SELECTION OF RELEVANT DATA
IN ANNUAL-COST STUDIES
An existing factory must be enlarged or replaced to accommodate new production ma-
chinery. The structure was built at a cost of $130,000. Its present book value, based on
straight-line depreciation, is $35,000, but it has been appraised at $40,000. If the struc-
ture is altered, the cost will be $80,000 and its service life will be extended 8 years, with
a salvage value of $30,000. A new factory could be purchased for $250,000. It would
have a life of 20 years and a salvage value of $35000. Annual maintenance costs of the
new building would be $8000, compared with $5000 in the enlarged structure. Howev-
er, the improved layout in the new building would reduce annual production costs by
$12,000. All other expenses for the two structures are estimated as being equal. Using
an investment rate of 8 percent, determine which is the more attractive investment for
this firm.
Calculation Procedure:
- Segregate the relevant data for the existing structure
Relevant data-present resale value. Irrelevant data-cost of construction and present book
value. - Record the pertinent cost data for each scheme
Classify the income that would accrue from one scheme as a "cost" of its alternative.
Thus
Enlarged building New building
Initial cost or payment, $ 80,000 250,000
Resale value existing building, $ 40,000
Total first cost, $ 120,000 250,000
Salvage value, $ 30,000 35,000
Life, years 8 20
Operating cost, $ 5,000 8,000
Production "cost," $ 12,000- Compute the annual cost of the enlarged building
Using the capital-recovery factor for Z 1 = 8 percent, n = 8 years, we have A = ($120,000 -
$30,0,000)(0.17401) + $30,000(0.08) + $5000 + $12,000 = $35,061. - Compute the annual cost of the new building
Using the capital-recovery factor for / = 8 percent, n = 20 years gives A = ($250,000 -
$35,000)(0.10185) + $35,000(0.08) + $8000 = $32,698.
Since the new building has an annual cost almost $2400 less than the enlarged existing
structure, the new building is the more economical choice.
Related Calculations: This general procedure can be used to compare any two
or more alternatives having characteristics similar to those described above.