# Equivalent Annual Cost - EAC

## What is the 'Equivalent Annual Cost - EAC'

The equivalent annual cost (EAC) is the annual cost of owning, operating and maintaining an asset over its entire life. EAC is often used by firms for capital budgeting decisions. The equivalent annual cost methodology allows a company to compare the cost effectiveness of various assets that have unequal lifespans.

Next Up

## BREAKING DOWN 'Equivalent Annual Cost - EAC'

In capital budgeting, EAC is used for a variety of purposes. Most often, EAC is used to analyze two or more possible projects with different lifespans and where costs are the most relevant variable. Other typical uses of EAC include calculating the optimal life of an asset, determining if leasing or purchasing an asset is the better option, determining the magnitude of which maintenance costs will impact an asset, determining the necessary cost savings to support purchasing a new asset, or to determine the cost of keeping existing equipment.

## Calculating the Equivalent Annual Cost and Example

The formula for calculating the EAC is straightforward. It is equal to net present value (NPV) divided by A(t,r), which is the present value annuity factor, taking into account r, the cost of capital, and t, the number of years in question. The resulting EAC allows managers to compare NPVs of differing projects over different periods, to accurately determine the best option.

The annuity factor A(t,r) is calculated as follows:

A(t,r) = (1 - (1 / (1 + r) ^ t)) / r

As an example, consider two alternative investments in machinery equipment. Machine A has an initial capital outlay of \$105,000. It has an expected lifespan of three years and an annual maintenance expense of \$11,000. Machine B has an initial capital outlay of \$175,000, an expected lifespan of five years, and an annual maintenance expense of \$8,500. The cost of capital for the firm making the decision is 5%.

First, the A(t,r) of each project must be calculated. These calculations would be as follows:

Machine A A(t,r) = (1 - (1 / (1 + 5%) ^ 3)) / 5% = 2.72

Machine B A(t,r) = (1 - (1 / (1 + 5%) ^ 5)) / 5% = 4.33

Next, the initial costs must be divided by the A(t,r) and the annual maintenance cost added in. The resulting calculation is the EAC.

EAC Machine A = \$105,000 / 2.72 + \$11,000 = \$49,557

EAC Machine B = \$175,000 / 4.33 + \$8,500 = \$48,921

By standardizing the annual cost, a manager in charge of a capital budgeting decision where cost is the only issue would select Machine B, because it has an EAC that is \$636 lower than Machine A.

RELATED TERMS
1. ### Annualized Total Return

The average amount of money earned by an investment each year ...
2. ### Cost Accounting

A type of accounting process that aims to capture a company's ...
3. ### Total Project Approach

A way to compare net income or contribution margin results by ...
4. ### Applied Cost

A term used in cost accounting to denote the cost assigned to ...
5. ### Cost Of Capital

The required return necessary to make a capital budgeting project, ...
6. ### Replacement Cost

The cost to replace the assets of a company or a property of ...
Related Articles
1. Investing

### What is Equivalent Annual Cost?

The equivalent annual cost, or EAC, represents the annual cost of owning an asset over its entire lifespan.
2. Investing

### Explaining Cost Of Capital

Cost of capital is the cost of funds used to finance a business.
3. Managing Wealth

### What Determines Your Cost Basis?

In any transaction between a buyer and seller, the initial price paid in an exchange for a product or service will qualify as the cost basis. When it comes to securities and related financial ...
4. Investing

### Explaining Capitalized Cost

A capitalized cost is an expense associated with a fixed asset that is added to the basis of that asset and expensed over its depreciable life.
5. Markets

### Understanding Marginal Cost of Production

Marginal cost of production is an economics term that refers to the change in production costs resulting from producing one more unit.
6. Investing

### What's Capitalization?

Capitalization has different meanings depending on the context.

### What Are The Different Types Of Costs In Cost Accounting?

Cost accounting measures several different types of costs associated with a company’s production processes.
8. Investing

### Understanding Capital Assets

A capital asset is one that a company plans on owning for more than one year, and uses in the production of revenue.
9. Investing

### Calculating Net Present Value at Different Points Using Excel

Calculating the net present value (NPV) of your investment projects using Excel.
10. Investing

### Understanding Historical Cost

Historical cost equals the original purchase price of an asset recorded on a company’s balance sheet.
RELATED FAQS
1. ### What is the formula for calculating net present value (NPV)?

Learn about the formula for net present value (NPV) and how this calculation is used in capital budgeting to determine which ... Read Answer >>
2. ### Do companies measure their cost of debt with before- or after-tax returns?

Understand the before and after-tax calculations of cost of debt capital and how each is useful in deciding between funding ... Read Answer >>
3. ### How are fixed costs treated in cost accounting?

Learn how fixed costs and variable costs are used in cost accounting to help a company's management in budgeting and controlling ... Read Answer >>
4. ### How do you calculate costs of capital when budgeting new projects?

Discover how a company should estimate its costs of capital when budgeting for a new business project using the weighted ... Read Answer >>
5. ### What are typical examples of capitalized costs within a company?

Learn examples of capitalized costs such as expenses incurred to put fixed assets to use as well as software development ... Read Answer >>
6. ### What is the difference between the cost of capital and the discount rate?

Learn about the differences between the cost of capital and the discount rate as they relate to estimating a required return ... Read Answer >>
Hot Definitions
1. ### AAA

The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
2. ### GBP

The abbreviation for the British pound sterling, the official currency of the United Kingdom, the British Overseas Territories ...
3. ### Diversification

A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique ...
4. ### European Union - EU

A group of European countries that participates in the world economy as one economic unit and operates under one official ...
5. ### Sell-Off

The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
6. ### Brazil, Russia, India And China - BRIC

An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...