Question

SUNK AND OPPORTUNITY COSTS FOR DECISION MAKING

Mrs Johnston has taken out a lease on a shop for a down payment of $5000. Additionally, the rent under the lease amounts to $5000 per annum. If the lease is cancelled, the initial payment of $5000 is forfeit. Mrs Johnston plans to use the shop for the sale of clothing, and has estimated operations for the next 12 months as follows:
$. $.

Sales 115,000
Less Valued-added Tax (VAT) 15,000
Sales less VAT 100,000
Cost of goods sold 50,000
Wages and wage-related costs. 12,000
Rent including the down payment. 10,000
Rates, heating, lighting and insurance. 13,000
Audit, legal and general expenses. 2,000
87,000
New profit before tax 13,000

In the figures, no provision has been made for the cost of Mrs Johnston but it is estimated that one (1) half of her time will be devoted to the business, She is undecided whether to continue with her plans because she knows that she can sublet the shop to a friend for a monthly rent of $550 if she does not use the shop herself.

You are required to:
(a) explain and identify the 'sunk' and 'opportunity' costs in the situation depicted above
(b) state what decision Mrs Johnston should make according to the information given, supporting your conclusion with a financial statement.

Answer 1

a) The 'sunk' costs in this situation are the initial payment of $5000 for the lease and the rent of $5000 per annum. The 'opportunity' cost is the potential rent of $550 per month if Mrs. Johnston sublets the shop instead.

b) Mrs. Johnston should continue with her plans to use the shop for the sale of clothing as it would result in higher profitability.

Step-by-step explanation:

a) The 'sunk' costs in this situation are the initial payment of $5000 for the lease and the rent of $5000 per annum. These costs are already paid and cannot be recovered if the lease is cancelled. The 'opportunity' cost in this situation is the potential rent of $550 per month that Mrs. Johnston could receive if she sublets the shop to a friend instead of using it herself.

b) Mrs. Johnston's financial situation can be detailed as follows:

• 
  
• Sales: $115,000
• 
  
• Less VAT: $15,000
• 
  
• Sales less VAT: $100,000
• 
  
• Cost of Goods Sold: $50,000
• 
  
• Wages and Wage-Related Costs: $12,000
• 
  
• Total Rent (including down payment): $10,000
• 
  
• Rates, Heating, Lighting, and Insurance: $13,000
• 
  
• Audit, Legal, and General Expenses: $2,000
• 
  
• Total Costs: $87,000
• 
  
• New Profit Before Tax: $13,000

Given this information, Mrs. Johnston will have a new profit before tax of $13,000 if she operates the business. However, if she decides to sublet the shop for a monthly rent of $550, she would forfeit the down payment (sunk cost), but generate a different stream of income without the operational hassle. To support her decision, she would need to compare the new profit before tax to the total opportunity cost of not subletting, which is $6,600 annually ($550 x 12).

Based on the financial information provided, Mrs. Johnston's decision to operate the clothing store yields a higher profit ($13,000) than the potential rental income from subletting ($6,600). Therefore, the financially justified decision would be to continue with her plans to operate the clothing store.