SEPTEMBER 2012
Khaas Baat : A Publication for Indian Americans in Florida

Accounting

WHY SUNK COSTS ARE IRRELEVANT IN BUSINESS

By Kamlesh H. Patel, CPA

Once your business incurs costs that can’t be recovered, those costs become irrelevant to subsequent business decisions. Such expenditures, known as sunk costs, can include money paid, time spent, or resources used that are no longer retrievable.

For example: You’ve invested $20,000 in an expansion project, and it’s become apparent that it will cost another $10,000 to complete it. Regardless of what you do going forward, you’ll be unable to retrieve the initial $20,000. Now an opportunity arises where you can buy an equivalent completed facility for $6,000.

At this point, your only choice is whether to spend $10,000 or $6,000 for the same facility. Whatever you decide, the initial $20,000 investment will be gone – a sunk cost. All else being equal, the rational choice is to buy the $6,000 facility.

Now assume the same $20,000 sunk cost with an additional $6,000 needed for completion. An opportunity to buy a similar completed facility for $8,000 arises. Obviously you’ll go forward with the $6,000 completion costs, even though the total cost of the facility will be $26,000 rather than $8,000. The $20,000 sunk cost remains irrelevant.

Another example: Your company has spent time and money developing an innovative new product, and you’re justifiably proud of the result. However, when you test market the product on your customers, you learn that most of them have no interest in it and wouldn’t buy it at any feasible price. Clearly it’s time to swallow your pride (along with the sunk development costs) and walk away from the product.

It’s hard to disregard time and money you’ve already expended, but once such costs become irretrievable, it’s simply counterproductive to factor them into any subsequent decision process. From that point forward, your choices should be based solely on expected future costs versus future benefits.

CONSIDER HARVESTING CAPITAL GAINS IN 2012

Usually, investors in securities try to harvest capital losses at the end of the year. Those losses may offset capital gains and then a portion of your highly taxed ordinary income. But this year, the tax landscape has changed dramatically. Because tax rates are going up in 2013 – absent any new legislation – you could be tempted to pass up some losses and recognize more gains.

This could be one of those unusual times when it makes sense to pay tax on income sooner rather than later.

After capital losses are used to offset capital gains, you can use any excess loss to offset up to $3,000 of ordinary income in the current year. If you still have an excess loss, it can be carried over to next year when the entire process starts again. Because capital losses may eliminate or reduce your current income tax liability, investors often seek out losses at year-end.

However, there are unique circumstances in 2012. First, the tax brackets will be adjusted upward in 2013, with a top rate of 39.6 percent replacing the current top rate of 35 percent. Second, the maximum tax rate of 15 percent on net long-term capital gain (0 percent for low-income investors) will jump to 20 percent (10 percent for low-income investors). And third, a special 3.8 percent Medicare surtax may apply to certain “net investment income.” Therefore, a high-earning investor may pay an effective federal income tax of 43.4 percent on some income.

Instead of aiming for tax losses, you might focus on realizing capital gains before 2013. This way, you can lock in the more favorable tax rates for capital gains in 2012, even though you won’t benefit from tax deferral.

Of course, every situation is different. Consider all the relevant tax and financial factors in your investment decisions.

FINANCIAL PRESSURES SQUEEZE THE “SANDWICH GENERATION”

The “baby boomers,” Americans born between 1946 and 1964, are moving like a wave into their 50s and 60s. Unfortunately, many of them are facing dual financial pressures. Their kids may need help paying for increasingly expensive colleges. Their folks are getting older and living longer, and boomers may be called on to make up the shortfall in their parents’ retirement income, or to pay for long-term care. On top of that, boomers are struggling to provide for their own retirement and pay for their groceries. No wonder they feel squeezed.

If you’re part of the “sandwich generation,” take heart. Careful planning and a little diligence can help to alleviate some of this pressure.

First, identify your priorities. Then set realistic goals to address them, putting the bulk of your financial resources and energy toward meeting the most important goals first.

RETIREMENT. You may have to rethink your retirement target age in light of other financial demands like college tuition and care for elderly parents. Working longer can have distinct benefits. Besides funding an accustomed lifestyle for a few more years, working longer and leaving your retirement accounts intact will give the funds more time to grow.

EDUCATION. If your child is still young, start saving early and invest for growth. If your child is ready to start college but isn’t financially prepared, consider letting him or her finance a portion of the cost by working or obtaining loans. College-age kids have their working lives ahead of them and can use their future income to repay loans.

PARENTS. For many, helping to pay for the high cost of a parent’s long-term care is a priority. A year in a nursing home can cost $30,000 or more. At some point, your parents may need your financial help to cope with such high expenses. In the meantime, suggest that your parents consider options such as long-term care insurance.

Kamlesh H. Patel, CPA, can be reached at (813) 949-8889 or e-mail kpaccounting@verizon.net or kpinsurance@verizon.net

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