Replacement studies222.txt

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Replacement study

(industrial engineering) An economic analysis involving the comparison of an existing facility and a proposed replacement facility.

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=====================================================================================http://ptucse.loremate.com/peemt/node/33Q. 1. Describe Replacement Analysis.

Ans. Replacement analysis is one of the most important and most common types ofIternative comparisons encountered in practice. In replacement analysis, one ofthe feasible alternatives involves maintaining the status quo; the analysis, one of the feasible alternatives involves maintaining status quo; the remaining alternatives provide replacement options that are available. In some organizations, replacement analysis are performed routinely in an effort to ensure that the best equipment and facilities are in use, compared to their possible successors.

The reasons for considering replacement are numerous. Firstly, the current asset

(defender) may have number of deficiencies including high set-up cost; excessive maintenance, declining production efficiency energy consumption, and physicalimpairment. For example, when you are confronted with a car that is expensive to operate and maintain, or one soon to need a major overhaul, you being to consider replacing the car.

Secondly, potential replacement assets (challengers) may take advantage of new technology and be easily set up, maintained at low cost, high in output, energy efficient and possessing increased capabilities, perhaps at a vastly reduced cost. For example, some new generation computer-controlled manufacturing equipment has rendered many old machines economically obsolete. Also, we can relate to thephenomenal accomplishments with which calculators and personal computers have resulted in increased capabilities, vastly lower prices, and economic obsolescence

for equipment only a few years old.

Finally, the environment affects replacement decisions. Consumer demand preferences change, and present equipment may be unable to adapt to the new designs dictated by consumers. Demand levels may also cause equipment capacity to be relatively high or low, resulting in inefficiency or inability to perform. Rental firms specializing in equipment, automobiles, furniture, and so forth, may affect ownership decisions by offering lease options. Also, outside contractors may be able to perform some tasks cheaper and better than in house facilities. All of theabove considerations and more may affect the decision to keep or replace an asset.

Two approaches are commonly used in replacement analysis. One is the cash flow a

pproach in which actual cash flows associated with keeping, purchasing, or leasing an - asset are used directly. The other is the outsider viewpoint approach in which the cash flow profiles by an objective outsider are used. Which approachis used in a replacement analysis is strictly a matter of preference. Both are-mathematically equivalent and yield consistent decisions.

Q. 2. What is the need of replacement studies?


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Ans. (i) Physical Impairment : The existing equipment is completely or partially worn out and will no longer function satisfactorily without expensive repairs.

(ii) Inadequacy : The equipment does not have sufficient capacity to meet the present demands.

(iii) Obsolescence : Lessening in the demand for the services rendered by the

equipment or by the availability of more efficient tool or un-economic maintenance are the few reasons.

(iv) Rental Possibilities : It is possible to rent identical or comparable equipment thus freeing capital for them and more profitable use.

(v) Rapid Technological Changes : Recognition and handling of replacement problems have paid off quite well in many companies. Some of the advantages are:

(a) Maintenance costs would be reduced.

(b) Production costs would be reduced and would keep the company competitive.

(c) Losses, scraps, rework would be reduced.

(d) Modernization would be introduced which will help to take-off productivity and returns,

(e) Delays off down-time costs would be reduced.

(f) Enthusiam and morale of workers would be increased resulting into increasedhuman efficiency, better human relations.

It is clear from these points that replacement should be based on economy, since it is an economic venture which must yield considerable profits. Replacement also add modernization which is essential for growth. Some other reasons which have already been discussed above may include inadequacy, excessive maintenance, de

cline of efficiency, obsolescence etc.There are three basic ingredients to the successful handling of replacement problems.

(i)There must be clearly stated policies to guide the persons handling the replacement problems.

(ii)The replacement problems must be recongnised in the organisation structure by specific assignment of responsibility.

(iii)A systematic procedure must be established and used in solving specific problems.

