Equipment Decisions

before you start

Manufacturing businesses rely on equipment to ensure the viability of their company. If the equipment needs maintenance or replacement, the business loses money, so management must make strategic decisions about this equipment. Because equipment can be costly, managers need to focus on relevant financial data to help make informed managerial decisions.

1. Lease or Sell Equipment

Sometimes, a piece of equipment is no longer used by a business, due to changes in the manufacturing process or discontinuation of a product line. In these cases, management must decide what to do with the old equipment. There are three main options management can choose from in these scenarios: scrap the equipment, lease out the equipment, or sell the equipment. In this lesson we will focus on the lease or sell options. A lease or sell review is a differential analysis tool that compares the financial outcomes of selling a piece of equipment outright or leasing it to another firm for a period of time.

Two important pieces of information about a piece of equipment or other asset must be ascertained before the lease or sell review can begin. The book value of an asset is determined by subtracting the accumulated depreciation of an asset from the cost of obtaining the asset. Book value is a sunk cost and is not relevant to future decisions. The market value of an asset is the amount an asset could be sold for in a given market. It is often confused with book value, but the two are not the same.

did you know

The distinction between book value and market value can be confusing for non-accountants, in part because most non-accountants encounter the term "book value" in relation to car prices. The book value of a car is technically the same concept as the book value of any other asset—the original cost minus depreciation—but the confusion comes from a standard guide in automobile pricing that has been in publication for a century. The Kelley Blue Book lists the market price of new and used cars, but the name of the publication often leads people to think "book price" means "the price listed in the book."

EXAMPLE

Pierson Apparel has equipment it is no longer using, due to the discontinuation of their athletic shoe line. Pierson is weighing the options of selling or leasing the equipment and wants to determine what the best option is. Pierson has collected the following information regarding its options:

Cost of equipment (Balance Sheet)	$400,000
Accumulated Depreciation (Balance Sheet)	(250,000)
Book Value of Equipment	$150,000
Sell Alternative:
Sales Price	$170,000
Commission on Sale	5%
Lease Alternative:
Total Revenue for 3-year Lease	$225,000
Estimated repair expense	$15,000
Estimated insurance expense	$10,000
Estimated property tax expense	$5,000
Residual Value at the end of the 3rd year of the lease	0

think about it

Even though leasing the equipment yields a better overall financial benefit for Pierson Apparel, the revenue from the lease will be realized over a three-year period. What types of opportunity cost(s) could that have for Pierson Apparel?

Let's walk through the steps of conducting a lease or sell review.

step by step

1. Calculate the appropriate revenue for each decision.
2. Calculate the corresponding costs for each decision.
3. Determine the profit or loss for each option.
4. Determine the differential effects of selling instead of leasing.

1a. Calculate the appropriate revenue for each decision - Step One

Projected revenues for lease or sell decisions are calculated much like projected figures for budgeted financial statements. Data is obtained by examining market information or from historical business decisions. The figures are given to us in the example but need to be carefully analyzed to help make the most accurate decisions.

As with any decision, you need to understand what information is needed to make the decision, before you start. Taking the time to identify relevant costs, prior to crunching the numbers is just as important as the final numbers. Keep in mind if you put inaccurate numbers into calculations, they will yield inaccurate information. Accountants call this GIGO (garbage in, garbage out).

1b. Calculate the corresponding costs for each decision - Step Two

Costs for the lease decision include estimations of equipment repair, insurance on the equipment, and property taxes paid on the equipment.

formula to know

Cost of Leasing Formula:

Cost of leasing equipment = Estimated repair costs + estimated insurance costs + estimated property taxes

formula to know

Cost of Selling Formula:

Costs of selling equipment = Sale price x commission on sales

think about it

This may not be an exhaustive list of the costs associated with leasing the equipment. It is important for management to know all pertinent information when making decisions. What other costs might be involved in leasing equipment?

