10 Replacement Models

10.1 INTRODUCTION
The problem of replacement occurs when the job performing units like men, machines, equipment,
and others become less effective or useless due to either sudden or gradual deterioration in their effi-
ciency or failure or complete breakdown. For example, an electric light bulb fails all of a sudden an
pipeline get blocked, parts of machines become faulty. These are some situations that need most eco-
nomic replacement policy for replacing faulty units or to take some remedial to restore efficiency.
Suppose an item goes on performing and with decreasing efficiency, then it requires more money to
he spent in order to increase the operating cost, repair cost and so on. In such a situation the replace-
ment of an old item with new one is the only alternative. Thus, the problem of replacement is to decide
the best policy to determine an age at which the replacement is most economical instead of continuous
increases in cost. The need for replacement arises in many situation like.
(i) We may decide either to wait for complete failure of the item or to replace earlier due to high
expense.
(ii) The expensive items may be considered individually to decide whether we should replace now or
when it should be next replaced.
(iii) Whether the replaced item is of same type or of different type (latest model) of the item. The
main objective of replacement is to direct the organisation for maximising its profit (or minimis-
ing its cost).
Replacement problems can be classified as:
(i) When the equipment deteriorates with time due to constant use and needs increased operating
and maintenance cost.
(ii) When equipments such as light bulbs, tubes, radio and television parts, and so on, do not give
any indication of deterioration with time, but fail completely all of a sudden.
(iii) Existing working staff in an organisation reduces gradually due to retirement, death, and so on.

Failure Mechanism of Items

There are two types of failures:
(i) Gradual failure: It is progressive in nature, that is, the lifetime increases, but its efficiency dete-
riorates causing

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 Chapter 10  •  Replacement Models397

(a) increased maintenance and operating costs,

(b) decreased productivity, and
(c) decrease in the value of the equipment, that is, resale or salvage value.
Sudden failure: This type of failure occurs after some period of service rather than deterioration
(ii)
while in service. The period of giving desired service is not constant but follows some frequency
distribution which may be progressive, retrogressive or random in nature.
(a) Progressive failure: If the probability of failure increase with the increases in its life, then
the failure is said to be progressive
For example: electric light bulbs, automobile tubes.
(b) Retrogressive failure: If the probability of failure in the beginning of the life of an item is
more and due to change of time, the chances of time, the chances of failure decreases, then
the failure is said to be retrogressive.
(c) Random failure: The constant probability of failure is associated with items that fail from
random causes like physical shocks not related to age. In such a case, virtually all items fail
before ageing has any effect.

10.2  REPLACEMENT OF ITEMS THAT DETERIORATEs GRADUALLY

Generally, the cost of maintenance and repair of certain items increases with time. When years go by,
these costs become so high that it is more economical to replace the item by a new one. In this situa-
tion, a replacement is necessary.

10.2.1 Replacement Policy When Value of Money Does Not Change

with Time
Theorem
The cost of maintenance of a machine is given as a function increasing with time and its scrap value
is constant.
(a) If time is a continuous variable, then the average annual cost will be minimised by replacing
the machine when the average cost to date becomes equal to the current maintenance cost.
(b) If time is a discrete variable, then the average annual cost will be minimised by replacing the
machine when the next period’s maintenance cost becomes greater than the current average cost.
Proof: The aim is to find the optimum replacement age of an item whose running or maintenance cost
increases with time and the value of money remains constant during the period. Let
C: capital cost of the item
S: scrap value of the item
n: number of years that the equipment would be in use
f (t): maintenance cost function
A(n): Average total annual cost
(a) When t is a continuous variable: If the item is used for n years, then the total cost used during
this period is:
Total cost = Capital cost - Scrap value + Maintenance cost
n

= C − S + ∫ f (t )dt
0

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Average annual total cost is given by

n
Total cost C − S 1
A(n) = = + ∫ f (t )dt
n n n0
Now, we find such time n for which A(n) is minimum. Therefore, differentiating A(n) with
respect to ‘n’, we get
n
dA(n) 1 1 C −S
= f (n) − 2 ∫ f (t )dt − 2
dn n n 0 n
= 0 for minimum of A(n)
which implies
n
C −S 1
f (n) = + ∫ f (t )dt
n n0
= A(n)

d2
Note that [ A(n)] ≥ 0 at f (n) = A(n).
dn2
When time t is a discrete variable: Since the time t is taken as discrete, it can take the values
(b)
1, 2, 3, …
Then,
C −S 1 n
A(n) = + ∑ f (t )
n n l =1

By using finite differences A(n) will be minimum if the relationship is satisfied.

