# Capital Equipment Replacement Decisions

Ali Zuashkiani Condition Based Maintenance Laboratory University of Toronto
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1

Capital Equipment Replacement
• Constant Annual Utilization

• Varying Annual Utilization

• Technological Improvement

• Tracking Individual Units

• Repair versus Replace
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Economic Life Problem
Optimum replacement age Total cost

Annual Cost

Operations and maintenance cost Fixed cost Ownership cost

Replacement Age ( years) www.ipamc.org
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Economic Life Model: [constant utilization]
Construction of model:
C1 C2 C3 A – Sn

0

1

2

3

n years

Replacement Cycle

Note:
Above assumes costs in year are paid at the end of year.
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Time Value of Money: Discounted Cash Flow Analysis

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Concept of Economic Life
N = 1 year A – S1 A – S1 A – S1 A – S1 A – S1 A – S1 A – S1 …….. c1 c1 c1 c1 c1 c1 c1 ……..
0 1 2 3 4 5 6 Years

N = 2 years A – S2 c1 c2
0 1

A – S2 c1
2

A – S2 c2
3 4

A – S2 c1 c2
5 6

…….. c1 ……..
Years

N = 3 years A – S3 c1 c2
0 1

A – S3 c3
2 3

A – S3 c1 c2
4

…….. c1 ……..

c3
5 6

Years www.ipamc.org
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Time Value of Money
\$100 \$100 + 10 = \$110 \$110 + 11 = \$121

i = 10% 0 1

i = 10% 2

The above concept is familiar to many, i.e. investments grow in value
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Example
Problem: Assume we have a payment to make, 2 years from now, of \$121. What is its value today? (i.e. its present value) \$121

?
0 Solution: P = 121 1 1 1 + 0.1 = \$100
2

2 (Assume i=10%)

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Equivalent Annual Cost (EAC): Use of the Capital Recovery Factor (CRF)
i (1 + i ) n CRF = (1 + i )n − 1

EAC = Present Value x CRF
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Selecting an Alternative
In the following example, we will consider two (equivalent) criteria:
(i) (ii) Present value Equivalent annual cost

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Example: Statement of Problem
A contractor requires specialized equipment for a period of 3 years. Given the costs and salvage values in the following table, which is the best alternative?
Equipment A B C Purchase Price 5000 3000 6000 Installation Cost 100 100 100 Operating Cost 1 100 200 50 2 100 300 80 3 100 400 100 Salvage Value 3000 1500 3500

NOTE: Costs in \$ x 100

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For Equipment A
\$5000 \$100 0 \$100 \$100 \$100 \$3000

1

2

3

• •

Present Value (PV) = ? Assume that discount factor r = 0.9 Recall: r = 1 / 1+i where i = interest rate appropriate for discounting (in this case, assume i = 11%) PV = 5000 + 100 + 100 (0.9)1 + 100 (0.9)2 + 100 (0.9)3 – 3000 (0.9)3 = \$3157

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For Equipment B
PV = 3000 + 100 + 200 (0.9)1 + 300 (0.9)2 + 400 (0.9)3 – 1500 (0.9)3 = \$2721

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For Equipment C
PV = \$3731 Therefore, the best alternative using the present value concept is B (since it has the minimum PV).

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• Dealing with the same example, rather than the present result in terms of the Present Value of a stream of cash flows, we frequent convert this PV to an Equivalent Annual Cost (EAC) - sometimes referred to as Annual Equivalent Evaluation. • To convert PV to EAC, multiply PV by the Capital Recovery Factor (CRF):

An Alternate Approach

EAC = PV x CRF
where CRF =

i (1+i)n (1+i)n - 1

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Example: Equipment A
EAC = 3157 i (1+i)n (1+i)n - 1 = 3157 0.11 (1 + 0.11)3 (1 + 0.11)3 - 1 = 3157 x 0.4092 = \$1291.89 Graphically, we have:
\$1291.89 \$1291.89

Recall: PV = \$3157

\$1291.89

0

1

2

3

Note: The PV of this is the same as the PV of the original stream of cash flows for Equipment A. www.ipamc.org
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Economic Life Model: [constant utilization]
Construction of model:
PV of above cycle: C1(n) = C1r1 + C2r2 + C3r3 + -------- + Cnrn In general:

