Westwood Furniture Company is considering the purchase of two different items of equipment, as described below:

Machine A:
A compacting machine has just come onto the market that would permit Westwood Furniture Company to compress sawdust into various shelving products. At present, the sawdust is disposed of as a waste product. The following information is available on the machine:
a. The machine would cost $420,000 and would have a 10% salvage value at the end of its 12-year useful life. The company uses straight-line depreciation and considers salvage value in computing depreciation deductions.
b. The shelving products manufactured from use of the machine would generate revenues of $300,000 per year. Variable manufacturing costs would be 20% of sales.
c. Fixed expenses associated with the new shelving products would be (per year): advertising, $40,000: salaries, $110,000; utilities, $5,200; and insurance, $800.

Machine B:
A second machine has come onto the market that would allow Westwood Furniture Company to automate a sanding process that is now done largely by hand. The following information is available:
a. The new sanding machine would cost $234,000 and would have no salvage value at the end of its 13-year useful life. The company would use straight-line depreciation on the new machine.
b. Several old pieces of sanding equipment that are fully depreciated would be disposed of at a scrap value of $9,000.
c. The new sanding machine would provide substantial annual savings in cash operating costs. It would require an operator at an annual salary of $16,350 and $5,400 in annual maintenance costs. The current hand-operated sanding
procedure costs the company $78,000 per year in total.

Westwood Furniture Company requires a simple rate of return of 15% on all equipment purchases. Also, the company will not purchase equipment unless the equipment has a payback period of 4.0 years or less.
Required:
1. For machine A:
a. Prepare an income statement showing the expected net operating income each year from the new shelving products. Use the contribution format.
b. Compute the simple rate of return.
c. Compute the payback period.
2. For machine B:
a. Compute the simple rate of return.
b. Compute the payback period.
3. According to the company’s criteria, which machine, if either, should the company purchase?

           WESTWOOD FURNITURE COMPANY

1) MACHINE A:

a)                                      Income Statement

                                                                          $                           $

Revenue                                                                                 300,000

Variable Cost                                                                         (60,000)

Contribution Margin                                                              240,000

Fixed Expenses:

Advertising                                                 40,000

Salaries                                                       110,000

Utilities                                                           5,200

Insurance                                                          800

Depreciation                                                 31,500

Total Fixed Expense                                                            (187,500)

Net Operating Income                                                        52,500

b) Simple rate of return = (Average Annual Income/Initial Investment) * 100

                                       = (52500/378000) * 100

                                       = 13.89%

c) Payback period = Investment/Annual Income

                              = 420000/84000

                              = 5 years

2) MACHINE B:

a) Simple rate of return = (Average Annual Income/Initial Investment) * 100

                                       = (38250/225000) * 100

                                       = 17%

b) Payback period = Investment/Annual Income

                              = 225000/56250

                              = 4 years

3) According to the company's criteria, machine B should be purchased because it meets the requirement of Payback period of 4 years or less and the required rate of return of 15% and above. While machine A does not meet any of these criteria.

Explanation:

1a) Variable cost = 300000 * 0.2 = $60,000

Depreciation = (cost - salvage value)/useful life

                      = (420000 - 42000)/12

                      = #31,500

b) Initial Investment = Cost of the machine - salvage value

                             = 420000 - 42000

                             = 378000

c) For Payback Period = Depreciation is ignored as it is not a cash item, therefore, Annual Income = 52500 + 31500 = 84000

Also note that the salvage value comes after the 12 years, so it is ignored

2a) Income = Savings from old machine - (Annual salary + annual maintenance cost) - Depreciation

=  78000 - (16350 + 5400) - 18000

= 78000 - 21750 - 18000

= 38250

Depreciation = 234000/13 = 18000

Initial Investment =  Cost of machine - Salvage value from old machine

                            = 234000 - 9000

                            = 225000

For Payback Period = Depreciation is ignored as it is not a cash item, therefore, Annual Income = 38250 + 18000 = 56250