A(n + 1) - A(n) ≥ 0 and A(n) - A(n - 1) ≤ 0
For this, we write

C − S 1 n +1  C − S 1 n 

A(n + 1) − A(n) = 
n + 1
+
n + 1
∑ f (t ) − 
n
+ ∑ f (t )
n
 t =1   t =1 
1  n
 1 n

=
n +1 C − S + ∑ f ( t ) + f (n + 1)  −  C − S + ∑ f (t )
t =1  n t =1 
f (n + 1) n  1 1  1 1
= + ∑ f (t )  −  + (C − S)  − 
n +1 t =1  n + 1 n   n + 1 n 
f (n + 1) 1  n 
=
n +1
− ∑ f (t ) + (C − S)
n(n + 1)  t =1 

since A(n + 1) - A(n) ≥ 0,

f (n + 1) 1  n 
n +1
≥  ∑
n(n + 1)  t =1
f (t ) + (C − S)

⇒ f (n + 1) ≥ A(n).

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 Chapter 10  •  Replacement Models399

Similarly, it can be shown that

A(n) − A(n − 1) ≤ 0 ⇒ f (n) ≤ A(n − 1)

This suggests the optimal replacement policy as:

Replace the machine at the end of n years when the maintenance cost in the (n + 1)th year is more
than the average total cost in the nth year and the nth year maintenance cost is less than the previous
year’s average total cost.

Example 1
The cost of a machine is `6,100 and its scrap value is only `100. The maintenance costs are found from
experience to be:

Year 1 2 3 4 5 6 7 8
Maintenance
100 250 400 600 900 1,250 1,600 2,000
cost in `

When should machine be replaced?

Solution: Find an average cost per year during the life of the machine. That is,
Total cost in a year
= Capital (or purchase) cost-Scrap value + Maintenance (running) cost.
We calculate the average cost per year during the life of the machine, which are given in Table 10.1

Table 10.1
Replace at Maintenance Cumulative Difference Total cost Average cost
the end of cost depreciation between price ¬f (n ) + C - S ¬f (n ) + C - S
year f (n) cost (or) and scrap value n
(n) maintenance C-S
cost
¬f (n )
1 100 100 6,000 6,100 6,100
2 250 350 6,000 6,350 3,175
3 400 750 6,000 6,750 2,250
4 600 1,350 6,000 7,350 1,837
5 900 2,250 6,000 8,250 1,650
6 1,250 3,500 6,000 9,500 1,583
7 1,600 5,100 6,000 11,100 1,586
8 2,000 700 6,000 13,100 1,638

From Table 10.1, it may be observed that the average cost per year is minimum in the sixth year
(`1,583) and the maintenance cost in the seventh year (`1, 600) becomes greater than the average cost
for six years. Hence, the machine should be replaced at the end of the 6th year.

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Example 2
(a) Machine A costs `9,000. Annual operating costs are `200 for the first year, and then increase
by `2,000 every year. Determine the best age at which to replace the machine. If the optimum
replacement policy is followed, what will be the average yearly cost of owning and operating the
machine?
(b) Machine B costs `10,000. Annual operating costs are `400 for the first year, and then increase by
`800 every year. You now have a machine of type A which is one year old. Should you replace it
with B: if so when?

Solution: (a) Let the machine have no scrap (resale) value when replaced. For Machine A, the average
total cost is computed as follows:

Replace at the Maintenance ¬f (n ) + C - S

end of year cost f (n) ¬f (n ) C-S ¬f (n ) + (C - S )
n
(n)
1 200 200 9,000 9,200 9,200
2 2,200 2,400 9,000 11,400 5,700
3 4,200 6,600 9,000 15,600 5,200

4 6,200 12,800 9,000 21,800 5,450

5 8,200 21,000 9,000 30,000 6,000

From the Table, it follows what the Machine A may be replaced at the end of the 3rd year.
(b) For Machine B, we compute the average cost per year.

