Optimization

S. Maiti ∗

Department of Mathematics
The LNM Institute of Information Technology,
Jaipur-302031, India

1 Replacement Model
All equipments deteriorate with age and usage, unless some action is taken to maintain them.
Sometime, it is more economical to replace the equipment altogether rather than to maintain
it. We will study how the optimal decision regarding maintenance and replacement should be
taken. In the beginning, two types of replacement models are considered. In the 1st type, we
take those equipments which deteriorate with time. In 2nd type, we consider those equipments
which do not appreciably deteriorate with time, but fail instantaneously and completely. Finally,
a multi-stage dynamic replacement model will discussed.
The value of a physical asset (except land) deteriorates with passage of time. The reduction
in value of the asset may be due to physical depreciation, functional depreciation or accident.
The physical depreciation (change in demand for service) lowers the ability of the asset to
perform the service. For functional depreciation, the reduction in demand may be due to the
fact that a new asset which makes old asset uneconomical or it may be due to the fact that the
asset can’t meet the demand placed on it. Due to accident, a sudden reduction in the value of
the asset occurs. The insured losses are not treated as depreciation but minor uninsured losses
may be treated a depreciation.
The capital which must be recovered from a depreciable asset is (i) the difference of its first
cost and its salvage value at the time of removal (ii) the interest on the unrecoverable balance
during the life of the asset. For this, future cost of the asset must be predicted. It is customary
to assume that the value of the asset decreases with time (may be yearly). The decrease must
be predicted by previous experience or by using some mathematical function.
∗
Email address: maiti0000000somnath@gmail.com/somnath.maiti@lnmiit.ac.in (S. Maiti)

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1.1 Example 1: How frequently, a running car should be replaced?
A car is running as a taxi. The cost of a new car is Rs. 600000. The available data of cost for
various parameters is given in Table 1. All data is in thousand of rupees. The salvage value
(resale) value is amount for which the car can be sold at the end of that year and the running
(maintenance) cost is the cost of gasoline, repair etc. (i) How frequently the car should be
replaced? (ii) Suppose the car, at present, is one year old and we need a car for next 6 years.
What decision we should take about its replacement?

Table 1: The available data of cost for various parameters

Year 1 2 3 4 5 6 7
Salvage 400 280 200 120 60 60 40
value
Running 80 100 120 140 180 240 320
cost

1.2 Solution of Example 1

(i) We first make Table 2 for the given data in Table 1. Here, depreciation is the difference
between purchase price and salvage value and the total running cost is the sum of running cost
for previous years.

Table 2: The available data of cost (in thousands) for various parameters
Replacement at Total running Depreciation Total cost Average
the end of year cost cost per
year
280
1 80 200 280 1
=280
500
2 180 320 500 2
=250
700
3 300 400 700 3
=233.3
920
4 440 480 920 4
=230
1160
5 620 540 1160 5
=232
1400
6 860 540 1400 6
=233.3
1740
7 1180 560 1740 7
=248.57

We find that the lowest average cost (230 thousands) is achieved by replacing the car at
the end of 4th year.

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 (ii) We make the Table 3 where costs are calculated starting from age 2 as the car is already
1 year old.

Table 3: The available data of cost (in thousands) for various parameters of a 1 year old car
Replacement at Total run- Depreciation Total cost
the end of year ning cost
2 100 120 220
3 220 200 420
4 360 280 640
5 540 340 880
6 780 340 1120

The cost of running the present car for its balance life and the cost of new car for balance
of 6 years (because we need a car for next 6 years) must both be accounted. Suppose that we
replace the present car at the end of 3rd year (i.e. after two years from the present time), then
from the Table 3, present car will cost Rs. 420 thousands (for two years). For remaining 4 years,
we shall have to buy a new car (as we need a for next 6 years) for which we can calculate the
cost from the table 2 as Rs. 920 thousands. Thus for the next 6 years, the total cost would be
420+920=1340 thousands.
Note: Replacement at the end of the 3rd year means, we are using for next two years the
1 year old car and then next 4 years we need a new car.
This total cost is calculated and shown in Table 4 for each possible year of replacement of
the present car namely 2nd, 3rd, 4th, 5th and 6th years.

Table 4: The data of total cost (in thousands) for 6 years for replacement of 1 year old car
Present car is re- Cost of Cost of new Total cost
placed at the end present car car
of year
2 220 1160 1380
3 420 920 1340
4 640 700 1340
5 880 500 1380
6 1120 280 1400

From the last column of Table 4, we find that the optimal decision is to replace the present

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car at the end of 3rd year and buy a new car for the last 4 years. Alternatively, we can replace
the present car at the end of 4th year and buy a new car for the last three years.

1.3 System deteriorating gradually

The obvious assumption is that maintenance cost of the asset increases with time.

