26PGA - Horngren'S Financial And Managerial Accounting

Question

Oak Petroleum has spent \(202,000 to refine 63,000 gallons of petroleum distillate, which can be sold for \)6.00 per gallon. Alternatively, Oak can process the distillate further and produce 58,000 gallons of cleaner fluid. The additional processing will cost \(1.80 per gallon of distillate. The cleaner fluid can be sold for \)9.10 per gallon. To sell the cleaner fluid, Oak must pay a sales commission of \(0.12 per gallon and a transportation charge of \)0.19 per gallon.

Requirements 

1. Diagram Oak’s decision alternatives, using Exhibit 25-18 as a guide. 

2. Identify the sunk cost. Is the sunk cost relevant to Oak’s decision? 

3. Should Oak sell the petroleum distillate or process it into cleaner fluid? Show the expected net revenue difference between the two alternatives.

Step-by-Step Solution

Answer

The company should focus on processing the product further.

Step 1: Meaning of Sunk Cost

The term sunk cost refers to the cost that has already been incurred by a business concern and is irrecoverable. Such costs are considered irrelevant when making decisions regarding outsourcing, making, buying, and processing a product further.

Step 2: Diagram for decision alternatives

Step 3: Identification of sunk cost

According to the given scenario, Oak Petroleum has to bear the sunk cost in both situations. Hence, the joint cost is irrelevant in making a decision to choose an alternative. 

Step 4: Preparation of analysis

Differential analysis of revenue:

Particulars	Sell ($)	Processed further ($)	Difference ($)
Revenue	378,000	527,800	149,800

 

Incremental analysis of whether Oak should sell or process further:

Particulars	Amounts ($)
Expected increase in revenue	149,800
Less: Expected increase in cost (63000*1.80)	(113,400)
Expected increase in profit	$36,400

 

According to the analysis, it is concluded that the company should process the petroleum distillate because it will increase the profits by $36,400.