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Retain or Replace Equipment - One other point about...

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Retain or Replace Equipment Management often has to decide whether to continue using an asset or replace it. To illustrate, assume that Jeffcoat Company has a factory machine with a book value of $40,000 and a remaining useful life of four years. A new machine is available that costs $120,000. It is expected to have zero salvage value at the end of its four-year useful life. If Jeffcoat acquires the new machine, variable manufacturing costs are expected to decrease from $160,000 to $125,000 annually, and the old unit will be scrapped. The incremental analysis for the four-year period is as follows. 23-9 Incremental analysis—retain or replace equipment In this case, it is advantageous to replace the equipment. The lower variable manufacturing costs related to the new equipment more than offset its purchase cost.
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Unformatted text preview: One other point about Jeffcoat's decision: The book value of the old machine does not affect the decision. Book value is a sunk cost , which is a cost that cannot be changed by any present or future decision. Sunk costs are not relevant in incremental analysis . In this example, if the company retains the asset, book value is depreciated over its remaining useful life. Or, if the company acquires the new unit, book value is recognized as a loss of the current period. Thus, the effect of book value on current and future earnings is the same regardless of the replacement decision. However, any trade-in allowance or cash disposal value of the existing asset is relevant to the decision, because the company will not realize this value if the old asset is continued in use....
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