Marginal cost

Marginal revenue

Sunk cost

Opportunity cost

1. Marginal Cost

Marginal cost of a product is the cost of producing an additional unit of that

product. Let the cost of producing 20 units of a product be Rs. 10,000, and the cost of

producing 21 units of the same product be Rs. 10,045. Then the marginal cost of

producing the 21st unit is Rs. 45.

2. Marginal Revenue

Marginal revenue of a product is the incremental revenue of selling an additional

unit of that product. Let, the revenue of selling 20 units of a product be Rs. 15,000

and the revenue of selling 21 units of the same product be Rs. 15,085. Then, the

marginal revenue of selling the 21st unit is Rs. 85.

3. Sunk Cost

This is known as the past cost of an equipment/asset. Let us assume that an

equipment has been purchased for Rs. 1,00,000 about three years back. If it is considered

for replacement, then its present value is not Rs. 1,00,000. Instead, its present market

value should be taken as the present value of the equipment for further analysis.

So, the purchase value of the equipment in the past is known as its sunk cost.

The sunk cost should not be considered for any analysis done from now onwards.

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4. Opportunity Cost

In practice, if an alternative (X ) is selected from a set of competing alternatives

(X,Y ), then the corresponding investment in the selected alternative is not available

for any other purpose. If the same money is invested in some other alternative (Y ), it may

fetch some return. Since the money is invested in the selected alternative (X ), one has

to forego the return from the other alternative (Y ).

The amount that is foregone by not investing in the other alternative (Y ) is known

as the opportunity cost of the selected alternative (X ). So the opportunity cost of an

alternative is the return that will be foregone by not investing the same money in another

alternative.

1.9 Break-Even Analysis

The main objective of break-even analysis is to find the cut-off production volume from

where a firm will make profit.

Let

s = selling price per unit

v = variable cost per unit

FC = fixed cost per period

Q = volume of production

The total sales revenue (S) of the firm is given by the following formula:

S=s

given as

TC = Total variable cost + Fixed

cost

=v

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Q + FC

The linear plots of the above two equations are shown in Fig. .

The intersection point of the total sales revenue line and the total

cost line is called the break-even point.

the break-even sales quantity.

At the intersection point, the total cost is equal to the total revenue.

This point is also called the no-loss or no-gain situation.

quantity, the total cost is more than the total revenue.

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Sales (S)

Profit

Break-even

sales

Variable cost (VC)

Fixed cost (FC)

Loss

Fig.

Break-even chart.

For any production quantity which is more than the break-even quantity, the

total revenue will be more than the total cost. Hence, the firm will be making profit.

Profit = Sales (Fixed cost + Variable costs)

= s Q (FC + v Q)

The formulae to find the break-even quantity and break-even sales quantity

Fixed cost

Break-even quantity =

Selling

FC

s-v (in units)

=

Break-even sales =

Fixed cost

Selling price/ unit

Selling price/ unit Variable cost / unit

FC

s (Rs.)

sv

The contribution is the difference between the sales and the variable costs. The

margin of safety (M.S.) is the sales over and above the break-even sales. The

formulae to compute these values are

Contribution = Sales Variable costs

Contribution/unit = Selling price/unit Variable cost/unit

M.S. = Actual sales Break-even sales

=

Profit

sales

Contribution

M.S. as a per cent of sales = (M.S./Sales)

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P/V ratio is a valid ratio which is useful for further analysis.

The different formulae for the P/V ratio are as follows:

P/V ratio =

Sales

=

Sales

BEP =

Fixed cost

P/V ratio

Whether it is a business situation or a day-to-day event in somebodys personal life,

there are a large number of economic decision making involved. One can manage

many of these decision problems by using simple economic analysis.

For example, an industry can source its raw materials from a nearby place or from a

far-off place. In this problem, the following factors will affect the decision:

Price of the raw material

Transportation cost of the raw material

`Availability of the raw material

Quality of the raw material

Consider the alternative of sourcing raw materials from a nearby place

with the following characteristics:

The raw material is more costly in the nearby area.

The availability of the raw material is not sufficient enough to

support the operation of the industry throughout the year.

The raw material requires pre-processing before it is used

in the production process. This would certainly add cost to the

product.

The cost of transportation is minimal under this alternative.

On the other hand, consider another alternative of sourcing the

raw materials from a far-off place with the following characteristics:

The raw material is less costly at the far off place.

The cost of transportation is very high.

The availability of the raw material at this site is abundant and it

can support the plant throughout the year.

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The raw material from this site does not require any pre10

Department of Mechanical Engineering

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processing before using it for production.

The cost of a product can be reduced greatly by substitution of the raw materials.

Among various elements of cost, raw material cost is most significant and it forms

a major portion of the total cost of any product.

So, any attempt to find a suitable raw material will bring a reduction in the total

cost in any one or combinations of the following ways:

Reduced machining/process time

Enhanced durability of the product

Cheaper raw material price

alternate raw material which will provide the necessary functions that are provided by

the raw material that is presently used.

In this process, if the new raw material provides any additional benefit, then it

should be treated as its welcoming feature. This concept is demonstrated with numerical

problem given below

Example

In the design of a jet engine part, the designer has a choice of specifying either an

aluminium alloy casting or a steel casting. Either material will provide equal service, but

the aluminium casting will weigh 1.2 kg as compared with 1.35 kg for the steel casting.

The aluminium can be cast for Rs. 80.00 per kg. and the steel one for Rs. 35.00 per

kg. The cost of machining per unit is Rs. 150.00 for aluminium and Rs. 170.00 for steel.

Every kilogram of excess weight is associated with a penalty of Rs. 1,300 due to

increased fuel consumption. Which material should be specified and what is the

economic advantage of the selection per unit?

Solution

(a) Cost of using aluminium metal for the jet

engine part:

Weight of aluminium casting/unit = 1.2 kg

Cost of making aluminium casting = Rs. 80.00 per kg

Cost of machining aluminium casting per unit = Rs. 150.00

Total cost of jet engine part made of aluminium/unit

= Cost of making aluminium casting/unit

+ Cost of machining aluminium

casting/unit

= 80 1.2 + 150 = 96 + 150

= Rs. 246

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Weight of steel casting/unit = 1.35 kg

Cost of making steel casting = Rs. 35.00 per kg

Cost of machining steel casting per unit = Rs. 170.00

Penalty of excess weight of steel casting = Rs. 1,300 per kg

Total cost of jet engine part made of steel/unit

= Cost of making steel casting/unit

+ Cost of machining steel

casting/unit

+ Penalty for excess weight of steel

casting

= 35 1.35 + 170 + 1,300(1.35 1.2)

= Rs. 412.25

DECISION

The total cost/unit of a jet engine part made of

aluminium is less than that for an engine made of steel. Hence,

aluminium is suggested for making the jet engine part. The

economic advantage of using aluminium over steel/unit is Rs.

412.25 Rs. 246 = Rs. 166.25

1.12.1 Design Selection for a Product

a. The design modification of a product may result in reduced raw

material requirements, increased machinability of the materials and

reduced labour.

b. Design is an important factor which decides the cost of the product for a

specified level of performance of that product.

Example

(Design selection for a process industry). The chief engineer of refinery

operations is not satisfied with the preliminary design for storage tanks to be

used as part of a plant expansion programme. The engineer who submitted

the design was called in and asked to reconsider the overall dimensions in the

light of an article in the Chemical Engineer, entitled How to size future

process vessels?

The original design submitted called for 4 tanks 5.2 m in diameter and 7

m in height. From a graph of the article, the engineer found that the present

ratio of height to diameter of 1.35 is 111% of the minimum cost and

that the minimum cost for a tank was when the ratio of height to diameter was

4 : 1. The cost for the tank design as originally submitted was

estimated to be Rs. 9,00,000. What are the optimum tank dimensions if the

volume remains the same as for the original design? What total savings may be

expected through the redesign?

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Solution

(a) Original design

Number of tanks = 4

Diameter of the tank = 5.2 m

Radius of the tank = 2.6 m

Height of the tank = 7 m

Ratio of height to diameter = 7/5.2 = 1.35

Volume/tank = (22/7)r 2h = (22/7)(2.6) 2 7

= 148.72 m3

(b) New design

Cost of the old design = 111% of the cost of the new design (optimal

design)

Optimal ratio of the height to diameter = 4:1

h:d=4:1

4d = h

d = h/4

r = h/8

Volume = (22/7)r2h = 148.72 (since, the volume remains the same)

(22/7)(h/8)2h = 148.72

h3 = 148.72

(22/7)

h = 14.47 m

64 = 3,028.48

Therefore,

Diameter of the new design = 1.81

= 3.62 m

Cost of the new design = 9,00,000

(100/111)

= Rs. 8,10,810.81

Expected savings by the redesign = Rs. 9,00,000 Rs. 8,10,810.81

= Rs. 89,189.19

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While planning for a new component, a feasible sequence of operations with

the least cost of processing is to be considered.

The process sequence of a component which has been planned in the past is

not static.

It is always subject to modification with a view to minimize the cost of

manufacturing the component.

So, the objective of process planning/process modification is to identify the

most economical sequence of operations to produce a component.

The steps in process planning are as follows:

1. Analyze the part drawing to get an overall picture of what is

required.

2. Make recommendations to or consult with product engineers

on product design changes.

3. List the basic operations required to produce the part to

the drawing or specifications.

4. Determine the most practical and economical manufacturing

method and the form or tooling required for each operation.

5. Devise the best way to combine the operations and put them

in sequence.

6. Specify the gauging required for the process.

Steps 35 aim to determine the most practical and economical sequence of

operations to produce a component. This concept is demonstrated with a

numerical problem.

Example

The process planning engineer of a firm listed the sequences of operations as

shown in Table to produce a component.

Table Data for Example

Sequence

Process sequence

1

2

3

Turning Milling Drilling

All operations are performed with CNC machine

The details of processing times of the component for various operations and

their machine hour rates are summarized in Table below

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Operation

Machine hour

sequence rate

(Rs.)

Turning

Process

1

200

Milling

400

14

Shaping

350

10

Drilling

300

CNC operations

1,000

component.

Solution (a) Cost of component using process sequence 1.

sequence 1 of the component is as follows:

The process

The calculations for the cost of the above process sequence are summarized in Table.

Table

Operation

Operation

Time

Machine

No.

Cost

hour rate

(min)

(hr)

(Rs.)

(Rs.)

Turning

0.083

200

16.60

Milling

0.133

400

53.20

Shaping

10

0.167

350

58.45

Drilling

0.050

300

15.00

Total: 143.25

(b) Cost of component using process sequence 2.

of the component is as follows:

The calculations for the cost of the above process sequence are given in

Table

Table Workings for Process Sequence 2

Operation

Operation

Time

Machine

No.

