Maintain, Refurbish, or Replace

Published on Tuesday, 10 December 2013 08:40:50    Written by Marc
In capital expenditure planning, the question about what to do with equipment that is getting older, or more precisely, closer to the end of its life, seems to always come back repeatedly. With just about every piece of equipment, the question will be asked, “Should we continue to maintain it, refurbish it, or simply replace it?”

replace maintain or refurbishI did some research to try and find information on the internet about how to conduct these decisions and there does not seem to be anything specific to help companies, which is interesting considering how often people in companies are faced with such decision making. Therefore, I decided to try it and see what criteria and items we should consider when faced with choices such as maintaining, refurbishing, or replacing equipment.

While there are some formulas, concepts, and opinions on what a company should do with aging equipment and unfortunately, things do not seem to work the same in theory as in real life. It is not like gravity, which can be calculated with precision, and works both the same way in real life and theory. Because people do not manage everything with formulas, the reality of what is done is often different from the cold logic.

An Example

For example, take a piece of equipment, say a widget maker. If the cost of the equipment is $100,000 and it costs normally $10,000 to maintain it. Over the years, some parts will start to break and you will most probably find yourself replacing them here and there. The first five years you only had to do normal maintenance. Now, it is a $10,000 motor. The coming year, you are probably looking at a $12,000 mechanism and a $5,000 control system that you needed to change. While the rest of the widget maker is still good, you start to think that at the rate you are changing parts, soon you will have paid for a new widget maker in parts alone, without having a new widget maker. How long should you continue to maintain the equipment this way before you do a complete refurbish or a replacement?

While each situation is different, the approach to the problem should not always be. Regardless of what the equipment is, there are basic elements that are the same:

  1. The equipment had an original cost and now has a residual value (even if its zero, the idea is that you can put an approximate value on the equipment)
  2. The equipment has maintenance costs (these are costs which regardless if your equipment was old or fairly new you would have anyway, much like oil change in a car)
  3. The equipment has irregular costs (parts breaking that need to be replaced, adjustment requirements that are not deemed to be standard maintenance)
  4. The equipment has downtime cost (how much you lose in production when the equipment goes down).
  5. What is the cost of new equipment?
  6. What are the features (including efficiency related ones) of new equipment? In this, we include the loss of opportunity in keeping our old non-efficient equipment alive.
  7. What is the period you want to consider (in months or years)?

These seven items above represent the bulk of the inputs you need to consider when deciding whether to continue to maintain, refurbish, or replace a piece of equipment.

How People Normally Calculate In Order to Make Decisions

The theoretic way to look at things is to calculate all costs for a considered period of time and see what makes more sense, whether to continue maintaining the equipment, refurbishing it, or replacing it. How is this done? Let us have a look.

Say you want to consider the best decision for the next five years, and you choose this because you know that new equipment would give you five years without having any major components breaking, you would only need to conduct normal maintenance for the first five years on new equipment.

Then, consider for each of the three scenarios: Maintain, refurbish, or replace. What would be the total cost? We must remember that to get a good picture, we need to include the depreciation cost as well, not only the cost to operate the equipment.

We are at the end of year six and need to take a decision on our widget maker. Let us see our choices:

  1. Maintain

    You equipment is now six years old (from the example above) and since you amortized it over five years, it is already fully amortized. Let us assume that you are now expensing all parts that you replace (in real life, you would probably amortize some major parts that extend the life of the equipment).

    Therefore, in year six, you spent $10,000 for parts in addition to the normal $10,000 for maintenance and in year seven, you now anticipate spending another $17,000 on parts, in addition to normal maintenance costs. For years eight to 11 your guess is that you will continue to replace about $17,000 of parts each year. Let us go to item number two and come back to the maintain scenario later.

  2. Refurbish

    We know that for the coming year, year seven, we will need to spend $17,000 for parts and probably that same amount for years eight to 11, so for five years in total (years seven to 11 included), a total of $85,000, not counting the normal maintenance of $10,000 per year. Suppose you could refurbish the equipment for $50,000 today and have equipment that would be under warrantee for one year would it make sense to refurbish it? Before we answer this, let us look at choice number three.

