Construction equipment

Equipment Life and Replacement Alternatives

Physical Life: This is the duration from the acquisition of the machine to the end of its operational capability. During this
phase, the machine goes through wear and tear, and the goal is to maximize its productive physical life.

Profit Life: Within the overall physical life, there is a specific period when the machine transitions from incurring costs to
becoming profitable. Initially, the machine takes some time to generate enough income to cover its capital cost.
Subsequently, it enters a phase where it earns more than it costs to own, operate, and maintain.

Economic Life: As the machine ages, it eventually reaches a point where the costs associated with keeping it operational,
including repairs and maintenance, start outweighing the income it generates during operational periods. This marks the
end of its economic life. An equipment fleet manager needs tools to identify this crucial point, helping them decide when
it is no longer financially prudent to retain the machine. At this juncture, the machine can be replaced, either by
purchasing a new one or leasing an equivalent piece.

Determining the appropriate timing to replace a piece of equipment requires that its owner include not only ownership
costs and operating costs, but also other costs that are associated with owning and operating the given piece of
equipment. These include depreciation, inflation, investment, maintenance, repair, downtime, and obsolescence costs.

Inflation: Like all everything, equipment replacement costs are affected by economic and industry inflation. Economic
inflation is defined as the loss in buying power of the national currency, and industry inflation is the change in
construction costs due to long and short-term fluctuations in commodity pricing.

For example, The Consumer Price Index (CPI) is a commonly used measure that shows how the prices of things
we buy change over time. It helps us understand if our money can buy the same things or less. So when the cost
 of steel went up a lot in the construction industry from 2004-2005, that's called industry inflation because it's
specific to that business.

When we decide whether to replace equipment, we usually think about inflation. But, if we're using a method
that compares different options, we can kind of ignore the effects of inflation. This is because we can assume it's
making all the choices more expensive in a similar way. So, we can focus on the differences between the options
without worrying too much about how inflation is affecting each one.

Downtime: Downtime is the time that equipment does not work due to repairs or mechanical adjustments (Douglas
1978). Downtime tends to increase as equipment usage increases. Availability, the portion of the time when
equipment is in actual production or is available for production, is the opposite of downtime.

Let's say a piece of equipment is down for repairs 10 percent of the time. That means it's available and working
properly 90 percent of the time. When the equipment is down, it costs money because you still have to pay for
owning it, operating it, paying the operator, and you lose productivity since the equipment isn't available to
work.

Productivity is how well the equipment can do its job at its usual speed. When productivity drops, it means the
equipment isn't working as efficiently as it should. This can make production more expensive because you might
need to use the equipment for longer periods or get more equipment to keep up the same level of production.

Obsolescence: Obsolescence is the reduction in value and marketability due to competition from newer or more
productive models. Obsolescence can be subdivided into two types: technological and market preference.
Technological obsolescence can be measured in terms of productivity. Over the short term, technological obsolescence
has typically occurred at a fairly constant rate. Market preference obsolescence occurs as a function of customers’
taste. This is much less predictable, although just as real, in terms of lost value.

THEORETICAL METHODS

Example: An aggregate producing company presently owns a fleet of 7.5 cubic yard on-highway dump trucks that cost
$65,000 each. These trucks are currently 1-year-old and the annual maintenance and operating cost is $30,000 per truck
for the first year and increases by$2000 each year. The revenue of each truck is $70,000 for the first year and decreases
by about$1750 per year thereafter. The owner of the company visits a national equipment show and after talking to one
of the salespersons at the show comes back and asks his equipment fleet manager to take a look at replacing the current
dump trucks with a new model that employs a new technology, which will reduce maintenance expenditure. The new
proposed replacement trucks are of the same size and cost $70,000 each. The annual maintenance and operating cost is
$30,000 per truck for the first year but only increases by $1500 per year thereafter. The revenue of each truck is the
same as for current model truck. This company uses the double-declining balance method for calculating depreciation.
The trucks currently in use will becalled as the ‘‘current trucks’’ and the new model trucks will be called as the ‘‘proposed
truck’’ in the tabular examples that follow.
Intuitive method

 Intuitive method is perhaps the most prevalent one for making replacement decisions due to its simplicity and
reliance on individual judgment. This method mainly depends on professional judgment or an apparent
feeling of correctness to make replacement decisions. Equipment is often replaced when it requires a major
overhaul or at times at the beginning of a new equipment-intensive job. In addition to these situations,
availability of capital is often a decisive factor because no reserve has been built up in anticipation of
replacement. However, none of these judgmental decisions has a sound economic basis to be used as a
criterion for an orderly, planned replacement program.
 While the problem could be solved using intuition, there's no clear logical answer for determining the economic
life of the two truck types. On the surface, keeping the current trucks, which are only a year old and generate
revenue at the same rate as the new trucks, might seem like the better choice. Since the expected savings from
reduced maintenance costs for the new trucks don't appear significant, the owner is likely to opt for the current
trucks, which are $5000 cheaper. This case illustrates that the decision is influenced by "professional judgment"
but fails to consider the potentially overlooked long-term maintenance and operating costs. It overlooks the
potential long-term benefits of reduced maintenance costs for the new trucks. In essence, it highlights a flaw in
decision-making where short-term savings are prioritized over considering the comprehensive, long-term
implications of the decision.

