4.1. Calculation of Investment Costs

So, basically that is what is this economic life. Economic life means it is a time during which the cost of holding the machine will be minimum. So, beyond the economic life you can see that there will be increasing costs associated with the machine, either due to increase in the operating cost that is repair and the maintenance costs or increase in downtime costs or increasing obsolescence cost.

Economic life refers to the optimal period during which an asset, such as a machine, operates efficiently and economically. Up to its economic life, the costs associated with the asset—like repairs, maintenance, and downtime—are lower. However, once the economic life ends, these costs start to escalate, leading to higher total costs as the machine ages and potentially becomes less effective.

Consider a car, which, for the first five years, requires minimal maintenance and runs efficiently. After five years, however, repairs become more frequent and costly—like needing new brakes or tires—making it less economical to keep. This represents the concept of economic life.

In this example, we are going to see how to estimate the economic life of the machine. So, basically, so, here we are going to estimate economic life for a track mounted front shovel. The purchase price is 35,00,000. So, the machine is expected to last for 8 useful years and the depreciation is assumed to follow double declining balance method.

In this case study, the track-mounted front shovel is purchased for 35,00,000 and is expected to last 8 years. To assess its economic life, we apply the double declining balance method of depreciation, which accelerates the depreciation in the early years of the machine’s life. This technique helps in understanding how quickly the machine's value decreases over its useful life.

Imagine you buy a new laptop for a significant amount of money. Initially, it may lose value quickly as newer models are released, similar to a machine used in construction. This rapid depreciation reflects its declining worth over time, mimicking what happens with business equipment.

To get the depreciation using double declining balance method, we apply the formula. The first year depreciation D1 is calculated as 2/n × Book Value of the previous year. For the first year, D1 = 2/8 × 35,00,000 = 8,75,000. After 1 year, book value is 35,00,000 - 8,75,000 = 26,25,000.

The double declining balance method accelerates depreciation by applying a constant rate to the declining book value of the asset each year. For our example, we compute the first year's depreciation as 8,75,000, significantly reducing the machine's book value to 26,25,000 for the second year, and this process repeats for subsequent years.

Think of a new phone that loses value rapidly in its first year due to constant releases of newer models. The same principle applies when we compute depreciation—showing how quickly assets lose their initial value.

Due to inflation, the average cost of the equipment increases approximately by 6% per year. This means that the machine cost is going to increase by 2,10,000 every year due to the effect of inflation, which has to be considered during replacement analysis.

Inflation impacts the future costs of machinery, leading to an annual increase in its cost of 6%. This increase adds an important factor in replacement analysis, as it implies that one must account for rising costs when considering whether to keep or replace a machine.

Consider how the price of groceries increases each year due to inflation. If you’re budgeting for future expenses, you have to account for this rise, similarly to how companies must factor in rising machinery costs when planning replacements.

This replacement analysis involves evaluating all costs associated with machine ownership, including depreciation, inflation, and maintenance. Cumulative investment costs per hour can be calculated along with their impact across multiple years of use.

Cumulative costs refer to the total investment over time, highlighting how each logistical aspect (like depreciation and inflation) compounds when assessing whether to maintain or replace equipment. This cumulative perspective provides insights into the 'true cost' of retaining machinery versus investing in new assets.

If you keep a car for many years, all the maintenance, repair, and fuel costs accumulate. You might eventually spend more than a new one would cost due to constant repairs and inefficiencies, demonstrating the importance of cumulative cost analysis.

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