Q. 3. What is MAPI formula?

Ans. MAPI formula for replacement were developed by the Machinery and Allied Products Institute of Washington D.C. to enlightended thinking on the subject of equipment replacement. These formulae were developed in Dynamic Equipment Policy b


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y eorge Terborgh, Director of Research of MAPI.

MAPI formulae are used to determine whether equipment should be replaced based on capital costs, interest, operating costs, and costs associated with physical impairment and onsolescence.

Terborgh introduced some new terms such as:

Defender present asset whose replacement is under consideration.

Challenger asset under consideration as a replacement for another asset, usually the present defender.

Q. 4. Write a short note on replacement policies.

Ans. There are general guidelines carry out actual replacement studies, Such policies should cover the followmg points :

(i) The general outlook on operational effectiveness of the existing assets These will of course vary but depend on the effectiveness and competitiveness of ou

r production machinery and the policy must give enough opportunity to keep close to machinery developments, so that the replacements may be profitable.

(ii) The policy may include the aspect of finance condition and the interest rates.

(iii) The policy should also cover the aspect of regular checks on the possibility of replacing each asset.

(iv) The policy should also identify the types of persons who can carry out such studies in the organisation. Good replacement tsudies from team work. The persons may be drawn from maintenance deptt industrial engg. deptt., production deptt. accounting deptt. etc.

There would not be any basic change between the studies carried out in small scale industry or medium industry.

Q. 5. Write a short note on economic life of an asset.

Ans. The economic life is the number of years of use that minimizes an asset s equivalent annual cost. Theoretically, at the end of an asset s economic life, it isreplaced with another asset having the same cost data as the initial asset. This

replacement is repeated over and over again. In this way, the costs over period of time are minimized. Also, in comparing assets on the basis of costs, the used in the comparison should be based on each asset s respective economic life.

The economic life occurs, with yearly increasing operation and maintenance costs, because the total equivalent annual cost consists of an increasing and a decreasing cost component. That is, the equivalent annual amounts of the yearly operations and maintenance costs increase as the years of use increase. At the same,the equivalent annual cost of the capital recovery and return decreases as the number of years of use increases. The economic life can determined using either a


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conventional or revenue requirement approach.

Q. 6. What is the use of accounting data in economic ? Explain.

Ans. Since accounting data are the basis for many engineering economy studies, caution should be exercised in their use. An understanding of the relevance of accounting data is essential for us proper utilization. Two examples of the pertinence of cost accounting data are presented in the action.

Cost data must be applicable. It is common to that a reduction in labour costs will result in a proportionate decrease in overhead costs, particularly if overhead is allocated on a labour cost basis. In one instance a company was manufacturing an oil field specialty.

An analysis revealed per item costs as follows:

Direct labour $ 4.18

Direct material . 1.84

Factory overhead $4.18* 2.30 .9.62Factor cost per item $15.63

The factory cost of $15.36 was slightly less than the price of the item in question. The first suggestion was to cease making the article. But after further analysis it became clear that the overhead of $9 61 would not be incurred if the item was discontinued. The overhead rate used was based on heavy equipment required for most of the work in the department and on early earnings of workmen who averaged $585 per hour. For the job in position only a light drill press and handtools were used Little work reduction in cost would have resulted from not using them in the manufacture the articles.

Q 7 What is pattern of maintenance costs in Replacement analysis ?

Ans. The maintenance cost means scattered maintenance cost i.e. it may vary in any Way. Therefore, it is very difficult to have any definite relationship between maintenance cost and capital cost.

Sometimes, the maintenance costs are approximately constant in succeeding year,so constant maintenance cost will never justify replacement. However, if no interest or salvage value is involved, then an equation for average cost of a year o

f service can be written as:

where: CA = average annual cost of capital recovery and maintenance

P = initial cost of asset

mc = constant yearly maintenance cost


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n = number of years of life

Obviously, CA will never reach to minimum unless interest and salvage values are involved.

