HRM 500: 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.
- 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.
- 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.