REPLACEMENT AND

MAINTENANCE
ANALYSIS
 INTRODUCTION
Organizations providing goods/services use several facilities like equipment
and machinery which are directly required in their operations.
In addition to these facilities, there are several other items which are
necessary to facilitate the functioning of organizations.
All such facilities should be continuously monitored for their efficient
functioning; otherwise, the quality of service will be poor.
Besides the quality of service of the facilities, the cost of their operation and
maintenance would increase with the pas age of time.
Hence, it is an absolute necessity to maintain the equipment in good
operating conditions with economical cost.
Thus, we need an integrated approach to minimize the cost of maintenance.
In certain cases, the equipment will be obsolete over a per od of time.
 REASONS FOR REPLACEMENT
There are two basic reasons for considering the replacement of an equipment—
1. Physical impairment of the various parts or
2. Obsolescence of the equipment.
Physical impairment refers only to changes in the physical condition of the machine itself.
This would lead to a decline in the value of the service rendered, increased operating
cost, increased maintenance cost or a combination of these.
Obsolescence is due to improvement of the tools of production, mainly improvement in
technology. So, it would be uneconomical to continue production with the same machine
under any of the above situations. Hence, the machines are to be periodically replaced.
Sometimes, the capacity of existing facilities may be inadequate to meet the current
demand. Under such situation, the following alternatives will be considered.
Replacement of the existing equipment with a new one.
Augmenting the existing one with an additional equipment.
 TYPES OF MAINTENANCE
Maintenance activity can be classified into two types:
1. Preventive maintenance
2. Breakdown maintenance.
Preventive maintenance (PM) is the periodical inspection and service
activities which are aimed to detect potential failures and perform
minor adjustments or repairs which will prevent major operating
problems in future.
Breakdown maintenance is the repair which is generally done after
the equipment has attained down state.
 Cont.
It is often of an emergency nature which will have
associated penalty in terms of expediting cost of
maintenance and down time cost of equipment.
Preventive maintenance will reduce such cost up
to a point. Beyond that point, the cost of
preventive maintenance will be more when
compared to the breakdown maintenance cost.
The total cost, which is the sum of the preventive
maintenance cost and the breakdown
maintenance cost, will go on decreasing with an
increase in the level of maintenance up to a point.
Beyond that point, the total cost will start
increasing. The level of maintenance
corresponding to the minimum total cost is the
optimal level of maintenance.
 TYPES OF REPLACEMENT
PROBLEM
Replacement study can be classified into two categories:
1. Replacement of assets that deteriorate with time (Replacement due
to gradual failure, or wear and tear of the components of the
machines).
This can be further classified into the following types:
(i) Determination of economic life of an asset.
(ii) Replacement of an existing asset with a new asset.
2. Simple probabilistic model for assets which fail completely
(replacement due to sudden failure).
 DETERMINATION OF ECONOMIC
LIFE OF AN ASSET
Any asset will have the following cost components:
Capital recovery cost (average first cost), computed from the first cost
(purchase price) of the machine.
Average operating and maintenance cost (O & M cost)
Total cost which is the sum of capital recovery cost (average first cost)
and average maintenance cost.
A typical shape of each of the above costs with respect to life of the
machine is shown in Fig.
 Cont.
• From Fig., it is clear that the capital recovery cost
(average first cost) goes on decreasing with the life of
the machine and the average operating and
maintenance cost goes on increasing with the life of
the machine.
• From the beginning, the total cost continues to
decrease up to a particular life and then it starts
increasing.
• The point where the total cost is minimum is called
the economic life of the machine.
• If the interest rate is more than zero per cent, then
we use interest formulas to determine the economic
life.
• The replacement alternatives can be evaluated based
on the present worth criterion and annual equivalent
criterion
REPLACEMENT OF EXISTING ASSET WITH A
NEW ASSET
In this section, the concept of comparison of replacement of an existing
asset with a new asset is presented.
In this analysis, the annual equivalent cost of each alternative should be
computed first.
Then the alternative which has the least cost should be selected as the
best alternative.
Some preliminary concepts which are essential for this type of replacement
analysis are
Capital Recovery with Return
Concept of Challenger and Defender
 CAPITAL RECOVERY WITH
RETURN
Consider the following data of a machine. Let
P = purchase price of the machine, F = salvage value of the machine at the end of machine life, n = life of the
machine in years, and i = interest rate, compounded annually
The corresponding cash flow diagram is shown in Fig.
 CONCEPT OF CHALLENGER AND
DEFENDER

