REPLACEMENT THEORY

1. A firm is considering replacement of a machine, whose cost price is Rs. 12200 and the scrap
value, Rs. 200. The running (maintenance and operating) cost in rupees are found from
experience to be as follows:
Year Running cost (Rs.)
1 200
2 500
3 800
4 1200
5 1800
6 2500
7 3200
8 4000
When should the machine be replaced?

Answer: cost of machine C = Rs. 12200; scrap value s = Rs. 200

In order to determine the optimal time n when the machine should be replaced, we calculate an
average total cost per year during the life of the machine as shown in the table below.

Year Running Resale Change in resale Effective Total Average

(1) cost (Rs.) value value (Rs.) (4) running cost cost (Rs.) cost (Rs.)
(2) (Rs.) (3) (Rs.) (5) (6) (7) = (6)/(1)
= (4) + (2)
1 200 200 12200-200 = 12000 12200 12200 12200
2 500 200 0 500 12700 6350
3 800 200 0 800 13500 4500
4 1200 200 0 1200 14700 3675
5 1800 200 0 1800 16500 3300
6 2500 200 0 2500 19000 3167
7 3200 200 0 3200 22200 3171
8 4000 200 0 4000 26200 3275

From the above table, it is observed that the average total cost per year is Rs. 3171 for year 6.
Thus the optimum replacement age is year 6, i.e., the machine can be replaced at the end of year
6.

2. The cost of a machine is Rs. 6100 and its scrap value is Rs. 100. The maintenance costs
found from experience are as follows:
Year Maintenance cost (Rs.)
1 100
2 250
3 400
4 600
5 900
 6 1200
7 1600
8 2000
When should the machine be replaced?

Answer: cost of machine C = Rs. 6100; scrap value s = Rs. 100

In order to determine the optimal time n when the machine should be replaced, we calculate an
average total cost per year during the life of the machine as shown in the table below.

Year Mainten Resale Change in resale Effective Total Average

(1) ance cost value value (Rs.) (4) Maintenance cost (Rs.) cost (Rs.)
(Rs.) (2) (Rs.) (3) cost (Rs.) (5) (6) (7) = (6)/(1)
= (4)+(2)
1 100 100 6100-100 = 6000 6100 6100 6100
2 250 100 0 250 6350 3175
3 400 100 0 400 6750 2250
4 600 100 0 600 7350 1838
5 900 100 0 900 8250 1650
6 1200 100 0 1200 9450 1575
7 1600 100 0 1600 11050 1579
8 2000 100 0 2000 13050 1631

From the above table, it is observed that the average total cost per year is Rs. 1575 for year 6.
Thus the optimum replacement age is year 6, i.e., the machine can be replaced at the end of year
6.

3. A firm is considering replacement of a machine whose cost price is Rs. 17500 and the scrap
value is Rs. 500. The maintenance costs (in Rs.) are found from experience to be as follows:
Year Maintenance cost (Rs.)
1 200
2 300
3 3500
4 1200
5 1800
6 2400
7 3300
8 4500
When should the machine be replaced?

Answer: cost of machine C = Rs. 17500; scrap value s = Rs. 500

In order to determine the optimal time n when the machine should be replaced, we calculate an
average total cost per year during the life of the machine as shown in the table below.
Year Mainten Resale Change in resale Effective Total Average
(1) ance cost value value (Rs.) (4) Maintenance cost (Rs.) cost (Rs.)
(Rs.) (2) (Rs.) (3) cost (Rs.) (5) (6) (7) = (6)/(1)
= (4)+(2)
1 200 500 17500-500 = 17000 17200 17200 17200
2 300 500 0 300 17500 8750
3 3500 500 0 3500 21000 7000
4 1200 500 0 1200 22200 5550
5 1800 500 0 1800 24000 4800
6 2400 500 0 2400 26400 4400
7 3300 500 0 3300 29700 4243
8 4500 500 0 4500 34200 4275

From the above table, it is observed that the average total cost per year is Rs. 4243 for year 7.
Thus the optimum replacement age is year 7, i.e., the machine can be replaced at the end of year
7.

4. A firm is using a machine whose purchase price is Rs. 13000. The installation charges
amount to Rs. 3600 and the machine has a scrap value of Rs. 1600, because the firm has a
monopoly of this type of work. The maintenance cost in various years is given in the
following table:
Year Maintenance cost (Rs.)
1 250
2 750
3 1000
4 1500
5 2100
6 2900
7 4000
The firm wants to determine after how many years should the machine be replaced on
economic considerations, assuming that the machine replacement can be done only at the
year ends.

