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# Sunk Cost and Avoidable Costs

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#### Solution Preview

2. The Han calendar company started business on 1 January 2009. The company prints calendars to be used as advertisements by local firms. The firm has been losing money. They are now (1 March 2010) deciding whether to stop producing. The question is how much they will save by going out of business, that is, how much of their costs are sunk and how much of their costs are avoidable. For each item in this list, say how much of the cost is avoidable and why.

(a) For each calender the firm produces, it needs to buy paper and ink. It buys the paper and ink for each job in the appropriate amount, and has no stock of paper or ink on hand at the end of a job.

There is no sunk cost. If the firm goes out of business, the cost of paper and ink will be totally avoided. We save 100% on this cost.

(b) The firm rented a facility in which to produce. The annual rent is 25, 000 dollars, payable on 1 January of each year. They can break their lease with six month's ...

#### Solution Summary

Sunk cost is assessed.

\$2.19

## Business costs for Exquisite Portraits

On the first day of the new year to get her business started, the owner/photographer of Exquisite Portraits Inc. paid \$200 for business cards, \$1,000 for a listing in Yellow Pages, and \$250 for an annual business license. She also leased a professional portrait camera and studio lighting equipment by signing an agreement to pay a monthly lease of \$1,000 each month for the next 12 months. This lease is ironclad: She must pay for all 12 months and she cannot sublease to anyone else. She rents her office and studio for \$1,400 per month that must be paid at the beginning of each month. She does not have a lease on the office/studio, so she can vacate the office/studio at the end of any month should she decide to move to a new location or to go out of business. After she opens the office/studio on the first day of each month, her monthly cost of electricity for lighting the office and running her coffee machine is constant at \$45 per month, because she always keeps the lights on in the office and drinks the same amount of coffee no matter how many photos she shoots each month. Additional electricity is required for the portrait studio lights. , which varies directly with the number of hours the lights are used each month for photo sessions. Last year, before starting this business, the owner of Exquisite Portraits Inc. earned a salary of \$5,000 per month working at a bank. Answer the following questions about the costs for Exquisite Portraits Inc.

a) What are the monthly fixed costs, quasi-fixed costs, and variable costs for Exquisite Portraits Inc.?

b) If the owner of Exquisite Portraits Inc. wants to close her studio and go out of businesses at the end of August, identify her sunk costs and avoidable costs.

c) At the end of August, what role would the sunk costs play in the owner/photographers decision to go out of business?

d) In making her decision to start her own business, would her decision have been more or less difficult to make if sunk costs were zero at Exquisite Portraits? Explain.

2) At a management luncheon, two managers were overheard arguing about the following statement : â?? A manager should never hire another worker if the new person causes diminishing returns.â? Is this statement correct? If so, why? If not, explain why not?

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