Cost savings: replacement decision Rossman Instruments, Inc., is considering leasing new state-of-the-art machinery at an annual cost of $900,000. The new machinery has a four year expected life. It will replace existing machinery leased one year earlier at an annual lease cost of $490,000 committed for five years. Early termination of this lease contract will incur a $280,000 penalty. There are no other fixed costs.
The new machinery is expected to decrease variable costs from $42 to $32 per unit sold because of improved materials yield, faster machine speed, and lower direct labor, supervision, materials handling, and quality inspection requirements. The sales price will remain at $56. Improvements in quality, production cycle time, and customer responsiveness are expected to increase annual sales from 36,000 units to 48,000 units.
The variable costs stated earlier exclude the inventory carrying costs. Because the new machinery is expected to affect inventory levels, the following estimates are also provided. The enhanced speed and accuracy of the new machinery are expected to decrease production cycle time by half and, consequently, lead to a decrease in work-in-process inventory level from 3 months to just 1.5 months of production. Increased flexibility with these new machines is expected to allow a reduction in finished goods inventory from 2 months of production to just 1 month. Improved yield rates and greater machine reliability will enable a reduction in raw materials inventory from 4 months of production to just 1.5 months. Annual inventory carrying cost is 20% of inventory value.
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CATEGORY
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OLD MACHINE
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NEW MACHINE
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Average per unit cost of raw materials inventory
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$12
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$11
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Average per unit cost of work-in-process inventory
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25
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20
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Average per unit cost of finished goods inventory
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46
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36
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Variable cost per unit sold
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42
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32
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Required
(a) Determine the total value of annual benefits from the new machinery. Include changes in inventory carrying costs.
(b) Should Rossman replace its existing machinery with the new machinery? Present your reasoning with detailed steps identifying relevant costs and revenues.
(c) Discuss whether a manager evaluated on the basis of Rossman’s net income will have the incentive to make the right decision as evaluated in part b.