First determine what relevant costs Premier will incur if it keeps the old machine.
1. The original cost ($90,000), current book value ($57,000), accumulated depreciation ($33,000), and annual depreciation expense ($11,000) are different measures of a cost that was incurred in a prior period. They represent irrelevant sunk costs.
2. The $14,000 market value represents the current sacrifice Premier must make if it keeps using the existing machine. In other words, if Premier does not keep the machine, it can sell it for $14,000. In economic terms, forgoing the opportunity to sell the machine costs as much as buying it. The opportunity cost is therefore relevant to the replacement decision.
3. The salvage value of the old machine reduces the opportunity cost. Premier can sell the old machine now for $14,000 or use it for five more years and then sell it for $2,000. The opportunity cost of using the old machine for five more years is therefore $12,000 ($14,000 $2,000).
4. Because the $45,000 ($9,000 x 5) of operating expenses will be incurred if the old machine is used but can be avoided if it is replaced, the operating expenses are relevant costs. Next, determine what relevant costs will be incurred if Premier purchases and uses the new machine.
1. The cost of the new machine represents a future economic sacrifice Premier must incur if it buys the new machine. It is a relevant cost.
2. The salvage value reduces the cost of purchasing the new machine. Part ($4,000) of the $29,000 cost of the new machine will be recovered at the end of five years. The relevant cost of purchasing the new machine is $25,000 ($29,000 $4,000).
3. The $22,500 ($4,500 x 5) of operating expenses will be incurred if the new machine is purchased; it can be avoided if the new machine is not purchased. The operating expenses are relevant costs.
The relevant costs for the two machines are summarized here.
|
Old Machine |
New Machine |
||
|
Opportunity cost |
$14,000 |
Cost of the new machine |
$29,000 |
|
Salvage value |
(2,000) |
Salvage value |
(4,000) |
|
Operating expenses |
45,000 |
Operating expenses |
22,500 |
|
Total |
$57,000 |
Total |
$47,500 |
The analysis suggests that Premier should acquire the new machine because buying it produces the lower relevant cost. The $57,000 cost of using the old machine can be avoided by incurring the $47,500 cost of acquiring and using the new machine. Over the five year period, Premier would save $9,500 ($57,000 $47,500) by purchasing the new machine. One caution: this analysis ignores income tax effects and the time value of money, which are explained later. The discussion in this chapter focuses on identifying and using relevant costs in decision making.