How to Determine the Replacement Cost of Equipment

The decision to replace a piece of equipment should be based on facts and figures. The judgment which the owner-manager of a small company makes should be the result of weighing the costs of keeping the old equipment against the cost of its replacement.

This guide discusses the elements involved in making such a cost comparison. Examples are used to il­lustrate the gathering and use of the appropriate cost figures.

Sooner or later, you must decide whether you should keep an existing unit of equipment or replace it with a new unit. As time goes by, equipment deteriorates and becomes obsolete. Frequent breakdowns occur, defective output increases, unit labor costs rise, and production schedules cannot be met. At some point, these occur­rences become serious enough to cause you to wonder whether or not you should replace the equipment.

The problem is that the new equipment costs money, and the question that comes to you is: Will the advan­tages of the new equipment be great enough to justify the investment it requires?

You answer this question by making a cost comparison.

To recognize the better alternative you need to know the total cost of each alternative - keeping the old equipment or buying a replacement. Once these costs are determin­ed, you can compare them and identify the more economical equipment. The paragraphs that follow discuss the individual costs which you must consider when computing the total cost of the old and new equip­ment.

Depreciation

One of the costs connected with any type of equipment is depreciation. For cost comparison purposes, deprecia­tion is simply the amount by which an asset decreases in value over some period of time. For example, if you bought a piece of equipment for $20,000 and sold it for $6,000 after seven years of service, you would say that the depreciation during the seven-year period was $20,000 minus $6,000, or $14,000. This $14,000 was one of your costs of owning the equipment for that period.

From this, it follows that when considering equipment replacement, you must calculate the future depreciation expense that you will experience with both the old and the new equipment.

Insofar as the new equipment is concerned, this calls for knowing certain things about the equipment. You need to know (1) its first cost, (2) its estimated service life, and (3) its expected salvage value. The difference between the first cost and the salvage value will repre­sent the amount by which the equipment will depreciate during its life - that is, during the time you expect to use it.

You determine the depreciation expense for the old equipment in the same general way but for one impor­t difference. The difference is that no expenditure is required to procure the equipment because you already own it. However, a decision to keep it does require an investment at the present time. This investment is equal to the asset's market value - that is, to the amount of money the asset would bring in if it were replaced and sold. If this amount is not equal to the equipment's book value. the depreciation expense that was shown for accounting purposes is in error because it did not reflect the actual depreciation.

So to determine the actual future depreciation expense that will be experienced with the old equipment, you must know (1) its present market value, (2) its estimated remaining service life, and (3) its expected salvage value at the end of that life. The difference between the pre­sent market value and the future salvage value represents the amount by which the equipment will depreciate during its remaining life in your business.

To sum up, you must begin your cost comparison by determining the first cost of the new equipment and estimating its service life and salvage value. Also, you must determine the market value of the old equipment and estimate its remaining service life and future salvage value.

Interest

In addition to depreciation, every piece of equipment generates an interest expense. This expense occurs because owning an asset ties up some of your capital. If you had to borrow this capital you would have to pay for the use of the money. This "out-of-pocket" cost is one of the costs of owning the equipment.

The story is the same even when you use your own money. In this case, the amount involved is no longer available for other investments which could bring you a return. This "opportunity cost" is one of the costs of  owning the equipment.

To cite an example, suppose that the market value of an asset during a given year is $10,000. Suppose also that at the same time, you are getting capital at a cost of 15 percent per year. On the other hand, suppose that if you converted the asset into cash, you could invest the money and realize a rate of return of 15 percent per year. In either case, a decision to own that asset during that year would be costing you 15 percent of $10,000, or $1,500 in interest.

Thus, in any comparison of equipment alternatives, you must take the cost of money into account. So, when determining whether or not existing equipment should be replaced, you must estimate what money is costing you in terms of a percent per year.

Operating Costs

There is a third type of cost - the cost of operation - that is experienced with a piece of equipment. Typical operating cost are expenditures for labor, materials, supervision, maintenance, and power.

These cost must be considered because your choice of equipment affects them. You may find it convenient to estimate these costs on an annual basis. You can get figures for each unit of equipment by estimating its next-year operating costs as well as the annual rate at which these costs are likely to increase as wage rates rise and the equipment deteriorates.

For example, you might say that operating cost for the new equipment are likely to be $16,000 during the first year of its life. You might also estimate that after the first year, the operating costs will increase at a rate of $500 a year.

