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

9-2 SI-4251 Ekonomi Teknik Muhamad 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?

9-3 SI-4251 Ekonomi Teknik Muhamad 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

9-4 SI-4251 Ekonomi Teknik Muhamad 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

9-5 SI-4251 Ekonomi Teknik Muhamad 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

Sunk Cost = Book Value – Realizable Value

9-6 SI-4251 Ekonomi Teknik Muhamad 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.

9-7 SI-4251 Ekonomi Teknik Muhamad 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

 EUAW defender = 187,894,255 Retained old crane

 EUAW challenger = 263,395,000

 More realistic condition  reduced salvage value for old

equipment

9-8 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Defender vs. More than One Challengers
Initial Current Salvage Trade- Annual Remaining
Cost Book Value in Value Cost Service
Value life
DEFENDER 850,000 435,000 221,500 - 45,000 6
CHALLENGER 1 590,000 220,120 328,750 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 – 328,700) (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.

For Previous Example
Alternative way:
 EUAW defender = 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

9-10 SI-4251 Ekonomi Teknik Muhamad 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)

9-11 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Replacement Analysis with One Additional Period
Timing for Replacement
Calculate Defender
Calculate EUAW
start Challenger, EUAWC
Cost for the next
Year., CD

Calculate EUAWD EUAWC < CD

Compare
for remaining life
of defender,
EUAWC : CD

EUAWC > CD

Compare EUAWC > EUAWD

EUAWC : Retain DEFENDER
EUAWD

EUAWC < EUAWD

stop
Select CHALLENGER
replace DEFENDER

9-12 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Replacement Analysis with Additional Period

Initial Annual Add Annual Trade Salvage Service

Cost Cost Annual Reduction in Cost Value Life
Cost in Book
Value
D 3,850,000 235,000 150,500 375,000 345,000 235.000 4
C-1 2.590,000 195,000 315.700 6

@ i = 12%  (A/P, 12, 6) = 0.2642 ; (A/F, 12, 6) = 0.1142

9-13 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Replacement Analysis with Additional Period
n Defender Challenger
Book Value CD or EUAWD Book Value EUAWC
0
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)
+ AOC + Additional AOC (A/G, i, n)

9-14 SI-4251 Ekonomi Teknik 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

9-15 SI-4251 Ekonomi Teknik Muhamad 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

9-16 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

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.