Question

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 the introduction of competing products has reduced the expected sales of your new product to $2 million. If it would cost $4 million to finish development and make the product, you go ahead and do so. The most you should pay to complete development is $ million.

Answer 1

$5 million

Step-by-step explanation:

The initial investment of $5 million is now a sunk cost and is essentially irrelevant to future decision making.

If you stop production you will have spent $5 million.

If you continue, you will still have spent $5 million.

However,

if you spend an additional $4 million you will make $2 million giving you a loss of $2 million.

If you want to look at this mathematically:

Cost of stopping production: $5 million

Cost of continuing:

= $5 million + $4 million - $2 million

= $7 million

As you can see, the cost of continuing is higher. So, he will be willing to pay the amount that is below $5 million because it costs him $7 million to get $2 million in sales.

Therefore, the most he should pay to complete development is $5 million that is the cost of stopping production.