Engineering Economics

ECOR 3800 - Lecture Notes

Lecture 5: Replacement Decisions

By: Ahmed Hassan

Based on: Engineering Economics: Financial Decision Making for
Engineers, 7th edition
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7.3 Capital Costs and Other Costs of Assets
• Purchasing assets is a decision to acquire production
capacity.
• Relevant costs associated with owning assets:
1. Capital costs (P): difference between price paid and
what it can be sold for later (usually expressed as EAC).
2. Installation costs (I): not reversable after the fact.
– Includes lost production time and lost output.
3. Operating and maintenance (O&M) costs:
– The cost of using the asset to produce goods/services.
• Note: Capital costs of the asset over time include 1 and 2.

2
7.2 Reasons for Replacement or Retirement
• Replacement becomes necessary if there is a cheaper
way to get the service provided.
• Productive assets may deteriorate over time.
• Technological or organizational change allow for cheaper
methods.
• The service provided is no longer adequate.
– It has insufficient capacity to meet growing demand.
– It no longer produces items of high enough quality.
– It becomes more expensive over time
• The asset may be retired (removed w/o replacement):
– Changes in demand, production, technology

3
Introduction
• When an asset is evaluated, you have one of four
choices:

1. Keep the asset in use without change (do nothing).

2. Overhaul the asset to improve its performance.

3. Remove it from use without replacement.

4. Replace the current asset with another asset.

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Introduction
• Chapters 4-5 discussed Comparison Methods, but
Replacement Decisions needs special attention.
– We need to consider the cost of replacement.
– The service life has been assumed in earlier chapters –
this chapter shows how the service life of an asset is
calculated.
– Assumptions about how an asset may be replaced in
the future can affect a current decision.

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7.1 A Replacement Example
(Example 7.1)
Sergio’s landscaping business is trying to determine how long should
lawn-mowers be kept before getting replaced to minimize maintenance
cost and lost time needed for replacement? The average cost of a new
lawn mower is $600, and it declines in value at a rate of 40% per year.
Interest rate is 5%. The cost of repairs is $60/repair. It is also estimated
that you lose 2 hours of time for each repair, hours that could have been
used to provide services for $20/hr. The table below shows the schedule
of repairs of a lawn-mower by age.
Year of operation Number of repairs required
1 0
2 1
3 2
4 4
5 8

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7.1 A Replacement Example
(Example 7.1)
• While repair costs increase on an annual basis, buying lawn mowers
more frequently increase capital costs.
• If following the multiple service life methods, we have to find the least
common multiple between 1,2,3,4 and 5 years, which is a service life
of 60 years.
• Alternatively, we can evaluate the annual worth. And since the profit is
not going to change regardless of when we replace the mowers, this
approach is referred to as the Equivalent Annual Cost (EAC)
approach
• Using the capital recovery formula, we can calculate the equivalent
annual capital costs of replacing a lawnmower every N years as
follows:
EAC(capital) = A = (P – S)(A/P, i, N) + Si

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7.1 A Replacement Example
(Example 7.1)
• A replacement decision also depends on O&M costs.
• The EAC of operating and maintaining, EAC (O&M), a lawnmower
can be computed assuming it is kept for N years is calculated by
converting all the O&M costs into equivalent annual costs
Replacement Salvage EAC Capital Annual EAC Repair
Period (years) Value Costs Repair Costs Costs EAC Total
1 $360.00 $270.00 $0.00 $0.00 $270.00
Lowest
2 216.00 $217.32 100.00 48.78 266.10
EAC
3 129.60 $179.21 200.00 96.75 275.96
4 77.76 $151.17 400.00 167.11 318.27
5 46.66 $130.14 800.00 281.64 411.79

