Module 9: Replacement Analysis

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.
Outline Module 9
 Replacement
 Defender – Challenger Concept
 Replacement Analysis
 Replacement Analysis with Additional Period
 Minimum-Cost Life Analysis or Economic
Service Life


2 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Questions Concerning Replacement
 Do we need (want) to replace the
one we currently used
(defender) with another
(challengers)?
 What will we propose to replace
the old one?
 When is the best time to do it?


3 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Reasons for Replacement
 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:
 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
4 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Changing Value in Time

cost Total Annual Cost

Annual O & M Cost

Annual Investment Cost

Time at minimum cost (Capital Recovery)

time

5 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Defender – Challenger Concept in
Replacement Analysis
 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

S u n k C o st = B o o k V a lu e – R e a liza b le V a lu e

6 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

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.

7 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Example
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)

 For i= 11%  (A/P, 11, 5) = 0.2706 (A/F, 11, 5) =
0.1606 R e ta in e d o ld
cra n e

 EUAW defender = 187,894,255
 EUAW challenger = 263,395,000

8
 More realistic condition  reduced salvage value
SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
for old equipment
Defender vs. More than One Challengers

Initial Current Salvage Trade- Annual Remainin

Cost
DEFENDER 850,000 Book Value
435,000 221,500-in Cost
45,000 6g Service
CHALLENGE 590,000 Value 220,120328,75011,000
Value life

6

R 1
CHALLENGE 410,000 289,400330,0009,750 6
R 2
CHALLENGE 395,700 250,000295,0007,300 6
R 3

 @ 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 – 328,700) (A/P, 12, 6)
+ 11,000 – 220,120 (A/F, 12, 6) = 54,884.55

9 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
For Previous Example
Alternative way:


 EUAW defender = 37,500,000 – 234,575,000 (A/F,

i, 5) Retained old
 = - 35,368,145 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


10 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Replacement Analysis with One Additional Period
Timing for Replacement
 It is common practice to consider a replacement
analysis not based on a particular point in time
but in latter times as the decision might be
changed.
 The analysis is done through comparing the value
of defender with that of a challenger for
additional period.
 Replacement is made whenever the cost for
retaining the defender, CD is more than that of
the challenger (EUAWC)

11 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Replacement Analysis with One Additional Period
Timing for Replacement

start Calculate EUAW Challenger , EUAWC Defender

Calculate Cost for the next Year., C D

EUAW C < C D
Calculate EUAWD for remaining life of defender, Compare EUAWC : CD

EUAW C > C D

EUAW C > EUAW D

Compare EUAWC : EUAWD Retain DEFENDER

EUAW C < EUAW D

stop

Select CHALLENGER replace DEFENDER

12 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Replacement Analysis with Additional Period

 Initial Annual Add Annual Trade Salvage Service
D  Cost
3,850,000 Cost
235,000 Annual 375,000
150,500 Reduction 345,000
in Cost 235.000
Value 4Life
C-1 2.590,000 195,000 Cost in Book 315.700 6
Value


 @ i = 12%  (A/P, 12, 6) = 0.2642 ; (A/F, 12, 6) =
0.1142


13 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Replacement Analysis with Additional Period
n Defender Challenger
 Book Value CD or Book Value EUAWC
0 EUAWD
1
2
3
4
5


 EUAWD = BVn (A/P, i, n) – SV(A/F, i, n) + BV1(P/F, i, 1)
(A/P, i, 1)
 +BV2(P/F, i, 2)(A/P, i, 2)+ …….
 + BVn-1 (P/F, i, n-1)(A/P, i, n-1)
14
 + AOC + Additional AOC
SI-4251 (A/G,Teknik
Ekonomi i, n)Muhamad Abduh, Ph.D.
Minimum-Cost Life Analysis
 Economic Service Life (ESL) is the number or 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).
Cost Total Annual Cost
(TAC)
Annual O & M Cost
(AOC)

Annual Investment Cost

(AIC)

Time at Minimum Cost Time, j

15 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Minimum-Cost Life Analysis

EUAWk = BV0 (A/P, i, k) – BVk (A/P, i, k) +[ΣAOCj (P/F, i, j)](A/P, i, k)
 where: BV 0 =P AIC = Annual Investment Cost
 BV k = SV TAC = Total Annual Cost
 k = life of service
 AOCj = annual cost at year j

Year of BVj AOCj Equivalent AICj TACj
service, k AOCj Or EUAWk
(a) (b) (c) (d) = EUAW(c) (e) (f) = (d)+(e)
1
2
3
…
k-1
k

16 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Homework #9
 Redo the replacement analysis for the
mobile crane problem in this module’s
example using ESL.


17 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.