UNIT 5.- Replacement analysis and cost engineering.

5.1 Fundamentals of replacement analysis.

The replacement analysis is used to determine if a piece of equipment is operating from

an economical way or if operating costs can be reduced, by acquiring
a new team.
Additionally, through this analysis, it can be determined if the current team needs to be
replaced immediately or is it better to wait a few years before changing it.
Continuing with the analysis that the financial channel is conducting on the assets
physicists and as a complement to the articles made in the past tense, it is presented
below is a thorough study of the importance of decision-making
performed by the financial administrator at the time of replacing their
fixed assets.

A physical asset replacement plan is of vital importance in any process.

economic, because a hasty replacement causes a decrease in liquidity and
a late replacement causes loss; this happens due to cost increases of
operation and maintenance, therefore the timely moment must be established
for replacement, in order to obtain the greatest economic advantages.

A physical asset should be replaced when the following arise

causes:
Insufficiency.
High maintenance cost.
Obsolescence.

The economic life of goods

The economic life is understood as the period for which the uniform annual cost
the equivalent is minimal. For old assets, the useful life is not taken into account.
remaining, since almost everything can keep running indefinitely but to
a cost that can be excessive if constantly repaired.

From an economic point of view, the most used techniques in the analysis of
replacement are:

Optimal replacement period = Economic life

This technique consists of calculating the equivalent uniform annual cost of the asset.
when this is withheld for a certain number of years and in this way
select the number of years for which the cost is minimized.
5.2 Economic useful life.
The asset that supports the production of a company has a useful life as such,
that is to say, there comes a time when due to wear it can no longer be used
for the purposes for which it was manufactured or acquired. It can even be economically
It is more profitable to withdraw it from the company's assets before that moment. Everything
fixed asset has a useful or economic life that is correlated with the level of
usage intensity or utilization and it is "The time interval that minimizes costs"
annual totals equivalent to the asset or that maximizes its equivalent income
"neto" is also known as the minimum cost life or the optimal interval of
replacement. One of the most important aspects to make a decision about the
replacement of an asset is the cost pattern incurred by the activities of
operation, this allows designing the horizon of the project.

The economic life is understood as the period for which the uniform annual cost
the equivalent is minimal. For old assets, the useful life is not taken into account
remaining, since almost everything can be kept running indefinitely but at
a cost that can be excessive if it is repaired constantly.

From an economic point of view, the most used techniques in the analysis of
The replacements are the following and are presented below:

Optimal replacement period = Economic life.

This technique involves calculating the equivalent uniform annual cost of the asset,
when this is held for a certain number of years and in this way
select the number of years for which the cost is minimal.

It may be desirable to know the number of years that an asset should last.
to remain in service to minimize its total cost, considering the value of
money in time, the recovery of capital investment and annual costs of
operation and maintenance.

This minimum cost time is a value n to which reference is made by

various names such as the life of economic service, life of minimum cost,
retirement life and replacement life. Up to this point, it has been assumed that life
of an asset is known or given. We need to develop an analysis that helps us
determine the life of an asset (value n) that minimizes the total cost. Such analysis
it is appropriate for the asset to currently be in use and the replacement to be considered
or it is being considered the acquisition of a new asset.
In general, with each passing year of use of an asset, the effects are observed.
following trends:

The equivalent annual value of the annual operating cost (AOC) increases. Also
the term CAO can refer to maintenance costs and
operation (M&O).
The annual equivalent value of the initial investment of the asset or initial cost decreases.
The amount of exchange or actual salvage value decreases in relation to
initial cost

These factors cause the total VA curve of the asset to decrease for some years.
and increased from there onwards. The total VA curve is determined using the
next relationship for a number k of years:

VA total = VA of the investment + VA of the CAO

The minimum total VA value indicates the value n during the economic service life.
the value n when the replacement is the most economical. This should be the life of the asset
estimate used in an economic engineering analysis, if considered
only the economy.

The approach to estimating n in service life analysis uses VA calculations.

conventional. The life value index is increased from 1 to k, where the value
the longest possible lifespan is N, that is, k = 1,2,..., N.

