Equivalent Annual Cost

The annual cost incurred by the investor for owning and operating an asset till the asset becomes a scrap is called equivalent annual cost of the asset (EAC). Equivalent annual cost is used to forecast the annual capital budgeting. It helps the investor to choose out the best asset from the pool of asset that is available.

Equivalent annual cost is calculated using the formula,

EAC=X*r/ (1-(1+ r) ^-n)

Where X is the asset price, r is the discount rate and n is the number of periods.

The advantages of calculating the equivalent annual cost are,

• It can be used to compare two or more asset having different life span. NPV method is not useful if the asset has a different life span, and hence this method is used for the same.
• It is also useful to determine the cost price for the old machine by including depreciation and other such factors while calculating the cost.
• It is useful for comparing the cost of old machine with the new machine.
• It is also useful in comparing the cost of two machines that perform same work but function altogether different.
• It is useful in forecasting the life span of the machine.
• It is useful to make decision between two asset of  which one is expensive but have very less maintenance cost and the second one have  is cheap but have a very high maintenance cost.

It must be noted that the equivalent annual cost of an asset increases as the time period increases due to the increase in maintenance cost of the asset. The asset is usually used until it is felt by the owner that it can be used efficiently and it acts as an asset to the company. After the above period the asset are usually sold or dumped.

Equivalent annual cost plays an important role in deciding whether to continue usage of the asset or sell it. If the EAC exceeds the desired operating efficiency level then the owner might decide upon to sell it or dump it.