𝑆 3 = 𝐵𝑉 3 = 600 × (1 − 0.4) = $129.6

𝐸𝐴𝐶 3 = 600 − 129.6 𝐴/𝑃, 5%, 3 + 129.6 ∗ 0.05 = 179.21
𝐸𝐴𝐶 & 3 = [100 𝑃/𝐹, 5%, 2 + 200 𝑃/𝐹, 5%, 3 ](𝐴/𝑃, 5%, 3) = 96.75

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7.1 A Replacement Example
(Example 7.1)
• If Sergio keeps his lawnmowers for 2 years and then
replaces it, his average annual costs are minimized.
• Therefore, from this example, the economic life of the
lawnmower is 2 years.
• Assuming that the asset and replacement are identical,
and this sequence continues indefinitely in the future.
• The existing physical asset is called the defender.
• The potential replacement is called the challenger.
• Challenger and defender do not always have to be the
same. Often, they can be different.

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7.3 Replacement decisions
• Three situations will be examined when replacement is
decided upon:
1. Defender and challenger are identical and the
need for the asset repeats indefinitely.
2. Challenger repeats indefinitely but is different from
the defender.
3. Defender and challenger are different and do not
repeat.

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7.3 Replacement decisions
• Three situations will be examined when replacement is
decided upon:
1. Defender and challenger are identical and the
need for the asset repeats indefinitely.
2. Challenger repeats indefinitely but is different from
the defender.
3. Defender and challenger are different and do not
repeat.

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7.4 Defender and Challenger Are Identical
• Assumptions (relative to time horizon):
– The defender /challenger are technologically identical.
– Lives of these identical assets are assumed to be short
– Relative prices/interest rates are assumed constant.
• We model the replacement decision as if it were to
take place a large number of times (i.e., cyclic
replacement).
• Then determine the minimum-cost lifetime of the
assets.

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7.4 Defender and Challenger Are Identical
• Since Capital Costs decrease (per period) while O&M generally
increases (per period) over time; there usually is a lifetime that will
minimize EAC (total costs). This is the economic life of the asset!

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 Example 7.2
• Jiffy printer company is considering installing an automated plastic
moulding system to produce parts for printers. The moulder costs
$200,000 and the installation costs are estimated to be $50,000.
Operating and maintenance costs are expected to be $300,000 in the
first year and to rise at the rate of 5% per year. Jiffy estimates
depreciation to be 40% per year. The company uses an MARR of 15%
for capital investment. How long should the company keep the moulder
before replacing? What is the economic life of the moulder?
Year Salvage EAC capital O&M PW O&M PW O&M (cum.) EAC O&M EAC total
1 $120,000.00 $167,500.00 $300,000.00 $260,869.57 $ 260,869.57 $300,000.00 $467,500.00
2 $ 72,000.00 $120,290.70 $315,000.00 $238,185.26 $ 499,054.82 $306,976.74 $427,267.44
3 $ 43,200.00 $ 97,053.64 $330,750.00 $217,473.49 $ 716,528.31 $313,822.89 $410,876.53
4 $ 25,920.00 $ 82,375.46 $347,287.50 $198,562.76 $ 915,091.07 $320,524.70 $402,900.16
5 $ 15,552.00 $ 72,272.28 $364,651.88 $181,296.43 $ 1,096,387.50 $327,069.44 $399,341.73 Moulder should
6 $ 9,331.20 $ 64,993.26 $382,884.47 $165,531.52 $ 1,261,919.02 $333,445.58 $398,438.84 be changed
7 $ 5,598.72 $ 59,584.19 $402,028.69 $151,137.48 $ 1,413,056.50 $339,642.77 $399,226.96
8 $ 3,359.23 $ 55,467.80 $422,130.13 $137,995.09 $ 1,551,051.58 $345,651.98 $401,119.79 every 6 years
9 $ 2,015.54 $ 52,273.43 $443,236.63 $125,995.51 $ 1,677,047.10 $351,465.49 $403,738.92
10 $ 1,209.32 $ 49,753.45 $465,398.46 $115,039.38 $ 1,792,086.48 $357,076.93 $406,830.38

