engineering economins-replacement and retention decisions

8/17/2019 Engineering Economins-Replacement and Retention Decisions

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Chapter 11

Replacement and

Retention Decisions


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• Learning Outcomes: – Perform a replacement/retention study

between an in-place asset process or

system and one that could replace it!


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Replacement and Retention

• "he #undamental $uestion: –

%hould it be replaced now or later& – 'nswers the (uestion whennot if to

replace


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Replacement %tudy

• Replacement %tudy usually designed

to )rst ma*e the economic decisionto retain or replace now . – "o replace-+study is complete

– "o retain-+re,isit cost estimates and

decision

• application of the ' method ofcomparing une(ual-life alternati,es


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11!1-.asics of Replacement%tudy


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hy we should Replace&

• Reduced Performance-.ecause of

physical deterioration the abilityto perform at an epected le,el ofreliability (being available and

performing correctly when needed)

or productivity 0performing at agi,en le,el of (uality and (uantity isnot present


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Reduced Performance


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• 'ltered Re(uirements-2ew

re(uirements of accuracy speed orother speci)cations cannot be metby the eisting e(uipment or system!


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'ltered Re(uirements


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• Obsolescence-3nternational

competition and rapidly changingtechnology ma*e currently usedsystems and assets performacceptably but less productively

than e(uipment coming a,ailable!


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Obsolescence


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"erminologies

• Defender-is the currently installedasset!

• Challenger-the potentialreplacement!

•

4ar*et 5alue-is the current ,alue ofthe installed asset if it were sold ortraded on the open mar*et! 'lsocalled Trade-in Value.

• ' ,alues- rimar economic


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"erminologies

• 6conomic %er,ice Life 06%L-thenumber of years at which the lowest' of cost occurs .

• Defender #irst Cost-initial in,estmentamount P used for the defender!

• Challenger #irst Cost-the amount ofcapital that must be reco,ered0amorti7ed when replacing a

defender with a challenger!


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%un* Cost• ' sun* cost is a prior ependiture or loss

of capital 0money that cannot be

recovered by a decision about thefuture. "he replacement alternati,e foran asset system or process that hasincurred a non reco,erable cost should notinclude this cost in any direct fashion8sun* costs should be handled in a realisticway using ta laws and write-o9

allowances!


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%un* Cost Reminder

• ' sun* cost should ne,er be added tothe challengers )rst cost because itwill ma*e the challenger appear tobe more costly than it actually is .


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2on-owners 5iewpoint• "he non-owner’s viewpoint also called the

outsider’s viewpoint or consultant’s viewpoint,

provides the greatest ob;ecti,ity in areplacement study! "his ,iewpoint performsthe analysis without bias8 it means theanalyst owns neither the defender nor

the challenger. 'dditionally it assumes theser,ices pro,ided by the defender can bepurchased now by ma*ing an “initialinvestment” equal to the market value of

the defender.


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Planning ! Cost estimates for e,ery life cycle of the defender andchallenger will be the same as in their )rst cycle!

• hen the planning horizon is limited to a speci)ed study

period the assumptions abo,e do not hold!


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Example


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11!=-6conomic %er,ice Life


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6conomic %er,ice Life

• "he economic ser,ice life 06%L is thenumber of years n at which theequivalent uniform annual worth!"# of costs is the minimumconsidering the most current cost

estimates o,er all possible years thatthe asset may pro,ide a neededser,ice!

• also referred to as the economic life


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6conomic %er,ice Life

• 6%L indicates that the asset shouldbe replaced to minimi7e o,erallcosts!

• "o perform a replacement studycorrectly it is important that the 6%Lof the challenger and the 6%L of thedefender be determined since theirn values are usually not pre

established!


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Determining 6%L• Calculate the "otal ' of costs- sum of capital

reco,ery 0CR which is the ' of the initial in,estment and any sal,age

,alue and the ' of the estimated annual operating cost 0'OC

• "he 6%L is the n ,alue for the smallest total' of costs !

• $emember% "hese ' ,alues are costestimates so the ' ,alues are negati,enumbers! "herefore ?@=AA is a lower costthan ?BAA!


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Determining 6%L-"he two 6%L components

• &ecreasing cost of capitalrecovery. "he capital reco,ery is the ' ofin,estment8 it decreases with each year ofownership! "he sal,age ,alue ! , which usuallydecreases with time, is the estimated mar*et,alue 045 in that year!

