The company that you manage has invested $5 million in developing a new product, but the development is not
quite finished. At a recent meeting, your salespeople report that because of increasing competition in the industry
the expected sales of your new product will be only $3 million.
(i) If it would cost $1 million more to finish the development of the product, should you go ahead and do so? Why or why not? show calculations
(ii) If it would cost $4 million more to finish the development, should you go ahead and do so? Why or why not? show calculations
(iii) What is the most or maximum additional amount that you should pay to complete development of the product?
(iv) What is the sunk cost in this case?
To answer these questions, we need to compare the costs of finishing the development of the product with the expected sales revenue. Let's break down each scenario:
(i) If it would cost $1 million more to finish the development of the product:
- Expected sales revenue: $3 million
- Additional cost to finish development: $1 million
To determine whether to proceed, we compare the expected sales revenue with the additional cost:
$3 million - $1 million = $2 million
Since the expected sales revenue ($3 million) is higher than the additional cost to finish development ($1 million), it would be financially viable to proceed with finishing the development.
(ii) If it would cost $4 million more to finish the development:
- Expected sales revenue: $3 million
- Additional cost to finish development: $4 million
Again, we compare the expected sales revenue with the additional cost:
$3 million - $4 million = -$1 million
In this case, the expected sales revenue is lower than the additional cost to finish development, resulting in a negative value. Therefore, it would not be advisable to proceed with finishing the development since it would result in a net loss.
(iii) To determine the maximum additional amount to pay for completing development:
- Expected sales revenue: $3 million
- Current investment in development: $5 million
The maximum additional amount that should be paid is the difference between the expected sales revenue and the current investment:
$3 million - $5 million = -$2 million
In this case, the maximum additional amount to pay is -$2 million, meaning any additional investment would result in a net loss. Therefore, it is not recommended to pay anything beyond the current investment for completing development.
(iv) The sunk cost in this case refers to the initial investment made by the company, which is $5 million. A sunk cost is a cost that has already been incurred and cannot be recovered. In decision-making, sunk costs should not be considered, as they are irrelevant to the current situation.