Capital Equipment

Replacement Decisions

Ali Zuashkiani
Condition Based Maintenance
Laboratory
University of Toronto
www.ipamc.org
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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)

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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 A – S2 A – S2 A – S2 ……..
c1 c2 c1 c2 c1 c2 c1 ……..

0 1 2 3 4 5 6 Years
N = 3 years
A – S3 A – S3 A – S3 ……..
c1 c2 c3 c1 c2 c3 c1 ……..

0 1 2 3 4 5 6 Years
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 Time Value of Money

$100 + 10 $110 + 11
$100
= $110 = $121

i = 10% i = 10%
0 1 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 1 2
2
Solution: P = 121 1 (Assume i=10%)
1 + 0.1

= $100
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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) Present value

(ii) 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 Purchase Installation Operating Cost Salvage
Price Cost 1 2 3 Value

A 5000 100 100 100 100 3000

B 3000 100 200 300 400 1500

C 6000 100 50 80 100 3500

NOTE: Costs in $ x 100 www.ipamc.org

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 For Equipment A
$5000
$100 $100 $100 $3000
$100

0 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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 An Alternate Approach …
• 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):

EAC = PV x CRF
where CRF = i (1+i)n
(1+i)n - 1 www.ipamc.org
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Example: Equipment A

EAC = 3157 i (1+i)n Recall: PV = $3157

(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 $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 + ( A – Sn ) rn

In general:

n
C1 (n) = ∑ Ci r i + r n ( A − Sn )
i =1
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Economic Life Model: [constant utilization]
Construction of model:
Consider the second cycle: C1 C2 C3 A – Sn

0 n years 2n years
First Cycle n years

PV of 2nd cycle discounted to start of 2nd cycle:

C1r1 + C2r2 + C3r3 + -------- + Cnrn + ( A – Sn ) rn

n
In general:
C 2 (n) = ∑ Ci r i
+ r n
( A − Sn )
i =1
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Optimal Replacement Interval for Capital
Equipment: Minimization of Total Cost
Replace Replace Replace
C1 C2 Cn C1 C2 Cn C1 C2 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) Since C1(n) = C2(n) = C3(n) ……

C(n) = ----------- n
1 - rn ∑Ci r i
+ r n
( A − Sn )
C(n) = i =1
−
1 r n
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 Example
Have A Ci, Si, r:
C(n)1.2

22500 1 23701
0.8

0.6

21735
0.4

19421 20790
0.2

0
Economic life
1 2 3 4
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 Recall r = 1 / (1 + i) r = 0.9

Therefore i = 0.11 and EAC = $2,136

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 Note :
A better assumption for cash flows may be:
A Sn
C1 C2 C3 Cn
USED IN
AGE/CON
AND
PERDEC 0 1 2 3 n-1 n
SOFTWARE
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: 18,000 kg
Current policy: 5 years replacement cycle

K Fleet
Utilization: 110,000 km/year per tractor
Fleet size: 17
Tractor weight: 23,000
Current policy: 5 year replacement cycle
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 Title: BEST ESTIMATE RESALE VALUES
Number of Years: 5
Acquisition Cost: 85000

Age of Vehicle O&M Cost Rate for Cash Trade- EAC

(In Today’s Flow in Value Best Year
Dollars) Discounting Highlighted
1 Year Old 29352 10% 60000 65,787
2 Year Old 45246 10% 40000 70,541
3 Year Old 52626 10% 25000 72,459
4 Year Old 53324 10% 20000 71,101
5 Year Old 42363 10% 15000 68,234

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

80

75

70

65

60
1 2 3 4 5

Age of Trucks (years)

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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 July 1 July 1 July 1 Today

1997 1998 1999 2000

Historical Costs

$330,000 $369,000 $302,000 $216,000

Year 1 Year 2 Year 3 Year 4

2002 Dollars (inflation = 5% P.A.)

$401,117 $427,164 $332,955 $226,800

Year 1 Year 2 Year 3 Year 4

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 Haul Truck Replacement
Continued…

