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A company has just tested the market for a new product. The test indicates that the...

A company has just tested the market for a new product. The test indicates that the product may capture about 40 percent of the market share. It is also expected that 25 percent of the new product’s share will be at the cost of an existing product. The new product can be manufactured in the existing facilities, which could also be used to meet the expected increase in one of the company’s existing products. The company’s financial analyst argues that she would include the test costs in the new product’s cash flows since they were incurred for testing the new product but would exclude the lost contribution on an existing product and the value of the existing facilities to be used for the manufacture of the new product because no out-of-pocket cost is incurred. Do you agree with the analyst? Why or why not?

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Answer #1

There is concept of sunk cost. Sunk costs are the ones which are already incurred. Any response to project acceptance or rejection will not get this money back hence for any project planning these costs are ignored. Inital testing costs are this nature only hence we should not include these costs in initial cost so we do not agree with accountant here.

Lost contribution is the money which the organisation was earning before the project. Any new project appraisal is done on top up of existing contribution. Because this contribution was the money which was there in place. If company has decided to take up the new project then they will analyse the increamental cashflows and also they will want to get that contribution which is lost. hence we do not agree with the accountant to exclude the lost contribution in project appraisal.

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