Sensitivity Analysis

 Sensitivity analysis determines how a measure of worth PW, AW, FW, IROR,
is altered when one or more parameters (MARR , first cost, annual maintenance
cost , salvage value, estimated life, and materials costs) vary over a selected
range of values.
 To perform sensitivity analysis, follows the following steps:

- Identify which parameter (s) of interest might vary from the most likely
estimated value.
- Identify the range of values change for this/these parameter (s).
- Identify the economic decision criterion (e.g., NPW, , AW, FW, IROR. etc.)
that will be used to perform the economic analysis.
- Compute the results for each parameter, using the measure of worth as
a basis.
- To better interpret the sensitivity, graphically display the parameter versus the
measure of worth.
Example (1):
The purchasing cost of a given equipment is $ 90,000 and its income for the
first year is $ 30,000 decreasing annually by $ 3,000. If the interest rate changes
between 10% and 25% and the equipment age ranges from 8 to 12 years. It is
required to study the sensitivity of the decision considering the effect of the
change of the interest rate and the age using the AW method. Neglect the
equipment salvage value.
Solution:
The cash flow could be represented as follows:
The sensitivity of the decision to the change is the interest rate:
In this case, let’s assume that the average age of the equipment is 10 years.
Then, calculate the AW at different values for i, (10, 15, 20 and 25%)
i = 10%
AW = -90000 (A/P, 10%, 10) + 30000 – 3000(A/G, 10%, 10)
= -90000 (0.16275) + 30000 – 3000 (3.7255) = $ 4176
Similarly, The AW could be calculated at different i as follows:
i = 15% AW = $ 1919
i = 20% AW = - $ 687
i = 25% AW = - $ 3600
the change of the interest rate changes the values of the AW from being positive
to negative. Accordingly, the decision changes with the change of the i values.

The sensitivity of the decision to the change is the equipment age:

In this case, let’s assume that the average interest rate is 15%.
Then, calculate the AW at different age values (8, 10 and 12 years).
n=8 AW = $ 1599.6
n = 10 AW = $ 1917.9
n= 12 AW = $ 1775.77
the decision does not affected with the change of the equipment life.
Example (2):
A company must decide whether to install a new type of equipment or ·not.
A pilot test reveals that the new equipment is effective, but the maintenance
costs for it may be high.
The amount of revenue expected form the new design depends on the quantity of
the product. The engineering department has provided the following estimates:
First Cost = $ 180,000
Useful life (N) = 4 years
Annual maintenance cost (M) = $ 40,000
Annual revenue (R) = $ 100,000
There is no salvage value and the company uses an MARR of 12%.
Assuming the useful life, maintenance cost, and revenues may vary as much as
±50 percent.
study the sensitivity of the decision using the PW method.
Solution:
The cash flow could be represented as follows:
 Breakeven Analysis
- Breakeven analysis finds the value of a parameter that makes two elements
equal.
- A fundamental of accounting is that all revenues and costs must be accounted
for and the difference between the revenues and costs is the profit, or loss, of
the business.
- Costs, which may be linear or nonlinear, usually include two components:
fixed and variable.
Examples of fixed costs include rent, salaries and insurance.
Examples of variable costs include labor, materials, equipments, indirect
costs, contractors, advertisement, and warranty.
- Fixed costs are reduced through improved equipment, information systems,
and workforce utilization;
-Variable costs change with production level, workforce size, and other
parameters. It is usually possible to decrease variable costs through better
product design, manufacturing efficiency, improved quality and safety, and
higher sales volume.

Profit = revenue - total cost

Example (3)
A factory produces a certain units. Each unit sells for $ 15 and costs $ 5. The
annual maintenance and operation costs are $ 75,000. Calculate the number of
units that should be produced to justify keep this business running.
Solution:
Let’s assume that number of units produced is X. Accordingly, the cost of units
equal 5Xand the annual revenue is 15X.
The total annual cost = 75000 + 5X
At breakeven point when total costs equal total revenue:
75000 + 5X= 15X
Then, X = number of units produced = 7500 units
The investment in this project would be acceptable when the production
increases than 7500 units per year, otherwise it is rejected.
Example (4):
There are two proposals for a new project. The information related to both
alternatives is shown in the following table. If the interest rate is 10%, find:
a. The volume of production that justifies the purchase of alternative A.
b. If the production of this project is 2000 ton annually, which alternative do
you recommend for purchasing?

Solution:
First, let’s calculate the AW for both alternatives:
AWA = -230000 (A/P, 10%, 10) - 35000 + 40000(A/F, 10%, 10) = - 69,922
AWB = - 80000 (A/P, 10%, 5) -15000 = - 36,103
Assume that x represents the annual production (ton/year), the direct costs for
both alternatives could be represented as:
Direct cost A = 15x
Direct cost B = 40x
Accordingly, the total cost for both alternatives are:
Total cost A = 69922 + 15x
Total cost B = 36103 + 40x
By equating the total cost for both alternatives, then, the breakeven point
equals; x = 1353 ton/year

a. Thus means that, if the annual production is more than 1353 ton, then
alternative A is better.

b. In case of the required production is 2000, then alternative A is better. As

shown in the figure below, if the production is less than 1353 ton annually
then it is better to use alternative B. While alternative A is better in case
of production is more than 1353 ton annually.
Example (5):
It is required to calculate the breakeven point for the three options listed in the
table below. Which alternative do you recommend?

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