- A company manufactures a product that has generated 1,000 defective units. The cost to manufacture these units was $15,000. The units can be sold as scrap for $2,000. Alternatively, they can be reworked for an additional cost of $6,000. If reworked, the units can be sold for $9,000. What is the net financial advantage or disadvantage of reworking the units compared to selling them as scrap?
Answer: Advantage of $1,000
The original manufacturing cost of $15,000 is a sunk cost and is irrelevant to the decision. The decision should compare the incremental revenues and costs of the two alternatives.
- Reworking: Incremental Revenue $9,000 - Incremental Cost $6,000 = Net inflow of $3,000.
- Selling as scrap: Incremental Revenue $2,000.
The financial advantage of reworking is the difference between these two outcomes: $3,000 - $2,000 = $1,000.
- A movie studio spent $100 million producing a film. Before its release, market tracking suggests it will be a flop. The studio must now decide whether to spend an additional $30 million on a marketing campaign. With the campaign, box office revenues are projected to be $50 million. Without the campaign, they are projected to be $10 million. In this decision, the $100 million production cost is:
Answer: A sunk cost, and the campaign should be approved because its incremental benefit exceeds its incremental cost.
The $100 million production cost is a sunk cost and should be ignored. The decision to market the film should be based on incremental revenues and costs. The incremental cost of the campaign is $30 million. The incremental revenue from the campaign is the difference between revenue with the campaign ($50 million) and revenue without it ($10 million), which is $40 million. Since the incremental benefit of $40 million exceeds the incremental cost of $30 million, the campaign is financially justified.
- A company is considering replacing an old machine with a new one. The old machine was purchased for $80,000, has accumulated depreciation of $50,000, and a current book value of $30,000. Its current salvage value is $12,000. If kept, it will have a remaining useful life of 5 years with no salvage value. The new machine costs $70,000 and will reduce annual operating costs by $15,000 over its 5-year life. In the decision analysis to replace the machine, which of the following represents the total amount of sunk costs?
Answer: $80,000
A sunk cost is a cost that has already been incurred and cannot be recovered. In this equipment replacement decision, the only true sunk cost is the original purchase price of the old machine ($80,000). The book value is an allocation of this sunk cost, and the salvage value is a future relevant cash flow.
- A company is evaluating a project with the following estimated annual financial data: Sales revenue of $300,000, variable costs of $180,000, and direct fixed costs of $50,000 for equipment rental. In addition, $40,000 of existing corporate overhead would be allocated to the project. The project also requires a project manager who is currently employed by the company at a salary of $80,000; if the project is not undertaken, the manager will be laid off. What is the expected annual financial impact of undertaking the project?
Answer: Loss of $10,000
To find the project's financial impact, we must sum all relevant revenues and costs. Relevant items are those that change as a result of the decision.
Relevant Revenue: $300,000
Relevant Costs:
- Variable costs: $180,000
- Equipment rental: $50,000 (This is a direct, future cost)
- Manager's salary: $80,000 (This is a relevant, avoidable cost because the manager would otherwise be laid off)
The allocated corporate overhead ($40,000) is irrelevant as it is not an incremental cost.
Net Impact = $300,000 - ($180,000 + $50,000 + $80,000) = $300,000 - $310,000 = -$10,000 loss.
- A company has 500 units of a raw material in its inventory that were purchased for $10 per unit. Due to a change in product design, this material is no longer needed for its original purpose. The material has no scrap value. However, it can be used as a substitute for another material in a different production process. The other material currently costs $7 per unit. In an analysis of the new production process, what is the relevant cost of the 500 units of obsolete material?
Answer: $3,500
The original purchase price of $10 per unit ($5,000 total) is a sunk cost. The relevant cost of using an asset is its opportunity cost. In this case, by using the obsolete material in the new process, the company avoids having to buy the substitute material at $7 per unit. This cost saving is the opportunity cost. Therefore, the relevant cost of using the 500 units is 500 units * $7/unit = $3,500.
- A company signed a five-year, non-cancelable lease for office space at a cost of $10,000 per month. Two years into the lease, the company decides to move to a new location. The old office space cannot be sublet. The company must continue to pay the rent on the old space for the remaining three years. The cost of the new office space is $12,000 per month. In the analysis of whether to move, the rent on the old office space is considered:
Answer: An irrelevant cost because the payments will be made regardless of the decision to move.