Replace at
f (n) ¬f (n ) C-S f (n ) + (C - S ) ¬ (n ) + C - S
the end of
year (n) n

1 400 400 10,000 10,400 10,400

2 1,200 1,600 10,000 11,600 5,800
3 2,000 3,600 10,000 13,600 4,533
4 2,800 6,400 10,000 16,400 4,100
5 3,600 10,000 10,000 20,000 4,000
6 4,400 14,400 10,000 24,400 4,066

From the two Tables, we observe that the average cost for Machine B is lower than the average cost for
Machine A. So Machine B should be replaced by Machine A.
Next, to decide the time of replacement we compare the minimum average cost for B (`4,000) with
yearly cost of maintaining and using Machine A. Since there is no resale value, we consider only the
maintenance cost. Machine A is kept as long as the yearly maintenance cost is lower than `4,000 and
replace when it exceeds `4,000.

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 Chapter 10  •  Replacement Models401

On a one-year old Machine A, `2,200 would be required for maintenance in the next year, and
`4,200 is needed for the following year. Since the maintenance cost in the third years is more than the
lowest in average cost (`4,000) of Machine B, Machine A should be replaced by Machine B after two
years. As Machine A is one year old, the replacement should be one year from now.
Example 3
A taxi owner estimates from his past records that the cost per year for operating a taxi whose purchase
price when new is `60,000. These are given below.

Age in years 1 2 3 4 5
Operating cost (`) 10,000 12,000 15,000 18,000 20,000

After 5 years, the operating cost is `6,000 K where K = 6, 7, 8, 9, 10, age in years. If the resale value
decreases by 10% of purchase price each year, what is the optimum replacement policy? Cost of the
money is zero.
10
Solution: 10% of purchase price = `60, 000 × = ` 6, 000.
100
Thus, the resale value decreases by `6,000 every year. The average annual cost of the taxi is com-
puted as follows.
Years Operating ¬f (n ) + C - S
Resale value S C-S ¬f (n ) + (C - S )
(n) cost f (n) n
1 10,000 54,000 6,000 16,000 16,000
2 12,000 48,000 12,000 34,000 17,000
3 15,000 42,000 18,000 55,000 18,333
4 18,000 36,000 24,000 79,000 19,750
5 20,000 30,000 30,000 1,05,000 21,000
6 36,000 24,000 36,000 1,47,000 24,500
7 42,000 18,000 42,000 1,95,000 27,857
8 48,000 12,000 48,000 2,49,000 31,125
9 54,000 6,000 54,000 3,09,000 34,333
10 60,000 0 60,000 3,75,000 37,500
The optimum period for replacement is one year.
Example 4
An auto owner finds from his past records that the cost per year of an auto whose purchase price is
`60,000 are:
Year 1 2 3 4 5 6 7 8
Running price 10,000 12,000 14,000 18,000 23,000 28,000 34,000 40,000
Resale price 30,000 15,000 7,500 3,750 2,000 2,000 2,000 2,000
(a) Determine at what age is its replacement due.
(b) Let the owner have 3 auto two of which are two years old and the third, is one year old. The
cost price, running costs and resale value of these autos is same as given in part (a). Now, the

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owner is considering a new type of autos with 50% more capacity than one of the old one at a
unit price of `80,000. He estimates that the running costs and resale price for the new auto will
be as follows:

Year 1 2 3 4 5 6 7
Running cost 12,000 15,000 18,000 24,000 31,000 40,000 50,000
Resale price 40,000 20,000 20,000 5,000 3,000 3,000 3,000

Assuming the loss of flexibility due to the new autos is of no importance, the owner will con-
tinue to have sufficient work for three of the old autos, what should his policy be?
Solution: The computation of average cost per year during the life of the auto are:

