Cornerstone Bank paid $120,000 for a check-sorting machine in January 2013. The
ID: 2511953 • Letter: C
Question
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: Six-year savings ($110,000-$70,000) 6 years Cost of new machine. Loss on disposal of old machine . . . . . . . $240,000 (168,000) (72,000) 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.Explanation / Answer
Answer:
(a). Manager's decision to not go with the replacement is based on the analysis represented by the President which has certain limitations. Those limitations have thus shown the final advantage or disadvantage to break even which is certainly not the case here.
President's analysis results in the net income change to be zero because of the model being used which is considering the book value of the old machine. This needs to be reconsidered for the company to be arrive at a more profitable decision.
(Note :
Case 1
If the machine is retained, the book value will depreciate over the course of its remaining useful life.
Case 2
If the new machine is acquired, the book value of the old machine will be considered as a loss.
In both the cases, the ultimate result is same and thus the book value has no effect on earnings whatsoever. )
(b). Differential analysis of six-year totals.
Retain Equipment
(Keep using the old machine for next 6 years)
Replace Equipment
(Get the new machine for the next 6 years)
Net Income
Increase (Decrease)
$660,000
Method for calculating Variable manufacturing cost :
Variable manufacturing cost = Annual operating cost x Number of years
(c). Some limitations of the model are
i. The above model considers the book value of the old machine as a loss.
ii. Genrally, the company also considers the cash dispose value of the existing machine that is to be replaced which is of utmost relevance is missing here.
iii. Moreover, the book value of the old machine should not affect the decision. Since book value is a sunk cost which is not considered in a differential analysis.
Also, if the manager goes for the replacement of the machine now and spends $168,000. One year later, a machine comes with an even lesser annual operating cost and this time again the same model is used to determine whether or not to go for the replacement. Again the loss on disposal of the machine being used (i.e $140,000) will be considered. This would result in more frustration for the manager considering the fact that the company bought a new machine one year before is irrelevant now. This analysis is henceforth troublesome and needs to be replaced with differential analysis for better decision making.
Differential AnalysisRetain Equipment
(Keep using the old machine for next 6 years)
Replace Equipment
(Get the new machine for the next 6 years)
Net Income
Increase (Decrease)
Variable manufacturing costs$660,000
$420,000 $240,000 New machine cost $168,000 ($168,000) Sale of old machine - - Total $660,000 $588,000 $72,000