Equivalent Annual Cost
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 lifecycle. 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 EAC originated in the fields of capital budgeting and financial management. It aims to help companies make more scientific comparisons of the cost-effectiveness of different assets when making long-term investment decisions. As companies increasingly focus on capital efficiency and return on investment, EAC has become a commonly used analytical tool.
Categories and Characteristics: EAC mainly falls into the following categories:
- Fixed Asset EAC: Used to evaluate the annual cost of fixed assets such as machinery, equipment, and buildings.
- Current Asset EAC: Used to evaluate the annual cost of current assets such as inventory and accounts receivable.
- Comprehensiveness: Covers various costs including purchase, operation, and maintenance of the asset.
- Comparability: By converting the costs of assets with different lifespans into annual costs, it makes different assets comparable.
Specific Cases:
- Case 1: A company needs to choose between two machines. Machine A has a lifespan of 5 years and a total cost of $500,000; Machine B has a lifespan of 10 years and a total cost of $800,000. By calculating the EAC, the company finds that Machine A's EAC is $100,000/year, while Machine B's EAC is $80,000/year, making Machine B the more economical choice.
- Case 2: A company plans to purchase a new truck with a lifespan of 8 years and a total cost of $400,000. By calculating the EAC, the company finds that the truck's EAC is $50,000/year. The company can compare this data with the EAC of other transportation options to make the optimal decision.
Common Questions:
- How is EAC calculated? The formula for EAC is: EAC = Total Cost / Asset Lifespan.
- Why is EAC important? EAC helps companies make more scientific comparisons in capital budgeting decisions, especially when asset lifespans differ.
- Common Misconceptions: Some companies may overlook operating and maintenance costs and focus only on purchase costs, leading to inaccurate EAC calculations.
