Describe the significance of "Annual Equivalent Value" in Asset Replacement decisions ?

The parts replacement decision & Average Annual  Equivalent Costs

The parts replacement 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 parts replacement 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?

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 are based on the study of the following factors:

Depreciation/Interest/Operating costs/Revenues Annual Average costs/The old equipment/Annual Depreciation expense/Annual Interest Expense/Annual Operating costs/Average annual costs/ The new equipment/Item average annual costs are useful for comparisons

Annual Interest Expense. Next, you calculate the average annual interest expense. The maximum investment in the equipment is $7,000, its present market value. But as time goes by, the investment in the asset decreases because its market value decreases. The minimum investment is reached at the end of the equipment's life when it has a salvage value of $1,000. The average investment will be the average of these maximum and minimum values. You calculate it

Average investment = $7000 + $1000 /2 =$4000

To determine the average annual interest expense, you multiply the average investment ($4,000, in this example) by the annual interest rate of12 percent. Doing so yields:

Annual Interest = $4,000 x .12 = $480

Annual Operating Costs. You can determine the average annual operating costs by computing the average of the individual annual operating costs. In this example,

they are estimated to be $8,000, $8,200, $8,400, and $8,600. The average for these figures is $8,300 which you obtain as follows:

Annual operating costs =(  $8,000 + $8,200 + $8,400 + $8,600 )  /4 =  $8300

Total Average Annual Equivalent  Cost. For the old equipment, the total average annual cost is simply the sum of the calculated average annual cost for: (1) depreciation, (2) interest, and (3) operating expenses.

This sum is $10,280, as shown below.

Item Average annual cost

Depreciation $1,500

Interest480

Operating Costs8,300

Total $10,280