+ ( A – Sn ) rn

C1 (n) =

n

i =1

∑ Ci r i

+ r n ( A − Sn )
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Economic Life Model: [constant utilization]
Construction of model:
Consider the second cycle: C1 C2 C3 A – Sn

0 First Cycle

n years n years

2n years

PV of 2nd cycle discounted to start of 2nd cycle: C1r1 + C2r2 + C3r3 + -------- + Cnrn In general:

+ ( A – Sn ) rn

C 2 (n) =

n

i =1

Ci r i + r n ( A − Sn ) ∑
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Optimal Replacement Interval for Capital Equipment: Minimization of Total Cost
Replace C1 C2 Cn C1 C2 Replace Cn C1 C2 Replace Cn C1

0

1

2 … n-1 n

1

2 … n-1

n

1

2 … n-1 n

1…

Cycle 1

Cycle 2

Cycle 3

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Economic Life Model: [constant utilization]
Construction of model:
Similarly, we can obtain: C3(n) , C4(n) , etc Thus PV of this chain of replacement is: C(n) = C1(n) + C2(n)rn + C3(n)r2n + C4(n)r3n + ………. Summing to infinity then for the geometric progression we get: C1(n) C(n) = ----------1 - rn Since C1(n) = C2(n) = C3(n) ……

C(n) =

i =1

Ci r i + r n ( A − Sn ) ∑ − rn 1
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n

Example
Have A C(n)
1.2

Ci, Si,

r:
23701

22500 1
0.8

0.6

21735
0.4

19421
0.2 0

20790

Economic life

5 years Thus the economic life of the asset is 2 years with an associated total discounted cost of \$19,421 EAC = 19,421 * i Therefore Recall r = 1 / (1 + i) i = 0.11 and r = 0.9

1

2

3

4

EAC = \$2,136
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Note :
A better assumption for cash flows may be:
USED IN AGE/CON AND PERDEC SOFTWARE

A

C1

C2

C3 n-1

Cn

Sn

0

1

2

3

n

Replacement Cycle

NOTE : NEED TO BE CLEAR WHERE CASH FLOW OCCURS
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Fleet Statistics
S Fleet Utilization: 60,000 km/year per tractor Fleet size: 19 Tractor weight: Current policy: K Fleet Utilization: 110,000 km/year per tractor Fleet size: 17 Tractor weight: Current policy: 23,000 5 year replacement cycle
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18,000 kg 5 years replacement cycle

Title:

BEST ESTIMATE RESALE VALUES 5 85000
Rate for Cash TradeFlow in Value Discounting 10% 10% 10% 10% 10% 60000 40000 25000 20000 15000 EAC Best Year Highlighted 65,787 70,541 72,459 71,101 68,234
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Number of Years: Acquisition Cost:
Age of Vehicle O&M Cost (In Today’s Dollars) 29352 45246 52626 53324 42363

1 Year Old 2 Year Old 3 Year Old 4 Year Old 5 Year Old

DATA ANALYSIS: Equivalent Annual Cost vs Age of Trucks
EAC - \$\$ (Thousands)

80 75 70 65 60
1 2 3 4 5
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Age of Trucks (years)

Haul Truck

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Haul Truck Replacement
MD452
Jan 1, 1998 Jan 1, 1999 Jan 1, 2000 Jan 1, 2001

\$165,000 \$165,000 \$105,000 \$246,000 \$115,000 \$187,500 \$187,500

\$28,500

July 1 1997 Historical Costs

July 1 1998

July 1 1999

July 1 2000

Today

\$330,000 Year 1

\$369,000 Year 2

\$302,000 Year 3

\$216,000 Year 4

2002 Dollars (inflation = 5% P.A.) \$401,117 Year 1 \$427,164 Year 2 \$332,955 Year 3 \$226,800 Year 4

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Haul Truck Replacement
Continued…
Truck MD452 \$401,117 \$427,164 \$332,955 \$226,800

Year 1 2 3 4

MD450

MD451

MD453

Average \$396,270 \$411,246 \$329,963 \$279,279

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Haul Truck Replacement
Why are O&M costs declining in years 3 and 4? Or Why are O&M costs so high in years 1 and 2? Due to developing maintenance expertise?