Truck
Year MD450 MD451 MD452 MD453 Average
1 $401,117 $396,270
2 $427,164 $411,246
3 $332,955 $329,963
4 $226,800 $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? www.ipamc.org
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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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 Haul Truck Replacement
Input Data: 100T Haul Truck
Acquisition Cost: $700,000
Interest Rate Appropriate for Discounting: 11%
Year O&M Cost Resale (or Equivalent
($/year) Trade-In) Annual Cost
value at End ($)
of Year
1 188,858 450,000 523,244
2 217,770 300,000 491,415
3 329,963 275,000 471,321
4 279,279 250,000 448,800
5 300,000 (est) 150,000 450,678
6 350,000 (est) 100,000 451,224
6
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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
Replacement Age (Months) www.ipamc.org
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Feller Buncher

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Economic Life: before and after tax
calculation (Feller Buncher data)
EAC (Before tax)
220000

200000
EAC

180000

EAC (After tax)

160000

140000

120000
1 2 3 4 5 6 7 8 9 10
Year www.ipamc.org
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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

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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 www.ipamc.org
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Kiruna trucks - INCO
 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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 Model Variables
• Two Major Components:

1. Ownership Costs

• A Æ Acquisition Cost of the Kiruna Truck

• CCA Æ Capital Cost Allowance, the depreciation rate of

the truck

• Un Æ Undepreciated Capital Cost in year n

• Sn Æ Salvage Value in year n

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 Model Variables
2. Operating and Maintenance Cost

• Cj Æ Maintenance Cost in year j, comprised of labour,

material and other costs

– Labour costs Æ work hours associated with a work order,

multiplied by a standard rate
– Material costs Ætotal of all part costs used in performing
maintenance, as recorded on a work order
– Other Costs ÆWarranty, 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 Value
A $1.8 M
i 12%
r 0.89286
Sn 0
CT 33.7%
CCA 30%

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 Forecasted O&M Costs
• Forecasts presented below (in red):

Age of Truck O&M Costs % Increase

1 134,258 -
2 341,271 154
3 444,073 30
4 669,650 51
5 803,682 20
6 767,651 -4
7 806,034 5
8 846,335 5
9 888,652 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
Annual Cost

and Operation
Cost

Fixed Cost

Ownership Cost

Bus Replacement Age

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 Economic Life Calculations: Transit
Fleet Replacement

Table A: Table B:
“High” Trend in Resale Values “Low” Trend in Resale Values
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Economic Life Calculations: Transit
Fleet Replacement
1.2
1.1 c(t) = 0.302 + 0.723 (cum.km/106)2
1.0
0.9
0.8
$/km c(t)

0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.0
km
0 200000 400000 600000 800000 1000000
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 96000
Bus Utilization Trend
84000

y = [9.11574031 x 104] - [9.722352231 x 101]x

72000
- [1.475740136 x 10-2]x2 + [7.403868263 x 10-4]x3
- [1.575402140 x 10-6]x4 + [9.488071440 x 10-10]x5
60000
+ [4.192383586 x 10-13]x6 - [7.567287679 x 10-16]x7
km /yr

48000 + [3.266561486 x 10-19]x8 - [4.786922264 x 10-23]x9

36000

24000

12000

0
0 400 800 1200 1600 2000

Highest Bus Number

Least
Utilized Utilized
x
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 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 S = $1000

Bus
1 2 3 4 19 20 Age

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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 www.ipamc.org

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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

• Purchasing problem
– 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
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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

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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 2 3 4 5 6 7 8
Years

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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Caterpillar 992D Wheel Loader

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 Repair vs. Replace

Cash Flows Associated with Acquiring New

Equipment at Time ‘T’

