Replacement and Retention Decisions

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Replacement and Retention Decisions

• Engineering Economics

Lecture 7 17 September, 2004
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Need for Replacement

• As was mentioned in the previous lectures, each
  piece of equipment or a system has a useful life
  after which it must be retired.
• In a business environment, the decision to retire
  and replace such equipment or a system is based
  on economical analysis.
• Very often the reasons for replacement are
• Reduced performance due to equipment ageing
• New functional and/or performance requirement
• Obsolescence and lack of support

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Reduce Performance

• Physical deterioration of equipment or a system
  as a result of ageing leads to reduced levels of
  reliability and productivity
• That is where a good operation and maintenance
  practice can be valuable.

4
New Requirements

• Equipment or a system that cannot meet the new
  requirements such as accuracy, speed, or other
  specifications
• Change in industrial or business processes may
  require additional functionality.
• Very often the choice is between the replacement
  or the enhancement through retrofitting or upgrade

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Obsolescence

• Obsolescence is the effect of rapidly changing
  technology.
• Obsolescence is often a result of ever-decreasing
  development cycle time to bring new products to
  market.
• Obsolescence can be planned, when buying new
  equipment be aware of the life cycle.
• Lack of technical support and spare parts

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Replacement Study Terminology

• Defender (D) and Challenger (C) are the names of
  two mutually exclusive alternatives.
• Defender is the currently installed asset
• Challenger is the potential replacement
• AW (Annual Worth) values are used as the primary
  economic measure between the defender and
  challenger.
• Economic Service Life (ESL) is the number of
  years at which the lowest AW of cost occurs.

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Replacement Study
Study period specified ?
Yes
No
Develop succession options for D and C using AWD
and AWC
Perform ESL analysis
PW or AW for each option
AWD
AWC
Select best option
Select better AW
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Economic Service Life (ESL)

• The best value for n is not known in this type
  of problem.
• The ESL for a given asset is
• The number of years where the AW of the future
  costs is minimum
• Using the cost estimates of all possible years
  that the asset may provide a needed service!
• Termed The minimum cost life

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ESL Analysis

• One estimates the ESL for the challenger, and the
  ESL for the current defender.
• Estimating ESL requires the estimates of future
  operating and maintenance costs and any salvage
  value.
• Apply an Annual Worth Analysis for assumed values
  of n 1, 2,
• Economic Service Life (ESL) is the number of
  years at which the lowest AW of cost occurs.

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ESL General Format

• Compute
• Total AW - Capital Recovery - AW of operating
  costs
• Total AW - CR - AW of AOC
• Salvage values may be incorporated into the
  capital recovery term.
• Do this for n 1, then n 2, then n and
  observe the min. cost n value.

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Minimum Cost Life

• The minimum cost life is
• That value of n that yields the lowest annual
  cost over the range of n values applied.
• Capital Recovery topic See Chapter 6, Section
  2 to review and lecture 4.

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Components of ESL

• Capital Recovery Costs (CRC)
• CRCs generally decrease with each year of
  operation
• The longer one uses an asset, the costs
  associated with owning the asset are spread out
  over more and more time periods.

Sn
0 1 2 . . .
n-1 n
Diagram for Capital Recovery
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Capital Recovery Formula

• CRC Setup

CRC(i) -P(A/P,i,n) S(A/F,i,n)
CRC(i) is the annual cost of owning an asset
over n time periods.
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Annual Operating Cost Component

• Annual Operating Costs (AOC) is end-of-year
  estimated costs of operating the asset in
  question.
• AOCs tend to increase over time
• One wants to distribute the AOC over a range of
  assumed number of years
• n 1, then 2, then 3, ...

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Plotting ESL

• The ESL can be visualized by plotting three
  curve forms
• Plot the CRCs over assumed values of n
• Plot the AOCs over the same assumed values of
  n
• Plot the sum of the CRC and AOC over the same
  assumed values of n (Total AW of AOCs)
• Examine the AW plot to observe the minimum cost
  life of the respective asset.

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Typical ESL Plot
Total AW of costs
AW of AOC
AW of costs, /year
Capital recovery
Economic service Life
Years
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Example (11.2)

• Defender Asset
• 3 years old now
• Market value now 13,000
• 5-year study period assumed
• Requires estimates of the future salvage values
  and annual operating costs for the 5-year period.

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Future Market Values

• Estimated Future Market Values and AOCs
• MktVt AOCt
• t 1 9,000 -2,500
• t 2 8,000 -2,700
• t 3 6,000 -3,000
• t 4 2,000 -3,500
• t 5 0 -4,500

Mkt. Values are decreasing AOCs are increasing
Assume the interest rate is 10 per year.
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Example Find the ESL

• Period-by-period analysis
• For k 1 year

AW(10)1 (-13,000)(A/P,10,1)
9,000(A/F,10,1) 2,500
-7,800 ( for one year!)
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Example Find the ESL

• Period-by-period analysis
• For k 2 years

S2 8,000
0 1 2
AOC1 -2,500
AOC2 -2,700
P13,000
AW(10)2 (-13,000)(A/P,10,2)
8,000(A/F,10,2) -2,500(P/F,10,1)
2,700(P/F,10,2)(A/P,10,2) -6,276/yr for 2
years.
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Example Find the ESL

• Period-by-period analysis
• For k 3 years

S3 6,000
0 1 2
3
AOC1 -2,500
AOC2 -2,700
P13,000
AOC3 -3,000
AW(10)3 (-13,000)(A/P,10,3)
6,000(A/F,10,3) -2500(P/F,10,1)
2,700(P/F,10,2) 3,000(P/F,10,3(A/P,10,3)
-6,132/yr for 3 years.
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Example Continued

• A similar analysis for k 4 and 5 is conducted
• The AW(10)k, K 1,2,3,4,5 are tabulated as
• Total AWk
• k1 -7,800
• k2 -6,276
• k3 -6,132
• k4 -6,556
• k5 -6,579

Min. Cost Year 3 years
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11.2 Spreadsheet Format
Base Input Parameters
Schedule of Est. Mkt. Values and AOCs/year
Tabulation of CRSs, AOCs and Total AW(i)
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Plots for Example
Min AW Year!
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ESL vs. AW Analysis

• Traditional AW Analysis
• The number of years n is fixed or assumed
• First cost at t 0 is known
• Estimate the salvage value at t n
• ESL Analysis
• The number of yearsn varies from t 1 to t
  k
• Year-by-year analysis using AW(i)
• Table of possible future salvage (market) values
  for the asset in question.
• Table of future AOCs, year by year.

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ESL vs. AW

• AW analysis is for a fixed time period with a
  table of AOCs and one estimated future salvage
  value out at t n.
• ESL is a period-by-period variant of AW where a
  table of estimated future salvage values may be
  provided and a tabulation of a set of AWs for
  each time period evaluated.
• Seeking the min. AW life in an ESL analysis.

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Marginal Cost Approach

• Marginal Costs are year-by-year estimates of the
• Costs of owning the asset, and
• Costs of operating the asset for the current year
  in question.
• Three Components of Marginal Costs
• Cost of ownership (loss in Mkt. Value/yr)
• Foregone interest of Mkt. Value at
  beginning of the year
• AOC for each year.

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Marginal Cost Analysis

• Compute the marginal costs per year
• Find their equivalent annual worth
• AW of marginal costs total AW of costs
• Can perform either a ESL analysis or a Marginal
  Cost analysis when yearly Market Values are
  estimated
• Same result!

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References

• Blank, L., Tarquin, A., Engineering Economy,
  McGraw-Hill, 5/e - Chapter 11

Thank you for your attention