Question

John and Jane Brown have been living at their present home for the past 6 years. During that time, they have replaced the water heater for $375, have replaced the dishwasher for $599, and have had to make miscellaneous repair and maintenance expenditures of approximately $1,500. They have decided to move out and rent the house for $975 per month. Newspaper advertising will cost $75. John and Jane intend to paint the interior of the home and power-wash the exterior. They estimate that that will run about $900.The house should be ready to rent after that. In reviewing the financial situation, John views all the expenditures as being relevant, so he plans to net out the estimated expenditures discussed above from the rental income. Do John and Jane understand the difference between sunk costs and opportunity costs? Explain the two concepts to them. Which of the expenditures should be classified as sunk cash flows, and which should be viewed as opportunity cash flows?

Answer 1

SUNK COST-It is the cost which has already been incurred in the past and no future decision can change it because it has been occurred in the past and we cannot recover it no matter what the outcome is and is thus it is an irrelevant cost.

OPPORTUNITY COST-It is the next best alternative cost and it is a relevant cost as it is different under different alternatives and has implication on the decision to be made.it is represented by the benefits that one misses out while choosing one alternative in place of other.

replaced the water heater for $375- it is a sunk cost because it has been already incurred in the past and the decision to rent the house cannot recover it because it is sunk and is thus an irrelevant cost while considering the expenditure.

replaced the dishwasher for $599-it is a sunk cost because it has been already incurred in the past and the decision to rent the house cannot recover it because it is sunk and is thus an irrelevant cost while considering the expenditure.

miscellaneous repair and maintenance expenditures of approximately $1,500-t is a sunk cost because it has been already incurred in the past and the decision to rent the house cannot recover it because it is sunk and is thus an irrelevant cost while considering the expenditure.

Newspaper advertising will cost $75.it is an opportunity cost and is hence relevant because it will only be incurred as a result of their decision to rent out their house so it is relevant and must be considered while calculating the relevant expenditure.

home and power-wash the exterior will run about $900.-it is an opportunity cost and is hence relevant because it will only be incurred as a result of their decision to rent out their house so it is relevant and must be considered while calculating the relevant expenditure.

rent the house for $975 per month- It is an opportunity cash flow income that they will earn as a result of letting out their house and is thus relevant while making a decision because it has future implications.