R A-Sp,T A-Sn A-Sn

Cp,1 Cp,2 Cp,3 … Cp,T Ct,1 Ct,2 Ct,3 … Ct,n Ct,1 Ct,2 Ct,3 … Ct,n

0 1 2 … T-1 T 1 2 … n-1 n n+1 n+2 …n-1 2n

(Years)

Today

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 Repair vs. Replace
A = $ 1,083,233 (Unit operational)
R A-Sp,T A-Sn A-Sn

Cp,1 Cp,2 Cp,3 …Cp,T Ct,1 Ct,2 Ct,3 … Ct,n Ct,1 Ct,2 Ct,3 … Ct,n

0 1 2 … T-1 T 1 2 … n-1 n 1 2 . . . n-1 2n (Years)

Today Cash Flows Associated with Acquiring New Equipment at Time T

R = $390,000 (includes arms + Z•bars) Excludes Front Variable Maintenance Costs

Frame, Rear Frame and Bucket components (excludes operator, fuel, wear parts)
Cp,1 = $ 138,592 Sp,0 = $ 300,000 Ct,1 = $ 38,188 S1 = $ 742,500
Cp,2 = $ 238,033 Sp,1 = $ 400,000 Ct,2 = $ 218,583 S2 = $ 624,000
Cp,3 = $ 282,033 Sp,2 = $ 350,000 Ct,3 = $ 443,593 S3 = $ 588,000
Sp,3 = $ 325,000 Ct,4 = $ 238,830 S4 = $ 450,000

••••
•••• www.ipamc.org
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 The Solution
R A-Sp,T A-Sn A-Sn

Cp,1 Cp,2 Cp,3 …Cp,T Ct,1 Ct,2 Ct,3 … Ct,n Ct,1 Ct,2 Ct,3 … Ct,n

0 1 2 … T-1 T 1 2 … n-1 n 1 2 . . . n-1 2n (Years)

Today Cash Flows Associated with Acquiring New
Equipment at Time T

Change-over time to new loader, T

T=0 T=1 T=2 T=3
Overall 449,074 456,744 444,334 435,237
EAC ($)
Note: n = 11 yrs
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 The Bad News

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 T=1 T=2 T=3

Overall 449,074 471,725 459,319 450,217
EAC ($)

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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83
 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
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Reference: Professional Engineering, May 2001
84
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 www.ipamc.org

87
 Estimated cost, (X)
greater than AMCL, (LI) J =1
Estimate, (X), of for a vehicle of age I
maintenance cost Age of
in next year. vehicle
I
Distribution of
this cost of fI(X)
Age of Estimated cost, (X) less
vehicle than or equal to AMCL, J =I+1
(LI) for a vehicle of age I
Age of
vehicle

n years n-1 years

to end of to end of
planning planning
horizon horizon
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88
Consider a vehicle of age 5 years…
MEAN MAINTENANCE
COST = $700

17%

0 300 1500 $
AMCL = L5 = $1055
If buy new vehicle and sell 5 year old vehicle:
Cost = $2800 – 15% of $2000
= $2500 (± Bal. Adj.) www.ipamc.org
89
 Recall
MEAN MAINTENANCE
COST = $700

If buy new vehicle and

17% sell 5 year old vehicle:

Cost = $2800 – 15% of $2000

= $2500 (± Bal. Adj.)

0 300 1500 $
AMCL = L5 = $1055
J = 1 YR OLD
5 YR OLD L5= $1055
PROB. = 17%
Cost = $2500
I
Estimate
J = 6 YR OLD
L5= $1055
PROB. = 83%
10 YRS TO GO Cost = $700
EXP. COST = $2500 (0.17) + $700 (0.83) = $1006
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 7 K K 7
6 P 6
KEE R
5 R 5
R
RE

4 4
AGE

PL
AC

3 3
E

2 K K 2
1 1
R R
0 0
10 YR TO GO 9 YR 8 YR … 2 YR 1 YR 0 YR
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.

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

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