ASSET LIFE CYCLE

6-2

Session objectives

To understand Asset life cycle system

components
To understand the Life cycle costing Process
To understand the high cost contributors of
the asset system components
To comprehend the asset life cycle cost
implementation processes
 6-3

Definition of Asset Life Cycle

Several researchers give definition to life cycle such as the US

Department of Defense and the International Electro-technical
Commission (IEC 60300-3-3: Standards, 2004).

The general definition of life cycle is that, the lifetime of equipment from
the begging of its introduction to the market until its declination.

During life cycle cost estimation different perspective of life cycle are
considered. These perspectives can be categorized into three;

Marketing Perspective,
Production Perspective And
Customer Perspective.
 6-4

In marketing perspective life Finally when the products are delivered to

cycle of equipment's starts from the customer the customer will see the
in product under the eye of customer
Introduction Phase, perspective which are,
Growth, Purchased,
Maturity Operating,
Declining Phase. Support,
A manufacturer will view the Maintenance And
production perspective which is Disposal.
classified under five stages;
Production Conception,
Design,
Production And Process
Development,
Production & Logistics.
 6-5

The life of equipment mathematical in three ways; physical life, profit life,
and Economic life.
 6-6

Physical life which can also be referred as service life is the phase in
which the equipment is performing the intended purpose.
Repair and maintenance actions provided during its life time
determine the duration of the physical or service life of
equipment's.

Profit life is the most wish for phase of the equipment life, since at this
stage the equipment will generate a profit which is the growth and
maturity phase of the marketing perspective

Economic life as the life of the equipment, in which the ownership cost
decreases while the operating cost increases, this shows that the
equipment is costing more to operate than to own which is a declining
phase.
 6-7

Replacement analysis should be Other factors which affect the

conducted before the equipment analysis of equipment analysis
reaches to economic life in order are the concept of
to maximize profits.
Depreciation,
If the equipment ages beyond its Inflation,
economic life a loss of profit will Investment,
occur due to high maintenance Maintenance And Repairs,
and operating cost. Downtime, & obsolescence
In order to make decision on
proper timing of equipment
replacement, both physical and
economic life should be consider
together.
 6-8

One of the tools that are used to determine the economic life of
equipment is life cycle costing.

Life cycle costing has two components;

Ownership costs (initial costs, depreciation, insurance, taxes,
storage, and investment costs) and
Operating (operation, repair and maintenance, any other
consumable equipment cost)
 6-9

Definition of Life Cycle Costing (LCC)

Reference Definition of Life Cycle Costing

NATO/RTO Life cycle costing (LCC) is the discipline or process of collecting,
Publication interpreting and analysing data and applying quantitative tools
and techniques to predict the future resources that will be
required in any life cycle stage of a system of interest.
Buildings and Life cycle costing (LCC) is a technique which enables
Constructed Asset comparative cost assessment to be made over a specified
Standards: ISO- period of time, taking into account all relevant economic factors
15686-5 both in terms of initial costs and future operational costs.
 6-10

Petroleum and Life cycle costing (LCC) is the systematic consideration of the
Natural Gas difference between costs and revenues associated with the
Industries-Life acquisition and ownership of alternative options required to fulfil
Cycle Costing EN an asset need.
ISO 15663 1&2
IEC-60300-3-3: Life cycle costing (LCC) is the process of economic analysis to
International assess the life cycle cost of a product over its life cycle or a
Electro-technical portion thereof.
Commission
 6-11

Life cycle costing is increasingly being used in the industrial sector around
the world to make various types of decisions that directly or indirectly
concern engineering equipment and systems. There could be many reasons
for this upward trend, such as

Competition;
Increasing operation and maintenance costs;
Budget limitations;
Expensive products or systems (e.g., military systems, space systems,
and aircraft);
Rising inflation; and
Increasing awareness of cost effectiveness among product,
equipment, and system users.
 6-12

