OPERATIONS RESEARCH: Replacement Theory

(Model)

By Sumit Jain
 Operations Research – Syllabus Overview By Sumit Jain

Unit Session Topic / Sub-topic Description Unit Session Topic / Sub-topic Description
OPERATIONS RESEARCH: CRITICAL PATH METHOD (CPM)/
 Meaning of OR PROGRAMMABLE EVALUATION REVIEW TECHNIQUES (PERT):
 Scope of Operations Research in Management,  Preparation of Net Work Diagram,
 Methodology of Operations Research,  Calculation of Floats,
 Types of Models, Advantages and Limitations of  Calculation of Time Estimates
III  Probability Calculation.
Models.
I REPLACEMENT THEORY:
 Need of Replacement
LINEAR PROGRAMMING:  Criteria for replacement single unit replacement and group
 Meaning of Linear Programming replacement.
 General mathematical formulation of Linear Decision Theory & Decision Trees
Programming, Graphical analysis, Simple Simplex Introduction to Decision Trees, Steps of Decision-Making Process,
method (Only Maximization Cases) Types of Decision-Making Environment.
IV (Theoretical Approach)
Decision Making under Risk: Expected Monetary Value (EMV),
TRANSPORTATION MODEL: Analysis with Decision Trees, Applications of Decision Theory &
Decision Tree
 Definition, Formulation,
 Methods to find initial basic feasible solution, (N-W Game Theory
Corner, Row / column / Matrix Minima, VAM)
II  Optimization (MODI & Stepping Stone Method) Introduction to Game Theory in OR, Two-Person Zero-Sum
V
 Time Minimization Games, Pure & Mixed Strategies, Games in Operations
ASSIGNMENT PROBLEMS: Management, Application of Game Theory in Decision-Making
 Definition
 Formulation and solution of Assignment problems.
 OPERATIONS RESEARCH: REPLACEMENT THEORY
Learning Objectives of PERT & CPM:
After reading this chapter, you will be able to:

• Understanding the fact that replacement of depreciable assets is necessary.

• Formulating theories for Replacement Theory

• Understanding replacement policy for goods whose cost of maintenance increases with time

and the value of money also changes at a constant rate at that time.

• Understanding the mechanism behind sudden failure of systems.

• Analyzing group replacement policy.

By Sumit Jain
 OPERATIONS RESEARCH: REPLACEMENT THEORY -
Introduction
Machines, equipment, and vehicles all do not work forever and they need to be replaced sooner or

later. With passage of time, the working efficiency of such assets goes down and increasingly greater amounts of

money are required to keep them running efficiently. But, at the same time, the longer the period an asset of this

type is used, the better it is because the original cost gets spread over a longer time and we can postpone the cost

of replacing it. The question facing a manager is as to when such an asset should be replaced: should it be used

until it breaks down and cannot be used any more or should it be replaced before this stage arrives? Further, while

the assets like machines and vehicles wear and tear gradually over fairly predictable range of time, there are others

like bulbs and electronic components which fail suddenly and need to be replaced immediately as they fail. The

present chapter considers this problem of replacement. It helps the manager to find answers to questions like the

following:

By Sumit Jain continue…

 OPERATIONS RESEARCH: REPLACEMENT THEORY -
Introduction
• For a gradually depreciating asset, given the cost of running and maintenance along with its cost price and the resale
value at different intervals of time, after what intervals of time should it be replaced?
• During the currency of use of an asset, if a better model or a new substitute becomes available, should the old asset be
replaced with the new one? In case we decide for this, then at what time should the replacement be done
immediately or after some specified time?
• If the time value of money is taken into consideration, then after what period would the replacement of the asset be
due?
• How to plan for the replacement of the items like bulbs and electronic components which are used in bulk and may fail
randomly? At what regular intervals of time it may advisable to replace them all?
• How is replacement of staff of an organization, which may be necessitated by reasons of death, departure, and
retirement, etc., of the employees, to be planned?
The answers to such questions are given by the theory of replacement on the cost considerations. Computation of
average costs, discounting of future costs/revenues, understanding application of probability, probability distribution and
expected value are the essentials for this chapter.
By Sumit Jain
 OPERATIONS RESEARCH: REPLACEMENT THEORY -
Introduction
Introduction

In any establishment, sooner or later all equipment need to be replaced. A replacement is called for whenever new

equipment offers more efficient or economical service than the old, existing one. For example, the old equipment

might fail and work no more, or is worn out and needs substantial expenditure on its maintenance. The problem, in

such situations, is to determine the best policy to be adopted with respect to replacement of the equipment. The

replacement theory provides answer to this question in terms of optimal replacement period. In our analysis, we

shall consider the question of replacement in the following situations…

 OPERATIONS RESEARCH: REPLACEMENT THEORY -
Introduction
• In respect of equipment/assets that deteriorate in performance over a time and may be restored in whole or in

part by expending maintenance costs. Thus, the existing assets might be good technically, yet on economic

considerations, it may not be worthwhile continuing with them and hence replacement may be called for.

Machinery, equipment, buildings fall in this category.

• In respect of units that perform adequately until sudden complete failure. The length of their service until failure

varies randomly over some predictable range. Car bulbs, tubes, some electronic components, etc. are the items

that are considered in this category.

• In respect of replacement of staff of an organization which diminishes gradually due to death, retirement,

retrenchment and other reasons.

We shall consider the three situations one by one.

