What is Equivalent Annual Cost ?

1306 reads · Last updated: December 5, 2024

Equivalent annual cost (EAC) is the annual cost of owning, operating, and maintaining an asset over its entire life. Firms often use EAC for capital budgeting decisions, as it allows a company to compare the cost-effectiveness of various assets with unequal lifespans.

Definition

Equivalent Annual Cost (EAC) refers to the annual cost of owning, operating, and maintaining an asset over its entire life cycle. Companies often use EAC in capital budgeting decisions because it allows them to compare the cost-effectiveness of various assets with unequal lifespans.

Origin

The concept of Equivalent Annual Cost originated in the fields of capital budgeting and financial management, aimed at helping companies make more effective cost comparisons when selecting investment projects. As companies increasingly focus on capital efficiency, EAC has become a standard analytical tool.

Categories and Features

EAC is primarily used to compare assets with different lifespans. Its feature is to spread the total cost over each year, allowing assets with different lifespans to be compared on the same basis. The formula for calculating EAC is: EAC = Total Cost / Annuity Factor, where the annuity factor is based on the asset's lifespan and discount rate.

Case Studies

Case Study 1: A company considers purchasing two machines, Machine A with a lifespan of 5 years and a total cost of $500,000, and Machine B with a lifespan of 3 years and a total cost of $300,000. By calculating the EAC, the company finds that Machine A has a lower EAC and thus chooses Machine A. Case Study 2: Another company uses EAC to compare different brands of office equipment and ultimately selects the equipment with the best EAC performance, saving on long-term costs.

Common Issues

Common issues include accurately estimating the lifespan and discount rate of an asset, and handling uncertain future costs. A misconception might be that EAC is applicable to all types of cost comparisons, whereas it is mainly suited for capital-intensive assets.

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