Automobile replacement case studies for engineering economy classes

Automobile replacement case studies for engineering economy classes

Hartman, Joseph C

ABSTRACT

Case studies have long been used to supplement material in engineering economy courses. To develop these studies is difficult in that the amount of information provided to the student may either trivialize the project or complicate it beyond reason. However, with the wealth of information on the Worldwide Web, this task has become easier. A case study involving the replacement of automobiles is presented and classroom experiences are shared.

INTRODUCTION

Case studies have long been used to supplement material in a variety of courses, including engineering economics. The development of a case study that is both interesting to students, yet useful as an instructional tool is difficult, because it depends on the amount of information provided to the students. If too much information is provided, the problem becomes similar to end-of-chapter problems (although longer) with a trivial solution. Conversely, providing too little information leaves the students frustrated and continually questioning directions in which to approach the problem and where to find relevant data.

Although techniques to analyze cash flows may be thoroughly taught in engineering economy classes, a case study is generally considered imperative to illustrate the process of project evaluation. This process includes defining alternative solutions, developing their cash flow profiles, making an evaluation and finally, a recommendation. This recommendation should be supported with documentation, including a detailed explanation of the analysis with relevant data and valid assumptions.

Relevant case studies that use investment analysis are difficult because they involve the forecasting of future incremental cash flows. This problem is compounded in replacement analysis because the forecasts must include information about the current asset (defender) and all replacement options (challengers). However, experience in both undergraduate and graduate classes has shown that case studies involving the replacement of a personal automobile emphasize the critical steps of a complete investment analysis while providing an interesting and relevant problem for the students. More importantly, data are accessible from sources including the Worldwide Web. Thus, details for the case study need not be elaborate because the necessary information is readily available.

This paper presents a case study problem that has been tested in both an undergraduate class in engineering economy and a graduate class in replacement analysis. Differences in the two studies may be summarized by the required solution methods. In the undergraduate class, cash flows for competing assets were analyzed under common infinite horizon assumptions. For the graduate class, dynamic programming models were developed to analyze a variety of challengers at one time. Despite the solution procedure, the setup of the data is quite similar. The next section presents the problem. The following section defines the necessary data and possible sources. Additionally, the difficulty or ease of estimating certain parameters is discussed in this section. Finally, the paper concludes with the solution and discussion of an example problem.

CASE STUDY PROBLEM STATEMENT

In hopes of stressing concepts presented in lectures and providing an interesting problem, the evaluation of the replacement of a personal automobile was assigned. The formal problem statement is as follows:

This is an analysis that you can use in your everyday life: the evaluation of replacing your personal automobile. For this study, you are to economically evaluate the difference between keeping your current car (if you do not have one, pretend you do) and replacing your auto with (I) the current (new) version of your car and (2) a car of a different class (such as a small coupe with a sedan or a sports utility vehicle). Additionally, you must consider at least two different methods of financing the purchase. This may include the evaluation of a lump sum purchase, financing over a number of years or leasing the automobile.

Provide a detailed write-up of your analysis, including data estimates with sources. All assumptions must be stated and supported. Finally, any complications in the analysis, either with data collection, estimation, or in the economic evaluation itself, should be explained thoroughly. If possible, provide an alternative analysis or method in which to alleviate these difficulties.

This problem captures the variety of issues and complications relevant to replacement analysis, including the modeling of deterioration and technological change in cash flows. Additionally, multiple challengers are analyzed to highlight the possible solution scenarios. Issues relevant to investment analysis, such as different financing issues and the choice of a MARR, are also included. Note that altering the phrase “a personal automobile” to “a company automobile” would necessitate using after-tax analysis. Finally, the case study also envelops other course work, including statistics and forecasting, to supplement cash flow estimation topics.

RELEVANT COSTS AND SOURCES OF INFORMATION

A variety of costs and parameters are relevant to this analysis. Here is a list of costs plus possible sources of information that may be included. The difficulty in obtaining this information is also discussed. Note that the intent here is not to promote certain Web pages or companies, but rather provide examples of where information may be found. A user is encouraged to search for more sources on the subject. Many search engines exist, such as AltaVista [12] on the World Wide Web.

