Question 1 (10 Marks - Suggested time approx. 23 minutes) Northern Lights Compan

Question

Question 1 (10 Marks - Suggested time approx. 23 minutes)
Northern Lights Company is considering the purchase of a new machine. The invoice price
of the machine is $140,000, freight charges are estimated to be $4,000, and installation
costs are expected to be $6,000. Salvage value of the new equipment is expected to be zero
after a useful life of 5 years. Existing equipment could be retained and used for an additional
5 years if the new machine is not purchased. At that time, the salvage value of the
equipment would be zero. If the new machine is purchased now, the existing machine would
have to be scrapped. Northern Lights’ accountant, Lisah Huang, has accumulated the
following data regarding annual sales and expenses with and without the new machine.
? Without the new machine, Northern Lights can sell 12,000 units of product annually at a
per unit selling price of $100. If the new machine is purchased, the number of units
produced and sold would increase by 10%, and the selling price would remain the same.
? The new machine is faster than the old machine, and it is more efficient in its usage of
materials. With the old machine the gross profit rate will be 25% of sales, whereas the
rate will be 30% of sales with the new machine.
? Annual selling expenses are $180,000 with the current equipment. Because the new
equipment would produce a greater number of units to be sold, annual selling expenses
are expected to increase by 10% if it is purchased.
? Annual administrative expenses are expected to be $100,000 with the old machine, and
$113,000 with the new machine.
? The current book value of the existing machine is $36,000. Northern Lights uses straightline
depreciation.
Required
Prepare an incremental analysis (over the 5 years) showing whether Northern Lights should
keep the existing machine or buy the new machine. (Ignore income tax effects.)

Explanation / Answer

Income calculation without new machine (with old machine)

Annual Sale = 12000 Units

Sale Price = 100 per unit

Gross Profit = 25 % of sales

Annual Selling Expenses = $180000

Annual Adm. Expenses = $100000

Current value of machinery = 36000

Useful life remaining = 5 Years

Salvage value = Zero

Depreciation Per year (SLM) = Value / Useful Life = 36000 / 5 = $7200 Per Year

Total Income for 5 Years = 12800 x 5 =$64000

Calculation of net income with new machine

Machine Cost = 140000 + 4000 + 6000 = $150000

Salvage Value = Zero

Useful Life = 5 Years

Depreciation per year = Value of machine / useful Life = 150000 / 5 = $30000 Per Year

Annual Sales Units = 12000 + 10% of 120000 = 13200 Units

Sales Price = $100 per unit

Gross Profit = 30% of sales

Annual Sales Expenses = 180000 + 10% of 180000 = 198000

Annual Adm Expenses = $113000

Total Income for 5 Years = 55000 x 5 =$275000

So, Net income with old machine for 5 years is $ 64000 whereas net income for 5 years with new machine is $275000 after leaving the machine value zero in balance sheet after 5 years means full absorbtion of machine cost.

So it is prudent for northern lights to purchase new machinery so it should buy the new machine.

Y 1 Y2 Y3 Y4 Y5 Annual Sales (Units) 12000 12000 12000 12000 12000 Sales Price Per Unit 100 100 100 100 100 Sales VAlue 1200000 1200000 1200000 1200000 1200000 Gross Profit (25% of Sales) 300000 300000 300000 300000 300000 Annual Selling Expenses 180000 180000 180000 180000 180000 Annual Adm. Expenses 100000 100000 100000 100000 100000 Depreciation 7200 7200 7200 7200 7200 Net Income 12800 12800 12800 12800 12800

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