Chapter 12 - Replacement

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EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz

Industrial & Manufacturing Engineering Department Cal Poly Pomona

EGR 403 - The Big Picture

Framework: Accounting & Breakeven Analysis Time-value of money concepts - Ch. 3, 4 Analysis methods
Ch. 5 - Present Worth Ch. 6 - Annual Worth Ch. 7,7A,8 - Rate of Return (incremental analysis) Ch. 9 - Benefit Cost Ratio & other methods

Refining the analysis

Ch. 10, 11 - Depreciation & Taxes Ch. 12 - Replacement Analysis
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Replacement Analysis
When should a new truck replace the existing truck? When should a process be redesigned? When should a product be redesigned?
The most common question asked in industry is when should the existing be replaced?

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Replacement Analysis Terms

Defender - the existing equipment or building previously implemented. Challenger - the proposed replacement currently under consideration.

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Aspects of Replacement Analysis

Using available data to determine the analysis technique. Determining the base comparison between alternatives. Using analysis techniques when:
Defender marginal cost can be computed and is increasing. Defender marginal cost can be computed and is not increasing. Defender marginal cost is not available.

Considering possible future challengers. After-tax analysis.

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The Replacement Problem

Engineers replace the existing due to:
Obsolescence - technological change. Depletion - loss of market value. Deterioration - wear that is overly expensive to repair.
Shall the defender be replaced now or be maintained for one or more periods.
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Issues (Consider Before Starting)

Is it morally or ethically right to do this project? If a unit fails, must it be removed permanently from service? Or repaired? Are standby units available if the system should fail? Do components or units fail independently of the failure of other components? Is there a budget constraint? In the event that the unit can be repaired after failure is their a constraint on the capacity of the repair facility?
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Issues (Continued)
Is there only one replacement allowed over the planning horizon? Are subsequent replacements allowed at any time during the study period? Is their more than one replacement unit (price and quality combination) available at a given point in time? Do future replacement units differ over time? Are technological improvements considered? Is preventative maintenance included in the model?
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Issues (Continued)
Are periodic operating and maintenance costs constant or variable over time? Is the planning horizon finite or infinite? Are consequences other than economic impacts, i.e., sociotechnical issues considered? Are income tax consequences considered? Is inflation considered? Does replacement occur simultaneously with retirement, or are there nonzero lead times? Are cash flow estimates deterministic or stochastic?
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Replacement Analysis Decision Chart

Where Defender Marginal Cost 1 Available Defender Marginal Cost Increasing Defender Next-year Marginal Cost EUAC at Minimum Cost Life EUAC over Remaining Useful Life
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Compare Best Challenger EUAC at Minimum Cost Life EUAC at Minimum Cost Life EUAC at Minimum Cost Life
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Available

Not increasing

Not available

What Is the Basic Comparison?

Identify the defender and the best challenger.
Product. Machine. Process. Personnel. Mix.

Decision Criteria leads to one of the following: If the defender is more economical, it should be retained. If the challenger is more economical, it should be installed.
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Minimum Cost Life of the Challenger

Calculate the EUAC for each value of the useful life (e.g., n = 1, n = 2, n = 3, etc.) The number of years at which the EUAC is minimized is the minimum cost life (economic useful life) Consider Example 12 - 1
$7500 initial cost (P) $900 arithmetic gradient maintenance cost (G) $500 uniform cost (A) and 400 arithmetic gradient operating cost (G)
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EUAC calculations for increasing values of useful life

Year EUAC of Capital Recovery Costs -7500 EUAC of Maintenance and Repair Costs 0 -900 $8,100.00 $4,205.77 $2,910.25 $2,264.41 $1,878.42 $1,622.37 $1,440.54 $1,305.11 $1,200.60 $1,117.72 $1,050.57 $995.21 $948.91 $909.73 $876.22 EUAC of Operating Costs -500 8% -400 $8,600.00 $5,330.77 $4,643.62 $4,589.55 $4,778.84 $5,081.62 $5,442.31 $5,833.19 $6,238.94 $6,650.43 $7,061.93 $7,469.68 $7,871.18 $8,264.69 $8,649.02 $0.00 $500.00 $432.69 $692.31 $853.87 $879.50 $1,263.56 $1,061.58 $1,661.82 $1,238.59 $2,048.71 $1,410.54 $2,424.30 $1,577.47 $2,788.67 $1,739.41 $3,141.93 $1,896.41 $3,484.18 $2,048.53 $3,815.55 $2,195.80 $4,136.17 $2,338.30 $4,446.19 $2,476.08 $4,745.75 $2,609.22 $5,035.01 $2,737.78 EGR 403 - Cal Poly Pomona - SA15 EUAC Total Interest rate

