REPLACEMENT MODELS

REPLACEMENT OF EQUIPMENT WHICH DETERIORATES WITH TIME

The simplest replacement model deals with equipment whose efficiency deteriorates with time.
Replacement decisions of such items are based on the economic life cycle cost concept or
average monthly/annual operating costs over an optimum life cycle period. The cost of
maintenance and operation increased with time. The salvage value of the item decreases with
time. These two costs form the major decision criteria for such models.
Example 1
A manufacturing concern in considering replacement of a lathe machine which costs Ksh.125
000. The estimated resale value and the maintenance cost (in 000s of Ksh) of the machine, based
on past experience with similar machines are following:

Year 1 2 3 4 5 6
Maintenance cost 2 5 8 12 18 25
Resale value 100 80 60 40 30 20

When should the machine be replaced?

Solution If the machine is replaced at the end of the first year, we would have incurred
maintenance cost for the first year and would also lose the capital value which is the difference
between the cost of the machine and its resale value (assuming that the value of money remains
constant over time). If replaced in the second year, the maintenances costs incurred till the end
of second year are the sum of the maintenance costs incurred in the first and the second year.
The capital cost is the cost of the machine less its resale value. The costs for each successive
year are tabulated as follows:

Replace Maintenance Cumulative Resale Capital Total Average

at the end cost maintenance value cost cost cost
of year cost 125 (d) (c) +(e (f)/(a)

(a) (b) (c) (d) (e) (f) (g)

1 2 2 100 25 27 27
2 5 7 80 45 52 26
3 8 15 60 65 80 26.67
4 12 27 40 85 112 28
5 18 45 30 95 140 28

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6 25 70 20 105 175 29.16

From the table it can be seen that the average cost is the lowest for Year 2. Hence the machine
should be replaced after two years.
Example 2(a): Machine A costs Ksh.80000. Annual operating costs are Ksh.2000 for the first
year and they increase by 15000 every year. Determine the age at which to replace the machine
assuming that it has no resale value. What will be the average yearly cost of operating and
owning the machine, if the optimal replacement policy is followed?
Solution The cost are tabulated under:

Replace at the Operating Cumulative capital cost Total cost Average cost
end of year cost operating cost of machine (c) + (d) (e)/(a)

(a) (b) (c) (d) (e) (f)

1 2000 2000 80000 82000 82000

2 17000 19000 80000 99000 49500
3 32000 51000 80000 131000 43667
4 47000 98000 80000 178000 44500
5 62000 160000 80000 240000 48000

As can be seen from the table, the minimum average cost occurs when the machine is replaced at
the end of three years. The average annual cost of owning and operating the machine will be
Ksh.43667.
Example 2(b) Another machine B costs Ksh.100,000 and it has no resale value. Annual
operating costs for the first year are Ksh.4000 and they increase by Ksh.7000 every year. The
firm has a machine of type A which is one year old. Should the firm replace it with B and if so,
when?
Solution The costs for machine B are following:

Replace at the Operating Cumulative capital cost Total cost Average cost
end of year cost operating cost of machine (c) + (d) (e)/(a)

(a) (b) (c) (d) (e) (f)

1 4000 4000 100000 104000 104000

2 11000 15000 100000 115000 57500
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3 18000 33000 100000 133000 44333
4 25000 58000 100000 158000 39500
5 32000 90000 100000 190000 38000
6 39000 129000 100000 229000 38167