• If an existing equipment is considered for replacement with a new equipment,

then the existing equipment is known as the defender and the new
equipment is known as challenger.
• Assume that an equipment has been purchased about three years back for Rs.
5,00,000 and it is considered for replacement with a new equipment.
• The supplier of the new equipment will take the old one for some money, say,
Rs. 3,00,000.
• This should be treated as the present value of the existing equipment and it
should be considered for all further economic analysis.
• The purchase value of the existing equipment before three years is now
known as sunk cost, and it should not be considered for further analysis.
SIMPLE PROBABILISTIC MODEL FOR ITEMS
WHICH FAIL COMPLETELY
Electronic items like transistors, resistors, tube lights, bulbs, etc. could fail all
of a sudden, instead of gradual deterioration.
The failure of the item may result in complete breakdown of the system. The
system may contain a collection of such items or just one item, say a tube
light.
Therefore, we use some replacement policy for such items which would avoid
the possibility of a complete breakdown.
The following are the replacement policies which are applicable for this
situation.
1. Individual replacement policy. Under this policy, an item is replaced
immediately after its failure.
 Cont.
2. Group replacement policy. Under this policy, the following decision
is made:
At what equal intervals are all the items to be replaced
simultaneously with a provision to replace the items individually
which fail during a fixed group replacement period?
There is a trade-off between the individual replacement policy and
the group replacement policy.
Hence, for problems, each of the replacement policies is evaluated
and the most economical policy is selected for implementation.
EXAMPLE 8.4 Two years ago, a machine was purchased at a cost of Rs.
2,00,000 to be useful for eight years. Its salvage value at the end of its life is Rs. 25,000.
The annual maintenance cost is Rs. 25,000. The market value of the present machine is
Rs. 1,20,000. Now, a new machine to cater to the need of the present machine is
available at Rs. 1,50,000 to be useful for six years. Its annual maintenance cost is Rs.
14,000. The salvage value of the new machine is Rs. 20,000. Using an interest rate of
12%, find whether it is worth replacing the present machine with the new machine.
Solution Alternative 1—Present machine
Purchase price = Rs. 2,00,000 Present value (P) = Rs. 1,20,000 Salvage value (F) = Rs. 25,000
Annual maintenance cost (A) = Rs. 25,000 Remaining life = 6 years
Interest rate = 12%
The cash flow diagram of the present machine is illustrated in Fig. 8.4.
 The annual maintenance cost for the preceding periods are not shown in
this figure. The annual equivalent cost is computed as

