Unformatted text preview: mple, you may have purchased an expensive shirt that was hopelessly shrunk in the
dryer. Would you now attempt to buy a matching pair of pants because you had invested so much in
the shirt? Obviously not. The amount you previously spent on the shirt is no longer relevant to your
decision; it is a sunk cost and should not influence your future actions.
In business decision making, sunk costs should be ignored. Instead, the focus should be on relevant
costs. Relevant items are those where future costs and revenues are expected to differ for the
alternative decisions under consideration. The objective will be to identify the decision yielding the
best incremental outcome as it relates to relevant costs/benefits. Download free ebooks at bookboon.com
7 Cost Characteristics and Decision-Making Ramifications Analytics for Managerial Decision Making 1.2 A Basic Illustration of Relevant Cost/Benefit Analysis
During a recent ice storm, Dillaway Company’s delivery truck was involved in a traffic accident.
The truck originally cost $60,000, and was 40% depreciated. An insurance company has provided
Dillaway $30,000 for the damages that were incurred. Dillaway took the truck to a local dealer who
offered two options: (a) repair the truck for $24,000, or (b) buy the truck “as is, where is” for
$10,000. Dillaway has found an undamaged, but otherwise identical, used truck for sale on the
internet for $32,000 what decision is in order?
The truck’s original cost of $60,000 is sunk, and irrelevant to the decision process. The degree to
which it is depreciated is equally irrelevant. The financial statement “gain” that would be reported
on a sale is irrelevant. The $30,000 received from the insurance company is the same whether the
truck is sold or repaired; because it does not vary among the two alternatives it is irrelevant (i.e., it is
not necessary to factor it into the decision process). All that matters is to note that the truck can be
repaired for $24,000, or the truck can be sold for $10,000 and a similar one purchased for $3...
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