?

?
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Haul Truck Replacement
Examining newest group of 5 trucks [MD464-468] that came into service 2 years ago we get: Average yr 1 O&M cost: \$171,300 Average yr 2 O&M cost: \$207,400

In today’s prices we have: Yr 1: \$188,858 Yr 2: \$217,770
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Input Data: 100T Haul Truck Acquisition Cost: \$700,000

Haul Truck Replacement

Interest Rate Appropriate for Discounting: 11% Year O&M Cost Resale (or Equivalent (\$/year) Trade-In) Annual Cost value at End (\$) of Year 1 188,858 450,000 523,244 2 3 4 5 6
6

217,770 329,963 279,279 300,000 (est) 350,000 (est)

300,000 275,000 250,000 150,000 100,000

491,415 471,321 448,800 450,678 451,224
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Remarks: Haul Truck Economic Life
When dealing with capital equipment replacement problems, there are frequently significant uncertainties associated with future costs, interest rates and possibly the demands that will be placed on the equipment. However, the availability of specially-designed pc software enables valuable sensitivity analyses to be undertaken.
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Remarks: Haul Truck Economic Life
These “what if” analyses allow the engineer to examine the effect that various estimates of trade-in values, interest rates and so on, will have on replacement cycles. Since a high degree of confidence can be associated with final recommendations to senior management on equipment economic life, the chances of obtaining approval for major capital expenditures is generally increased significantly.
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Seamer Replacement
1.4
Seamer Discounted Total Cost Dollars * 106

1.2

1.0

0.8 0 12 18 24 30 36
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Replacement Age (Months)

Feller Buncher

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Economic Life: before and after tax calculation (Feller Buncher data)
EAC (Before tax)

220000 200000

EAC

180000 160000 140000 120000 1 2 3 4 5 6 7 8 9 10 www.ipamc.org
36 EAC (After tax)

Year

Replacement Age Study: Alcao Vehicles

Determining the optimal replacement age for two floor sweepers, a fork-lift truck, and a GM Suburban
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Example of the Use of AGE/CON:
Determining Optimal Replacement Age for Municipal Dump Trucks

In this case, optimal replacement age is after 7 years www.ipamc.org of operation
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A Further Example:
Determining Optimal Replacement Age for 4x4 Pick-up Trucks

In this case, optimal replacement age is after 5 years www.ipamc.org of operation
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Analysis of Alcao Vehicle #1:
Floor Sweeper

www.ipamc.org Conclusion: Continue using this vehicle (i.e. do not replace yet)
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Results
• For each of the four vehicles analyzed, the Equivalent Annual Cost continually decreased as the replacement age increased • As a result, the optimal replacement policy is to continue using the vehicles

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Recommendations
• Although the EAC is still decreasing as the vehicles get older, the marginal decrease from year to year is getting smaller • This suggests that the EAC may increase in the near future • Therefore, this very same cost analysis should be performed on a yearly basis to determine the year where the EAC begins to increase • It is at this point that the vehicles should be replaced
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Economic Life Model
Economic Life
total cost

maintenance

\$\$

downtime operations inventory

depreciation

Time
Source: H. Greene & R.E. Knorr, Managing Public Equipment, American Public Works Association, Kansas City, 1989. www.ipamc.org

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Establishing The Economic Life of a Fleet of Mobile Equipment

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Kiruna trucks - INCO

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Objectives
• Determine the optimal replacement policy for the fleet of Kiruna Haulage Trucks • Introduce capital equipment replacement in an overall maintenance strategy • Present a framework to be applied to other capital equipment fleets at Inco
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An Optimal Replacement Policy
• Ensures the efficient use of capital equipment by minimizing the total costs/age of a mobile fleet • Allows for better planning in vehicle replacement • Employs a structured decision making technique for replacement cycles • Allows for flexibility and practicality in replacement decisions
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Two Major Components:
1. Ownership Costs
• • • • A