1

2

3

Turning

Milling

Drilling

(min)

(hr)

Cost

hour rate

(Rs.)

(Rs.)

16.60

0.083

200

14

0.233

400

0.050

300

93.20

15.00

Total: 124.80

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3 of the component is as follows:

Only CNC operations

The calculations for the cost of the above process sequence are summarized

in Table

Table

Operation

Operation

Time

Machine

No.

1

Cost

hour rate

CNC operations

(min)

(hr)

(Rs.)

(Rs.)

0.133

1,000

133

The process sequence 2 has the least cost. Therefore, it should be selected for

manufacturing the component.

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2.1 INTRODUCTION

Value analysis is one of the major techniques of cost reduction and cost

prevention. It is a disciplined approach that ensures necessary functions for minimum

cost without sacrificing quality, reliability, performance, and appearance. According

to the Society of American Value Engineers (SAVE),

Value Analysis is the systematic application of recognized techniques which

identify the function of a product or service, establish a monetary value for the

function and provide the necessary function reliably at the lowest overall cost.

It is an organized approach to identify unnecessary costs associated with any

product, material part, component, system or service by analysing the function and

eliminating such costs without impairing the quality, functional reliability, or the

capacity of the product to give service

2.1.1 WHEN TO APPLY VALUE ANALYSIS

One can definitely expect very good results by initiating a VA programme if one

or more of the following symptoms are present:

1. Companys products show decline in sales.

2. Companys prices are higher than those of its competitors.

3. Raw materials cost has grown disproportionate to the volume of production.

4. New designs are being introduced.

5. The cost of manufacture is rising disproportionate to the

volume of production.

6. Rate of return on investment has a falling trend.

7. Inability of the firm to meet its delivery commitments.

2.1.2 Value

The term value is used in different ways and, consequently, has different

meanings. The designer equates the value with reliability; a purchase person with

price paid for the item; a production person with what it costs to manufacture, and a

sales person with what the customer is willing to pay.

Example

Cost value. It is the summation of the labour, material, overhead and all other

elements of cost required to produce an item or provide a service compared to a base.

Exchange value. It is the measure of all the properties, qualities and

features of the product, which make the product possible of being traded for another

product or for money.

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It is a special type of cost reduction technique. It critically investigates and

analyses the different aspects of materials, design, cost and production of each and

every component of the product in produce it economically without decreasing its

utility, function or reliability.

Applications

The various application areas of value engineering are machine tool

industries, industries making accessories for machine tools, auto industries, import

substitutes, etc.

2.2 INTRODUCTION

In the process of carrying out business activities of an organization, a

component/product can be made within the organization or bought from a subcontractor.

Each decision involves its own costs.

So, in a given situation, the organization should evaluate each of the above make or

buy alternatives and then select the alternative which results in the lowest cost. This is an

important decision since it affects the productivity of the organization

In the long run, the make or buy decision is not static. The make option of a

component/product may be economical today; but after some time, it may turn out to be

uneconomical to make the same.

Thus, the make or buy decision should be reviewed periodically, say, every 1 to 3

years. This is mainly to cope with the changes in the level of competition and various

other environmental factors.

Make or Buy Decisions - is a determination whether to produce a component part

internally or to buy it from an outside supplier. The Organization should evaluate the

costs and benefits of manufacturing a product or product component against purchasing it

and then select the alternative which results in the lower cost.

In this section the criteria for make or buy are discussed.

1. Criteria for make

The following are the criteria for make:

1. The finished product can be made cheaper by the firm than by

outside suppliers.

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number of outside firms which are unable to meet the

demand.

3. The part has an importance for the firm and requires extremely

close quality control.

4. The part can be manufactured with the firms existing

facilities and similar to other items in which the company has

manufacturing experience.

2. Criteria for buy

The following are the criteria for buy:

1. Requires high investments on facilities which are already

available at suppliers plant.

2. The company does not have facilities to make it and there

are more profitable opportunities for investing companys

capital.

3. Existing facilities of the company can be used more

economically to make other parts.

4. The skill of personnel employed by the company is not readily

adaptable to make the part.

5. Patent or other legal barriers prevent the company for making the part.

6. Demand for the part is either temporary or seasonal.

2.3 APPROACHES FOR MAKE OR BUY DECISION

Types of analysis followed in make or buy decision are as follows:

1. Simple cost analysis

2. Economic analysis

3. Break-even analysis

1. Simple Cost Analysis

The concept is illustrated using an example problem.

EXAMPLE

A company has extra capacity that can be used to produce a sophisticated

fixture which it has been buying for Rs. 900 each. If the company makes the

fixtures, it will incur materials cost of Rs. 300 per unit, labour costs of Rs. 250

per unit, and variable overhead costs of Rs. 100 per unit. The annual fixed cost

associated with the unused capacity is Rs. 10,00,000. Demand over the next year

is estimated at 5,000 units. Would it be profitable for the company to make the

fixtures?

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Solution

We assume that the unused capacity has alternative use.

Cost to make

Variable cost/unit = Material + labour + overheads

= Rs. 300 + Rs. 250 + Rs. 1 0 0

= Rs. 650

Total variable cost = (5,000 units) (Rs. 650/unit)

= Rs. 32,50,000

Add fixed cost associated

with unused capacity

Total cost

Cost to buy

Purchase cost

+ Rs. 10,00,000

= Rs. 42,50,000

= Rs. 45,00,000

with unused capacity

Total cost

+ Rs. 10,00,000

= Rs. 55,00,000

The cost of making fixtures is less than the cost of buying fixtures from

outside. Therefore, the organization should make the fixtures.

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2. Economic Analysis

The following inventory models are considered to illustrate this concept:

Purchase model

Manufacturing model

The formulae for EOQ and total cost (TC) for each model are

given in the following table:

Purchase model

Manufacturing model

2Co D

Q1 =

TC = D

P+

2CD

-------Cc (1 r/k)

Q2 =

Cc

DCo

Q1 Cc

+

Q1

2

TC = D

P+

DCo

Q2

+ Cc (k r)

Q2

2*k

where

D = demand/year

P = purchase price/unit

Cc = carrying cost/unit/year

Co = ordering cost/order or set-up cost/set-up

k = production rate (No. of units/year)

r = demand/year

Q1 = economic order size

Q2 = economic production size

TC = total cost per year

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EXAMPLE

An item has a yearly demand of 2,000 units. The different costs in

respect of make and buy are as follows. Determine the best option.

Buy

Item cost/unit

Procurement cost/order

Set-up cost/set-up

Annual carrying cost/

item/year

Production rate/year

Rs. 8.00

Rs. 120.00

Make

Rs. 5.00

Rs. 60.00

Rs.

1.60

Rs. 1.00

8,000 units

Solution

Buy option

D = 2,000 units/year

Co = Rs. 120/order

Cc = Rs. 1.60/unit/year

Q1 =

2Co D

=

Cc

2 2,000 120

1.60

TC = DP +

DCo

Q1Cc

+

Q1

2

548 1.60

2,000 120

+

2

548

= Rs. 16,876.36

= 2,000

8+

Make option

Co = Rs. 60/set-up

r = 2,000 units/year

Cc = Re 1/unit/year

k = 8,000 units/year

Q2 _

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2Cor

Cc[1 (r/k)]

2 60 2,000

= 566 units (approx.)

1.0(1 2,000/8,000)

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TC = DP +

Q2

D Co

+ Cc (k r)

2k

Q2

= 2,000

5.00 +

566

2,000 60

+ 1.0 (8,000 2,000)

2 8,000

566

= Rs. 10,424.26

Therefore, the firm should go in for the making option.

3. Break-even Analysis

The break-even analysis chart is shown in Fig.

Sales (S)

Profit

B

Variable cost (VC)

Loss

Fixed cost (FC)

C

Production quantity

Fig. 13.1

Break-even chart.

TC = total cost

FC = fixed cost

TC = FC + variable cost

B = the intersection of TC and sales (no loss or no gain situation)

A = break-even sales

C = break-even quantity/break-even point (BEP)

The formula for the break-even point (BEP) is

FC

BEP =

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EXAMPLE

There are three alternatives available to meet the demand of a

particular product. They are as follows:

(a) Manufacturing the product by using process

A (b) Manufacturing the product by using

process B (c) Buying the product

The details are as given in the following table:

Cost elements

Manufacturing

the product by

process A

Variable/unit (Rs.)

Manufacturing

the product by

process B

5,00,000

6,00,000

175

150

Buy

125

The annual demand of the product is 8,000 units. Should the company make the

product using process A or process B or buy it?

Solution

Annual cost of process A = FC + VC Volume

= 5,00,000 + 175 8,000

= Rs. 19,00,000

Annual cost of process B = FC + VC Volume

= 6,00,000 + 150 8,000

= Rs. 18,00,000

Annual cost of buy

= Purchase price/unit

= 125 8,000

= Rs. 10,00,000

Volume

Since the annual cost of buy option is the minimum among all the alternatives, the company

should buy the product

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2.4 Function

Function is the purpose for which the product is made. Identification of the basic

functions and determination of the cost currently being spent on them are the two major

considerations of value analysis.

Function identifies the characteristics which make the product/component/

part/item/device to work or sell. Work functions lend performance value while sell

functions provide esteem value.

Verbs like support, hold, transmit, prevent, protect, exhibits, control,

etc., are used to describe work functions, while attract, enhance, improve, create,

etc., are used to describe sell functions. For example, in a bus driver cabin, the

functional analysis of some of the parts are given in Table

Component of study

Functional analysis

Verb

Noun Steering

wheel

Control

Change

Stop

Vehicle Wiper

Clear

Water

Horn

Make

Sound

Side mirror

Show

Side traffic

Rarely do all functions assume equal importance. Usually, some functions are more important than

others. Functions can be classified into the following three categories:

1. Primary function

2. Secondary function

3.Tertiary function

1. Primary functions are the basic functions for which the product is specially designed to achieve. Primary

functions, therefore, are the most essential functions whose non-performance would make the product

worthless, e.g. a photo frame exhibits photographs, a chair supports weight, a fluorescent tube gives light.

2. Secondary functions are those which, if not in-built, would not prevent the device from performing its

primary functions, e.g., arms of a chair provide support for hands. Secondary functions are usually related to

convenience. The product can still work and fulfill its intended objective even if these functions are not inbuilt and yet they may be necessary to sell the product.

3. Tertiary functions are usually related to esteem appearance. For example, Sunmica top of a table gives

esteem appearance for the table.

