BobJohnson decidedto buy anew home. After looking at tracts of new homes, he dec
ID: 1165473 • Letter: B
Question
BobJohnson decidedto buy anew home. After looking at tracts of new homes, he decided that a custom-built home was preferable. He hired an architect to prepare the plans for a fee of $7000. While a building con- tractor was working on a bid to construct the home on a lot Bob already owned, Bob found a standard house plans on the Internet for $200 that he and his wife liked better. Bob then asked the contractor to provide a bid to construct this "stock plan" home. The building contractor submitted the following bids: 2-36 Custom-designed home Stock plan home $258,000 261,000 Bob was willing to pay the extra $3000 for the stock- plan home. Bob's wife, however, felt they should go ahead with the custom-designed home, for, as she put it, "We can't afford to throw away a set of plans that cost $7000." Bob agreed, but he disliked the thought of building a home that is less desirable than the stock plan home. Which house would you advise him to build? Explain.Explanation / Answer
This is an example of 'sunk cost'.
A sunk cost is a cost that an entity has incurred, and which it can no longer recover by any means. Sunk costs should not be considered when making the decision to continue investing in an ongoing project, since these costs cannot be recovered.
The $4,000 is a past cost and should not be allowed to alter a subsequent decision unless there is some real or perceived effect. Since either home is really an individual plan selected by the homeowner, each should be judged in terms of value to the homeowner vs. the cost. On this basis the stock plan house appears to be the preferred alternative.
My advice to Bob would be to go for the stock-plan home that suits his requirements better than the custom-designed home. The amount spent on the architect of $4000 is a sunk cost and can not be recovered in any way and should not disrupt his decisions of choosing the most optimal alternative.