  3. Replace

    In this choice, we simply replace the equipment by a new one. If the new purchased equipment is as good as the original one, it should give us five years headache free so only the normal maintenance cost of $10,000 (assuming here that it is the same cost) needs to be considered. However, the cost of the new equipment is $130,000, which is more than the original $100,000 one we purchased six years ago. The good thing is that this new equipment is 10% more productive and should bring in, say, $30,000 more revenue per year.

Now, even with the info on the three choices, we still do not know what to do. Let us go back to choice number two for a second. In this situation, paying for $50,000 now should make the equipment last another five years instead of continuing to pay $85,000 over the next five years to continue to maintain it. Suppose your cost of access to money is 10% a year. We will use this as a discount rate.

If you calculate your costs for both scenarios, paying $17,000 per year over five years is the same in today’s money as $70,885 (I assume we pay the $17,000 in the beginning of each year). In this case, we see that it makes more sense to refurbish the equipment for $50,000 today than to continue to pay $17,000 per year for repairs. This is what theory says. In real life however, we are dealing with unknowns.

  • We do not know if the refurbish will really last five years before other parts will break.
  • We do not know if we will be able to continue to purchase spare parts in the future. What if the manufacturer stops supporting this equipment and it is not possible to get new parts anymore? (That would obviously force a replacement of the equipment).
  • We only can assume the linear cost of $17,000 per year if we continue to maintain the equipment, who knows if the costs will not escalate or if the equipment will not completely die on us next year.
  • How much downtime will we be having in the coming years? If the equipment is crucial to the operations and keeps breaking down each month, you might want to refurbish it even if the cost today is higher than the estimated cost of continuing to maintain the equipment.

Let us look again at the replacement choice now:

For $130,000, you can purchase a brand new widget maker, which, because of increased efficiency will bring you $30,000 in additional annual revenue. If you make 10% profit on your revenue (I take 10% since it is easy to calculate here), that new widget maker brings in $3,000 in savings compared to other choices.

If you amortize it over the next five years, we can consider the full cost in our analysis (assuming it will be worth zero at the end of five years). The $3,000 in extra profit for five years at 10% discount rate (supposing we get the revenue at year-end) represents approximately $11,372 in today’s money. I use a 10% discount rate because it is easier to calculate here.

The total cost of the new widget maker is really $130,000 - $11,372 or $118,628. In this case, we are assuming that the new widget maker will be up and running to full capacity with no problem or adjustments needed from day one. Again, in reality things are often very different.

In theory, spending $50,000 to refurbish the equipment makes more sense than purchasing a new widget maker, even if the new one is more efficient. The costs here are $50,000 compared to a new $118,628.

However, since life is not theory, you will need to consider the risks such as what are the chances that the refurbished equipment will really live for an extra five years without having to replace other parts. Also, consider your downtime cost carefully. If you have equipment, which is central to your operations and you are having problems getting replacement parts, having to wait days for a new part for your widget maker can dramatically increase the annual cost of the equipment, especially if you do not have the luxury of having another widget maker on standby. If you can estimate your downtime cost (which is not always easy to do), then you should integrate it into the calculations as well.

In Summary

Analyse each of your three choices, whether to continue to maintain, refurbish or replace your equipment, ideally considering all costs in today’s money, but keep in mind that some numbers will only be assumptions for which you sometimes have little control. You need to reflect about the risk of each of these assumptions going in the wrong direction and consider the possibilities for a situation where you hit a brick wall and need to take a decision rapidly.

Finally, while the numbers can help you decide, many other factors would often need to consider. For example, new equipment tend to deliver better quality (some will argue, rightfully, the opposite and that they don’t make the equipment as solid and good as they used to) and better quality can bring added benefits like winning more work (or stealing a client from your competition). New equipment can often produce more, sometimes using less space (and we all know real estate is not free).

However, new equipment also comes with risk and sometimes unforeseen costs (training, debugging, optimizing) not counting the risk that the equipment, if it is something very new, will simply not deliver. A while ago, we wrote a blog on 30 Things To Not Forget When Purchasing a CapEx.

Deciding on maintaining, refurbishing, or replacing equipment is not an easy process, but if you weight in all inputs you will be in a better position to make that decision.