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9 Profitability and
Engineering Economics
4. Capitalized costs 5. Payback period
Peters and Timmerhaus1 present an excellent discussion of all these methods.
Figure 9.1 illustrates the well-known concept in balancing fixed capital charges for a fabric filter against operating cost to find the minimum of the sum of the two.
9.2.2 INCREMENTAL RATEOF RETURNON INVESTMENTS ASA MEASUREOF PROFITABILITY
One of the more simple methods of profitability analysis is based on rate of return and the incremental rate of return. It is assumed that there is a base case design that will provide the desired pollution control and meet the profitability objective set as the rate of return. As pointed out above, in some cases, a pollution control apparatus must be built even if it does not meet the profitability objective of a company. The base case should represent a system operating under nearly optimum conditions. All other designs are then compared against this base case. Let us define the following terms:
ROI is the percent return on investment
IROI is the incremental percent return on investment
P is the annual profit from investment (income − expenses), or incremental profit or annual savings
I is the total investment or incremental investment ROI or IROI= P
I (9.1)
The process is as follows:
• Set the base case—the alternative case that meets ROI at the least total initial cost.
Total cost
Operating cost
Annualized costs
Fixed capital
Total fabric area (in. ft2)
FIGURE 9.1 Optimization of cost for a typical fabric filter or baghouse.
• Check IROI with the base case compared to the alternative case that meets the ROI and has the second lowest initial cost.
• Accept the second alternative as the base case if IROI is met.
• With this new base case, check ROI compared to the alternative that has the third lowest initial cost and then check the IROI. Set new base case if IROI is met.
• Repeat process with all alternatives and select one that meets the ROI and the IROI by balancing the initial cost the ROI and the IROI.
9.2.2.1 Example of IROI Comparing Two Cases
A company needs to purchase a cyclone to control dust from one of its foundry operations. The company expects to receive 12% ROI before taxes. The company is considering two offers. One manufacturer proposes a carbon steel cyclone to do the job; the other manufacturer proposes a stainless steel cyclone that costs more but has a longer service life and lower maintenance and power cost. Data on the two cyclones are as follows:
Carbon steel cyclone Installed cost = $40,000 Service life = five years Salvage value = 0 Stainless steel cyclone
Installed cost = $40,000 Service life = five years Salvage value = 0
Lowered maintenance and power costs = $1100 Which cyclone should the company purchase?
Straight-line depreciation will be used. Other methods of depreciation will be discussed later in Section 9.3.
The decision will be made based on an IROI calculation. The incremental invest- ment is the difference between the costs of the two cyclones.
Incremental investment = $60,000 − $40,000 = $20,000 Depreciation
Carbon steel cyclone= $ , = year
$ /
40 000
5 8000
Depreciation
Stainless steel cyclone= $ , = year
$ /
60 000
10 6000
Annual savings with purchase of stainless steel cyclone
Savings=$8000−$6000+$1100=$3100/ year Incremental return on investment = IROI
IROI Amount of savings Cost difference
= = $ × =
$ , 3100
20 000 100 115 5. % This is greater than the required 12.0% return.
Therefore, the company should purchase the stainless steel cyclone.
9.2.2.2 Example of IROI with Four Cases
This example requires establishing a base case and comparing the other cases to the base case. The cases are lined up with the least expenses case as the first item.
The rest of the cases are then put in order of increasing cost. The least expensive case is taken as the base case and it is determined if it meets the ROI. If it does meet the ROI, then continue on to examine the second case, then the third case and so forth.
If any case does not meet the ROI, it must be discarded. After every case is reviewed and all cases that meet the ROI are established, the basic case is then established. The IROI of the next accepted case is then determined, and if it meets the ROI, which was originally set, it is then accepted as the base case and the first case is discarded. The process then continues with the third case and the calculation is continued until all originally accepted cases are reviewed.
As in the following example, if there are only a few number of cases, if the IROI in the first calculation is acceptable, it can then be set as the base case and proceed to compare the third case to it. Then just continue until all cases are reviewed. An example follows.
A chemical plant must install a new control system. Four alternatives A, B, C, and D are being considered. Each alternative will result in a reduction of emissions from the current 2000 T/year. The emissions fee is $35/T, and, therefore, the new equipment will reduce the annual emission fee. Furthermore, two of the processes will result in saving product for which an additional cost saving can be included.
The company is demanding a 15% return on any investment. Which of the processes should be selected?
Control System Design A B C D
Installed cost ($) 100,000 150,000 200,000 250,000 Operating cost ($) 5,000 10,000 15,000 10,000 Fixed charges (%)
Initial cost ($/year)
10 10 10 10
10,000 15,000 20,000 25,000
Emission reduction 900 T 1200 T 1200 T 1500 T
($) 31,500 42,000 42,000 52,500
Product saved ($/year) 0 6,000 8,000 21,000
Design A serves as the base case.
A. Annual savings= +0 31 500 5 000 10 000, − , − , =$16 500, ROI= 16,500 × =
100,000 100 16.5%
Meets ROI criteria.
B. Annual savings=6 000, +42 000 10 000 15 000, − , − , =$23 000, ROI= 23 000 × =
150 000, 100 15 3
, . %
This ROI is acceptable.
IROI=23 000× = 50 000, 100 46 0
, . %
This IROI is acceptable, therefore, this becomes the base case.
C. Annual savings=8 000, +42 000 15 000 20 000, − , − , =$15 000, ROI= 15 000 × =
200 000, 100 7 5
, . %
This is an unacceptable ROI. Design C must be rejected. Design D is now compared to Design B, which is the current base case.
D. Annual savings=21 000, +52 500 10 000 25 000, − , − , =$38 500, ROI= 38 500 × =
250 000, 100 15 4
, . %
This is an acceptable ROI.
IROI 38,500
100,000 100 38.5%
= × =
In this case, Design B produces nearly the same ROI and results in a better IROI.
Select Design B and get a greater return on the incremental money.