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Sunk cost/Opportunity cost

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PP8-6 Sunk costs and opportunity costs

Covol Industries is developing the relevant cash flows associated with
the proposed replacement of an existing machine tool with a new,
technologically advanced one. Given the following costs related to the
proposed project, explain whether each would be treated as a sunk cost or an
opportunity cost in developing the relevant cash flows associated with the proposed
replacement decision.

a. Covol would be able to use the same tooling, which had a book value of
$40,000, on the new machine tool as it had used on the old one.

b. Covol would be able to use its existing computer system to develop programs for
operating the new machine tool. The old machine tool did not require these programs.
Although the firm's computer has excess capacity available, the capacity
could be leased to another firm for an annual fee of $17,000.

c. Covol would have to obtain additional floor space to accommodate the larger
new machine tool. The space that would be used is currently being leased to
another company for $10,000 per year.

d. Covol would use a small storage facility to store the increased output of the new
machine tool. The storage facility was built by Covol 3 years earlier at a cost of
$120,000. Because of its unique configuration and location, it is currently of no
use to either Covol or any other firm.

e. Covol would retain an existing overhead crane, which it had planned to sell
for its $180,000 market value. Although the crane was not needed with the
old machine tool, it would be used to position raw materials on the new
machine tool.

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Solution Summary

The solution explains the classification of given costs as sunk cost or opportunity cost

Solution Preview

A sunk cost is a cost which is already incurred prior to the decision
An opportunity cost is a loss of income if the asset is put to alternative use

a. Covol would be able to use the same tooling, which had a book value of
$40,000, on the new machine tool as it had used on the old one.

Sunk Cost - The cash to buy the tooling is already spent and the book value is a sunk cost

b. Covol would be able to use its existing computer system ...

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