Discussion:
Equipment replacement decisions and performance evaluation
Bob Moody manages the Knoxville plant of George Manufacturing. He has been approached by a representative of Darda Engineering regarding the possible replacement of a large piece of manufacturing equipment that George 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, Moody is hesitant. Moody is hoping to be promoted next year to manager of the larger Chicago plant, and he knows that the accrual-basis net operating income of the Knoxville 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 $300,000. It has a current book value of $120,000, two remaining years of useful life, and a market value of $72,000. Annual depreciation expense is $60,000. It is expected to have a salvage value of $0 at the end of its useful life.
• The new equipment will cost $180,000. It will have a two-year useful life and a $0 salvage value. George uses straight-line depreciation on all equipment.
• The new equipment will reduce electricity costs by $35,000 per year, and will reduce direct manufacturing labor costs by $30,000 per year.
For simplicity, ignore income taxes and the time value of money.
Required
1. Assume that Moody's priority is to receive the promotion, and he makes the equipment replacement decision based on next year's accrual-based net operating income. Which alternative would he choose? Show your calculations.
2. What are the relevant factors in the decision? Which alternative is in the best interest of the company over the next two years? Show your calculations.