Information regarding current operations of the Farrell Corporation is given bel
ID: 2351392 • Letter: I
Question
Information regarding current operations of the Farrell Corporation is given below:Sales $950,000
Variable Costs $450,000
Fixed Costs $310,000
A proposed addition to Farrell's factory is estimated by the sales manager to increase sales by a maximum of $750,000. The company's accountants have determined that the proposed addition will add $320,000 to fixed costs each year.
a) Explain why the existing $310,000 of fixed costs is a sunk cost while the $320,000 of fixed costs associated with the proposed addition is an out of pocket cost.
b) Calculate by how much the proposed addition will either increase or reduce operating income.
Explanation / Answer
a. Sunk cost of $310,000 - A sunk cost is a cost that was incurred in the past and cannot be altered by any current or future decision. Out-of-pocket costs are paid in cash at or near the time they are incurred. So $320,000 cost is an Out of Pkt cost b. Current Net Income = Sales - Var cost - Fixed costs = 950,000-450,000-310,000 = 190000 CM ratio = COnt/Sales = (950000-450000)/950000 = 52.63% Post addition, Sales = 950,000+750,000 = 1700,000 So Cont = CM Ratio*Sales = 52.63%*1700,000 = 894,710 So Net Income = COnt - FC = 894,710 - (310,000 +320,000) = 264,710 So Post addition, Net income Increases by ( 264,710 -190,000) = 74,710