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1 Chapter 12 - Replacement Click here for Streaming Audio To Accompany Presentation (optional) Click 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 Cal Poly Pomona - SA152 EGR 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 Replacement Analysis

3 EGR Cal Poly Pomona - SA153 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?

4 EGR Cal Poly Pomona - SA154 Replacement Analysis Terms Defender - the existing equipment or building previously implemented. Challenger - the proposed replacement currently under consideration.

5 EGR Cal Poly Pomona - SA155 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.

6 EGR Cal Poly Pomona - SA156 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.

7 EGR Cal Poly Pomona - SA157 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?

8 EGR Cal Poly Pomona - SA158 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?

9 EGR Cal Poly Pomona - SA159 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?

10 EGR Cal Poly Pomona - SA1510 Replacement Analysis Decision Chart CompareWhere Not increasing Increasing Defender Marginal Cost Not available Available Defender Marginal Cost EUAC at Minimum Cost Life EUAC over Remaining Useful Life 3 EUAC at Minimum Cost Life 2 Next-year Marginal Cost 1 Best Challenger Defender AnalysisTechniques

11 EGR Cal Poly Pomona - SA1511 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.

12 EGR Cal Poly Pomona - SA1512 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 –$7500 initial cost (P) –$900 arithmetic gradient maintenance cost (G) –$500 uniform cost (A) and 400 arithmetic gradient operating cost (G)

13 EGR Cal Poly Pomona - SA1513 EUAC calculations for increasing values of useful life

14 EGR Cal Poly Pomona - SA1514 Graph of EUAC by n. Economic Useful Life is where Total EUAC is minimized

15 EGR Cal Poly Pomona - SA1515 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)

16 EGR Cal Poly Pomona - SA1516 Marginal Cost for a New Item: Example 12-2

17 EGR Cal Poly Pomona - SA1517 Marginal Cost Data Defender Is the marginal cost of defender increasing? Here the marginal costs are increasing. Example 12-3

18 EGR Cal Poly Pomona - SA1518 Replacement Analysis Technique #1 Replace when the marginal cost of ownership of the defender is more than the EUAC of the challenger. Defender Marginal costs are increasing

19 EGR Cal Poly Pomona - SA1519 Analysis Technique # 1 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. Is Appropriate When Replacement Repeatability Assumptions Hold

20 EGR Cal Poly Pomona - SA1520 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.

21 EGR Cal Poly Pomona - SA1521 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.

22 EGR Cal Poly Pomona - SA1522 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.

23 EGR Cal Poly Pomona - SA1523 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.

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