AE(12%) = (P – F)(A/P, 12%, 6) + F × i + A

= (1,20,000 – 25,000)(0.2432) + 25,000 × 0.12 + 25,000
= Rs. 51,104

Alternative 2 Purchase price (P) = Rs. 1,50,000 Salvage value (F) =

Rs. 20,000
Annual maintenance cost (A) = Rs. 14,000 Life = 6 years
Interest rate = 12%
The cash flow diagram of the new machine is depicted in Fig. 8.5.
The formula for the annual equivalent cost is
AE(12%) = (P – F)(A/P, 12%, 6) + F × i + A
= (1,50,000 – 20,000)(0.2432) + 20,000 × 0.12 + 14,000
= Rs. 48,016
Since the annual equivalent cost of the new machine is less than that of the present machine, it is
suggested that the present machine be replaced with the new machine.
EXAMPLE 8.5 A diesel engine was installed 10 years ago at a cost of Rs.
50,000. It has a present realizable market value of Rs. 15,000. If kept, it can be
expected to last five years more, with operating and maintenance cost of Rs. 14,000
per year and to have a salvage value of Rs. 8,000 at the end of the fifth year. This
engine can be replaced with an improved version costing Rs. 65,000 which has
an expected life of 20 years. This improved version will have an estimated annual
operating and maintenance cost of Rs. 9,000 and ultimate salvage value of Rs. 13,000.
Using an interest rate of 15%, make an annual equivalent cost analysis to determine
whether to keep or replace the old engine.
Solution Alternative 1— Old diesel engine
Purchase price = Rs. 50,000 Present value (P) = Rs. 15,000 Salvage value (F) = Rs.
8,000
Annual operating and maintenance cost (A) = Rs. 14,000 Remaining life (n) = 5 years
Interest rate = 15%
The cash flow diagram of the old diesel engine is shown in Fig. 8.6.
The formula for the annual equivalent cost is
For comparing the engines based on equal lives (20 years), the annual equivalent figures are
given in Fig. 8.8. Equal lives are nothing but the least common multiple of the lives of the
alternatives.
Since the annual equivalent cost of the old diesel engine is less than that of the new diesel engine, it is
suggested to keep the old diesel engine. Here, an important assumption is that the old engine will be
replaced four times during the 20 years period of comparison
 DEPRECIATION
 Any equipment which is purchased today will not work for ever.
This may be due to wear and tear of the equipment or
obsolescence of technology. Hence, it is to be replaced at the
proper time for continuance of any business.
 The replacement of the equipment at the end of its life involves
money. This must be internally generated from the earnings of
the equipment. The recovery of money from the earnings of an
equipment for its replacement purpose is called depreciation fund
since we make an assumption that the value of the equipment
decreases with the passage of time.
 Thus, the word “depreciation” means decrease in value of any
physical asset with the passage of time.
 METHODS OF DEPRECIATION
There are several methods of accounting depreciation
fund. These are as follows:
1.Straight line method of depreciation
2.Declining balance method of depreciation
3.Sum of the years—digits method of depreciation
4. Sinking-fund method of depreciation
5. Service output method of depreciation
Straight Line Method of Depreciation
In this method of depreciation, a fixed sum is charged as the depreciation
amount throughout the lifetime of an asset such that the accumulated sum at the
end of the life of the asset is exactly equal to the purchase value of the asset.
Here, we make an important assumption that inflation is absent.
Let
P = first cost of the asset,
F = salvage value of the asset
n = life of the asset,
Bt = book value of the asset at the end of the
period t, Dt = depreciation amount for the
period t.
The formulae for depreciation and book value
are as follows:
Dt = (P – F)/n
Bt = Bt–1 – Dt = P – t × [(P – F)/n]
EXAMPLE 9.1 A company has purchased an equipment whose first cost is Rs.
1,00,000 with an estimated life of eight years. The estimated salvage value of the
equipment at the end of its lifetime is Rs. 20,000. Determine the depreciation
charge and book value at the end of various years using the straight line method
of depreciation.
If we are interested in computing Dt and Bt for a specific period (t), the formulae
can be used. In this approach, it should be noted that the depreciation is the same
for all the periods.
EXAMPLE 9.2 Consider Example 9.1 and compute the depreciation and the
book value for period 5.
 Declining Balance Method of Depreciation
In this method of depreciation, a constant percentage of the book value
of the previous period of the asset will be charged as the depreciation
amount for the current period. This approach is a more realistic
approach, since the depreciation charge decreases with the life of the
asset which matches with the earning potential of the asset. The book
value at the end of the life of the asset may not be exactly equal to the
salvage value of the asset. This is a major limitation of this approach.
Let
P = first cost of the asset,
F = salvage value of the asset,
n = life of the asset,
Bt = book value of the asset at the end of the period t, K = a fixed percentage, and
Dt = depreciation amount at the end of the period t.
The formulae for depreciation and book value are as follows:
Dt = K × Bt-1
Bt = Bt–1 – Dt = Bt–1 – K × Bt–1
= (1 – K) × Bt–1
The formulae for depreciation and book value in terms of P are as follows:
Dt = K(1 – K)t–1 × P Bt = (1 – K)t × P
While availing income-tax exception for the depreciation amount paid in each year, the rate
K is limited to at the most 2/n. If this rate is used, then the corresponding approach is called
the double declining balance method of depreciation.
EXAMPLE 9.3 Consider Example 9.1 and demonstrate
the calculations of the declining balance method of
depreciation by assuming 0.2 for K.
 
Solution
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
K = 0.2
The calculations pertaining to Dt and Bt for different
values of t are summarized in Table 9.2 using the
following formulae:
Dt = K × Bt–1
Bt = Bt–1 – Dt
EXAMPLE 9.4 Consider Example 9.1 and calculate the depreciation and the book value
for period 5 using the declining balance method of depreciation by assuming 0.2 for K.

Solution
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
K = 0.2

Dt = K(1 – K)t –1 × P
D5 = 0.2(1 – 0.2)4 × 1,00,000
= Rs. 8,192

Bt = (1 – K)t × P
B5 = (1 – 0.2)5 × 1,00,000
= Rs. 32,768
9.2.3 Sum-of-the-Years-Digits Method of Depreciation
In this method of depreciation also, it is assumed that the book value of
the asset decreases at a decreasing rate. If the asset has a life of eight
years, first the sum of the years is computed as

Sum of the years = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 = 36 = n(n + 1)/2

The rate of depreciation charge for the first year is assumed as the highest
and then it decreases. The rates of depreciation for the years 1–8,
respectively are as follows: 8/36, 7/36, 6/36, 5/36, 4/36, 3/36, 2/36, and
1/36.
For any year, the depreciation is calculated by multiplying the
corresponding rate of depreciation with (P – F).
Dt = Rate × (P – F) Bt = Bt–1 – Dt
The formulae for Dt and Bt for a specific year t are as follows:
EXAMPLE 9.5 Consider Example 9.1 and
demonstrate the calculations of the sum-of-the-
years-digits method of depreciation.