The average cost of Machine B is Ksh.38000 per annum which is less than the average cost of
Machine A. Machine A should therefore be replaced with Machine B.
Machine A is one year old. In the second year, Ksh.17000 [see Example (a) will be spent on the
operating cost. This being less than the average per annum cost of Machine B, we should retain
Machine A. In the third year the operating cost of Machine A is Ksh.32000 which is still less
than the average cost of owning and operating Machine B. Hence, retain Machine A for the third
year also. In the fourth year the average cost of operating Machine A is Ksh.47000 which is
more than the average annual cost of Machine B. Hence Machine A should be replaced by
Machine B after 3 years.
Example 2(c) When the firm is just ready to replace Machine A with another machine of the
same type, it receives information that Machine B will become available in a year. What should
the firm do?
Solution It is obvious that Machine B is superior to Machine A as its per annual average cost is
lesser. The firm will replace Machine A with another machine of the same type after three years
(see Example a). The firm now has a choice to either replace Machine A with another Machine
A or to retain Machine A for another year and then replace it with Machine B. We have already
seen from the solution to Example (b) that if Machine A is one year old it should be replaced by
Machine B only after 3 years. Let us tabulate the costs for both options for the next three years.
As the option of retaining Machine A for the fourth year and then replacing by Machine B is
cheaper, it should be adopted.
Replace Machine A Retain Machine A for one more year and replace with
with Machine A Machine B thereafter when it becomes available

Year 1 Cost Ksh.82000 Year 1 CostKsh.47000 (4th year for A)

Year 2 Cost Ksh.17000 Year 2 CostKsh.38000 (Average annual cost of B)
Year 3 Cost Ksh.32000 Year 3 CostKsh.38000
Total Ksh131000 Total Ksh.123000

REPLACEMENT OF ITEMS THAT FAIL COMPLETELY

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The second type of replacement problem is concerned with items that either work or fail
completely. It is sometimes more economical to replace the group of say bulbs as a whole even
if some of the bulbs are functioning satisfactorily than to replace each item as it fails
Example Past data has revealed that, out of 100 new light bulbs, on an average:
90 survive for at least I month
75 survive for at least 2 months
50 survive for at least 3 months
20 survive for at least 4 months
0 survive for more than 5 months
The cost of a new bulb is Ksh.10. However, if we buy bulbs in bulk a quantitative discount is
given and the cost of buying 1000 bulbs at a time is Ksh.9000. The Organization has about 1000
bulbs.
The problem can now be stated as: Should each bulb be replaced as it fails or should the whole
group of bulbs be replaced after some interval of time?
Solution Average bulb life: From the data it can be seen that
By the end of month 1, 10 lamps will have failed
By the end of month 2, a further 15 lamps will have failed
By the end of month 3, a further 25 lamps will have failed
By the end of month 4, a further 30 lamps will have failed
By the end month 5, a further 20 lamps will have failed
Now, we can draw up a mortality table (Failure table) as given below

Life in months 1 2 3 4 5
Probability of failure 0.10 0.15 0.25 0.30 0.20

Expected mean life of a lamp = 1 x 0.10 +2 x 0.15 + 3 x 0.25 + 4 x 0.30 + 5 x 0.20

= 3.35 months
Individual replacement. Since the total number of bulbs is 1000, numbers replaced per month
are given as:
1000 3.35 =299 (under steady state conditions)
Average monthly cost of individual replacements = Cost of electrician and cost of bulbs
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Assume the cost of cost of labour is Ksh 6000 per month, then;
Average monthly cost is Ksh.6000 +2990 = 8990
Average cost to replace an individual bulb is Ksh.30

Group replacement. As it is necessary to ensure that all 1000 bulbs are functional at all times,
group replacement will involve replacing individual bulbs as they fail and replacing the entire
group after sometime. We will, therefore, need to calculate the rate at which individual
replacements are necessary.
At the end of first month, 10 per cent or 100 bulbs would have failed and been replaced. At the
beginning of the second month, we would have 900 original bulbs and 100 replacements. By
the end of the second month, out of the 900 originals 150 would have failed and out of the 100
bulbs replaced at the end of the first month 10 would have failed since they are one month old.
Thus, in the second month, we will have to replace 160 bulbs. By the end of the third month,
250 out of the 750 original bulbs will fail, 15 out of the 100 bulbs replaced at the end of the
first month would fail (15 per cent fail because they are two months old) and 16 bulbs out of the
160 replaced by the end of the second month would fail (10% fail because they are one month
old). We would thus have to replace 250 +15 + 16 =281 bulbs. A complete table for six months
is tabulated as:

