Question

Exercise 1-16 Cost Classifications for Decision Making (LO1-5] 

Warner Corporation purchased a machine 7 years ago for $345,000 when it launched product P50. Unfortunately, this machine has broken down and cannot be repaired. The machine could be replaced by a new model 300 machine costing $336,950 or by a new model 200 machine costing $300,800. Management has decided to buy the model 200 machine. It has less capacity than the model 300 machine, but its capacity is sufficient to continue making product P50. Management also considered, but rejected, the alternative of dropping product P50 and not replacing the old machine. If that were done, the $300,800 invested in the new machine could instead have been invested in a project that would have returned a total of $400,000. 

Required:

 1. What is the total differential cost regarding the decision to buy the model 200 machine rather than the model 300 machine?

 2. What is the total sunk cost regarding the decision to buy the model 200 machine rather than the model 300 machine?

 3. What is the total opportunity cost regarding the decision to invest in the model 200 machine? 

Answer 1

1.

Differential cost = Model 300 Machine - Model 200 Machine = 336,950 - 300,800 = $ 36,150

2.

Sunk Cost is the cost that has already been incurred and is not relevant to the decision making. In this case it is the purchase price of the machine that was purchased 7 years ago.

Sunk cost = $ 345,000

3.

Opportunity cost is the benefit foregone when one option is selected over the other. In this case it is the income that would have been earned from the project.

So the opportunity cost is $ 400,000