Formulation of the problem
A production manager may have an opportunity to replace a piece of old equipment by a more recent, and often more efficient, one. Again, if this decision results in a very different distribution of cash flows over several years, time value of money matters and capital budgeting should be preferred. However, when the question is about precipitating a replacement which would happen in the short term anyway (doing it one year earlier for instance) or if cash flows are relatively similar across years (i.e. cash flows from operating activities far outweigh cash flows from investing activities), differential analysis is easier and good enough.
Classification based on relevance
The decision to replace an old equipment is interesting to illustrate the notion of cost relevance. This decision really highlights how management accounting differs from financial accounting and how financial accounting may be misleading because it takes into account sunk costs. Typically, When you replace an equipment, there are two distinct actions: buying the new equipment and disposing of the old equipment. From the perspective of financial accounting, buying the new asset has no impact on your operating income and when you dispose of the old equipment, you record a net gain or a net loss on asset disposal (the money obtained by selling it minus its book). This approach however accounts for irrelevant costs (book values) and ignore relevant costs.
First, the book value of the old equipment, and any subsequent depreciation, are irrelevant because they are sunk costs and not avoidable. Second, salvages values, i.e. the market value of an asset at the expected time of its disposal, are always relevant. Third, since you can only salvage an equipment you own, whether you keep or replace it affects the salvage values you can earn and when you earn them. Finally, differences in operating costs should be accounted for over the remaining useful life of the old asset.
Net Economic Impact and indifference points
For this exercise, you can download here data and solutions if you did not already. Try to compute the net economic impact and the indifference point in volume (\(Q\)), unit variable cost change (\(\Delta V_c\) related to the savings on each unit produced), and fixed cost change (\(\Delta FC\), i.e. the impact of buying the new machine and selling the old one). The assumptions about the old and new equiment are in the third table on the first sheet of the Excel file. Assume that the change in unit variable costs affect all three coktails.
The new equipment may also affect the cost structure, increasing or decreasing the proportion of fixed costs. Therefore, it may have an impact on the degree of operating leverage, i.e. the volatility of operating income. Such an impact may be very important to consider in highly turbulent environments.
The disposal of the old asset should be done in a way respectful of the environment: as much as possible it hould be dismantled and recycled, not dumped. This may entail extra-costs for the company, but mitigates long-term adverse consequences on the planet.
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