While the decision to sign the lease is in the past, the payments themselves are future cash outflows. However, because the lease is non-cancelable and the space cannot be sublet, the company must pay the $10,000 per month for the next three years whether they move or stay. Since this cost does not differ between the alternatives, it is an unavoidable future cost and is therefore irrelevant to the decision. It is not technically a sunk cost, which is a past cost.
- A division is evaluating a special project that requires the use of an existing machine. The machine was purchased 4 years ago for $200,000 and has a current book value of $80,000. Its current market value is $50,000. If used for the project, the machine's market value in three years will be $20,000. The annual depreciation expense on the machine is $20,000. For purposes of deciding whether to accept the project, what is the total relevant cost of using the machine for the three-year project, ignoring the time value of money?
Answer: $30,000
The relevant cost of using an existing asset is the opportunity cost, which is the decline in its market value from being used in the project. The book value ($80,000) and the associated depreciation ($20,000 per year) are based on the original sunk cost and are irrelevant. The relevant cost is the difference between the machine's current market value ($50,000) and its market value after the project ($20,000). The cost is $50,000 - $20,000 = $30,000.
- If FoodCorp closes the restaurant permanently, which of the following represents a relevant benefit that should be included in the analysis?
Answer: The $85,000 proceeds from equipment disposal plus elimination of future operating losses
Relevant benefits include actual cash proceeds ($85,000 from equipment sale) and elimination of future operating losses (avoidable costs minus lost revenues). Choice A incorrectly uses book value instead of actual sale proceeds, Choice B represents overhead that would be reallocated rather than eliminated, Choice D incorrectly references sunk cost and non-cash depreciation.
- A company is considering launching a new product. The following costs have been identified: (1) $100,000 for R&D completed last year; (2) $250,000 for new manufacturing equipment; (3) $15,000 for a marketing study completed last month; (4) $50,000 for an initial advertising campaign. Which of these items is a sunk cost at the time of the launch decision?
Answer: Items (1) and (3) only.
Sunk costs are costs that have already been incurred and cannot be changed by any future decision. At the time of the launch decision:
(1) The $100,000 R&D cost was incurred last year and is a sunk cost.
(2) The $250,000 for new equipment is a future cost that is relevant to the decision.
(3) The $15,000 for the marketing study was incurred last month and is a sunk cost.
(4) The $50,000 advertising campaign is a future cost required for the launch and is relevant.
Therefore, only the R&D and marketing study costs are sunk.
- Five years ago, a company bought a machine for $250,000. It has been fully depreciated for tax purposes and has a book value of zero. The machine can be sold today for $30,000. Alternatively, it can be retooled for $40,000 and used on a three-year project, which would generate incremental cash inflows of $25,000 per year. After three years, the machine would have no salvage value. What is the net financial advantage or disadvantage of retooling the machine for the project?
Answer: Advantage of $5,000
The original cost and book value are sunk and irrelevant. The decision is to retool or sell. The analysis should compare the incremental benefits and costs of retooling.
Incremental benefit = $25,000/year * 3 years = $75,000.
Incremental costs = $40,000 (retooling cost) + $30,000 (opportunity cost of not selling today).
Total incremental costs = $70,000.
Net financial advantage = $75,000 - $70,000 = $5,000.
- A company owns a patent with a book value of $50,000 that is currently unused. The company is considering a new project that would make use of this patent. If the project is not pursued, the company can sell the patent to another firm for $75,000. If the project is pursued, the patent will be fully utilized and have no value at the end of the project's life. How should the patent be treated in the project evaluation?
Answer: As a relevant opportunity cost of $75,000.
The book value of the patent ($50,000) is an allocation of a past (sunk) cost and is irrelevant. However, by using the patent in the project, the company forgoes the opportunity to sell it for $75,000. This foregone cash inflow is an opportunity cost, which is a relevant cost for decision-making. Therefore, a cost of $75,000 should be included in the project analysis.
- If the electronics product line is dropped, the direct fixed expenses would be eliminated. The common fixed expenses would continue, as they are allocated from corporate headquarters. What would be the impact on the company's overall net operating income if the product line is dropped?
Answer: Income would decrease by $80,000.
The decision to drop the product line should be based on its segment margin, which is the contribution margin less direct fixed expenses. The allocated common fixed expenses are irrelevant because they will continue regardless. The segment margin is $300,000 (Contribution Margin) - $220,000 (Direct Fixed Expenses) = $80,000. This $80,000 represents the product line's contribution to covering the company's common fixed costs. If the line is dropped, this contribution is lost, and overall company income will decrease by $80,000.
