Least Cost Decisions
Least Cost Decisions:
Revenues are not directly involved in some decisions. For example, a company that does not charge for delivery service may need to replace an old delivery truck, or a company may be trying to decide whether to lease or to buy its fleet of executive cars.
In situations such as these, where no revenues are involved, the most desirable alternative will be the one that promises the least total cost from the present value perspective. Hence, these are known as least cost decisions. To illustrate a least cost decision, consider the following data:
Example:
Val-Tek Company is considering the replacement of an old threading machine. A new threading machine is available that could substantially reduce annual operating costs. Selected data relating to the old and the new machines are presented below:
| Old Machine | New Machine | |
| Purchase cost when new | $200,000 | $250,000 |
| Salvage value now | 30,000 | — |
| Annual cash operating costs | 150,000 | 90,000 |
| Overhaul needed immediately | 40,000 | — |
| Salvage value in six years | 0 | 50,000 |
| Remaining life | 6 years | 6 years |
| Val-Tek Company uses a 10% discount rate |
Total Cost Approach or Total Cost Method:
Following is the analysis of the alternatives using total cost approach:
The Total Cost Approach (Lease Cost Decision)
| Item | Year(s) | Amount of Cash Flows | 10% Factor* | Present Value of Cash Flows |
| Buy the new machine: | ||||
| Initial investment | Now | $(250,000) | 1.000 | $(250,000)** |
| Salvage of the old machine | Now | 30,000 | 1.000 | 30,000** |
| Annual cash operating cost | 1 – 6 | (90,000) | 4.355 | (391,950) |
| Salvage of the new machine | Now | 50,000 | 0.564 | 28,200 |
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| Net present value | 583,750 | |||
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| Keep the old machine: | ||||
| Overhaul needed now | Now | $(40,000) | 1.000 | (40,000) |
| Annual cash operating costs | 1 – 6 | (150,000) | 4.355 | (653,250) |
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| present value of net cash outflows | $693,250 | |||
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| Net present value in favor of buying the new machine | $109,500 | |||
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| * All present value factors are from Future Value and Present Value Tables page – Table 3 and Table 4. ** These two figures could be netted into a single $220,000 incremental cost figure ($250,000 – $30,000 = $220,000) |
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As shown in the above solution, the new machine has the lowest total cost when the present value of the net cash outflow is considered.
Incremental Cost Approach or Incremental Cost Method:
An analysis of the two alternatives using the incremental cost approach is presented below:
The Incremental Cost Approach (Lease Cost Decision)
| Item | Year(s) | Amount of Cash Flows | 10% Factor* | Present Value of Cash Flows |
| Incremental investment to buy the new machine | Now | $(210,000) | 1.000 | $(210,000)** |
| Salvage of the old machine | Now | 30,000 | 1.000 | (30,000)** |
| Salvage in annual cash operating costs | 1 – 6 | 60,000 | 4.355 | 261,300 |
| Difference in salvage value in six years | 6 | 50,000 | 0.564 | 28,200 |
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| Net present value in favor of buying the new machine | $109,500 | |||
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| * All present value factors are from Future Value and Present Value Tables page – Table 3 and Table 4. ** These two items could be netted into a single $180,000 incremental cost figure ($210,000 – $30,000 = $180,000). |
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This solution represents the differences between the alternatives as shown under the total cost approach.
In Business | Trading in that Old Car?Consumer reports magazine provides the following data concerning the alternatives of keeping a four year old Ford Taurus for three years or buying a similar new car to replace it. The illustration assumes the car would be purchased and used in suburban Chicago.
Consumer Reports is ordinarily extremely careful in its analysis, but it has omitted in this case one financial item that would clearly differ substantially between the alternatives and hence would be relevant. What is it? Source: “When to Give Up on Your Clunker,” Consumer Reports, August 2000, pp. 12-16. |
You may also be interested in other articles from “capital budgeting decisions” chapter:
- Capital Budgeting – Definition and Explanation
- Typical Capital Budgeting Decisions
- Time Value of Money
- Screening and Preference Decisions
- Present Value and Future Value – Explanation of the Concept
- Net Present Value (NPV) Method in Capital Budgeting Decisions
- Internal Rate of Return (IRR) Method – Definition and Explanation
- Net Present Value (NPV) Method Vs Internal Rate of Return (IRR) Method
- Net Present Value (NPV) Method – Comparing the Competing Investment Projects
- Least Cost Decisions
- Capital Budgeting Decisions With Uncertain Cash Flows
- Ranking Investment Projects
- Payback Period Method for Capital Budgeting Decisions
- Simple rate of Return Method
- Inflation and Capital Budgeting Analysis
- Income Taxes in Capital Budgeting Decisions
- Review Problem 1: Basic Present Value Computations
- Review Problem 2: Comparison of Capital Budgeting Methods
- Future Value and Present Value Tables
Other Related Accounting Articles:
- Inflation and Capital Budgeting Analysis
- Capital Budgeting: The Net Present Value
- Incremental Cash Flow Analysis
- Joint Product Cost Analysis for Managerial Decisions and Profitability Analysis
- Pooled Internal Rate of Return
- Financial Leverage
- Bank Investment Contract
- Turn Over Rate Calculation
- Installment Method of Revenue Recognition
- Paid In Capital
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