REPLACEMENT OF OLD EQUIPMENT

The decision to replace a piece of equipment should be based on facts and figures. The judgment which the owner manager of a small company makes should be the result of weighing the costs of keeping the old equipment against the cost of its replacement. Sooner or later, one must decide whether to keep an existing unit of equipment or replace it with a new unit.  As tie goes by equipment deterioration and becomes obsolete. Frequent breakdowns occur, defective output increases, unit labour costs rise and production schedules cannot be met. At some point, these occurrences become serious enough to cause us to wander whether or not we should replace the equipment.

To recognize the better alternative we need to know the total cost of each alternative keeping the old equipment or buying a replacement. Once these costs are determined we can compare them and identify the more economical equipment.

Let us consider few essential factors that influence the buying of new equipment or the replacement of old equipment:-

  • Depreciation– One of the costs connected with any type of equipment is depreciation. For cost comparison purposes, depreciation is simply the amount by which an asset decreases in value over some period of time e.g. if we brought a piece of equipment for Rs 1 lakh (Rs 1,00,000) and sold it for Rs 30,000 after 7 years of service, we would say that the depreciation is 1,00,000- 30,000= 70,000 (was one of the costs owing the equipments for that period). From this it follows that when considering equipment replacement one must calculate the future depreciation expense that one will experience with both the old and the new equipment. As far as the new equipment is concerned this calls for knowing certain things about the equipments:-
  • Its initial cost. 2) Its estimated service life. 3) Its expected salvage value (the estimated value that an asset will realize upon its sale at the end of its useful life).

The difference between the first cost and the salvage value will represent the amount by which the equipment will depreciate during its life i.e. during the time we expect to use it.

To determine the actual future depreciation expense that will be experienced with the old equipment we must know: – 1) Its market value 2) Its estimated remaining service life. 3) Its expected salvage value at the end of that life. The difference between the 1) and 3) represents the amount by which the equipment will depreciate during its remaining life in the business.

  • Interest– Every piece of equipment generates an interest an interest expense. The expense occurs because owing an asset ties up some of your capital. If you had to borrow this capital you would have to pay for the use of the money. The “opportunity cost” is one of the costs of owing the equipments. In any comparison of equipment alternatives, you must take the cost of money into account. So when determining whether or not existing equipment should be replaced you must estimate what money is costing you in terms of a percent per year.
  • Operating costs– Typical operating cost are expenditures for labour, materials, supervision, maintenance and power. These costs must be considered because of your choice of equipment affect them. It may be convenient to estimate these costs on annual basis. One can get figures for each unit equipment by estimating its next year operating costs as well s the annual rate at which these costs are likely to increase as wage rates rise and the equipment deteriorates. We might say that the operating cost for the new equipment is likely to be Rs 15,000-20,000 during ist year of life. It can also be estimated that after 1st year, the operating costs will increase at a rate of Rs 1000-5000 a year.

One can simplify the problem of estimating these costs by either a) ignoring these costs that are the same for the old and new equipment or b) estimating only the difference between the operating costs of the two units.

With this simplification, the total costs which you calculate for each type of equipment will be understated by the same amount. Therefore, the difference between these total costs will remain the same and we will still be able to recognize the more economical alternative.

  • Revenues– Often the revenues generated by the old and the new equipment will be the same. When this is true, revenues can be ignored for the same reason that you can ignore equal operating costs.

But if revenues are affected by the choice of equipment they must be considered e.g. we must know that the higher quality of output from the new equipment will increase annual sales by Rs 50,000. We can handle this difference in revenues in either of the 2 ways:-

  1. One way is to show the Rs 50,000 as an additional annual cost that will be experienced with the old equipment. b) The other way is to treat Rs 50,000 as a negative cost and associate it with new equipment.