Revenue vs Cost Dominated Methods, Value Engineering and Time Value of Money
(A) Differentiate Revenue Dominated and Cost Dominated Methods of Cash Flow
| Revenue Dominated Method | Cost Dominated Method |
|---|---|
| It is used when the revenue or income generated by alternatives is the main factor. | It is used when the cost of alternatives is the main factor. |
| The alternative giving higher revenue or economic benefit is generally preferred. | The alternative having lower equivalent cost is generally preferred. |
| It is suitable when alternatives have different revenues or benefits. | It is suitable when alternatives provide nearly the same revenue or service. |
In short: Revenue-dominated: higher revenue is better.
Cost-dominated: lower cost is better.
(B) Explain Various Steps Involved in Value Engineering Procedure
Value Engineering is a systematic method of improving the value of a product by maintaining its required function while reducing unnecessary cost. The procedure consists of the following stages.
1) Information Phase: Collect information about the product, customer requirements, functions, cost and performance.
2) Function Phase: Identify and define the functions which the product or component must perform.
3) Creative Phase: Generate different alternative ways of achieving the required functions.
4) Evaluation Phase: Compare the alternatives on the basis of cost, quality, reliability, safety and technical feasibility.
5) Development Phase: Develop the selected alternative into a practical design or manufacturing process.
6) Implementation Phase: Present, approve and implement the selected improvement after technical verification.
7) Follow-up Phase: Check whether the expected function, performance and economic benefits have been achieved.
Example: An expensive machine cover can be replaced by a cheaper material or manufacturing method if it provides the same required protection.
Explain Time Value of Money with Example
Time Value of Money (TVM) means that the value of money changes with time. Money available today is more valuable than the same amount received in the future, because present money can be invested and can earn interest. The important terms are present worth, future worth, interest rate and number of periods.
For compound interest:
F = P(1+i)n
Where,
P = Present worth
F = Future worth
i = Interest rate per period
n = Number of periods
Example: If ₹10,000 is invested at 10% interest for 2 years,
F = 10,000(1+0.10)2
F = ₹12,100
Thus, ₹10,000 today becomes ₹12,100 after 2 years.
Coffee Shop vs Ice Cream Shop
Given:
| Particular | Coffee Shop | Ice Cream Shop |
|---|---|---|
| First Cost | ₹2,50,000 | ₹3,50,000 |
| Annual Property Tax | ₹80,000 | ₹1,50,000 |
| Annual Income | ₹8,00,000 | ₹9,80,000 |
| Life | 20 years | 20 years |
| Salvage Value | 0 | 0 |
Step 1: Calculate Annual Net Income
Coffee Shop:
Net Income = Annual Income – Property Tax = 8,00,000 – 80,000 = ₹7,20,000
Ice Cream Shop:
Net Income = 9,80,000 – 1,50,000 = ₹8,30,000
Step 2: Calculate Rate of Return
Coffee Shop:
Rate of Return = 7,20,000 / 2,50,000 x 100 = 288%
Ice Cream Shop:
Rate of Return = 8,30,000 / 3,50,000 x 100 = 237.14%
Decision:
Coffee Shop gives a higher return: 288% > 237.14%
Therefore, the Coffee Shop should be selected.
Selection of Elevator Bid
Given: i = 15%, n = 15 years
Equivalent Uniform Annual Cost:
EUAC = P(A/P, i, n) + A
For 15% interest and 15 years,
(A/P, 15%, 15) ≈ 0.1710
1. Almico Company
Initial cost: P = ₹4,50,000
Annual O&M cost: A = ₹27,000
Capital recovery = 4,50,000 x 0.1710 = ₹76,950
Therefore, EUAC = 76,950 + 27,000 = ₹1,03,950/year
2. Bevel Company
Initial cost: P = ₹5,40,000
Annual O&M cost: A = ₹28,500
Capital recovery = 5,40,000 x 0.1710 = ₹92,340
Therefore, EUAC = 92,340 + 28,500 = ₹1,20,840/year
Decision
| Company | Equivalent Annual Cost |
|---|---|
| Almico | ₹1,03,950/year |
| Bevel | ₹1,20,840/year |
Since the Almico Company has the lower equivalent annual cost, its bid should be accepted.
Therefore, accept Almico Company’s bid.