Explain why the existing $310,000 of fixed costs is a sunk cost while the $320,000 of fixed costs associated with the proposed addition is an out-of-pocket cost. Calculate by how much the proposed addition will either increase or reduce operating income.
Incremental analysis
Information regarding current operations of the Farrell Corporation is given below:
Sales $950,000
Variable Costs $450,000
Fixed Costs $310,000
A proposed addition to Farrell's factory is estimated by the sales manager to increase sales by a maximum of $750,000. The company's accountants have determined that the proposed addition will add $320,000 to fixed costs each year. Variable costs are expected to be at the same percentage as they currently are before the proposed addition.
(a) Explain why the existing $310,000 of fixed costs is a sunk cost while the $320,000 of fixed costs associated with the proposed addition is an out-of-pocket cost.
(b) Calculate by how much the proposed addition will either increase or reduce operating income.