Question

Exercise 1-2.

Sunk Cost [LO 2]

Rachel Cook owns Campus Copies, a copy business with several high-speed copy machines. One is a color copier that was purchased just last year at a cost of $25,000. Recently a salesperson got Rachel to witness a demo of a new $23,000 color copier that promises higher speed and more accurate color representation. Rachel is interested but she can’t get herself to trade in a perfectly good copier for which she paid $25,000 and replace it with one that will cost $23,000.

Required:                                 

Write a paragraph explaining why the cost of the old copier is irrelevant to Rachel’s decision.

Answer 1

Sunk Costs is the costs which have already been incurred. Sunk costs are irrelevant in decision making as they have already been incurred and acceptance and rejection of the project will not affect them. Examples of Sunk costs is the expenditure incurred on research and development
In the above scenario, color copier was purchased last year and some new copier is available with new features.
Carrying value of old copier = Purchase cost - Accumulated depreciation
Even the carrying value of old copier is irrelevant in decision making as market value is considered while evaluating whether to continue or purchase the new one.
Analysis would be as Follows :
Net savings from new copier over the life	xxxx
Add Sale Value of old copier	xxxx
Less Purchase cost of new copier	(xxxx)
Net Benefit (Loss) from new copier	xxxx
If answer comes in positive then new copier should be accepted and vice versa
If you see the above analysis we have not used purchase cost and even the carrying value. Thus they are ignored as they are sunk cost