Initial year Arithmetic gradient 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

<-----MIN

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Graph of EUAC by n.
Economic Useful Life is where Total EUAC is minimized

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Marginal Costs
Marginal Costs are the year by year costs for keeping an asset. Example 12-2 illustrates the calculation of the marginal costs for a new item. Marginal Cost includes:
Loss in value of the asset by retaining it for one more year Lost interest on the money tied up in the asset Costs and expenses directly related to the project or asset (e.g., insurance, operating and maintenance)

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Marginal Cost for a New Item: Example 12-2

Expense Cost Years 0 1 3 Incremental cost thereafter $ $ 500.00 $ 1,500.00

Investment Cost $25,000.00 Annual O&M $ 2,000.00 Cost Annual Insurance $ 5,000.00 Cost Useful Life 7 (years) MARR 15% Loss in Market Value $ $ $ $ $ $ $

Year 0 1 2 3 4 5 6 7

Market Value $ $ $ $ $ $ $ $ 25,000.00 18,000.00 13,000.00 9,000.00 6,000.00 4,000.00 3,000.00 2,500.00

Foregone Interest

O&M Cost

Insurance Cost $ 5,000.00 $ 5,000.00 $ 5,000.00 $ 6,500.00 $ 8,000.00 $ 9,500.00 $11,000.00

Total Marginal Cost $17,750.00 $15,200.00 $13,950.00 $14,350.00 $14,900.00 $15,600.00 $16,950.00 16

7,000.00 $3,750.00 $ 2,000.00 5,000.00 $2,700.00 $ 2,500.00 4,000.00 $1,950.00 $ 3,000.00 3,000.00 $1,350.00 $ 3,500.00 2,000.00 $ 900.00 $ 4,000.00 1,000.00 $ 600.00 $ 4,500.00 500.00 $ 450.00 $ 5,000.00 EGR 403 - Cal Poly Pomona - SA15

Marginal Cost Data Defender

Expense Investment Cost Annual O&M Cost Annual Insurance Cost Useful Life (years) MARR Cost $15,000.00 $10,000.00 $ 5 15% Loss in Market Value $ $ $ $ $ 1,000.00 1,000.00 1,000.00 1,000.00 1,000.00 Years 0 1 Incremental cost thereafter $ $ 1,500.00 $ -

Example 12-3

Is the marginal cost of defender increasing? Here the marginal costs are increasing.

Year 0 1 2 3 4 5 6 7

Market Value $ $ $ $ $ $ 15,000.00 14,000.00 13,000.00 12,000.00 11,000.00 10,000.00

Foregone Interest $2,250.00 $2,100.00 $1,950.00 $1,800.00 $1,650.00

O&M Cost

Insurance Cost $ $ $ $ $ -

Total Marginal Cost $13,250.00 $14,600.00 $15,950.00 $17,300.00 $18,650.00

$10,000.00 $11,500.00 $13,000.00 $14,500.00 $16,000.00

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Replacement Analysis Technique #1

Defender Marginal costs are increasing

Replace when the marginal cost of ownership of the defender is more than the EUAC of the challenger.

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Analysis Technique # 1
Is Appropriate When Replacement Repeatability Assumptions Hold The best challenger is available in all subsequent years and will be unchanged in economic cost. The period of needed service is infinitely long. These assumptions appear to be rather restrictive.
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Relaxing the Restrictions

This spreadsheet considers that:
The best challenger is available in subsequent years at the same economic cost. The project life is known and limited.

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Replacement Analysis Technique #2

If the replacement repeatability assumption holds, compare EUAC of the defender asset at its minimum cost life against the EUAC of the challenger at its minimum cost life.

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Replacement Analysis Technique #3

Compare the EUAC of the defender over its stated life against the minimum EUAC of the challenger.
Here defining defender and challenger first costs can be an issue. Trade-in value is not a suitable value. Appropriate value is the market value.

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After Tax Replacement Analysis

Adds expanded perspective as changes occur in: Remaining economic life of defender. Economic life of challenger. Defender vs. Challenger comparisons. Affected by: Depreciation MACRS. Assets market value over time.

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