1. Cost Accounting for Decision-making
Lesson 7

2. Different Types of Business Decisions (Retain or Replace Equipment)
Part III
Different Types of Business Decisions
(Retain or Replace Equipment)

3. Five Types of Business Decisions
Hire, make or buy
Accept or reject an order at a special price
Eliminate or retain an unprofitable segment
Retain or replace equipment
Sell or process further
Teacher highlights the fourth type of decision-making situation – retain or replace equipment.

4. Retain or Replace Equipment
The decision to retain or replace equipment should be made very carefully because it usually involves a significant amount of cash outflow from the business. Besides the financial aspect, management should also consider the differential benefits derived from the replacement; such as an increased production capacity would enable an increased sales.
Teacher introduces some considerations in retaining/replacing non-current assets.

5. Factors to be considered:
Incremental cost / saving due to the improved efficiency provided from the new equipment.
Difference in value between options; such as the trade-in value / disposal value of the old equipment / the cost of the new equipment.
The book value of the old equipment is irrelevant because it is a sunk cost which would not affect the decision-making process.
Teacher explains some important factors for consideration in making replacement / retainment decision.

6. Retain or Replace Equipment
DECISION RULE
If the incremental costs of retaining > the incremental costs for replacing
Purchase the new equipment
If the incremental costs of retaining < the incremental costs for replacing
Retain the old equipment
Teacher explains the decision rule for retaining or replacing an equipment.

7. Example for Retaining or Replacing Equipment
The machine that a company is currently using was purchased three years ago (Original cost is $210,000 with a current book value of $120,000). It has a remaining useful life of four years and the variable costs associated are $100,000 per annum. If the machine is replaced, it can be sold for $60,000. A new model of the machine is now available and can be purchased at a cost of $200,000. The new machine has a four-year useful life and is able to reduce the company’s current variable costs by 40%.
If the existing machine can be sold at a second-hand market for $60,000, should the company retain or replace it?
Teacher uses the example to illustrate the decision to retain or replace an equipment.

8. Points to Note for Making the Decision
What are the relevant costs for retaining the existing machine?
What are the relevant benefits and costs for buying the new machine?
Compare the differences and make a conclusion.
Teacher explains the relevant points in making the decision.

9. Suggested Solution
Retain old machine
Buy new machine
Difference $
Purchase price
Sunk cost
(200,000)
Book value
N/A
Disposal value
60,000
Variable costs (4 yrs)
(400,000)
(240,000)
160,000
Total cost
(380,000)
20,000
Teacher explains the solution and makes a conclusion.
The company should replace the existing machine with the new one in order to save up to $20,000.

10. Activity 1: Class Discussion
What other factors the company should consider before making a final decision?
Teacher invites students to share their ideas on the factors that should be considered in making the replacement decision.

11. Factors to be Considered
Quality of the products: Will the products be made of a higher quality?
Environmental concerns: Is the new machine has an environmental conscious design?
Employee concerns: Is the new machine more safe to operate?
Teacher explains some possible factors for replacement decision..

12. Activity 2 – Group Discussion
A company is considering to replace an old delivery van with a new one. If it decides not to buy a new one, the old van has to be overhauled.
Information related to the old delivery van:
Original purchase price: $350,000
Accumulated depreciation: $250,000
Annual operating costs: $60,000
Disposal value at present: $40,000
Cost of overhaul: $80,000
Annual operating costs saved after the overhaul: $10,000
Disposal value (after overhaul) at the end of 6 yrs: $500
Students are divided into groups of three to four and they are required to determine the answers for the question.

13. Information related to the new delivery van:
Original purchase price: $450,000
Annual operating costs: $20,000
Disposal value at the end of 6 years: $10,000
Required:
1.State all relevant costs.
State all irrelevant costs.
Should the company purchase the new delivery van?

14. Suggested Solution 1. Relevant costs include:
- Purchase price of the new delivery van
- Cost of overhauling the old delivery van
- Disposal value of the old delivery van at present
- Disposal value of the two vans (new and after overhaul one) at the end of Year 6
- Annual operating costs for both the new and the
old delivery vans
Irrelevant costs include:
- Original purchase price of the old delivery van
- Accumulated depreciation of the old delivery van
- Annual operating costs of the old delivery van
(before the overhaul)
Teacher explains the answers and makes comments.

15. 3.
Retain old van
Buy new van
Difference $
Purchase price
(450,000)
Cost of overhaul
(80,000)
80,000
Disposal value at present
40,000
Disposal value after 6 yrs
500
10,000
9,500
Operating costs (6 yrs)*
(300,000)
(120,000)
180,000
Total costs
(379,500)
(520,000)
(140,500) *
Operating costs for the old van: ($60,000 - $10,000) x 6 years = $300,000
Operating costs for the new van: $20,000 x 6 years = $120,000
The company should not replace the delivery van. It can save $140,500 for keeping the old one.

16. Homework: Q8
Teacher asks students to do Question 8 at home.

17. END