Lesson FA-20-060-05 Incremental Analysis Part 5 Retain or

File: FA-20-060-05-Workbook.pdf Title: Managerial Accounting – Incremental Analysis – Retain or Replace

Lesson FA-20-060-05 Incremental Analysis Part 5 – Retain or Replace

This workbook contains notes and worksheets to accompany the corresponding video lesson available online at:

Permission is granted for educators and students to make copies and redistribute this document without fee provided the copyright notice and page footer is retained. All other intellectual property rights are reserved by the copyright holder.

_____________________________________________________________________________________________ Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 1 of 17 videos for this lesson are available at evideolearner.com Revised: 2011-05-24


Incremental Analysis – Part 5 – Retain or Replace [Clip 21] Retain or Replace Decision Incremental Analysis Scenarios 

Recall, we said there are five common scenarios in which we can apply incremental analysis principles: o Accept or Reject a Special Order Decision o Make or Buy Decision (Insource or Outsource) o Continue or Discontinue a Business Segment Decision o Sell now or Process Further (and Sell later) Decision o Retain or Replace Decision

Incremental Analysis Cost Factors 

Relevant revenue or cost – is one which differs among the decision alternatives and has characteristics that make it relevant



Opportunity cost – is the implied cost associated with passing up a benefit of one decision alternative by making an alternate decision



Sunk cost – is a cost which has been incurred in the past and is not relevant to a future decision



Direct fixed cost – is a cost which can be directly associated with a product, service, or activity o Direct fixed costs are usually relevant unless they are sunk costs



Indirect fixed cost – is a fixed cost which cannot be directly associated with a product, service, or activity, and thus is allocated using a set of rules or assumptions o Are usually not relevant to a short-term decision

Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved videos for this lesson are available at evideolearner.com

Page 2 of 17 Revised: 2011-05-24


Retain or Replace Decision 

The fifth scenario we want to study is the “retain or replace” decision.



The basic scenario is one in which a company has an asset that can be replaced or retained.



If the existing asset has no further useful life, but continues to be necessary, this decision is relatively straightforward – Replace!



If the existing asset can continue to be used, then the decision becomes more complex. It is necessary, in this case, to compare the incremental revenues and costs associated with retaining the old asset versus replacing it with a new asset.

Retain or Replace Decision (continued) May be a Short-term or a Long-term Decision 

In many, if not most cases, the retain or replace decision is not a short-term decision since many assets have useful lives that extend beyond a single year.



In the case of an asset that has a useful life beyond a single year, it is critical to remember to account for the revenues and costs over the entire life of the asset.




Relevant Topics Beyond the Scope of this Lesson 

Time Value of Money. Long-term decisions of this type should take into consideration the time value of money. This topic is covered in the lesson on capital budgeting. o The time value of money is beyond the scope of this lesson. Rather, our focus is on incremental analysis principles that can be applied in a more complex decision process.



Different Useful Lives. Comparative decisions of this type may include situations in which the remaining useful life of an existing asset and the life of the replacement asset are different. o Differing lives of assets introduce complications addressed in graduate courses that are beyond the scope of this lesson. All asset examples in this lesson will have the same useful life.



Environmental Concerns. Intuition and an environmentally responsible philosophy suggest that if a company has a perfectly useful asset in service that continues to be needed, it should be retained rather than replaced. o Environmental concerns can be factored into the financial decision process if quantified properly. Factoring in environmental costs is beyond the scope of this lesson.



Tax Consequences. Finally, in many cases there are tax benefits involved in replacing an asset. o Tax benefits are also beyond the scope of this lesson. Tax consequences will be ignored in our discussions.




[Clip 22] Example 17 - Retain or Replace Decision - Hudson Company – Case 1 Example 17. Hudson Company – Case 1 Hudson Company manufactures a variety of products for the building industry. Hudson currently uses a machine purchased one year ago with a remaining useful life of three years (original cost of $100,000, book value of $75,000). Variable costs associated with use of this machine are $122,000 per year. If the old machine is replaced it will be scrapped. An advanced technology version of the machine is now available and can be purchased for $90,000. The new machine is more efficient, has a 3-year life, and will reduce variable costs by 20%. Should Hudson Company replace the existing machine? (see Appendix 1 for the Solution)




