Replacement Theory

The problem of replacement arises when any one of the components of productive
resources, such as machinery, building and men deteriorates due to time or usage.

The examples are:

(a) A machine, which is purchased and installed in a production system, due to usage
some of its components wear out and its efficiency is reduced.

(b) A building in which production activities are carried out, may leave cracks in walls,
roof etc, and needs repair.

(c) A worker, when he is young, will work efficiently, as the time passes becomes old and
his work efficiency falls down and after some time he will become unable to work.
The exact age or time for replacement is needed to be calculated and sometimes it
becomes a critical issue, especially in case of machines and equipments, because the
resale value decreases as the decision to replace gets postponed. Replacement Model
helps in determining the optimum time of replacement by considering the running
costs and the capital cost of purchasing the equipment. These associated costs can be
expressed as the average costs and this average cost goes on decreasing with the
postponement of replacement decision. But a time will come when the average cost
starts increasing calling the owner to replace the machine or equipment.
Thus the problem of replacement is experienced in systems where machines, individuals or capital assets are the main

production or job performing units. The characteristics of these units is that their level of performance or efficiency

decreases with time or usage and one has to formulate some suitable replacement policy regarding these units to keep the

system up to some desired level of performance. We may have to take different type of decision such as:

(a) We may decide whether to wait for complete failure of the item (which may result in some losses) due to deterioration

or to replace earlier at the expense of higher cost of the item,

(b) The expensive item may be considered individually to decide whether we should replace now or, if not, when it

should be reconsidered for replacement,

(c) Whether the item is to be replaced by similar type of item or by different type for example item with latest technology

The problem of replacement is encountered in the case of both men and machines. Using probability, it is possible to

estimate the chance of death or failure at various ages. The main objective of replacement is to help the organization for

maximizing its profit or to minimize the cost.

Costs Associated with Maintenance:
to find optimal replacement period so as to minimize the maintenance cost one need to
understand the various cost associated with maintenance. Various costs to be discussed are:
a) Purchase cost or Capital cost: ( C ) This cost is independent of the age of the machine or
usage of the machine. This is incurred at the beginning of the life of the machine, i.e. at the
time of purchasing the machine or equipment. But the interest on the invested money is an
important factor to be considered.
b) Resale value / Depreciation: (S) As the age of the machine increases, the resale value
decreases as its operating efficiency decreases and the maintenance costs increases. It
depends on the operating conditions of the machine and life of the machine.
c) Running costs including maintenance, Repair and Operating costs: These costs are the
functions of age of the machine and usage of the machine. As the usage increases or the age
increases, due to wear and tear, many components fail to work and they are to be replaced.
As the age increases, failures also increase and the maintenance costs goes on increasing.
At some period the maintenance costs are so high, which will indicate that the replacement
of the machine or equipment is essential.
Some notations used:
Running cost
Cum. Running cost
Resale value
Capital cost
Total cost
Average cost
 Rules of Problem
The Optimum Replacement is calculated according to the following rules:-

I. If the scrap value of equipment is zero i.e. The depreciation cost is not given,
then replace the equipment when the maintenance cost become greater then the
current average cost.

II. If you are given the resale value/depreciation cost, the maintenance cost & the
cost of equipment, then the optimum replacement period is determined by the
minimum value of the average cost to date.
Problem: A firm is thinking of replacing a particular machine whose cost price is
₹12,200. The scrap value of the machine is ₹200/-. The maintenance costs are found
to be as follows:

Year 1 2 3 4 5 6 7 8

Maintenance Cost in ₹ 220 500 800 1200 1800 2500 3200 4000

Determine when the firm should get the machine replaced.

