In: Accounting
Question 1 (10 Marks - Suggested time approx. 23 minutes)
Northern Lights Company is considering the purchase of a new
machine. The invoice price
of the machine is $140,000, freight charges are estimated to be
$4,000, and installation
costs are expected to be $6,000. Salvage value of the new equipment
is expected to be zero
after a useful life of 5 years. Existing equipment could be
retained and used for an additional
5 years if the new machine is not purchased. At that time, the
salvage value of the
equipment would be zero. If the new machine is purchased now, the
existing machine would
have to be scrapped. Northern Lights’ accountant, Lisah Huang, has
accumulated the
following data regarding annual sales and expenses with and without
the new machine.
? Without the new machine, Northern Lights can sell 12,000 units of
product annually at a
per unit selling price of $100. If the new machine is purchased,
the number of units
produced and sold would increase by 10%, and the selling price
would remain the same.
? The new machine is faster than the old machine, and it is more
efficient in its usage of
materials. With the old machine the gross profit rate will be 25%
of sales, whereas the
rate will be 30% of sales with the new machine.
? Annual selling expenses are $180,000 with the current equipment.
Because the new
equipment would produce a greater number of units to be sold,
annual selling expenses
are expected to increase by 10% if it is purchased.
? Annual administrative expenses are expected to be $100,000 with
the old machine, and
$113,000 with the new machine.
? The current book value of the existing machine is $36,000.
Northern Lights uses straightline
depreciation.
Required
Prepare an incremental analysis (over the 5 years) showing whether
Northern Lights should
keep the existing machine or buy the new machine. (Ignore income
tax effects.)
Income calculation without new machine (with old machine)
Annual Sale = 12000 Units
Sale Price = 100 per unit
Gross Profit = 25 % of sales
Annual Selling Expenses = $180000
Annual Adm. Expenses = $100000
Current value of machinery = 36000
Useful life remaining = 5 Years
Salvage value = Zero
Depreciation Per year (SLM) = Value / Useful Life = 36000 / 5 = $7200 Per Year
Y 1 | Y2 | Y3 | Y4 | Y5 | |
Annual Sales (Units) | 12000 | 12000 | 12000 | 12000 | 12000 |
Sales Price Per Unit | 100 | 100 | 100 | 100 | 100 |
Sales VAlue | 1200000 | 1200000 | 1200000 | 1200000 | 1200000 |
Gross Profit (25% of Sales) | 300000 | 300000 | 300000 | 300000 | 300000 |
Annual Selling Expenses | 180000 | 180000 | 180000 | 180000 | 180000 |
Annual Adm. Expenses | 100000 | 100000 | 100000 | 100000 | 100000 |
Depreciation | 7200 | 7200 | 7200 | 7200 | 7200 |
Net Income | 12800 | 12800 | 12800 | 12800 | 12800 |
Total Income for 5 Years = 12800 x 5 =$64000
Calculation of net income with new machine
Machine Cost = 140000 + 4000 + 6000 = $150000
Salvage Value = Zero
Useful Life = 5 Years
Depreciation per year = Value of machine / useful Life = 150000 / 5 = $30000 Per Year
Annual Sales Units = 12000 + 10% of 120000 = 13200 Units
Sales Price = $100 per unit
Gross Profit = 30% of sales
Annual Sales Expenses = 180000 + 10% of 180000 = 198000
Annual Adm Expenses = $113000
Y1 | Y2 | Y3 | Y4 | Y5 | |
Annual Sales Units | 13200 | 13200 | 13200 | 13200 | 13200 |
Sales Price per unit | 100 | 100 | 100 | 100 | 100 |
Sales | 1320000 | 1320000 | 1320000 | 1320000 | 1320000 |
Gross Profit (30% of sales) | 396000 | 396000 | 396000 | 396000 | 396000 |
Anual Selling Expenses | 198000 | 198000 | 198000 | 198000 | 198000 |
Annual Adm. Expenses | 113000 | 113000 | 113000 | 113000 | 113000 |
Depreciation for the year | 30000 | 30000 | 30000 | 30000 | 30000 |
Net Income | 55000 | 55000 | 55000 | 55000 | 55000 |
Total Income for 5 Years = 55000 x 5 =$275000
So, Net income with old machine for 5 years is $ 64000 whereas net income for 5 years with new machine is $275000 after leaving the machine value zero in balance sheet after 5 years means full absorbtion of machine cost.
So it is prudent for northern lights to purchase new machinery so it should buy the new machine.