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.

Short answer

Answer

The company should focus on processing its product further.

Step-by-step solution

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.

Diagram for decision alternatives

Identification of sunk cost

As per the given scenario, Elm Petroleum has to bear the sunk cost in both situations. Hence, thejoint cost is irrelevant in making the decision to choose an alternative.

Preparation of analysis

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.