Question

Auto Parts, Inc. is medium-sized company that manufactures auto parts in Buffalo, New York. The company currently loses $30,000 per month. The owner of the company is evaluating whether she should shut down the factory. She thinks that the factory should continue to operate until the economic environment improves and buyer for the factory can be identified. The logic of the owner is that her company has already invested millions of dollars in the factory over the years. The monthly fixed costs for the factory are $40,000. The CEO of Auto Parts, Inc. thinks the factory should be shut down because most the monthly fixed costs ($40,000/month) are sunk costs. Do you agree with the owner or the CEO? Explain the logic of your argument, including a numerical demonstration.

Answer 1

No, I do not agree with the CEO.

Sunk cost is the one which is incurred in past and cannot be avoided now, and thus, not involved in any decision making.

Further it is not regularly incurring cost.

A company shall operate till the time the company is able to recover its variable costs.

Here the company is recovering the entire variable cost as the fixed cost = $40,000, and losses are $30,000

That means $40,000 - $30,000 = $10,000 is the amount after meeting the variable cost the company recovers as part of fixed cost.

If a company can meet its variable cost, it shall not shut down. Therefore, CEO's decision is wrong.