The TechGuide Company produces and sells 6.500 modular computer desks per year a

Question

The TechGuide Company produces and sells 6.500 modular computer desks per year at a selling price of $650 each. Its current production equipment, purchased for $1,350,000 and with a five-year useful life, is only two years old. It has a terminal disposal value of $0 and is depreciated on a straight-line basis. The equipment has a current disposal price of $500,000. However, the emergence of a new molding technology has led TechGuide to consider either upgrading or replacing the production equipment. The following table presents data for the two alternatives: All equipment costs will continue to be depreciated on a straight-line basis. For simplicity, ignore income taxes and the time value of money. Should TechGuide upgrade its production line or replace it? Show your calculations. Now suppose the one-time equipment cost to replace the production equipment is somewhat negotiable. All other data are as given previously. What is the maximum one-time equipment cost that TechGuide would be willing to pay to replace rather than upgrade the old equipment? Assume that the capital expenditures to replace and upgrade the production equipment are as given in the original exercise, but that the production and sales quantity is not known. For what production and sales quantity would TechGuide (i) upgrade the equipment or (ii) replace the equipment? Assume that all data are as given in the original exercise. Dan Doria is TechGuide's manager, and his bonus is based on operating income. Because he is likely to relocate after about a year, his current bonus is his primary concern. Which alternative would Doria choose? Explain.

Explanation / Answer

Altrnative 1 : Upgrade

Alternative 2 : Replace

Alternative 2, i.e Replacing the old equipment gives a higher total operating income over the life of the investment. Therefore, TechGuide should replace its production line

Increase in fixed cost per annum = $ 1,400,000 - $ 1,170,000 = $ 230,000

Increase in contribution margin per unit= $ 150 - $ 85 = $ 65

Break-even volume = 230,000 / 65 = 3,538 units

Upto 3,538 units, it will be profitable to continue with the current production line.

Beyond 3,538 units of production, it will be profitable to replace the old production line.

Year 1 Year 2 Year 3 Total Sales 4,225,000 4,225,000 4,225,000 Variable cost 975,000 975,000 975,000 Contribution margin 3,250,000 3,250,000 3,250,000 Depreciation expense 1,170,000 1,170,000 1,170,000 Operating income 2,080,000 2,080,000 2,080,000 6,240,000

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