Some time choice to be made between retention or replacement of equipment. Basically, replacement of machine or equipment is a capital investment or long-term decision requiring use of discounted cash flow technique. But, here discussion is confined to short range problems. Therefore, only one aspect of replacement will be dealt with, i.e. how to deal with written down/book value of old equipment. And differential cost approach is primarily followed because replacement will invariably involve additional fixed cost. Major considerations relevant to 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 equipments is relevant for the decision and be 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 analysis.
Items Of Differential Cost:
- Capital equipment and associated cost, viz, interest and depreciation.
- Loss on sales of old equipment ( if affect 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 old machine.