VA = -(P/A,i,k) + VS(A/F,i,k) - ∑ CAOj(P/F,I,j)(A/P,i,k)

Where P = initial investment or initial cost of the asset

VS = salvage value after keeping the asset for k years

annual operation cost for year j (j = 1, 2,...,k)

5.3 Conducting a replacement analysis.

The economic engineering studies of replacement alternatives are going to
ending using the same basic methods as other economic analyses that
implies two or more alternatives. However, the situation in which it must be taken
A decision takes on different forms. Sometimes, one seeks to withdraw an asset without
replace it (abandonment), or keep it as a backup instead of giving it the use
primordial. At other times it is necessary to decide whether the new requirements of the
production can be achieved with the increase of capacity or efficiency of the
existing asset(s). However, it is common for the decision to hinge on
to replace or not an asset (old) that is already owned, which is referred to
defender, by another new one. The assets (new) that constitute one or more
Replacement alternatives are called challengers.

The replacement analysis plays a vital role in economic engineering when it

they compare an active defender (in use) and one or more challengers. To carry out the
analysis, the evaluator takes the perspective of a company consultant: none
the asset is currently owned and the two options are to acquire the asset
used or acquire a new asset.

In a replacement study, two equivalent approaches can be taken to

determine the initial cost P for the alternatives and when conducting the analysis:
Cash flow focus. Recognize that there is a real advantage in cash flow.
cash for the challenger if the defender is exchanged. For the analysis, use the
following guidelines: Defender: The amount of the initial cost is zero. Challenger: The cost
Initial is the actual cost minus the nominal exchange value of the defender. For
using this method, the estimated life of the defender, that is, their remaining life, and the
the challenger's must be equal.
Opportunity cost approach. Suppose that the amount of exchange of
the defender is lost and the defender's service can be acquired as an asset
used for its exchange cost. Defender: The initial cost is the value of
exchange. Challenger: The initial cost is your actual cost. When the remaining life of the
the defender and the challenger’s life are unequal, it is necessary to preselect a
study period for the analysis. It is commonly assumed that the annual value
continues in the same amount calculated for an alternative with a lower value n
that the study period.

If this assumption is not appropriate, conduct the analysis using new ones.
estimates for the defender, the challenger, or both. If the study period is
shorten so that it is less than one or both of the life estimations of the
alternatives, it is necessary to recover the initial cost and the required return to the
TMAR in less time than expected normally, which will increase the way
artificial the value(s) VA.

The use of a shortened study period is generally a decision

Administrative. A sunk cost represents a previous capital investment that
it cannot fully recover or at all. When performing an analysis of
replacement, no cost lost (for the defender) is added to the initial cost of
challenger, as the analysis will be unfairly biased against the challenger due to a
artificially higher resulting VA value. This chapter detailed the
procedure to select the number of years in order to retain an asset; it
he used the criterion of economic service life.

The economically best value occurs when the resulting VA value from the
the equation is minimum at a specified return rate. Although in general it is not
correct, if the interest is not considered (i = 0), the calculations are based on
simple common averages. When conducting a replacement analysis for a year to the
or an additional year before or after the estimated life has been
achieved, it is calculated

5.4 Replacement analysis during a specific study period.

The study period or planning horizon is the number of years

selected in the economic analysis to compare the alternatives of defense
and as a challenger. When selecting the study period, one of the two following
situations are common:

The anticipated remaining life of the defender is equal to or shorter than the life of the
challenger. If the defender and the challenger have equal lives, either one should be used.
of evaluation methods with the most recent information

5.5 Cost Engineering.

Engineering today is not limited to problem solving in its
corresponding fields of knowledge, but takes into account all
the variables that can affect the application of the solutions and the development of
projects. One of these variables is the economy and costs, which can
change the decision-making or the way in which they should be raised
solutions, for this reason it is considered necessary for engineers to be aware
of the importance of this branch of engineering which is gaining more and more relevance every day.
importance.

The cost is the total approved expenditure after the completion of a project.
which makes it clear that the cost of a project is the one recorded at its completion,
after each expense, disbursement or charge attributable was accounted for
directly or indirectly, as well as the benefit that the contractor obtained in their
case.