Constantly increasing maintenance cost means there is a rising trend in maintenance cost so there will be a minimum average total cost at some point in the life of the asset it interest is assumed to be zero the average annual cost for an asset with increasing maintenance cost may be expressed as :

C = average annual cost

P = initial cost of asset

Q = annual constant portion of operating cost of asset (maintenance cost is a part of operating cost)

m = amount by which maintenance costs increase each year

n = life of the asset in year

To get minimum annual cost, differentiate C with respect to n and equate it to z

ero,

Q. 8. Describe various theories of profit.

Ans: Various theories of profit have been put forth by different economists to explain the profits. The important among these are :

(1) Risks and Uncertainty theory(2) Dynamic Approach to the Profit Theory

(3) Residual Or Rent theory of Profits.

1. Risk and Uncertainty Theory. This theory was introduced by Howley and according to him net profit is the residual income of the owner after making payments for all factors or production and is the reward for the risk taken by him. It concludes that profits are due to the risk taken by the owner. The owner has to bear the risk of losing capital, there are certain risks which can not be issued. They are known as uninsurable risks. We cannot predict when fashion will change or when new invention will come or when will war outbreak etc. There are unforese

eable changes and hence in value risks

which cannot be insured payments made for these uninsurable risks are called profits .

2. Dynamic Theory of Profits. Mr. J.B. Clark introduced this theory. According to Clark, the pure profit in a dynamic society is the residual income of the owner after making all payments including rent, wages interest and salary of management. Such pure profit in the form of residual earning result only in a dynamic society where the changes in population, changes in the stock of capital, changes


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in tastes of fashions, changes in production techniques and changes in management principles, occur dynamically. In a static society since there are no such changes, no pure profit may result. Thus pure profit is a sign of progress. Thus to increase profit an owner may produce a new commodity, popularise it and earn large profit and soon competition sets in the profit decline. Thus in maintaining pure profits high continuous progress is essential.

3. Rent Theory of Profit. This theory was introduced by Walker, who considered profit as a form of rent. He says that owner earns profit in the same way as land earns rent.

Marshall has criticized theory for the following reasons :

(a) Whereas rent on land is in the form of surplus earnings, profit is not.

(b) Land may produce zero or positive, zero or negative rent whereas net profitmay be positive, zero or negative.

Q. 9. Write a short note on Annuity.

Ans. Annuity : An annuity is a series of equal payments occurring at equal periods of time. It may also be said as Equal payment or uniform payment series. In certain business dealings, equal payments are made at the end of equal periods of time and all such accumulated payments are allowed to earn compound interest. Periods of time may be of any length say a year and a month etc. But periods should be of equal length. Interest is expressed in yearly terms but the actual interest is paid at the end of each equal period. Hire purchase payments, instalment buying, L.I.C. premium payments etc. are done by this method.

Features. These have the following common features:

(i) These involve series of payments.

(ii) All payments are of equal amount.(iii) Payments occur at equal time intervals.

(iv) All payments are made at the end of periods.

(v) Compound interest is earned on all accumulated payments.

Q. 10. What are the advantages of cash flow analysis?

Ans. Advantages of cash flow analysis.

1. It is useful in evaluating current cash position and financial policies, from this, the management will know how much cash is needed, how much can be generated internally and how much it should arrange from outside. Thus, it is especially useful in preparing cash budgets.

2. The comparison of original forecast with actual result may highlight trends of movement that might otherwise go undetected.


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3. As it gives the amount of cash inflows of operation the management may consider the possibility of retiring long-term loans, replacement of plant facilitiesetc.

4. It enables to answer the queri6s relating to a situation when the business has made a profit and yet runs out of money or when it has suffered a loss and still has plenty of money at bank.

Though the cash flow statement cannot replace the usual financial statements, it serves as a very useful supplementary statement. It provides a barometer for measuring any change in the speed with which cash is flowing through the different parts of the business and its impact on the profitability of the business.

Q. 11. Describe Economic evaluation criterion of the project.

Ans. No project can be taken granted economical viable project, unless it is not evaluated under the constraints. Sometimes a project becomes nonviable since it could not take-off on due-date. Change in starting date may change all the previous cost estimates and implementation schedule of the project Therefore, for de

claring a project economically viable, the following three sets of information must be examined:

(i) Computed estimates of the net capital outlay required for the proposed project and the future estimate of cash-flows as anticipated.

