Replacement Analysis is the economic analysis to compare existing and new facilities. It is a decision situation encountered in the business firms and government organization as well as individuals in which an existing asset should be retired from use or continued in service or replaced with a new asset. Replacement study in engineering economics provides the information for sound decisions that improve the operating efficiency and the competitive position of the enterprise. Replacement analysis is one of the most important and most common types of iterative comparisons encountered in practice.
There are numerous reasons for considering replacement. Firstly, the current asset may have a number of deficiencies including high set up cost, excessive maintenance, declining production, efficient energy consumption and physical impairment.
Secondly, potential replacement assets may take advantage of new technology and be easily set up, low-cost maintenance, high output, energy efficient and possessing increased potentialities, perhaps at a vastly reduced cost.
Replacement is never a question of ‘if we replace’ but a rather a question of ‘when we replace’.
Replacement of an existing asset should be considered in case of following reasons:
The advantages of replacement analysis are as follows:
The basic requirements for the successful handling of replacement problems are as follows:
These are the names of two mutually exclusive alternatives. The defender is the currently installed asset and the challenger is the potential replacement asset.
Defender first cost is the initial investment amount ‘P’ used for the defender. The current market value (MV) is the current estimate to use for ‘P’ for the defender in a replacement study.
It is the amount of cost that must be recovered when replacing a defender with a challenger. This amount is almost always equal to ‘P’, the first cost of the challenger.
These are used as the primary measure of comparison between the defender and challenger.
The period of time in years that results in the minimum equivalent uniform annual cost of owning and operating an asset.
The time period in years that an asset is kept in productive service. It is an estimate of how long an asset is expected to be used in a trade or business to produce income.
These are the year by year estimates of the costs to own and operate an asset for that year. It includes loss in value of the asset by retaining it for one or more year, cost and expenses directly related to the project or asset (Insurance, operating and maintenance etc.)
The highest estimated price that a buyer would pay and a seller would receive for an item in an open and competitive market.
In a cash flow approach, proceeding from the sale of the old machine is treated as down payment towards as down payment towards purchasing the new machine. This approach is meaningful when both the defender and challenger have the same useful life.
In an opportunity cost approach, proceedings from the sale of the old machine are treated as the investment required to keep the old machine. This approach is more commonly practiced in replacement analysis.
The economic service life (ESL) is the number of the year (n*) at which the equivalent uniform annual worth (AW) of costs is the minimum, considering the most current cost estimates over all the possible years that the asset may provide a needed service. We should use the respective economic service lives of the defender and the challenger when conducting a replacement analysis.
The objective is to find the number of the year (n*) that minimizes the equivalent uniform annual worth of costs is minimum.
The costs of owning an operating an asset can be divided into two categories: capital costs and operating costs. Capital costs have two components: the initial investment and the salvage value at the time of disposal of the asset. The initial investment for the challenger is simply its purchase price. For the defender, we should treat the opportunity cost as its initial investment. We will use N to represent the length of time in years the asset will be kept, I to denote the initial investment and SN to designate the salvage value at the end of the ownership period of N years. The annual equivalent of capital costs which is called the capital recovery cost over the period of N years.
Capital Recovery cost (CR) = I (A/P, i%, N) – SN (A/P, i%, N)
The operating cost of an asset includes operating and maintenance (O & M) costs, labor costs, material costs and energy consumption costs. Here O & M costs tend to increase as the function of the age of the asset but other costs often remain constant for same equipment from year to year if the usage of the equipment remains constant. We use OCn to represent the total operating costs in year n of the ownership period and OC(i) to represent the annual equivalent of the operating costs over a life span of N years.
Operating Cost (OC) = ∑ OCn (P/F, i%, N). (A/P, i%, N) where n = 1 to N
The total annual equivalent costs of owning and operating an asset are summation of the capital recovery costs and the annual equivalent of operating costs of the asset
Total Cost (TC) = CR (i) + OC (i)
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