Barriers facing LCC implementation

Over the years, various advantages and disadvantages of life cycle costing have
been identified by various professionals. Some of the important advantages of life
cycle costing are shown in Figure.
Useful to A useful tool for
reduce the making In contrast, some of the main
total cost decisions associated
with equipment disadvantages of life cycle costing include
Useful to replacement, that it
control planning, and is time consuming;
programs budgeting
is costly;
has doubtful data accuracy;
Useful in An excellent tool for
comparing making a selection is a trying task when attempting to
the cost of among obtain data for analysis.
competing the competing
projects contractors/manufac
turers
 6-13

The main constraint are

Data. It is normally relatively easy to establish the acquisition cost of an item. It

is far more difficult to measure the operation and maintenance cost that
is likely to be incurred after purchase. Additionally, much of the through
life data, reliability for example, will be provided by the manufacturer;
this must be treated with caution especially if it is not contractually
binding.

Resources. Undertaking an LCC analysis can take considerable manpower

resources. These can be reduced by the use of proprietary LCC models,
but they are generally expensive and more complex than needed for the
majority of purchasing decisions. Departments should therefore
undertake the analysis manually or consider producing simple computer
spreadsheets using relatively inexpensive software packages to meet
their LCC needs.
LIFE CYCLE COST
MODELS
 6-15

Introduction

LCC includes every cost that is appropriate and appropriateness changes with
each specific case which is tailored to fit the situation. LCC follows a process as
shown in Figure 1. The steps are:
Step 1-Identify what has to be analyzed and the time period for the project life
study along with the appropriate financial criteria.
Step 2-Focus on the technical features by way of the economic consequences
to look for alternative solutions.
Step 3-Develop the cost details by year considering memory joggers for cost
structures.
Step 4-Select the appropriate cost model, simple discrete, simple with some
variability for repairs and
replacements, complex with random variations, etc. required by project
complexity.
Step 5-Acquire the cost details.
 6-16
Step 6-Assemble the yearly cost profiles.
Step 7-For key issues prepare breakeven
charts to simplify the details into
time and money.
Step 8-Sort the big cost items into a Pareto
distribution to reconsider further
study.
Step 9-Test alternatives for high cost items
such as what happens if
maintenance cost is 10% than
planned, etc.
Step 10-Study uncertainty/risk of errors or
/alternatives for high cost items as
a sanity check and provide
feedback to the LCC studies in
iterative fashion
Step 11-Select the preferred course of
action and plan to defend the
decisions with graphics
 6-17

The basic tree for LCC starts with a very simple tree based on the costs for
acquisition and the costs for sustaining the acquisition during its life

Acquisition and sustaining costs are

not mutually exclusive. If you acquire
equipment or processes, they always
require extra costs to sustain the
acquisition, and you cant sustain
without someone having acquired
the item.
Acquisition and sustaining costs are
found by gathering the correct
inputs, building the input database,
evaluating the LCC and conducting
sensitivity analysis to identify cost
drivers.
6-18
 6-19

Frequently the cost of sustaining equipment is 2 to 20 times the acquisition cost. The
first obvious cost (hardware acquisition) is usually the smallest amount of cash that will
be spent during the life of the acquisition and most sustaining expenses are not obvious.
 6-20

Mathematical LCC model

Mathematical Models are based on some mathematical relationship and

their subcategories including support models, design trade models and
total cost models
There are many inputs to Life cycle models:

Warranty coverage periods Mean time between failure

Average material cost of failure Mean time to repair
Cost of training Spare requirements
Cost of installation Cost of labour per corrective
Systems or items price maintenance action
Cost of carrying spares in inventory Time to spend for travel
 6-21

Model I
The equipment or system life cycle cost is divided into two
main parts: recurring cost and nonrecurring cost.

Thus, the system or equipment life cycle cost is expressed

by:
LCC= RC+NRC
where
LCC is item or system life cycle cost.
RC is recurring cost.
NRC is nonrecurring cost.
 6-22

The recurring cost, RC, is expressed by:

RC =OC+ IC+ SC+MC+MTC

Where OC is operating cost.