𝑆 = 𝑃(1 − 𝑑) 𝐸𝐴𝐶 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑃 + 𝐼 − 𝑆 𝐴⁄𝑃 , 15%, 𝑛 + 𝑆𝑖

𝑃𝑊 𝑂&𝑀 = 𝑂&𝑀(𝑃/𝐹, 15%, 𝑛) 𝐸𝐴𝐶 𝑂&𝑀 = 𝑃𝑊(𝑂&𝑀) ∗ (𝐴/𝑃, 15%, 𝑛)

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7.3 Replacement decisions
• Three situations will be examined when replacement is
decided upon:
1. Defender and challenger are identical and the
need for the asset repeats indefinitely.
2. Challenger repeats indefinitely but is different from
the defender.
3. Defender and challenger are different and do not
repeat.

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7.5 Challenger Is Different from Defender;
Challenger Repeats Indefinitely
Decision rule to minimize cost is as follows:
1. Determine the Economic Life of the challenger and
its associated EAC.
2. Determine the remaining Economic Life of the
defender and its associated EAC.
3. If the EAC(defender) > EAC(challenger), replace
now. Otherwise, do not replace now.

16
7.5 Challenger Is Different from Defender;
Challenger Repeats Indefinitely
• For assets “in place” for many years, annual capital
costs will be low in comparison to O&M costs and
EAC(total) will be increasing each N.

17
7.5 Challenger Is Different from Defender;
Challenger Repeats Indefinitely
• Use One year principle: When above exists and the
yearly operating costs are monotonically increasing, the
economic life of the defender is one year and total EAC
is the cost of using the defender for one more year.
• The one year principle implies:
– If EAC of keeping Defender one more year exceeds
the EAC of Challenger at its economic life, replace
defender immediately.

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Example 7.4
• An asset is 3 years old; O&M = $5000 per year,
increasing by 10% per year; the salvage value is
currently $60,000 and is expected to be $50,000 one
year from now. Can the one year principle be used?

Answer:
• The capital costs are not low compared to the O&M
costs, even though the O&M costs are monotonically
increasing. The one year principle can not be used.

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Example 7.5
• An asset is 10 years old; O&M = $5000 per year,
increasing by 10% per year; the salvage value is
currently $8000 and is expected to be $7000 one year
from now. Can the one year principle be used?

Answer:
• The capital costs are low compared to the O&M costs,
and the O&M costs are monotonically increasing. The
one year principle can be used.

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7.6 The Irrelevance of Sunk Costs
• Once an asset has been installed and has been
operating for some time, the costs of installation, and
all other costs incurred up to that time are no longer
relevant to any decision to replace the current asset.

• These costs are called sunk costs.

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Example 7.8
Jiffy printer company (example 7.2) bought the moulder expecting its
production to be 200,000 units per year. Unfortunately, it turned out that
its production is only 150,000 units. This means that instead of the initial
cost per unit expected of $398,439/200,000= $1.99 per unit, the actual
cost is $398,439/150,000=$2.66 per unit. Another option for Jiffy is to
start subcontracting the production at a cost of $2.50 per unit. Does it
make since to do that after year 2, or should the company wait at least
one more year?
Year Salvage EAC capital O&M PW O&M PW O&M (cum.) EAC O&M EAC total
1 $120,000.00 $167,500.00 $300,000.00 $260,869.57 $ 260,869.57 $300,000.00 $467,500.00
2 $ 72,000.00 $120,290.70 $315,000.00 $238,185.26 $ 499,054.82 $306,976.74 $427,267.44
3 $ 43,200.00 $ 97,053.64 $330,750.00 $217,473.49 $ 716,528.31 $313,822.89 $410,876.53
4 $ 25,920.00 $ 82,375.46 $347,287.50 $198,562.76 $ 915,091.07 $320,524.70 $402,900.16
5 $ 15,552.00 $ 72,272.28 $364,651.88 $181,296.43 $ 1,096,387.50 $327,069.44 $399,341.73
6 $ 9,331.20 $ 64,993.26 $382,884.47 $165,531.52 $ 1,261,919.02 $333,445.58 $398,438.84
7 $ 5,598.72 $ 59,584.19 $402,028.69 $151,137.48 $ 1,413,056.50 $339,642.77 $399,226.96
8 $ 3,359.23 $ 55,467.80 $422,130.13 $137,995.09 $ 1,551,051.58 $345,651.98 $401,119.79
9 $ 2,015.54 $ 52,273.43 $443,236.63 $125,995.51 $ 1,677,047.10 $351,465.49 $403,738.92
10 $ 1,209.32 $ 49,753.45 $465,398.46 $115,039.38 $ 1,792,086.48 $357,076.93 $406,830.38

