The Shamrock Manufacturing Chicago plant manager, Sean Fitzpatrick is contemplating replacing a large piece of manufacturing equipment. Mr. Fitzpatrick is also inline for a promotion to Shamrocks larger Houston plant within the next year, and is hesitant to make any decisions that will reduce short-run operating income and his performance evaluation. While the prospective replacement equipment promises to reduce cash operating costs, it costs $90,000, as well as the loss on disposal cost of the old equipment, which has not fully depreciated. Prior to making a decision, Mr. Fitzgerald must identify all relevant costs and chose a decision for the best interest of Shamrock (Datar, Rajan, 2013).
The available data to consider in this case is the old machines purchase price ($150,000); the current book value of the old machine ($60,000); the market value of the old machine ($36,000); the cost of the new equipment ($90,000); and the reduction in annual cash operating costs ($32,500). All historical costs are considered irrelevant, as they have already occurred and have no effect on future costs. The only relevant costs that should be considered for this decision are the future cash operating costs, the disposal value of the old machine, and the cost of the new machine that will be deprecated over the next two years.
Based on the #1 and #2 worksheets in Appendix A of this document, year one yields an increase in expenditures of $6500, but includes the $24,000 loss of disposal of the old machine, which is irrelevant. The only relevant data is the total two-year costs shown on worksheet #2 that shows a reduction in total relevant cash flow of $11,000. The results of worksheet #1 are not beneficial for Mr. Fitzgerald, but the overall results in year two benefit Shamrock. Based on the #3 worksheet, with a lower new equipment cost ($77,000), year one breaks even, which is irrelevant, and the total two-year reductions in total relevant cash flow are $24,000.
Based solely on the worksheet information (Appendix A), the company should replace the equipment. All relevant costs located in worksheets #2, and #3 indicate that Shamrock manufacturing will benefit by replacing the machines at either equipment cost. However, worksheet #1 presents a problem for Mr. Fitzgerald as it shows a $6500 increase in the first year expenses, which are irrelevant in the long-run, but may encourage Mr. Fitzgerald not to purchase the new equipment because it may reflect badly on the short-run net operating income of his plant during the evaluation period for his promotion. Worksheet #3 offers a breakeven scenario in the first year and a $24,000 reduction in relevant cash flows in year two, which is the best option for Mr. Fitzgerald and Shamrock, if available.
Datar, S., Rajan, M., (2013). Financial and Managerial accounting, custom edition, Pearson Learning Solutions, Ch. 9
Shamrock Manufacturing relevant cash flow analysis
5-Step Critical Thinking Decision-Making Process Matrix
Step 1: Identify the problem(s) and uncertainties.
What exactly is the problem…
Sean Fitzpatrick has an opportunity to decrease long-run cash flow by replacing a large piece of plant equipment.
The problem is this …
Mr. Fitzpatrick is up for a promotion and is concerned that any short-run decreases in operating income will affect his performance evaluation.
This is an important problem because…
Mr. Fitzpatrick’s decision may be good for the company, but could hurt his career aspirations.
The key question(s) that needs to be answered to solve this problem is… What is the best decision for shamrock in the long-run?
Step 2: Obtain information.
The following information is needed to answer this question… What are the relevant costs that impact the decision to keep or replace the equipment? Based on the #1 and #2 worksheets, what decision would be made in years one and two? Based on the #3 worksheet, would the decision be different for years one and two compared to the initial cost of the new equipment?
Some important assumptions I am using in my thinking are…
I believe that the best decision for Shamrock is not the best decision for Mr. Fitzpatrick, which creates an ethical dilemma.
The points of view relevant to this problem belong to…
Note: Remember to view the information you have obtained for potential bias. This is from the perspective of your own bias to the research and the bias of the authors who compiled the data and the research you gathered. In other words, do not discount the importance of other’s data because of your own bias(is). Step 3: Make predictions about the future.
If this problem gets solved, some important implications are… Long-run relevant cash flows will be reduced, and operating income will increase.
If this problem does not get solved, some important implications are… An opportunity to decrease relevant cash flows will be missed.
The potential alternative solutions to solve the problem are… Keep the status quo or make a tough decision that will benefit Shamrock in the long-run.
Note: if the problem is one-dimensional, there may be just one correct solution. Step 4: Make decisions by choosing among alternatives.
What is the best solution and why…
By the new equipment, because it decreases long-run relevant cash flows.
Step 5: Implement the decision, evaluate performance, and learn. In business, the fifth step in the decision making process is implementation. In the MBA program, most times you will end with Step 4 since you will not have the opportunity to implement. You may be asked to develop an implementation plan and recommend how you will evaluate performance in some assignments.