Question

Differential Analysis for Machine Replacement

Kim Kwon Digital Components Company assembles circuit boards by using a manually operated machine to insert electronic components. The original cost of the machine is $68,700, the accumulated depreciation is $27,500, its remaining useful life is five years, and its residual value is negligible. On May 4 of the current year, a proposal was made to replace the present manufacturing procedure with a fully automatic machine that has a purchase price of $142,900. The automatic machine has an estimated useful life of five years and no significant residual value. For use in evaluating the proposal, the accountant accumulated the following annual data on present and proposed operations:

	Present Operations		Proposed Operations
Sales	$217,800		$217,800
Direct materials	$74,200		$74,200
Direct labor	51,500		—
Power and maintenance	4,800		25,400
Taxes, insurance, etc.	1,700		5,700
Selling and administrative expenses	51,500		51,500
Total expenses	$183,700		$156,800

a. Prepare a differential analysis dated May 4 to determine whether to continue with the old machine (Alternative 1) or replace the old machine (Alternative 2). Prepare the analysis over the useful life of the new machine. If an amount is zero, enter "0". For those boxes in which you must enter subtracted or negative numbers use a minus sign.

Differential Analysis
Continue with Old Machine (Alt. 1) or Replace Old Machine (Alt. 2)
May 4
	Continue with Old Machine (Alternative 1)	Replace Old Machine (Alternative 2)	Differential Effect on Income (Alternative 2)
Revenues:
Sales (5 years)	$	$	$
Costs:
Purchase price
Direct materials (5 years)
Direct labor (5 years)
Power and maintenance (5 years)
Taxes, insurance, etc. (5 years)
Selling and admin. expenses (5 years)
Income (Loss)	$	$	$

Answer 1

Ans:

			Continue	Replace	Differential
			with old	old	Effect on
			machine	machine	income
Revenues
Sales(5 years)			1,089,000	1,089,000	0
Costs:
purchase price			0	-142900	-142,900
Direct materials ( 5 years)			-371,000	-371,000	0
Direct labor (5 years)			-257500	0	257,500
power and maintenance (5 years)			-24,000	-127,000	-103,000
Taxes, insurance ,etc.(5 years)			-8,500	-28500	-20,000
Selling and administrative expense			-257,500	-257,500	0
income(l0ss)			170,500	162100	-8400

Based on the above analysis, it is recommended that the old machine should not be replaced as the differential income is negative. This means the incremental costs are more than the incremental savings. The savings is in the form of decrease in labour costs, however the increase in other costs as well as the purchase price offset the savings, hence it is recommended not to replace the old machine and continue with the old machine.

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