IC is inventory cost.
SC is support cost.
MC is manpower cost.
MTC is maintenance cost.
 6-23

The nonrecurring cost, NRC, is expressed by:

NRC = Cp +Ci +Cq +Cr+ Ct +Crm+ Cs

where
Cp is procurement cost.
Ci is installation cost.
Cq is qualification approval cost.
Cr is research and development cost.
Ct is training cost.
Crm is reliability and maintainability improvement cost.
Cs is support cost.
 6-24

Mode II
If the equipment or system life cycle cost is divided into three
main parts: procurement cost, initial logistic cost, and recurring cost,
the system or equipment life cycle cost is expressed by:

LCC=C1 +C2 +C3

where
LCC is item or system life cycle cost.
C1 is acquisition or procurement cost.
C2 is initial logistic cost.
C3 is recurring cost.
 6-25

Model III
If the system life cycle cost is divided into five main parts: research and
development cost, the cost of associated systems, investment cost,
termination cost, and operating and support cost, the
system life cycle cost is expressed by:

LCC=C1 +C2 +C3 +C4 +C5

where
LCC is system life cycle cost.
C1 is research and development cost.
C2 is cost of associated systems.
C3 is investment cost.
C4 is termination cost.
C5 is operating and support cost.
 6-26

Model IV
The life cycle cost can be
expressed by:

LCC = Ccp +Cdp +Cpp +Cop

Where

LCC is life cycle cost.

Ccp is cost associated with the
conceptual phase.
Cdp is cost associated with the
definition phase.
Cpp is cost associated with the
procurement phase.
Cop is cost associated with the
operational phase.
The operational phase cost is
expressed by:
Cop= Cm +Cfo +Coa
Where
Cm is maintenance cost.
Cfo is functional operating cost.
Coa is operational administrative
cost.
 6-27

Mode V

The life cycle cost is expressed by:

LCC= Crd +Cpc +Cos +Crt

Where

LCC is life cycle cost.

Crd is research and development cost.
Cpc is production and construction cost.
Cos is operation and support cost.
Crt is retirement and disposal cost.
 6-28

Cost estimation method

Over the years, many methods have been developed to estimate costs
which are useful for application in the area of life cycle costing.
Cost Estimation Method I

This method is considered quite useful to obtain quick approximate cost

estimates for similar new plants, projects, or equipment of different
capacities.
The cost-capacity
where relationship is defined by
Cn is cost of the new plant, project, or equipment under consideration.
Co is cost of the old but similar equipment, plant, or project.
Kn is capacity of the new plant, project, or equipment.
= Ko is capacity of old but similar equipment, plant, or project.
a is the cost-capacity factor whose frequently used value is 0.6. The proposed values for this
factor for items such as heat exchangers, heaters, pumps, and tanks are 0.6, 0.8, 0.6, and
0.7, respectively
 6-29

Example :An electric utility spent $900 million to construct a 1,000 megawatt
(MW) nuclear power generating station. In order to satisfy the increasing demand
for electricity, the company is planning to construct a 2,000 MW nuclear power
generating station. Calculate the cost of the new station, if the value of the cost-
capacity factor is 0.6. By substituting the given data values into the above
Equation, we get

2000 0.6
= 900 =$1,364.15 Million
1000

Thus, the construction cost of the new

nuclear power station will be $1,364.15
million.
 6-30

Cost Estimation Method II

This method is known as the Lang factor method, after its originator, H. L.
Lang . The method is used for obtaining quick order-of-magnitude cost
estimates by utilizing historical average cost factors. Lang proposed to estimate
total plant costs from the delivered equipment cost by using three factors as
multipliers: n = 3.10 (for solid process plants), n = 3.63 (for solid-fluid plants),
and n = 4.74 (for fluid process plants) . Thus, the total estimate for plant cost is
obtained by using

TPC=(n)(DEC)

where
TPC is the total estimate for plant cost.
n is the Lang factor, whose value depends on the nature of the plant.
DEC is delivered equipment cost.
 6-31

Example: Assume that a fluid-processing plants delivered equipment cost

is $40 million. Calculate the total plant cost. By substituting the given data
value and information

TPC = (4.74 )(40)

=$ 1896 million

Thus, the total plant cost will be $189.6 million.

