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 $4-$year expected life. It will replace existing machinery leased

$1$ year earlier at an annual lease cost of $$490,000$ committed for $5$ 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 cutomer 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

under $1\mathrm{.}5$ 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 $1\mathrm{.}5$ months. Annual inventory carrying cost is $20\%$ of

inventory value.

Category Old Machine New Machine

Average per unit cost of raw materials inventory $$12$ $$11$

Average per unit cost of work$-$in$-$process inventory $2520$

Average per unit cost of finished goods inventory $4636$

Variable cost per unit sold $4232$

a$)$ What is the total value of annual benfits from the new machinery, including changes in

inventory carrying costs? Round all calculations to whole dollar amounts.

$Answer

b$)$ Rossman's will incur an early termination penalty on the existing equipment lease. Would you

still advise the company to replace the existing equipment? Answer $2$

Yes