Equipment Replacement Oilers Company makes a computer desk that it sells for $30 under a contract to a large computer retailer. The company operates one shift in its Ohio plant. The annual normal capacity is 100,000 units.
Oilers pays direct labor at $8.00 per hour. An employee can produce a desk in 2 hours. Each desk requires 8 board feet of hardboard costing $0.25 per board foot. Indirect manufacturing costs (man- ufacturing overhead) at normal capacity of 100,000 units are described by the following formula:
Total costs = Fixed costs + (Variable cost per uunit X units manufactured) Total costs = $25,0000 + ($0.30/unit X units manufactured)
Some years ago, Oilers installed a saw that now has a carrying (book) value of $20,000, which is being depreciated at $2,000 a year. At the time of installation, the saw was expected to have no salvage value at the end of its useful life because that value would equal its dismantling costs.
A sales agent from Whalers Company is encouraging Oilers Company to replace the saw with a numerical saw. In addition to being able to perform precision cutting, the new saw also will reduce by half the time to make a desk. Because the new saw is more powerful than the present one, utility costs are expected to increase by $0.10 per unit.
The new saw will cost $100,000, including installation, testing, and transportation charges. Its estimated useful life is 10 years and will be depreciated using the straight-line (SL) method with
$10,000 estimated salvage value.
Whalers Company agrees that, if Oilers buys the saw, Whalers will buy the old one for $4,000 and charge Oilers no dismantling costs. The income tax rate is 40 percent. Oilers management expects a 15 percent after-tax return on investment. The loss on the trade-in of the current saw is allowable as an income-tax deduction.
Required
1. As a financial analyst for Oilers, you are charged with analyzing the purchase of the new saw. In preparing a report for the president, you must determine the following for management's consideration:
a. The contribution margin per unit under current operating conditions.
b. The standard overhead rate (application rate) per unit under current operating conditions.
c. The formula for indirect manufacturing costs (manufacturing overhead), assuming the purchase and installation of the new saw.
d. The new saw's manufacturing overhead standard rate (application rate) per unit, based on a normal capacity of 100,000 units.
e. The contribution margin per unit, assuming the sales price remains unchanged, if the new saw is purchased and installed.
f. The net additional investment for the new saw, assuming that Oilers decides to purchase and install it.
g. The expected net additional cash flow per year if the new saw is purchased and installed. Assume that the company sells all that it produces.
2. The firm will be able to reduce approximately half of the hourly production workers currently on its payroll if the new saw is purchased. The plant has been in its current location for more than 50 years. Over 40 percent of the households in this small southeast Ohio town have at least one member who works for the firm. Should the firm purchase the state-of-the-art equipment? Why or why not?