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Examples

Let us consider a single example of painting a company bus to explain all the above three functions. Here, the

primary function of painting is to avoid corrosion.

The secondary function is to identify the company to which the bus belongs by the colour ofthe paint (e.g. blue

colour for Ashok Leyland Ltd.).

The tertiary function is to impart a very good appearance to the bus by using brilliant colours.

2.5 Aims The aims of value engineering are as follows:

Simplify the product.

Use (new) cheaper and better materials.

Modify and improve product design.

Use efficient processes.

Reduce the product cost.

Increase the utility of the product by economical means.

Save money or increase the profits.

2.6 Value Engineering Procedure

The basic steps of value engineering are as follows:

(a) Blast (i) Identify the product.

(ii) Collect relevant information.

(iii) Define different functions.

(b) Create (iv) Different alternatives.

(v) Critically evaluate the alternatives.

(c) Refine (vi) Develop the best alternative.

(vii) Implement the alternative.

Step 1: Identify the product. First, identify the component for study. In future, any design change should add

value and it should not make the product as obsolete one. Value engineering can be applied to a product as a whole or to

sub-units.

Step 2: Collect relevant information. Information relevant to the following must be collected:

Production processes, machine layout and instruction sheet

Time study details and manufacturing capacity

Complete cost data andmarketing details

Latest development in related products

Step 3: Define different functions. Identify and define the primary, secondary and tertiary functions of the

product or parts of interest. Also, specify the value content of each function and identify the high cost areas.

Step 4: Different alternatives. Knowing the functions of each component part and its manufacturing details,

generate the ideas and create different alternatives so as to increase the value of the product.Value engineering should be

done after a brain storming session. All feasible or non-feasible suggestions are recorded without any criticism; rather,

persons are encouraged to express their views freely.

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2.7 Interest Formulas Interest rate can be classified into simple interest rate and compound

interest rate.

In simple interest, the interest is calculated, based on the initial deposit for every

interest period. In this case, calculation of interest on interest is not applicable.

In compound interest, the interest for the current period is computed based on the

amount (principal plus interest up to the end of the previous period) at the

beginning of the current period.

The notations which are used in various interest formulae are as follows:

P = principal amount

n = No. of interest periods

i = interest rate (It may be compounded monthly, quarterly,

semiannually or annually)

F = future amount at the end of year n

A = equal amount deposited at the end of every interest period

G = uniform amount which will be added/subtracted period after period

to/from the amount of deposit A1 at the end of period 1

2.8 Time Value of Money - . It represents the growth of capital per unit period. The period

may be a month, a quarter, semiannual or a year.

An interest rate 15% compounded annually means that for every hundred

rupees invested now, an amount of Rs. 15 will be added to the account at the

end of the first year. So, the total amount at the end of the first year will be Rs.

115.

At the end of the second year, again 15% of Rs. 115, i.e. Rs. 17.25

will be added to the account.

Hence the total amount at the end of the second year will be Rs. 132.25. The

process will continue thus till the specified number of years.

If an investor invests a sum of Rs. 100 in a fixed deposit for five years with an

interest rate of 15% compounded annually, the accumulated amount at the end of

every year will be as shown in Table

Compound Amounts

(amount of deposit = Rs. 100.00)

Year end

0

1

2

3

4

5

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Interest

(Rs.)

Compound amount

(Rs.)

15.00

17.25

19.84

22.81

26.24

100.00

115.00

132.25

152.09

174.90

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The formula to find the future worth in the third column is

F=P

(1 + i)n

where

P = principal amount invested at time 0,

F = future amount,

i = interest rate compounded annually,

n = period of deposit.

The maturity value at the end of the fifth year is Rs. 201.14. This means that the

amount Rs. 201.14 at the end of the fifth year is equivalent to Rs. 100.00 at time 0

(i.e. at present). This is diagrammatically shown in Fig. 3.1. This explanation assumes

that the inflation is at zero percentage.

2.9 Single-Payment Compound Amount - Here, the objective is to find the single future sum (F) of

the initial payment (P) made at time 0 after n periods at an interest rate i compounded every

period.

F

0

P

2

3

i%

. .

.

The formula to obtain the single-payment compound amount is

F = P(1 + i)n = P(F/P, i, n)

where

(F/P, i, n) is called as single-payment compound amount factor.

2.10 Single-Payment Present Worth Amount - Here, the objective is to find the present worth

amount (P) of a single future sum (F) which will be received after n periods at an interest rate of

i compounded at the end of every interest period.

F

. .

.

.

2

3

4

n

i%

P

Cash flow diagram of single-payment present worth amount.

0 1

P=

= F(P/F, i, n)

(1 + i)n

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Where

(P/F, i, n) is termed as single-payment present worth factor.

In this type of investment mode, the objective is to find the equivalent

amount (A) that should be deposited at the end of every interest period for n interest

periods to realize a future sum (F) at the end of the nth interest period at an interest

rate of i.

n

i%

.

1

2

3

4 .

0

A

A

A

i%

A = equal amount to be deposited at the end of each interest period

n = No. of interest periods

i = rate of interest

F = single future amount at the end of the nth period

A=F

i

= F(A/F, i, n)

(1 + i)n 1

Where

(A/F, i, n) is called as equal-payment series sinking fund factor.

2.12 Equal-Payment Series Present Worth Amount The objective of this mode of investment is to

find the present worth of an equal payment made at the end of every interest period for n

interest periods at an interest rate of i compounded at the end of every interest period.

The corresponding cash flow diagram is shown in Fig. 3.8. Here,

P = present worth

A = annual equivalent payment

i = interest rate

n = No. of interest periods

The formula to compute P is

P=A

(1 + i)n 1

= A(P/A, i, n)

i(1 + i)n

Where

(P/A, i, n) is called equal-payment series present worth factor

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2.13 Equal-Payment Series capital recovery The objective of this mode of investment is

to find the annual equivalent amount (A) which is to be recovered at the end of every

interest period for n interest periods for a loan (P) which is sanctioned now at an interest

rate of i compounded at the end of every interest period

P

i%

1

P = present worth (loan amount)

A = annual equivalent payment (recovery amount)

i = interest rate

n = No. of interest periods

The formula to compute P is as follows:

A=P

i(1 + i)n

= P(A/P, i, n)

(1 + i)n 1

Where,

(A/P, i, n) is called equal-payment series capital recovery factor.

2.14 Uniform Gradient series annual equivalent The objective of this mode of investment is to

find the annual equivalent amount of a series with an amount A1 at the end of the first year

and with an equal increment (G) at the end of each of the following n 1 years with an

interest rate i compounded annually.

The corresponding cash flow diagram is shown in Fig

0

A1

A1+G

.

.

10

A1+2G

A1+3G

A1+ (n 1)G

The formula to compute A under this situation is

(1 + i)n in 1

A = A1 + G

i(1 + i)n i

= A1 + G (A/G, i, n)

here

Where

(A/G, i, n) is called uniform gradient series factor.

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2.15 Effective Interest rate Let i be the nominal interest rate compounded annually. But, in

practice, the compounding may occur less than a year. For example, compounding may

be monthly, quarterly, or semi-annually. Compounding monthly means that the interest is

computed at the end of every month. There are 12 interest periods in a year if the

interest is compounded monthly. Under such situations, the formula to compute the

effective interest rate, which is compounded annually, is Effective interest rate, R = 1 +

i/C C 1

where,

i = the nominal interest rate

C = the number of interest periods in a year.

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3.1 Introduction

In this method of comparison, the cash flows of each alternative will be reduced to time

zero by assuming an interest rate i. Then, depending on the type of decision, the best

alternative will be selected by comparing the present worth amounts of the alternatives.

The sign of various amounts at different points in time in a cash flow diagram is to be

decided based on the type of the decision problem.

In a cost dominated cash flow diagram, the costs (outflows) will be assigned with positive

sign and the profit, revenue, salvage value (all inflows), etc. will be assigned with negative

sign.

In a revenue/profit-dominated cash flow diagram, the profit, revenue, salvage value (all

inflows to an organization) will be assigned with positive sign. The costs (outflows) will be

assigned with negative sign.

In case the decision is to select the alternative with the minimum cost, then the alternative

with the least present worth amount will be selected. On the other hand, if the decision is to

select the alternative with the maximum profit, then the alternative with the maximum present

worth will be selected.

3.2 BASES FOR COMPARISON OF ALTERNATIVES

In most of the practical decision environments, executives will be forced to select the

best alternative from a set of competing alternatives.

Let us assume that an organization has a huge sum of money for potential investment and

there are three different projects whose initial outlay and annual revenues during their lives

are known. The executive has to select the best alternative among these three competing

projects.

There are several bases for comparing the worthiness of the projects. These bases are:

1. Present worth method

2. Future worth method

3. Annual equivalent method

4. Rate of return method

3.2.1 PRESENT WORTH METHOD

In this method of comparison, the cash flows of each alternative will be reduced to

time zero by assuming an interest rate i.

Then, depending on the type of decision, the best alternative will be selected by

comparing the present worth amounts of the alternatives.

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In a cost dominated cash flow diagram, the costs (outflows) will be assigned with

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positive sign and the profit, revenue, salvage value (all inflows), etc. will be assigned

with negative sign.

In a revenue/profit-dominated cash flow diagram, the profit, revenue, salvage value

(all inflows to an organization) will be assigned with positive sign. The costs

(outflows) will be assigned with negative sign.

3.1.1.1 Revenue-Dominated Cash Flow Diagram

A generalized revenue-dominated cash flow diagram to demonstrate the

present worth method of comparison is presented in Fig.

S

R1

.

R2

R3

Rj

Rn

To find the present worth of the above cash flow diagram for a given

interest rate, the formula is

PW(i) = P + R1[1/(1 + i)1] + R2[1/(1 + i)2] + ...

+ Rj [1/(1 + i) j] + Rn[1/(1 + i)n] + S[1/(1 + i)n]

3.1.1.2 Cost-Dominated Cash Flow Diagram

A generalized cost-dominated cash flow diagram to demonstrate the present worth

method of comparison is presented in Fig.

S

C1

C2

Cj

Cn

P

To compute the present worth amount of the above cash flow diagram for a given interest

rate i, we have the formula

PW(i) = P + C1[1/(1 + i)1] + C2[1/(1 + i)2] + ... + Cj[1/(1 + i) j]

+ Cn[1/(1 + i)n] S[1/(1 + i)n]

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EXAMPLE

Alpha Industry is planning to expand its production operation. It has identified three different

technologies for meeting the goal. The initial outlay and annual revenues with respect to each of the

technologies are summarized in Table 1. Suggest the best technology which is to be implemented

based on the present worth method of comparison assuming 20% interest rate, compounded

annually.