- A company spent $30,000 to train its workforce on a specific software system. A year later, a new, more efficient system is available. Adopting the new system costs $50,000 but is expected to generate cost savings of $20,000 per year for its 4-year life. What is the net financial benefit of adopting the new system over the 4-year period?
Answer: Benefit of $30,000
The $30,000 spent on training for the old system is a sunk cost and irrelevant to the decision to switch. The decision should be based on the future costs and benefits of the new system. The total benefit (cost savings) over 4 years is $20,000/year * 4 years = $80,000. The cost to adopt the new system is $50,000. The net financial benefit is $80,000 (total savings) - $50,000 (cost) = $30,000.
- A consulting firm spent $50,000 last year developing a proprietary financial modeling template. The firm is now bidding on a project that will require $30,000 in labor costs and $5,000 in travel costs. The project will also require 100 hours of computer time on the firm's server. The server has excess capacity, and the variable costs of running the server are negligible. The firm's policy is to allocate server overhead at a rate of $20 per hour. In determining the minimum bid price for the project, what total cost figure should be used?
Answer: $35,000
The minimum bid price should be based on the relevant, incremental costs of the project.
- The $50,000 spent developing the template is a sunk cost and irrelevant.
- The labor costs ($30,000) and travel costs ($5,000) are future, incremental costs and are relevant.
- The server overhead allocation ($20/hour * 100 hours = $2,000) is irrelevant because it is an allocation of existing costs and using the server does not incur any additional variable costs as there is excess capacity.
Therefore, the total relevant cost is $30,000 + $5,000 = $35,000.
- AutoParts Inc. has been producing Component X internally at a cost of $18 per unit (including $6 allocated fixed overhead). An outside supplier offers to provide Component X for $15 per unit. AutoParts produces 10,000 units annually and would eliminate 60% of the allocated fixed overhead if production stops. The freed-up capacity could be used to produce Component Y, which would generate a contribution margin of $45,000. What is the total relevant cost of continuing to make Component X internally?
Answer: $165,000 ($120,000 + $45,000 opportunity cost)
Relevant costs of internal production include: variable costs $120,000 (10,000 × $12) plus opportunity cost of $45,000 from foregone Component Y production. The unavoidable fixed overhead ($24,000 = 40% × $60,000 total) continues regardless and is irrelevant. Choice A omits opportunity cost, Choice B includes irrelevant unavoidable overhead, Choice D double-counts by including both unavoidable overhead and opportunity cost.
- BuildCorp purchased land for $200,000 five years ago, intending to build a warehouse. Current market value is $350,000. The company now faces three options: (1) build the planned warehouse at a cost of $800,000, (2) sell the land immediately, or (3) hold the land as an investment expecting 5% annual appreciation. BuildCorp's cost of capital is 8%. In evaluating whether to build the warehouse, which amount represents the relevant cost of the land?
Answer: $350,000, representing the current opportunity cost of using the land
When evaluating business decisions involving assets you already own, the key principle is that sunk costs are irrelevant—only opportunity costs matter. The relevant cost is what you give up by choosing one option over the next best alternative.
The correct answer is D) $350,000 because this represents the opportunity cost of using the land for the warehouse. If BuildCorp builds the warehouse, they sacrifice the ability to sell the land today for $350,000. This current market value is what they're truly "spending" by committing the land to warehouse construction, regardless of what they originally paid.
A is wrong because the $200,000 original purchase price is a sunk cost—money already spent that can't be recovered regardless of the decision. Historical costs are never relevant in forward-looking business decisions.
B incorrectly applies the cost of capital to the current market value. The 8% cost of capital doesn't determine the land's opportunity cost; it would be used to evaluate the warehouse project's overall profitability, not the land's relevant cost.
C represents the land's expected value if held as an investment (350,000×1.05=367,500), but this isn't the opportunity cost of building today. The decision is being made now, so the current market value of $350,000 is what's being sacrificed.
