Chapter 10 Dealing with Uncertainty

Section 10.4.1 Breakeven Analysis

Useful for choosing among alternatives when costs or revenues are
highly sensitive to a single factor that is hard to estimate (e.g., operating
hours per year, useful life, etc.)

General Procedure:
1. Write an expression of equivalent worth for each alternative in terms of the
common factor.

2. Equate the equivalent worths and solve for the value of the common
factor. This value is the breakeven point (B.E.P.).

3. Estimate whether the actual factor value will be higher or lower than the
B.E.P. and then choose the appropriate alternative.

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Example 10-1 on pages 429 - 431
Suppose that there are two alternative electric motors that provide 100 hp
output. An Alpha motor can be purchased for $12,500 and has an efficiency
of 74%, an estimated life of 10 years, and estimated maintenance cost of
$500 per year. A Beta motor will cost $16,000 and has an efficiency of 92%,
a life of 10 years, and annual maintenance costs of $250. Annual taxes and
insurance costs on either motor will be 1-1/2% of the investment. If the
minimum attractive rate of return is 15%, how many hours per year would
the motors have to be operated at full load for the annual costs to be equal?
Assume that salvage values for both motors are negligible and that electricity
costs $0.05 per kilowatt-hour.

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Example 10-1
Decision Criterion: Minimize Equivalent Uniform Annual Cost (AC)
AC = CR + Operating cost + Taxes & Ins. + Maintenance
Alpha Beta
Purchase Price $12,500 $16,000
Maintenance Cost/yr 500 250
Annual Taxes & Insurance 12,500(0.015) 16,000(0.015)
Efficiency 74% 92%
Useful Life (yrs) 10 10
output power
Note: Electrical Efficiency = , and 1 hp = 0.746 kW
input power

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Example 10-1: Solution
At breakeven, ACα = ACβ

$2,490 + $5.04X + $500 + $187 = $3,190 + $4.05X + $250 + $240

$3,177 + $5.04X = $3,680 + $4.05X
Solving for X, we find X = 508 hours/year

AC,$

X, hrs/yr

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Sensitivity Analysis Example
Estimated Value
Investment cost $ 95,000
Useful life 10 years
Salvage value $ 10,000
Net Annual receipts $ 20,000
MARR 12%
Evaluate the sensitivity of PW to 50% changes in:
a) investment cost
b) net annual receipts
c) MARR

To which factor is the decision most sensitive?

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Sensitivity Example Continued
PW of most likely estimates:
PW(12%) = -$95,000 + $20,000(P/A,12%,10) + $10,000(P/F,12%,10)
= $21,224

Summary of Results:
PW at - 50% change PW at + 50% change Decision
in factor value in factor value Reversal
Investment cost $68,724 -$26,276 +22.3%
Net annual receipts -$35,278 $77,726 -18.8%
MARR $57,786 -$3,209 +42.7%

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Chapter 10 - Example 10-4
A machine for which most likely cash flow estimates are given in the
following list is being considered for immediate installation. Because of the
new technology built into this machine, it is desired to investigate its PW
over a range of 40% in:
(a) initial investment,
(b) annual net cash flow,
(c) salvage value, and
(d) useful life.
Based on these estimates, how much can the initial investment increase
without making the machine an unattractive venture?

Draw a diagram that summarizes the sensitivity of present worth to changes

in each separate parameter when the MARR = 10% per year.

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Example 10-4 Set Up
PW(10%) = -11,500 + 3,000(P|A,10%,6) + 1,000(P|F,10%,6)
= $2,130

a) When the Initial Investment varies by ±p%

PW = (1± p%/ 100)(-1,500) + 3,000(P|A,10%,6)+ 1,000(P|F,10%,6)

b) When Net Annual Cash Flow varies by ±a%

PW = -11,500 + (1± a%/100)(3,000)(P|A, 10%,6) + 1,000(P|F,10%,6)

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Example 10-4 Set Up Continued
c) When Salvage Value varies by ±s%
PW = -11,500 + 3,000(P|A,10%,6) + (1± s%/ 100 )(1,000)(P|F,10%,6)

d) When the Useful Life varies by ±n%

n%
PW = -11,500 + 3,000[P|A, 10%, 6(1± /100 )]
+ 1,000[P|F,10%,6(1± n%/ 100)]

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Example 10-4 Continued
Which parameter is most sensitive to change?