Model Variables

Acquisition Cost of the Kiruna Truck

CCA Capital Cost Allowance, the depreciation rate of the truck Un Sn Undepreciated Capital Cost in year n Salvage Value in year n
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Model Variables
2. Operating and Maintenance Cost
• Cj Maintenance Cost in year j, comprised of labour, material and other costs
– Labour costs work hours associated with a work order, multiplied by a standard rate – Material costs total of all part costs used in performing maintenance, as recorded on a work order – Other Costs Warranty, Subcontracting, and miscellaneous charges

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Values for the Model Variables
• Recall from the model development, the key variables in the model:

Variable A i r Sn CT CCA

Value \$1.8 M 12% 0.89286 0 33.7% 30%
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Forecasted O&M Costs
• Forecasts presented below (in red):
Age of Truck 1 2 3 4 5 6 7 8 9 O&M Costs 134,258 341,271 444,073 669,650 803,682 767,651 806,034 846,335 888,652 % Increase 154 30 51 20 -4 5 5 5
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Bus Economic Life
Terms of reference: To determine the economic life for the range of GMC buses operated by the Société de Transport de la Communauté Urbaine de Montréal (STCUM)

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Economic Life Calculations: Transit Fleet Replacement
Optimum Replacement Age Total Cost Maintenance and Operation Cost

Annual Cost

Fixed Cost Ownership Cost Bus Replacement Age www.ipamc.org
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Economic Life Calculations: Transit Fleet Replacement

Table A: “High” Trend in Resale Values

Table B: “Low” Trend in Resale Values www.ipamc.org
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Economic Life Calculations: Transit Fleet Replacement
1.2 1.1 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 0

c(t) = 0.302 + 0.723 (cum.km/106)2

\$/km c(t)

200000

400000

600000

800000 1000000

km

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96000

Bus Utilization Trend
y = [9.11574031 x 104] - [9.722352231 x 101]x - [1.475740136 x 10-2]x2 + [7.403868263 x 10-4]x3 - [1.575402140 x 10-6]x4 + [9.488071440 x 10-10]x5 + [4.192383586 x 10-13]x6 - [7.567287679 x 10-16]x7

84000

72000

60000

km /yr

48000

+ [3.266561486 x 10-19]x8 - [4.786922264 x 10-23]x9

36000

24000

12000

0 0 400 800 1200 Bus Number 1600 2000

Highest Utilized

Least Utilized

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x

Economic Life Calculations: Transit Fleet Replacement
1) Newest 100 buses will travel 8,636,059 km each bus travels 86,361 km cost/bus = 86,361 (0.303) = \$26,197 in 1st year 2) Similarly next 100 buses each travel on average 78,093 km/yr in 2nd year cost/bus = 78,093 (0.313) = \$24,472 in 2nd year

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Economic Life Calculations: Transit Fleet Replacement
A = \$96,300

EAC = \$30,031
\$26,197 \$24,472 1 2 3 4 S = \$1000 19 20 Bus Age
58

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Economic Life Calculation
Low Resale Value Trend Acquisition cost at start of replacement cycle

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Overall Fleet Savings Summary

* Using high resale value trend + Using low resale value trend

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Optimizing Economic Life Decisions for Bus Fleets of the Town of Markham

By: Cheung- Ki Derek Siu Monique Ka Yee Ho

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Background
• The analysis will cover the whole bus fleet, which consists of conventional and specialized buses. • The conventional bus fleet is composed of 54 coaches, which provide 11 service routes. • The specialized bus fleet is composed of 6 vehicles.
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Existing Problems
• Increase in costs due to frequent repair
– Mechanical problems due to engine wear-out

– Shortage of new buses from the bus manufacturer

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Primary Analysis
• The two bus fleets had different number of buses and different utilization patterns. Therefore, the analysis was divided into two main parts: – Conventional Bus Fleet – Specialized Bus Fleet

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Conventional Bus Fleet Analysis
• AGE/CON was employed and the results were deduced from its outputs. • EAC for 18 years, for interest rates from 0% to 20%, was obtained. The interest rate selected was equal to the prime rate of 6.75% at the time; i = 6% and 8% were considered, thus the optimal economic life determined was 13 years.
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Assumptions
• O&M Cost was obtained by adding up the cost of repair, fuel, tires, and cleaning. • Parameters used in AGE/CON: – “Low” trend of resale value. – Utilization trend of year 2000: fitted to the 9th degree polynomial function. – Linear Operations and Maintenance Cost function.
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AGE/CON Example

i = 6%

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Utilization Trend Curve

Usage (km)

