Relevant Costs to Repair, Retain or Replace Equipment

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  • 0:00 Making Changes to Equipment
  • 0:40 Looking at Relevant Costs
  • 1:20 Understanding Fixed &…
  • 1:58 Grasping the Effects…
  • 2:47 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

Managers of all types are constantly having to decide whether or not to repair, retain, or replace equipment. In this lesson, we learn how to make those decisions based off of relevant costs, with or without the inclusion of sunk costs.

Making Changes to Equipment

For whatever reason, your company is considering making a change to its equipment. However, the decision to make a change to existing equipment should not be taken lightly, and certainly not just because some salesperson tells you that its time. Instead, a company should consider relevant costs, or in this case, all of those financial factors that actually matter when making the decision to repair, retain, or replace equipment. In this lesson, we'll look at the impact these types of decisions have on fixed costs, paying special attention to the idea of a sunk cost.

Looking at Relevant Costs

First, let's start by looking at relevant costs to making a change to equipment. A business has a lot of moving financial parts, so it's best to eliminate all those that frankly don't matter. After all, if you're considering a new widget press, that probably doesn't impact the pay of your accounting department too greatly. By looking only at relevant costs, we can disregard all those distractions that simply don't matter. Once we've found all the relevant costs, we can then use incremental analysis to help us make a decision. Remember that incremental analysis allows us to focus only on the incremental differences of different courses of action as they affect the relevant costs.

Understanding Fixed & Variable Costs

Two different types of costs will emerge as you begin to look at relevant costs. Fixed costs are those costs that will remain the same no matter how many or how few units you produce. If you need to build a new factory, building the site will be a fixed cost. Variable costs, on the other hand, change depending on how many units you build, such as the wages paid per unit. When looking at how you are going to recover your costs and make a profit, you look at how many units you expect to sell. If you expect to sell plenty of units, you can likely take on a larger fixed cost, but will want a smaller variable cost.

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