Year (n) Running cost ¬f (n ) C-S ¬f (n ) + (C - S ) ¬f (n ) + C - S

`f (n) n
1 10,000 10,000 30,000 40,000 40,000.00
2 12,000 22,000 45,000 67,000 33,500.00
3 14,000 36,000 52,000 88,500 29,500.00
4 18,000 54,000 56,250 1,10,250 27,562.00
5 23,000 77,000 58,000 1,35,000 27,000.00
6 28,000 1,05,000 58,000 1,63,000 27,166.00
7 34,000 1,39,000 58,000 1,97,000 28,142.85
8 40,000 1,79,000 58,000 2,37,000 29,625.00

It may be noted that the average cost per year is minimum in the 5th year. Hence, the auto should be
replaced after 5th year.

Average Cost of New Auto

Year Running cost ¬f (n ) C-S ¬f (n ) + (C - S ) ¬f (ns ) + C - S
(n) `f (n) n
1 12,000 12,000 40,000 52,000 52,000.00
2 15,000 27,000 60,000 87,000 43,500.00
3 18,000 45,000 0,000 1,15,000 38,333.33
4 24,000 69,000 75,000 1,44,000 36,000.00
5 31,000 1,00,000 77,000 1,77,000 35,400.00
6 40,000 1,40,000 77,000 2,17,000 36,166.66
7 50,000 1,90,000 77,000 2,67,000 38,142.85
8 61,000 2,51,000 77,000 3,28,000 41,000.00

The new auto should be replaced after every 5th year. The average yearly cost would be `35,400. Since
the capacity of the new auto is 50% more than that of the old auto, therefore, capacity of two new autos

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 Chapter 10  •  Replacement Models403

is equivalent to three smaller autos. Thus, the minimum average yearly cost for the new auto will be
2
equal to 35, 400 × = ` 23, 600, which is less than average yearly cost `27,000 for one of the old autos.
3
Hence, the old, smaller auto should be replaced by a new auto.
The 3 old autos should be replaced with 2 new autos as the running cost for the next year of the 3
old autos exceeds the average yearly cost of 2 new autos.
The total cost of autos in the subsequent years are as follows:

Years Total cost of old autos

1 40,000
2 67,000 - 40,000 = 27,000
3 88,500 - 67,000 = 21,500
4 1,10,250 - 88,500 = 27,750
5 1,35,500 - 1,10,250 = 25,250
6 1,63,000 - 1,35,500 = 27,500

The average cost for 2 new autos will be 35,400 × 2 = `70,800, for 3 old autos 27,000 × 3 = `81,000.
Further, it is given that two autos are two years old and one is one year old. Therefore, total average
cost during first year will be 21,500 × 2 + 27,000 = `70,000 as two of the autos would be running in
the third year and the third one in the second year. Similarly, the average cost in the subsequent years
will be

2 × 21, 750 + 21, 500 = ` 65, 000 (2nd year )

2 × 25, 250 + 21, 750 = ` 72, 250 (3rrd year )
2 × 27, 500 + 25, 250 = ` 80,250 (4th year)

The total cost of three old autos up to the third year is `65,000 which is less than total average cost for
new autos. Total cost for three old autos during the fourth year is `72,250 which is more than the total
average cost for new autos (`70,800). Hence, all the three old autos should be replaced after two years
of service without waiting for the replacement age of five years.

10.2.2  Replacement Policy When Value of Money Changes with Time

Money value: The two interpretations of the phrase ‘money is 10% worth per year’ is as follows:
1. Spending `100 today is equivalent to spending `110 in a year’s time.
2. One rupee after a year from now is equivalent to (1.1)−1 rupee today.
Present worth factor: Since one rupee after a year from now is equivalent to (1.1)−1 rupee today
at the interest rate 10% per year, one rupee spent two years from now is equivalent to (1.1)−2
today. Similarly, we can say one rupee spent n years from now is equivalent to (1.1)−n today. The
quantity (1.1)−n is called the present worth factor (pwf) or present value of one rupee spent n
years from now.
Discount rate (depreciation value): The pwf of unit amount to be spent after one year is given
by V = (1 + r)−1 where r is the interest rate. Then V is called the discount rate.

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