Example 17. Hudson Company – Case 1 Retain or Replace Decision Worksheet

Retain

Replace

Change in Revenue, Costs, and Net Income

Total Costs




[Clip 23] Example 18 - Retain or Replace Decision - Hudson Company – Case 2 Example 18. Hudson Company – Case 2 Suppose the facts in Case 1 remain the same, except the old machine can be sold for $60,000. Recap of facts: Old Machine

New Machine

Original cost

$100,000

$90,000

Book value

$75,000

Not applicable

Variable costs per year

$122,000

20% less

Salvage value

$60,000

Not applicable

3 yrs

3 yrs

Useful Life

Should Hudson Company replace the existing machine? (see Appendix 1 for the Solution)





Retain


Replace




[Clip 24] Example 19 - Retain or Replace Decision - Hudson Company – Case 3 Example 19. Hudson Company – Case 3 Suppose the facts in Case 2 remain the same, except the variable costs associated with operating the old machine are $180,000 per year. Recap of facts: Old Machine

New Machine

Original cost

$100,000

$90,000

Book value

$75,000

Not applicable

Variable costs per year

$180,000

20% less

Salvage value

$60,000

Not applicable

3 yrs

3 yrs

Useful Life

Should Hudson Company replace the existing machine? (see Appendix 1 for the Solution)





Retain


Replace


Page 10 of 17 Revised: 2011-05-24


[Clip 25] Example 20 - Retain or Replace Decision - Kansas City Manufacturers - Case 1

Example 20. Kansas City Manufacturers – Case 1 Kansas City Manufacturers produce and sell a product in high demand that is manufactured with a specialized machine. Suppose the following facts are gathered regarding a retain or replace decision involving an existing machine owned by Kansas City Manufacturers. Recap of facts: Old Machine

New Machine

50,000 units

5% more

$32

$32

Original cost

$700,000

$900,000

Book value

$600,000

Not applicable

$17

25% less

$450,000

Not applicable

4 yrs remaining

4 yrs

Annual production capacity Product selling price

Variable costs per unit Salvage value Useful Life

Should Kansas City Manufacturers replace the existing machine? (see Appendix 1 for the Solution)


Page 11 of 17 Revised: 2011-05-24


Example 20. Kansas City Manufacturers – Case 1 Retain or Replace Decision Worksheet

Retain


Replace


Page 12 of 17 Revised: 2011-05-24


[Clip 26] Example 21 - Retain or Replace Decision - Kansas City Manufacturers - Case 2 Example 21. Kansas City Manufacturers – Case 2 Suppose the facts in Case 1 are the same, except the new machine has the same annual production capacity as the old and variable costs per unit operating the new machine will be 10% less than that of the old machine. Recap of facts: Old Machine

New Machine

50,000 units

same

$32

$32

Original cost

$700,000

$900,000

Book value

$600,000

Not applicable

$17

10% less

$450,000

Not applicable

4 yrs remaining

4 yrs

Annual production capacity Product selling price

Variable costs per unit Salvage value Useful Life

Should Kansas City Manufacturers replace the existing machine? (see Appendix 1 for the Solution)


Page 13 of 17 Revised: 2011-05-24


Example 21. Kansas City Manufacturers – Case 2 Retain or Replace Decision Worksheet

Retain


Replace


Page 14 of 17 Revised: 2011-05-24


APPENDIX 1 – SOLUTIONS

Incremental Analysis – Part 5 – Retain or Replace [Clip 22] Example 17 - Retain or Replace Decision - Hudson Company - Case 1 SOLUTION:

 [Clip 23] Example 18 - Retain or Replace Decision - Hudson Company - Case 2 SOLUTION:




Page 15 of 17 Revised: 2011-05-24


[Clip 24] Example 19 - Retain or Replace Decision - Hudson Company - Case 3 SOLUTION:

 [Clip 25] Example 20 - Retain or Replace Decision - Kansas City Manufacturers - Case 1 SOLUTION:




Page 16 of 17 Revised: 2011-05-24


[Clip 26] Example 21 - Retain or Replace Decision - Kansas City Manufacturers - Case 2 SOLUTION:


Page 17 of 17 Revised: 2011-05-24

Lesson FA-20-060-05 Incremental Analysis Part 5 Retain or

Recommend Documents