How to Calculate the Equivalent Annual Cost
When you calculate the equivalent annual cost, or EAC, you're figuring out what you'll spend per year to own and maintain an asset over its useful life. It's an important tool in the capital budgeting process because it allows you to compare the cost effectiveness of assets that have different life spans.
To calculate equivalent annual cost, you first need to average the cost over years of useful life. Useful life is defined by the length of time an asset can be reasonably used to be of benefit to a business. Divide the purchase price plus maintenance and operating costs by the number of years of useful life to get the equivalent annual cost.
Suppose you need to purchase a new piece of equipment for your business. Machine A costs $15,000 and has a useful life of eight years. Machine B costs $18,000 and can be expected to last 10 years.
Add the cost of operation (such as fuel costs) to the cost of routine maintenance and repair. In this case, assume that machine A uses $1,000 worth of electricity per year. Machine B is a diesel-powered machine that costs $850 a year to run. Both machines require a yearly cleaning and maintenance check that costs $300.
- Purchase price: $15,000
- Cost to run: $1,000/year x 8 years = $8,000
- Cost to maintain: $300/year x 8 years = $2,400
$15,000 + $8,000 + $2,400 = $25,400
$25,400/8 years = $3,175, the equivalent annual cost of machine A
- Purchase price: $18,000
- Cost to run: $850/year x 10 years = $8,500
- Cost to maintain: $300/year x 10 years = $3,000
$18,000 + $8,500 + $3,000 = $29,500
$29,500/10 years = $2,950, the equivalent annual cost of machine B
As you can see from this example, machine B costs more initially. However, when you calculate equivalent annual cost, machine B costs less. You can use this method to calculate the equivalent annual cash flow from each machine in your business.
Two users may not have the same useful life estimates for items even when those items are identical. For example, consider a truck that's driven 100,000 miles per year and frequently encounters icy roads treated with salt. The useful life of the truck is going to be less than that of a vehicle the same age, make and model that's only driven 60,000 miles a year in a mild climate.
Useful life may vary for other reasons, including the following:
- Technological improvement: More memory for a desktop computer is one example. The useful life is extended because it can meet the needs of a business for a longer period of time.
- Changes in the law: New codes and regulations may render equipment obsolete. For instance, cribs at a child care center may have to be replaced to meet new safety codes.
- Economic changes: A downturn in the overall economy or within the business may mean that equipment purchases or upgrades have to be postponed.
The IRS's Internal Revenue Manual 1.35.6 contains a table that classifies items according to estimated useful life. You can use IRM figures when calculating equivalent annual cost. Some categories and useful life estimates from the manual include:
- Mainframe computer systems and servers: seven years
- Desktops and laptops: three years
- Telecommunications equipment: seven years
- Non-IT equipment: 10 years
- Furniture and fixtures: eight years
- Internal-use software: case by case basis
- Software licenses: three to seven years
- Laboratory or forensic equipment: 10 years
- Vehicles: five years