Table 1

Initial outlay

(Rs.)

Technology 1

Technology 2

Technology 3

Annual revenue

(Rs.)

12,00,000

20,00,000

18,00,000

Life

(years)

4,00,000

6,00,000

5,00,000

10

10

10

Solution

In all the technologies, the initial outlay is assigned a negative sign and

the annual revenues are assigned a positive sign.

TECHNOLOGY 1

Annual revenue, A = Rs. 4,00,000

Interest rate, i = 20%, compounded annually

Life of this technology, n = 10 years

The cash flow diagram of this technology is as shown in Fig. 4.3.

4,00,000 4,00,000 4,00,000

4,00,000

10

i =20%

12,00,000

Fig.

PW(20%)1 = 12,00,000 + 4,00,000

= 12,00,000 + 4,00,000

(4.1925)

= 12,00,000 + 16,77,000

= Rs. 4,77,000

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TECHNOLOGY 2

Annual revenue, A = Rs. 6,00,000

Interest rate, i = 20%, compounded annually

Life of this technology, n = 10 years

The cash flow diagram of this technology is shown in Fig. 4.4.

6,00,000

6,00,000 6,00,000

10

i = 20%

20,00,000

Fig.

PW(20%)2 = 20,00,000 + 6,00,000

= 20,00,000 + 6,00,000

(4.1925)

= 20,00,000 + 25,15,500

= Rs. 5,15,500

TECHNOLOGY 3

Annual revenue, A = Rs. 5,00,000

Interest rate, i = 20%, compounded annually

Life of this technology, n = 10 years

The cash flow diagram of this technology is shown in Fig. 4.5.

5,00,000

5,00,000 5,00,000

10

i =20%

18,00,000

Fig.

PW(20%)3 = 18,00,000 + 5,00,000

= 18,00,000 + 5,00,000

(4.1925)

= 18,00,000 + 20,96,250

= Rs. 2,96,250

From the above calculations, it is clear that the present worth of technology 2

is the highest among all the technologies. Therefore, technology 2 is suggested

for implementation to expand the production.

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In the future worth method of comparison of alternatives, the future worth of various alternatives

will be computed.

Then, the alternative with the maximum future worth of net revenue or with the minimum future

worth of net cost will be selected as the best alternative for implementation.

3.1.2.1 Revenue-Dominated Cash Flow Diagram

A generalized revenue-dominated cash flow diagram to demonstrate the future worth

method of comparison is presented in Fig.

S

R1

R2

R3

Rj

Rn

P

Fig Revenue-dominated cash flow diagram.

In Fig. P represents an initial investment, Rj the net-revenue at the end of the jth year, and S

the salvage value at the end of the nth year.

The formula for the future worth of the above cash flow diagram for a given interest rate, i is

FW(i) = P(1 + i)n + R1(1 + i)n1 + R2(1 + i)n2 + ...

+ R j(1 + i)nj + ... + Rn + S

In the above formula, the expenditure is assigned with negative sign and the revenues are

assigned with positive sign.

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A generalized cost-dominated cash flow diagram to demonstrate the future worth method

of comparison is given in Fig.

S

0

C1 C2

P

Cj

Cn

In Fig. 5.2, P represents an initial investment, Cj the net cost of operation and

maintenance at the end of the j th year, and S the salvage value at the end of

the nth year.

The formula for the future worth of the above cash flow diagram

for a given interest rate, i is

FW(i) = P(1 + i)n + C1(1 + i )n1 + C2(1 +

i)n2 + ...

+ Cj(1 + i)nj + ... + Cn S

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EXAMPLE

Consider the following two mutually exclusive alternatives:

End of year

Alternative

A (Rs.)

50,00,000

20,00,000

20,00,000

20,00,000

20,00,000

B (Rs.)

45,00,000

18,00,000

18,00,000

18,00,000

18,00,000

worth method of comparison.

Solution Alternative A

Initial investment, P = Rs. 50,00,000

Annual equivalent revenue, A = Rs. 20,00,000

Interest rate, i = 18%, compounded annually

Life of alternative A = 4 years

The cash flow diagram of alternative A is shown in Fig.

20,00,000

20,00,000

20,00,000

20,00,000

i =18%

50,00,000

The future worth amount of alternative B is computed as

FWA(18%) = 50,00,000(F/P, 18%, 4) + 20,00,000(F/A, 18%, 4)

= 50,00,000(1.939) + 20,00,000(5.215)

= Rs. 7,35,000

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Alternative B

Initial investment, P = Rs. 45,00,000

Annual equivalent revenue, A = Rs. 18,00,000

Interest rate, i = 18%, compounded annually

Life of alternative B = 4 years

The cash flow diagram of alternative B is illustrated in Fig..

18,00,000

18,00,000

18,00,000

18,00,000

i =18%

45,00,000

Fig.

FWB(18%) = 45,00,000(F/P, 18%, 4) + 18,00,000 (F/A, 18%, 4)

= 45,00,000(1.939) + 18,00,000(5.215)

= Rs. 6,61,500

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In the annual equivalent method of comparison, first the annual equivalent cost or

the revenue of each alternative will be computed.

Then the alternative with the maximum annual equivalent revenue in the case of

revenue-based comparison or with the minimum annual equivalent cost in the

case of cost- based comparison will be selected as the best alternative.

3.1.3.1 Revenue-Dominated Cash Flow Diagram

A generalized revenue-dominated cash flow diagram to demonstrate the annual

equivalent method of comparison is presented in Fig.

S

R1

0

R2

R3

Rj

Rn

P

Fig. Revenue-dominated cash flow diagram.

In Fig. P represents an initial investment, Rj the net revenue at the end of the

j th year, and S the salvage value at the end of the nth year.

The first step is to find the net present worth of the cash flow diagram using the

following expression for a given interest rate, i:

PW(i) = P + R1/(1 + i)1 + R2/(1 + i)2 + ...

+ Rj/(1 + i) j + ... + Rn/(1 + i)n + S/(1 + i)n

In the above formula, the expenditure is assigned with a negative sign and the

revenues are assigned with a positive sign.

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A generalized cost-dominated cash flow diagram to demonstrate the annual

equivalent method of comparison is illustrated in Fig.

S

0

C1

C2

Cj

Cn

P

In Fig, P represents an initial investment, Cj the net cost of operation and maintenance at

the end of the jth year, and S the salvage value at the end of the nth year.

The first step is to find the net present worth of the cash flow diagram using the following

relation for a given interest rate, i.

PW(i) = P + C1/(1 + i)1 + C2/(1 + i)2 + ...

+ Cj/(1 + i) j + ... + Cn/(1 + i)n S/(1 + i)n

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EXAMPLE

A company provides a car to its chief executive. The owner of the

company is concerned about the increasing cost of petrol. The cost per litre

of petrol for the first year of operation is Rs. 21. He feels that the cost of petrol

will be increasing by Re.1 every year. His experience with his company car

indicates that it averages 9 km per litre of petrol. The executive expects to

drive an average of 20,000 km each year for the next four years. What is the

annual equivalent cost of fuel over this period of time?. If he is offered

similar service with the same quality on rental basis at Rs. 60,000 per year,

should the owner continue to provide company car for his executive or

alternatively provide a rental car to his executive? Assume i = 18%. If the

rental car is preferred, then the company car will find some other use within

the company.

Solution

Average number of km run/year = 20,000 km

Number of km/litre of petrol = 9 km

Therefore,

Petrol consumption/year = 20,000/9 = 2222.2 litre

Cost/litre of petrol for the 1st year = Rs. 21

Cost/litre of petrol for the 2nd year = Rs. 21.00 + Re. 1.00

= Rs. 22.00

Cost/litre of petrol for the 3rd year = Rs. 22.00 + Re. 1.00

= Rs. 23.00

Cost/litre of petrol for the 4th year = Rs. 23.00 + Re. 1.00

= Rs. 24.00

Fuel expenditure for 1st year = 2222.2 21 = Rs. 46,666.20

Fuel expenditure for 2nd year = 2222.2 22 = Rs. 48,888.40

Fuel expenditure for 3rd year = 2222.2 23 = Rs. 51,110.60

Fuel expenditure for 4th year = 2222.2 24 = Rs. 53,332.80

The annual equal increment of the above expenditures is Rs. 2,222.20

(G). The cash flow diagram for this situation is depicted in Fig.

0

A1

A1 +G

A1 +2G

A1 +3G

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A = A1 + G(A/G, 18%, 4)

= 46,666.20 + 2222.2(1.2947)

= Rs. 49,543.28

The proposal of using the company car by spending for petrol by the

company will cost an annual equivalent amount of Rs. 49,543.28 for four

years. This amount is less than the annual rental value of Rs. 60,000.

Therefore, the company should continue to provide its own car to its

executive.

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The rate of return of a cash flow pattern is the interest rate at which the present worth of that

cash flow pattern reduces to zero.

In this method of comparison, the rate of return for each alternative is computed. Then the

alternative which has the highest rate of return is selected as the best alternative.

A generalized cash flow diagram to demonstrate the rate of return method of comparison is

presented in Fig

S

R1

R2

R3

Rj

Rn

.

j

n

0 1

2

3

P

Fig. Generalized cash flow diagram.

In the above cash flow diagram, P represents an initial investment, Rj the net revenue at the

end of the jth year, and S the salvage value at the end of the nth year.

The first step is to find the net present worth of the cash flow diagram using the following

expression at a given interest rate, i.

PW(i) = P + R1/(1 + i)1 + R2/(1 + i)2 + ...

+ Rj/(1 + i) j + ... + Rn/(1 + i)n + S/(1 + i)n

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EXAMPLE

A person is planning a new business. The initial outlay and cash

flow pattern for the new business are as listed below. The expected

life of the business is five years. Find the rate of return for the

new business.

Period

Cash flow

(Rs.)

1,00,000

30,000

30,000

30,000

30,000

30,000

Solution

Initial investment = Rs. 1,00,000

Annual equal revenue = Rs. 30,000

Life = 5 years

The cash flow diagram for this situation is illustrated in Fig.

30,000

30,000

30,000

30,000

4

30,000

5

1,00,000

PW(i) = 1,00,000 + 30,000(P/A, i, 5)

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When i = 10%,

PW(10%) = 1,00,000 + 30,000(P/A, 10%, 5)

= 1,00,000 + 30,000(3.7908)

= Rs. 13,724.

When i = 15%,

PW(15%) = 1,00,000 + 30,000(P/A, 15%, 5)

= 1,00,000 + 30,000(3.3522)

= Rs. 566.