PURCHASE PRICE

Obviously, the purchase price of a new automobile is the easiest cash flow to estimate because it is readily available. There are a variety of sources for this estimate, including manufacturer home pages, newspaper or television advertisements and individual dealers.

SALVAGE VALUES

Salvage values are traditionally supplied in blue books that may be obtained from local libraries. However, the Kelley Blue Book [10] and Edmund’s blue book [5] Web pages have detailed salvage value estimates for many used automobiles based on the model year. The values are adjusted according to mileage and options on the automobile.

OPERATING COSTS

Every automobile purchased has a fuel efficiency rating for both city and highway driving. Deterioration of this efficiency over time is not easy to estimate, although personal automobile records may show changes in fuel consumption with respect to age and mileage. Also, sources such as Automotive Fleet [3] give estimates on the expected drop in fuel efficiency over time. Fuel prices themselves are easily obtained at any gas station, with historical data available through price indices from sources such as Standard and Poor’s Statistical Service [13] or the American Petroleum Institute [1].

ROUTINE MAINTENANCE COSTS

They generally specify routine maintenance, such as tuning the engine and changing the oil, filters, tires and brake pads, in any owner’s manual (e.g., 3000 miles between oil changes), but if not, may be approximated by a mechanic or the driver. These costs are easily estimated from company advertisements such as Econo Lube, Jiffy Lube, Meineke, Midas and Pep Boys. These companies also have home pages containing information on expected repairs over time and on prices. The information may also be found in the annual estimates of Automotive Fleet [2].

UNEXPECTED MAINTENANCE COSTS

Unexpected maintenance costs due to part failure or accidents are the hardest costs to estimate. However, Consumer Reports [8] publishes an annual magazine and book reviewing the reliability of certain cars, which should help provide an estimate in this area. Insurance companies provide estimates on possible accidents based on driver statistics, which should not change from car-to-car for one driver. However, the amount of damage (and thus cost) resulting from an accident depends on the car. This information is also available through Consumer Reports [9] with its safety inspections.

INSURANCE COSTS

Because most states require drivers to have car insurance, these data are generally available to the student. And, students may inquire about different rates for different automobiles. Estimates may be obtained by telephone or through home pages such as Gieco On-Line Insurance Quotes [6].

FINANCING COSTS AND OPTIONS

Newspaper and television advertisements are very specific (read the fine print) about terms of leases and financing deals. These terms include the number and size of payments, up-front and end-of-term charges. Banks and loan institutions may provide similar information. On the Worldwide Web, loan information may be obtained from sources such as BanxQuote [4] or GMAC [7].

INFLATION ESTIMATES

Inflation may be estimated for individual commodities or taken to be a general value for all costs in the problem. Price indices are published in many sources, including Standard and Poor’s Statistical Service [ 13]. Obviously, the above data do not complete the problem; historical data must be used to forecast future data. This is illustrated in the following section.

REPLACEMENT WITH SIMILAR CHALLENGER SOLUTION

This section provides a basic solution to the first case of examining the option of replacing an automobile with its newer version. In the interest of space, only some options are evaluated here (no financing). Rather, an example of the process for evaluating the replacement of an automobile with a similar challenger, including estimating relevant costs, is provided with a dynamic programming solution.

In this problem, the defender was a 1991 Ford Taurus GL Sedan, with the 1997 version serving as the challenger. The purchase price of the challenger was $19,445 in Edmund’s blue book [5]. This Web site contained purchase price data for the past 8 years, which were used to forecast future purchase prices (see appendix). Additionally, the current salvage values listed were used as estimates for future salvage values (see appendix).

It was assumed that the car would be driven 10,000 miles per year (6,000 city and 4,000 highway). This was reflected in the salvage value estimates. The mileage, along with fuel efficiency (MPG) ratings and the price of gasoline ($1.30 per gallon in 1997 dollars), determined the operating costs of the car. Two assumptions were made here with respect to operating costs. First, the operating costs of each car would increase with age and usage, reflecting an assumed .25 MPG drop in efficiency per year. Second, the MPG rating of future sedans would increase, reflecting an improvement in technology. It was expected that every 4 years (starting in 1998), the challenger’s MPG rating would increase 1.5 over the previous rating. The challenger’s MPG rating for the highway was assumed to be 28 and for the city, 21. The defender’s 1997 ratings were 23.5 and 15.5, respectively.

