13.20 Equipment replacement, relevant costs, sensitivity analysis. (30–40 min) 1 The first step is to analyse all relevant operating cash flows and align them with the appropriate alternative. This analysis is as follows
Moulding machine (1) Automatic machine (2) Increment (3) Sales (irrelevant) Costs Direct materials Direct manufacturing labour Variable overhead Fixed overhead (irrelevant) Marketing and administrative costs (irrelevant) Total relevant operating cash outflows – £10,000 20,000 15,000 –
– £45,000 – £9,000 10,000 7,500 –
– £26,500 – £1,000 10,000 7,500 –
– £18,500 Because the automatic machine produces twice as many units per hour, the direct manufacturing labour cost with the automatic machine would be £10,000; variable overhead, being 75% of direct manufacturing labour cost, would be £7,500. Solution Exhibit 13.20 indicates that the automatic machine has a £9,423 net present- value advantage over the moulding machine. Note The book value of the old machine is irrelevant and thus is completely ignored. In the light of subsequent events, nobody will deny that the original £50,000 investment could have been avoided, with a little luck or foresight. But nothing can be done to alter the past. The question is whether the company will nevertheless be better off buying the new machine. Management would have been much happier if the £50,000 had never been spent in the first place, but the original mistake should not be compounded by keeping the old machine.
