Where and how to include Initial investment costs in (cost or profit comparison)

Question

Hi Guys,

I am a bit confused on how to inlcude Initial Investment Costs in Cost and Profit Comparisons.

In a case where they compare the cost savings of two trucks they inlcude via depreciation.

But in the Military Helicopter Case (here on Preplounge), where they compare in the end the profit, in the Total Cost they include the initial Cost directly.

From my understanding when calculating the profit or when doing the Cost Comparison one should always use only the depreciation amount as it shows up on the income statement.

Anybody has an explanation in which cases (profit or reveneu calculation vs cost comparison) one should include which cost (depreciation or initial investment cost)

Thanks in advance :)

Answer 1

In the first case, you are calculating annual costs. So you take the initial investment and turn it into an yearly cost dividing it by the expected useful life of the asset.

In the second case, you are comparing the total lifetime costs. So you just take the total initial cost as it is.

Now understand this. If in the first case you wanted to compare the total lifetime costs (which would also be perfectly fine) - there would be no need to annualize the initial cost. On the other hand, you would need to take all the yearly costs and multiply them by the useful life of the asset to get to the total cost.

Why isn't this the suggested answer? Simple: it would require more calculations. So the real reason why you use the annual cost in the first case is not a technical reason (both are fine), but a practical one: it's the fastest way to get to the answer.

Answer 2

This is a good question because candidates often mix investment costs (CAPEX) with operating costs (OPEX), which can get really messy.

CAPEX and OPEX are of course linked in the sense that any investment is depreciated in the P&L and becomes an operating expense. So basically, both approaches are fine:

If it's ROI you're after, keep operating profit separate from investments and compare the two for ROI calculations i.e. do not transfer investment via depreciation into P&L
If it's profit you want to focus on then calculate net profit over time i.e. capture investment as depreciation expense over time

It's just important to not double dip. Corresponding NPVs have to be the same - otherwise something is not right.

Hope this helps!