Identification of opportunity cost and sunk cost
Sunk Cost refers to the cost that was incurred in past and cannot be altered through new decisions . It can also be called as irrelevant cost for decision making purpose since it has been incurred and it does not make any difference if the proposal is accepted or rejected. In the case of Tom, the sunk cost relates to the house purchase. During 2004, he has purchased the house in $500,000 which at present has worth $375000. The sunk cost here will be $125000 ($500,000-$375000).
Opportunity cost refers to the benefits forgone due to the selection of one option over the other . In simple terms, it the cost of what could be earned if a particular decision was taken or not taken. In the given case, Tom has two salary offers. The net income earned in offer A will be $3025161 whereas in offer B $3455935. As, in offer B, Tom is required to stay 500 miles away from the company which will make the moving cost of $55000 (375000-425000-5000). Hence, in the offer B, the net amount for Tom will be (3455935-55000) = $3400935. On acceptance of offer A, the opportunity cost will be ($3025161-3400935) = -$375774. Whereas, in the case of B, the opportunity cost will be (3400935-3025161= $375774.
Tom’s net income at the end of retirement in offer A and offer B
Years to retire = 12 years
Each year increase = 4%
Offer B= 15% high salary than A
First month salary: offer A= $200000, Offer B= $200000 + (200000*.15) =$230000
Net present value of offer A and B if discounted at 8%
Net Present Value is the sum of difference of cash inflows and cash outflows discounted by a cut off rate, known as discounting factor or desired rate of return. Following is the calculation and summary of NPV of two alternatives before Tom:
NPV in offer A = {$200,000/(1+.08)^1} + {$208,000/(1+.08)^2} + {$216,320/(1+.08)^3} + {$224972.8/(1+.08)^4} + {$233971.7(1+.08)^5} + {$243330.6/(1+.08)^6} + {$253063.8/(1+.08)^7} + {$263186.4(1+.08)^8} + {$273713.8/(1+.08)^9} + {$284662.4/(1+.08)^10} + {$296048.9/(1+.08)^11} + {$307890.8/(1+.08)^12} = $1698772.71 so, NPV = $3025161-$1698772.71 = $1326388
NPV in offer B = {$230,000/(1+.08)^1} + {$239200/(1+.08)^2} + {$248768/(1+.08)^3} + {$258718.7/(1+.08)^4} + {$269067.5(1+.08)^5} + {$279830.2/(1+.08)^6} + {$291023.4/(1+.08)^7} + {$302664.3(1+.08)^8} + {$314770.9/(1+.08)^9} + {$327361.7/(1+.08)^10} + {$340456.2/(1+.08)^11} + {$354074.4/(1+.08)^12} = $2094196.45 so, NPV= $3455935-$2094196.45 = $1361738.81
The above calculations show that Net Present Value (NPV) of offer A is $1326388 and of offer B is $1361738.81. According to NPV criteria of selection, offer B seems more attractive.
Decision
After careful evaluation of both the options Tom should accept the offer B, as not accepting the offer B will result him loss of $375774. The selection of offer B is recommended because offer B presents more money benefits as compared to offer A as it has higher NPV.
Work cited
Drury, Colin. Cost and Management Accounting. Oxford: Cengage Learning, 2009. Print.