 6-32

Cost Estimation Method III

This method is basically a refinement of the Lang factor method and is known
as the Hand method, after its originator, W. E. Hand. In the refinement, Hand
proposed the use of different factors for various groups of equipment.
The total installed cost for each equipment group is defined by
ICt m DEC =( )( )
where
ICt is total installed cost of each equipment group.
m is the Hand factor that covers field materials (structures, insulation,
piping, electrical, finishes, and foundations), labor, and indirect
costs.The values of the Hand factor for various groups of equipment are
2 (fired heaters), 2.5 (compressors), 2.5 (miscellaneous equipment),
3.5 (heat exchangers), 4 (pumps), 4 (pressure vessels), 4 (instruments),
and 4 (fractionating towers).
DEC is delivered equipment cost.
Note that the Hand factors do not incorporate a contingency allowance.
 6-33

Cost Estimation Method IV

This method is quite useful to make an order-of-magnitude approximation of
operating labor requirements in the absence of a Manning table. The method
is known as the Wessell method. Thus, the Wessell equation is expressed by

where
OH is number of operating man-hours.
l is tons of product.
K is total number of process steps.
P is capacity expressed in tons per day
The values of a are 23 (for a batch
operation with maximum labor), 10
(for a well-instrumented continuous
process operation), and 17 (for an
operation with average labor
requirements).
 6-34

Cost Estimation Method V

This method is known as the turnover ratio method and is considered the most
efficient approach to estimating plant costs. However, it is probably the least
accurate.
TOR =AS/I
where
TOR is turnover ratio.
AS is gross annual sales.
I is fixed capital investment.
The gross annual sales, AS, is expressed by
AS=(SP)(PR)
where
SP is unit selling price.
PR is yearly production rate.
Note that the value of the turnover ratio, TOR, usually varies from around 0.2 to 8.
 6-35

Example: Assume that a factory is to manufacture 50,000 units/year

of a certain product. The selling price of a unit is $500. Calculate the
fixed capital investment, if the turnover ratio is 4

4= (500)(50,000)/I
By rearranging Equation (4.33), we obtain

I =$6 25 million
Thus, the fixed capital investment for the factory is $6.25 million.
 6-36

Example
A company using machining equipment to manufacture a certain type
of engineering part is contemplating replacing it with a better version.
Four different pieces of machining equipment, manufactured by four
different manufacturers, are being considered for its replacement;
their data are presented in the Table below
 6-37

Life Cycle Cost Analysis: Machining Equipment A

The expected cost, Cfa, of failure per year of machining equipment A is given by
Cfa = (2000)(0.08)
= $160
where Cfa is the machining equipment A annual expected failure cost.
The present value, PVaf, of machining equipment A life cycle failure cost is
expressed by

where
PVaf is present value of machining equipment A life cycle failure cost.
i is annual interest rate.
k is machining equipments expected useful life in years.
 6-38

The present value, PVao , of machining equipment A life cycle operating cost is
given by

where
PVao is present value of machining equipment A life cycle operating cost.
Coa is machining equipment A annual operating cost.

Thus, the life cycle cost of machining equipment A is given by

LCCa =PCa +PVaf +PVao
where
LCCa is machining equipment A life cycle cost.
PCa is machining equipment A procurement cost.
LCCa= $345,337. 13
 6-39

Life Cycle Cost Analysis: Machining Equipment B

The expected cost, Cfb, of failure per year of machining equipment B is
given by
Cfb =(2500)(0.07)
=$175
where Cfb is machining equipment B annual expected failure cost.
the present value, PVbf, of machining equipment B life cycle failure cost
is given by

where PVbf is present value of machining equipment B life cycle failure cost.
$1,288. 01
 40

the present value, PVbo, of machining equipment B life cycle operating cost is
expressed by

=$51,520.61
where
PVbo is present value of machining equipment B life cycle operating cost.
Cob is machining equipment B annual operating cost.

Thus, the life cycle cost of machining equipment B is given by

LCCb= PCb+ PVbf +PVbo
where
LCCb is machining equipment B life cycle cost.
PCb is machining equipment B procurement cost.

LCCb=$322 808 62
 41

Life Cycle Cost Analysis: Machining Equipment C

The expected cost, Cfc, of failure per year of machining equipment C is given by
Cfc =(3000)(0.06)
=$180
where Cfc is machining equipment C annual expected failure cost.
the present value,PVcf, of machining equipment C life cycle failure cost is expressed by

where PVcf is present value of machining equipment C life cycle failure cost.

