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Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Engineering Economy

Chapter 11: Breakeven and

Sensitivity Analysis

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The objective of Chapter 11 is to

illustrate breakeven and

sensitivity methods for

investigating variability in

outcomes of engineering projects.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

To this point we have assumed a high

degree of confidence in estimated values.

• The degree of confidence is sometimes called

assumed certainty, and decisions made on the

basis of this kind of analysis are called decisions

under certainty.

• In virtually all situations, ultimate economic

results are unknown.

• Breakeven and sensitivity analysis are used to help

understand how our decision might be affected if

our original estimates are incorrect.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The breakeven point is the value of a key

factor at which we are indifferent between

two alternatives (one may be “do nothing”).

The breakeven point is the value of y where

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Common factors to consider for

breakeven analysis.

• annual revenue and expenses

• rate of return

• market (or salvage) value

• equipment life

• capacity utilization

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Should Jim sell his gas-guzzler?

Jim's 1998 minivan is quite functional, but it

only averages 20 miles per gallon (mpg). He has

found a somewhat newer vehicle (roughly the

same functionality) that averages 26 mpg. He can

sell his current minivan for $2800 and purchase

the newer vehicle for $4,000. Assume a cost of

gasoline $4.00 per gallon How many miles per

year must Jim drive if he wants to recover his

investment in three years? Assume an interest

rate of 6%, zero salvage value for either vehicle

after three years, and identical maintenance cost.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Gas-guzzler solution

Current minivan

New vehicle

Equating these, and solving for x, we find

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The “one time good deal” Cash-For-Clunkers program offered by the federal government proved a temporary boon

for car dealers. In addition to this program, dealers were

eager to add their own incentives. Bill Mitselfik was

considering two different deals he could make for his new

car. He can finance the purchase price, $25,000, entirely

through the dealer at a 1.9% APR (compounded monthly)

for 5 years, with payments monthly. Alternatively, the

dealer will give Bill a cash rebate and provide financing at

9% APR (compounded monthly) for 5 years, with monthly

payments. What is the value of the rebate for which Bill

would be indifferent between the two financing options?

Pause and solve

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The “one time good deal” Cash-For-Clunkers program offered by the federal government proved a temporary boon

for car dealers. In addition to this program, dealers were

eager to add their own incentives. Bill Mitselfik was

considering two different deals he could make for his new

car. He can finance the purchase price, $25,000, entirely

through the dealer at a 1.9% APR (compounded monthly)

for 5 years, with payments monthly. Alternatively, the

dealer will give Bill a cash rebate and provide financing at

9% APR (compounded monthly) for 5 years, with monthly

payments. What is the value of the rebate for which Bill

would be indifferent between the two financing options?

Solution

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

We use sensitivity analysis to see what

happens to project profitability when the

estimated value of study factors are

changed.

• What if expenses are 10% higher than expected—

is the project profitable?

• What if sales revenue is 15% lower than expected?

• What change in either expenses or revenues will

cause the project to be unprofitable (decision

reversal)?

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Reconsidering Jim's gas-guzzler.

Considering that Jim drives about 10,000 miles per

year, our previous analysis would indicate that he

should purchase the vehicle that gets better mileage.

However, what if gas prices drop by 10%? Should Jim

still sell his gas-guzzling minivan?

So, if gas prices drop by 10%, Jim should keep his minivan.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Acme Delivery is considering a proposal for new package

tracking technology. The system has an estimated initial cost of

$1.9 million and will require upgrades and maintenance of

$140,000 each year. Acme estimates that improved tracking will

save approximately $680,000 per year, after system operating

expenses. Acme has a MARR of 15% per year, and the study

period for this technology is 6 years, after which time Acme

expects the entire system will need to be replaced. The PW of

this proposal is

PW(15%) = -$1,900,000+($680,000 - $140,000)(P/A,15%,6) =

$143,630

Determine how sensitive the decision to invest in the system is to

the estimates of initial investment cost and annual savings.

Pause and solve

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Spreadsheets are very useful in

performing sensitivity analysis.

• Formulas easily reflect changes in parameter

values.

• Tables and plots can provide quick answers and

visual cues to the effect of changes.

• A spider plot can be especially useful in sensitivity

studies.

• It can be useful to examine more than one

alternative on a plot, or to examine sensitivity of

incremental cash flows.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

[Note that the steeper the curve, the more sensitive is

the PW to the factor.]

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Changing the value of more than one

factor at a time.

• To this point we have only looked at changes in

one factor at a time.

• In reality, each factor considered can change, so it

is useful to look at the effect of simultaneous

changes in factors of interest.

• One way to accomplish this is to use the

Optimistic-Most Likely-Pessimistic (O-ML-P)

technique.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Optimistic-Most Likely-Pessimistic

• Establish optimistic (the most favorable), most likely, and

pessimistic (the least favorable) estimates for each factor.

• The optimistic condition, which should occur about 1 time

out of twenty, is when all factors are at their optimistic

levels. Similarly for pessimistic condition.

• The most likely condition should occur roughly 18 times

out of 20.

• Perform EW calculations under each condition for insight

into the sensitivity of the solution.

• The results can be seen on a spider plot for further insight.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Consider investment in a new crane.

Assume a MARR of 8%.

Estimation Condition

Optimistic (O) Most Likely (M) Pessimistic (P)

Investment, I $240,000 $270,000 $340,000

Useful life, N 10 yr 8 yr 5 yr

Market value, MV $20,000 $15,000 $8,000

Annual revenues, R $100,000 $80,000 $50,000

Annual expenses, E $10,000 $15,000 $20,000

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Considering O-ML-P for I and R (fix E,

MV, and life at their ML levels). Value

in each cell is the PW for the project.

Investment, I

Revenues, R Optimistic (O) Most Likely (M) Pessimistic (P)

Optimistic, (O) $256,568 $226,568 $156,568

Most Likely, (M) $141,636 $111,636 $41,636

Pessimistic, (P) -$30,764 -$60,764 -$130,764

This suggests that perhaps some additional effort should be

place on getting refined estimates of revenues. Of course,

the complete study needs to consider the other factors.