Consolidated Drugs, Inc. has spent $4 million developing andtesting a new anti-a

Question

Consolidated Drugs, Inc. has spent $4 million developing andtesting a new anti-aging drug. Management now estimates thatit will cost $2 million to produce and market this newproduct. The present value of total revenue from all futuresales of this drug is estimated to be $5 million. On the basisof these numbers, management is recommending dropping the projectsince costs will exceed revenues.   A.) Do youagree with this recommendation? Explain.
B.) Thehead of the accounting department indicates that if the product isproduced and marketed, $4 million of corporate overhead expenseswill be assigned to the product. Does this new informationchange your answer to (a) Explain. Consolidated Drugs, Inc. has spent $4 million developing andtesting a new anti-aging drug. Management now estimates thatit will cost $2 million to produce and market this newproduct. The present value of total revenue from all futuresales of this drug is estimated to be $5 million. On the basisof these numbers, management is recommending dropping the projectsince costs will exceed revenues.   A.) Do youagree with this recommendation? Explain.
B.) Thehead of the accounting department indicates that if the product isproduced and marketed, $4 million of corporate overhead expenseswill be assigned to the product. Does this new informationchange your answer to (a) Explain.

Explanation / Answer

It's just a matter of considering what the total loss will be, and trying to minimize it.  If the company has already spent $4M developing the drug and they decide to drop the project, they have lost $4M.  However, in case A, they have the opportunity to make $5M by taking on an additional $2M in costs.  This would give them a total loss of just $1M ($5M in revenue minus $4M in development and $2 to produce and market the drug).  In case B, however, the total loss would increase to $5M (costs - $4M + $2M + $4M in overhead; $5M in revenue = $5M loss).  In that case, the project should be stopped in order to minimize the losses.

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