The replace hardware option is for if you want to maintain the historic data. The workflow should be:
1. Turn on / install new device
2. Disable the old device
3. Go to old device's manage page
4. Select 'replace hardware'
5a. If new device is in 'new devices', you can select it from there
5b. If new device is not in 'new devices', then add the device using Device Setup -> Add, and then select the device as a replacement
6. Power down the old device
The option also appears if you go to a group / folder list, click on 'modify devices' (checkboxes should appear next to device names). Then select the device that is being replaced and choose the 'replace hardware' option at the bottom.