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Engineering Economy
Magister Teknik Sipil
Program Pascasarjana
Universitas Katolik Parahyangan

2018

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Incremental B/C Analysis

The Criterion

The Procedure

1. For each alternative, determine the equivalent PW, AW, or

FW values for costs (C) and benefits (B) (Visually check the
PW, AW, or FW values to ensure that the larger cost
alternative also yields larger benefits. If benefits are not
larger, the comparison is unnecessary).
2. Order the alternatives by increasing total equivalent cost.

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( Leland Blank, Anthony Tarquin, 2008)

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Incremental B/C Analysis

The Procedure

3. Determine the incremental costs and benefits between the

first two ordered alternatives over their least common
multiple of lives.
4. Calculate the ∆ B/C ratio.
5. If ∆B/C ≥ 1, eliminate 1; 2 is the survivor; otherwise 1 is the
survivor.
6. Continue to compare alternatives using steps 2 through 5
until only one alter-native remains as the survivor

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( Leland Blank, Anthony Tarquin, 2008)

( Leland Blank, Anthony Tarquin, 2008)

Incremental B/C Analysis

Example
1. The city of Garden Ridge, Florida has received two designs for a
new wing to the municipal hospital. The costs and benefit are the
same in most categories, but the city financial manager decided
that the following estimates should be considered to determine
which design to recommend at the city council meeting next
week. The patient benefit is an estimate of the amount paid by
an insurance carrier, not the patient, to occupy a hospital room
with the features included in the design of each room. The
discount rate is 5% per year, and the life of the addition is
estimated at 30 years.

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Use conventional B/C ratio analysis to select design 1 or 2.

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Incremental B/C Analysis

Solution Data:

Apply the incremental B/C procedure with no dis-benefits

included and direct benefits estimated

Most of the cash flows are already annualized, thus more easier
used AW

Ordering the alternatives Alt. 1, and Alt. 2

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( Leland Blank, Anthony Tarquin, 2008)

Incremental B/C Analysis

Solution
Data:

Calculate the incremental between the first two ordered alternatives

∆ = 1,050,000 − 800,000 = 250,000

The incremental B/C ratio is

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( Leland Blank, Anthony Tarquin, 2008)

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( Leland Blank, Anthony Tarquin, 2008)

Incremental B/C Analysis

Next Data:
problem!

Once the two designs were publicized, the privately owned hospital in the
directly adjacent city of Forest Glen lodged a complaint that design 1 will
reduce its own municipal hospital’s income by an estimated $500,000 per
year because some of the day-surgery features of design A duplicate its
services.

Subsequently, the Garden Ridge merchants’ association argued that

design 2 could reduce its annual revenue by an estimated $400,000,
because it will eliminate an entire parking lot used by their patrons for
short-term parking. The city financial manager stated that these concerns
would be entered into the evaluation as dis-benefits of the respective
designs. Redo the B/C analysis to determine if the economic decision is
still the same as when dis-benefits were not considered
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( Leland Blank, Anthony Tarquin, 2008)

Incremental B/C Analysis

Next Data:
problem!

The revenue loss estimates are considered dis-benefits

Design 1 dis-benefits = $500.000
Design 2 dis-benefits = $400.000

Since the dis-benefits of design 2 are $100,000 less than those of 1, this
positive difference is added to the $250,000 benefits of 2 to give it a total
benefit of $350,000.
Awal tanpa disbenefits

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Evaluating the Projects

• Present Worth (PW) Method

– Net Present Value (NPV)
Remember
• Annual Worth (AW) Method again the
• Rate of Return (ROR) methods!
• Benefit Cost Ratio (BCR)
• Payback Period (PP)

PAYBACK PERIOD ANALYSIS

• A.ka. Payout analysis a.ka simple payout method

• The payback period np is the time, usually in years.

• It will take for estimated revenues and other

economic benefits to recover the initial investment
P and a specific rate of return i%.

• The np value is generally not an integer.

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PAYBACK PERIOD ANALYSIS

• After np years, the cash flows will recover the

investment and a return of i%.

• In payback analysis all net cash flows occurring after

np years are neglected

• In reality, the asset or alternative is used for more

than np years, a larger return may result.

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PAYBACK PERIOD ANALYSIS

• This approach significantly different from the
approach of all other evaluation methods (PW, AW,
ROR, B/C) where all cash flows for the entire useful
life are included.

• Therefore, the pay-back period np should not be

used as the primary measure of worth to select an
alternative.

