IE 347 FALL 2022 / 2023

December 19 - 21, 2022 - Week 12

 Announcements

No recitation but office hours

Quiz 2 – December 23, Friday, 1:40 p.m.

Quiz 3 – January 4 Wednesday, 5:40 p.m.

 IE 347 Week Topics

BENEFIT / COST ANALYSIS

INDEPENDENT ALTERNATİVES

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Benefit /Cost Analysis – Two Mutually Exclusive Alternatives

•Conventional B/C – Alt 1 = 10/2 = 5

•Conventional B/C – Alt 2 = 12/3 = 4
•Both B/C values are > 1
•Which one would you select?

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Benefit /Cost Analysis – Two Mutually Exclusive Alternatives

•Conventional B/C – New = 100/50

•Conventional B/C – Upgrade = 195/100

Incremental B/C of Upgrade over New = 95 / 50 = 1.9

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 Benefit /Cost Analysis – Dominated Alternatives

At least two non dominated mutually exclusive alternatives

Two alternatives
Multiple alternatives

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 B /C Analysis – Two Mutually Exclusive Alternatives

•Requires a proper ordering of the alternatives

•Order alternatives on the basis of Total Equivalent Costs

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Benefit/Cost Analysis – Two Mutually Exclusive Alternatives

Incremental B/C analysis

1.Determine the total equivalent costs for both alternatives

2. Order the alternatives by the total equivalent cost, smaller first.

Calculate the incremental cost (D C) for the larger-cost alternative over the
smaller-cost alternative.

3. Calculate the total equivalent benefits and disbenefits for both alternatives.
Calculate incremental net benefits (D(B − D)) for the larger-cost alternative
over the smaller-cost alternative.

4 Calculate the incremental B/C ratio

D(B − D)/D C

5 Select the higher-cost alternative if D(B − D)/D C > 1

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 B /C Analysis – Two Mutually Exclusive Alternatives
The construction department of a ministry has received designs for the new
municipal hospital from two architectural consultants.

The financial estimates are given as:

Design A Design B
Construction cost $ 1,000,000 1,500,000
Building maintenance cost
$ per year 35,000 55,000
Patient usage cost
$ per year 450,000 200,000

The discount rate is 5%, and the life of the building is estimated as 30 years.
Use conventional B/C analysis to select design A or B.

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 B /C Analysis – Multiple Mutually Exclusive Alternatives

1.Determine the total equivalent costs for all alternatives

2. Order the alternatives by the total equivalent cost, smallest first.

Calculate the incremental cost (D C) for
the second smallest-cost alternative (challenger) over
the smallest-cost alternative (defender).

3. Calculate the total equivalent benefits and disbenefits for defender and challenger.
Calculate incremental net benefits (D(B − D)) for the challenger over the defender.

4. Calculate the incremental B/C ratio

D B/ C = D(B − D)/D C

5. If D B/C > 1 eliminate the defender and challenger becomes defender

Otherwise eliminate the challenger and keep the defender
Stop if all alternatives are evaluated, defender is the selected choice
Let the next smallest-cost alternative be challenger
Go to Step 3

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 B / C Analysis – Multiple Mutually Exclusive Alternatives

A municipal is seeking a developer that will place a major water park in the city
area. An initial investment cost and annual operating costs will be given to the
developers depending on their investment size. The developers will get
reductions in property tax for 8 years. Each proposal includes a different
entrance fee that residents of the county will pay when using the park. The fees
will be effective for 8 years.

Proposal 1 Proposal 2 Proposal 3

Initial Cost, $ $250,000 $350,000 500,000
Operating Cost, $/year 25,000 35,000 50,000
Entrance Fees, $ / year 500,000 450,000 425,000
Tax Reduction, $ /year 310,000 320,000 320,000

The discount rate is 7 %. Which proposal should be selected under a study

period of 8 years?

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 Alternatives

Mutually Exclusive Alternatives

Independent Alternatives

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 Independent Alternatives

Selection of one project in the set does not impact acceptance or

rejection of any other project

Due to the budget contraint all promising projects cannot accepted together.

The available budget should be distributed among promising projects

to maximize the return on investments using a measure of worth,
usually the PW value.

The associated problem is refered to as capital budgeting (knapsack)

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 Capital Budgeting Problem

Other Dependencies

Projects A and B are mutually exclusive

Project C can only be accepted if project D is accepted

Projects A and C are strict compliments

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 Capital Budgeting Problem

Project Lives
Equal Life Projects

Unequal Life Projects

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 Capital Budgeting Problem

Unequal Life Projects

There is no life cycle of a project beyond its estimated life

LCM life assumption is not valid in capital rationing

But there is an implied reinvestment assumption:

All positive net cash flow of a project are reinvested
at the MARR from the time they are realized until
the end of the longest-lived project.

Therefore, the use of LCM of lives or longest-lived life, nL is not

necessary, each project’s PW is calculated over its own life nj

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 Solution Procedures

Mathematical Program

Project Bundling

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 Mathematical Model

Parameter
NCFkt : net cash flow of project k at time t

Decision Variable
xk : project k is selected or not, k = 1,.., m

Objective Function
Maximize sum of PW s of independent projects

Constraints
Sum of initial investments cannot exceed budget limit b
A project is completely selected or not

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 Mathematical Model

Project Initial Annual Inflows

k Investment Life NCFkt

A $-8,000 6 $3,870
B -15,000 9 2,930
C -8,000 5 2,680
D -8,000 4 2,540

MARR = 15% per year

b = $20, 000

Formulate the problem of selecting from set of independent projects as an IP

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 Complexity

NP-hard in the ordinary sense

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 Selection under Budget Limitation

Additional Constraints

Projects A and B are mutually exclusive

Project C can only be accepted if project D is accepted

Projects E and F are strict compliments

Time dependent budget limitations

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 Project Bundles

bundle = collection of independent projects

All possible mutually exclusive bundles

Do-nothing project
one project at a time
two projects at a time
...
all n projects together

Total number of mutually exclusive bundles

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 Project Bundles

Initial Annual Cash Flows

Project k Investment n NCFkt PWk
A $-8,000 6 $3,870 $6,646
B -15,000 9 2,930 -1,019
C -8,000 5 2,680 984
D -8,000 4 2,540 -748

MARR = 15% per year

b = $20, 000

Define all mutually exclusive bundles

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 Project Bundles

Project Initial Investment Annual Cash Flows

k NCFk0 n NCFkt PWk
A $-8,000 6 $3,870 $6,646
B -15,000 9 2,930 -1,019
C - 8,000 5 2,680 984
D - 8,000 4 2,540 -748

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 Project Bundles

m = 4 projects 24 – 1 = 15 bundles

m = 6 projects 26 – 1 = 64 – 1 = 63 bundles

m = 30 projects 230 -1 = 1,073,741,823 bundles

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 Project Bundles vs Mathematical Model

• Small problems – Project Bundles

• Large problems – Mathematical Model

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