Study tip: In managerial accounting decisions, always ask "What am I giving up?" rather than "What did I pay?" Relevant costs are future opportunity costs, never historical sunk costs. - RetailCorp operates a chain of stores and is evaluating whether to close its downtown location. The store generates annual revenues of $800,000 and has the following annual costs: store manager salary $65,000, sales staff wages $180,000, rent $120,000 (non-cancelable lease with 3 years remaining), utilities $25,000, allocated corporate overhead $75,000, and inventory costs $350,000. If closed, the manager would be transferred to another location at the same salary, and corporate overhead would be reallocated to other stores. Which amount represents the relevant annual costs for the closure decision?
Answer: $555,000 (sales wages, utilities, and inventory costs only)
Relevant costs are those that can be avoided by closing. These include: sales staff wages $180,000, utilities $25,000, and inventory costs $350,000 = $555,000. The manager salary is not relevant (transferred, not eliminated), rent is not relevant (non-cancelable), and overhead is not relevant (reallocated, not eliminated). Choice B includes overhead that continues, Choice C includes unavoidable rent, Choice D excludes inventory costs which would be avoided.
- ServiceCorp signed a 5-year office lease two years ago at $8,000 per month. Due to business growth, the current space is inadequate. The company can: (1) stay in current space and rent additional space at $4,000 per month, (2) break the current lease by paying a $75,000 penalty and sign a new lease for larger space at $15,000 per month, or (3) sublet the current space for $6,000 per month (while still paying the original lease) and rent new space at $15,000 per month. For the decision analysis, how should the original lease payment be treated?
Answer: As a sunk cost that should be ignored in all alternatives since the lease was signed in the past
When analyzing business decisions, you must distinguish between costs that will actually change based on your choice versus costs that remain the same regardless. This is a classic relevant versus irrelevant cost scenario.
The original $8,000 monthly lease payment is a sunk cost because ServiceCorp is legally obligated to pay it no matter what they decide. Let's examine what happens under each alternative: If they stay put (option 1), they pay the $8,000. If they break the lease (option 2), they pay a penalty to escape the $8,000 obligation. If they sublet (option 3), they still pay the original $8,000 but receive $6,000 back from the subtenant. In every scenario, the $8,000 affects their cash flow, but since it doesn't differ between alternatives, it's irrelevant to the decision analysis.
Answer A incorrectly treats the lease as relevant simply because it's a legal obligation. Legal obligations can still be sunk costs if they don't vary between alternatives. Answer B mischaracterizes this as an opportunity cost—opportunity costs represent the value of foregone alternatives, not existing contractual commitments. Answer C wrongly suggests the cost is relevant for alternative 1 just because the lease arrangement doesn't change, but relevance depends on whether costs differ between options, not whether arrangements change.
Remember this key principle: only costs that differ between alternatives should influence your decision. If a cost appears in all scenarios (even if modified by penalties or subletting), focus on the incremental differences, not the base amount.
- A pharmaceutical company has invested $10 million in the initial research for a new drug. The next phase, clinical trials, will cost an additional $4 million. The company's analysts project a 70% chance of success. If successful, the drug will generate net future profits of $20 million. If it fails, the company will lose the entire investment. What is the expected value of proceeding with the clinical trials?
Answer: Gain of $10,000,000
The $10 million initial investment is a sunk cost and is irrelevant to the decision to proceed. The decision should be based on the expected value of the future outcomes versus the future costs.
Expected future profit = (Probability of Success Profit if Successful) + (Probability of Failure Profit if Failure) = (0.70 $20,000,000) + (0.30 $0) = $14,000,000.
The cost to proceed is the $4,000,000 for clinical trials.
Expected value = Expected future profit - Future cost = $14,000,000 - $4,000,000 = $10,000,000.
- Manufacturing Inc. purchased specialized equipment three years ago for $180,000. The equipment has a current book value of $108,000 and could be sold today for $75,000. The company is considering replacing it with new equipment costing $250,000. If the old equipment is kept, it will require $40,000 in repairs next year and have annual operating costs of $85,000. The new equipment would have annual operating costs of $55,000. What is the relevant cost of keeping the old equipment for one more year?
Answer: $200,000 ($85,000 operating costs + $40,000 repairs + $75,000 opportunity cost)
Relevant costs include future cash flows and opportunity costs. Keeping the old equipment involves: $85,000 operating costs + $40,000 repairs + $75,000 opportunity cost (forgone sale proceeds) = $200,000. The book value of $108,000 is a sunk cost and irrelevant. Choice A ignores opportunity cost, Choice B incorrectly subtracts the opportunity cost and includes sunk cost, Choice D includes the sunk book value.
