Hawassa University

College of Business and Economics

Department of Accounting and Finance
Operations Research
Group Assignment

Name ID

1. Dagim Tigistu 0351/14

Replacement Theory
The replacement theory is used in the decision making process of replacing a used equipment
with a substitute; mostly a new equipment of better usage. It is concerned with the situations
that arise when some items such as machines, equipment, computer, etc. need replacement
due to their decreased efficiency, failure or break-down. The replacement problem arises
primarily because of the following reasons:

➢ The old item works badly or requires expensive maintenance

➢ The old item has failed due to accident or otherwise and does not work at all, or the old
item is expected to fail shortly.
➢ A better or more efficient design of machine or equipment has become available in the
market.

FAILURE MECHANISIM OF ITEMS

Gradual failure

Gradual failure is progressive in nature, i.e., as the life of an item increases, its operational
efficiency also deteriorates. This result in increase in running (maintenance and operating)
costs, decrease in its productivity, decrease in the resale or salvage value.

Sudden failure

This types of failure occurs in items after some period of desired service rather than
deterioration while in service. The period of desired service is not constant but follows some
frequency distribution. Sudden failure may be progressive, retrogressive or random in nature.

(a) Progressive failure - If the probability of failure of an item increases with the increase in its
life, then such a failure is called progressive failure. For example, light bulbs and tubes fail
progressively.

1
(b) Retrogressive failure - If the probability of failure at the beginning of the life of an item is more
but as time passes the chances of its failure become less, then such failure is said to be
retrogressive.

(c) Random failure - In this type of failure, the constant probability of failure is associated with
items that fail due to random causes but not related to age. For example, vacuum tubes in air-
born equipment have been found to fail at a rate independent of the age of the tube.

2
Costs Associated with Maintenance
(a) Purchase cost or Capital cost: ( C )

This cost is independent of the age of the machine or usage of the machine. This is incurred at
the beginning of the life of the machine, i.e. at the time of purchasing the machine or
equipment. But the interest on the invested money is an important factor to be considered.

(b) Salvage value / Scrap value / Resale value / Depreciation: (S)

As the age of the machine increases, the resale value decreases as its operating efficiency
decreases and the maintenance costs increases. It depends on the operating conditions of the
machine and life of the machine.

(c) Running costs including maintenance, Repair and Operating costs:

These costs are the functions of age of the machine and usage of the machine. As the usage
increases or the age increases, due to wear and tear, many components fail to work and they
are to be replaced. As the age increases, failures also increase and the maintenance costs goes
on increasing. At some period the maintenance costs are so high, which will indicate that the
replacement of the machine or equipment is essential.

3
REPLACEMENT OF ITEMS WHOSE EFFICIENCY REDUCES OR MAINTENCNCE COST INCREASES
WITH TIME OR DUE TO AGE AND MONEY VALUE IS NOT CONSIDERED

Costs to be considered: Various cost items to be considered in replacement decisions are the
costs that depend upon the choice or age of item or equipment. The costs those do not change
with the age of the machine or item need not be taken into consideration. The replacement of
items whose efficiency reduces with time is justified when the average cost per time period
goes on reducing longer the replacement is postponed. However, there will come an age at
which the rate of increase of running costs more than compensates the saving in average
capital costs. At this age the replacement is justified.

In the case of replacement of items whose efficiency deteriorates with time, the most
important criteria to be considered is the measurement of efficiency. Consider a machine, in
this case, the maintenance cost always increases with time and usage and a time comes when
the maintenance cost becomes large enough, which indicates that it is better and economical
to replace the machine with a new one. When we want to replace the machine, we may come
across various alternative choices, where we have to compare the various cost elements such
as running costs and maintenance costs to select optimal choice. The various techniques we
may come across to analyze the situation are:

(a) Replacement of items whose maintenance cost increases with time and value of money
remains same during the period,

(b) Replacement of items whose maintenance cost increases with time and the value of
money also changes with time, and

