Tommy has been using the same machines to make its name brand clothing for the l
ID: 2546062 • Letter: T
Question
Tommy has been using the same machines to make its name brand clothing for the last five years. A cost efficiency consultant has suggested that production costs may be reduced by purchasing more technologically advanced machinery. The old machines cost the company $100,000. The old machines presently have a book value of $50,000 and a market value of $10,000. They are expected to have an eight-year remaining life and $1,000 salvage value. The new machines would cost the company $50,000 and have operating expenses of $9,000 a year. The new machines are expected to have an eight-year useful life and $5,000 salvage value. The operating expenses associated with the old machines are $15,000 a year.
Should Tommy keep or replace the machine, and how would that decision impact profitability?
Explanation / Answer
Answer
Operating expenses + Opportunity cost ** - Salvage value
=($15,000 * 8 years) + $10,000 - $1,000 = $129,000
** Note : If old machine is continued than its a opportunity lost of selling the old machine at its current market value ie $10,000 which is a opportunity cost.
Purchase price + Operating expenses - Salvage value
= $50,000 + ($9,000 * 8 years ) - $5,000 = $117,000
Conclusion : Tommy should relace the machine. Since new machine 's the total cost less than the total cost of continuing the old machine , by replacing the old machine the profitability will increase by $12,000 ($129,000 - $117,000)