Paragon Products plc has a factory which manufactures a wide range of plastic household utensils. One of these is a plastic brush which is made from a special raw material used only for this purpose. The brush is moulded on a purpose-built machine which was installed in January 2009 at a cost of £210 000 with an expected useful life of seven years. This machine was assumed to have zero scrap value at the end of its life and was depreciated on the same straight line basis that the company used for all equipment.
Recently an improved machine has become available, at a price of £130 000, which requires two men to operate it rather than the five men required by the existing machine. It also uses a coarser grade of raw material costing £70 per tonne (1000 kg), compared with £75 per tonne for the present material. Further, it would use only 60 per cent of the power consumed by the existing machine. However, it has an expected life of only three years and an expected scrap value of £10 000.
The factory manager is considering replacing the existing machine immediately with the new one as the suppliers have offered him £40 000 for the existing machine, which is substantially more than could be obtained on the second-hand market, provided the new machine is installed by 1 January 2013. Unfortunately this would leave stocks of the old raw material sufficient to make 40 000 brushes which could not be used and which would fetch only £25 per tonne on resale.
The brush department is treated as a profit centre. Current production amounts to 200 000 brushes a year which are sold at a wholesale price of £1 each. The production of each brush uses 2 kg of the raw material, consumes 1 kW hour of electricity costing £0.05, and incurs direct labour costs amounting to £0.25 per brush. Overhead costs amount to £60 000 per annum and include £10 000 relating to supervision costs which vary according to the number of employees. The men no longer required to operate the new machine could be found employment elsewhere in the factory and would be paid their current wage although they would be performing less skilled work normally paid at 80 per cent of their current rate.
Requirements:
(a) Evaluate the proposal to replace the existing machine with the new model, ignoring the time value of money in your analysis.
(b) Construct brush department profit and loss accounts for each alternative for 2013, 2014 and 2015. Indicate how the factory manager's decision might be influenced by these figures.
(c) Explain how your analysis would be affected if the new machine had a longer expected life and the time value of money was to be taken into account