PW(10%) = 0 when Initial Investment increases 18.5%

PW(10%) = 0 when Net Annual Cash Flow decreases 16.3%

PW(10%) = 0 when Salvage Value decreases 378%**

** requires a negative Salvage Value

PW(10%) = 0 when Useful Life decreases 21.7%

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Section 10.4.3 Optimistic - Pessimistic Estimates
Exploring sensitivity by estimating one or more factors in a favorable
direction and in an unfavorable direction to investigate the effect on study
results.

Optimistic - 95th percentile (desirable)

Pessimistic - 5th percentile (undesirable)

Not only do we examine the Equivalent Worth (EW) for all three estimation
conditions, we examine the EW for all combinations of estimated outcomes
for the key factors being estimated.

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Problem 10-18 (page 455)
Suppose for an engineering project the optimistic, most likely, and
pessimistic estimates are as shown below.
Optimistic Most Likely Pessimistic
Capital Investment -$80,000 -$95,000 -$120,000
Useful Life 12 years 10 years 6 years
Market Value $30,000 $20,000 0
Net Annual Cash Flow $35,000 $30,000 $20,000
MARR 12%/yr 12%/yr 12%/yr
a) What is the AW for each of the three estimation conditions?

b) It is thought the most critical elements are useful life and net annual cash
flow. Develop a table showing the AW for all combinations of estimates
for these two factors, assuming that all other factors remain at their most
likely values.

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Problem 10-18 Set up
a) AW(12%) =

b) Set up a table to illustrate summary results:

Useful Life
Net Annual O ML P
Cash Flow (12 years) (10 years) (6 years)

O $35,000

ML $30,000

P $20,000

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ISE 2014 The Cost of Quality -- Revisited Chapter 10

Recall the handouts from Chapter 2 and 4 that discussed the cost of quality resulting from
product variability. In this scenario, a company is producing a high-volume item that sells for
$0.75 per unit. The variable production cost is $0.30 per unit. The company is able to produce
and sell 10,000,000 items per year when operating at full capacity.

The critical attribute for this product is weight. The target value for weight is 1000 grams
and the specification limits are set at ±50 grams. The filling machine used to dispense the
product is capable of weights following a normal distribution with an average (m) of 1000
grams and a standard deviation (s) of 40 grams. Because of the large standard deviation (with
respect to the specification limits), 21.12% of all units produced are not within the specification
limits (they either weigh less than 950 grams or more than 1050 grams). This means that
2,112,000 out of 10,000,000 units produced are non-conforming and cannot be sold without
being reworked.

Assume that non-conforming units can be reworded to specification at an additional fixed

cost of $0.10 per unit. Reworked units can be sold for $0.75 per unit. It has been estimated
that the demand for this product will remain at 10,000,000 units per year for the next five years.

To improve the quality of this product, the company is considering the purchase of a new
filling machine. The new machine will be capable of dispensing the product with weights
following a normal distribution with µ = 1000 grams and σ = 20 grams. As a result, the percent
of non-conforming units will be reduced to 1.24% of production. The new machine will cost
$710,000 and will last for at least five years. At the end of five years, this machine can be sold
for $100,000.

(a) Graph the sensitivity of the PW of the proposed investment with respect to changes in the
following factors when the MARR is 15%:
- investment cost of new machine
- cost of rework
- product demand
- life of product demand (e.g., 10,000,000 units for 3, 4, 5, 6 years)
- salvage value of new machine

(b) To which factor is the decision most sensitive?

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