01/10/2010
Outline Module 9

Replacement
Defender – Challenger Concept
Replacement Analysis
Replacement Analysis with Additional Period

Minimum-Cost Life Analysis or Economic Service Life



Module 9: Replacement Analysis
SI-4251 Ekonomi Teknik
Muhamad Abduh, Ph.D.
9-2
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Questions Concerning Replacement
Reasons for Replacement
 Do

we need (want) to replace the one
we currently used (defender) with
another (challenger)?
 What will we propose to replace the old
one?
 When is the best time to do it?


Decision on the utilization of (productive) assets was set for a
certain service life…
In times, the performance (expected or unexpected) of asset
will be reduced, and other alternatives are to be considered
Replacement is commonly considered due to the following
reasons:



9-3
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
9-4
Reduce in performance due to friction, deterioration
Increase requirements  we want better / higher standard
specifications (productivity, accuracy, ..) that the one we currently use
Obsolescence  new (alternative) makes the (still functioning) old
ones look less valuable
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
1
01/10/2010
Defender – Challenger Concept in
Replacement Analysis
Changing Value in Time
In accounting, the value of an asset at any given time is
estimated and recorded in a book  book value
However, things do not always proceed as we expected. The
real value of an asset differs than the one we estimated.
Sunk cost  cost we have to pay for bad decision in the past;
it is cost that we cannot recover

cost

Total Annual Cost
Annual O & M Cost
Time at minimum cost

Sunk Cost = Book Value – Realizable Value
Annual Investment Cost
(Capital Recovery)
time
9-5
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Example


9-6
Example
A mobile crane was bought for Rp 1,125,000,000 two years
ago and was estimated for having service life of 7 years before
it can be sold for Rp 234,575,000. This piece of equipment
requires an annual operation and maintenance of Rp
37,500,000. Today, the crane’s book value is Rp 821,570,000.
However, the best offer for that piece of equipment is only Rp
695,000,000.
A new crane worth Rp 1,110,000,000 is being considered for
replacement. This crane will have a service life of 5 years and
salvage value of Rp 360,000,000. The annual O&M cost is
estimated at Rp 21,400,000.
Sunk cost = Rp 821.575,000 – Rp 695,000,000 = Rp 126,575,000
Assuming the remaining service life and salvage value of the defender
remain the same, Comparing the old (defender) with the new one
(challenger):


EUAW defender
= 695,000,000 (A/P, i, 5) + 37,500,000 –
234,575,000 (A/F, i, 5)
EUAW challenger = 1,110,000,000 (A/P, i, 5) + 21,400,000 – 360,000,000
(A/F, i, 5)



SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
For i = 11%  (A/P, 11, 5) = 0.2706 (A/F, 11, 5) = 0.1606
EUAW defender = 187,894,255
EUAW challenger = 263,395,000

9-7
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
9-8
Retained old crane
More realistic condition  reduced salvage value for old
equipment
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
2
01/10/2010
For Previous Example
Defender vs. More than One Challengers
Initial
Cost
Current Salvage Trade- Annual Remaining
Book
Value in Value Cost
Service
Value
life
DEFENDER
850,000
221,500
-
45,000
6
CHALLENGER 1
590,000
435,000
220,120
328,750
11,000
6
CHALLENGER 2
410,000
289,400
330,000
9,750
6
CHALLENGER 3
395,700
250,000
295,000
7,300
6

@ i = 12%  (A/P, 12, 6) = 0.2642 ; (A/F, 12, 6) = 0.1142

EUAW defender = 45,000 – 221,500 (A/F, 12, 6) = 19,704.70
EUAW challenger-1 = (590,000 – 328,750) (A/P, 12, 6) + 11,000 –
220,120 (A/F, 12, 6) = 54,884.55

9-9
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Minimum-Cost Life Analysis


Alternative way:

EUAW
= 37,500,000 – 234,575,000 (A/F, i, 5)
= - 35,368,145
Retained old crane

EUAW challenger = (1,110,000,000 - 695,000,000) (A/P, i, 5) +
21,400,000 – 360,000,000 (A/F, i, 5) = 75,833,000
defender
9-10
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
How to Calculate ESL
Economic Service Life (ESL) is the number of year n at which the
equivalent uniform annual worth of costs is the minimum.
Due to reasons of weariness, in time the performance of asset is
decreasing.The ever increasing O&M cost decreasing annual capital cost is
accompanied by decreasing cost of capital (investment cost).
Year k
Market Value
($)
AOC
Total AW if
retained k
years
Note
min
ESL
0
1
2
Cost
Total Annual Cost
(TAC)
3
Annual Investment Cost
(AIC)
Time at Minimum Cost
9-11
…
Annual O & M Cost
(AOC)
Time, j
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
n
AWk = MV0 (A/P, i, k) - MVk (A/F, i, k) +[ΣAOCj (P/F, i, j)](A/P, i, k)
j=1…k
ESL is at the minimum of AWk
12
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
3
01/10/2010
Exercise



Defender
Two years ago, Toshiba Electronics made a $15 Million investment in new assembly line machinery. It
purchased approximately 200 units at $70,000 each and placed them in plants in 10 different countries.The
equipments sorts, tests, and performs insertion-order kitting one electronic components in preparation for
special-purpose printed circuit boards.This year, new international industry standards will require a $16,000
retro-fit on each unit, in addition to the expected operating cost. Due to the new standards, coupled with
rapidly changing technology, a new system is challenging the retention of these 2-year-old machines.The
chief engineer at Toshiba USA realizes that the economics must be considered, so he has asked that a
replacement study be performed this year and each year in the future, if need be. At i=10% and with the
estimates below, perform the replacement study now.
Year k
Challenger:

First Cost: $50,000

Future market values: decreasing by 20% per year

Estimated retention period: no more than 5 years

AOC estimates: $5000 in year 1 with increases of $2000 per year
Market Value
($)
AOC
Total AW if
retained k
years
Note
0
15,000
-
-
1
12,000
-20,000
-24,500
2
9,600
-8,000
-18,357
3
7,680
-12,000
-17,307 ESL, ND = 3
Defender:

Current international market value: $15,000

Future market values: decreasing by 20% per year

Estimated retention period: no more than 3 more years

AOC estimates: $4000 next year, increasing by $4000 per year thereafter, plus the $16,000 retro-fit next year
13
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Challenger
14
Conclusion

Year k
15
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Market Value
($)
AOC
Total AW if
retained k
years
Note
0
50,000
-
-
1
40,000
-5,000
-20,000
2
32,000
-7,000
-19,524
3
25,600
-9,000
-19,245
4
20,480
-11,000
-19,123 ESL, NC = 4
5
16,384
-13,000
-19,126
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Since at ND = 3, the AW of cost of the defender is
$17,307, and it is less than the AW of cost of the
challenger and the challenger AW at its ESL ($19,123),
then Toshiba expects to retain the old machine for 3
more years. Toshiba could perform the one-year-later
analysis 1 year from now.
For one-year-later analysis, the estimates of all future
costs should be updated first.
16
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
4
01/10/2010
Homework #9

Redo the replacement analysis for the mobile crane
problem in this module’s example using ESL.
9-17
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
5