Howdoweknowthatpastcosts

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Unformatted text preview: disposal is a combination of relevant and irrelevant items because it represents the difference between the book value and disposal value. It is best to consider each separately. Cost of new equipment is relevant because it is an expected future out flows. Depreciation on new equipment is relevant. Dr. Hussein Khasharmeh Dr. Hussein Khasharmeh Keep or Replace the Old Machine? Consider the following data to decide whether to keep or replace : Original cost Original cost Useful life in years Useful life in years Current age in years Current age in years Useful life remaining in years Useful life remaining in years Accumulated depreciation Accumulated depreciation Book value Book value Disposal value (in cash) now Disposal value (in cash) now Disposal value in 4 years Disposal value in 4 years Annual cash operating costs Annual cash operating costs Dr. Hussein Khasharmeh Dr. Hussein Khasharmeh Old Machine $10,000 $10,000 10 10 6 6 4 4 $ 6,000 $ 6,000 $ 4,000 $ 4,000 $ 2,500 $ 2,500 0 0 $ 5,000 $ 5,000 Replacement Machine $8,000 $8,000 4 4 0 0 4 4 0 0 N/A N/A N/A N/A 0 0 $3,000 $3,000 Cost Comparison Four Years Together Keep Replace Difference ash operating costs $20,000 $12,000 $8,000 Cash operating costs $20,000 $12,000 $8,000 ld equipment (book value): Old equipment (book value): Depreciation, or 4,000 – – Depreciation, or 4,000 – – Lump­sum write­off – 4,000 – Lump­sum write­off – 4,000 – isposal value – (2,500) 2,500 Disposal value – (2,500) 2,500 ew machine New machine acquisition cost – 8,000 (8,000) acquisition cost 8,000 (8,000) otal costs $24,000 Total costs $24,000 $21,500 $21,500 $2,500 $2,500 Dr. Hussein Khasharmeh Dr. Hussein Khasharmeh Note that the three relevant items Note are operating costs, disposal value, and acquisition cost. This gives replacement a net advantage of $2,500 over keeping, and the decision is to replace. replace Dr. Hussein Khasharmeh Dr. Hussein Khasharmeh Identify Irrelevant or Misspecified Costs The ability to recognize irrelevant costs is important The ability to recognize irrelevant costs is important to decision makers. How do we know that past costs, to decision makers. How do we know that past costs, although they are sometimes good predictors of future although they are sometimes good predictors of future costs, are irrelevant in decision making? Let’s consider costs, are irrelevant in decision making? Let’s consider such past costs as: such past costs as: Dr. Hussein Khasharmeh Dr. Hussein Khasharmeh Example, Suppose General Dynamics has 100 Example, Suppose General Dynamics has 100 obsolete aircraft parts in its inventory.. obsolete aircraft parts in its inventory The original manufacturing cost The original manufacturing cost of these parts was $100,000. of these parts was $100,000. General Dynamics can 1) remachine the parts General Dynamics can 1) remachine the parts for $30,000 and then sell them for $50,000, or for $30,000 and then sell them for $50,000, or 2) scrap them for $5,000. 2) scrap them for $5,000. Which should it do? Which should it do? Dr. Hussein Khasharmeh Dr. Hussein Khasharmeh Remachine Remachine $$50,000 50,000 30,000 330,000 0,000 30,000 Scrap Scrap Scrap Scrap $$5,000 5,000 00 Difference Difference Difference Difference $$45,000 45,000 330,000 0,000 Expected future revenue Expected future revenue Expected future costs Expected future costs Relevant excess of Relevant excess of revenue over costs $$20,000 ,000 15,000 rrevenue over costs evenue Remachine $$55,000 20,000 revenue Scrap $$15,000 Difference Accumulated historical Accumulated historical inventory cost** 1100,000 00,000 1100,000 00,000 00 iinventory cost nventory inventory Net loss on project $(80,000) $$((95,000) 95,000) $$15,000 15,000 Net loss on project Net $(80,000) Net **Irrelevant because it is unaffected by the decision. .The decision is IIrrelevant because it is unaffected by the decision The decision is rrelevant The Irrelevant The to remachine. . to remachine Dr. Hussein Khasharmeh Dr. Hussein Khasharmeh There a...
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