Question

Replace Equipment A machine with a book value of $80,000 has an estimated five-year life. A proposal is offered to sell the old machine for $50,500 and replace it with a new machine at a cost of $75,000. The new machine has a five-year life with no residual value. The new machine would reduce annual direct labor costs from $11,200 to $7,400. a. Prepare a differential analysis dated April 11 on whether to continue with the old machine (Alternative 1) or replace the old machine (Alternative 2). If an amount is zero, enter "0". Use a minus sign to indicate subtracted or negative numbers or a loss. Differential Analysis Continue with Old Machine (Alt. 1) or Replace Old Machine (Alt. 2) April 11 Continue with Old Machine (Alternative 1) Replace Old Machine (Alternative 2) Differential Effect on Income (Alternative 2) Revenues: Proceeds from sale of old machine $ $ $ Costs: Purchase price Direct labor (5 years) Income (Loss) $ $ $ b. Should the company continue with the old machine (Alternative 1) or replace the old machine (Alternative 2)

Answer 1

Answer:

Replace Equipment:

1. Differential Analysis:

i) Continue with Old Machine (Alt. 1):

Cost of old machine $80,000          $0

Direct labor (5 years)                        -$56,000

Income (Loss)                                   ($56,000)

ii) Replace Old Machine (Alt. 2)

Differential Effect on Income (Alternative 2)

Proceeds from sale of old machine $50,500

Purchase price for new equipment -$75,000

Direct labor (5 years)                        -$37,000

Income (Loss)                                   ($61,500)

b. Should the company continue with the old machine (Alternative 1) or replace the old machine (Alternative 2):

The company should continue with the old machine.  Taking Alternative 2 would cost the company $5,500 more than Alternative 1.

Explanation:

Differential analysis or incremental analysis is a management accounting technique which assesses the changes in revenues, costs, and profits that result from a business decision.

Differential cost is the difference in total costs between two acceptable alternative courses of action.  Differential revenue is the difference in sales that will be generated by two different courses of action.

In differential analysis, sunk (past) cost is not relevant for decision making.  This is why the book value of $80,000 is not considered in the decision of which alternative to take.