For older assets that conform to this pattern of costs, it is only necessary to check whether the defender needs replacing due to costs over the next year, because in subsequent years the case for the defender will only get worse, not better. If there is an uneven yearly pattern of operating costs, the one year principle cannot be used, because the current year might give an unrealistic value due to the particular expenses in that year.
An asset is three years old. Yearly operating and maintenance costs are currendy 5000 rand per year, increasing by 10% per year. The salvage value for the asset is currendy 60 000 rand and is expected to be 50 000 rand one year from now. Can the one year principle be used?
The capital costs are not low (and thus the EAC(capital costs) for any given service life is not low) compared to the operating and maintenance costs. Even though costs have a regular pattern, the one year principle cannot be used.il
An asset is 10 years old. Yearly operating and maintenance costs are currently S5000 per year, increasing by 10% per year. The salvage value of the asset is currently S8000 and is expected to be S7000 one year from now. Can the one year principle be used?
The capital costs are low compared to the operating and maintenance costs, and costs have a regular pattern. The one year principle can be used. [3
An asset is 10 years old. Operating and maintenance costs average £5000 per year, increasing by 10% per year. However, most of the operating and maintenance costs consist of a periodic overhaul costing £15 000 that occurs even- three years. The salvage value of the asset is currently £8000 and is expected to be £7000 one year from now. Can the one year principle be used?
The capital costs are low compared to the operating and maintenance costs but the operating and maintenance costs do not have an even pattern from year to year. The one year principle cannot be used.B
The one year principle can be used when it is clear that the key conditions—low-capital costs and a regular year-to-year pattern of monotonically increasing operating and maintenance costs—are satisfied. Where a situation is ambiguous, it is always prudent to fully assess the EAC of the defender.
To fully explore the case of a defender being replaced by a challenger that repeats, as well as to explore some other ideas useful in replacement analysis, the next three subsections cover examples to illustrate the analysis steps. In the first, we examine the situation of replacing subcontracted capacity with in-house production. This is an example of replacing a service with an asset. In the second example, the issue of sunk costs is examined by considering the replacement of an existing productive asset with a different challenger. In the final example, we look at the situation of making replacement decisions when there are irregular cash flows.
7.6.1 Converting From Subcontracted to In-House Production EXAMPLE 7.7
Currently, the Jiffy Printer Company of Example 7.2 pays a custom moulder €0.25 per piece (excluding material costs) to produce parts for its printers. Demand is forecast to be 200 000 parts per year. Jiffy- is considering installing the automated plastic moulding system described in Example 7.2 to produce the parts. Should it do so now?
In Jiffy's situation, the defender is the current technology: a subcontractor. The challenger is the automated plastic moulding system. In order to decide whether Jiffy is better off with the defender or the challenger, we need to compute the unit cost (cost per piece) of production with the automated moulder and compare it to the unit cost for the subcontracted parts. If the automated system is better, the challenger wins and should replace the defender.
From Example 7.2:
EAC(moulder) = 39 844
Dividing the EAC bv the expected number of parts needed per vear allows us to calculate the unit cost as 39 838/200 000 = 0.1992.
When the unit cost of in-house production is compared with the €0.25 unit cost of subcontracting the work, in-house production is cheaper, so Jiffy should replace the subcontracting with an in-house automated plastic moulding system.^
This example has illustrated the basic idea behind a replacement analysis when we are considering the purchase of a new asset as a replacement to current technology. The cost of the replacement must take into account the capital costs (including installation) and the operating and maintenance costs over the life of the new asset.
Ln the next subsection, we see how some costs are no longer relevant in the decision to replace an existing asset.
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