Question

Decision Making – Equipment Replacement

Mathews manages an assembly facility of Orthom Scientific. A supplier approaches Mathews about replacing a large piece of manufacturing equipment that Orthom uses in its process with a more efficient model. While the supplier made some compelling arguments in favor of replacing the 3-year-old equipment, Mathews is hesitant. Mathews is hoping to be promoted next year to manager of the larger plant near Orthom’s headquarters, and he knows that the accrual-basis net operating income of the assembly plant he manages will be evaluated closely as part of the promotion decision. The following information is available concerning the equipment replacement decision:

The historic cost of the old machine is $600,000. It has a current book value of $240,000, two remaining years of useful life, and a market value of $144,000. Annual depreciation expense is $120,000. It is expected to have a salvage value of $0 at the end of its useful life.

The new equipment will cost $360,000. It will have a 2-year useful life and a $0 salvage value. Orthom uses straight-line depreciation on all equipment.

The new equipment will reduce electricity costs by $70,000 per year and will reduce direct manufacturing labor costs by $60,000 per year.

For simplicity, ignore income taxes and the time value of money.

Required:

Assume that Mathews’ priority is to receive the promotion and he makes the equipment replacement decision based on next year’s accrual-based net operating income. Which alternative would he choose? Show your calculations.

What are the relevant factors in the decision? Which alternative is in the best interest of the company over the next 2 years? Show your calculations.

At what cost would Mathews be willing to purchase the new equipment? Explain.

Answer 1

Solution 1:

Change in accural based operating income for next year - Replacement decesion
Particulars	Amount
Saving in electricity cost	$70,000.00
Add: Reduction in direct manufacturing labor cost	$60,000.00
Less: Increase in depreciation Expense ($180,000 - $120,000)	$60,000.00
Less: Loss on sale of old equipment ($240,000 - $144,000)	$96,000.00
Increase (Decrease) in accural based net operating income	-$26,000.00

As there is decrease in accrual based operating income by $26,000 for next year, therefore Mathew should not replace the equipment.

Solution 2:

Differential Analysis - Replacement Decesion
Particulars	Amount
Incremental cash outflows:
Cost of new machine	$360,000.00
Less: Sale value of old machine	$144,000.00
Net Incremental Cash Outflows (A)	$216,000.00
Incremental Cash Inflows:
Savings in annual electricity cost ($70,000*2)	$140,000.00
Reduction in direct manufacturing labor cost ($60,000*2)	$120,000.00
Incremental cash inflows (B)	$260,000.00
Net Benefit from replacement (B - A)	$44,000.00

It is in the best interest of the company to replace the equipment as there is net benefit of $44,000 from replacement deceision.

Solution 3:

Cost at mathews be willing or purchase the equipment is the price at which there is no decrease in accrual based operating income for the next year.

Therefore net increase in accrual based operating income before considering increase in depreciation = $70000 + $60,000 - $96,000 = $34,000

Therefore maximum increase in depreciation allowed in order to maintain same accrual based operating income = $34,000

Total depreciation allowed on new equipment = $120,000 + $34,000 = $154,000

Cost at which mathews willling to purchase the new equipment = $154,000 * 2 = $308,000