1.2. Example of Estimating Economic Life

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 period during which a machine operates efficiently with minimal holding costs. Once this period ends, costs such as repairs, maintenance, and obsolescence start accumulating, making it costly to keep the machine. Therefore, understanding the economic life helps in knowing the optimal time to replace machinery to avoid unexpected losses and rising costs.

Think of a car that you own. In the first few years, the car runs smoothly and requires minimal maintenance. After several years, repairs begin to pile up, and it experiences more breakdowns. Eventually, it may become more expensive to maintain than to buy a new one. That optimal period before repairs increase rapidly is similar to the economic life of a machine.

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. So, we are going to follow double declining balance method to estimate the depreciation. And at the end of the 8 years you will be able to sell the machine at the cost of rupees 7,00,000. That means the salvage value of the machine is 7,00,000.

Here, we’re examining a specific example of a track mounted front shovel valued at 35 lakh. The machine can be effectively used for 8 years, during which it will depreciate using the double declining balance method. At the end of its life, the expectation is to sell it for a salvage value of 7 lakh. This understanding of purchase price, duration of use, and salvage value is crucial in calculating the total economic life.

Imagine buying a computer for your business. If you expect it to last for 5 years and it costs $1,000, and you can sell it for$200 after that, you can calculate how much value the computer provides to your business each year, helping you decide whether to upgrade or keep using it.

Due to inflation, you can see that annual increase of the average cost of the equipment is approximately 6%. That means, the machine cost is going to increase by 2,10,000 every year, due to the effect of inflation.

Inflation affects everything, including equipment costs. In this example, a 6% annual inflation rate causes the machine's cost to increase by about 2,10,000 each year. This factor must be considered when evaluating whether to keep the machine or replace it because it adds to the overall cost of ownership.

Consider your grocery bills. Each year, the price of items you purchase may increase due to inflation, meaning that what you could buy for $100 last year might now cost you$106. This price increase must be factored into your budget, just like increased costs for machinery must be factored into business decisions.

So, we have to estimate the economic life of this machine. For calculating the hourly maintenance and repair cost, downtime cost, and obsolescence cost of the machine, we have to use the following values and the equipment cost is given approximately as rupees 900 per hour.

To determine the total cost of ownership of the machine, one must calculate various factors including maintenance, repair, downtime, and obsolescence costs. The costs can be broken down into an hourly rate, which in this case is approximately 900 rupees per hour. Accurately estimating these costs is essential for informed decision-making about equipment replacement.

If you own a bicycle, you might think about the costs of maintenance (like tires or brakes), since it might cost you a few dollars each time. Keeping track of these small costs can help you determine whether to keep repairing your old bicycle or save up for a new, more efficient model.

Downtime is nothing but the unavailability of your machine for the productive work. So, it may be either due to the breakdown of the machine. As I told you, when the machine is not available for productive work, you will be facing some loss in productivity. The obsolescence cost is also important as the age of the machine increases, it becomes obsolete. There may be different reasons for the obsolescence either due to technological obsolescence, that is due to wear and tear, its productivity may get reduced, or it may be even due to market obsolescence.

Downtime refers to the periods when the machine is non-operational, causing lost productivity and increased costs. Additionally, a machine may become obsolete due to technological advancements or changing market demands, requiring new investments to maintain competitiveness. Understanding these factors helps inform decisions about whether to keep or replace machinery.

Imagine running a bakery with an oven that breaks down frequently. Each time it does, you can’t bake and lose customers. Similarly, if a newer oven exists that bakes faster or with better quality, your old oven may become less valuable, necessitating a replacement to avoid losing business altogether.

So, now let us work out the cost associated with the machine from the replacement analysis perspective. First we are going to estimate the depreciation and the replacement cost associated with this machine. The initial cost of the truck is 35,00,000 and the annual increase in the cost you can see that it is 2,10,000 every year, due to the inflation.

To analyze the replacement costs effectively, it is crucial to understand how depreciation affects the machine's value over time. Initially valued at 35 lakh, this truck will not only depreciate but also incur additional replacement costs yearly due to inflation. This highlights the importance of adjusting financial forecasts to reflect changing asset values.

Think of a smartphone. When you buy it for $800, its value decreases over time due to use and newer models being released. If you look to sell it a few years later, its market value will include depreciation and any new costs of similar models you might consider buying.

Now, what is the loss associated with the replacement? As I told you, due to inflation, there is an increase in costs every year. For instance, at the end of the first year, the book value is 26,25,000... loss on replacement.

When considering replacing a machine, it is essential to calculate the financial loss incurred from replacement. For example, if you wait until the end of the first year, after accounting for inflation and depreciation, you might find you're losing out. Evaluating losses helps in making timely decisions about replacements.

If you sell your old car just after the mechanic tells you it will need expensive repairs, the money you get from its sale may not cover the costs of a newer model. Identifying the right time for replacement can prevent unnecessary losses.

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