Bus Number

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Equivalent Annual Cost (EAC)

Equivalent Annual Cost (\$/year)

Year of Service

Minimum EAC in year 13

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Interpretation of Results
• The optimal solution’s (13 years) corresponding EAC is between \$116,000 and \$125,000. • The current replacement policy (18 years) has a corresponding EAC between \$120,000 and \$129,000. • Therefore, the potential cost savings are about \$216,000/year (= \$4,000 × 54 vehicles)

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Optimal Replacement Policy for Capital Equipment Taking Into Account Technological Improvement
Finite Planning Horizon (Section 4.5)
Fixed future operating time, n periods Replace with technologically improved equipment

A-Sp,T
Cp,1 Cp,2 Cp,3 Ct,1 Ct,2 Ct,n-T

0

1

2

3...

T

T+1

T+2 . . . n-1

n www.ipamc.org
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Noranda Equipment Replacement System
B. Buttimore, A. Lim

Source: B. Buttimore, A. Lim, Applied Systems and Cybernetics, Edited by G.E. Lasker, www.ipamc.org Vol. II: Systems Concepts, Models and Methodology, Pergamon Press Inc., 1981, pp. 1069-1073

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Introduction
The Noranda Equipment Replacement System is designed to analyze an existing fleet of equipment over a specified period to determine, using a total discounted cost method, if or when individual units in the fleet should be replaced by a proposed new unit.

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Time diagram for example

1
Years

2

3

4

5

6

7

8

existing shovel

new shovel

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System Input Includes
• Expected rate of return. • Depreciation rate. • Investment tax credit, capital cost allowance, CCA depreciation type, federal, provincial and mining tax rates. • Inflation rates. • Unit purchase year, and price. • Unit yearly total operating and maintenance cost. • Unit yearly total production. • Unit yearly salvage values. • Proposed replacement unit data.
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Conclusion
The Noranda Equipment Replacement System can be used to do the following analyses: • Compare the productivity of individual units with a fleet. • Find the “lemon” in a fleet of equipment. • Calculate the optimum year to replace a unit. • Sensitivity testing to see what effect rate of return, taxes or production, for example, have on replacement timing.
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Optimal Replacement Policy for Capital Equipment Taking Into Account Technological Improvement:
Infinite Planning Horizon
Total discounted costs C(T,n) Replacement with technologically improved Cp,1 Cp,2 Cp,T Ct,1 Ct,2 Ct,n Ct, Ct, Ct,n

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Repair vs. Replace
Cash Flows Associated with Acquiring New Equipment at Time ‘T’
R A-Sp,T Ct,1 Ct,2 Ct,3 … Ct,n A-Sn Ct,1 Ct,2 Ct,3 … Ct,n A-Sn

Cp,1 Cp,2 Cp,3 … Cp,T

0

1

2

… T-1

T

1

2

… n-1

n

n+1 n+2 …n-1 2n

(Years)

Today www.ipamc.org
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Repair vs. Replace
A = \$ 1,083,233 (Unit operational)
R Cp,1 Cp,2 Cp,3 …Cp,T A-Sp,T A-Sn Ct,1 Ct,2 Ct,3 … Ct,n A-Sn

Ct,1 Ct,2 Ct,3 … Ct,n

0 Today

1

2

… T-1

T

1

2 … n-1

n

1

2 . . . n-1

2n

(Years)

Cash Flows Associated with Acquiring New Equipment at Time T

Variable Maintenance Costs R = \$390,000 (includes arms + Z•bars) Excludes Front Frame, Rear Frame and Bucket components (excludes operator, fuel, wear parts)
Cp,1 = \$ 138,592 Cp,2 = \$ 238,033 Cp,3 = \$ 282,033 Sp,0 = \$ 300,000 Sp,1 = \$ 400,000 Sp,2 = \$ 350,000 Sp,3 = \$ 325,000 Ct,1 = \$ 38,188 Ct,2 = \$ 218,583 Ct,3 = \$ 443,593 Ct,4 = \$ 238,830 S1 = \$ 742,500 S2 = \$ 624,000 S3 = \$ 588,000 S4 = \$ 450,000