Month First 1000 Next 100 Next 160 replaced Next 281 Next 377 Next 350 Total failure
replaced in 1st in the 2nd month replaced in replaced in replaced in
month the 3rd month the 4th month the 5th month
1 100 100
2 150 10 160
3 250 15 16 281
4 300 25 24 28 377
5 200 30 40 42 38 350
6 20 48 70 57 35 230

Let us assume that 5 electricians hired for the full day will be required to replace all the 1000
bulbs in one day at a cost of ksh.1000.
Cost of replacing 1000 bulbs = 9000 (cost of bulbs) + 1000 (cost of labour) = 10000
Cost of replacing all bulbs at the end of first month = Cost of bulbs replaced as they fail + Cost
of replacing 1000 bulbs
Let us depict these costs in the following table:
Month at end No. of bulbs Cumulative Cost of cumm Cost of Total cost Average cost
of which all replaced nu. Of bulbs no. of bulbs replacing
bulbs are replaced replaced @ 1000 bulbs
replaced Ksh 30 per
bulb
1 100 100 3000 10000 13000 13000

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2 160 260 7800 10000 17800 8900
3 281 541 16230 10000 26230 8743
4 377 918 27540 10000 37540 9385
5 350 1268 38040 10000 48040 9608

The policy of replacing individual bulbs even when a full time electrician is employed will cost
Ksh.8990 at an average. As can be seen from the table, the lowest average monthly cost is
ksh.8743 and occurs if we replace individual bulbs as they fail and replace all bulbs at the end of
the 3rd month irrespective of whether they are working or not. Since this is a cheaper option, we
should adopt this policy.
Example Supply bins are located throughout a plant. When a bin is empty, the supervisor calls
the storeroom and they refill it. There are ten bins located over the plant. It has been suggested
that it might be cheaper to routinely refill all bins instead of sending a man out to refill and
individual bin as required. It is estimated that the time required to service a single bin costs
Ksh.30 but it would cost only ksh.100 to service all bins in one trip. The probability that a bin
will become empty is:

Time since refill (shifts) 1 2 3 4

Probability of becoming empty 0.1 0.2 0.5 0.2

What is the best policy for supply?

Solution
Average time before a bin become empty = 1 x 0.1 + 2 x 0.2 + 3 x 0.3 + 4 x 0.2 =2.2 shifts
Average number of bins to be filled per shift = 10/2.2 = 4.54
Average cost per shift if bins are filled always only when they become empty = 4.54 x 30 =
136.20
Let us now draw a table showing the number of bins that have to be replaced after every shift.

Shift First 10 Next replaced Next 2.1 Next 5.41 Next 3.47 Total bins
in 1st shift replaced in 2nd replaced in replaced in empty in the
shift 3rd shift 4th shift shift
1 1 1
2 2 0.1 2.1
3 5 0.2 0.21 5.51
4 2 0.5 0.42 0.54 3.46
5 0.2 1.05 1.08 0.34 2.67

Bins have to be filled as soon as they are empty to ensure that production does not stop, in
addition to periodic refilling of all bins. The associated costs are given in the following table.

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 Shift at the end No.of bins Cumulative Cost of Cost of Total cost Average cost
of which all bins refilled no. of bins cumulative no. refilling 10
are refilled refilled of bins bins
refilled@Ksh3
0
1 1 1 30.00 100 130.00 130.00
2 2.1 3.1 93.00 100 193.00 96.50
3 5.51 8.61 258.30 100 358.30 119.43
4 3.67 12.28 368.40 100 468.40 117.10
5 3.21 15.49 464.70 100 564.70 112.94

The lowest average cost is achieved if all bins are filled after two shifts, i.e. Ksh.96.50 per shift.
This is less than the average cost of refilling as the bins become empty, i.e Ksh.136.20. We
should adopt the policy as follows:
(a) Fill all bins as they become empty
(b) Fill all bins at the end of two shifts

STAFFING PROBLEMS

Personnel leave the organization either by choice, dismissal or retirements. These have to be
replaced. Sudden fluctuations in recruitment rates only provide a short term solution to
manpower problems. These results in peaks and troughs at a later date in the availability of
manpower affecting promotion policies and the efficiency of the organization. Replacement
modes can help to determine recruitment rates and lay down promotion policies. Let us examine
this with the help of an example.

