Module 9: Replacement AnalysisSI-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

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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:

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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 valuableSI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Changing Value in Time

cost

Total Annual Cost Annual O & M Cost

Time at minimum cost

Annual Investment Cost (Capital Recovery) time

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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 l e R e a l za b l V a l e u i e u

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

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ExampleSunk 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):

= 695,000,000 (A/P, i, 5) + EUAW defender 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)

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For i= 11% (A/P, 11, 5) = 0.2706 (A/F, 11, 5) = R e ta i e d o l n d 0.1606cra n e

EUAW EUAW

defender challenger

= 187,894,255 = 263,395,000

More realistic condition Ekonomi TeknikMuhamad Abduh, Ph.D. reduced salvage value SI-4251 for old equipment

Defender vs. More than One ChallengersInitial Current Salvage Trade- Annual Cost DEFENDER Cost 850,000 Book Value in 435,000 221,50045,000 Value CHALLENGE 590,000 Value 220,120328,75011,000 R1 CHALLENGE 410,000 289,400330,0009,750 R2 CHALLENGE 395,700 250,000295,0007,300 R3

Remainin g Service 6 life 6 6 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) = 54,884.55SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

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For Previous Example

Alternative way:

EUAW i, 5)

defender

=

37,500,000 234,575,000 (A/F, = - 35,368,145Retained 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

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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)

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Replacement Analysis with One Additional Period Timing for ReplacementstartCalculate 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 DRetain DEFENDER

Compare

EUAWC : EUAWD

stop

EUAW C < EUAW D

Select CHALLENGER replace DEFENDER

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Replacement Analysis with Additional Period

D C-1

Initial 3,850,000 Cost2.590,000

Annual Add Annual Trade Salvage Service 235,000 150,500 Cost Annual 375,000 Reduction 345,000 235.000 4 in Cost Value Life 195,000 315.700 6 Cost in Book Value

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

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Replacement Analysis with Additional Period n 0 1 2 3 4 5

Defender Book Value CD or EUAWD

Challenger Book Value EUAWC

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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) SI-4251 Ekonomi TeknikMuhamad 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 Cost15

Time, j

SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Minimum-Cost Life Analysis

EUAWk = BV0 (A/P, i, k) BVk (A/P, i, k) +[AOCj (P/F, i, j)](A/P, i, k) where:

BV BV

0 k

=P = SV

AIC = Annual Investment Cost TAC = Total Annual Cost

Year of service, k (a) 1 2 3 k-1 k16

BVj (b)

k = life of service AOCj = annual cost at year jAOCj (c)

Equivalent AOCj (d) = EUAW(c)

AICj (e)

TACj Or EUAWk (f) = (d)+(e)

SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Homework #9

Redo the replacement analysis for the mobile crane problem in this modules example using ESL.

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.