Exercise 14-31

Valley Pizzas owner bought his current pizza oven two years ago for $9,000, and it has one more year of life remaining. He is using straight-line depreciation for the oven. He could purchase a new oven for $ 1,900, but it would last only one year. The owner figures the new oven would save him $2,600 in annual operating expenses compared to operating the old one. Consequently, he has decided against buying the new oven, since doing so would result in a loss of $400 over the next year.

Required: 1. How do you suppose the owner came up with $400 as the loss for the next year if the new pizza oven were purchased? Explain. 2. Criticize the owners analysis and decision. 3. Prepare a correct analysis of the owners decision.

1.	The owners reasoning probably reflects the following calculation:
	Savings in annual operating expenses if old pizza oven is replaced ...........	$2,600
	Write-off of old ovens remaining book value ($9,000 3) ...........................	(3,000	)
	Loss associated with replacement ...............................................................	$ (400	)
2.	The owners analysis is flawed, because the book value of the old pizza oven is a sunk cost. It should not enter into the equipment replacement decision.
3.	Correct analysis:
	Savings in annual operating expenses if old pizza oven is replaced ...........	$2,600
	Acquisition cost of new oven, which will be operable for one year .............	(1,900	)
	Net benefit from replacing old pizza oven .......................................................	$ 700