Capital reco,ery " (#",i,n) ! (#$,i,n)


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Determining 6%L-"he two 6%L components

• "he current 45 is used for " when the asset is the

defender, and the estimated future %V values aresubstituted for the ! values in years &, ', , . . . ."lotting the # * series clearly indicates wherethe 6%L is located and the trend of the ' * curve

on each side of the +!.


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6pected Life• hen the expected life n is known and specied for

the challenger or defender, no ESL computations arenecessary. Determine the ' o,er n years, using the rst

cost or current mar*et ,alue estimated sal,age ,alue aftern years, and # estimates. This # value is the correctone to use in the replacement study!

•


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4arginal Costs• 'arginal costs '(# are year-by-year estimates of

the costs to own and operate an asset for that year! "hree components are added to determine the marginal

cost: – Cost of ownership 0loss in mar*et ,alue is the best estimate of this

cost

– #orgone interest on the mar*et ,alue at the beginning of the year

– 'OC for each year

• "he sum of the ' ,alues of the )rst two of thesecomponents is the capital reco,ery amount 0CR! 3t willfollow that the sum of the > components of 4arginal Costsis ;ust e(ual to your "otal ' Cost o,er * years 011!>

# of marginal costs 1total # of costs (&&.2)


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• +! analysis3 +4uation 5&&.67 is applied repeatedly for * &, ', . . . , &' years (columns , D and 6 in the top of #igure 11@>! Row 1 details thespreadsheet functions for year 1=! "he result in column # is the total '

series that is of interest now!

• %arginal cost (%)3 The functions in the bottom of $igure &&8 (columns, 9, and +) de,elop the three components added to obtain the 4Cseries! Row >> details the functions for year 1=! "he resulting ' ofmarginal costs 0column is the series to compare with the

corresponding 6%L series abo,e 0column #!

"he two ' series are identical thus demonstrating that 6(uationE11!BF is correct! "herefore either an 6%L or a marginal cost analysis willpro,ide the same information for a replacement study! 3n this case theresults show that the new *iln will ha,e a minimum ' of costs of ?@

1=!>= million at its full 1=-year life!


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Conclusion about n and '• )ear-by-year market value estimates are

made.

• )early market value estimates are notavailable.


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Conclusion about n and '• Gpon completion of the 6%L analysis the

replacement study procedure in %ection 11!> is

applied using the ,alues – Challenger alternati,e 0C: 'C for n years

– Defender alternati,e 0D: 'D for n9 years


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11!>-Performing aReplacement %tudy


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Performing a Replacement %tudy• Replacement studies are performed

in one of two ways: – with a study period speci)ed

– without a study period speci)ed


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Performing a Replacement %tudy "he replacement study procedure is:

*ew replacement study%

• +. On the basis of the better ' C or ' D,alue select the challenger C or defender D!hen the challenger is selected replace thedefender now and epect to *eep thechallenger for nC years! "his replacementstudy is complete! 3f the defender isselected plan to retain it for upto nD moreyears!2et year perform the following steps!


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Performing a Replacement %tudy,ne-year-later analysis%

• ! Determine if all estimates are still current for

both alternati,es especially ) rst cost mar*et,alue and 'OC! 3f not proceed to step >! 3f yesand this is year n9 , replace the defender. :f this isnot year n9 , retain the defender for another yearand repeat this same step. This step may berepeated se,eral times!

• . hene,er the estimates ha,e changed updatethem and determine new ' C and ' D ,alues!

3nitiate a new replacement study


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6ample


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11!H-'dditional Considerationsin a Replacement %tudy


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!dditional (onsiderations in a$eplacement /tudy• "here are se,eral additional aspects of

a replacement study that may be

introduced! "hree of these are identi)edand discussed in turn! – #uture-year replacement decisions at the

time of the initial replacement study – Opportunity cost ,ersus cash Iow

approaches to alternati,e comparison

– 'nticipation of impro,ed future challengers


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!dditional (onsiderations in a$eplacement /tudy• "he )rst costs for the C and D ha,e been

correctly ta*en as the initial in,estment for

the Challenger and current mar*et ,aluefor the Defender! "his is called theopportunity cost approach because itrecogni7es that a cash inIow of funds

e(ual to the mar*et ,alue is forgone if thedefender is selected! "his approach alsocalled the con,entional approach iscorrect for e,ery replacement study!


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!dditional (onsiderations in a$eplacement /tudy• ' second approach called the cash 0ow

approach1 recogni7es that when C is

selected the mar*et ,alue cash inIow for D isrecei,ed and in e9ect immediately reducesthe capital needed to in,est in the challenger!

