A Dynamic Programming Approach to Equipment Loss Analysis

Abstract

Frequently, managers concern themselves with the problem of when to replace a piece of equipment. Assuming adequate funds, replacement normally occurs when the item is worn out or when the cost of replacement is less than the increased economic value that will occur because of replacement. Unfortunately, this approach overlooks the problem faced by a firm's risk manager. The risk manager is concerned with the loss exposure that emanates from a particular piece of equipment. As an example, consider a boiler located in a manufacturing plant. A boiler can pose many problems from the perspective of the risk manager. Explosion of the boiler could result in damage to the boiler and probably to the boiler's physical environment. Profits may be lost because of a business interruption. Bodily injury and property damage actions in tort may arise. All of these types of potential losses play an important part in the risk manager's decision-making process. A risk manager might prefer to remove a piece of old equipment because of loss potential while a financial officer charged with the purchase of equipment may be unwilling to replace equipment that still has substantial economic value. This paper suggests the use of dynamic programming as an aid to the risk manager in equipment replacement decisions. The objective of the risk manager is to minimize potential losses, whereas the financial officer is typically concerned with maximizing profits. The systems viewpoint suggests that the concerns of the risk manager along with those of the financial officer should be considered in many decisions. However, all too often the risk manager does not have input into decisions in which his concerns should be recognized. The dynamic programming technique provides a program to minimize potential losses, and, in cases in which the suggested program differs from that of the financial manager, it can be used to emphasize the need to consider input from the risk manager.