5.2. Calculating Average Annual Investment

Now, let us move on to the next important component of the ownership cost and that is your cost of investment. So, investment cost it represents the annual cost of capital invested in the machine. So, it is similar to the cost of acquiring the ownership of the machine. You may have to purchase a machine or the equipment, either through borrowed funds, or you might have purchased either with your company assets.

Investment cost refers to the annual expense associated with the capital that has been invested in machinery or equipment. This can be through loans (borrowed funds) or through the organization's own resources (company assets). Understanding this cost is essential because it impacts the overall financial planning for any project or operation that involves machinery.

Think of investment cost like the rent you pay for an apartment. Whether you buy the apartment outright or rent it, you still have to budget for that expense each month. Similarly, when you buy equipment, whether through loans or savings, there's an ongoing cost associated with that investment.

Say if you are going for the borrowed funds, say for example, if you are going for the loan, so, the interest rate for to pay for the loan that will be considered as the cost of the interest. If you are going for the company assets, in that case, also you have to take the interest rate as the rate of return.

When calculating the investment cost, one must consider the interest on borrowed funds as a direct cost. If the equipment is purchased using company savings, then the interest rate serves as an opportunity cost—the return you could have earned if that money was invested elsewhere instead.

Imagine you have $1,000 that you can either use to buy a new laptop or invest in a stock that historically gives a 5$1,000; you're also losing out on the potential $50 you could have earned from the investment. This 'lost profit' is similar to calculating opportunity costs in business.

The cost of investment can be calculated by 2 different methods, as I told you earlier, one is a time value method, the other one is an average annual investment method. The average annual investment method will calculate the thing approximately as a percentage of average annual investment over the useful life of the machine.

The average annual investment method simplifies the calculation of investment cost by averaging the value of the machine over its useful life. This helps in computing costs while considering depreciation and provides an estimated representation of the annual cost related to the equipment. It contrasts with the time value method, which accounts for the timing of cash flows and provides a more precise evaluation.

This method can be likened to averaging your monthly expenses over the year. If you spend irregular amounts on activities—like a big shopping spree one month and nothing another month—you might use the average to manage your budget better, giving you a clearer view of what you can afford.

You know that your machine is going to depreciate gradually over a period of time over its useful life. To make our calculations convenient, as you know that all the components of the ownership costs which are expressed as a percentage of the value of the machine.

Depreciation is the reduction in value of the machine over time due to wear and tear or obsolescence. The average annual investment method factors in depreciation by allowing calculations to be expressed as a percentage of the average machine value, rather than a fixed figure. This provides a more accurate representation of ownership costs as the equipment ages.

Think of an item like a smartphone: When you buy a new one, its value decreases over time. By the end of the first year, that phone is worth less than when you bought it. If you were to sell it, you wouldn't get back what you initially paid. This concept of gradual loss in value is similar to how machinery depreciates.

So, the next important components of the ownership cost are the insurance costs, taxes, and the storage cost. All these components of the ownership costs are expressed as a percentage of average annual investment or the average value of the machine.

Ownership costs extend beyond the cost of investment. They include insurance, taxes, and storage costs, all of which can vary based on the value of the equipment. Expressing these costs as percentages of the average annual investment allows for a clearer understanding of the ongoing financial commitments associated with machine ownership.

This is similar to owning a house, where your expenses are not just the mortgage. You also pay property taxes, homeowners insurance, and maintenance costs. Each of these costs is a percentage of the home's value, providing a comprehensive look at your total cost of ownership.

So we have to remember this formula P(n + 1) + S(n - 1) / 2n to get the average value of the machine over its useful life.

This formula summarizes how to calculate the average annual investment by taking into account the purchase price (P), the salvage value (S), and the expected lifespan (n) of the machine. This reflects not only the investment cost but also how depreciation affects the overall expenditure associated with owning the equipment.

Considering our smartphone example again, imagine you plan to keep it for two years before selling it. You could estimate how much you can afford to set aside each month based on its initial cost and its expected resale value, providing a closer look at budgeting over its life cycle.

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