1.3.1 Gradually deteriorating system without present worth of money

We assume that the value of money remains the same with time i.e. one is indifferent to the
time at which the money is spent.
Example 2: A scooter rickshaw was purchased at a cost Rs. 34000/-. The scrap values at
the end of the different years and the maintenance cost for different years are given in Table 5.
What will be the replacement plan of the scooter rickshaw?

Table 5: The scrap values, maintenance cost of a scooter rickshaw

Year 1 2 3 4 5
Scrap value 30000 28000 26100 24000 21000
Running 1000 1500 1900 2800 4200
cost

Solution of example 2: We make the Table 6 with the help of given data of Table 5.

Table 6: Various cost of the running scooter rickshaw in example 2

Replacement at Total running Depreciation Total cost Average
the end of year cost cost per
year
5000
1 1000 4000 5000 1
=5000
8500
2 2500 6000 8500 2
=4250
12300
3 4400 7900 12300 3
=4100
17200
4 7200 10000 17200 4
=4300
1160
5 11400 13000 24400 5
=4880

We find that it is worthwhile to replace the scooter rickshaw every 3 years as the average
annual cost of replacing it at the end of 3 years is minimum.

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1.3.2 Gradually deteriorating system with present worth of money

Let the money carries a rate of interest r per year per rupee. Then a rupee spent now will be
worth (1 + r) after a year. For next year, the interest on (1 + r) at rate r will be r(1 + r). So
rupee will be worth (1 + r) + r(1 + r) = (1 + r)2 just after two year and (1 + r)n in just after n
years. This means one rupee just after n years is equivalent to (1 + r)−n today. i.e. the present
worth of one rupee is possible from rupee (1 + r)−n just after n years.
Let C: capital cost of asset in the beginning
Sn : salvage value of the asset at the end of nth year (n =1, 2, 3, · · · )
Rn : Running or maintenance cost of the asset assumed to be payable at the start of the nth
year (n =0, 1, 2, · · · )
1
γ= 1+r
. The situation of present model cab be depicted in Fig.
Consider the k-th period. The present value of Rk is Rk γ k . If we replace the asset at the
end of year k, the present vale of all (total) cost is

X
k
T C = C − γ k Sk + γ i Ri , (1)
i=0

the present worth of salvage cost Sk at the end of the k-th year is γ k Sk .
Observe that there will be no γS1 , γ 2 S2 etc. as the question of salvage value comes only
when the asset is replaced. To find the optimal k, it is not correct to find the average total cost
by dividing the above expression for T C by k and then finding k for which this average cost is
minimum. This is because average amount each year is not equivalent to same present value.
Thus approach must be modified. We assume that the total cost T C given by equation (1)
is equivalent of payment of equal installments of x at the beginning of each year for k years i.e.
k
T C = x + γx + γ 2 x + · · · + γ k−1 x = x 1−γ
1−γ
1−γ
. Or, x = T C 1−γ k . We seek that k which minimizes x.

x
Minimizing x is same as minimizing 1−γ
as 1 − γ does not involve k. Thus the optimal strategy
is to find k such that the following expression is minimized
P P
C − γ k Sk + ki=0 γ i Ri C + R0 − γ k Sk + ki=1 γ i Ri
f (k) = =
1 − γk 1 − γk
, k=1, 2, 3, · · ·
Example 3: Solve the Example 1 with an interest rate 10% per year.
1 1
Solution of example 3: Here C=600, R0 =80, γ = 1+r
= 1+0.1
= 0.9091
The minimum value of f (k) occurs for k = 5. Hence the optimal replacement period is
5 years. Comparing this with example 1, we find that the optimal period of replacement has
changed from 4 to 5 years. With interest rate 10%, the annual cost T C is (1 − γ)f (k) =

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 Table 7: The total cost of deteriorating system with present worth money in example 3
X k
Year Rk γ k k
γ Rk γ i Ri Sk γ k Sk Numerator f (k)
i=0
k of f (k)
1 100 0.9091 90.91 90.91 400 363.64 407.27 4480.418
2 120 0.8265 99.168 190.078 280 231.392 638.686 3679.0668
3 140 0.7513 105.182 295.26 200 150.26 825 3317.2496
4 180 0.683 122.94 418.2 120 81.96 1016.24 3205.7044
5 240 0.621 149.016 567.216 60 37.254 1209.962 3171.6696
6 320 0.5645 180.64 747.856 60 33.87 1393.986 3200.8864

0.0909 × 3171.6696 = 290.12. The average annual cost from example 1, when no interest was
charged is 230. The car must earn annual revenue of 230 if interest is not charged and a revenue
of 290.12 if the money is used to purchase the car and to run, it could be made to earn an
interest of 10% annually