Routine maintenance costs were expected to be the same for the defender and challenger, despite age. These annual costs, explained earlier, were expected to total $150 through historical usage and estimates from advertisements in a local paper. Note that when costs are the same for both a defender and challenger, they need not be included. However, they were included here to illustrate the estimation process because these costs would be needed for the question of replacement with an unlike challenger.

Age differences were reflected in the unexpected maintenance costs. These arise in two situations: failures and crashes. The Ford Taurus comes with a 3year/36,000-mile warranty. Thus, failures were expected to be reimbursed in full over this period. It was also assumed that a rental car was provided such that there was no loss in productivity with a car in the shop. For any year after year 3, it was assumed that failures occurred at known rates. These rates were estimated (and smoothed) through use of Consumer Reports [8] (see appendix). The rates were based on model year, but taken as predictions based on age. With estimates on the repair from a local mechanic, an expected-breakdown cost was assigned to the age of the automobile.

Consumer Reports [9] also provided data on injury claim rates from accidents, with the Ford Taurus rating much higher on average than other cars in the limited number of claims. Because the causes of accidents were not necessarily functions of the cars and because the claims were reportedly minimal, safety costs from different challengers were assumed to be negligible in this analysis. Insurance costs were assumed to be the same for either the challenger or defender. They were estimated at $700 per year, with a $200 premium for the first year if a new car were purchased.

In this analysis, a 5-year horizon was studied, with a new challenger available every year. Each car’s physical life was assumed to be 8 years in this study. The interest rate for discounting was 9%. However, it was assumed that operating, insurance and maintenance costs would rise an average of 3% per year. The solution was determined through dynamic programming, as described in Park and Sharp-Bette [11]. The solution, as expected, consisted of keeping the defender until it reached the end of its physical life and replacing it with a challenger for the remaining 3 years. The NPV cost for this decision was $19,934, as shown in the appendix.

REPLACEMENT WITH DISSIMILAR CHALLENGER SOLUTION

In the second part of the case study, with the challenger deEmed as an automobile of a different car class, students could show their creativity in solving a problem. For instance, rarely will an economic analysis lead one to replace a 5-year-old car that originally cost $12,000 with a new car that costs $30,000. Obviously, most students would rather own the $30,000 car, and further analysis may lead to the conclusion that the replacement should be made. For instance, after economic analysis of the defender and unlike challenger, various decision strategies may illustrate that the economic differences may not justify retaining the defender. Here is a synopsis of the strategies and considerations that were not present in the previous analysis:

UTILITY THEORY

Students developed utility functions to describe their preferences for newer cars. Utility was given to attributes such as safety, prestige, comfort and environmental considerations. The monetary utility value was used to justify the economic difference in replacing the defender with the unlike challenger.

WEIGHTING OF PARAMETERS

To promote the replacement of the defender, weights were assigned to specific costs such as possible safety savings. This led to lower annual equivalent costs for the challenger. For intangible parameters, such as those discussed above, weights could also be assigned to the expected values of worth (which may be determined through utility theory). This allows one to account for intangibles, both in value and rank of importance.

INCLUSION OF DIFFERENT CAPABILITIES

In replacement analysis, the challenger is assumed to have similar capabilities to the defender. Consider the replacement of a sports coupe with a sport-utility vehicle (SUV). Obviously, they both provide transportation. However, the SUV provides transportation in inclement weather, whereas the sports coupe may not function. This was one example of including different capabilities in the cost analysis. Benefits were assigned to a decreased probability of productivity loss due to inclement weather. Other factors may also account for differences in the economic evaluation.

EXPANDED COST ANALYSIS

Because the challenger is different, it is imperative that all relevant costs be included in the analysis. For instance, safety costs were eliminated in the first analysis because they were deemed the same for both the defender and challenger. However, costs resulting from a crash in a sports coupe would be very different from those in an SUV. These costs may be estimated through expected damages, both to the assets and to any persons involved. Including all costs may lead to replacement of the defender.

