Equipment purchases: Putting a number on it
By Pamela C. Moulton and Yifei Mao
When hospitality managers price out potential new or replacement equipment, they generally can choose among several different models that could do the job. Sometimes a particular model is a standout, but more often the comparison involves each model’s up-front costs, ongoing running costs, and expected useful life, as well as each machine’s specific features. However, we suggest that managers also include the opportunity cost of buying one machine over another. To help clarify this decision, we offer a calculation of the time value of money in the form of a discount rate. This discount-rate figure represents the firm’s cost of capital or its required return on investment. Effectively, the discount rate represents the opportunity cost of choosing one machine over another.
To facilitate this analysis, we developed the equivalent annual cost calculation (EAC), which involves a straightforward spreadsheet tool that we have made available through the Cornell Center for Hospitality Research (chr.cornell.edu). Our goal was to create a spreadsheet-based application that can be used to quickly compare the economic value of various equipment alternatives. Starting with the expectation of a machine’s life, one can plug in the annual operating cost, the acquisition cost (spread out over expected life), and the discount rate. The result will be a dollars-and-cents estimate of each machine’s EAC.
In many cases, a manager will simple choose the machine with the lowest EAC. But there may be other external considerations. For example, a particular machine might have a higher EAC (and thus be more expensive), but it also might be quieter. With the EAC figures in hand, a manager would be able to determine whether the quiet operation is worth the extra cost. Along the same line, a particular fryer might have a higher EAC, but it also might produce better fries. In that case, a manager could determine whether a higher price point might justify a slightly higher production cost.
We also note that the EAC calculation can support a firm’s equipment-replacement strategy. Managers may want to choose the equipment with a faster replacement cycle so that they can move up to better technology more quickly. In that case, the EAC calculation would reflect the value of being able to upgrade their equipment.
Enhancing Equipment Investment Decisions Using Equivalent Annual Cost, by Pamela C. Moulton and Yifei Mao; CHR Hospitality Tool, Volume 19, Number 3. Available at no charge from the Cornell Center for Hospitality Research.