Cost Estimation involves a priori calculation of what will be.

The work of the Cost Specialist is conjectural by excellence. Conjecture in the
the context we are dealing with is a judgment formed from the probable costs in which
it will be incurred, by the signs observed in a project - plans and
specifications and conditions that could prevail in the work, to determine
a fact how much does the work cost? based on:

Experience
Observations
Reasonings
Queries

Then cost engineering can be defined as: the art of applying

scientific and empirical knowledge to make the most realistic conjectures and
estimate the cost of a construction, as well as its control during the work.

Cost Engineering provides deep knowledge and analysis for a

efficient estimation, budget formulation, and cost control, throughout the
life cycle of a business or project, from its initial planning to the
start-up.

The estimation phase will cover data collection and its analysis, the methods
more suitable, the accuracy and types of estimates, along with the techniques
associated with the assessment and resolution of the most important problems for the
calculation of correct estimates.

The Budget Preparation presents a structure that meets the

management requirements.

The part related to Cost Control covers from basic design to

the launch, in which concepts and methods are discussed for a
efficient cost tracking.

5.5.1 Effects of inflation.

Inflation occurs because the value of money has changed; it has decreased. The value
the money has decreased and, as a result, more pesos are needed for less
goods. This is a sign of inflation. To compare monetary amounts that
They occur in different periods of time, the weighted values in different ways.
they must first be converted to constant value pesos in order to represent
the same purchasing power over time, which is especially important
when future amounts of money are considered, as is the case with all the
evaluation of alternatives.
Deflation is the opposite of inflation. The calculations for inflation are
equally applicable to a deflationary economy.

The money in a period of time, t1 can be brought to the same value as the money
in another period of time, t2 using the generalized equation:

Pesos in period t1 = pesos in period t2 / inflation rate between t1 and t2

The weights in the period t1 are called today's weights and the weights in the period
future pesos or current pesos of that time. If the inflation rate is presented
by period and n is the number of time periods between t1 and t2 the equation
anterior becomes:

Today's pesos = current pesos of that time / (1 + f)n

Another term for referring to today's pesos is pesos in values.

constants. It is always possible to set inflated future amounts in terms
of current pesos applying the previous equation.

Three different rates are used:

1. Real interest rate or inflation-free rate. This rate is obtained when the interest is calculated.
the effect of changes in the value of the currency has been removed. Therefore, the rate
Real interest presents a real gain in purchasing power.

2. Market interest rate if. As its name implies, this is the rate of
interest in the market, the rate of which is heard about and to which reference is made
reference every day. It is a combination of the real interest rate i and the rate
of inflation f, and consequently, it changes as the rate changes
inflation. It is also known as inflated interest rate.

3. Inflation rate f. It is a measure of the rate of change in value of the

currency.

5.5.2 Cost estimation and allocation of indirect costs.

A cost index is a ratio of the cost of an item today in relation to its

cost at some point in the past. Of these indices, the most familiar to the
Most people is the Consumer Price Index (CPI), which shows the
relationship between past and present costs for many of the items that
typical consumers must buy.

This index, for example, includes items such as rent, food,

transport and certain services. However, other indices are more relevant to
engineering, as they follow the cost of goods and services that are more
relevant for engineers
The indices are constructed from a mix of components to which they
they assign certain weights, sometimes subdividing the components into more
basic lines. For example, the equipment, the machinery, and the components of
support of the cost index of chemical plants is further subdivided into
process machinery, pipes, valves and accessories, pumps and compressors
etc. These subcomponents, in turn, are built from even more articles.
basics like pressure pipe, black pipe, and galvanized pipe.

