Relevant Costs and Differential Analysis Cornerstone Bank paid $120,000 for a ch
ID: 2511259 • Letter: R
Question
Relevant Costs and Differential Analysis
Cornerstone Bank paid $120,000 for a check-sorting machine in January 2013. The machine had an estimated life of 10 years and annual operating costs of $110,000, excluding depreciation. Although management is pleased with the machine, recent technological advances have made it obsolete. Con- sequently, as of January 2017, the machine has a book value of $72,000, a remaining operating life of 6 years, and a salvage value of $0.
The manager of operations is evaluating a proposal to acquire a new optical scanning and sort- ing machine. The new machine would cost $168,000 and reduce annual operating costs to $70,000, excluding depreciation. Because of expected technological improvements, the manager believes the new machine will have an economic life of 6 years and no salvage value at the end of that life. Prior to signing the papers authorizing the acquisition of the new machine, the president of the bank prepared the following analysis After looking at these numbers, the manager rejected the proposal and commented that he was “tired of looking at marginal projects. This bank is in business to make a profit, not to break even. If you want to break even, go work for the government.”
Required
a. Evaluate the president’s analysis.
b. Prepare a differential analysis of six-year totals for the old and the new machines.
c. Speculate on some limitations of the model or other issues that might be a factor in making a final decision.
Six-year savings ($110,000-$70,000) × 6 years). . . . . . . . . . . . . . . . . . . . . . . . . $240,000 Loss on disposal of old machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. Advantage (disadvantage) of replacement (72,000)Explanation / Answer
Answer a.
Here we are going to look into the relevant costs for the purpose of evaluation of buying new v/s keeping old. President's analysis included the loss on disposal of old machine. However the same is not relevant for the current decision since the same is already incurred. We should simply compare the additional cost incurred v/s savings in cost.
Savings in Cost - (110000-70000) x 6 = 240,000
Cost of new machine = 168,000
Advantage/(Disadvantage) = 72,000
Hence if we ignore the loss on disposal of old machine (being irrelevant to current decision making) out of President's analysis it leaves us with an advantage of replacement to the tune of $72000
Answer b.
Differential analysis wth relevant costs will be as follows:
Answer c.
The model does not consider the time value of savings/additional costs. The benefits @ $40,000/year is flowing in 6 consecutive years after incurring an additional cost of $168,000 instantaneously to give an absolute advantage of $72,000. Hence if we consider the present value of savings/additional cost, it might have different results altogether.
Again, there is also a chance of another technological advancement, wherein the new machine may become phased out resulting in a loss.
Another limitation may be inadequate estimation of operating cost of new machine. The new machine will be bought based on calculations with $70,000 operation costs per annum. However if such estimates turn unrealistic, it might result into a diadvantageous decision.
Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total Old 110,000 110,000 110,000 110,000 110,000 110,000 660,000 New 168,000 70,000 70,000 70,000 70,000 70,000 70,000 588,000 Advantage/(Disadvantage) (168,000) 40,000 40,000 40,000 40,000 40,000 40,000 72,000