OPERATING DECISIONS 131
Equipment replacement..................................
A further example of the use of relevant costs is in the decision to replace plant
and equipment. Once again, the concern is with future incremental cash flows, not
with historical or sunk costs or with non-cash expenses such as depreciation.
Mammoth Hotel Company replaced its kitchen one year ago at a cost of
£120,000. The kitchen was to be depreciated over five years, although it will still
be operational after that time. The hotel manager wishes to expand the dining
facility and needs a larger kitchen with additional capacity. A new kitchen will
cost £150,000, but the kitchen equipment supplier is prepared to offer £25,000 as
a trade-in for the old kitchen. The new kitchen will ensure that the dining facility
earns additional income of £25,000 for each of the next five years.
The existing kitchen incurs operating costs of £40,000 per year. Due to labour
saving technology, operating costs, even with additional dining, will fall to £30,000
per year if the new kitchen is bought. These figures are shown in Table 9.6. On a
relevant cost basis, the difference between retaining the old kitchen and buying
the new kitchen is a saving of £50,000 cash flow over five years. On this basis, it
makes sense to buy the new kitchen.
The original kitchen cost has been written down to £96,000 (cost of £120,000 less
one year’s depreciation at 20% or £24,000). The original capital cost is a sunk cost
and is therefore irrelevant to a future decision. The loss on sale of £71,000 (£96,000
writtendownvalue−£25,000 trade-in) will affect the hotel’s reported profit, but
it is not a future incremental cash flow and is therefore irrelevant to the decision.
However, there is a tension between a decision based on future incremental cash
flows and the reported financial position that will show a significant (non-cash)
financial loss in the year in which the old kitchen is written off. The political
aspects of such a decision were discussed in Chapter 5. Other aspects of capital
expenditure decisions are explained in Chapter 12.
Relevant cost of materials.................................
As the definition of relevant cost is the future incremental cash flow, it follows
that the relevant cost of direct materials is not the historical (or sunk) cost but the
Table 9.6 Relevant costs –equipment replacement
Retain old kitchen Buy new kitchen
Purchase price of new kitchen −£150,000
Trade-in value of old machine +£25,000
Operating costs
£40,000 p.a.×5years −£200,000
£30,000 p.a.×5years −£150,000
Additional income from dining of
£25,000 p.a.×5years+£125,000Total relevant cost −£200,000 −£150,000