Lecture No.

46
Chapter 14
Contemporary Engineering Economics
Copyright © 2010

Contemporary Engineering Economics, 5th edition, © 2010

Definition: Economic service life is the remaining useful life
of an asset that results in the minimum annual equivalent
cost.
Annual Equivalent Cost (AEC) = Capital Cost + Operating Cost

Contemporary Engineering Economics, 5th edition, © 2010

Mathematical Relationship
 Capital Cost:

 Operating Cost:

 Total Cost:

 Objective: Find n* that

minimizes AEC(i) n*

Contemporary Engineering Economics, 5th edition, © 2010

Example 14.3
Economic Service
Life for a Lift Truck
 Given: I = $18,000, i =  n = 1:
12%, Salvage value = -20%
$14,400
over the previous year,
O&M = $3,000 during the 0
1
first year, and 15% increase
$3,000
over the previous year
$18,000
thereafter

 n = 2:
 Find: Economic Service
$11,520
Life
0 1
2

$3,000
$3,450

$18,000

Contemporary Engineering Economics, 5th edition, © 2010

AEC Calculation If
you Kept the Truck
for 2 Years
 Ownership Cost:
CR(12%)  ($18,000  $11,520)(A / P ,12%,2)
(0.12)($11,520)
 $5,760
$5,217

 Operating Cost:
OR(12%)  $3,000(P / F ,12%,1)  $3,450(P / F ,12%,2)
(A / P ,12%,2)
 $3,212

 Annual Equivalent Cost:

AEC(12%)n2  $5,760
$5,217+$3,212
$3,212
 $8,429

Contemporary Engineering Economics, 5th edition, © 2010

Economic Service
Life Calculation
Using Excel
 Economic Service Life = 6
Years with AEC(12%) =
$7,977

 What It Really Means?

You purchase a brand new
lift truck for every 6 years,
assuming that the future
replacement cost as well as
operating costs remain
constant. Then the
equivalent annual cost of
owning and operating the
truck is $7,977.

Contemporary Engineering Economics, 5th edition, © 2010

Sensitivity of Economic Service Life

For an asset with non-increasing operating cost, keep

the asset as long as it lasts.
If everything remains the same, a higher interest rate
will tend to extend the economic service life (or defer
the replacement decision).

Contemporary Engineering Economics, 5th edition, © 2010

Replacement Decisions
 Defender: an old machine
 Challenger: a new
machine
 Current market value:
selling price of the
defender in the market
place

Contemporary Engineering Economics, 5th edition, © 2010

Example 14.2 -
Opportunity Cost
Approach
 Basic Principle: Treat
the proceeds from sale of the
old machine as the investment
required to keep the old
machine.

 Defender:
Market price: $10,000
Remaining useful life:
3 years
Salvage value: $2,500
O&M cost: $8,000

 Challenger:
Cost: $15,000
Useful life: 3 years
Salvage value: $5,500
O&M cost: $6,000
 Decision: Replace the
defender now

Contemporary Engineering Economics, 5th edition, © 2010

Required Assumptions and Decision
Frameworks
Planning Horizon (Study
Period)
Infinite planning
horizon
Finite planning
horizon
Technology
No technology
improvement is
anticipated over the
planning horizon
Technology
improvement cannot be
ruled out
Relevant Cash Flow
Information

Contemporary Engineering Economics, 5th edition, © 2010

Types of Typical Replacement Decision
Frameworks

Contemporary Engineering Economics, 5th edition, © 2010

Replacement Strategies under the Infinite
Planning Horizon
 Decision Rules:  Cash Flow Assumptions:
 Step 1: Compute the AECs for both the 1. Replace the defender now: The
defender and challenger at its economic cash flows of the challenger
estimated today will be used. An
service life, respectively. identical challenger will be used
 Step 2: Compare AECD* and AECC*. thereafter if replacement
 If AECD* > AECC* , replace the defender becomes necessary again in the
now. future. This stream of cash flows
is equivalent to a cash flow of
 If AECD* < AECC* , keep the defender AECC* each year for an infinite
at least for the duration of its number of years.
economic service life if there are no 2. Replace the defender, say, x years
technological changes over that life. later: The cash flows of the
 Step 3: If the defender should not be defender will be used in the first x
replaced now, conduct marginal analysis years. Starting in year x+1,the
to determine when to replace the cash flows of the challenger will
defender. be used indefinitely thereafter.

Contemporary Engineering Economics, 5th edition, © 2010

Example 14.4
Replacement Analysis
under an Infinite Planning
Horizon
 Defender:
 Current salvage value =
 Cash flow diagram for defender
$5,000, decreasing at an annual
rate of 25% over the previous when N = 4 years
year’s value
 Required overhaul = $1,200
 O&M = $2,000 in year 1,
increasing at the rate of $1,500
each year
Challenger:
 I = $10,000
 Salvage value = $6,000 after
one year, will decline 15% each
year
 O&M = $2,200 in the first
year, increasing by 20% per year
thereafter

 Find: (a) Economic service lives

for both defender and challenger,
(b) when to replace the defender

Contemporary Engineering Economics, 5th edition, © 2010

 Economic Service Life
 Defender  Challenger

Contemporary Engineering Economics, 5th edition, © 2010

Replacement Decisions (Example 14.4)
 Should replace the
ND*  2 years defender now? No,
because AECD* < AECC*
AECD*  $5,203  If not, when is the best
time to replace the
defender? Need to
NC*= 4 years conduct the marginal
analysis.
AECC*=$5,625
Contemporary Engineering Economics, 5th edition, © 2010
Marginal Analysis to
Determine when the
Defender should be
Replaced
Question: What is the  Step 1: Calculate the equivalent cost of retaining the
defender one more from the end of its economic
additional (incremental) cost service life, say 2 to 3.
for keeping the defender one
more year from the end of its $2,813(F/P,15%,1) + $5,000
economic service life, from Year - $2,109 = $6,126
2 to Year 3?
 Step 2: Compare this cost with AECC = $5,625 of the
challenger.
Financial Data:
 Conclusion: Since keeping the defender for the 3rd year
is more expensive than replacing it with the challenger,
• Opportunity cost at the end of DO NOT keep the defender beyond its economic
year 2: Equal to the market service life.
value of $2,813
• Operating cost for the 3rd year:
$5,000
• Salvage value of the defender at
the end of year 3: $2,109

Contemporary Engineering Economics, 5th edition, © 2010

Example 14.5
Replacement Analysis
under the Finite Planning
Horizon
 Given: Economic service lives for
both defender and challenger , and i
 Some Likely Replacement Patterns
= 15%

 Find: the most

plausible/economical replacement
strategy

Contemporary Engineering Economics, 5th edition, © 2010

Present Equivalent Cost for Each Option

Contemporary Engineering Economics, 5th edition, © 2010

Graphical
Representation of
Replacement
Strategies under a
Finite Planning
Horizon (Example
14.5)
Optimal Strategy:

Contemporary Engineering Economics, 5th edition, © 2010