When i = 18%,

PW(18%) = 1,00,000 + 30,000(P/A, 18%, 5)

= 1,00,000 + 30,000(3.1272)

= Rs. 6,184

i = 15% +

566 0

566 ( 6184)

(3%)

= 15% + 0.252%

= 15.252%

Therefore, the rate of return for the new business is 15.252%.

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4.1 Introduction

Organizations providing goods/services use several facilities like equipment and

machinery which are directly required in their operations. In addition to these facilities,

there are several other items which are necessary to facilitate the functioning of

organizations.

All such facilities should be continuously monitored for their efficient functioning;

otherwise, the quality of service will be poor. Besides the quality of service of the

facilities, the cost of their operation and maintenance would increase with the passage of

time.

Hence, it is an absolute necessity to maintain the equipment in good operating

conditions with economical cost. Thus, we need an integrated approach to minimize the

cost of maintenance. In certain cases, the equipment will be obsolete over a period of time.

If a firm wants to be in the same business competitively, it has to take decision on

whether to replace the old equipment or to retain it by taking the cost of maintenance and

operation into account.

There are two basic reasons for considering the replacement of an equipment physical

impairment of the various parts or obsolescence of the equipment.

Physical impairment refers only to changes in the physical condition of the machine

itself. This would lead to a decline in the value of the service rendered, increased

operating cost, increased maintenance cost or a combination of these.

Obsolescence is due to improvement of the tools of production, mainly improvement

in technology.

So, it would be uneconomical to continue production with the same machine

under any of the above situations. Hence, the machines are to be periodically replaced.

Sometimes, the capacity of existing facilities may be inadequate to meet the current

demand. Under such situation, the following alternatives will be considered.

Replacement of the existing equipment with a new one.

Augmenting the existing one with an additional equipment.

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Maintenance activity can be classified into two types:

Preventive maintenance and

Breakdown maintenance.

Preventive maintenance (PM) is the periodical inspection and service activities which

are aimed to detect potential failures and perform minor adjustments or repairs which will

prevent major operating problems in future.

Breakdown maintenance is the repair which is generally done after the equipment has

attained down state. It is often of an emergency nature which will have associated penalty

in terms of expediting cost of maintenance and down time cost of equipment.

Preventive maintenance will reduce such cost up to a point. Beyond that point, the cost

of preventive maintenance will be more when compared to the breakdown maintenance

cost.

The total cost, which is the sum of the preventive maintenance cost and the breakdown

maintenance cost, will go on decreasing with an increase in the level of maintenance up to

a point.

Beyond that point, the total cost will start increasing. The level of maintenance

corresponding to the minimum total cost is the optimal level of maintenance. The

concepts are demonstrated in Fig.

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Replacement study can be classified into two categories:

(a) Replacement of assets that deteriorate with time

(Replacement due to gradual failure, or wear and tear of the

components of the machines).

This can be further classified into the following types:

(i) Determination of economic life of an asset.

(ii) Replacement of an existing asset with a new asset.

(b) Simple probabilistic model for assets which fail completely

(replacement due to sudden failure).

Any asset will have the following cost components:

Capital recovery cost (average first cost), computed from the first cost

(purchase price) of the machine.

Average operating and maintenance cost (O & M cost)

Total cost which is the sum of capital recovery cost (average first cost)

and average maintenance cost.

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EXAMPLE

A firm is considering replacement of an equipment, whose first cost is Rs.

4,000 and the scrap value is negligible at the end of any year. Based on experience,

it was found that the maintenance cost is zero during the first year and it increases

by Rs. 200 every year thereafter.

(a) When should the equipment be replaced if i = 0%?

(b) When should the equipment be replaced if i = 12%?

(a) When i = 0%. In this problem

(i)

(ii)

by Rs. 200 every year thereafter.

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replacement period. The value corresponding to any end of year in this column

represents the total maintenance cost of using the equipment till the end of that

particular year.

Average total cost =

=

Replacement period

+

first cost

= Average

+ Average maintenance

he

t given period

cost for the given

for

period

Column F = Column E + Column D

The value corresponding to any end of year (n) in Column F represents

the average total cost of using the equipment till the end of that particular

year.

For this problem, the average total cost decreases till the end of year 6

and then it increases. Therefore, the optimal replacement period is six

years, i.e. economic life of the equipment is six years.

(b) When interest rate, i = 12%. When the interest rate is more than

0%, the steps to be taken for getting the economic life are summarized with

reference to Table

Table Calculations to Determine Economic Life (First cost = Rs. 4,000,

Interest = 12%)

End of

year

Maintenance

cost at end of

year

P/F, 12%,

n

(n)

Present worth as of

Summation of

Present worth of

present worth

beginning of year 1

cumulative

of maintenance

of maintenance

maintenance cost

costs

costs through year

& first cost

given

(B

D (Rs.)

E (Rs.)

B (Rs)

0.8929

0.00

0.00

200

0.7972

159.44

400

0.7118

600

0.6355

800

C)

A/P, 12%,

n

E + Rs. 4,000

F (Rs.)

Annual

equivalent

total

cost through

year given

H (Rs.)

4,000.00

1.1200

4,480.00

159.44

4,159.44

0.5917

2,461.14

284.72

444.16

4,444.16

0.4163

1,850.10

381.30

825.46

4,825.46

0.3292

1,588.54

0.5674

453.92

1,279.38

5,279.38

0.2774

1,464.50

1,000

0.5066

506.60

1,785.98

5,785.98

0.2432

1,407.15

1,200

0.4524

542.88

2,328.86

6,328.86

0.2191

1,386.65*

1,400

0.4039

565.46

2,894.32

6,894.32

0.2013

1,387.83

1,600

0.3606

576.96

3,471.28

7,471.28

0.1877

1,402.36

10

1,800

0.3220

579.60

4,050.88

8,050.88

0.1770

1,425.00

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1. Discount the maintenance costs to the beginning of year 1.

1

Column D = Column B

(1 + i)n

= Column B

(P/F, i, n) = Column B

Column C.

through the year given (Column E = Column D).

3. Find Column F by adding the first cost of Rs. 4,000 to

Column E.

4. Find the annual equivalent total cost through the years given.

Column H = Column F

= Column F

i(1 + i)n

(1 + i)n 1

Column G

total cost is minimum.

For this problem, the annual equivalent total cost is minimum at the end of

year 7. Therefore, the economic life of the equipment is seven years.

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In this section, the concept of comparison of replacement of an existing asset

with a new asset is presented. In this analysis, the annual equivalent cost of each

alternative should be computed first.

Then the alternative which has the least cost should be selected as the best

alternative. Before discussing details, some preliminary concepts which are essential

for this type of replacement analysis are presented.

Consider the following data of a machine.

Let

P = purchase price of the machine,

F = salvage value of the machine at the end of machine life,

n = life of the machine in years, and

i = interest rate, compounded annually

The corresponding cash flow diagram is shown in Fig

The equation for the annual equivalent amount for the above

cash flow diagram is

AE(i) = (P F )

(A/P, i, n) + F

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o If an existing equipment is considered for replacement with a new

equipment, then the existing equipment is known as the defender and the

new equipment is known as challenger.

o Assume that an equipment has been purchased about three years back for

Rs. 5,00,000 and it is considered for replacement with a new equipment.

The supplier of the new equipment will take the old one for some

money, say, Rs. 3,00,000.

o This should be treated as the present value of the existing equipment and

it should be considered for all further economic analysis.

o The purchase value of the existing equipment before three years is now

known as sunk cost, and it should not be considered for further analysis.

EXAMPLE

Two years ago, a machine was purchased at a cost of Rs. 2,00,000 to be

useful for eight years. Its salvage value at the end of its life is Rs. 25,000. The

annual maintenance cost is Rs. 25,000.

The market value of the present machine is Rs. 1,20,000. Now, a new

machine to cater to the need of the present machine is available at Rs. 1,50,000 to

be useful for six years. Its annual maintenance cost is Rs. 14,000. The salvage

value of the new machine is Rs. 20,000.

Using an interest rate of 12%, find whether it is worth replacing the present

machine with the new machine.

Solution

Alternative 1

Present machine

Purchase price = Rs. 2,00,000

Present value (P) = Rs. 1,20,000

Salvage value (F) = Rs. 25,000

Annual maintenance cost (A) = Rs. 25,000

Remaining life = 6 years

Interest rate = 12%

The cash flow diagram of the present machine is illustrated in Fig.

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25,000

1,20,000

2,00,000

2,20,000

annual maintenance cost for the preceding periods are not shown

in this figure. The annual equivalent cost is computed as

AE(12%) = (P F)(A/P, 12%, 6) + F

i+A

0.12 + 25,000

= Rs. 51,104

Alternative 2

New machine

Purchase price (P) = Rs. 1,50,000

Salvage value (F) = Rs. 20,000

Annual maintenance cost (A) = Rs. 14,000

Life = 6 years

Interest rate = 12%

The cash flow diagram of the new machine is depicted in Fig.

20,000

14,000

14,000

14,000

14,000

14,000

14,000

1,50,000

Fig.

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AE(12%) = (P F)(A/P, 12%, 6) + F

i+A

0.12 + 14,000

= Rs. 48,016

Since the annual equivalent cost of the new machine is less than that of the

present machine, it is suggested that the present machine be replaced with the

new machine.

Simple Probabilistic Model For Items Which Fail Completely

Electronic items like transistors, resistors, tubelights, bulbs, etc. could fail

all of a sudden, instead of gradual deterioration. The failure of the item may

result in complete breakdown of the system. The system may contain a

collection of such items or just one item, say a tubelight.

Therefore, we use some replacement policy for such items which would

avoid the possibility of a complete breakdown.

The following are the replacement policies which are applicable for this

situation.

(i) Individual replacement policy.

immediately after its failure.

(ii) Group replacement policy. Under this policy, the following decision is

made:

At what equal intervals are all the items to be replaced simultaneously with

a provision to replace the items individually which fail during a fixed group

replacement period?

There is a trade-off between the individual replacement policy and the

group replacement policy. Hence, for a given problem, each of the replacement

policies is evaluated and the most economical policy is selected for

implementation. This is explained with two numerical problems.

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EXAMPLE

The failure rates of transistors in a computer are summarized in

Table .

Table Failure Rates of Transistors in Computers

End of week

Probability of

failure to date

0.07

0.18

0.30

0.48

0.69

0.89

1.00

all the transistors are replaced simultaneously, it would cost Rs.

3.00 per transistor. Any one of the following two options can be

followed to replace the transistors:

(a) Replace the transistors individually when they fail

(individual replacement policy).

