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Question
Elm Petroleum has spent \(204,000 to refine 61,000 gallons of petroleum distillate, which can be sold for \)6.30 per gallon. Alternatively, Elm 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, Elm must pay a sales commission of \(0.10 per gallon and a transportation charge of \)0.16 per gallon.
Requirements
1. Diagram Elm’s decision alternatives, using Exhibit 25-18 as a guide.
2. Identify the sunk cost. Is the sunk cost relevant to Elm’s decision?
3. Should Elm sell the petroleum distillate or process it into cleaner fluid? Show the expected net revenue difference between the two alternatives.
Step-by-Step Solution
VerifiedAnswer
The company should focus on processing its product further.
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.
As per the given scenario, Elm Petroleum has to bear the sunk cost in both situations. Hence, the joint cost is irrelevant in making the decision to choose an alternative.
Differential analysis of revenue:
Particulars | Sell ($) | Processed further ($) | Difference ($) |
Revenue | 384,300 | 527,800 | 143,500 |
Incremental analysis of whether Elm Petroleum should sell or process further:
Particulars | Amounts ($) |
Expected increase in revenue | 143,500 |
Less: Expected increase in cost (61000*1.80) | (109,800) |
Less: Selling expense [(58000*0.1)+(58000*0.16)] | (15,080) |
Expected increase in profit | $18,620 |
As per the above analysis, it is concluded that the company should process the petroleum distillate further because it will increase the profits by $18,620.