Lesson FA-20-060-05 Incremental Analysis Part 5 Retain or ...evideolearner.com/ppv_ac20/fa/FA-20-060-05-Workbook.pdf · File: FA-20-060-05-Workbook.pdf Title: Managerial Accounting

File: FA-20-060-05-Workbook.pdf

Title: Managerial Accounting – Incremental Analysis – Retain or Replace

_____________________________________________________________________________________________ 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

Lesson FA-20-060-05

Incremental Analysis

Part 5 – Retain or Replace

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Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 2 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




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)





Retain or Replace Decision Worksheet

Retain

Replace

Change in

Revenue, Costs,

and Net Income

Total Costs





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

Useful Life 3 yrs 3 yrs








Retain

Replace

Change in

Revenue, Costs,

and Net Income





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:


Original cost $100,000 $90,000


Variable costs per year $180,000 20% less


Useful Life 3 yrs 3 yrs








Retain

Replace

Change in

Revenue, Costs,

and Net Income




[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:


Annual production capacity 50,000 units 5% more

Product selling price $32 $32

Original cost $700,000 $900,000


Variable costs per unit $17 25% less


Useful Life 4 yrs remaining 4 yrs

Should Kansas City Manufacturers replace the existing machine?







Retain

Replace

Change in

Revenue, Costs,

and Net Income




[Clip 26] Example 21 - Retain or Replace Decision - 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:


Annual production capacity 50,000 units same

Product selling price $32 $32

Original cost $700,000 $900,000


Variable costs per unit $17 10% less


Useful Life 4 yrs remaining 4 yrs

Should Kansas City Manufacturers replace the existing machine?







Retain

Replace

Change in

Revenue, Costs,

and Net Income




APPENDIX 1 – SOLUTIONS

Incremental Analysis – Part 5 – Retain or Replace

[Clip 22] Example 17 - Retain or Replace Decision - Hudson Company - Case 1

SOLUTION:


SOLUTION:





SOLUTION:

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

SOLUTION:




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

SOLUTION:

Documents

Lesson FA-20-060-05 Incremental Analysis Part 5 Retain or ...evideolearner.com/ppv_ac20/fa/FA-20-060-05-Workbook.pdf · File: FA-20-060-05-Workbook.pdf Title: Managerial Accounting