A replacement decision asks: keep using the existing asset (the defender), or replace it with a new one (the challenger)? Compute the EAC of each option and pick the lower one. The framing has a few subtleties specific to replacement analysis though.
Reasons to replace or retire an asset:
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Replacement (substituting a new asset for the old one) happens when the defender’s performance has degraded (rising maintenance costs, lower output, more downtime) or when a better technology has appeared (lower operating cost, higher capacity, new capabilities).
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Retirement (removing the asset entirely without replacement) happens when the service it provided is no longer needed.
The decision is recurring: defender vs. challenger is re-asked each year as long as the defender remains in service. New challengers may appear, the defender keeps aging, and what was the right call last year may not be the right call this year.
Economic life vs. physical life vs. service life
- Physical life is how long the asset can run before it physically falls apart. Can be decades.
- Service life is how long the asset is in service, which could be less than physical life if it’s retired early.
- Economic life is the cost-minimising life: the age at which the EAC of keeping the asset is at its minimum.
Economic life is usually shorter than physical life. As an asset ages, capital cost amortised per year (which falls, since you’ve owned it longer) trades off against operating-and-maintenance cost per year (which rises, since the asset is wearing out). The optimal hold is where the EAC bottoms out. Holding longer than economic life costs more even though the capital is “free” by then.
Ignore sunk costs
The defender’s original purchase price is a sunk cost, so it’s irrelevant. What matters for keep-or-replace is the defender’s current market value (the opportunity cost of not selling it now) and its future cash flows (O&M costs, eventual salvage).
So the defender’s “first cost” in the EAC calculation is the current market value, not the historical purchase price. Market value is what you’d get selling it today, which is the value you give up by keeping it.
Replacement scenarios
Three scenarios show up:
Scenario 1: Identical defender and challenger (asset need is indefinite, life cycle repeats).
The challenger today is identical to the defender, and any future replacement will also be identical. Stable technology, stable prices, stable interest rates. Rule: replace when EAC_capital is minimised, i.e. when the defender reaches its economic life. The replacement time falls straight out of the EAC vs. age curve.
Scenario 2: Different defender and challenger (same challenger continues indefinitely).
You have an old defender, a new challenger, and assume any future replacement is a new copy of the challenger. Rule:
- Find the economic life of the challenger and its EAC_c at that life.
- Compute the defender’s EAC_d for each remaining year of its useful life.
- If EAC_d > EAC_c at any point, replace now.
- Otherwise, monitor: as the defender ages, EAC_d eventually rises above EAC_c at year . Replace at year , the last year before the defender is more expensive.
Scenario 3: Different defender, different future challengers.
Future challengers are expected to be technologically different (cheaper, more capable, less polluting). The most realistic case for tech-heavy assets, and the messiest to analyse: it needs a forecast of future challenger economics, which is largely guesswork. Not covered here.
One-year principle
When capital costs are small relative to O&M costs and O&M costs rise steadily with age, the defender’s economic life simplifies to one year: the marginal year-of-keeping is the right comparison. EAC_total reduces to EAC_O&M evaluated at .
A handy shortcut for old, paid-off assets whose decision really is “one more year, or replace?” For assets whose capital was sunk long ago, the simplification is close to exact.
See Equivalent annual cost for the cost-component breakdown.