Example A marketing organization employs a number of salesmen. Past data has revealed that
the salesmen tend to leave the organization after some time. The date is shown below:

Length of Service 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
(Years)
Percentage expected to 5 10 18 25 30 43 52 60 75 80 87 92 96 99 100
leave by the end of the
period

The company wishes to maintain a sales force of 80 sales persons of whom 16 will be territory
managers, 24 will be area managers and the rest will be sales persons. What should be the
recruitment per year and when should persons be promoted, if all promotions are based on length
of service.

Solution If we assume that 100 persons are recruited every year then at the end of year one,
95 of those recruited in the previous year will be in the organization. At the end of year two, of
the original 100 only 90 would be left, whereas of those recruited at the end of year one, 95 will
be left. Similarly, we can work out for other years. The results are tabulated as follows:

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Length of 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Total
Service
(Years)

Percentage 0 5 10 18 25 30 43 52 60 75 80 87 92 96 99 10
expected to 0
leave by the
end of the
period

Number 10 95 90 82 75 70 57 48 40 25 20 13 8 4 1 0 728
remaining 0

Cumulative 10 195 28 36 44 51 56 61 65 68 70 71 72 72 728 72

total 0 5 7 2 2 9 7 7 2 2 5 3 7 8

If we keep recruiting at the rate of 100 persons per year, the organization will have 728 persons
under steady state conditions. The organization wishes to maintain a sales force of only 80
persons, hence recruitment rate should be:

100 x 80
Recruitment rate = 728 = 11

The organizational structure is:

Territory managers 16 20%

Area managers 24 30%
Sales persons 40 50%
Total 80 100%

If the organization had a strength of 728, it would have 364 sales persons, 218 area managers and
146 territory managers. We can now take the cumulative totals for each year in the table above,
364 persons would be sales persons, 582 persons will be sales persons and area managers and the
rest will be territory managers. It can be seen from the table that 367 persons would be present
who have three years and less length of service.it follows that sales persons are promoted to area
managers at the end of three years service. Similarly, it can be seen that 569 persons have six
years or less service and 617 persons have seven years or less service. We can conclude that area
managers would be promoted to territory managers in the seventh year of service.

The organization should have the following manpower policy:

Recruitment 11 sales persons per year

Promotion from sales person to area manager On completion of three years service
Promotion from area manager to territory manager On completion of six and a half
years service

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12.6 SUMMARY

Most equipment deteriorates with time. As the equipment ages, the maintenance and operating
costs increase while the salvage value decreases. Some equipments suffer from sudden failures,
for example, electric bulbs, electronic components and so on. Replacement models help in
finding economic life of an equipment and assist the decision maker in making decisions about
new acquisitions.

The economic life of equipment which deteriorates with time is based on its average operating
and maintenance cost. The cost at the end of any year is calculated as a sum total of the cost of
operations and maintenance incurred up to that time and the capital cost which is the cost of the
equipment less its salvage or resale value.
Average cost per year is calculated on this basis. The economic life of the equipment is the
number of years where the equipment has the least average cost per year.

In case of equipment which fails suddenly, the decision maker has to decide whether to replace
components as they fail or to carry out a group replacement at some point of time. Here again
average costs per period are worked out to determine the most economical policy.

In case discounted values of money are to be used, all costs should be converted to their present
value using discounted factors based on the discount rate.
Manpower replacement problems can also be dealt with the replacement models. Recruitment
rates and promotion policies can be formulated with the help of replacement models. The model
deals with simplistic human resource planning situations. More complex situations can be dealt
with by using Markov chains and stocks and flows models.