(b) Replace all the transistors simultaneously at fixed intervals

and replace the individual transistors as they fail in service

during the fixed interval (group replacement policy).

Find out the optimal replacement policy, i.e. individual

replacement policy or group replacement policy. If group

replacement policy is optimal, then find at what equal intervals

should all the transistors be replaced.

Solution

Assume that there are 100 transistors in use.

Let,

pi be the probability that a transistor which was new when

placed in position for use, fails during the ith week of its life.

Hence,

p1 = 0.07,

p2 = 0.11,

p5 = 0.21,

p3 = 0.12,

p6 = 0.20,

p4 = 0.18,

p7 = 0.11

Since the sum of pis is equal to 1 at the end of the 7th week, the

transistors are sure to fail during the seventh week.

Assume that

(a) transistors that fail during a week are replaced just before

the end of the week, and

(b) the actual percentage of failures during a week for a subgroup of transistors with the same age is same as the

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transistors.

Let

Ni = the number of transistors replaced at the end of the ith week

N0 = number of transistors replaced at the end of the week 0 (or

at the beginning of the first week).

= 100

N1 =

=

N2 =

=

=

N3 =

=

=

N4 =

=

=

N5 =

=

=

N6 =

=

=

N7 =

N0 p1 = 100 0.07 = 7

number of transistors replaced at the end of the 2nd week

N0 p2 + N1 p1

100 0.11 + 7 0.07 = 12

N0 p3 + N1 p2 + N2 p1

100 0.12 + 7 0.11 + 12 0.07

14

N0 p4 + N1 p3 + N2 p2 + N3 p1

100 0.18 + 7 0.12 + 12 0.11 + 14 0.07

21

N0 p5 + N1 p4 + N2 p3 + N3 p2 + N4 p1

100 0.21 + 7 0.18 + 12 0.12 + 14 0.11 + 21 0.07

27

N0 p6 + N1 p5 + N2 p4 + N3 p3 + N4 p2 + N5 p1

100 0.2 + 7 0.21 + 12 0.18 + 14 0.12 + 21 0.11 + 27 0.07

30

N0 p7 + N1 p6 + N2 p5 + N3 p4 + N4 p3 + N5 p2

+ N6 p1

= 100 0.11 + 7 0.2 + 12 0.21 + 14 0.18 + 21 0.12

+ 27 0.11 + 30 0.07

= 25

7

pi

i=1

=1

0.07 + 2

+5

0.11 + 3

0.21 + 6

0.12 + 4

0.2 + 7

0.18

0.11

= 4.39 weeks

(approx.) Therefore,

Cost of individual replacement

= (No. of failures/week

= 23

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Cost of transistor when replaced simultaneously = Rs. 3

Cost of transistor when replaced individually = Rs. 9

The costs of group replacement policy for several replacement

periods are summarized in Table.

Table Calculations of Cost for Preventive Maintenance

End of Cost of replacing

week

100 transistors

at a time

B (Rs.)

A

Total cost

individually during given

replacement period

C (Rs.)

1

2

300

300

7 9 = 63

(7 + 12) 9 = 171

300

(7 + 12 + 14)

300

(7 + 12 + 14 + 21)

300

(7 + 12 + 14 + 21 + 27)

300

(7 + 12 + 14 + 21 + 27 + 30)

300

(7 + 12 + 14 + 21 + 27 + 30 + 25)

(B + C)

D (Rs.)

9 = 297

9 = 486

9 = 729

Average

cost/week

(D/A)

E (Rs.)

363

471

363.00

235.50

597

199.00

786

196.50*

1,029

205.80

1,299

216.50

9 = 1,224 1,524

217.71

9 = 999

for the fourth week. Hence, the group replacement period is four

weeks.

Individual replacement cost/week = Rs. 207

Minimum group replacement cost/week = Rs. 196.50

Since the minimum group replacement cost/week is less than

the individual replacement cost/week, the group replacement

policy is the best, and hence all the transistors should be replaced

once in four weeks and the transistors which fail during this fourweek period are to be replaced individually.

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UNIT V DEPRECIATION

5.1 Introduction

Any equipment which is purchased today will not work for ever. This may be

due to wear and tear of the equipment or obsolescence of technology.

Hence, it is to be replaced at the proper time for continuance of any

business.

The replacement of the equipment at the end of its life involves money. This

must be internally generated from the earnings of the equipment.

The recovery of money from the earnings of an equipment for its replacement

purpose is called depreciation fund since we make an assumption that the value

of the equipment decreases with the passage of time.

Thus the word depreciation means decrease in value of any physical asset

with the passage of time.

5.2 Methods of Depreciation

There are several methods of accounting depreciation fund. These are

as follows:

1. Straight line method of depreciation

2. Declining balance method of depreciation

3. Sum of the yearsdigits method of depreciation

4. Sinking-fund method of depreciation

5. Service output method of depreciation

1. Straight Line Method of Depreciation

In this method of depreciation, a fixed sum is charged as the

depreciation amount throughout the lifetime of an asset such that the accumulated

sum at the end of the life of the asset is exactly equal to the purchase value of the

asset.

Here, we make an important assumption that inflation is absent.

Let

P = first cost of the asset,

F = salvage value of the asset

n = life of the asset,

Bt = book value of the asset at the end of the period t,

Dt = depreciation amount for the period t.

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The formulae for depreciation and book value are as follows:

Dt = (P F)/n

Bt = Bt1 Dt = P t

[(P F)/n]

EXAMPLE

A company has purchased an equipment whose first cost is Rs. 1,00,000 with an

estimated life of eight years. The estimated salvage value of the equipment at the end of

its lifetime is Rs. 20,000. Determine the depreciation charge and book value at the end of

various years using the straight line method of depreciation.

Solution

P

F

n

Dt

= Rs. 1,00,000

= Rs. 20,000

= 8 years

= (P F)/n

= (1,00,000 20,000)/8

= Rs. 10,000

In this method of depreciation, the value of Dt is the same for all the years.

The calculations pertaining to Bt for different values of t are summarized

in Table .

Table

End of year

(t)

Depreciation

(Dt)

Book value

(Bt = Bt1 Dt)

1,00,000

10,000

90,000

10,000

80,000

10,000

70,000

10,000

60,000

10,000

50,000

10,000

40,000

10,000

30,000

10,000

20,000

the formulae can be used. In this approach, it should be noted that the

depreciation is the same for all the periods.

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EXAMPLE

Consider Example and compute the depreciation and the book value for period 5.

P = Rs. 1,00,000

F = Rs. 20,000

n = 8 years

D5 = (P F)/n

= (1,00,000 20,000)/8

= Rs. 10,000 (This is independent of the time period.)

Bt = P t

(P F)/n

B5 = 1,00,000 5

(1,00,000 20,000)/8

= Rs. 50,000

2. Declining Balance Method of Depreciation

In this method of depreciation, a constant percentage of the book value

of the previous period of the asset will be charged as the depreciation

amount for the current period.

This approach is a more realistic approach, since the depreciation

charge decreases with the life of the asset which matches with the

earning potential of the asset.

The book value at the end of the life of the asset may not be exactly

equal to the salvage value of the asset. This is a major limitation of

this approach.

Let

P = first cost of the asset,

F = salvage value of the asset,

n = life of the asset,

Bt = book value of the asset at the end of the period t,

K = a fixed percentage, and

Dt = depreciation amount at the end of the period t.

The formulae for depreciation and book value are as follows:

Dt = K

Bt-1

Bt = Bt1 Dt = Bt1 K

= (1 K)

Bt1

Bt1

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as follows:

Dt = K(1 K)t1

P Bt = (1 K)t

P

While availing income-tax exception for the depreciation

amount paid in each year, the rate K is limited to at the most 2/n. If

this rate is used, then the corresponding approach is called the

double declining balance method of depreciation.

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EXAMPLE

Consider Example 9.1 and demonstrate the calculations of the

declining balance method of depreciation by assuming 0.2 for K.

Solution

P = Rs. 1,00,000

F = Rs. 20,000

n = 8 years

K = 0.2

The calculations pertaining to Dt and Bt for different values of t

are summarized in Table 9.2 using the following formulae:

Dt = K

Bt1

Bt = Bt1 Dt

Table

End of year

(n)

Depreciation

(Dt)

0

1

2

3

4

5

6

7

8

20,000.00

16,000.00

12,800.00

10,240.00

8,192.00

6,553.60

5,242.88

4,194.30

Book value

(Bt)

1,00,000.00

80,000.00

64,000.00

51,200.00

40,960.00

32,768.00

26,214.40

20,971.52

16,777.22

period t, the respective formulae can be used.

EXAMPLE

Consider Example 9.1 and calculate the depreciation and the

book value for period 5 using the declining balance method of depreciation by

assuming 0.2 for K.

Solution

P = Rs. 1,00,000

F = Rs. 20,000

n = 8 years

K = 0.2

Dt = K(1 K)t 1 P

D5 = 0.2(1 0.2)4 1,00,000

= Rs. 8,192

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Bt = (1 K)t

B5 = (1 0.2)

P

5

1,00,000

= Rs. 32,768

In this method of depreciation also, it is assumed that the book value of the

asset decreases at a decreasing rate. If the asset has a life of eight years, first the

sum of the years is computed as

Sum of the years = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8

= 36 = n(n + 1)/2

The rate of depreciation charge for the first year is assumed as the highest and then it

decreases. The rates of depreciation for the years 18, respectively are as follows:

8/36, 7/36, 6/36, 5/36, 4/36, 3/36, 2/36, and 1/36.

For any year, the depreciation is calculated by

multiplying the corresponding rate of depreciation with (P F).

Dt = Rate (P F)

Bt = Bt1 Dt

The formulae for Dt and Bt for a specific year t are

as follows:

Dt =

n t+1

(P F)

n(n + 1)/2

Bt = (P F)

(n t) (n t + 1)

+F

(n + 1)

n

EXAMPLE

Consider Example 9.1 and demonstrate the calculations of the

sum-of-the-years-digits method of depreciation.

Solution

P = Rs.

1,00,000

F = Rs.

20,000

Sum = n (n + 1)/2 = 8

9/2 = 36

n = 8 years

The rates for years 18, are respectively 8/36, 7/36, 6/36, 5/36, 4/36,

3/36,2/36 and 1/36.

The calculations of Dt and Bt for different values of t are summarized in

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Dt = Rate

(P F)

Bt = Bt1 Dt

Table

End of year

(n)

Depreciation

(Dt)

Book value

(Bt)

0

1

2

3

4

5

6

7

8

17,777.77

15,555.55

13,333.33

11,111.11

8,888.88

6,666.66

4,444.44

2,222.22

1,00,000.00

82,222.23

66,666.68

53,333.35

42,222.24

33,333.36

26,666.70

22,222.26

20,000.04

of the formulae would be better.

