9.6: Keep or Replace a Fixed Asset

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A company may consider replacing a fixed asset it currently owns and operates with one that is more efficient to reduce operating costs. The company can use differential analysis to compare the cost of keeping its original asset and the cost of replacing it with something new.

Example

McNamara Company is considering selling an existing piece of equipment for $75,000 and replacing it with new equipment that will cost $182,000. The old equipment cost $200,000 and currently has accumulated depreciation of $120,000. The estimated annual variable operational costs for the next six years are $21,000 for the old equipment and $6,000 for the new equipment.

Differential Analysis
	Keep	Replace	Difference
Revenue		$75,000
Costs:
Purchase price		182,000
Operating costs¹	$126,000	36,000
Income (loss)	($126,000)	($143,000)	$17,000

¹ $21,000 x 6 $\ \quad \quad$ $6,000 x 6

Replacing the equipment will generate revenue from the sale of the original asset, but the cost of acquiring the new asset will also be incurred. Each alternative has different annual operating costs. The purchase price of the original equipment is a sunk cost that will not be recouped or changed regardless of the decision; therefore, it is ignored. Each alternative independently generates a loss, so the choice with the lower loss is preferable. The company should keep and operate the original equipment.