PVcf= $1324,81
the present value, PVco, of machining equipment C life cycle operating cost is expressed
by

where
PVco is present value of machining equipment C life cycle operating cost.
Coc is machining equipment C annual operating cost.
 42

Thus, the life cycle cost of machining equipment C is given by

LCCc =PCc+ PVcf +PVco

where
LCCc is machining equipment C life cycle cost.
PCc is machining equipment C procurement cost.
LCCc=$339 165 37
 43

Life Cycle Cost Analysis: Machining Equipment D

The expected cost, Cfd, of failure per year of machining equipment D is given by
Cfd = (1000)(0.04) =40
where
Cfd is machining equipment D annual expected failure cost.
The present value, PVdf, of machining equipment D life cycle failure cost is
expressed by

where PVdf is present value of machining equipment D life cycle failure cost.

PVdf = $294 40
 44

The present value, PVdo, of machining equipment D life cycle operating cost is
given by

where
PVdo is present value of machining equipment D life cycle operating cost.
Cod is machining equipment D annual operating cost.
Pvdo= $ 58 880 69
Thus, the life cycle cost of machining equipment D is expressed by
LCCd==PCd +PVdf +PVdo

LCCd is machining equipment D life cycle cost.

PCd is machining equipment D procurement cost.

LCCd=$409,175.09
 45

Thus, the life cycle costs of machining equipment A, B, C,

and D are $345,337.13, $322,808.62, $339,165.37, and
$409,175.09, respectively. By examining these values, it is
concluded that machining equipment B should be purchased
because its life cycle cost is the lowest.
ASSESSMENT OF
ASSET LIFE
 6-47

Session objectives

To understand the concept and methodology of Replacement analysis

To predict and estimate the economic service life of an equipment
 6-48

Introduction

The decision to replace equipment or to retire it (to take the equipment

out of service without replacing it) can be motivated by the physical
impairment of the equipment, its obsolescence, or external economic
conditions.
Retirement and replacement decisions should always be based on
economics rather than on whether or not the equipment has reached the
end of its physical service life.
A piece of equipment may have many years of service life remaining
beyond the point at which it has become uneconomical to operate it.
All past investments and expenses connected with the equipment are
sunk costs, which do not enter into a retirement/replacement decision.
Only current and future costs and investments are relevant.
 6-49

Replacement Analysis

Reasons for replacing an asset

Physical Impairment
Altered Requirements
Technology

The replacement of assets often represents economic opportunity for the firm. We
compare the two alternatives:
The asset that we own: The Defender
Eg, an old machine
The Asset that we might buy to replace it: The Challenger
Eg, new machine

Factors to consider (or ignore)

Sunk Costs:- any past cost unaffected by any future decision
Existing Asset Value and the outsider viewpoint
Income Tax Considerations
Economic Life of the challenger and the defender
 Economic Service Life

An asset has various types of lives

Useful Life
Tax Life Minimize
Economic Life

Ownership (Capital)

Annual Equivalent Cost

cost

+
Definition: Economic service life is the
remaining useful life of an asset that Operating
results in the minimum annual
cost
equivalent cost.
 6-51

The Economic Life of an asset is

The period of time that minimizes the net annual cost (NAC) for the
investment (when it primarily consists of costs)
or
The period of time that maximizes the net annual worth (NAW) for the
investment (when it consists of costs and revenues)
Capital cost have two components: Initial investment (I) and the salvage
value (S) at the time of disposal.
The initial investment for the challenger is its purchase price. For the
defender, we should treat the opportunity cost as its initial investment.
Use N to represent the length of time in years the asset will be kept; I is
the initial investment, and SN is the salvage value at the end of the
ownership period of N years.
The operating costs of an asset include operating and maintenance (O&M)
costs, labor costs, material costs and energy consumption costs.
 NAC

OC (i)

CR(i)

n*
52
 6-53

As operating equipment ages, the usual pattern is for its capital costs
to decline while its operating costs rise.

When summed, these two cost functions often result in a cost

function that is generally U-shaped.