4
Replacement of Items whose Maintenance Cost Increases with Time and the Value of Money
Remains Same During the Period

5
Case 2.

Here time ‘t’ is considered as a discrete variable. In this case, the time period is taken as one
year and ‘t’ can take the values of 1, 2, 3 …etc., then,

6
Replacement of Items whose Maintenance Costs Increases with Time and Value of Money
also Changes with Time

Present worth factor: Before dealing with this model, it is better to have the concept of Present
value. Consider replacement of items which involve huge expenditure, both initial value
(Purchase price) and maintenance expenses. For a decision maker, there may be number of
alternatives for replacement. But he always chooses the alternative, which minimizes the
annual average cost. Here manager uses the concept of present value of money to select the
alternatives. The present value of number of expenditures incurred over different periods of
time represents their value at the current time. It is based on the fact that, one can invest
money at an interest rate ‘r’ to produce the same amount of money at the end of certain time
period or if an amount is to be spent in different years what is the worth of total expected
expenses or its worth today? We can also think in another way. Suppose a businessman
borrows money for his initial investment and working capital from various sources, he has to
pay interest for the money he has borrowed. The amount of interest he has to pay depends on
the rate of interest and the period for which he has borrowed (that is the period in which he
has repaid the amount borrowed). The borrowed money is known as Principal (P), and the
excess amount he has paid is known as Interest (i). The sum of both principal and the interest is
known as Amount (A).

7
REPLACEMENT OF ITEMS THAT FAIL COMPLETELY AND SUDDENLY AND ARE EXPENSIVE TO BE
REPLACED

There are certain items or systems or products, whose probability of failure increases with
time. They may work with designed efficiency throughout their life and if they fail to act they
fail suddenly. The nature of these items is they are costly to replace at the same time and their
failure affect the functioning of entire system. For example, resistors, components of air
conditioning unit and certain electrical components. If we do not replace the item immediately,
then loss of production, idle labour; idle raw materials, etc are the results. It is evident failure of
such items causes heavy losses to the organization. Such situations demand the formulation of
a policy, which will help the organization to avoid losses. sometimes we find it is better to
replace the item before it fails so that the expected losses due to failure can be avoided. The
following courses of action can be followed:

8
 Individual replacement policy

This policy states that replace the item soon after its failure. Here the cost of replacement
will be somewhat greater as the item is to be purchased individually from the seller as and
when it fails. From the time of failure to the replacement, the system remains idle. More
than that, as the item is purchased individually, the cost of the item may be more. In case,
the component or the item is not available in the local market, we have to get it from other
places, where the procurement cost may be higher for individual purchase. If the
management wants to adopt this policy, it may have to waste its time and money also the
losses due to failure.

Group replacement policy

If the organization has got the statistics of failure of the item, it can calculate the average
life of the item and replace the item before it fails, so that the system can work without
break. In this case, all the items, even they are in good working condition, are replaced at a
stipulated period as calculated by the organization by using the group replacement policy.
One thing we have to remember is that, in case any item fails, before the calculated group
replacement period, it is replaced individually immediately after failure. Hence this policy
utilizes the strategy of both individual replacement and group replacement.

The probability distribution of the failure of the item in a system can be determined by
mortality tables for life testing techniques.

Mortality Tables

The mortality theorem states that a large population is subjected to a given mortality law
for a very long period of time. All deaths are immediately replaced by births and there are
no other entries or exits. Here age distribution ultimately becomes stable and that the
number of deaths per unit of time becomes constant, which is equal to the size of the total
population divided by the mean age at death. If we consider the problem of human
population, no group of people ever existed under the conditions that:

(a) That all deaths are immediately replaced by births.

(b) That there are no other entries or exists. These two assumptions help to analyze the
situation more easily, by keeping virtual human population in mind. When we consider
an industrial problem, deaths refer to item failure of items or components and birth
refers to replacement by a new component.

9
10