Equivalent annual cost

Imagine you got a shiny new toy car for your birthday! Your parents spent $500 to buy it for you. However, like most things, your toy car won't last forever. Suppose it will last for five years before it stops working, and each year it will need some maintenance to keep it running.

Now, your parents want to compare the cost of keeping your toy car in good shape each year to the cost of buying a new one every year for the next five years. They want to make sure they spend as little money as possible overall.

To compare the costs, they calculate the equivalent annual cost. It's like taking the total cost of owning the car over five years and dividing it by five to see how much it costs per year on average.

So, let's say your parents estimate that each year, your toy car will cost $50 to maintain (oil changes, new batteries, etc.). Over the five years, that's a total cost of $250 (5 years x $50 per year).

Now, they figure out how much it would cost to buy you a new toy car every year for five years. Suppose a new car costs $600 each time, for a total of $3,000.

To compare the two options, your parents calculate the equivalent annual cost of owning your original toy car. They divide the total cost ($250) by five (the number of years) to get $50 as the equivalent annual cost.

So, in this case, keeping your toy car and maintaining it costs the same as buying a new one each year. But, since your parents already bought it, they decide to keep it and maintain it each year, knowing it will be cheaper in the long run.

That's what equivalent annual cost means! It helps you compare the total cost of owning something over several years by dividing it into an average annual cost.