Question

Pat, a Pizzeria manager, replaced the convection oven just six months ago. Today, Turbo Ovens Manufacturing announced the availability of a new convection oven that cooks more quickly with lower operating expenses. Pat is considering the purchase of this faster, lower-operating cost convection oven to replace the existing one they recently purchased. Selected information about the two ovens is given below:

Existing New Turbo Oven

Original cost $60,000 $50,000

Accumulated depreciation $ 5,000 —

Current salvage value $40,000 —

Remaining life 5 years 5 years

Annual operating expenses $10,000 $ 7,500

Disposal value in 5 years $ 0 $ 0

Required:

a. What costs are sunk?

b. What costs are relevant?

c. What are the net cash flows over the next 5 years assuming the Pizzeria purchases the new convection oven?

d. What other items should Pat, as manager of the Pizzeria, consider when making this decision?

Answer 1

a) Sunk costs are the cost that have been incurred in the past and which is having no relevance in future for the decision making. Over here, the cost of existing oven is sunk cost.

b) Relevant cost are the cost that are considered in decision making. Over here, cost of new oven is relevant cost.

c) Net Cash Outflows for the next 5 years considering Pizzeria purchases the new oven will be,

Cost of New Oven at year 0 = 50000

Salvage Value of existing oven at year 0 = 40000

Operating Exps for 5 years - 7500 * 5 = 37500

So, Net cash outflow at year 0 for next 5 years = 50000 + 37500 - 40000

= 47500

d) Pat should consider the following when making a desision:-

i) Quality of new oven

ii) Baking quality from new oven

iii) Pizza making capacity