••••

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••••

The Solution
R Cp,1 Cp,2 Cp,3 …Cp,T A-Sp,T A-Sn Ct,1 Ct,2 Ct,3 … Ct,n A-Sn

Ct,1 Ct,2 Ct,3 … Ct,n

0 Today

1

2

… T-1

T

1

2 … n-1

n

1

2 . . . n-1

2n

(Years)

Cash Flows Associated with Acquiring New Equipment at Time T

Overall EAC (\$)

Change-over time to new loader, T T=0 T=1 T=2 T=3 449,074 456,744 444,334 435,237

Note: n = 11 yrs www.ipamc.org
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Most likely additional component to be replaced at re-build: Front frame (\$99,870) ∴R = \$ 489,970 (was \$ 390,000)
Change-over time to new loader, T T=0 Overall EAC (\$) 449,074 T=1 471,725 T=2 459,319 T=3 450,217

Minimum

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The Life Cycle Cost Iceberg

Source: B.S. Blanchard and W.J. Fabrycky, Systems Engineering and Analysis, Prentice Hall, 1990

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Example: Nimrod Aircraft
• BAE Systems signed a contract with the Ministry of Defence to supply an upgraded fleet of Nimrod aircrafts for the year 2001 • Initial estimated cost of project was £2 billion • However, cost of project definition (initial stage of system planning) was only £24 million • Consequence: Initial estimated cost of the project was too optimistic, resulting in a lack of funding to complete the programme • BAE Systems now uses a life-cycle management approach
Reference: Professional Engineering, May 2001

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Whole Life Costing: B- 52

From: Professional Engineer, p 59, May 2002

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Annual Maintenance Cost Limit

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Trend in Equipment Condition
‘As New’ Condition

Equipment Condition

O/H Repair Replace

O/H O/H
Overhaul and Repair Consequences

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I
Age of vehicle

Estimate, (X), of maintenance cost in next year. Distribution of this cost of fI(X)

Estimated cost, (X) greater than AMCL, (LI) for a vehicle of age I

J

=1
Age of vehicle

Estimated cost, (X) less than or equal to AMCL, (LI) for a vehicle of age I

J

=I+1
Age of vehicle n-1 years to end of planning horizon
88

n years to end of planning horizon

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Consider a vehicle of age 5 years…
MEAN MAINTENANCE COST = \$700

17%

0

300

AMCL = L5 = \$1055

1500

\$

If buy new vehicle and sell 5 year old vehicle: Cost = \$2800 – 15% of \$2000 = \$2500 (± Bal. Adj.)
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Recall
MEAN MAINTENANCE COST = \$700

17%

If buy new vehicle and sell 5 year old vehicle:
Cost = \$2800 – 15% of \$2000 = \$2500 (± Bal. Adj.)

0

300

AMCL = L5 = \$1055

1500

\$

J
5 YR OLD

= 1 YR OLD

L5= \$1055 Cost = \$2500
Estimate

PROB. = 17%

I

L5= \$1055
10 YRS TO GO

J

= 6 YR OLD

PROB. = 83%
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Cost = \$700

EXP. COST = \$2500 (0.17) + \$700 (0.83) = \$1006

7 6 5 4 3 2 1 0
10 YR TO GO 9 YR

K
P KEE

K R R R

7 6 5 4 3 2
R

E AC PL RE

AGE

K R
8 YR

K

1 0

For each vehicle age, there are two alternatives – keep or replace Therefore, over 10 year period, there are: 210 = 1024 “Paths” – for each vehicle age Decision on whether to keep or replace depends on AMCL – which can an almost infinite number of values. www.ipamc.org
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2 YR

1 YR

0 YR

Asset Replacement
(Optimizing Life Cycle Decisions)
Software: •AGE/CON (Mobile equipment) •PERDEC (Fixed equipment) •www.banak-inc.com

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