The general equation for updating costs through the use of any index of
costs over a period from time t = 0 (base) to another moment t is:

Ct = C0It / I0

Ct = estimated cost at the present time t

C0 = cost at the previous moment t0

It = value of the index at time t

I0 = value of the index at time t0

5.5.3. Economic analysis after taxes

Performing an economic study without taking into account the effects of taxes on
the income of organizations can be misleading, because the
Taxes can change the decision made before taxes. The
the consideration of taxes in economic studies is a decisive factor in the
selection of investment projects, as it avoids accepting projects whose
Returns after applying taxes are mediocre. This section does not
will analyze government laws to determine the amount of taxes,
It will only be an introduction to the effect of taxes on studies.
of economic engineering

Tax definitions.
"Death and taxes are inevitable" (Richard Halliburton). There are taxes.
federal and state taxes that levy on income, property, and/or transactions. The
Wealth transfer through the tax mechanism is a concern
important for governments, and the payment of these taxes is a concern
greater than those that produce income. Taxes impose burdens on the
utilities that result in a reduction in their magnitude. The
income taxes simply constitute, in relation to studies of
economic engineering, another type of expenses, but which requires a different treatment
special. The main types of taxes and their are described below.
relevance regarding the studies of economic engineering.

Income taxes
They are the ones that are charged to the income of individuals or companies, with
rates that increase as income grows. These are based on the
net income after making the permitted deductions. The income
include merchandise and service sales to customers, the dividends that are
they receive from the actions, royalties, and other earnings that are a consequence of
the possession of capital or property. The deductions cover a wide variety
of expenses incurred during the generation of income, salaries,
salaries, benefits, materials, etc. are also deductible on occasions.
losses suffered from fires, theft, depreciation, etc.

Property taxes,
they are loaded on land, buildings, machinery and equipment, inventories, etc. The
The amount of taxes is a function of the estimated value of the assets and the rate.
tax. Property taxes are not usually a factor
significant in an economic engineering study compared to the
income tax

5.5.4 After-tax assessment of Present Value, Annual Value, and Rate

Return Intern

If the minimum after-tax return rate is established or known, it

They can use present value (PV) methods or annual value (CAUE) for
select the cheapest plan. Next we will look at the previous cases
mentioned in the following order:
A) annual value (CAUE);
B) present value (PV);
C) and internal rate of return.
Example 1 (for VP and VA): Using a return rate of 7%, select the plan
cheaper than those listed in examples 1 and 2 of the topic
4.2.4 (previous), using:
(a). CAUE and (b) present value analysis. (The plans are summarized to
continuation):

Solution:
A) The CAUE equations can be formulated and solved with i = 7% as follows:
The plan A is selected, as the CAUE values are positive (profit) and the
CAUE is larger.
The present value analysis would be based on a 30-year horizon to match
the expected useful lives. Using the previous annual values (CAUE);
The A plan is selected again because VPA is higher.
Comment: If only the pre-tax disbursement values are known,
such as annual operating costs, that is FCAI < 0, the taxes
related are a tax advantage that will be applied against other interests of the
company.
C) Using the internal rate of return method.
To determine the after-tax return, the following can be used
methods:
1. find the rate at which the present value of FCDI is equal to zero.
2. Find the rate at which the CAUE of the FCDI is equal to zero.

If there are 2 assets A and B, the return is found using one of these methods; without
embargo, the equations take these respective forms:

The second method (CAUE) will be used exclusively if there are 2 assets, because it is
compatible with the conventions used in previous chapters and generally
they can be calculated more simply for assets with unequal useful lives.

Example 2: Using the asset purchase described in example 1 of topic 4.2.3

and a straight-line depreciation, calculate the rate of return after
taxes. (Summary:
$100,000
50%)

Solution: Table 4.2.5.B presents the FCDI for the asset. The value equation
the return after tax is as follows:

By trial and error, i = 7.70%.

Comment: If you as an economist wish to use an inflated rate before
tax to approximate the tax effect on this type of asset, one can use the
next equation: pre-tax return rate = after-tax return rate
tax / (1-tax rate); to obtain i / (1-T) = 0.0770 / (1-0.50) =
0.1540, or 15.4%. The real return of the tax calculated using the FCAI figures
In table 4.2.5.B. it can be cleared from the equation:

Which gives a value of i = 14.56%. The comparison of 14.56% with the previously inflated rate
The 15.4% tax shows that the tax effect is slightly above
calculated using a pre-tax return of 15.4%.