Answer: cost of machine C = Rs. 13000; scrap value s = Rs. 1600; Installation charge: Rs. 3600
Total initial cost = C + Installation charge = Rs. (13000+3600) = Rs. 16600

In order to determine the optimal time n when the machine should be replaced, we calculate an
average total cost per year during the life of the machine as shown in the table below.

Year Mainten Resale Change in resale Effective Total Average

(1) ance cost value value (Rs.) (4) Maintenance cost (Rs.) cost (Rs.)
(Rs.) (2) (Rs.) (3) cost (Rs.) (5) (6) (7) = (6)/(1)
= (4)+(2)
1 250 1600 16600-1600 = 15000 15250 15250 17200
2 750 1600 0 750 16000 8000
 3 1000 1600 0 1000 17000 5667
4 1500 1600 0 1500 18500 4625
5 2100 1600 0 2100 20600 4120
6 2900 1600 0 2900 23500 3917
7 4000 1600 0 4000 27500 3929

From the above table, it is observed that the average total cost per year is Rs. 3917 for year 6.
Thus the optimum replacement age is year 6, i.e., the machine can be replaced at the end of year
6.

5. Following table gives the running costs per year and resale price of a certain equipment
whose purchase price is Rs. 5000.
Year Running cost Resale value (Rs.)
(Rs.)
1 1500 3500
2 1600 2500
3 1800 1700
4 2100 1200
5 2500 800
6 2900 500
7 3400 500
8 4000 500

At what year is the replacement due?

Answer: cost of machine C = Rs. 5000

In order to determine the optimal time n when the machine should be replaced, we calculate an
average total cost per year during the life of the machine as shown in the table below.

Year Running Resale Change in resale Effective Total Average

(1) cost (Rs.) value value (Rs.) (4) Running cost cost (Rs.) cost (Rs.)
(2) (Rs.) (3) (Rs.) (5) (6) (7) = (6)/(1)
= (4)+(2)
1 1500 3500 1500 3000 3000 3000
2 1600 2500 1000 2600 5600 2800
3 1800 1700 800 2600 8200 2733
4 2100 1200 500 2600 10800 2700
5 2500 800 400 2900 13700 2740
6 2900 500 300 3200 16900 2817
7 3400 500 0 3400 20300 2900
8 4000 500 0 4000 24300 3038
From the above table, it is observed that the average total cost per year is Rs. 2700 for year 4.
Thus the optimum replacement age is year 4, i.e., the machine can be replaced at the end of year
4.

6. Machine A costs Rs. 9000. Annual operating costs are Rs. 200 for the 1st year, and then
increase by Rs. 2000 every year. Determine the best age at which to replace the machine. If
the optimum replacement policy is followed, what will be the average yearly cost of owning
and operating the machine?
Machine B costs Rs. 10000. Annual operating costs are Rs. 400 for the 1st year, and then
increase by Rs. 800 per year. You now have a machine of type A which is one-year old,
should you replace it with B; if so, when?

Answer: for machine A, the average total costs are calculated as shown below.

Year Operating Resale Change in resale Effective Total Average

(1) cost (Rs.) value value (Rs.) (4) Operating cost cost (Rs.) cost (Rs.)
(2) (Rs.) (Rs.) (5) (6) (7) = (6)/(1)
(3) = (4)+(2)
1 200 0 9000 – 0 = 9000 9200 9200 9200
2 2200 0 0 2200 11400 5700
3 4200 0 0 4200 15600 5200
4 6200 0 0 6200 21800 5450
5 8200 0 0 8200 30000 6000

The table shows that the best age for the replacement of machine A is year 3. The average yearly
cost of owning and operating for this period is Rs. 5200.

For machine B, the average cost per year can similarly be computed as given in the following
table.
Year Operating Resale Change in resale Effective Total Average
(1) cost (Rs.) value value (Rs.) (4) Operating cost cost (Rs.) cost (Rs.)
(2) (Rs.) (Rs.) (5) (6) (7) = (6)/(1)
(3) = (4)+(2)
1 400 0 10000 10400 10400 10400
2 1200 0 0 1200 11600 5800
3 2000 0 0 2000 13600 4533
4 2800 0 0 2800 16400 4100
5 3600 0 0 3600 20000 4000
6 4400 0 0 4400 24400 4066

Since the minimum average cost of machine B is lower than that for machine A, machine A
should be replaced.

To decide the time of replacement, we should compare the minimum average cost for B (Rs.
4000) with yearly cost of maintaining and using the machine A. since, there is no salvage value
of the machine, and we shall consider only the maintenance cost. We would keep machine A so
long as the yearly maintenance cost is lower than Rs. 4000 and replace when it exceeds Rs. 4000.

On the one-year old machine A, Rs. 2200 would be required to be spent in the next year; while
Rs. 4200 would be needed in the year following. Thus we should keep machine A for one year
and replace it thereafter.