Question 4.A.17: A garage has an old car that it bought several months ago fo...
A garage has an old car that it bought several months ago for £3,000. The car needs a replacement engine before it can be sold. It is possible to buy a reconditioned engine for £300. This would take seven hours to fit by a mechanic who is paid £15 an hour. At present, the garage is short of work, but the owners are reluctant to lay off any mechanics or even cut down their basic working week because skilled labour is difficult to find and an upturn in repair work is expected soon.
Without the engine, the car could be sold for an estimated £3,500. What is the minimum price at which the garage should sell the car, with a reconditioned engine fitted, to avoid making a loss? (Ignore any timing differences in receipts and payments.)
The minimum price is the amount required to cover the relevant costs of the job. At this price, the business will make neither a profit nor a loss. Any price below this amount will result in a reduction in the wealth of the business. Thus, the minimum price is:
| £ | |
| Opportunity cost of the car | 3,500 |
| Cost of the reconditioned engine | 300 |
| Total | 3,800 |
The original cost of the car is a past cost and is therefore irrelevant. However, we are told that without the engine, the car could be sold for £3,500. This is the opportunity cost of the car, which represents the real benefits forgone, and should be taken into account.
The cost of the new engine is relevant because, if the work is done, the garage will have to pay £300 for the engine; it will pay nothing if the job is not done. The £300 is a future cost that varies with the decision and should be taken into account.
The labour cost is irrelevant because the same cost will be incurred whether the mechanic undertakes the work or not. This is because the mechanic is being paid to do nothing if this job is not undertaken; thus the additional labour cost arising from this job is zero.