 Maintena cumulative
Year nce Cost maintenance total cost(T) average cost=
Solution: in ₹ ( R ) cost ( ∑ R) = C-S + ∑ R total cost/year
Capital Cost ( C )= 12200
1 220
Scrap Cost (s)= 200 220 12220 12220.00
T=C-s+∑R 2 500 720 12720 6360.00
Average Cost= T/t
3 800 1520 13520 4506.67
Replace the machine at the 4 1200 2720 14720 3680.00
end of 6th year when the
5 1800 4520 16520 3304.00
average annual
maintenance cost is 6 2500 7020 19020 3170.00
minimum. 7 3200 10220 22220 3174.29
8 4000 14220 26220 3277.50
Problem: The maintenance cost and resale value per year of a machine
whose purchase price is Rs. 7000/ - is given below:
Year 1 2 3 4 5 6 7 8

Maintenance Cost in ₹ 900 1200 1600 2100 2800 3700 4700 5900
Resale value in ₹ 4000 2000 1200 600 500 400 400 400

Determine the optimum period of replacement of the machine.

Solution:
Capital Cost (C)= 7000

Running Cost cumulative

Year Running cost Resale total cost(T) = average cost=
in ₹ ( R )
( ∑ R) value ( s ) C-s + ∑ R total cost/year
1 900 900 4000 3900 3900.00
2 1200 2100 2000 7100 3550.00
3 1600 3700 1200 9500 3166.67
4 2100 5800 600 12200 3050.00
5 2800 8600 500 15100 3020.00
6 3700 12300 400 18900 3150.00
7 4700 17000 400 23600 3371.43
8 5900 22900 400 29500 3687.50

From the table we can see that the average cost is minimum at the end of the 5th
year. Hence the machine may be replaced at the end of the 5th year.
Problem: The initial cost of a vehicle is ₹3,800/- and the trade in value drops as
time passes until it reaches ₹600/-. The maintenance costs are as shown below.
Find when the replacement is due?

Year of service: 1 2 3 4 5

Year-end trade - in value in 2000 1200 800 700 600

Annual operating cost in Rs.: 1600 1900 2200 2500 2800

Annual Maintenance cost in 400 500 700 900 1100

Solution:
C = Capital cost in ₹ = 3800/-,
S (y) =, Scrap value or trade in value,
R (y) = Annual maintenance cost in ₹ +Annual operating cost in ₹
Here we can add operating cost and annual maintenance cost to get the running cost.
Running cumulative Resale value total cost(T) = average cost=
Year Annual Annual Cost in ₹ Running cost
operating Maintenance (R) ( ∑ R) (s) C-S + ∑ R total cost/year
cost in Rs.: cost in
1 1600 400 2000 2000 2000 3800 3800.00
2 1900 500 2400 4400 1200 7000 3500.00
3 2200 700 2900 7300 800 10300 3433.33
4 2500 900 3400 10700 700 13800 3450.00
5 2800 1100 3900 14600 600 17800 3560.00
The optimal replacement period is at the end of third year. And the minimum annual average cost is Rs. 3433.33
Replacement Policy for Items Whose Running Cost Increases with Time but
Value of Money Changes with Constant Rate During a Period
If the effect of the time on money is to be considered, then replacement decision must be based
upon an equivalent annual cost.
For example: if the interest rate on Rs 100 is 10 per cent per year, then the value of Rs 100 to be
spent after one year will be Rs 110. This is also called value of money.
Also, the value of money that decreases with constant rate is known as its depreciation ratio or
discounted factor. The discounted value is the amount of money required to build up funds at
compound interest that is sufficient to pay the required cost when due.
For example: if the interest rate on Rs 100 is r per cent per year, then the present value (or worth)
of Rs 100 to be spent after n years will be

where d is the discount rate or depreciation value.

After calculating depreciation value, we need to determine the critical age at which an item should
be replaced so that the sum of all discounted costs is minimum
Example: Let the value of the money be assumed to be 10 per cent per year and
suppose that machine A is replaced after every three years, whereas machine B is
replaced every six years. The yearly costs (in Rs) of both the machines are given
below:
Year 1 2 3 4 5 6
Machine A 1000 200 400 1000 200 400
Machine B 1700 100 200 300 400 500

Determine which machine should be purchased

Solution:

  A B
Year Cost Present worth Cost Present worth
1 1000 1000.00 1700 1700.00
2 200 181.82 100 90.91
3 400 330.58 200 165.29
4 1000 751.31 300 225.39
5 200 136.60 400 273.21
6 400 248.37 500 310.46
Total   2648.68   2765.26

Total present worth of machine A is less than the total present worth of machine B.
Thus machine A should be purchased.