Ideally, the equipment should be retired at the lowest point on this

total cost function.
Example 1
Investment in a machine: $15,000
Useful life 10 years
Salvage decreasing with time like the book value using SYD method. Assume
salvage after 10 years is zero
Operating cost is $500 in first year, but increases by 40% in each subsequent year
What is the economic life? The MARR is 18%

Let A(n) = cost in year n

S(n) = Salvage in year n
P = Investment at time 0
PA = present worth of annual costs
= A(1)(P/F, i, 1) + A(2)(P/F, i, 2) + + A(n)(P/F, i, n)
NAC = (P + PA)(A/P, i, n) S(n)(A/F, i, n)
54
 6-55

Computation of the Economic Life

Time Operating Salvage NAC The Economic Life Minimizes the NAC
Cost Value Find NAC(1), NAC(2),, NAC(10). The economic
0 15000 life is the life that minimizes NAC.
1 500 12273 5927
In this case the economic life = 6 years.
2 700 9818 566
9
3 980 7636 546
2
4 1372 5727 5307
5 1921 4091 5207
6 2689 2727 5162
7 3765 1636 5178
8 5271 818 525
6
9 7379 273 540
4
10 10331 0 5627
 6-56

Example 2
A machine has an initial cost of $10 000. Being a special-purpose
custom-built unit, it can only be resold as scrap at $500, no matter
what its age. The machine has a 10-year service life. The annual
operating costs are $2000 for each of the first two years, with an
increase of $600 per year thereafter. The MARR is 10%. When is
the optimum time to retire the machine?
The cost curve for this type of problem is the net EUAC, evaluated at
the MARR, as a function of time.
The net EUAC will be made up of two components: the capital
recovery cost,
 6-57

Replacement Economics

The decision to retire a piece of equipment is seldom taken without

replacing that equipment.
Thus, in most cases, a joint retirement /replacement decision is made.

Cash Flow Approach Opportunity Cost Approach

Treat the proceeds from Treat the proceeds from sale of

sale of the old machine the old machine as the
as down payment toward investment required to keep
purchasing the new the old machine.
machine.
Can be used in the
analysis period is same
for all alternatives.
Use NPW or AE analysis to
decide
 6-58

Example 3

It is 2016. Should you buy a new car to replace the old wreck? Your minimum
acceptable rate of return is 12%.

Old Car: New car:

Initial cost was $4,500 in 1995. The Cost is $8,250, less trade-in allowance
car was supposed to last for 8 years of $250. This car is supposed to last for
with a trade-in value $500 at the end 10 years with a trade-in value of $750
of 8 years. at the end of that time. If you sell it
Maintenance costs next year will be before the end of its useful life, you
$800, and are expected to go up by expect the trade-in value to be the
$400 a year in the coming years (800, same as the book value computed with
1200, 1600, . . .). straight-line depreciation. Maintenance
The car is now a death trap, not worth will be $100 per year for the first three
more than $250. To trade it in, you're years and $300 per year thereafter.
going to have to clean it up for a cost of
$50. In the future, net salvage value is
also expected to be $200 at any time.
 6-59

The Defender (Investment ) The Challenger (Investment )

Operating Costs and Revenues Operating Costs and Revenues

Salvage Value Salvage Value

Economic Life Economic Life
Investment for the Defender
The opportunity cost for the defender is the money that you give up by not disposing
of it. You must also add any costs at time 0 to make it equivalent to the challenger.
The investment consists of
the current market value for the defender,
less costs necessary for its disposal,
less taxes on the capital gain (when taxes are considered),
plus any real costs at time 0 necessary to keep the defender.
 6-60

