Chapter 8

Replacement analysis
 Organizations providing goods/services use several facilities like

equipment and machinery which are directly required in their
operations.
 All such facilities should be continuously monitored for their efficient

functioning; otherwise, the quality of service will be poor.
 Besides the quality of service of the facilities, the cost of their

operation and maintenance would increase with the passage of time.
 Hence, it is an absolute necessity to maintain the equipment in good

operating conditions with economical cost.
 Thus, we need an integrated approach to minimize the cost of

maintenance.
 In certain cases, the equipment will be obsolete over a period of time.

 If a firm wants to be in the same business competitively, it has to
take decision on whether to replace the old equipment or to retain it
by taking the cost of maintenance and operation into account.
 There are two basic reasons for considering the replacement of an

equipment—physical impairment of the various parts or
obsolescence of the equipment.
 Physical impairment refers only to changes in the physical

condition of the machine itself. This would lead to a decline in the
value of the service rendered, increased operating cost, increased
maintenance cost or a combination of these.
 Obsolescence is due to improvement of the tools of production,

mainly improvement in technology
 So, it would be uneconomical to continue production with the same
machine under any of the above situations. Hence, the machines are
to be periodically replaced.
 Sometimes, the capacity of existing facilities may be inadequate to

meet the current demand. Under such situation, the following
alternatives will be considered.
 Replacement of the existing equipment with a new one.
 increasing the service life of the existing equipment through

maintenance by changing the part of the equipment.
Replacement Decisions
 The decision to replace equipment or to retire it (to take the

equipment out of service without replacing it) can be motivated by
the physical impairment of the equipment, its obsolescence, or
external economic conditions
.
 Retirement and replacement decisions should always be based on
economics rather than on whether or not the equipment has reached
the end of its physical service life.
 A piece of equipment may have many years of service life

remaining beyond the point at which it has become uneconomical to
operate it.
Economic Life of an Asset
As operating equipment ages, the usual pattern is for its capital costs to
decline while its operating costs rise.
When summed, these two cost functions often result in a cost function
that is generally U-shaped.
Ideally, the equipment should be retired at the lowest point on this total
cost function.
Any asset will have the following cost components:
1. Capital recovery cost (average first cost), computed from the first
cost (purchase price) of the machine.
2. Average operating and maintenance cost (O & M cost)
3. Total cost which is the sum of capital recovery cost (average first
cost) and average maintenance cost.
A typical shape of each of the above costs with respect to life of the
machine is shown below
EXAMPLE
1.A firm is considering replacement of an equipment, whose first cost

is birr 4,000 and the scrap value is negligible at the end of any year.
Based on experience, it was found that the maintenance cost is zero
during the first year and it increases by birr 200 every year thereafter.
(a) When should the equipment be replaced if i = 0%?