OPERATIONS RESEARCH: REPLACEMENT THEORY FOR EQUIPMENT
WHICH DETERIORATES GRADUALLY
To determine the optimal replacement period, the period after which an equipment/machine should be appropriately
replaced, we proceed in the following manner. Initially, we shall assume that there is no time value of money. That is to
say, a rupee received at the end of a period, say 5 years, is regarded as good as a rupee received now.
We know that the cost of a piece of equipment over a given time period, say years, has three elements:
Purchase price - Value remaining after years + Maintenance cost for years
Let C - the purchase price of the equipment,
S - the scrap value of the equipment at the end of years,
- the maintenance cost of the equipment in year t.
The total cost, , of owning and maintaining the equipment for years shall be
Correspondingly, the average cost, , would be defined as,

In such a case, the optimal replacement period would be the one corresponding to which would be the minimum. To find
, we shall, first of all, determine the maintenance costs accumulated to the th year. To this, the cost of equipment, net of
its salvage value, would be added. The two would then be aggregated to get the total cost, , and then the total cost
divided by , the number of years, would give the average cost,
OPERATIONS RESEARCH: REPLACEMENT THEORY FOR EQUIPMENT
WHICH DETERIORATES GRADUALLY
When time value of money is not considered
Example: A firm is using a machine whose purchase price is Rs. 13,000. The installation charges amount to Rs. 3,600 and
the machine has scrap value of only Rs. 1,600 because the firm has a monopoly of this type of work. The maintenance
cost in various years is given in the following table:
Year 1 2 3 4 5 6 7 8 9
Cost (in Rs.) 250 750 1000 1500 2100 2900 4000 4800 6000

The firm wants to determine after how many years the machine should be replaced on economic consideration,
assuming that the machine replacement can be done only at the year ends.

By Sumit Jain
OPERATIONS RESEARCH: REPLACEMENT THEORY FOR EQUIPMENT
WHICH DETERIORATES GRADUALLY
Solution:
Determination of Optimal Replacement Period
Cumulative
Maintenance Capital Loss Total Running Average Cost
Years Maintenance
Cost, C–S Cost A
Cost,
1 250
2 750
3 1000
4 1500
5 2100
6 2900
7 4000
8 4800
9 6000
By Sumit Jain
OPERATIONS RESEARCH: REPLACEMENT THEORY FOR EQUIPMENT
WHICH DETERIORATES GRADUALLY
When time value of money is not considered
Example: The simple engineering company has a machine whose purchase price is Rs. 80,000. The expected
maintenance costs and resale price in different years are as given here:
Year 1 2 3 4 5 6 7
Maintenance Cost (in Rs.) 1000 1200 1600 2400 3000 3900 5000
Resale Value in (‘000 Rs.) 75 72 70 65 58 50 45

After what time interval, in your opinion, should the machine be replaced?

By Sumit Jain
 OPERATIONS RESEARCH: REPLACEMENT THEORY FOR EQUIPMENT
WHICH DETERIORATES GRADUALLY
Solution: Given Purchase Price of the Machine = Rs. 30,000/-
Year 1 2 3 4 5 6 7
Maintenance Cost (in Rs.) 1000 1200 1600 2400 3000 3900 5000
Resale Value in (‘000 Rs.) 75 72 70 65 58 50 45

Determination of Optimal Replacement Period

Cumulative Total
Years
Maintenance
Maintenance Resale Value Capital Loss Running Average
Cost,
Cost, (S) C–S Cost Cost A

1 1000
2 1200
3 1600
4 2400
5 3000
6 3900
7 5000
By Sumit Jain
OPERATIONS RESEARCH: REPLACEMENT THEORY FOR EQUIPMENT
WHICH DETERIORATES GRADUALLY
When time value of money is considered

By Sumit Jain
OPERATIONS RESEARCH: REPLACEMENT THEORY FOR EQUIPMENT
WHICH DETERIORATES GRADUALLY
When time value of money is considered
Example: A machine cost Rs. 15,000. The Running cost for the different years are given below:

Year 1 2 3 4 5 6 7
Running Cost (in Rs.) 2500 3000 4000 5000 6500 8000 10000

Find the optimum replacement period if the capital has money value 10% per year and has no salvage value.

By Sumit Jain
OPERATIONS RESEARCH: REPLACEMENT THEORY FOR EQUIPMENT
WHICH DETERIORATES GRADUALLY
Solution: Determination of Optimal Replacement Period

Price Total Cost =

Maint. Price Value Cumulative
Years Value Cost + Annualised Cost
Cost, of PV Factor
Factor

1 2500

2 3000

3 4000

4 5000

5 6500

6 8000

7 10000

By Sumit Jain
OPERATIONS RESEARCH: REPLACEMENT THEORY FOR EQUIPMENT
WHICH DETERIORATES GRADUALLY
When time value of money is considered
Example: A machine X costs Rs. 5,000. Its maintenance cost is Rs. 1,000 in each of the first four years and then it
increases by Rs. 200 every year. Assuming that the machine has no salvage value and the maintenance cost is incurred in
the beginning of each year, determine the optimal replacement time for the machine assuming that the time value of
money is 10% p.a.

By Sumit Jain
 OPERATIONS RESEARCH: REPLACEMENT THEORY FOR EQUIPMENT
WHICH DETERIORATES GRADUALLY
Solution: Determination of Optimal Replacement Period
Price Total Cost =
Maint. Price Value Cumulative
Years Value Cost + Annualised Cost
Cost, of PV Factor
Factor
1 1000
2 1000
3 1000
4 1000
5 1200
6 1400
7 1600
8 1800
9 2000
10 2200
11 2400
12 2600
By Sumit Jain
OPERATIONSOPERATIONS
RESEARCH: REPLACEMENT
RESEARCH: CPM THEORY

By Sumit Jain