Question

Last year, you estimated you would earn \(\$ 5\) million in sales revenues from developing a new product. So far, you have spent \(\$ 3\) million developing the product, but it is not yet complete. Meanwhile, this year you have new sales projections that show expected revenues from the new product will actually be only \(\$ 4\) million. How much should you be willing to spend to complete the product development? [LO 1.2] a. \(\$ 0\). b. Up to \(\$ 1\) million. c. Up to \(\$ 4\) million. d. Whatever it takes.

Short answer

Up to $1 million.

Step-by-step solution

Understanding the Problem

We initially estimated sales revenues of $5 million from the new product, and so far, $3 million has been spent on development. New projections indicate that the expected revenue decreased to $4 million. We need to determine how much more we can spend to complete the product development.

Calculate the Potential Profit or Loss

Our new expected revenue is $4 million. We have already spent $3 million. To break even, we should aim for the total spent to not exceed $4 million, which is our expected revenue.

Calculate Additional Amount to Spend

To not spend beyond projected revenue, we calculate the additional amount we can spend: Expected Revenue ($4 million) - Amount Already Spent ($3 million) = $1 million. Therefore, up to $1 million more can be spent to complete the product, without exceeding the projected revenue.

Key concepts

Opportunity Cost

Opportunity cost is a critical concept in decision-making processes. It represents the benefits or profits that a business foregoes by choosing one alternative over another. In the context of our exercise, the opportunity cost involves considering whether to spend additional funds to complete the product development or to allocate those resources elsewhere. By initially projecting $5 million in revenue, the company faced a different opportunity cost scenario compared to the updated projection of $4 million.
There are two key points to consider:

• Resources could be used to develop the product further or could be redirected to another project with potentially higher returns.
• Opportunity cost helps inform whether continuing with the current project is the best use of resources.

Understanding opportunity cost ensures businesses make informed choices and prioritize the best financial outcomes, without simply focusing on the money already spent.

Profit Maximization

Profit maximization involves making decisions that increase a company's net profit to the highest possible level. It requires comparing potential revenues and costs associated with various options. In the exercise, profit maximization dictates how much more should be spent on the development of the product. With new potential revenues capped at $4 million and considering $3 million already invested, the goal is to ensure that no more is spent than the projected revenue can recover.
Here's what this means practically:

• Additional development costs must not exceed the ability of the product to generate profit, which in this case suggests spending only up to $1 million more.
• Profit maximization does not solely focus on the revenues but considers the total cost and profit potential throughout the product's lifecycle.

Effective profit maximization helps protect a business from loss and ensures a calculated approach to spending further resources.

Cost-Benefit Analysis

Cost-benefit analysis is a systematic approach to evaluating the strengths and weaknesses of alternatives in terms of cost efficiency and expected value. In this problem, the analysis helps determine the financial viability of spending additional money to complete the product development.
Key aspects of conducting a cost-benefit analysis in the given scenario include:

• Assessing whether the $4 million expected revenue justifies spending beyond the current sunk cost of $3 million.
• Calculating the potential net profit or loss by weighing expected revenues against the total costs after further investment.

By doing a thorough cost-benefit analysis, the decision to spend any more money is rooted in rational evaluation rather than emotional attachment to the initial $3 million investment. It helps in drawing a clear line between profitable investments and those that will yield losses, aiding more strategic financial decision-making.