Replacement Problems

Replacement Problems
• Replacement of Items that deteriorate with
time
• Case1: Value of money does not change with
time
• Case 2: Time value of money is considered
 Simple Problem
• A machine costs Rs. 10000/-. Its operating cost and
resale values are given below. Determine at what
time its should be replaced
Year 1 2 3 4 5 6 7 8
Operating Cost 1000 1200 1400 1700 2000 2500 3000 3500
Resale Value 6000 4000 3200 2600 2500 2400 2000 1600
Solution: Cost is Rs. 10000/-

Year OC Cum OC SV Effective TC=C-SV + Average

cost (C-SV) Cum OC TC
1 1000 1000 6000 4000 5000 5000.00
2 1200 2200 4000 6000 8200 4100.00
3 1400 3600 3200 6800 10400 3466.67
4 1700 5300 2600 7400 12700 3175.00
5 2000 7300 2500 7500 14800 2960.00
6 2500 9800 2400 7600 17400 2900.00
7 3000 12800 2000 8000 20800 2971.43
8 3500 16300 1600 8400 24700 3087.50
 Explanation
• (Column 2): Operating cost (OC) is given in the
question
• (Column 3): With time total expenses on operating
cost will go on accumulating so it is cumulative OC
• (Column 4): Salvage Value (SV)/ Resale value Given
• (Column 5): Effective cost = Purchase cost – SV
• (Column 5): Total Cost = Effective cost + Cumulative
OC
• (Column 5): Average = Total cost divided by
respective years
• We will replace the machine at the end of 6th year as
after this average cost will increase
 Replacement Problem
(Time Value of Money)
• In this type of questions we are considering
the time value of money. It means future
value of money is less than the current value.
Or PV is the discounted value of the future
value of money.
• PV = FV / (1 +r)^n
• So in these questions we are discounting
(calculating) the given values year wise with
respect to different years
• In these question rate of interest will be given
which will be used as r in the above formula. And
then we will calculate the Present value (PV).
• Based upon given r PV factor will be calculated as
1 / (1 +r)^n for n=1,2,3 etc
• Important Point:
• Maintenance cost is assumed to be incurred at
the begining of the year hence PV factor for
maintenance/running/operating cost will be 1 for
the first year
• Salvage value/ Resale values are available at the
end of the year, hence salvage value will be
discounted value at the end of first year as given
by 1 / (1 +r)^n for n=1, 2, 3 etc
 Replacement Problem
(Time Value of Money)
A machine costs Rs 6000. The running cost and the salvage
value at the end of the year is given in the table below. If
the interest rate is 10 percent per year, when should the
machine be replaced?

Year 1 2 3 4 5 6 7
Running 1200 1400 1600 1800 2000 2400 3000
Cost
Salvage 4000 2666 2000 1500 1000 600 600
value
Solution: Given Cost is Rs. 6000/-

Cum
Year Rn pwf Rn * pwf Cum Rn SV SV* pwf pwf C-SV+RnC ATC
1 1200 1.00 1200.00 1200.00 4000 3636.364 1.00 3563.64 3563.636
2 1400 0.91 1272.73 2472.73 2666 2203.306 1.91 6269.42 3283.983
3 1600 0.83 1322.31 3795.04 2000 1502.63 2.74 8292.41 3031.365
4 1800 0.75 1352.37 5147.41 1500 1024.52 3.49 10122.89 2903.16
5 2000 0.68 1366.03 6513.43 1000 620.9213 4.17 11892.51 2852.014
6 2400 0.62 1490.21 8003.65 600 338.6844 4.79 13664.96 2852.342
7 3000 0.56 1693.42 9697.07 600 307.8949 5.36 15389.17 2873.655
0.51
 Explanation
• Column 1: Running Cost
• Column 2: Discounting factor or PV factor based
upon interest rates. For maintenance cost PV
factor will start from 1 as in this column. But for
discounting Salvage value we will have to take
0.91 as the PV factor for the first year
• Column 3: Present value of Running cost is
calculated by multiplying Column 1 with column 2
• Column 5: Cumulative cost of running cost
• Column 6: Salvage value as given
• Column 7: PV of salvage value has been
calculated. We will multiply 4000 with 0.91 and
so on because salvage value is taken as the end of
the first year.
• Column 8: Cumulative of PV factor is calculated
and this will be used as the value to calculate
average cost (instead of simple year)
• Column 9: Effective Cost= Purchase cost – salvage
value + Cumulative Running cost
• Column 10: Average cost is calculated by dividing
total cost (column10 to column 9)
• We will replace the machine at the end of 5th year
as after this average cost will increase
 Replacement of Items that Fail
Suddenly
• A large establishment has an installation with
1000 bulbs of a certain type. From the past data,
it has observed that the failure rates of these
bulbs are detailed here
End of week :1 2 3 4 5
Probability of failure:0.1 0.25 0.5 0.7 1.0
It is given that the cost of replacing an individual
bulb is Rs. 3 while if the entire group of bulb is
replaced the cost would be Rs. 1 per bulbs.
It is decided to replace all the bulbs simultaneously
at fixed intervals of time and also to replace the
individual bulbs that fall in between.
Assuming that all the bulbs failing during a week
might fall at any time of the week and that the
group replacements can be made only at the end
of a week., you are required to determine the
optimal interval between the group replacements
Also establish if the policy, as determined,
adopted is superior to the policy of replacing
bulbs as and when they fail, there being
nothing like a ‘group replacement’

Solution
Week : 1 2 3 4 5
Probability: 0.10 0.15 0.25 0.20 0.30