Nanny McPhee, the owner and manager of Nanny's Roasted Chicken Company, replaced the company's convection ovens just six months ago
Today, Green Valley Oven Manufacturing announced the availability of a new convection oven that cooks much more quickly with lower operating expenses. Nanny is considering the purchase of this faster, lower-operating cost, convection oven to replace the existing one they recently purchased. Selected information about the two ovens is given below:
Existing New Turbo Oven
Original cost $120,000 $100,000
Accumulated depreciation $ 10,000 ---
Current salvage value $80,000 ---
Remaining life 10 years 10 years
Annual operating expenses $20,000 $15,000
Disposal value in 10 years $ 0 $ 0
Required:
a. What costs are sunk?
b. What costs are relevant?
c. What are the net cash flows over the next 10 years assuming that Nanny purchases the new convection oven?
d. What other factors should Nanny consider when making this decision?
a. Sunk costs include the original cost of the existing convection oven and the accompanying accumulated depreciation.
b. Relevant costs include:
Acquisition cost of the new Turbo oven
Current disposal value of the existing convection oven
Annual operating expenses for the existing and the new Turbo oven
c. Net cash flows over 10 years with the new Turbo oven:
Cash inflow:
Decrease in annual operating expenses ($5,000 × 10 ) $ 50,000
Sale of the existing oven 80,000
Cash outflow:
Acquisition of the new Turbo oven (100,000 )
Net cash inflow $ 30,000
d. Other items the manager should consider when making this decision include:
? The Turbo Oven's reliability and efficiency is still unknown since it is a brand new product.
? If the Turbo Oven bakes faster as it claims, the company may be able to increase sales due to the quicker baking time.
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