Chapter 12 - Replacement Click here for Streaming Audio To Accompany Presentation (optional)

1. Chapter 12 - ReplacementClick here for Streaming Audio To Accompany Presentation (optional) EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona

2. EGR 403 - The Big Picture • Framework:Accounting& Breakeven Analysis • “Time-value of money” concepts - Ch. 3, 4 • Analysis methods • Ch. 5 - Present Worth • Ch. 6 - Annual Worth • Ch. 7,7A,8 - Rate of Return (incremental analysis) • Ch. 9 - Benefit Cost Ratio & other methods • Refining the analysis • Ch. 10, 11 - Depreciation & Taxes • Ch. 12 - Replacement Analysis EGR 403 - Cal Poly Pomona - SA15

3. Replacement Analysis • When should a new truck replace the existing truck? • When should a process be redesigned? • When should a product be redesigned? The most common question asked in industry is when should the existing be replaced? EGR 403 - Cal Poly Pomona - SA15

4. Replacement Analysis Terms • Defender - the existing equipment or building previously implemented. • Challenger - the proposed replacement currently under consideration. EGR 403 - Cal Poly Pomona - SA15

5. Aspects of Replacement Analysis • Using available data to determine the analysis technique. • Determining the base comparison between alternatives. • Using analysis techniques when: • Defender marginal cost can be computed and is increasing. • Defender marginal cost can be computed and is not increasing. • Defender marginal cost is not available. • Considering possible future challengers. • After-tax analysis. EGR 403 - Cal Poly Pomona - SA15

6. The Replacement Problem • Engineers replace the existing due to: • Obsolescence - technological change. • Depletion - loss of market value. • Deterioration - wear that is overly expensive to repair. Shall the defender be replaced now or be maintained for one or more periods. EGR 403 - Cal Poly Pomona - SA15

7. Issues (Consider Before Starting) • Is it morally or ethically right to do this project? • If a unit fails, must it be removed permanently from service? Or repaired? Are standby units available if the system should fail? • Do components or units fail independently of the failure of other components? • Is there a budget constraint? • In the event that the unit can be repaired after failure is their a constraint on the capacity of the repair facility? EGR 403 - Cal Poly Pomona - SA15

8. Issues(Continued) • Is there only one replacement allowed over the planning horizon? Are subsequent replacements allowed at any time during the study period? • Is their more than one replacement unit (price and quality combination) available at a given point in time? • Do future replacement units differ over time? Are technological improvements considered? • Is preventative maintenance included in the model? EGR 403 - Cal Poly Pomona - SA15

9. Issues (Continued) • Are periodic operating and maintenance costs constant or variable over time? • Is the planning horizon finite or infinite? • Are consequences other than economic impacts, i.e., sociotechnical issues considered? • Are income tax consequences considered? • Is “inflation” considered? • Does replacement occur simultaneously with retirement, or are there nonzero lead times? • Are cash flow estimates deterministic or stochastic? EGR 403 - Cal Poly Pomona - SA15

10. Where Compare Defender Marginal Cost Defender Marginal Cost Defender Best Challenger 1 Available Increasing Next-year Marginal Cost EUAC at Minimum Cost Life 2 Available Not increasing EUAC at Minimum Cost Life EUAC at Minimum Cost Life 3 Not available EUAC over Remaining Useful Life EUAC at Minimum Cost Life Replacement Analysis Decision Chart Analysis Techniques EGR 403 - Cal Poly Pomona - SA15

11. What Is the Basic Comparison? • Identify the defender and the best challenger. • Product. • Machine. • Process. • Personnel. • Mix. Decision Criteria leads to one of the following: If the defender is more economical, it should be retained. If the challenger is more economical, it should be installed. EGR 403 - Cal Poly Pomona - SA15

12. Minimum Cost Life of the Challenger • Calculate the EUAC for each value of the useful life (e.g., n = 1, n = 2, n = 3, etc.) • The number of years at which the EUAC is minimized is the minimum cost life (economic useful life) • Consider Example 12 - 1 • $7500 initial cost (P) • $900 arithmetic gradient maintenance cost (G) • $500 uniform cost (A) and 400 arithmetic gradient operating cost (G) EGR 403 - Cal Poly Pomona - SA15

13. EUAC calculations for increasing values of useful life EGR 403 - Cal Poly Pomona - SA15

14. Graph of EUAC by n. Economic Useful Life is where Total EUAC is minimized EGR 403 - Cal Poly Pomona - SA15

15. Marginal Costs • Marginal Costs are the year by year costs for keeping an asset. Example 12-2 illustrates the calculation of the marginal costs for a new item. • Marginal Cost includes: • Loss in value of the asset by retaining it for one more year • Lost interest on the money tied up in the asset • Costs and expenses directly related to the project or asset (e.g., insurance, operating and maintenance) EGR 403 - Cal Poly Pomona - SA15

16. Marginal Cost for a New Item: Example 12-2 EGR 403 - Cal Poly Pomona - SA15

17. Marginal Cost Data Defender Example 12-3 Is the marginal cost of defender increasing? Here the marginal costs are increasing. EGR 403 - Cal Poly Pomona - SA15

18. Replacement Analysis Technique #1 Defender Marginal costs are increasing • Replace when the marginal cost of ownership of the defender is more than the EUAC of the challenger. EGR 403 - Cal Poly Pomona - SA15

19. Analysis Technique # 1 Is Appropriate When Replacement Repeatability Assumptions Hold • The best challenger is available in all subsequent years and will be unchanged in economic cost. • The period of needed service is infinitely long. These assumptions appear to be rather restrictive. EGR 403 - Cal Poly Pomona - SA15

20. Relaxing the Restrictions • This spreadsheet considers that: • The best challenger is available in subsequent years at the same economic cost. • The project life is known and limited. EGR 403 - Cal Poly Pomona - SA15

21. Replacement Analysis Technique #2 • If the replacement repeatability assumption holds, compare EUAC of the defender asset at its minimum cost life against the EUAC of the challenger at its minimum cost life. EGR 403 - Cal Poly Pomona - SA15

22. Replacement Analysis Technique #3 • Compare the EUAC of the defender over its stated life against the minimum EUAC of the challenger. • Here defining defender and challenger first costs can be an issue. • Trade-in value is not a suitable value. • Appropriate value is the market value. EGR 403 - Cal Poly Pomona - SA15

23. After Tax Replacement Analysis • Adds expanded perspective as changes occur in: • Remaining economic life of defender. • Economic life of challenger. • Defender vs. Challenger comparisons. • Affected by: • Depreciation MACRS. • Assets market value over time. EGR 403 - Cal Poly Pomona - SA15