(ii) Availabilty of accurate cost estimates to the proposed project from the proper sources.

(iii) A correct planning and time-schedule for the execution of the proposed project so that long-term economic benefits to the promoters are maximised.

On the basis of above set of information, a methodology has got to be developed

for evaluating the profitability of the new investment. For this, a suitable criterion is to be found out on the basis of two basic principles :

(i) If other things being equal, bigger benefits are always preferable than smaller ones.

(ii) If other things being equal, early benefits are better than later benefits.

Methods to Assess Economic Viability of Proposed Project :

(i) Non-discounted cash flow method - pay back period.

(ii) Discounted cash flow methods:

(a) Net present value (NPV).

(b) Benefits-cost ratio (BCR).

(c) Interval rate of Return (IRR).

Details of these methods can be taken from any book on Economics or Financial-management.


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Satisfies and computer techniques which permit the quantitative handling of economic problems, the role of engineers in decision making has increased very much. We therefore, conclude that Engineering Economics deals with cost and other data pertaining to the functions carried out by engineers in engineering process. The study of engineering process takes birth when a want is felt and includes thefollowing steps:

1. An analysis of the want. .

2. Providing suitable solution ant its valuation.

3. Launching of the project and making of arrangement for finance.

4 Organization of project

5 Designing of the project and construction of the plant

6 Supervision and operation of production

7. Distribution of the product.

From this point of view, management may be considered as the art and science ofdirecting and coordinating efficiently all the above functions.

Q. 12. Describe the significance of Economics to Engineer.

Ans. Engineering and Technology are closely connected with economic science. Ineconomics, we study the way in which we make optimum use of scarce resources. An engineer s and an architect s problem is also very much the same. An engineer (or an architect) tries to construct or manufacture goods of a maximum utility with a given cost or a desired product at minimum cost. At various places in the engineering process the engineer is called upon to take decisions. These decisions have to be made on the basis of economic feasibility. At each point he is faced wi

th the question of cost. The law of equi-marginal utility can help an engineer to substitute one factor of production for another in such a way that he incuresminimum cost in production.

Besides, a problem is mostly such that it may be solved in more than one way with different results. One result may be superior to another in quality and technical excellence or may be more economical to obtain. The engineer has to choose the best way.

Thus, engineering problems2 are nothing but choice involving problems; and choice- making is entirely an economic problem. -

Sometimes engineers and architects have to work as a factory manager or as an ex

ecutive engineer, in which capacity they have a deep interest in the problem oflabour and personnel management. They, must then be fully aware about the labour laws. A knowledge of accounting and costing : auditing, depreciation; management, and the market condition is also very useful. Needless to say, one must alsohave an insight into

(i) social and psychological problem, pertaining to the production and (ii) thefactory management of the personnel. Management Science is assuming more and importance for engineers and architects.


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At present our country faces an acute food problem which is threatening a majorcastastroph in the future. As a matter of fact, the condition of agriculture isunsatisfactory. The problem is serious mainly due to fact that science and technology have not come to the rescue of agriculture. Agriculture is completely at the mercy of Nature. The fate of agriculture and hence, of the country can be changed if irrigation engineers give us a network of small and medium irrigation works all over the country. It has been observed that after the completion of many big irrigation and power projects, the farmer is not getting water and power either because it is too costly or because there are no distributaries. All theseare problems which only the engineers can solve. Mechanical

Engineers can also be useful in devising cheap and simple mechanical devices orappliances which our farmers can handle easily. In USA each farmer has a small workshop to repair his tools and implements : he also has adequate knowledge. Such a provision will be useful to our country. Electrical and Chemical Engineers can help agriculture by providing adequate and cheap electrically and fertilizer.

Thus agricultural engineering can help in increasing productivity by inventing better methods of production, better tools and equipments, insecticides and pesticides.