• The calculation can take one of two forms:

– Ignoring time-value-of-money (conventional PP; i=0%), or

– Including them (discounted PP; i>0%). 12

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PAYBACK PERIOD ANALYSIS

• This np value serves merely as an initial indicator
that a proposal is viable and worthy of a full
economic evaluation.

• Commonly used as initial project screening method

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PAYBACK PERIOD ANALYSIS

• The calculation can take one of two forms:
– Including time-value-of-money (discounted PP; i>0%).

– If the NCF values are equal each year, the P/A factor may
be used to find np.

– Ignoring time-value-of-money (conventional PP; i=0%)

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Example - Conventional PAYBACK PERIOD ANALYSIS

“A” company has just bought a new spindle machine at
a cost $105,000 to replace one that had a salvage
value of $20,000. The project annual after tax
savings due to improved efficiency, are as follows:

Find PP period by the Conventional PP!

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( Park, 2004)

Example - Conventional PAYBACK PERIOD ANALYSIS

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( Park, 2004)

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Example - Conventional PAYBACK PERIOD ANALYSIS

$35,000
- $10,000

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( Park, 2004)

Benefits & Flaws of PAYBACK PERIOD ANALYSIS

Conventional Approach

Project 2 better than Project 1 Why???

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Example - Discounted PAYBACK PERIOD ANALYSIS

The board of directors of “A” holding company has just

approved an $18M world wide financial services
contract. The services are expected to generate
new net annual revenues of $3M. The contract has
a potentially lucrative (profitable) repayment
clause to “A” of $3M at any time that the contract
is canceled by either party during the 10 years of
agreed- to contract period:
a. If the MARR is 15%, compute the PP (i>0%)
b. Determined the no-return PP (i=0%) and compare
it with the answer a.
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Example - Discounted
PAYBACK PERIOD ANALYSIS
Solution:
In $1,000,000 terms:

0 = −18 + 3( P / A,15%, n p ) + 3( P / F ,15%, n p )

np = 15.3 years, during the period of 10 years, the estimated
revenue will not deliver the required return.

Determined the no-return PP (i=0%) and compare it with the answer a.

t =n p

0 = − P + ∑ NCFt
t =1

0 = −18 + 3.n p + 3 n p = 5 years

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Example – Multi Alternatives PAYBACK PERIOD ANALYSIS

Two equivalent pieces of construction equipment are being considered for
purchase. Machine 2 expected to be versatile (able to adapt) and
technologically advanced enough to provide longer than Machine 1.
M1 M2
First Cost, $ 12,000 8,000
Annual income, $ 3,000 1,000 (years 1-5)
3,000 (years 6-15)
Maximum life, years 7 15

a. If the MARR is 15%, compute the discounted PP (i>0%)

b. Compare the result with AW analysis for revisit the decision.

i = 15,00%
n P/F F/P P/A A/P
4 0,5718 1,7490 2,8550 0,3503
5 0,4972 2,0114 3,3522 0,2983
6 0,4323 2,3131 3,7845 0,2642
7 0,3759 2,6600 4,1604 0,2404
13 0,1625 6,1528 5,5831 0,1791
14 0,1413 7,0757 5,7245 0,1747 21
15 0,1229 8,1371 5,8474 0,1710

Example – Multi Alternatives

PAYBACK PERIOD ANALYSIS
Data: M1 M2
First Cost, $ 12,000 8,000
Annual income, $ 3,000 1,000 (years 1-5)
3,000 (years 6-15)
Maximum life, years 7 15

The discounted PP (i>0%)

M1 0 = −12,000 + 3,000( P / A,15%, n p )
Select Machine 1
n p = 6.57 less than 7 - years life

M2 0 = −8,000 + 1,000( P / A,15%,5) + 3,000( P / A,15%, np − 5)( P / F ,15%,5)

n p = ??? it should be less than 15 - years life
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Example – Multi Alternatives

PAYBACK PERIOD ANALYSIS
M1

Select Machine 1

M2

0 = −8,000 + 1,000( P / A,15%,5) + 3,000( P / A,15%, np − 5)( P / F ,15%,5)

n p = 9.52 less than 15 - years life
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Example – Multi Alternatives

PAYBACK PERIOD ANALYSIS
Data: M1 M2
First Cost, $ 12,000 8,000
Annual income, $ 3,000 1,000 (years 1-5)
3,000 (years 6-15)
Maximum life, years 7 15

AW analysis for revisit the decision.

M1
AW1 = −12,000( A / P,15%,7) + 3,000 = 116
Select
M2 Machine 2
AW2 = −8,000( A / P,15%,15) + 1,000
+ 2,000( F / A,15%,10)( A / F ,15%,15)
AW2 = 485
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it's a wrap

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