Chapter 12 - Replacement Click here for Streaming Audio To Accompany Presentation (optional) Click here for Streaming Audio To Accompany Presentation (optional)

Chapter 12 - Replacement Click here for Streaming Audio To Accompany Presentation (optional)

EGR 403 Capital Allocation Theory

Dr. Phillip R. RosenkrantzIndustrial & Manufacturing Engineering Department

Cal Poly Pomona

http://video.csupomona.edu/PRRosenkrant/EGR403Lecture-15.asx

http://video.csupomona.edu/PRRosenkrant/EGR403Lecture-15.asx

EGR 403 - Cal Poly Pomona - SA15 2

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


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?


Replacement Analysis Terms

• Defender - the existing equipment or building previously implemented.

• Challenger - the proposed replacement currently under consideration.


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.


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.


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?


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?


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?


Replacement Analysis Decision Chart

CompareWhere

Not increasing

Increasing

Defender Marginal Cost

Not available

Available

Available

Defender Marginal Cost

EUAC at Minimum Cost Life

EUAC over Remaining Useful Life

3



2


Next-year Marginal Cost

1

Best Challenger

Defender

Ana

lysi

s T

echn

ique

s


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.


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)


Year

EUAC of Capital

Recovery Costs

EUAC of Maintenance and Repair

Costs

EUAC of Operating

CostsEUAC Total

Interest rate

Initial year -7500 0 -500

Arithmetic gradient

-900 -400

1 $8,100.00 $0.00 $500.00 $8,600.00 2 $4,205.77 $432.69 $692.31 $5,330.77 3 $2,910.25 $853.87 $879.50 $4,643.62 4 $2,264.41 $1,263.56 $1,061.58 $4,589.55 <-----MIN5 $1,878.42 $1,661.82 $1,238.59 $4,778.84 6 $1,622.37 $2,048.71 $1,410.54 $5,081.62 7 $1,440.54 $2,424.30 $1,577.47 $5,442.31 8 $1,305.11 $2,788.67 $1,739.41 $5,833.19 9 $1,200.60 $3,141.93 $1,896.41 $6,238.94

10 $1,117.72 $3,484.18 $2,048.53 $6,650.43 11 $1,050.57 $3,815.55 $2,195.80 $7,061.93 12 $995.21 $4,136.17 $2,338.30 $7,469.68 13 $948.91 $4,446.19 $2,476.08 $7,871.18 14 $909.73 $4,745.75 $2,609.22 $8,264.69 15 $876.22 $5,035.01 $2,737.78 $8,649.02

8%

EUAC calculations for increasing values of useful life


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


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)


Expense Cost YearsIncremental

cost thereafter

Investment Cost $25,000.00 0 $ - Annual O&M

Cost $ 2,000.00 1 $ 500.00

Annual Insurance Cost

$ 5,000.00 3 $ 1,500.00

Useful Life (years)

7

MARR 15%

Year Market ValueLoss in Market Value

Foregone Interest

O&M CostInsurance

Cost

Total Marginal

Cost0 $ 25,000.00 1 $ 18,000.00 $ 7,000.00 $3,750.00 $ 2,000.00 $ 5,000.00 $17,750.00 2 $ 13,000.00 $ 5,000.00 $2,700.00 $ 2,500.00 $ 5,000.00 $15,200.00 3 $ 9,000.00 $ 4,000.00 $1,950.00 $ 3,000.00 $ 5,000.00 $13,950.00 4 $ 6,000.00 $ 3,000.00 $1,350.00 $ 3,500.00 $ 6,500.00 $14,350.00 5 $ 4,000.00 $ 2,000.00 $ 900.00 $ 4,000.00 $ 8,000.00 $14,900.00 6 $ 3,000.00 $ 1,000.00 $ 600.00 $ 4,500.00 $ 9,500.00 $15,600.00 7 $ 2,500.00 $ 500.00 $ 450.00 $ 5,000.00 $11,000.00 $16,950.00

Marginal Cost for a New Item: Example 12-2


Marginal Cost Data DefenderExpense Cost Years

Incremental cost

thereafterInvestment Cost $15,000.00 0 $ -

Annual O&M Cost

$10,000.00 1 $ 1,500.00

Annual Insurance Cost

$ - $ -

Useful Life (years)

5

MARR 15%

Year Market ValueLoss in Market Value

Foregone Interest

O&M CostInsurance

Cost

Total Marginal

Cost0 $ 15,000.00 1 $ 14,000.00 $ 1,000.00 $2,250.00 $10,000.00 $ - $13,250.00 2 $ 13,000.00 $ 1,000.00 $2,100.00 $11,500.00 $ - $14,600.00 3 $ 12,000.00 $ 1,000.00 $1,950.00 $13,000.00 $ - $15,950.00 4 $ 11,000.00 $ 1,000.00 $1,800.00 $14,500.00 $ - $17,300.00 5 $ 10,000.00 $ 1,000.00 $1,650.00 $16,000.00 $ - $18,650.00 67

Is the marginal cost of defender increasing?

Here the marginal costs are increasing.

Example 12-3


Replacement Analysis Technique #1

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

Defender Marginal costs are increasing


Analysis Technique # 1

• 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.

Is Appropriate When Replacement Repeatability Assumptions Hold


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.



• 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.



• 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.


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.

Documents

Chapter 12 - Replacement Click here for Streaming Audio To Accompany Presentation (optional) Click here for Streaming Audio To Accompany Presentation (optional)