EXAMPLE

For Pierson Apparel, we can calculate the cost of leasing equipment by adding together the estimated repair costs ($15,000), the estimated insurance costs ($10,000), and the estimated property taxes ($5,000).
Cost of leasing equipment = $15,000 + $10,000 + $5,000
Cost of leasing equipment = $30,000

We can also calculate the costs of selling the equipment by multiplying the sale price ($170,000) by the anticipated commission on sales (5%).
Cost of selling equipment = $170,000 X 5%
Cost of selling equipment = $8,500

1c. Determine the profit or loss for each option - Step Three

Next, the profit or loss of the lease and sell options is determined by subtracting the cost of the leasing or selling from the potential revenue of each.

formula to know

Profit(loss) Due to Leasing Formula:

Profit (loss) due to leasing equipment = Revenue from leasing equipment - Cost of leasing equipment

formula to know

Profit(loss) Due to Selling Formula:

Profit(loss) due to selling equipment = Revenue from selling equipment - Cost of selling equipment

EXAMPLE

Pierson Apparel would see a revenue of $225,000 from leasing the equipment, from which we subtract the total leasing costs of $30,000.
Profit (loss) due to leasing equipment = $225,000 - $30000
Profit due to leasing equipment = $195,000

The revenue from selling the equipment would be $170,000, from which we subtract the total selling costs of $8,500.
Profit(loss) due to selling equipment = $170,000 - $8,500
Profit(loss) due to selling equipment = $161,500

1d. Determine the differential effects of selling instead of leasing - Step Four

To determine the differential effects of selling versus leasing, subtract the leasing revenue from the selling revenue, and the leasing costs from the selling costs. Finally, subtract the profit or loss from leasing from the profit or loss from selling, to reach the differential effect of selling. These calculations can be done in a simple spreadsheet, subtracting the leasing figures (column 1) from the selling figures (column 2).

formula to know

Differential Revenues Formula:

Differential Revenues = Revenue from selling - Revenue from leasing

formula to know

Differential Costs Formula:

Differential Costs = Costs from selling - Costs from leasing

formula to know

Differential Profit (Loss) From Selling Instead of Leasing Formula:

Differential Profit (loss) from selling instead of leasing = Differential Revenue - Differential Cost

EXAMPLE

Pierson Apparel prepares a differential analysis to determine whether selling or leasing the equipment will yield the best results.

Based on the lease or sell differential analysis, Pierson Apparel decides that leasing the equipment is the best option. If they sell the equipment, they will lose $33,500 of profit.

In this example of a lease or sell differential analysis, there is a financial advantage for Pierson Apparel to lease the equipment. There may be other cost factors involved such as differential revenue from investing the funds if the equipment was sold or differential tax effects of selling or leasing. For simplification, these factors were not included in the example but may be contributing factors in the lease or sell analysis.

hint

You may be wondering why we calculate the differential effects of the revenues and costs separately, instead of just subtracting the profit or loss from each option. True, they do lead to the same result, but often the people preparing these analyses and the people using them to make decisions are different people. In order for decision makers to get the best possible picture of the differences in all areas (revenues, costs, profit, or loss), the differential effects column is added for further clarification.

terms to know

Lease or sell decision

A differential analysis tool that compares the financial outcomes of selling a piece of equipment outright or leasing it to another firm for a period of time.

Book Value

The book value of an asset is determined by subtracting the accumulated depreciation of an asset from the cost of obtaining the asset. Book value is a sunk cost and is not relevant to future decisions.

Market value

Market value is the amount an asset could be sold for in a given market. It is often confused with book value, but the two are not the same.

2. Keep or Replace Equipment

A fixed asset is a long-term piece of equipment or property a business uses to generate income. As fixed assets are used, they wear out over time. Businesses need to keep a careful watch on these fixed assets and must determine when replacement is necessary. In a replace equipment differential analysis, managers must weigh the costs and benefits of replacing fixed assets against the costs and benefits of continuing with the old asset.

think about it

Think about an older car that needs frequent repairs. What information is needed to determine if the car should be repaired or replaced? These are the types of decisions managers make when looking at fixed assets.

EXAMPLE

On May 5, Victoria Vacuum Co. realized they had an old piece of equipment that was starting to wear out. The old equipment still works but has increasingly frequent breakdowns, which increases Victoria’s variable manufacturing cost. Victoria’s management has a decision to make about whether to keep the old equipment or replace it, so they initiate a differential analysis to inform this decision.

step by step

1. Determine the revenue and cost flows for continuing or replacing the old equipment
2. Calculate profit(loss) if continuing with the old equipment.
3. Calculate the profit(loss) of replacing the old equipment.
4. Compute the differential effects of replacing the old equipment for all revenues and costs.
5. Add all differential revenues and costs to determine the profit or loss of replacing the old equipment.

