Advanced: Decision relating to the timing of the conversion of a production process A company extracts exhaust gases from process ovens as part of the manufacturing process. The exhaust gas extraction is implemented by machin¬ ery which cost £100 000 when bought five years ago. The machinery is being depreciated at 10% per annum. The extraction of the exhaust gases enhances production output by 10000 units per annum. This production can be sold at £8 per unit and has variable costs of £3 per unit. The exhaust gas extraction machinery has directly attributable fixed operating costs of £16000 per annum.

The company is considering the use of the exhaust gases for space heating. The existing space heating is provided by ducted hot air which is heated by equipment with running costs of £10000 per annum. This equipment could be sold now for £20 000 but would incur dismantling costs of £3000. If retained for one year the equip¬ ment could be sold for £18 000 with dismantling costs of £3500.

The conversion to the use of the exhaust gases for space heating would involve the following:

(i) The removal of the existing gas extraction machinery. This could be implemented now at a dismantling cost of £5000 with sale of the machinery for £40 000. Alternatively it could be sold in one year’s time for £30 000 with dismantling costs of £5500.

(ii) The leasing of alternative gas extraction equipment at a cost of £4000 per annum with annual fixed running costs of £12 000.

(iii) The conversion would mean the loss of 30% of the production enhancement which the exhaust gas extraction provides for a period of one year only, until the new system is ‘run- in’.

(iv)The company has a spare electric motor in store which could be sold to company X for £3500 in one year’s time. It could be fitted to the proposed leased gas extraction equipment in order to reduce the impact of the production losses during the running-in period. This course of action would reduce its sales value to company X in one year’s time to £2000 and would incur £2500 of fitting and dismantling • costs. It would, however, reduce the produc¬ tion enhancement loss from 30% to 10% during the coming year (year 1). This would not be relevant in year 2 because of an anticipated fall in the demand for the product. The electric motor originally cost £5000. If replaced today it would cost £8000. It was purchased for another process which has now been discontinued. It could also be used in a cooling process for one year if modified at a cost of £1000, instead of the company hiring cooling equipment at a cost of £3000 per annum. Because of its modification, the elec¬ tric motor would have to be disposed of in one year’s time at a cost of £250.
Ignore the time value of money.
Required:

(a) Prepare an analysis indicating all the options available for the use of the spare electric motor and the financial implications of each. State which option should be chosen on financial grounds. (8 marks)

(b) Prepare an analysis on an incremental oppor¬ tunity cost basis in order to decide on finan¬ cial grounds whether to convert immediately to the use of exhaust gases for space heating or to delay the conversion for one year.