EAL Capital s EAC Dand M yes

EAC total 330 550 39 600 370350 22
eco EAC cop
7.7 When Capital or Operating Costs Are
Non-Monotonic
• Sometimes operating and/or capital costs do not
increase monotonically over time.
• In this case, the one year principle does not apply
because there may be one-time or periodic costs that
occur over the course of the next year.
• Such costs may make the costs of keeping the defender
for one more year greater than installing /using the
challenger over its economic life.
• However, there may be a life longer than one year over
which the cost of using the defender is less than the cost
of installing and using the challenger.

23
Example 7.9
• The Colossal Construction Company uses a generator to produce
power at remote sites.
• The existing generator is now three years old and cost
$110,000 when purchased
• Its current O&M costs are $10,000 increasing by $5,000 per year. In
addition, there is also an overhaul cost of $10,000 this year and every
third year from now
• The current salvage value is $24,000, expected to be $14,000 next year,
$9,800 the year after that, and then declining by 30% moving forward
• The new generator sells for $95 000 with negligible installation costs.
Further information about the new generator salvage values and O&M
costs are summarized in the next slide.

24
Example 7.9
The new generator has salvage values and operating costs
as shown below:
End of Year Salvage Value Operating Cost
0 $95 000
1 80 000 $10 000
2 70 000 10 000
3 60 000 12 000
4 50 000 15 000
5 40 000 20 000
6 30 000 20 000
7 20 000 20 000
8 10 000 30 000

If the MARR is 12%, Should the defender be replaced?

25
Example 7.9
• From Table 7.5 we see that the economic life is four
years.
• But operating costs of the defender are non-
monotonic!
• Therefore, we need to calculate the Economic life and
EAC of keeping the defender for the upcoming years.

26
7.3 Replacement decisions
• Three situations will be examined when replacement is
decided upon:
1. Defender and challenger are identical and the
need for the asset repeats indefinitely.
2. Challenger repeats indefinitely but is different from
the defender.
3. Defender and challenger are different and do not
repeat.

27
7.8 Challenger Is Different from Defender;
Challenger Does Not Repeat
• Normally we expect the future challengers to be better
than the current challenger.
– Do we skip over the current challenger and wait for the
next “new and improved” challenger?
• We must enumerate all possible combinations of
replacement options and evaluate all to make a
choice.
– EAC for each combination must be calculated.
– Number of combinations increases quickly.
– Typically, very little information is available on the costs
and benefits of future challengers.
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Example 7.10
• In a simple situation where you have a defender that can be kept for upto 5
years, a first challenger that can also be kept for upto 5 years, and a second
challenger that can be kept for upto 2 years….You will have 15 different
alternatives!!
Decision Alternative Defender Life in Years First Challenger Life in 2nd Challenger Life in
Years Years
1 5 0 0
2 4 1 0
3 4 0 1
4 3 2 0
5 3 1 1
6 3 0 2
7 2 3 0
8 2 2 1
9 2 1 2
10 1 4 0
11 1 3 1
12 1 2 2
13 0 5 0
14 0 4 1
15 0 3 2

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