QUESTIONS

1 What is replacement? Describe some important replacement situations and replacement

policies.
2 Explain the different types of replacement models.
3 A firm is considering replacement of a machine whose cost is Ksh.122000 and the scrap
value is Ksh.10000. The maintenance costs are found from experience to be as follows:

Year 1 2 3 4 5 6 7 8

Maintenance 2 5 8 12 18 25 32 40
costs (000s)

When should the machine be replaced?

4 The data on operating costs per year and resale prices of equipment whose purchase price
is Ksh.10000 are:

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 Year Operating cost (Ksh.) Resale value (Ksh.)

1 1500 5000
2 1900 2500
3 2300 1250
4 2900 600
5 3600 400
6 4500 400
7 5500 400

What is the optimum period of replacement?

5 The following table gives the running costs and the resale price in thousands of rupees of
an equipment whose purchase price is Ksh.50000.

Year 1 2 3 4 5 6 7 8

Maintenance 15 16 18 21 25 29 34 40
costs (000s)

Resale value 35 25 17 12 8 5 5 5
(000s)

At what year is replacement due?

6 A fleet owner finds from his past records that the costs per year of running a truck whose
purchase price is Ksh.600000 are:

Year 1 2 3 4 5 6 7 8

Maintenance 100 120 140 180 230 280 340 400

costs (000s)
Resale value 300 150 75 37.5 20 20 20 20
(000s)

At what age should the truck be replaced?

7 The truck owner in Question 6 has three trucks, two of which are two years old and the
third is one year old. He is considering replacing them with a new type of truck with 50
per cent more capacity than the old ones at a unit price of Ksh.800000. He estimates that
the running cost and the resale price will be as follows:

Year 1 2 3 4 5 6 7 8

Maintenance 120 150 180 240 310 400 500 600

costs (000s)
Resale value 400 200 100 50 30 30 30 30
(000s)

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 Assuming that the loss of flexibility due to fewer trucks is of no importance and that he
will continue to have sufficient work for three of the old trucks, what should his policy
be?

8 Machine A costs Ksh.45000 and the operating costs are estimated at Ksh.1000 for the
first year, increasing by Ksh.10000 per year in the second and subsequent years.
Machine B costs Ksh.50000 and the operating costs are Ksh.2000 for the first year,
increasing by Ksh.4000 per year in the second and subsequent years. If you now have a
machine of Type A should you replace it with B? if so, when? Assume that both the
machines have no resale value.

9 The management of a large hotel is considering the periodic replacement of light bulbs
fitted in its rooms. There are 500 rooms in the hotel and each room has 6 bulbs. The
management is presently following a policy of replacing bulbs as they fail and replacing
the whole lot every 4 months. The cost of replacing individual bulbs as they fail is
Ksh.30 and the cost of replacing the whole lot is Ksh.30000. Is the hotel following the
most economic policy? If not what policy should the hotel adopt? The mortality rate of
bulbs is given below:

Month of use 1 2 3 4 5

% of bulbs failing by that month 10 25 50 80 100

10 A computer has a large number of components all of which have to be fully working and
failures have to be replaced to maintain operational efficiency. If the component is
replaced individually then the cost of a single replacement is Ksh.20 whereas if all the
components are replaced concurrently, the cost of a single component is Ksh.7.
Determine the best replacement policy, if the mortality data is:

Mortality statistics: Observed number 500.

End of week 1 2 3 4 5 6

No. of components servicing 455 375 250 75 15 0

11 When should be following type of machine be replaced?

Cost price Ksh.10000

Operating cost Ksh.1000 first year, increasing by Ksh.200 every year
Resale value Ksh.5000 first year, decreasing by Ksh.500 every year

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12 Cool Homes hires out 300 air-conditioners. The hiring period varies as per the table
given below:

Length of hire 1 2 3 4
(Years)

Percentage of hiring 30 40 20 10

Determine how many new are needed each year to maintain the companys total rentals at
300 air-conditioners.

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