• ;se of the cash


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!dditional (onsiderations in a$eplacement /tudy

• the cash Iow approach can wor* onlywhen challenger and defender li,esare eactly e(ual! "his is commonlynot the case8 in fact the 6%L analysisand the replacement study procedure

are designed to compare twomutually eclusi,e une4ual-lifealternati,es ,ia the annual worth

method.


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!dditional (onsiderations in a$eplacement /tudy• ' basic premise of a replacement study is

that some challenger will replace the

defender at a future time pro,ided theser,ice continues to be needed and aworthy challenger is a,ailable! "heepectation of e,er-impro,ing challengers

can o9er strong encouragement to retainthe defender until some situationalelementsJtechnology costs mar*etIuctuations contract negotiations etc


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!dditional (onsiderations in a$eplacement /tudy• "here are se,eral additional aspects of

a replacement study that may be

introduced! "hree of these are identi)edand discussed in turn! – #uture-year replacement decisions at the

time of the initial replacement study – Opportunity cost ,ersus cash Iow

approaches to alternati,e comparison

– 'nticipation of impro,ed future challengers


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• "he replacement study is nosubstitute for forecasting challengera,ailability! :t is important tounderstand trends, new advances,and competitive pressures that can

complement the economic outcomeof a good replacement study .


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• 3t is often better to compare achallenger with an augmenteddefender in the replacement study!'dding needed features to acurrently installed defender may

prolong its useful life andproducti,ity until challenger choicesare more appealing!


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++.2 $eplacement /tudy overa

/peci3ed /tudy 4eriod


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$eplacement /tudy over a/peci3ed /tudy 4eriod

• hen the time period for the replacement studyis limited to a speci)ed study period or planning

hori7on for eample years the 6conomic%er,ice Life 06%L analysis is not performed!• "he 'nnual orth 0' ,alues for the challenger and for

the remaining life of the defender are not based on theeconomic ser,ice life8 the 'nnual orth 0' is

calculated o,er the study period only! hat happens tothe alternati,es after the study period is not consideredin the replacement analysis!


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• hen performing a replacement study o,er a)ed study period it is crucial that the

estimates used to determine the 'nnual orth0' ,alues be accurate and used in the study! "his is especially important for the defender!

#ailure to do the following ,iolates the

re(uirement of e(ual-ser,ice comparison!• hen the defenders remaining life is shorter than the

study period1 the cost of providing the defendersser,ices from the end of its epected remaining life to theend of the study period must be estimated as accuratelyas possible and included in the replacement study!


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O,er,iew of the replacement studyprocedure for a stated study period!

&. !uccession options and 'nnual orth 0 # )values !

– De,elop all the ,iable ways to use the defender andchallenger during the study period! "here may be only one

option or many options8 the longer the study period themore comple this analysis becomes! "he ' ,alues forthe challenger and defender cash Iows are used to buildthe e(ui,alent cash Iow ,alues for each option!

=! !election of the best option .

– "he Present orth 0P or 'nnual orth 0' for eachoption is calculated o,er the study period! %elect the optionwith the lowest cost or highest income if re,enues areestimated! 0's before the best option will ha,e thenumerically largest Present orth 0P or 'nnual orth0' ,alue!


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• hen a study period shorter than the life of thechallenger is de)ned the challengers capital

reco,ery amount increases in order to reco,erthe initial in,estment plus a return in thisshortened time period!


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• 3f there are se,eral options for the number of years that thedefender may be retained before replacement with thechallenger the )rst step of the replacement studyJ

succession options and ' ,aluesJmust include all the,iable options! #or eample if the study period is B yearsand the defender will remain in ser,ice 1 year or = yearsor > years cost estimates must be made to determine ',alues for each defender retention period! 3n this case

there are four options8 call them K and M!


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++.5 $eplacement 6alue


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$eplacement 6alue• Often it is helpful to *now the minimum mar*et ,alue of the

defender necessary to ma*e the challenger economicallyattracti,e! 3f a reali7able mar*et ,alue or trade-in of at least

this amount can be obtained from an economic perspecti,ethe challenger should be selected immediately! "his is abrea*even value between ' C and ' D 8 it is referred toas the replacement value $6# ! %et up the relation ' CN ' D with the mar*et ,alue for the defender identi)ed as

R5 which is the un*nown! "he ' C is *nown so R5 can bedetermined! "he selection guideline is as follows:

– 3f the actual mar*et trade-in exceeds the brea*e,enreplacement value the challenger is the betteralternati,e and should replace the defender now!


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engineering economins-replacement and retention decisions

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