NEAR OPTIMAL REPLACEMENT

Despite the use of intangible analysis such as utility theory, situations arose such that replacing a defender with a challenger could not be economically justified. When this occurred and the replacement was still desired, analysis determined the most economical time to replace the defender. An economic gap still existed between the defender and challenger, but analysis determined when this gap was at a minimum.

Including this option truly makes this project a case study, because the student must completely analyze each replacement option and exhibit some creativity in the evaluation. The analogy of the difficulty in determining the value of replacing an asset in a manufacturing setting with an advanced technology was raised, because sometimes economic considerations are inconclusive. Various research methods have been presented to handle this difficult question, and the students applied these methods to their own automobile replacements.

CONCLUSION

Case studies are an integral part of teaching engineering economy because they allow a student to experience the evaluation of a project, from its inception and definition to analysis and recommendation. Unfortunately, developing case studies is difficult; the problem must provide only some, not all, the relevant data as “given,” yet still make the problem solvable.

This paper has shown that the analysis of replacing a personal automobile may be appropriate for a fundamental case study in engineering economics. The problem requires the analysis of replacing a defender with both a similar and dissimilar challenger. While both analyses stress the required steps for an investment analysis, the second analysis allows the student to exhibit creativity in the solution method as difficulty may arise in the economic evaluation of intangible factors.

Another advantage to this study is that data are readily available, especially from sources on the Worldwide Web, so that students may forecast costs and develop cash flows. This is generally considered a hard task in investment analysis and alleviates the difficulty in providing data for case studies. Topics of cash flow development and the evaluation of intangible factors may not be stressed in engineering economy courses; therefore, this case study is seen as an important supplement.

ACKNOWLEDGMENTS

I thank the students from both my undergraduate Engineering Economy class (IE124) and graduate Replacement Analysis class (IE 405) during the 1997 spring semester at Lehigh University. Although it was known that information was readily available on the Worldwide Web, these students showed their “Web expertise” in bringing this case study to life.

REFERENCES

[1] American Petroleum Institute, http://www.api.org. [2) CH, MIKE. Brake, air conditioning and tire maintenance costs decline. Automotive Fleet: Car and Light Truck Fleet and Leasing Management Magazine, 35(5):1 8B25, March 1996.

[3] ANTICH, MIKE. Fleet car operating costs decline 10%, trucks increase 5%. Automotive Fleet: Car and Light Truck Fleet and Leasing Management Magazine, 35(1):18B31, November 1995.

[41 BanxQuote Banking and Trading Center, http://banx.com. [5] Edmund’s Auto Pricing, http://www.edmunds.com. [61 Gieco On-line Insurance Quotes, http://www.gieco.com. [7] GMAC Financial Services Home Page, http:/www.gmacfs.com. [8] KAGAN, J. (ed.). Reliability of used cars. Consumer Reports, 62(4):70B85, April 1997.

[9] KAGAN, J. (ed.). 1997 Cars: Safety. Consumer Reports, 62(4):59B61, April 1997. [10l Kelley Blue Book, http://www.kbb.com.

[11] PARK, C.S. and G.P. SHARP-BETTE. Advanced Engineering Economics. John Wiley and

Sons, New York, 1990.

[12] Search at Alta Vista, http://altavista.digital.com.

[13] Standard and Poor’s Statistical Service. Current Statistics. Basic Statistics. Basic Statistics, 62, 1996.

JOSEPH C. HARTMAN

Department of Industrial and Manufacturing Systems Engineering Lehigh University

BIOGRAPHICAL SKETCH

JOSEPH C. HARTMAN is an Assistant Professor in the Department of Industrial and Manufacturing Systems Engineering at Lehigh University. He received his Ph.D. and M.S. in Industrial Engineering from the Georgia Institute of Technology and B.S. in General Engineering from the University of Illinois at Urbana-Champaign. He is a member o f ASEE, IIE, INFORMS and NSPE, and he currently serves as director of the Engineering Economy Division of IIE and as an area editor for The Engineering Economist.

Copyright Institute of Industrial Engineers Spring 1998

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