g2 sunk costs and opportunity costs davul Industries is developing the relevant
ID: 2430083 • Letter: G
Question
g2 sunk costs and opportunity costs davul Industries is developing the relevant cash flows associated with the proposed replacement of an existing machine tool with a new, tech- nologically advanced one. Given the following costs related to the proposed project, ex- pain whether each would be treated as a smk cost or an opportunity cost in developing the relevant cash flows associatied with the proposed replacement decision a. Covol would be able to use the same tooling, which had a book value of P1 1-5 $40,000, on the new machine tool as it had uwed on the old one.Explanation / Answer
Solution:
(a)Book value of old tooling used in the new machine = Sunk cost------------$ 40,000
This is because the tooling had been acquired in the past and the company cannot cannot change its cost now or in the future and it has been depreciated for accounting purposes and is now shown at book value. Irrespective of the use , this book value of $ 40,000 will be written off as depreciation.This is a sunk cost as the expenditure was incurred in the past and has no effect on the future decision making .
(b) Excess capacity of the computer used for programs=Opportunity Cost----$ 17,000
There is an opportunity cost because if the excess apacity was not used for programs it would have profitably been leased out at an annual fee of $17000.This opportunity has been foregone by the organization in order to use it for making programs. This is because every resource can be put to alternative uses.Therefore cost of opportunity foregone=$17,000
(c) Additional Floor space required-------------------------= Opportunity Cost-----$ 10,000
This space is currently leased out which earns a contribution of $ 10,000 per year. By withdrawing the space from the lease the company loses $10,000 . The contribution lost is the opportunity cost of the space used for this proposed project. That is the value that is given up to achieve or acquire something else.
(d) Cost of building storage facility--------------------------= Sunk cost--------------$ 1,20,000
The cost of building incurred was a past expenditure i.e historical cost and that cost has already been incurred and cannot be cannot be changed or avoided currently or in the future. It does not affect any the decision making process as that depends on the future course of the business activities and the main aim of any organization is to base their strategy on how to take the business forward based on the future costs.
(e) Cost of retaining old crane--------------------------------= Opportunity Cost-----$ 1,80,000
The crane would have been sold for $ 1,80,000 .Since the crane has not been sold and has been retained for the proposed project thereby the organization loses $ 1,80,000. This cost incurred by not enjoying the benefit that the organization would have received by taking the second best option available .This is the opportunity cost of retaining the crane for the proposed project.
Therefore the cost of the new proposed project=$ 17,000+$10,000+$1,80,000=$ 2,07,000
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