Engineers can play an important role in searching substitutes for making the country self-sufficient in the matter of power, steel and fertilizers. This will save much foreign exchange which we pay to foreign countries.

Q 13 What do you understand by economic life of a project ? Also discuss challenger and defender.

Ans. Economic life can be less than absolute physical life for reasons of technological obsolesence, physical deterioration, or product life cycle.

Terbordg dramatically described the replacement problem as a battle between thecurrent machine, which he called the defender , and a new and better machine which

he called the challenger . In his analysis economic lives of both the challenger and defender are estimated and then the time adjusted costs of the challenger arecompared to the time adjusted costs of defender. If the time adjusted costs of the challenger is lower than the time adjusted cost of the defender, replacementis indicated.

The problem however, is that the economic life of the challenger is difficult to estimate. The optimal length of time a investment is maintained, its economic life, depends upon not only the newest products available today, but those available tomorrow and so on into the future. If the economic life of an investment is unknown, how then can its cost be calculated ?

While this issue of economic life was raised with production machinery in mind i

t is very relevant, at least as a starting point, for information systems investment.

In an environment with no technological progress, one in which the hardware, and software available next year are no better than those of this year, economic life ii simply that life when the sum of the discounted capital and operating costs are at a minimum, the average capital costs of an is investment falls the longer the system is in operation. The only incentive to replace is that some operating costs, such its program maintenance or software support may increase over time and that these costs may be reduced through replacement.


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To make the economic life problem more manageable. Terborg made the assumption that, present challenger will accumulate operating inferiority at a constant rateover it s life. This suggests that the pace of information technology is constant,which we know is not true.

From this assumption, it is possible to determine the economic life of an investment. The Uniform Annual Equivalent, UAE, is the uniform amount whose value is equal to the time adjusted costs, both investment outlays and obsolescence, incurred every year over the life of an investment,

Q. 14. Useful Applications of Life-Cycle Cost Analysis.

Ans. Life-Cycle Cost Analysis (LCCA) has applications for many areas of interest to

State and local transportation agencies. Common applications of LCCA include the following :

Designing, selecting and documenting the most affordable means of accomplishing

a specified project or objective For instance, if a bridge must be replaced, LCCA can be used to select the replacement option that would cost the least over the expected life of the bridge.

Evaluating payment preservation strategies-the costs of each strategy can be evaluated relative to the expected effects it will have on delaying the costs of expensive rehabilitations or reconstructions.

Among other requirements, the VE- team must consider the lowest life-cycle costmeans of accomplishing a project.

Project planning and implementation, especially the use and timing of work zones. LCCA allows the analyst to balance higher agency and/or contractor costs assoc

iated with off-peak work hours against reduced traveler delay costs associated with fewer work zones during peak periods.

Q. 15. Discounted Cash Flow Method.

Ans: A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital)to arrive at a present value, which is used to evaluate the potential for invest

ment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Calculated as :

There are many variations when it comes to what you can use for your cash flowsand discount rate in a DCF analysis. Despite the complexity of the calculationsinvolved, the purpose of DCF analysis is just to estimate the money you d receive


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from an investment and to adjust for the time value of money. DCF models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom garbage in, garbage out . Small changes in inputs can result in large changes in the value of a company. Instead of frying toproject the cash flows to infinity, a terminal value approach is often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on.

Q. 16. Demerits of Limitations of Discounted Cash Flow Method.

Ans. (1) It involves a good amount of calculations hence it is difficult and complicated.

But the supporters of this method rebute the argument and assert that difficulty of the

method is unfamiliarity rather than its complexity.

(2) It does not correspond to accounting concept for recording costs and revenue

s with the consequence that special analysis is necessary for the study of capital investment.

(3) The selection of cash inflows is based on sales forecastes which is in itself an indeterminable element.

(4) The economic life of an investment is very difficult to forecast exactly.

(5) The method considers discount on expected rate of return but the determine action of rate of return is in itself a problem.

Despite the above defects, the method provides an opportunity for making valid comparisons between long-term competitive capital projects.

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