The interest rate assumed is a critical item in the
analysis. How does a maintenance manager
decide what value to use? Long-term treasury
bond yields are often used
analysis. How does a maintenance manager
decide what value to use? Long-term treasury
bond yields are often used
Operation and Maintenance Engineering Branch,
D-5850, Denver Office, for the proper rate for
your problem.
D-5850, Denver Office, for the proper rate for
your problem.
3.2. Sunk costs.- Funds that have been spent
are called "sunk costs." In economic analysis,
always disregard sunk costs (except possibly to
learn and moan) as they are now financially
irrelevant. Economic analysis is for the purpose
of examining expenditure of funds for future
alternatives. Therefore, when a project is being
built, an economic analysis that is performed in
successive years during construction would
show declining project costs, since funds already
spent for construction are "sunk" and are no
longer evaluated. If the benefits of such a project
remain constant, or increase, the B/C
(benefit/cost) ratio would increase for each new
year in which the economic analysis is
performed. With zero base budgeting concepts,
economic analyses are often performed each
year for a particular project, and if the project
develops as expected, the successive analyses
show increasing B/C ratios.
are called "sunk costs." In economic analysis,
always disregard sunk costs (except possibly to
learn and moan) as they are now financially
irrelevant. Economic analysis is for the purpose
of examining expenditure of funds for future
alternatives. Therefore, when a project is being
built, an economic analysis that is performed in
successive years during construction would
show declining project costs, since funds already
spent for construction are "sunk" and are no
longer evaluated. If the benefits of such a project
remain constant, or increase, the B/C
(benefit/cost) ratio would increase for each new
year in which the economic analysis is
performed. With zero base budgeting concepts,
economic analyses are often performed each
year for a particular project, and if the project
develops as expected, the successive analyses
show increasing B/C ratios.
An example of a maintenance problem involving
sunk costs is:
sunk costs is:
· Problem.- $1,000,000 have been spent
on procurement and installation of airblast
power circuit breakers. After 3 years of
service, it has been found that the
breakers are totally unreliable and will
have to be replaced. The salvage value of
the breakers for scrap metal is $10,000
net, Including removal costs. The cost of
suitable new oil breakers is $1,500,000;
should they be purchased?
on procurement and installation of airblast
power circuit breakers. After 3 years of
service, it has been found that the
breakers are totally unreliable and will
have to be replaced. The salvage value of
the breakers for scrap metal is $10,000
net, Including removal costs. The cost of
suitable new oil breakers is $1,500,000;
should they be purchased?
· Solution.- The only relevant costs for
economic analysis are: $1,500,00 (new
breakers) - $10,000 (salvage) =
$1,490,000 (net). The decision to spend a
net of $1,490,000 for new breakers is
independent of the $1,000,000 sunk cost.
economic analysis are: $1,500,00 (new
breakers) - $10,000 (salvage) =
$1,490,000 (net). The decision to spend a
net of $1,490,000 for new breakers is
independent of the $1,000,000 sunk cost.
4. ECONOMIC LIFE AND TERMINAL VALUE
An economic analysis extending over
several years must recognize that
equipment wears out and must be replaced.
Usually it is not obvious what equipment life
to assume, and we must rely on what
experience has shown from operating
similar equipment. Reclamation engineers have
made detailed studies of equipment operating
histories and have been able to establish
statistical "service life" values for a wide variety
of equipment and structures. A summary of
these studies may be found in "Replacements-
Units, Service Lives, Factors," Bureau of
Reclamation, pages III-1 through III-11, May,
1989.
several years must recognize that
equipment wears out and must be replaced.
Usually it is not obvious what equipment life
to assume, and we must rely on what
experience has shown from operating
similar equipment. Reclamation engineers have
made detailed studies of equipment operating
histories and have been able to establish
statistical "service life" values for a wide variety
of equipment and structures. A summary of
these studies may be found in "Replacements-
Units, Service Lives, Factors," Bureau of
Reclamation, pages III-1 through III-11, May,
1989.
4.1. Economic life.- The service life, or eco-
nomic life, of a class of equipment is the time in
which savings (benefits) gained through using
the equipment accrue to the organization.
There are three ways to determine whether
equipment has reached the end of its useful
service life:
nomic life, of a class of equipment is the time in
which savings (benefits) gained through using
the equipment accrue to the organization.
There are three ways to determine whether
equipment has reached the end of its useful
service life:
· Physical life - Determined to be over when
the machine is no longer repairable
the machine is no longer repairable
· Technological life - Determined to be over
when the machine is made obsolete by
availability of improved models.
when the machine is made obsolete by
availability of improved models.
· Product life - Determined to be over when
there is limited production of an item, and
the life ends with production of the last unit.
there is limited production of an item, and
the life ends with production of the last unit.
In evaluating these three methods, the shortest
life from among the three should be used in the
economic analysis.
life from among the three should be used in the
economic analysis.
4.2. Terminal value.- The selvage value, or terminal
value, of equipment is determined, at the end of the
equipment life, to be the sale value minus the cost
of disposal. Terminal values are usually determined
by making straight-line or percentage projections of
equipment resale data. The most familiar source of
terminal value data is the "Blue Book" used by
automotive dealers in determining used car trade-in
allowances for new car purchases. The terminal
value, of equipment is determined, at the end of the
equipment life, to be the sale value minus the cost
of disposal. Terminal values are usually determined
by making straight-line or percentage projections of
equipment resale data. The most familiar source of
terminal value data is the "Blue Book" used by
automotive dealers in determining used car trade-in
allowances for new car purchases. The terminal
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