Solution
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
Sum = n (n + 1)/2 = 8 × 9/2 = 36
The rates for years 1–8, are respectively 8/36,
7/36, 6/36, 5/36, 4/36, 3/36, 2/36 and 1/36.
The calculations of Dt and Bt for different
values of t are summarized in Table 9.3 using
the following formulae:
Dt = Rate × (P – F) Bt = Bt–1 – Dt
 Sinking Fund Method of Depreciation
In this method of depreciation, the book value decreases at
increasing rates with respect to the life of the asset. Let
P = first cost of the asset,
F = salvage value of the asset,
n = life of the asset,
i = rate of return compounded annually,
A = the annual equivalent amount,
Bt = the book value of the asset at the end of the period t, and
Dt = the depreciation amount at the end of the period t.
The loss in value of the asset (P – F) is made available an the form
of cumulative depreciation amount at the end of the life of the asset
by setting up an equal depreciation amount (A) at the end of each
period during the lifetime of the asset.
A = (P – F) × [A/F, i, n]
 EXAMPLE 9.7 Consider Example 9.1 and give the calculations
regarding the sinking fund method of depreciation with an interest
rate of 12%, compounded annually.
Solution
P = Rs. 1,00,000 F = Rs. 20,000 n = 8 years i=12%
A = (P – F) × [A/F, 12%, 8]
= (1,00,000 – 20,000) × 0.0813
= Rs. 6,504
In this method of depreciation, a fixed amount of Rs. 6,504 will be depreciated at the end
of every year from the earning of the asset. The depreciated amount will earn interest for
the remaining period of life of the asset at an interest rate of 12%, compounded annually.
For example, the calculations of net depreciation for some periods are as follows:
Depreciation at the end of year 1 (D1) = Rs. 6,504. Depreciation at the end of year 2
(D2) = 6,504 + 6,504 × 0.12
= Rs. 7,284.48
Depreciation at the end of the year 3 (D3)
= 6,504 + (6,504 + 7,284.48) × 0.12
= Rs. 8,158.62
Depreciation at the end of year 4 (D4)
= 6,504 + (6,504 + 7,284.48 + 8,158.62) × 0.12
= Rs. 9,137.65
These calculations along with book values are summarized in Table
9.4.
EXAMPLE 9.8 Consider Example 9.1 and compute D5 and B7 using the sinking fund method
of depreciation with an interest rate of 12%, compounded annually.
Solution
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
i = 12%
Dt = (P – F) (A/F, i, n) (F/P, i, t – 1)
D5 = (P – F) (A/F, 12%, 8) (F/P, 12%, 4)
= (1,00,000 – 20,000) × 0.0813 × 1.574
= Rs. 10,237.30
This is almost the same as the corresponding value given in the table. The minor difference is
due to truncation error.
Bt = P – (P – F) (A/F, i, n) (F/A, i, t)
B7 = P – (P – F) (A/F, 12%, 8) (F/A, 12%, 7)
= 1,00,000 – (1,00,000 – 20,000) × 0.0813 × 10.089
= 34,381.10
 EVALUATION OF PUBLIC ALTERNATIVES
In evaluating alternatives of private organizations, the criterion is to select the
alternative with the maximum profit. The profit maximization is the main goal of
private organizations while providing goods/services as per specifications to their
customers.
But the same criterion cannot be used while evaluating public alternatives.
Examples of some public alternatives are constructing bridges, roads, dams,
establishing public utilities, etc.
The benefits may occur at different time periods of the public activity. For
the purpose of comparison, these are to be converted into a common time
base (present worth or future worth or annual equivalent). Similarly, the
costs consist of initial investment and yearly operation and maintenance
cost. These are to be converted to a common time base as done in the
equivalent benefits. Now the ratio between the equivalent benefits and
equivalent costs is known as the “Benefit-Cost ratio”. If this ratio is at least
one, the public activity is justified; otherwise, it is not justified. Let
BP = present worth of the total benefits
BF = future worth of the total benefits
BA = annual equivalent of the total benefits
P = initial investment
PF = future worth of the initial investment
PA = annual equivalent of the initial investment
C = yearly cost of operation and maintenance
CP = present worth of yearly cost of operation and maintenance