Question

The Enhanced Products Division of Forrest Industries makes ceramic pots that are used to hold large decorative plants. During 2013, the division produced 10,000 pots and incurred the following costs:

Unit-level materials costs (10,000 @ $15)- 150,000

Unit-level labor cost (10,000 @ $20)- 200,000

Unit level overhead cost (10,000 @$16)- 160,000

Depreciation expense on equipment*- 30,000

Other manufacturing overhead**- 36,000

*The equipment was purchased for $150,000 and has a current book value of $120,000, remaining useful life of four years, and a zero salvage value. If the company does not use the equipment, it can be leased for $8,000 per year.

**Includes supervisors' salaries and rent for manufacturing plant.

The division is considering replacing the equipment used to manufacture its ceramic pots. Replacement equipment can be purchased at a price of $200,000. The new equipment, which is expected to last 4 years and have a salvage value of $20,000, will reduce unit-level labor costs by 25 percent.

The division desires to maintain its production and sales at 10,000 ceramic pots per year:

a) What is the amount of the total relevant cost of operating the existing equipment?

b) What is the amount of the total relevant cost of operating the new equipment?

c) True or False: The existing equipment should be replaced.

Answer 1

Relevant costs are future costs that change between the alternatives.

The unit-level material costs, unit-level overhead cost, other manufacturing overhead costs are irrelevant since they do not change whether existing equipment or new equipment is used. The depreciation of the existing equipment is irrelevant since it is a sunk cost. These costs have thus been excluded from the computation of the total relevant cost.

	For 4 years
	Existing Equipment	New Equipment
Purchase cost of new equipment		200000
Salvage value of new equipment		-20000
Unit-level labor cost	800000	600000
Opportunity cost of leasing the equipment	32000
Total relevant cost $	832000	780000

a) Total relevant cost of operating the existing equipment: $832,000

b) Total relevant cost of operating the new equipment: $780,000

c) The existing equipment should be replaced: True