Chapter 23: Sell or Process

Evaluation of Sell or Process Further Decisions In many businesses, a common decision involves determining whether to sell a partially completed product as is or to process it further into a more valuable product. This decision is based on a comparison of incremental costs and incremental revenues that would result from further processing. Key Concepts: • • • Incremental Costs: These are additional costs required to further process a product. Examples include extra materials, labor, and overhead expenses directly associated with further processing. Incremental Revenues: These are the additional revenues gained from selling the processed product compared to selling it as is. Sunk Costs: Costs already incurred, such as initial production or harvesting expenses, which do not change based on the decision to sell or process further. These costs are irrelevant to the decision. Example: Peanut Processing Decision A company has already spent $30,000 to harvest peanuts. It faces two options: 1. Sell the peanuts as is for $50,000. 2. Process the peanuts further into a nutritional supplement: o Additional processing cost: $80,000. o Resulting revenue from the nutritional supplement: $150,000. Incremental Analysis: • • • Revenue from Selling as Is: $50,000 (relevant). Revenue from Processing Further: $150,000 (relevant). Incremental Cost for Further Processing: $80,000 (relevant). Calculation of Incremental Income: 1. Income if Sold as Is: Revenue=$50,000 2. Income if Processed Further: Revenue−Incremental Costs=$150,000−$80,000=$70,000 3. Comparison: Incremental Income from Processing Further=$70,000−$50,000=$20,000 Decision: Since the income from processing further ($70,000) is higher than the income from selling as is ($50,000), the company should process the peanuts further and earn an additional $20,000. Decision Rule: Select the option that provides the higher income. The previously incurred $30,000 harvesting cost is a sunk cost and does not affect this decision. Scrap or Rework Analysis Another variation of this decision-making process is determining whether to scrap defective products or rework them to make them saleable. Example: Rework or Scrap Defective Units FasTrac has 1,000 defective units with the following details: • • • • Sunk Cost: $10,000 spent to manufacture these units (irrelevant to the decision). Sell as Scrap: The defective units can be sold for $4,000. Rework Cost: It will cost $8,000 to rework the units. Revenue from Reworked Units: The reworked units can be sold for $15,000. Incremental Analysis: • • • Scrap Value: $4,000 (relevant as an opportunity cost). Cost to Rework: $8,000 (relevant). Revenue from Reworked Units: $15,000 (relevant). Calculation of Incremental Income: 1. Income if Sold as Scrap: Scrap Revenue=$4,000 2. Income if Reworked: Revenue−Rework Cost=$15,000−$8,000=$7,000 3. Comparison: Incremental Income from Reworking=$7,000−$4,000=$3,000 Decision: Since reworking the units yields $7,000 and selling as scrap yields $4,000, FasTrac should rework the units to gain an additional $3,000 in income. NEED-TO-KNOW 23-3 Examples 1. Milk Processing Decision: o Initial Costs: $20,000 (sunk and irrelevant). o Sell as Is: Revenue of $40,000. o Process into Ice Cream: Additional cost of $25,000, resulting in a revenue of $60,000. Incremental Analysis: Income if Sold as Is: $40,000. o Income if Processed: $60,000 - $25,000 = $35,000. o Decision: The company should sell the milk as is because the income is higher by $5,000 ($40,000 - $35,000). 2. Handbag Rework Decision: o Initial Costs: $50,000 (sunk and irrelevant). o Sell as Scrap: $15,000. o Rework Cost: $9,000, with resulting sales of $20,000. o Incremental Analysis: o o o Income if Scrapped: $15,000. Income if Reworked: $20,000 - $9,000 = $11,000. Decision: The company should scrap the handbags since the income from selling as scrap ($15,000) is higher than the income from reworking ($11,000) by $4,000. Summary When making sell or process further and scrap or rework decisions, managers focus on the additional costs and revenues associated with each option. Sunk costs are excluded from the analysis because they do not change regardless of the decision made. Instead, the focus is on incremental benefits (additional revenues) and incremental costs (additional expenses) to determine which alternative is more financially beneficial.