Question

A company incurred $1,000 in costs to produce 500 units which sell for $1,500. Upon inspection, it was determined the units were defective and reworking the units would cost an additional $1.50 per unit. The defective units can be sold as is for $1.00 each. How should the company handle the defective units?

Answer 1

Answer:

rework the units by spending $750 extra in order to get $1,500 in revenue

Explanation:

The company incurred in the following sunk costs:

• production costs = $2 per unit

Since the 500 units were all defective the company can:

sell the defective units at $1 each = $1 x 500 = $500 revenue

reworking the units for $1.50 each and selling them for $3 ⇒ contribution margin = $3 - $1.50 = $1.50 per unit, which results in a $750 gross profit

The company must consider the $1,000 spent first as sunk costs, since whatever action they decide, they will not recover them. Therefore the company must only analyze the alternatives starting from scratch.  

Answer 2

The company should handle the defective units by: Reworking the units which will generate incremental income of $750.

Incremental costs to rework or sold

Incremental income if sold= $1.00 x 500

Incremental income if sold= $500

Revenue:

Revenue=($3 x 500)

Revenue=$1,500

Incremental costs to rework:

Incremental costs to rework =($1.50 x 500)

Incremental costs to rework=$750

Inconclusion the company should handle the defective units by: Reworking the units which will generate incremental income of $750.

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