Replacement Analysis and Economic Service Life

Replacement Analysis:

Replacement Analysis is the economic analysis to compare existing and new facilities. It is a decision situation encountered in the business firms and government organization as well as individuals in which an existing asset should be retired from use or continued in service or replaced with a new asset. Replacement study in engineering economics provides the information for sound decisions that improve the operating efficiency and the competitive position of the enterprise. Replacement analysis is one of the most important and most common types of iterative comparisons encountered in practice.

There are numerous reasons for considering replacement. Firstly, the current asset may have a number of deficiencies including high set up cost, excessive maintenance, declining production, efficient energy consumption and physical impairment.

Secondly, potential replacement assets may take advantage of new technology and be easily set up, low-cost maintenance, high output, energy efficient and possessing increased potentialities, perhaps at a vastly reduced cost.

Replacement is never a question of ‘if we replace’ but a rather a question of ‘when we replace’.

Replacement of an existing asset should be considered in case of following reasons:

1. Obsolescence occurs when the technology of an asset is exceeded by newer and/ or different technologies.
2. Depletion : the gradual decrease of market value of an asset as it is being consumed or exhausted
3. Deterioration due to ageing: the general condition of loss in value of some asset due to the ageing process. The ageing process is normally associated with additional maintenance and operating expenses.
4. Physical impairment: The existing equipment is completely or partially worn out and will no longer function suitably without expensive repairs
5. Inadequacy: The equipment does not have sufficient capacity to meet the present demands.
6. Rapid Technological Changes: Recognition and handling of replacement problems have paid off quite well for many companies.

The advantages of replacement analysis are as follows:

1. Reduction in maintenance cost
2. Keep the company in competitive position with reduction in production cost
3. Reduction in losses, rework, scraps
4. Introduce modernization which helps to take off productivity and returns
5. Reduce delays off down time costs
6. Increase enthusiasm and morale of workers resulting increased human efficiency and better human relations

The basic requirements for the successful handling of replacement problems are as follows:

1. Must have clearly stated policies to guide the persons handling the replacement problems
2. Replacement problems must be recognized in the organization structure by specific assignment of responsibility
3. Systematic procedure must be established and used in solving specific problems

Terminologies Incorporated in Replacement Analysis:

1. Defender and Challenger:

These are the names of two mutually exclusive alternatives. The defender is the currently installed asset and the challenger is the potential replacement asset.

2. Defender first cost:

Defender first cost is the initial investment amount ‘P’ used for the defender. The current market value (MV) is the current estimate to use for ‘P’ for the defender in a replacement study.

3. Challenger first cost:

It is the amount of cost that must be recovered when replacing a defender with a challenger. This amount is almost always equal to ‘P’, the first cost of the challenger.

4. AW values:

These are used as the primary measure of comparison between the defender and challenger.

5. Economic life:

The period of time in years that results in the minimum equivalent uniform annual cost of owning and operating an asset.

6. Useful life:

The time period in years that an asset is kept in productive service. It is an estimate of how long an asset is expected to be used in a trade or business to produce income.

7. Marginal cost:

These are the year by year estimates of the costs to own and operate an asset for that year. It includes loss in value of the asset by retaining it for one or more year, cost and expenses directly related to the project or asset (Insurance, operating and maintenance etc.)

8. Market price:

The highest estimated price that a buyer would pay and a seller would receive for an item in an open and competitive market.

Approach for comparing Defender and Challenger:

1. Cash flow approach:

In a cash flow approach, proceeding from the sale of the old machine is treated as down payment towards as down payment towards purchasing the new machine. This approach is meaningful when both the defender and challenger have the same useful life.

2. Opportunity Cost Approach:

In an opportunity cost approach, proceedings from the sale of the old machine are treated as the investment required to keep the old machine. This approach is more commonly practiced in replacement analysis.

Economic Service Life (ESL):

The economic service life (ESL) is the number of the year (n*) at which the equivalent uniform annual worth (AW) of costs is the minimum, considering the most current cost estimates over all the possible years that the asset may provide a needed service. We should use the respective economic service lives of the defender and the challenger when conducting a replacement analysis.

The objective is to find the number of the year (n*) that minimizes the equivalent uniform annual worth of costs is minimum.

The costs of owning an operating an asset can be divided into two categories: capital costs and operating costs. Capital costs have two components: the initial investment and the salvage value at the time of disposal of the asset. The initial investment for the challenger is simply its purchase price. For the defender, we should treat the opportunity cost as its initial investment. We will use N to represent the length of time in years the asset will be kept, I to denote the initial investment and S_N to designate the salvage value at the end of the ownership period of N years. The annual equivalent of capital costs which is called the capital recovery cost over the period of N years.

Capital Recovery cost (CR) = I (A/P, i%, N) – S_N (A/P, i%, N)

The operating cost of an asset includes operating and maintenance (O & M) costs, labor costs, material costs and energy consumption costs. Here O & M costs tend to increase as the function of the age of the asset but other costs often remain constant for same equipment from year to year if the usage of the equipment remains constant. We use OC_n to represent the total operating costs in year n of the ownership period and OC(i) to represent the annual equivalent of the operating costs over a life span of N years.

Operating Cost (OC) = ∑ OC_n (P/F, i%, N). (A/P, i%, N) where n = 1 to N

The total annual equivalent costs of owning and operating an asset are summation of the capital recovery costs and the annual equivalent of operating costs of the asset

Total Cost (TC) = CR (i) + OC (i)

BIBLIOGRAPHY:

Chan S.Park, Contemporary Engineering Economics, Prentice Hall, Inc.
E. Paul De Garmo, William G.Sullivan and James A. Bonta delli, Engineering
Economy, MC Milan Publishing Company.
James L. Riggs, David D. Bedworth and Sabah U. Randhawa,Engineering
Economics, Tata MCGraw Hill Education Private Limited.