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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 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 ...

    Solution Summary

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

    $2.19