Question

Last week, Outback Clinic bought a new MRI machine for $1 million. The machine will perform 500,000 tests over its useful life. Total variable costs are $5 per MRI, and the clinic is planning to charge $10 per MRI. This month, a competing MRI manufacturer introduced a similar MRI machine for the same price. In effect, the introduction of this MRI machine made the resale or trade-in value of the existing MRI machine $0. Total variable costs are $2 per test. Using differential cost analysis, should Outback Clinic keep the existing MRI machine or buy the new one?

A. Keep the existing MRI machine
B. Buy the new MRI machine
C. Trade-in the existing MRI machine
D. Keep both MRI machines

Answer 1

Outback Clinic should opt to buy the new MRI machine because a differential cost analysis shows that, despite the initial $1 million investment, they would save $1.5 million in variable costs over the machine's useful life.

Step-by-step explanation:

The decision for Outback Clinic to either keep their existing MRI machine or purchase a new one should be based on a differential cost analysis. Currently, the clinic's machine has a variable cost of $5 per MRI, whereas the new machine offers a reduced variable cost of $2 per MRI. Despite the existing machine now having zero resale value due to the new machine's introduction, the sunk cost of the existing machine (the initial $1 million) should not factor into the decision to keep or replace it.

To perform the analysis, we’ll look at the incremental costs and benefits of replacing the machine. If Outback Clinic can administer 500,000 MRIs over the life of a machine, the total variable cost savings by switching to the new machine would be ($5 - $2) × 500,000 = $1,500,000. Therefore, even though the initial investment of $1 million for the new MRI machine is significant, the reduction in variable costs surpasses this investment over the machine’s useful life, making the purchase of the new machine the better economic choice.