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Chapter 12 - Replacement
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EGR 403 Capital Allocation Theory
Dr
...
Rosenkrantz
Industrial & Manufacturing Engineering Department
Cal Poly Pomona

EGR 403 - The Big Picture
• Framework: Accounting & Breakeven Analysis
• “Time-value of money” concepts - Ch
...
5 - Present Worth
Ch
...
7,7A,8 - Rate of Return (incremental analysis)
Ch
...
10, 11 - Depreciation & Taxes
– Ch
...

• Challenger - the proposed replacement
currently under consideration
...

Determining the base comparison between
alternatives
...

Defender marginal cost can be computed and is not
increasing
...


Considering possible future challengers
...

EGR 403 - Cal Poly Pomona - SA15

5

The Replacement Problem
• Engineers replace the existing due to:
– Obsolescence - technological change
...

– Deterioration - wear that is overly expensive to
repair
...

EGR 403 - Cal Poly Pomona - SA15

6

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?
EGR 403 - Cal Poly Pomona - SA15

7

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?
EGR 403 - Cal Poly Pomona - SA15

8

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
...
, 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?
EGR 403 - Cal Poly Pomona - SA15

9

Replacement Analysis Decision Chart
Where

Compare

Defender
Marginal Cost

Defender
Marginal Cost

Defender

Best
Challenger

1

Available

Increasing

Next-year
Marginal Cost

EUAC at
Minimum
Cost Life

2

Available

Not increasing

EUAC at
Minimum
Cost Life

EUAC at
Minimum
Cost Life

3

Not available

EUAC over
Remaining
Useful Life

EUAC at
Minimum
Cost Life

EGR 403 - Cal Poly Pomona - SA15

10

What Is the Basic Comparison?
• Identify the defender and the best challenger
...

Machine
...

Personnel
...


Decision Criteria leads to one of the following:
If the defender is more economical, it should be retained
...

EGR 403 - Cal Poly Pomona - SA15

11

Minimum Cost Life of the Challenger
• Calculate the EUAC for each value of the
useful life (e
...
, n = 1, n = 2, n = 3, etc
...
00
$4,205
...
25
$2,264
...
42
$1,622
...
54
$1,305
...
60
$1,117
...
57
$995
...
91
$909
...
22

-400

$0
...
00
$432
...
31
$853
...
50
$1,263
...
58
$1,661
...
59
$2,048
...
54
$2,424
...
47
$2,788
...
41
$3,141
...
41
$3,484
...
53
$3,815
...
80
$4,136
...
30
$4,446
...
08
$4,745
...
22
$5,035
...
78
EGR 403 - Cal Poly Pomona - SA15

$8,600
...
77
$4,643
...
55
$4,778
...
62
$5,442
...
19
$6,238
...
43
$7,061
...
68
$7,871
...
69
$8,649
...

Economic Useful Life is where Total EUAC is minimized

EGR 403 - Cal Poly Pomona - SA15

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Marginal Costs
• Marginal Costs are the year by year costs for
keeping an asset
...

• 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
...
, insurance, operating and maintenance)

EGR 403 - Cal Poly Pomona - SA15

15

Marginal Cost for a New Item: Example 12-2
Expense

Cost

Investment Cost $25,000
...
00
Cost
Annual Insurance
$ 5,000
...
00
18,000
...
00
9,000
...
00
4,000
...
00
2,500
...
00

3

$ 1,500
...
00 $3,750
...
00
5,000
...
00 $ 2,500
...
00 $1,950
...
00
3,000
...
00 $ 3,500
...
00 $ 900
...
00
1,000
...
00 $ 4,500
...
00 $ 450
...
00
EGR 403 - Cal Poly Pomona - SA15

Insurance
Cost
$ 5,000
...
00
$ 5,000
...
00
$ 8,000
...
00
$11,000
...
00
$15,200
...
00
$14,350
...
00
$15,600
...
00
16

Marginal Cost Data Defender
Expense

0
1
2
3
4
5
6
7

Years

Investment Cost
Annual O&M
Cost
Annual Insurance
Cost
Useful Life
(years)
MARR

Year

Cost
$15,000
...
00

1

$ 1,500
...
00
14,000
...
00
12,000
...
00
10,000
...


5
15%
Loss in
Market
Value

Market Value
$
$
$
$
$
$

-

Example 12-3

$
$
$
$
$

Foregone
Interest

1,000
...
00
1,000
...
00
1,000
...
00
$2,100
...
00
$1,800
...
00

$10,000
...
00
$13,000
...
00
$16,000
...
00
$14,600
...
00
$17,300
...
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
...

• The period of needed service is infinitely long
...

EGR 403 - Cal Poly Pomona - SA15

19

Relaxing the Restrictions
• This spreadsheet considers that:
– The best challenger is available in subsequent years at
the same economic cost
...


EGR 403 - Cal Poly Pomona - SA15

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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
...

•Here defining defender and challenger first costs can be an issue
...

–Appropriate value is the market value
...

– Economic life of challenger
...
Challenger comparisons
...

– Assets market value over time

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