2a. Determine the revenue and cost flows for continuing or replacing the old equipment - Step One

First, identify the revenue and cost flows associated with keeping the old equipment and associated with replacing it.

EXAMPLE

Victoria collects the following information in order to perform a keep or replace equipment differential analysis.

Old Equipment:
Book Value	$150,000
Estimated annual variable manufacturing cost	$370,000
Estimated selling price	$80,000
Estimated remaining useful life	5 years
New Equipment:
Purchase price of new equipment	$325,000
Estimated annual variable manufacturing costs	$200,000
Estimated residual value	0
Estimated useful life	5 years

2b. Calculate profit(loss) if continuing with the old equipment - Step Two

When determining the costs associated with continuing with the old equipment, managers often lump costs like repairs, projected downtime, and maintenance into annual variable manufacturing costs. Annual variable manufacturing costs serve as a “catch all” for all of these types of costs.

EXAMPLE

Since there are only variable manufacturing costs associated with Victoria's old equipment, the loss on keeping the old equipment is -$370,000.

2c. Calculate the profit(loss) of replacing the old equipment - Step Three

When reviewing costs associated with replacing old equipment, managers must try to estimate these costs to the best of their ability. Determining the cost of a new piece of equipment is relatively simple, but estimating the annual variable manufacturing costs can be complex. Managers should research the costs associated with new equipment and question others who have used similar equipment to identify repair, maintenance, and downtime costs. Equipment manufacturers are also a good source of information when making these decisions.

formula to know

Profit(Loss) of Replacing Equipment Formula:

Profit (loss) of replacing equipment = Proceeds from sale of old equipment - Purchase price of new equipment - Variable manufacturing costs of new equipment over five years

EXAMPLE

For Victoria, the profit or loss of replacing the equipment is calculated by subtracting the purchase price of the new equipment ($325,000) and the variable manufacturing costs of the new equipment ($200,000) from the sale price of the old equipment ($80,000).
Profit (loss) of replacing equipment = $80,000 - $325,000 - $200,000
Profit (loss) of replacing equipment = -$445,000

2d. Compute the differential effects of replacing the old equipment for all revenues and costs - Step Three

As in other differential analyses, we subtract the costs, revenues, and differential variable costs of the second option (replacing the old equipment) from the costs, revenues, and differential variable costs of the first option (continuing with the old equipment).

EXAMPLE

For Victoria, the following calculations are made and added to a differential analysis spreadsheet.

Differential Revenue = Revenue from replacing old equipment - Revenue from continuing with old equipment
Differential Revenue = $80,000 - $0
Differential Revenue = $80,000

Differential Cost of Purchasing = Cost of replacing old equipment - Purchase price of continuing with old equipment
Differential Cost of Purchasing = ($320,000) - $0
Differential Cost of Purchasing = ($320,000)

Differential Variable Manufacturing Costs (5 years) = Variable Manufacturing Cost of replacement equipment - Variable Manufacturing Cost of old equipment
Differential Variable Manufacturing Costs (5 years) = ($200,000) - ($370,000)
Differential Variable Manufacturing Costs (5 years) = $170,000

2e. Add all differential revenues and costs to determine the profit or loss of replacing the old equipment - Step Three

To determine the profit or loss from replacing the old equipment, subtract the purchase price of the new machine, and the variable manufacturing cost differential from the differential proceeds from the sale of the old machine.

formula to know

Profit(Loss) of Replacing Old Equipment Formula:

Profit or loss of replacing old equipment = Differential Revenue + Differential Cost of Purchasing + Differential Variable Manufacturing Costs over five years

EXAMPLE

Below is the completed differential analysis for Victoria Vacuums.

Even though variable manufacturing costs will be much greater over the 5-year period, it is still more financially viable to continue with the old equipment. The loss on the purchase of a new machine would be $75,000.

As you can see from this example, continuing with the old machine is sometimes the better choice. But like any decision management makes, there are opportunity costs that should be considered. Management may want to consider using their money for other purposes to reach target returns on investment or contemplate the time value of money in alternate uses of funds.

terms to know

Fixed Asset

A long-term piece of equipment or property a business uses to generate income.

Replace Equipment Decision

A differential analysis tool that compares costs and benefits of replacing fixed assets against the costs and benefits of continuing with the old asset.