What are sunk costs? Give an example.
Sunk costs are the costs incurred in the past by the business entities, and they are also considered to be irrelevant to the decision-making process.
In accounting, cost refers to the amount of money spent by the business to acquire goods or services. Costs are incurred to generate revenues and flow the money out of business.
Sunk costs refer to the costs spent by the business in the past, and based on that, future activities are decided, which cannot be changed. Such costs are irrelevant to the business concerns while making a decision.
For instance, a business bought furniture for $10,000 5 years ago and deals in old furniture. Now the business is planning to buy new furniture. In the given scenario, $10,000 spent in the past is a sunk cost as the business cannot do anything to change that.
Green Thumb operates a commercial plant nursery, where it propagates plants for garden centers throughout the region. Green Thumb has $5,300,000 in assets. Its yearly fixed costs are $625,000, and the variable costs for the potting soil, container, label, seedling, and labor for each gallon-size plant total $1.70. Green Thumb’s volume is currently 490,000 units. Competitors offer the same plants, at the same quality, to garden centers for $4.00 each. Garden centers then mark them up to sell to the public for $9 to $12, depending on the type of plant.
1. Green Thumb’s owners want to earn an 10% return on the company’s assets. What is Green Thumb’s target full product cost?
2. Given Green Thumb’s current costs, will its owners be able to achieve their target profit?
3. Assume Green Thumb has identified ways to cut its variable costs to $1.55 per unit. What is its new target fixed cost? Will this decrease in variable costs allow the company to achieve its target profit?
4. Green Thumb started an aggressive advertising campaign strategy to differentiate its plants from those grown by other nurseries. Green Thumb does not expect volume to be affected, but it hopes to gain more control over pricing. If Green Thumb has to spend $135,000 this year to advertise and its variable costs continue to be $1.55 per unit, what will its cost-plus price be? Do you think Green Thumb will be able to sell its plants to garden centers at the cost-plus price? Why or why not?
This problem continues the Piedmont Computer Company situation from Chapter 24. Piedmont Computer Company’s payroll accountant has submitted her resignation and will be leaving the company in two weeks. The company must decide if it will hire a replacement or outsource the payroll position. The current employee earns a salary of $40,000. Medical insurance, employer payroll taxes, and contributions to the pension plan for this position cost $7,600. The company has already invested $22,000 in payroll software. Required annual updates to remain in compliance with all state and federal laws are $495. The company also spends $1,750 per year in professional development for this position to ensure the employee stays up-to-date with payroll changes. Piedmont Computer Company pays its employees weekly. Payroll Professionals will process the company’s weekly payroll for $1,000 per week. This fee also includes preparing all necessary payroll tax returns, reports, and W-2s.
1. Prepare a differential analysis to determine if Piedmont Computer Company should replace the employee or outsource the payroll function.
2. What other factors should Piedmont Computer Company consider in making this decision?
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