Question

Sean Fitzpatrick manages the Peoria plant of Garcia Manufacturing. A representative of Darien Engineering approaches Fitzpatrick about replacing a large piece of manufacturing equipment that Garcia uses in its process with a more efficient model. While the representative made some compelling arguments in favor of replacing the 3-year-old equipment, Fitzpatrick is hesitant. Fitzpatrick is hoping to be promoted next year to manager of the larger Detroit plant, and he knows that the accrual-basis net operating income of the Peoria plant will be evaluated closely as part of the promotion decision. The following information is available concerning the equipment replacement decision:

• The historic cost of the old machine is $800,000. It has a current book value of $320,000, two remaining years of useful life, and a market value of $200,000. Annual depreciation expense is $160,000. It is expected to have a salvage value of $0 at the end of its useful life.
• The new equipment will cost $500,000. It will have a 2-year useful life and a $0 salvage value. Garcia uses straight-line depreciation on all equipment.
• The new equipment will reduce electricity costs by $90,000 per year and will reduce direct manufacturing labor costs by $85,000 per year.

If Garcia decides to replace the equipment, the next year’s accrual-based net operating income would

		decrease by $35,000
		decrease by $20,000
		increase by $65,000
		decrease by $40,000
		increase by $50,000

Answer 1

The correct answer is

Decrease by $ 35000

Explanation

Net increase (decrease) in accrual income = Saving in electricity cost + saving in direct labour cost - Increase in depreciation expense - Loss on sale of machinery

= 90000 + 85000 - ((500000/2)-160000) - (3200000-200000)

=- $ 35000

= $ 35000 Decrease