The Red Phaser division of Sulu Enterprises expects to report a pretty good year to headquarters and to shareholders. They expect to produce and sell 40,000 phasers throughout the galaxy this year. While the machinery currently used in the production process is fairly old, it is not very expensive to operate. It has a current book value of $250,000, one remaining year of useful life, and no expected salvage value at the end of the year. However, the machine could be sold for $100,000 now.
Because the machinery is not state-of-the-art, the production process is fairly labor intensive. As a result, the company’s labor costs are high. In addition, the current production process also consumes a lot of variable overhead.
Another factor that is expected to contribute to this year’s success is the foresight (or luck) of Red Phaser’s purchasing manager, Mr. Rickey. Mr. Rickey purchased 40,000 pounds of Alpha, the raw material that the current machinery uses to produce phasers, at the end of last year for $10 per pound. This was quite fortunate, since the price of Alpha has subsequently skyrocketed, and now costs $20 per pound. Under current operating conditions, the 40,000 pounds of Alpha on hand is enough to satisfy this year’s production of 40,000 units of output (each unit of output requires 1 pound of raw material Alpha on the currently used machine). Another factor that is expected to add to this year’s success is a current change in the policy of the federation of republics in the galaxy. The new policy has banished taxes on income.
Using the current machine, the company therefore expects the costs that will appear in their operating income for the coming year to be
Direct Materials 1 lb.of Alpha @ $10 per lb $10.00
Direct Labor 1.6 hrs @ $12.50 per hr 20.00
Variable Overhead @ $8 per unit 8.00
Fixed Overhead $250,000/40,000 units 6.25
Total Cost Per Unit $44.25
The manager of the Red Phaser division is considering replacing the old machine with a new one. The new machine offers the flexibility of being capable of processing either Raw Material Alpha or a newly developed synthetic raw material Beta. However, the new machine does not work very efficiently with raw material Alpha. Half of the Alpha gets wasted in the process, which means that 2 lbs. of raw material Alpha are necessary to produce a unit of output with the new machine. The new machine is very efficient at using the new synthetic — it requires 1 pound of the synthetic material Beta to produce a unit of output. Neither the choice of the machine nor the choice of the raw material is expected to have any perceptible effect on the quality of the finished product. Production and sales volumes are expected to be 40,000 units regardless of which machine is used.
The new machine would be rented for $300,000. While it is expensive, the new machine is also more sophisticated than the old machine. As a result, the labor time would be cut by 25 percent. Dr. Scotty, the production engineer of Red Phaser, favors replacing the old machine. He argues that if the new machine is obtained, raw material Beta should be used because it is less expensive than either the old Material Alpha or any new Alpha that might have to be purchased. That is, he calculates that it will cost $12 for materials to make a unit of output using raw material Beta (i.e., 1 lb. of Beta @ $12/lb.), versus $20 for using the old Alpha (2 lbs. @ $10/lb.) or $40 for using any newly purchased Alpha (2 lbs. @ $20/lb.). Mr. Rickey informed Dr. Scotty that, if not used, the existing stock of Alpha can be sold in the market, at a price of $12 per pound.
To support his argument for acquiring the new machine, Dr. Scotty provides the following calculation of Red Phaser’s expected operating costs with the new machine.
Direct Materials 1 lb. of Beta @ 12 per lb. $12.00
Direct Labor 1.2 hours @ $12.50 per hour 15.00
Variable Overhead @ 40 percent of Direct Labor 6.00
Fixed Overhead $300,000/40,000 units 7.50
Total Cost per unit $40.50
Required:
- What should Red Phaser do? Support your answer with relevant cash flows and a discussion of all relevant factors.
- Ignore your answer to part (1). The comparison in the statement of the problem implicitly assumes that direct labors costs change depending on which machine is used. That is, the new machine will decrease labor costs by 25 percent. According to the galactic labor laws, the company must pay 75% of wages to any displaced workers for one year. However, the displaced workers can be redeployed for some other less productive activities without having to pay full 100% of wages. How does this change your analysis, if company has no other activities to engage the displaced workers? Or, have some less productive activities to use the displaced workers? Will this labor law work in the direction of favoring replacing the old machine or keeping it? Support your answer with relevant cash flows and a discussion of all relevant factors.
- Suppose in addition to information in question 2, the sales volume for Red Phaser is expected to be considerably higher than 40,000, will this work in the direction of favoring replacing or keeping the old machine?