(b) When should the equipment be replaced if i = 12%?
2. A company has already identified machine A and determined the
economic life as four years by assuming 15% interest rate. The
annual equivalent total cost corresponding to the economic life is
birr. 2,780.Now, the manufacturer of machine B has approached the
company. Machine B, which has the same capacity as that of
machine A, is priced at birr. 6,000. The maintenance cost of
machine B is estimated at birr. 1,500 for the first year and an equal
yearly increment of birr. 300 thereafter. If the money is worth 15%
per year, which machine should be purchased? (Assume that the
scrap value of each of the machines is negligible at any year.)
Determination of economic life and corresponding annual
equivalent total cost of machine B.
3. Two years ago, a machine was purchased at a cost of birr 200,000 to
be useful for eight years. Its salvage value at the end of its life is birr
25,000. The annual maintenance cost is birr 25,000. The market value
of the present machine is birr 120,000. Now, a new machine to cater to
the need of the present machine is available at birr 150,000 to be useful
for six years. Its annual maintenance cost is birr 14,000. The salvage
value of the new machine is birr 20,000. Using an interest rate of 12%,
find whether it is worth replacing the present machine with the new
machine.
Exercise
1. A diesel engine was installed 10 years ago at a cost of birr
50,000. It has a present realizable market value of birr. 15,000. If
kept, it can be expected to last five years more, with operating and
maintenance cost of birr. 14,000 per year and to have a salvage
value of birr. 8,000 at the end of the fifth year. This engine can be
replaced with an improved version costing birr. 65,000 which has
an expected life of 20 years. This improved version will have an
estimated annual operating and maintenance cost of birr. 9,000 and
ultimate salvage value of birr. 13,000. Using an interest rate of
15%, make an annual equivalent cost analysis to determine whether
to keep or replace the old engine.
2. A steel highway bridge must either be reinforced or replaced.
Reinforcement would cost birr 660,000 and would make the bridge fit
for an additional five years of service. If it is reinforced, it is estimated
that its net salvage value would be birr 4,00,000 at the time it is retired
from service. The new pre stressed concrete bridge would cost birr
1500,000 and would meet the foreseeable requirements of the next 40
years. Such a bridge would have no salvage value. It is estimated that
the annual maintenance cost of the reinforced bridge would exceed
that of the concrete bridge by birr 96,000. If the bridge is replaced by
a new pre stressed concrete bridge, the scrap value of the steel would
exceed the demolition cost by birr 4,20,000. Assume that the money
costs the state 10%. What would you recommend?
3.A machine was purchased two years ago for birr. 10,000. Its annual
maintenance cost is birr. 750. Its life is six years and its salvage
value at the end of its life is birr. 1,000. Now, a company is offering
a new machine at a cost of birr. 10,000. Its life is four years and its
salvage value at the end of its life is birr. 4,000. The annual
maintenance cost of the new machine is birr. 500. The company
which is supplying the new machine is willing to take the old
machine for birr. 8,000 if it is replaced by the new machine. Assume
an interest rate of 12%, compounded annually.
(a) Find the comparative use value of the old machine.
(b) Is it advisable to replace the old machine?
4.A machine can be sold now for $15 000; if kept for another year, its
salvage value will decline to $13 000. The operating expenses for this
year are expected to be $30 000. A new machine is available for $50
000, with expected operating expenses of $18 000 for the first year,
increasing by $1000 a year because of deterioration. It is believed that
after 5 years new technology would make replacement necessary; the
new machine's salvage value at that time is estimated to be $20 000.
The MARR is 20%. Should the new machine be acquired?
5.A contractor can purchase a used machine for $1000. The
market value of the machine is expected to decrease $70 the first
year and $60 per year, the second and third years. Operating
disbursement is estimated at $8000 the first year and is expected
to increase by $175 a year thereafter. An alternative is to buy a
new machine costing $10 000. It is believed that the salvage value
of this machine will decrease by 15% each year over a maximum
service life of 20 years. The operating expenses are estimated at
$6050 the first year and are expected to increase by $135 a year
after that. If the MARR is 10%, which machine should be bought,
and when should that machine be replaced? (Assume that the used
machine is unique, but that new machines are always available.)

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Replacement analysis

 Organizations providing goods/services use several facilities like

 All such facilities should be continuously monitored for their efficient

 Besides the quality of service of the facilities, the cost of their

 Hence, it is an absolute necessity to maintain the equipment in good

 Thus, we need an integrated approach to minimize the cost of

 In certain cases, the equipment will be obsolete over a period of time.

 There are two basic reasons for considering the replacement of an

 Physical impairment refers only to changes in the physical

 Obsolescence is due to improvement of the tools of production,

 Sometimes, the capacity of existing facilities may be inadequate to

 Replacement of the existing equipment with a new one.

 increasing the service life of the existing equipment through

 The decision to replace equipment or to retire it (to take the

 A piece of equipment may have many years of service life

2. Average operating and maintenance cost (O & M cost)

1.A firm is considering replacement of an equipment, whose first cost

(a) When should the equipment be replaced if i = 0%?

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