Question

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Question 1 Murl Plastics Ltd purchased a new machine one year ago at a cost of £66,000. Although the machine operates well, the managing director (MD) wondered if the company should replace it with a new electronically operated machine that has just come on the market. The new machine would reduce annual operating costs by two-thirds, as shown in the comparative data below: Purchase cost new Estimated useful life new Annual operating costs Annual straight-line depreciation Remaining book value Salvage value now Salvage value in 5 years Present machine £66,000 6 years 42,000 11,000 55,000 10,000 New machine £90,000 5 years 14,000 18,000 In trying to decide whether to purchase the new machine, the MD has prepared the following analysis: Book value of the old machine £55,000 10,000 Less salvage value Net loss from disposal 45,000 'Even though the new machine looks good,' said the managing director, 'we can't get rid of the old one if it means taking a huge loss on it. We'll have to use it for at least a few more years. Sales are expected to be £200,000 per year, and selling and administrative expenses are expected to be £128,000 per year, regardless of which machine is used. a) Prepare a summary profit statement covering the next five years, assuming: I. That the new machine is not purchased. (8 marks) II. That the new machine is purchased. (8 marks) b) Determine the desirability of purchasing the new machine using only relevant costs in your analysis. (9 marks) Page 2 of 6

Answer 1

(a) Year 1 Old Machine Year 2 200000 200000 Year 3 Year 4 Year 5 200000 200000 200000 Sales Less: Costs Annual Operating Costs Selling and Admin Expenses Depreciation Profit 42000 128000 11000 19000 42000 128000 11000 19000 42000 128000 11000 19000 42000 128000 11000 19000 42000 128000 11000 19000 Year 1 New Machine is purchased Year 2 Year 3 200000 200000 Year 4 Year 5 200000 200000 200000 Sales Less: Costs Annual Operating Costs Selling and Admin Expenses Depreciation 14000 14000 128000 18000 40000 14000 128000 18000 40000 14000 128000 18000 14000 128000 18000 40000 128000 18000 40000 Profit 40000

(b) Now we shall consider the desirability of purchasing the new Machine by comparing the Relevant Costs in both the proposals The First Proposal is using the old machine and Second Proposal is Selling the old one at accounting loss of 45000 and buying the new one Relevant Costs in this proposal shall be Annual Operating costs and Depreciation as these are the only costs that differ in the two proposals We shall not consider the loss on sale of old machine as its the sunk cost. Annual Operating Costs Depreciation Old Machine 42000 11000 53000 New Machine 14000 18000 32000 Net Benefit Per Year (53000-32000) 21000 New Machine Should be purchased as the relevant costs are lower.