Minimum Cost Method

 Minimizing equipment costs is always an important goal for equipment owners. However, it is a paramount to
public agencies that own large and small fleets of construction equipment, as they have no mechanism to
generate revenue to offset their costs. To achieve this goal, the minimum cost method focuses on minimizing
equipment costs based on not only cost to operate and maintain (O&M costs) a piece of equipment but also
the decline in its book value due to depreciation. This is quite straightforward and furnishes a rational method
with which to conduct the objective comparison of alternatives rather than the intuitive method’s professional
judgment. In Douglas’ minimum cost method, the decision to replace equipment is made when the estimated
annual cost of the current machine for the next year exceeds the minimum average annual cumulative cost of
the replacement.
 The economic life of a machine is determined by finding the year when the average annual cumulative cost is at
its lowest, ensuring the least cost over an extended period.
 For the current truck in Table 3.8, this minimum occurs at the end of the eighth year, while for the proposed
truck in Table 3.9, it's at the end of the ninth year. This results in minimum average annual costs of $44,989 for
the current trucks and $43,699 for the proposed trucks.
 Table 3.10 provides a direct comparison of cumulative average annual costs for both types of trucks side by side.
It enables the analyst to not only compare the projected annual cost for the current equipment but also make an
 annual comparison of the average annual costs for each alternative.

Maximum Profit Method

 This method is based on maximizing equipment profit. The method should be used by organizations that are
able to generate revenue and hence profits from their equipment. It works very well if the profits associated
with a given piece of equipment can be isolated and clearly defined. However, it is not often easy to separate
annual equipment profit from entire project or equipment fleet profit. When it proves impossible, the
minimize cost method should be used to make the replacement decision.
 For the maximum profit method, the economic life of equipment is the year in which the average annual
cumulative profit is maximized. This results in higher profits over a long period of time. The next issue in this
method is to identify the proper timing of the replacement. This occurs when the next year’s estimated annual
 profits of the current equipment fall below the average annual cumulative profit of the proposed
replacement.
 Tables 3.11 and 3.12 highlight the importance of using the maximum profit method to calculate the economic
lives of the alternatives in the example. The economic life of equipment is the year when the average annual
cumulative profit is at its highest, ensuring greater profits over an extended period. In Table 3.11, for the current
trucks, this occurs at the end of the fifth year, with a maximum average annual cumulative profit of $20,511. For
the proposed trucks in Table 3.12, the peak profit of $24,486 is in the fourth year. As the proposed trucks'
maximum average annual cumulative profit is higher ($24,486) than that of the current trucks ($20,511), it
suggests that the proposed trucks should replace the current trucks.
 The next step in this approach is to figure out when it's best to replace the equipment. This happens when the
expected yearly profits of the current equipment for the upcoming year drop below the average yearly
cumulative profit of the suggested replacement. In this case, the current trucks never achieve estimated yearly
profits surpassing $24,486, which is the average yearly profit of the proposed model. Consequently, this suggests
that replacing them right away would be the optimal decision.

Payback Period Method

Payback period method, which is based in engineering economics and can be generally applied.

 The payback period is the time required for a piece of equipment to return its original investment by generating
profit. The capital recovery is calculated using the total of net savings on an after-tax basis and the depreciation
tax benefit disregarding financing costs. This method furnishes a metric that is based in time rather than money
 and allows the comparison of alternatives based on how long it takes for each possible piece of equipment to
recover its investment. The payback period method is useful when it is hard to forecast equipment cash flow due
to market instability, inherent uncertainty, and technological changes. This method springs from classical
engineering economic theory and thus does not seek to identify the economic life of the equipment or economic
effects beyond the payback period. Therefore, it is recommended that this method be used in conjunction with
other analysis methods to furnish another slant on the view optimizing the equipment replacement decision.

For the current trucks in Example 3.1, the payback method is calculated as follows:

 Initial cost of the current truck = $65,000

 Cumulative profits for the first 3 years = $57,790
 Difference = $65,000 - $57,790 = $7210
 Profit of the fourth year = $23,134
 Proportional fraction of the third year = $7210/$23,134 = 0.31
 Payback period for the current trucks = 3.31 years

For the proposed trucks, the payback method is calculated as follows:

 Initial cost of the proposed truck = $70,000

 Cumulative profits for the first 2 years = $46,870Difference = $70,000 - $46,870 = $23,130
 Profit of the third year = $25,952
 Proportional fraction of the third year = $23,130/$25,952 = 0.89
 Payback period for the proposed trucks = 2.89 years

As seen in the calculation above, the payback period for the proposed replacement trucks is 2.89 years, which is shorter
than the 3.31-year payback period for the current trucks. This indicates to the analyst that the new equipment will
recoup its investment for the owner 5 months earlier than the existing fleet. Consequently, replacing the current trucks is
once again recommended. When this information is considered along with the earlier analyses involving cost and profit,
it strongly supports the case for replacing the current fleet with the new model featuring the latest technology. These
three methods together form a powerful set of analytical tools for making this crucial decision.