Replacement Decision A company may have been producing products in an old machine and equipment. Management may be interested to produce products replacing these old machine and equipments by new ones. The decision of whether to produce the products in old equipment or produce them in new only by replacing old ones is known as replacement decision. It is a long term investment decision. In order to take decision, differential cost analysis is followed. Replacement decision can be analyzed on two ways –Annual basis ( based on annual proportion) –Whole basis (Based on total period) In replacement decision, book values of the old machines are regarded as relevant cost which is the main determinant of the replacement decision. However, it does not consider the present value of the cash inflows and outflows. Therefore, the details should be studied in the capital budgeting decision.

A company is considering the purchase of a high-speed lathe to replace a standard lathe that is now in use. Selected information on the two machines is given below: Particulars Standard lathe High-speed lathe Original cost new$40,000$60,000 Accumulated depreciation to date10,000– Current salvage value8,000– Estimated cost savings each year over the standard lathe –15,000 Remaining years of useful life5 years Required: Prepare a computation covering the five-year period that will show the net advantage or disadvantage of purchasing the high-speed lathe. Ignore income taxes, and use only relevant costs in your analysis.

ParticularsAmount Cost saving ($15,000 × 5 years)$ 75,000 Cost of new machine($ 60,000) Disposal value of old machine8,000 Net advantages23,000 Decision: The net advantage of replacing standard lathe by high speed lathe is $23,000. Relevant Cost Analysis

CASE- The Matz Machine Shop purchased a new machine one year ago at a cost of $45,000. The machine has been very satisfactory, but the shop manager has just received information on a computer controlled machine that is vastly superior to the machine that has been purchased. Comparative data on the two machines follow: Present machineProposed new machine Purchase cost new$ 45,000$ 80,000 Estimated useful life new9 years8 years Annual straight line depreciation$ 5,000$ 10,000 Remaining book value40,000– Salvage value now10,000– Annual costs to operate22,5007,500 The shop manager would like to purchase the new machine, but his enthusiasm has been dampened considerably by the following computation:

Remaining book value of the old machine$ 40,000 Less: Salvage value of the old machine10,000 Net loss from disposal$ 30,000 After considering the matter, the shop manager has commented to his assistant, “There’s no way we can buy that new machine. If the boss found out that we took a loss on the old machine, somebody’s head would roll.” Sales from the shop are expected to remain unchanged at $81250 per year. Selling and administrative expenses will be $37500 per year. Required: Prepare a summary income covering the next eight years, assuming: a)That the new machine is not purchased. b)That the new machine is purchased