EXAMPLE 9.6 Consider Example 9.1 and find the depreciation and book

value for the 5th year using the sum-of-the-years-digits method of depreciation.

Solution

P = Rs. 1,00,000

F = Rs. 20,000

n = 8 years

Dt =

n t+1

(P F)

n(n + 1)/2

D5 =

8 5+1

(1,00,000 20,000)

8(8 + 1)/2

= Rs. 8,888.88

Bt = (P F)

n t n t+1

+F

n+1

n

B5 = (1,00,000 20,000)

= 80,000

(3/8)

85 85+1

+ 20,000

8

8+1

(4/9) + 20,000

= Rs. 33,333.33

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In this method of depreciation, the book value decreases at increasing rates with

respect to the life of the asset

Let

P = first cost of the asset,

F = salvage value of the asset,

n = life of the asset,

i = rate of return compounded annually,

A = the annual equivalent amount,

Bt = the book value of the asset at the end of the period t, and

Dt = the depreciation amount at the end of the period t.

The loss in value of the asset (P F) is made available an the form of cumulative

depreciation amount at the end of the life of the asset by setting up an equal

depreciation amount (A) at the end of each period during the lifetime of the asset.

A = (P F) [A/F, i, n]

The fixed sum depreciated at the end of every time period earns an interest at

the rate of i% compounded annually, and hence the actual depreciation amount

will be in the increasing manner with respect to the time period. A generalized

formula for Dt is

Dt = (P F) (A/F, i, n) (F/P, i, t 1)

The formula to calculate the book value at the end of period t is

Bt = P (P F) (A/F, i, n) (F/A, i, t)

The above two formulae are very useful if we have to calculate Dt and

Bt for any specific period.

If we calculate Dt and Bt for all the periods, then the tabular approach

would be better.

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EXAMPLE

Consider Example and give the calculations regarding the sinking fund

method of depreciation with an interest rate of 12%, compounded annually.

Solution

P = Rs.

1,00,000

F = Rs.

20,000

n = 8 years

i = 12%

A = (P F) [A/F, 12%, 8]

= (1,00,000 20,000) 0.0813

= Rs. 6,504

depreciated at the end of every year from the earning of the asset.

The depreciated amount will earn interest for the remaining period of life

of the asset at an interest rate of 12%, compounded annually.

For example, the calculations of net depreciation for some periods are as

follows:

Depreciation at the end of year 1 (D1) = Rs. 6,504.

Depreciation at the end of year 2 (D2) = 6,504 + 6,504

= Rs. 7,284.48

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= 6,504 + (6,504 + 7,284.48)

= Rs. 8,158.62

.12

= 6,504 + (6,504 + 7,284.48 + 8,158.62)

= Rs. 9,137.65

0.12

Table

End of year

t

Fixed

depreciation

(Rs.)

Net depreciation

Dt

(Rs.)

Book value

Bt

(Rs.)

0

1

2

3

4

5

6

7

8

6,504

6,504

6,504

6,504

6,504

6,504

6,504

6,504

6,504

6,504.00

7,284.48

8,158.62

9,137.65

10,234.17

11,462.27

12,837.74

14,378.27

1,00,000.00

93,496.00

86,211.52

78,052.90

68,915.25

58,681.08

47,218.81

34,381.07

20,002.80

Bt = Bt1 Dt

EXAMPLE

Consider Example and compute D5 and B7 using the

sinking fund method of depreciation with an interest rate of 12%,

compounded annually.

Solution

P = Rs. 1,00,000

F = Rs. 20,000

n = 8 years

i = 12%

Dt = (P F) (A/F, i, n) (F/P, i, t 1)

D5 = (P F) (A/F, 12%, 8) (F/P, 12%, 4)

= (1,00,000 20,000) 0.0813 1.574

= Rs. 10,237.30

the table. The minor difference is due to truncation error.

Bt = P (P F) (A/F, i, n) (F/A, i, t)

B7 = P (P F) (A/F, 12%, 8) (F/A, 12%, 7)

= 1,00,000 (1,00,000 20,000)

0.0813

10.089

= 34,381.10

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In some situations, it may not be realistic to compute depreciation

based on time period. In such cases, the depreciation is computed

based on service rendered by an asset. Let

P=

F=

X=

x=

salvage value of the asset

maximum capacity of service of the asset during its lifetime

quantity of service rendered in a period.

rendered: Depreciation/unit of service = (P F)/X

Depreciation for x units of service in a period =

PF

(x)

X

EXAMPLE

The first coat of a road laying machine is Rs. 80,00,000. Its salvage value

after five years is Rs. 50,000. The length of road that can be laid by the

machine during its lifetime is 75,000 km. In its third year of operation, the

length of road laid is 2,000 km. Find the depreciation of the equipment for that

year.

Solution

P = Rs. 80,00,000

F = Rs. 50,000

X = 75,000 km

x = 2,000 km

PF

x

Depreciation for x units of service in a period = X

(80,00,000 50,000)

75,000

= Rs. 2,12,000

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In evaluating alternatives of private organizations, the criterion is to select the

alternative with the maximum profit.

The profit maximization is the main goal of private organizations while

providing goods/services as per specifications to their customers.

But the same criterion cannot be used while evaluating public alternatives.

Examples of some public alternatives are

constructing bridges,

roads, dams,

establishing public utilities, etc.

The main objective of any public alternative is to provide goods/services to the

public at the minimum cost. In this process, one should see whether the benefits of the

public activity are at least equal to its costs.

5.4 Inflation Adjusted Decisions

Inflation is the rate of increase in the prices of goods per period. So, it has a

compounding effect. Thus, prices that are inflated at a rate of 7% per year will increase

7% in the first year, and for the next year the expected increase will be 7% of these new

prices.

If economic decisions are taken without considering the effect of inflation into

account, most of them would become meaningless and as a result the organizations

would end up with unpredictable return.

5.5 Procedure To Adjust Inflation

A procedure to deal with this situation is summarized

now.

1. Estimate all the costs/returns associated with an investment proposal in terms of

todays rupees.

2. Modify the costs/returns estimated in step 1 using an assumed inflation rate so that

at each future date they represent the costs/returns at that date in terms of the

rupees that must be expended/received at that time, respectively.

3. As per our requirement, calculate either the annual equivalent amount or future

amount or present amount of the cash flow resulting from step 2 by considering

the time value of money.

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WORKEDOUT PROBLEMS

A person deposits a sum of Rs. 20,000 at the interest rate of 18% compounded

annually for 10 years. Find the maturity value after 10 years.

Solution

P = Rs. 20,000

i = 18% compounded annually

n = 10 years

F = P(1 + i)n = P(F/P, i, n)

= 20,000 (F/P, 18%, 10)

= 20,000 5.234 = Rs. 1,04,680

The maturity value of Rs. 20,000 invested now at 18% compounded yearly is equal

to Rs. 1,04,680 after 10 years.

A person wishes to have a future sum of Rs. 1,00,000 for his sons education after 10

years from now. What is the single-payment that he should deposit now so that he gets the

desired amount after 10 years? The bank gives 15% interest rate compounded annually.

Solution

F

i

n

P

= Rs. 1,00,000

= 15%, compounded annually

= 10 years

= F/(1 + i)n = F(P/F, i, n)

= 1,00,000 (P/F, 15%, 10)

= 1,00,000 0.2472

= Rs. 24,720

The person has to invest Rs. 24,720 now so that he will get a sum of Rs.

1,00,000 after 10 years at 15% interest rate compounded annually.

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A company has to replace a present facility after 15 years at an outlay of Rs. 5,00,000. It

plans to deposit an equal amount at the end of every year for the next 15 years at an interest

rate of 18% compounded annually. Find the equivalent amount that must be deposited at the

end of every year for the next 15 years.

Solution

F=

n=

i=

A=

Rs. 5,00,000

15 years

18%

?

5,00,000

i = 18%

3

4

15

A

A

A

A

A

Fig. Cash flow diagram of equal-payment series sinking fund.

i

A=F

= F(A/F, i, n)

(1 + i)n

1

= 5,00,000

0.0164

= Rs. 8,200

The annual equal amount which must be deposited for 15 years is Rs. 8,200.

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A company wants to set up a reserve which will help the company to have an annual

equivalent amount of Rs. 10,00,000 for the next 20 years towards its employees welfare

measures. The reserve is assumed to grow at the rate of 15% annually. Find the singlepayment that must be made now as the reserve amount.

Solution

A = Rs. 10,00,000

i = 15%

n = 20 years

P=?

The corresponding cash flow diagram is illustrated in Fig.

P

i = 15%

0

.

..

20

10,00,000

1,00,00,00010000001000000 100000

Fig.

(1 + i)n 1

P=A

= A(P/A, i, n)

n

i(1 + i)

= 10,00,000

= 10,00,000

6.2593

= Rs. 62,59,300

The amount of reserve which must be set-up now is equal to Rs. 62,59,300.

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A bank gives a loan to a company to purchase an equipment worth Rs. 10,00,000 at an

interest rate of 18% compounded annually. This amount should be repaid in 15 yearly equal

installments. Find the installment amount that the company has to pay to the bank.

Solution

P = Rs. 10,00,000

i = 18%

n = 15 years

A=?

The corresponding cash flow diagram is shown in Fig..

10,00,000

i = 18%

1

.

A

.

.

15

A=P

i(1 + i)n

(1 + i)n 1

= P(A/P, i, n)

= 10,00,000

= 10,00,000

(0.1964)

= Rs. 1,96,400

The annual equivalent installment to be paid by the company to the bank is Rs. 1,96,400.

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A person is planning for his retired life. He has 10 more years of service. He would like to

deposit 20% of his salary, which is Rs. 4,000, at the end of the first year, and thereafter

he wishes to deposit the amount with an annual increase of Rs. 500 for the next 9 years

with an interest rate of 15%. Find the total amount at the end of the 10th year of the above

series.

Solution

Here,

A1 = Rs. 4,000

G = Rs. 500

i = 15%

n = 10 years

A=?&F=?

The cash flow diagram is shown in Fig.

1

4,000

i = 15%

3

4,000 + 500

4,000 + 1,000

4,000 + 1,500

4,000 + 4,500

Fig. Cash flow diagram of uniform gradient series annual equivalent amount.

