Relevant costs: replacement decision Rossman Instruments, Inc. is considering leasing new state-of-the-art machinery at an annual cost of $900,000. The new machinery has a four-year expected life. It will replace existing machinery leased one year earlier at an annual lease cost of $490,000 committed for five years. Early termination of this lease contract will incur a $280,000 penalty. There are no other fixed costs.

The new machinery is expected to decrease variable product costs from $42 to $32 per unit because of improved materials yield, faster machine speed, and lower direct labor, supervision, materials handling, and quality inspection re¬ quirements. The sales price will remain at $56. Improvements in quality, produc¬ tion cycle time, and customer responsiveness are expected to increase annual sales from 36,000 units to 48,000 units.

The variable product costs stated earlier exclude the inventory carrying costs. Because the new machinery is expected to affect inventory levels, the fol¬ lowing estimates are also provided. The enhanced speed and accuracy of the new machinery are expected to decrease production cycle time by half, and consequently, lead to a decrease in work-in-process inventory level from three months to just one and one-half months of production. Increased flexibility with these new machines is expected to allow a reduction in finished goods inventory from two months of production to just one month. Improved yield rates and greater machine reliability will enable a reduction in raw materials inventory from four months of production to just one and one-half months. Annual inven¬ tory carrying cost is 20% of inventory value.

REQUIRED

(a) Determine the total value of annual benefits from the new machinery. In¬ clude changes in inventory carrying costs.

(b) Should Rossman replace its existing machinery with the new machinery?
Present your reasoning with detailed steps identifying relevant costs and revenues.

(c) Discuss whether a manager evaluated on the basis of Rossman's net income will have the incentive to make the right decision as evaluated in

(b) above.

CATEGORY Average per unit cost of raw materials inventory Average per unit cost of work-in-process inventory Average per unit cost of finished goods inventory Selling cost per unit sold Variable product cost per unit purchased OLD MACHINE NEW MACHINE $12 $11 25 20 38 28 4 4 42 32