Beware
Don't use any defender characteristics to compute the challenger
investment, costs, or salvage. Don't use any challenger characteristics to
compute the defender investment, costs, or salvage
The Defender The Challenger
Investment: PD = $200. Investment: PC = $8,250
Operating Cost: Operating Cost:
AD(n) = $800 + $400 (n-1) AC(n) = $100, $100, $100, $300, $300, $300, ...
Salvage Value: SD(n) = $200 Salvage Value: SC(n) = $8,250 $750n
NACD(n) NACC(n)
= PD(A/P, i, n) + $800 + = PC(A/P, i, n) + 100 SC(n)(A/F, i, n)
$400(A/G, i, n) 200(A/F, i, n) for n = 1, 2, 3
NACC(n)
= PC(A/P, i, n) + 300 200(P/A, i, 3) (A/P,i, n)
SC(n)(A/F, i, n)
for n = 4,,10
 6-61
Defender Challenger
Age A(n) S(n) NAC Age, A(n) S(n) NAC Notes
,n n All parameters of the
0 200 0 8250 defender and challenger are
1 800 200 824 1 100 7500 1840 independent.
2 1200 200 1013 2 100 6750 1798 Use economic lives in the
3 1600 200 1194 3 100 6000 1757 analysis.
The economic life of the
4 300 5250 1760 defender is often one year.
Which do we select? 5 300 4500 1747 The economic life of the
Defender cost for one challenger is often its useful
more year: $824 6 300 3750 1728
Challenger cost per life.
7 300 300 1705 Choose the winner on the
year: $1632
8 300 2250 1681 basis of minimum NAC or
maximum NAW
9 300 1500 1657

10 300 750 1632

 Example 4
United Airlines (UAL) is in the process of replacing many of its 111-airplane
wide-body fleet, as well as some of its 97 aging Boeing 757 narrow-body
planes. What basis do they make the fleet-replacement decisions?
 Sunk Cost associated with an
Assets Disposal
Given: Original investment = $20,000,
current market value = $10,000, repair cost
made in the past = $5,000

Find: Relevant cost for replacement

analysis

Lost investment value, $10,000

Repair cost made, $5,000
Total sunk cost = $15,000
Relevant cost for replacement
analysis = current market value =
$10,000
 Opportunity Cost
Approach
Basic Principle: Treat the proceeds
from sale of the old machine as the
investment required to keep the old
machine.
Defender:
Market price: $10,000
Remaining useful life: 3 years
Salvage value: $2,500
O&M cost: $8,000
P(12%)D=$10,000+$8000(P/A,12%,3)-
Challenger: $2500(P/F,12%,3)=$27,435
Cost: $15,000
Useful life: 3 years NAC(12%)D= P(12%)D(A/P,12%,3)=$11,423
Salvage value: $5,500 P(12%)c=$15,000+$6000(P/A,12%,3)-
O&M cost: $6,000 $5500(P/F,12%,3)=$25,469
NAC(12%)c=P(12%)c(A/P,12%,3)=$10,615

Decision: Replace the defender now

 6-65

Example 5

An old pump (Pump A) is operating in a petrochemical plant. At pump

failure, the process shuts down and financial losses are incurred as
each hour of down time. The plant is planning to buy a new pump
(Pump B) for a replacement of the old one the plant has a useful life of
another 9 years and the plant will be sold-out during this interval. The
plant wants to make a decision either to buy a new one (Pump B) or to
continue with the old one. The data needed for the analysis is given
below
 6-66

Defender: Existing Pump A Challenger: Replacement Pump B

Capital investment when purchased 5
Capital investment = $16,000
years ago: $17,000
Useful life: another 9 years
Useful life = 9 years
Depreciation: SL with half-year Depreciation: MACRS
convention Tax Life: 5 years
Tax Life: 9 yrs Estimated market value at the end of
Annual Expenses 9 years = $3,200
Replacement of impeller and bearings Annual Expenses
= $1,750 Operating and maintenance =
Operating and maintenance = $3,250 $3,000
Taxes and insurance = $17,000 Taxes and insurance = $16,000 2%
2% = $340
= $320
Total $5,340
Present Market Value $750
Total $3,320
Estimated market value at the end of Effective income tax (capital gains)
the 9 years = $200 rate = 40%
Current book value = $8500 MARR (before taxes) = 10%, MARR
(after taxes) = 6%
 6-67

Reference

1. Park,Chan S. Contemporary Engineering Economics Upper Saddle

river, N.J.: Prentice hall,c2007
2. Park, Chan S. Fundamentals of engineering economics Upper Saddle
river, N.J.: Prentice hall,c2008
3. Josea. Sepulveda, Williame. Souder and Byrons. Gottfried Schaums
Outline of Theory and Problems of Engineering Economics