Some time choice to be made between retention or replacement of equipment. The primary function of equipment managers is to replace the right equipment at the right time and at the lowest overall cost. Basically, replacement of machine or equipment is a capital investment or long-term decision requiring the use of a discounted cash flow technique. But, here the discussion is confined to short-range problems. The judgment which the owner-manager of a small company makes should be the result of weighing the costs of keeping the old equipment against the cost of its replacement. Therefore, only one aspect of replacement will be dealt with, i.e. how to deal with written down/book value of old equipment. And the differential cost approach is primarily followed because the replacement will invariably involve additional fixed cost. To recognize the better alternative you need to know the total cost of each alternative – keeping the old equipment or buying a replacement. Major considerations relevant to the decision are given below:
- Determine relevant items of cash outflows and inflows due to the decision.
- Book value or written down value is irrelevant for the decisions- loss on sale of old machinery is irrelevant for this decision.
- Sales proceeds of old equipment are relevant for the decision and are considered for this analysis.
- Replacement of machinery may bring down the cost per unit, but it may involve capital outlay. Here the firm may have to decide at what point replacement will be justified.
- Profit or loss on sales of assets being replaced may affect tax payment and this taxation effect should be included in the analysis.
Items Of Differential Cost:
- Capital equipment and associated cost, viz, interest and depreciation.
- Loss on sales of old equipment (if affected by tax)
- Increase in fixed overhead cost.
Items of Differential Benefits:
- Saving in operating cost – tax benefits if any
- Increase volume and value of production
- Realizable value of the old machine.