(205)---REPLACEMENT OF AN EXISTING ASSET

Replacement of an Existing Asset

We have discussed in our previous posts the method of constant replication or replacement chains to choose between assets with different lives. In those cases we assumed that assets are replaced at the end of their physical lives. In practice, replacement decisions should be governed by the economics and necessity considerations. An equipment or asset should be replaced whenever a more economic alternative is available.

A number of companies follow the practice of approving a new machine only when the existing one can no longer perform its job. These companies follow a simple policy of replacement: replacement is necessary when the machine is beyond repair. They do not decide when to replace, the machine decides for them. This is one of the most expensive wrong policies, which a company could follow. Such a policy erodes the company’s profitability by protecting high operating costs. If the competitors follow cost-reduction policies by following a systematic replacement policy and are able to reduce prices in the future, the high cost company will be squeezed out of the market sooner or later.

Management should follow a replacement policy based on economic considerations and decide when to replace. An economic analysis may indicate to replace machine when it is, say, 5 years old with an improved alternative. If the replacement actually takes place when the machine is, say, 20 years old when it is beyond any repair, the company has been incurring extra costs and losing profits for 15 years.