A = A1 + G

(1 + i)n in 1

i(1 + i)n i

= A1 + G(A/G, i, n)

= 4,000 + 500(A/G, 15%, 10)

= 4,000 + 500

3.3832

= Rs. 5,691.60

This is equivalent to paying an equivalent amount of Rs. 5,691.60 at the end of every

year for the next 10 years. The future worth sum of this revised series at the end of the

10th year is obtained as follows:

F = A(F/A, i, n)

= 5,691.60(20.304)

= Rs. 1,15,562.25

At the end of the 10th year, the compound amount of all his payments will be Rs.

1,15,562.25.

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A person invests a sum of Rs. 5,000 in a bank at a nominal interest rate of 12% for 10

years. The compounding is quarterly. Find the maturity amount of the deposit after 10

years.

Solution

P = Rs. 5,000

n = 10 years

i = 12% (Nominal interest rate)

F=?

METHOD 1

No. of interest periods per year = 4

No. of interest periods in 10 years = 10 4 = 40

Revised No. of periods (No. of quarters), N = 40

Interest rate per quarter, r = 12%/4

= 3%, compounded quarterly.

F = P(1 + r)N = 5,000(1 + 0.03)40

= Rs. 16,310.19

METHOD 2

No. of interest periods per year, C = 4

Effective interest rate, R = (1 + i/C )C 1

= (1 + 12%/4)4 1

= 12.55%, compounded annually.

F = P(1 + R)n = 5,000(1 + 0.1255)10

= Rs. 16,308.91

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PART A (2 MARKS)

1. What is elasticity of Demand?

Elasticity of demand may be defined as the degree of responsiveness of quantity

demanded to a Change in price.

2.

Cost may be defined as a total of all expenses incurred, whether paid of

outstanding in the manufacture and sale of a product.

Opportunity cost may be defined as the potential benefit that is given up as you

seek an alternative course of action. In other words, the expected return or benefit for

gone in rejecting one course of action for another.

4. What do you mean by marginal cost?

The institute of cost & works Accountants of India defined marginal cost as, the

amount at any given volume of output by which aggregate cost are changed, if the

volume of output is increased or decreased by one unit.

5. Explain marginal costing?

Marginal costing is defined by the ICWA as, the ascertainment by

differentiating between fixed costs, of marginal costs and of the effect on profit of changes

in volume or type of output.

6. What is meant by marginal revenue?

The revenue that can be obtained from selling one more unit of product is called

marginal revenue.

7. Give a short note on sunk cost?

A cost which was incurred or sunk in the past and is not relevant to the particular

decision making is a sunk cost or sunk loss. It may be variable or fixed or both.

8.

The elements of cost are:

V Materials

Labor cost

Expenses

Institute of costs and Management Accountants, (I.C.M.A) London has defines

costing as the ascertainment of costs. it refers to the techniques and process of

ascertaining costs and studies the principles and rules concerning the determination of

costs of products and services .

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The Break-even point is, therefore, the volume of output at which neither a profit

is made nor a loss is incurred. It is a point where the total sales are equal to total cost.

11. Define P/V ratio.

Profit-Volume ratio expressed as a percentage indicates the relative profitability of

different products

PART: B (16 MARKS)

1. Explain in detail about flow in an economy?

2. Explain the concept of law of supply and demand with suitable example?

3. Briefly explain about element of cost and its classification?

4. Explain the concept of break even analysis with clear diagram?

5. Briefly explain about process planning and its various types?

PART A (2 MARKS)

Make or buy decision is a determination whether to produce a component

part internally or to buy it from an outside supplier.

The Organization should evaluate the costs and benefits of

manufacturing a product or product component against purchasing it and

then select the alternative which results in the lower cost.

13. What are the different approaches followed in make or buy decision?

The following are the approaches followed in make or buy decision.

Simple cost analysis

Economic analysis

Break-even analysis

14. What is mean by value analysis/value engineering?

Value analysis is a special type of cost reduction technique.

It critically investigates and analyses the different aspects of materials,

design, cost and production of each and every component of the product in

produce it economically without decreasing its utility, function or

reliability.

15. What do you mean by value of a product?

Value differs from both price and cost in the sense that it is the cost proportionate

to the function. We can express value mathematically as Value =function or utility/ cost

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Function specifies the purpose of the product or what the product does, what is its

utility etc.

17. What are the different types of values?

Cost value

Exchange value

Use value

Esteem value

18. What are the various functions of a product?

Functions can be classified into the following three categories:

Primary functions

Secondary functions

Tertiary functions

19. Write any four objectives of value analysis.

Reduce the cost of the product

Simplify the product

Use (new) cheaper and better materials

Modify and improve product design so as to make it acceptable to

consumer

20. List any four advantage of value engineering.

Value engineering/analysis identifies and reduces the product cost.

It modifies and improve the product design

It increases the performance/utility of the product by economical means.

It helps to generate new ideas.

PART :B (16 MARKS)

1. Explain in details about criteria for make or buy decision and its approaches? (Also see

problems)

2. Problems in single payment compound amount method?

3. Problems in single payment present worth factor?

4. Problems in equal payment series sinking fund factor method?

5. Problems in equal payment series present worth factor method?

6. Problems in equal payment series capital recovery factor method?

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PART A (2 MARKS)

21. What is revenue dominated cash flow?

The profit/revenue, salvage value of all inflows to an organization will be assigned

with positive sign and the cost outflows will be assigned with negative sign is called

revenue dominated cash flow.

22. What is cost of dominated cash flow?

The cost outflow will be assigned with positive sign and profit, revenue

salvage value all inflows etc,.

Will be assigned with negative sign is called cost dominated cash flow.

23. Mention the various rate of return method.

Internal rate of return(IRR)

Average rate of return(ARR)

Net present value method (NPV)

Pay-back period (PBP)

24. What is rate of return?

Rate of return is the break-even interest rate, I, which equates the present worth of

a projects cash outflows to the present worth its cash inflow

25. What is present worth method?

The present worth measures the surplus in an investments project at time zero (0).

The present worth of all cash inflows is computed the present worth of all cash

outflows associated with an investment of project is called present worth method.

1. Problems in present worth method (Revenue dominated cash flow diagram)

2. Problems in future worth method (Revenue dominated cash flow diagram)

3. Problems in Annual equivalent method (Revenue dominated cash flow diagram)

4. Problems in Annual equivalent method (cost dominated cash flow diagram)

5. Problems in rate of return method

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PART A (2 MARKS)

26. What is future worth analysis?

Net future worth measures the surplus at time period other then 0.

Future worth analysis is particularly useful in an investment situation where we

need to compute the equivalent worth of a project at the end of its investment

period.

27. What is annual equivalent method?

The criterion provide a basis for measuring investment worth by determining equal

payments on an annual basis is called annual equivalent method.

28. What is Replacement analysis?

Replacement analysis involves the Replacement of existing obsolete or worn-out

assets in order to avoid failure in operations.

The problems often faced by management of various industries are whether to

replace equipment or to continue to use existing equipment, and when existing

equipment should be replaced with efficient equipment.

This class of decision analysis is known as replacement analysis.

29. What is mean by gradual failure?

Gradual failure is progressive in nature.

It can be depicted in machine equipment, which is gradually depreciating or

deteriorating with the time resulting in very high operating and maintenance cost

and/or decreased residual value.

It is easier to predict such type of failure and taking the corrective measures by

providing a replacement policy for such machine equipment.

30. Define economic service life of an asset?

The economic service life of an asset is defined to be the period of useful life that

minimizes the annual equivalent cost of owning and operating the asset.

31. What are the types of replacement problem?

(a) Replacement of assets that deteriorate with time (replacement due to gradual

failure, or were and tear of the components of the machine).

This can be further classified in to the following types:

1. Determination of economic life an asset

2. Replacement of an asset with a new asset.

(b)Simple probabilistic model for assets which fails completely. (Replacement due

to sudden failure).

32. Explain annual equivalent total cost.

Annual equivalent total cost of owning and operating an asset is a

summation of the capital recovery cost (average first cost) and the annual equivalent

operating cost of the asset.

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Corrective or Breakdown maintenance.

Scheduled maintenance

Preventive maintenance and

Predictive maintenance.

34. State the main causes of breakdown.

Failure to replace worn out parts

Lack of lubrication

Indifference towards minor faults

35. State any two disadvantages of break down maintenance.

1. Delays in production

2. Faster plant deterioration

It is comparatively a newer maintenance technique.

Equipment conditions are measured periodically or on a continuous basis

and this enable maintenance men to take a timely action such as

equipment adjustments repair or overhaul.

UNIT-V DEPRECIATION

PART A (2 MARKS)

37. Define the term Depreciation.

Depreciation is the process of allocating the acquisition cost of the tangible assets

less salvage value, if any, in a systematic and a rational manner over the estimated life of

the asset.

38. Mention the various method used in depreciation calculation.

The various methods used in depreciation calculation are:

1. Straight line method

2. Declining method

3. Sum of the years digits method

4. Sinking fund or annuity method

5. Service output method

39. What is service output method of depreciation?

Service output method of depreciation is a type of computing depreciation base on

service rendered by an asset

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The causes of depreciation are:

Wear and tear

Depletion

Obsolescence

Lapse of time

41. Write five reasons for providing depreciation.

The reasons for providing depreciations are:

To know the correct profits

To show correct financial position.

To make provision for replacement of asset

To compute tax liability

To decide for show much to buy or sell the assets in the second hand

market

42. What is evaluation of public alternatives?

Evaluation of public alternatives is nothing but the selecting of best alternative

from the available alternatives.

43. Define the term inflation?

Inflation may be defined as a sustained in the general price level.

It is an economic condition where there is a rise in prices resulting in the

fall in the purchasing power of money

44. What is sinking fund?

A depreciation fund equal to be actual loss in the value of the asset is

estimated for each year.

This amount is invested outside the business in a separate account called

sinking fund.

45. What is amortization?

Amortization is a routine decrease in value of an intangible asset, or the

process of paying off a debt over time through regular payments.

Amortization refers to the expensing of intangible capital assets (intellectual

property: patents, trademarks, copyrights. Etc,) in order to show their

decrease in value as a result of use or passage of time.

1. Problems in different types of depreciation methods

(16)

(16)

(16)

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4. (a) (i) How to adjust inflation in evaluating public alternatives? Explain the procedure.

(8)

(ii)Find the depreciation annuity by annuity method after three years, when the initial cost

of the machine is Rs 8,00,000 an salvage value at the end of three years is Rs 4,00,000.Rate of

interest 10 %

(8)

5. (i) What is economic life of an asset? How to determine it? Explain

(ii) The cost of a machine is Rs 1,60,000 and its scrap value is Rs 40,000 .Estimate life 5

years .Using sum of years digits method ,determine depreciation charges for each year.

(16)

SCE

32

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