Question

3. Chavez Company is considering purchasing new equipment or overhauling its existing equipment. The manager has gathered the following information: Current machinery: Original cost $ 50,000 Accumulated depreciation 40,000 Annual operating costs 5,000 Current market value 1,500 Salvage value at the end of five years - Cost of overhauling machinery: Cost of overhaul $ 12,000 Annual operating costs after overhauling 2,000 Salvage value at the end of five years - New machinery: Cost $ 56,000 Annual operating costs 1,000 Salvage value at the end of five years -

Required:

a) Identify the sunk costs associated with this decision.

b) Compute the increase or decrease in total income over the five-year period if the company chooses to buy the new equipment.

c) Compute the increase or decrease in total income over the five-year period if the company chooses to overhaul its existing machinery. d) What is your recommendation for this decision

Answer 1

a) Sunk cost is the cost which has already been occured. They are irrelevant for decision making. Sunk cost are past cost.

original cost of old machine	$          50,000.00	Sunk cost and irrelevant
Accumulated Depreciation of old machine	$          40,000.00	Sunk cost and  irrelevant

b)  

	Buy new machine	Keep old machine
Net aquisition cost (56000 - 1500)	$          54,500.00	$                 -
Net operating costs for  5 years	$            5,000.00 ($1000 * 5)	$     25,000.00 ($5000 * 5)
Salvage value at the end of 5 year	$                       -	$                 -
Total Relevant Cost	$          59,500.00	$     25,000.00
Decrease in total income by		$     34,500.00

c)

	Overhauling	Keep old machine
Net aquisition cost	$          12,000.00	$                 -
Net operating costs for  5 years	$          10,000.00 ($2000 * 5)	$     25,000.00 ($5000 * 5)
Salvage value at the end of 5 year	$                       -	$                 -
Total Relevant Cost	$          22,000.00	$     25,000.00
Increase in total income by	$ 3,000.00

d)  Chavez Company should overhaul the existing machine as there will be increase in income by $3000