You can simplify the problem of estimating these costs by either (1) ignoring those costs that are the same for the old and the new equipment or (2) estimating only the differences between the operating costs of the two units. With this simplification, the total costs which you calculate for each type of equipment will be understated by the same amount. Therefore, the difference between these total costs will remain the same, and you will still be able to recognize the more economical alternative.

Everyone needs To be knowledgeable about the Decision Making Process. All of us rely on information, and tools or techniques, to
assist us in our daily lives.

When we head out To eat, the restaurant is the tool which supplies us with the information required to decide what to purchase and
how much to invest.

Running a Business also requires making decisions using information and techniques - how much inventory to maintain, what price to
sell it in, what credit agreements to provide, just how many people to employ.

Decision Making Procedure in business is the systematic procedure for identifying and solving issues, of asking questions and
finding answers. Decisions are made under conditions of uncertainty. The future is not understood and sometimes even the last is
suspect. This guide opens the door for company owners and managers to find out about the variety of techniques which can be
utilised to boost your decision making process in a world of doubt, change, and uncontrollable conditions.

A General Approach to Decision Making Procedure. If a scientist, or an executive of a significant company, or a small business
owner you can gain from improving your decision making abilities. The general approach to systematically solving issues is the
same. The following 7 step method to enhance management decision making can be used to study nearly all issues faced by a
business.

State that the problem. A issue first must exist and be recognized. What is the problem and why is it a issue. What's perfect and
how do present operations vary from this ideal. Describe why the symptoms (what's going wrong) and the causes (why is it going
wrong). Attempt to define all terms, concepts, factors, and relationships. Quantify the issue to the extent possible. If the
problem, not accurately and quickly fulfilling customer orders, try to determine just how many orders were incorrectly filled and
the length of time it took to fulfill them.

Define the Objectives. What are the objectives of the study. Which objectives are the most critical. Objectives are said by an
action verb like to reduce, to grow, or to improve. Returning to the customer order problem, the major objectives is: 1) to raise
the proportion of orders filled correctly, and 2) to decrease the time it takes to order and process. A sub-objective could
include to simplify and streamline the order fulfilling process.

Develop a Diagnostic Framework. Next set a diagnostic framework, which is, decide what methods will be used, what types of
information are required, and also how and where the info is to be found. Is there going to be a customer survey, a summary of
company documents, time and motion tests, or something different. Which are the assumptions (facts assumed to be right ) of the
study. What are the standards used to evaluate the study. What time, budget, or other limitations are there. What type of
quantitative or other specific processes will be utilized to analyze the information. (Some of that will be covered shortly). In
other words, the diagnostic framework determines the scope and processes of the entire study.

Collect and Analyze the Data. The next step is to gather the data (by following the procedures established in Step 3. Raw data is
then tabulated and coordinated to facilitate analysis. Tables, charts, graphs, indexes and matrices are a number of the standard
tactics to organize raw data. Analysis is the important requirement of audio business decision making. What does the data show.
What facts, patterns, and trends can be viewed in the information. Many of the quantitative techniques covered under can be used
during the step to determine facts, patterns, and trends in data. Obviously, computers are used widely in this measure.

Generate Alternative Solutions. After the analysis was completed, some specific conclusions about the character of the issue and
its resolution must have been reached. The next step is to create alternative solutions to the problem and position them in order
of the net benefits. But how are alternatives best generated. Again, there are some well established techniques such as the
Nominal Group Method, the Delphi Method and Brainstorming, amongst others. In these methods a team is involved, all people who
have reviewed the information and analysis. The method is to get an informed group suggesting many different feasible solutions.

Grow an Action Plan and Implement. Pick the ideal solution to the issue but be sure to understand clearly why it's best, that is,
how it achieves the goals established in Step 2 better than its alternatives. Then develop an effective method (Action Plan) to
execute the solution. At this stage a significant organizational thought arises - that is going to be accountable for seeing the
implementation through and what power does he possess. The selected manager ought to be accountable for seeing that all of tasks,
deadlines, and reports have been performed, met, and composed. Details are important in this step: reports, programs, activities,
and communication will be the key elements of any activity plan. There are several methods available to decision makers
implementing an action plan. The PERT method is a method of laying out an entire interval such as an action program. PERT will be
covered shortly.

Evaluate, Obtain Feedback and Monitor. Following the Action Plan was implemented to Fix a problem, management has to evaluate its
own effectiveness. Assessment Criteria have to be ascertained, feedback channels developed, and observation performed. This
Measure ought to be done following 3 to 5 weeks and again at 6 months. The goal is to answer the bottom line question. Has the
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