Jeff Howell is a production manager at a metal fabricating plant. Last night he

Question

Jeff Howell is a production manager at a metal fabricating plant. Last night he read an article about a new piece of Equipment that would dramatically reduce his division's costs. Jeff was very excited about the prospect, and the first thing he did this morning was to bring the article to his supervisor. Nathan Peas, the plant manager. The following converstation occurred:
Jeff: Nathan, I thought you would like to see this article on the new PDD1130;
they've made some fatastic changes that could save us millions of dollars.
Nathan: I appreciate your interest Jeff, but I actually have been aware of the new
machine for two months. The problem is that we just bought a new machine
last year. We spent $2 million on that machine, and it was supposed to last us 12 years. If we replace it now should our existing machine for a couple of
years, and then when it becomes obvious that we have to have a new
machine, I will make the proposal
Instructions:
Jeff just completed a course in managerila accounting, and he believes that Nathan is making a big mistake. Write a memo from Jeff to Nathan explaining Nathan's decision-making error.

Explanation / Answer

Sunk Costs are past costs that have already been incurred and cannot be recovered.Whatever amounts are invested on old machines are called Sunk Cost. If the sunk cost amount is higher than the investment of a new machine, then we have to replace the old machine with new machine. If we are comparing the profit margins between the old and new machines,we can take decision to replace the existing one. A replacement ,on the other hand, is the substitution of a similar one.If the replacement cost is lower than the expenditure on the existing machine ,then it is better to replace the existing one.

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