In deciding whether to continue or abandon project, expected future revenue should be compared with relevant cost. If, the future revenue is higher than the relevant cost, the project should continue. However, qualitative factors are very important in decisions to continue or abandon a project.
If, a firm abandons a project only on economic consideration, it might severely affect the corporate image and dilute the corporate brand. The dilution of corporate reputation and brand adversely affects future business.
Moreover, abandonment of a project of national importance or a project, acceptance of which brought high visibility to the firm, hurts the pride of employees and might have a significant dysfunctional effect. Therefore, it is a tough decision to abandon a project.
The following illustrations will explain the cost and revenue considerations, which influence such a decision.
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Illustration:
Tanya Limited (TL) has undertaken a research project on behalf of a client. You have been asked to review the project because the project’s total cost has been estimated at CU 2,400,000 (comprises CU 1,000,000 already incurred and estimated future cost of CU 1,400,000), which exceeds the contracted value of CU 1,750,000 for the completed research.
The future cost has been estimated as follows:
The overhead comprises depreciation of plant and equipment (CU 200,000) and an allocation of general overheads incurred by the business based on 80% of material cost.
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The following information is also available:
1. If the project is abandoned, the client will receive CU 750,000 as compensation.
2. Materials- Contracts have already been finalized for purchase of CU 500,000 of materials. This special type of material has no alternative use on other projects and if not used in this project the material would have to be disposed of incurring a cost of CU 75,000.
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3. Staffing- Staff cost includes salary (CU 125,000 p.a. each) of two highly skilled researchers, allocation of part of the salary of a supervisor who has overall charge of several projects. If the project is abandoned, the research workers would be declared redundant, each receiving CU 50,000 in compensation.
4. Overheads- Highly specialized equipment, having no alternative use, was bought at CU 400,000 at the commencement of the project. The estimated costs included second year depreciation (CU 200,000) of this equipment. Estimated scrap value of this equipment is CU 50,000, if disposed of now and CU 20,000 if disposed of after a year.
Required:
(a) Give your recommendation whether on financial grounds the project should be continued or abandoned. Give reasons for inclusion of each item of expenditure in your calculation.
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(b) Briefly explain any non-financial factors which would need to be considered before finally deciding to abandon such a research project.
Solution:
(a)
Reasons for inclusion or exclusion of each item of expenditure:
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1. The committed cost of material is a sunk cost for the decision, hence irrelevant. The material has no alternative use, and therefore, the question of opportunity cost does not arise. The use of material would result in savings of disposal cost of Rs 75,000.
2. Supervisor’s salary, allocated to this project, is an unavoidable cost because the total salary of the supervisor would remain unaffected by the decision under consideration. It is assumed that there will be no benefit flowing from the release of the supervisor’s time and there is no opportunity cost. Therefore, the supervisor’s salary allocated to the project has been completely ignored.
3. If the project continues, the researchers will be paid salaries and if the project is abandoned they will receive compensation. Hence only the differential cost is relevant for the decision. It is assumed that compensation will not be paid at the end of the completion of the project.
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4. General overheads will not be avoided ever if the project is discontinued. Therefore, general overheads are irrelevant. The depreciation charge is an apportionment of sunk cost and hence irrelevant. Equipment has no alternative use; hence there is no opportunity cost. The only relevant cost is the differential scrap value, i.e., the difference between the present scrap value and year-end scrap value.
(b) Non-financial matters which need consideration are:
Completion of the research project will provide qualitative benefits to TL. Accumulation of knowledge will help TL in securing future projects and will provide economic and other benefits through dissemination of knowledge.
Moreover, the firm will get publicity arising from successful completion of the project. The visibility is very important for firms which are engaged in research projects and for which advertisement or any other publicity campaign are not effective and may sometime create wrong impression about the firm.
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Abandonment of the project might result in loss of the goodwill and consequently, the firm will find it difficult to get sponsors for research projects. Abandonment of the project might adversely affect the morale of the research staff and the firm may lose researchers. It will also fail to attract talent in future.