TYPES OF REPLACEMENT
DECISIONS
Aging assets may be:
• kept without major change
• retired (removed) without
replacement
• overhauled to improve
performance
• replaced with another asset.
JK Higginson: Engineering
Economics
1
WHY REPLACE ONE ASSET
WITH ANOTHER?
• If the current asset is
inadequate and has to be
replaced
• If the current asset is
adequate, but there is a less
expensive or more efficient
way to obtain the same
service
JK Higginson: Engineering
Economics
2
RELEVANT COSTS FOR
ANALYZING ASSET
REPLACEMENT
• Capital costs
• Installation costs
Installation costs occur at the
beginning of the life of new
assets and are not reversible
once the asset has been put in
place
• Operating and maintenance
costs
Operating and maintenance
costs typically increase as the
asset ages.
• Disposal costs and salvage costs
JK Higginson: Engineering
Economics
3
MAKING REPLACEMENT
DECISIONS
• Once a new asset has been put
in place, the incremental cost of
keeping it typically is low. This
gives the existing asset (called
the defender) an advantage over
a potential replacement (called
the challenger).
• To make a replacement decision,
all relevant costs must be
considered. Typically, this is
done through equivalent annual
cost (EAC) computations.
JK Higginson: Engineering
Economics
4
TYPES OF REPLACEMENT
DECISIONS
Case 1: Challenger is the same as the
Defender (the “economic life”
problem).
Case 2: Challenger is different than
the Defender, and succeeding
Challengers are the same as the
first Challenger.
Case 3: Challenger is different than
the Defender, and succeeding
Challengers are different from the
first Challenger.
JK Higginson: Engineering
Economics
5
CASE 1: CHALLENGER IS
THE SAME AS DEFENDER
• In the case when technology is not
changing quickly and when prices and
interest rates are not changing rapidly,
an asset often will be replaced with the
same type of asset.
• Each asset is replaced when its
lifetime cost is minimized. At this time,
the asset is said to have reached the
end of its economic life.
• The lifetime will be the same for all
replacement assets for the time period
over which the asset is needed
(assumed to be a long time). This
results in cyclic replacement.
JK Higginson: Engineering
Economics
6
ECONOMIC LIFE OF AN
ASSET
• Equivalent annual cost (EAC) of capital
costs decrease as the asset is kept
longer.
• EAC of operating and maintenance
costs increase as the asset is kept
longer.
• There will be a lifetime that will
minimize:
(EAC of capital costs) +
(EAC of operating and maintenance
costs)
• This is the “economic life” of the asset.
JK Higginson: Engineering
Economics
7
CASES 2 AND 3: CHALLENGER
IS DIFFERENT FROM DEFENDER
Case 2: All succeeding challengers
are the same as the current
challenger.
Case 3: The challengers after the
current challenger will be
different (most likely better).
JK Higginson: Engineering
Economics
8
CASE 2: SEQUENCE OF
IDENTICAL CHALLENGERS
Step 1: Find EAC at the economic life of
the challenger.
Step 2: Find the cost of keeping the
defender one year.
Step 3a: If EAC(defender, one more year)
 EAC(challenger), keep the defender
at least one more year
Step 3b: ELSE:
IF:
there is a “life” for the defender that
will give an EAC less than
EAC(challenger), keep the defender
for that “life” and then replace
ELSE:
replace the defender immediately
JK Higginson: Engineering
Economics
9
ASSUMPTIONS MADE IN THE
SOLUTION OF EXAMPLE 2
• The challenger will be replaced by a
stream of machines with identical
technology (that is what allowed us to
compute the economic life of the
challenger).
• The installation cost of the Defender is
irrelevant because we cannot change
the past; ie., it is a “sunk cost”.
• The “first cost” of keeping the Defender
is its salvage value now, i.e. the
revenue that we would receive if we
sold it now. This is the “opportunity
cost” of keeping it.
JK Higginson: Engineering
Economics
10
CASE 3: SEQUENCE OF
DIFFERENT CHALLENGERS
• Normally, we may expect the future
challengers to be better than the
current challenger.
• Then, do we skip over the current
challenger and wait for the next “new
and improved” challenger?
• Do we wait even longer for the nextgeneration “new and improved”
challenger?
• We would have to enumerate all
possible combinations of decisions and
evaluate all decisions to make a
choice.
JK Higginson: Engineering
Economics
11
CASE 3: SEQUENCE OF
DIFFERENT CHALLENGERS
• The EAC for each project would have
to be calculated (quite a bit of work!).
• The list would increase geometrically if
we expect that each Challenger was
different from the preceding one.
• Typically, we will have very little
information about the costs and
benefits of new challengers.
• It is often reasonable to assume that
all challengers in the future will be
approximately the same as the current
challenger.
• How do we make a replacement
decision when we need the asset for a
finite period of time (e.g., for a contract
of specified length)?
JK Higginson: Engineering
Economics
12