REPLACEMENT AND MAINTENANCE ANALYSIS

Introduction

Organizations providing goods/services use several facilities like equipment and

machinery which are directly required in their operations. In addition to these facilities, there
are several other items which are necessary to facilitate the functioning of organizations.

All such facilities should be continuously monitored for their efficient functioning;
otherwise, the quality of service will be poor. Besides the quality of service of the facilities,
the cost of their operation and maintenance would increase with the passage of time.

Hence, it is an absolute necessity to maintain the equipment in good operating conditions

with economical cost. Thus, we need an integrated approach to minimize the cost of
maintenance. In certain cases, the equipment will be obsolete over a period of time.

If a firm wants to be in the same business competitively, it has to take decision on whether
to replace the old equipment or to retain it by taking the cost of maintenance and operation into
account.

There are two basic reasons for considering the replacement of an equipment physical
impairment of the various parts or obsolescence of the equipment.

Physical impairment refers only to changes in the physical condition of the machine itself.
This would lead to a decline in the value of the service rendered, increased operating cost,
increased maintenance cost or a combination of these.

Obsolescence is due to improvement of the tools of production, mainly improvement in

technology.

So, it would be uneconomical to continue production with the same machine under any of
the above situations. Hence, the machines are to be periodically replaced.

Sometimes, the capacity of existing facilities may be inadequate to meet the current
demand. Under such situation, the following alternatives will be considered.

ü Replacement of the existing equipment with a new one.

ü Augmenting the existing one with an additional equipment.

Types of Maintenance
Maintenance activity can be classified into two types:
 o Preventive maintenance and
o Breakdown maintenance.

Preventive maintenance (PM) is the periodical inspection and service activities which are
aimed to detect potential failures and perform minor adjustments or repairs which will prevent
major operating problems in future.

Breakdown maintenance is the repair which is generally done after the equipment has
attained down state. It is often of an emergency nature which will have associated penalty in
terms of expediting cost of maintenance (Expediting Expense — costs to complete repairs to
put the insured back in business as rapidly as possible, even if a temporary arrangement.)
and down time cost of equipment.

Preventive maintenance will reduce such cost up to a point. Beyond that point, the cost of
preventive maintenance will be more when compared to the breakdown maintenance cost.

The total cost, which is the sum of the preventive maintenance cost and the breakdown
maintenance cost, will go on decreasing with an increase in the level of maintenance up to a
point.

Beyond that point, the total cost will start increasing. The level of maintenance
corresponding to the minimum total cost is the optimal level of maintenance.
Types of Replacement Problem

Replacement study can be classified into two categories:

 (a) Replacement of assets that deteriorate with time (Replacement due to gradual failure, or
wear and tear of the components of the machines).

This can be further classified into the following types:

(i) Determination of economic life of an asset.

(ii) Replacement of an existing asset with a new asset.

(b) Simple probabilistic model for assets which fail completely (replacement due to
sudden failure).

Determination of Economic Life of an Asset

Any asset will have the following cost components:

✓ Capital recovery cost (average first cost), computed from the first cost (purchase
price) of the machine.

✓ Average operating and maintenance cost (O & M cost)

✓ Total cost which is the sum of capital recovery cost (average first cost) and average
maintenance cost.

EXAMPLE
Life span of the machine is 7 years.

Capital recovery cost (average first cost)

Average total cost = [ First cost (FC) + Summation of maintenance cost] /

Replacement period
Column F = Column E + Column D

The value corresponding to any end of year (n) in Column F represents the
average total cost of using the equipment till the end of that particular year.

For this problem, the average total cost decreases till the end of year 6 and
then it increases. Therefore, the optimal replacement period is six years, i.e.
economic life of the equipment is six years.
 (b) When interest rate, i = 12%. When the interest rate is more than 0%, the
steps to be taken for getting the economic life are summarized with reference to
Table

Coloumn C = Present worth/future worth at 12% interest rate = P/F = 1/(1+i)^n

Coloumn G = [i(1+i)n]/[(1+i)n – 1]

[NOTE: Uniform Annual Series and Present Value

More Interest Formulas

Uniform annual series and present value

Go to questions covering topic below

Suppose that there is a series of "n" uniform payments, uniform in amount and uniformly spaced,
such as a payment every year. Let "A" be the amount of each uniform payment.

Let "P" be a single amount equivalent to the series, with "P" occurring one period before the first "A"
payment. Note that although "P" is an abbreviation of "Present," the single amount "P" may actually
occur in the future as long as it occurs exactly one period before the first "A" payment.

The relationship between P and A is

P = A [ (1 + i)n - 1] / [ i (1 + i)n]
Salvage value is the estimated resale value of an asset at the end of its useful life.

Capital recovery = the earning back of the initial funds put into an investment.

Equivalent annual cost (EAC) is the annual cost of owning, operating, and maintaining an asset
over its entire life.

REPLACEMENT OF EXISTING ASSET WITH A NEW ASSET

• In this section, the concept of comparison of replacement of an existing asset

with a new asset is presented.
• In this analysis, the annual equivalent cost of each alternative should be
computed first.
• Then the alternative which has the least cost should be selected as the best
alternative Before discussing details, some preliminary concepts which are
essential for this type of replacement analysis are presented.
 Capital Recovery with Return

Concept of Challenger and Defender

• If an existing equipment is considered for replacement with a new equipment,

then the existing equipment is known as the defender and the new equipment is
known as challenger.
• Assume that an equipment has been purchased about three years back for
Rs 5 00 000 and it is considered for replacement with a new equipment The
supplier of the new equipment will take the old one for some money, say
Rs 3 00 000
• This should be treated as the present value of the existing Equipment and it should
be considered for all further economic analysis The purchase value of the existing
equipment before three years is now known as sunk cost and it should not be
considered for further analysis

EXAMPLE: Two years ago, a machine was purchased at a cost of Rs 2 00 000

to be useful for eight years Its salvage value at the end of its life is Rs 25 000 The
annual maintenance cost is Rs 25 000 The market value of the present machine
is Rs 1 20 000 Now, a new machine to cater to the need of the present machine
is available at Rs 1 50 000 to be useful for six years Its annual maintenance cost
is Rs 14 000 The salvage value of the new machine is Rs 20 000 Using an interest
rate of 12 find whether it is worth replacing the present machine with the new
machine
Equivalent annual cost (EAC) is the annual cost of owning, operating, and
maintaining an asset over its entire life.