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A company is considering replacing an old piece of machinery, which cost $105,000 and has $55,000 of accumulated depreciation to date, with a new machine that has a purchase price of $83,000. The old machine could be sold for $56,300. The annual variable production costs associated with the old machine are estimated to be $8,500 per year for eight years. The annual variable production costs for the new machine are estimated to be $5,000 per year for eight years.
a. Prepare a differential analysis dated April 29 to determine whether to continue with (Alternative 1) or replace (Alternative 2) the old machine.
b. What is the sunk cost in this situation?

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Answer:

Replacing the old machine would produce a net saving of $1,300

The sunk cost in this situation is the purchase cost (i.e $105,000) of the old machine.

Explanation:

Differential Analysis

Purchase cost of the new machine                                 (83,000)

Savings from annual variable cost(8500×8)                   68,000

Variable cost of running the new machine (5,000×8)   (40,000)

Scrap value of the old machine                                        56,300  

Differential savings                                                            1,300  

Replacing the old machine would produce a net saving of $1,300

The sunk cost in this situation is the purchase cost (i.e $105,000) of the old machine. It is a past cost incurred as a result old decision.

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