Difficulty: Intermediate | Prerequisites: Introduction to managerial accounting, basic understanding of cost behaviour (fixed vs. variable), and familiarity with relevant cost analysis.
Precision Worldwide, Inc. (PWI) is a Harvard Business School case used in managerial and cost accounting courses to teach relevant cost analysis and sunk cost reasoning. The case centres on a replacement-parts business: PWI sells steel rings for its industrial machines, but a competitor has just launched a plastic ring that lasts longer and costs less to make. Hans Thorborg, the general manager, must decide what to do with a large steel inventory that is rapidly becoming obsolete. If you have covered cost classification, contribution margin, and the difference between sunk costs and incremental costs, you are ready for this case.
PWI has over $390,000 worth of steel inventory that a new, cheaper, longer-lasting plastic ring has made obsolete. The core question is whether to keep converting that steel into rings and selling them, or to stop immediately and absorb the loss. The case teaches that the steel cost is sunk, so the decision should turn on incremental costs and revenues going forward, not on recovering money already spent.
Sunk cost
A cost that has already been incurred and cannot be recovered, regardless of any future action. Think of it as money that is gone no matter what you decide next.
Relevant cost (also: incremental cost, differential cost)
A future cost that differs between decision alternatives. In simple terms, it is the cost that actually changes depending on which option you pick.
Opportunity cost
The benefit foregone by choosing one alternative over another. If PWI keeps making steel rings, the opportunity cost is whatever else that production capacity or capital could have been used for.
Obsolete inventory
Stock that can no longer be sold at its normal price because a newer or better product has replaced it. In this case, the steel and finished steel rings are becoming obsolete because of the competitor's plastic ring.
Contribution margin
Selling price minus variable costs per unit. This tells you how much each unit sold contributes toward covering fixed costs and generating profit.
Replacement part (aftermarket part)
A component sold separately to maintain or repair a machine already in use. PWI's rings are replacement parts for its industrial equipment.
Inventory write-off (also: write-down)
An accounting entry that reduces the recorded value of inventory to reflect its actual realisable value. When inventory becomes obsolete, the business recognises the loss on its books.
PWI has manufactured industrial machines and equipment for over 90 years, operating plants in multiple countries.
The Frankfurt plant produces and sells replacement parts, including steel rings used in PWI machines.
Steel rings have a normal service life of about two months and are replaced individually as they wear out.
Replacement parts are a recurring revenue stream, sold separately from the machines themselves.
A competitor introduced a plastic ring that outperforms PWI's steel ring on two dimensions: longer lifespan and lower manufacturing cost.
PWI's sales manager flagged the threat immediately and asked how quickly PWI could develop its own plastic ring.
PWI's developmental engineer estimated the company could produce its own plastic ring by mid-September, at a development cost of $7,500.
The management team agreed: begin plastic ring development as soon as possible.
PWI holds a large inventory of steel purchased specifically for ring production, valued at over $390,000.
The steel cannot be sold to outside buyers, so it has no alternative use or resale value.
Finished steel rings already in stock also cannot easily be sold once customers learn about the plastic alternative.
The central decision: should Hans Thorborg allow the remaining steel inventory to be converted into steel rings, or should production stop?
The $390,000 already spent on steel is a sunk cost. It has been paid and cannot be recovered regardless of what PWI does next.
The relevant costs are incremental: the additional labour and overhead required to convert raw steel into finished rings, and the potential reputational damage from selling an inferior product.
If the contribution margin on selling the remaining steel rings (revenue minus the incremental conversion costs) is positive, there is a short-term financial argument for continuing production.
If customers discover the plastic ring exists and feel misled, the reputational cost may outweigh any short-term contribution margin.
PWI's team worried that selling steel rings while knowing a superior product exists could damage customer trust.
Customers who buy steel rings and then learn about the plastic alternative may feel the company acted in bad faith.
Long-term customer relationships and brand reputation are harder to quantify but can be far more costly than a one-time inventory write-off.
This is the same decision companies face whenever a product line is disrupted by new technology. Think of a manufacturer sitting on warehouses of old-model components when a next-generation version launches. The sunk cost principle applies everywhere from tech hardware (unsold previous-generation phones) to pharmaceuticals (drugs approaching patent expiry with newer alternatives available). The reputational dimension mirrors how car dealerships handle selling a model year they know is about to be replaced: transparency tends to cost less in the long run than short-term margin.
Students often think PWI should keep selling steel rings to "recover" the $390,000. That logic treats a sunk cost as recoverable. The steel money is gone whether or not the rings are sold.
Some students confuse the full cost of a steel ring (including allocated overheads and the raw material already paid for) with the incremental cost of converting steel into a ring. Only incremental costs matter for this decision.
A common error is ignoring reputational cost because it is hard to quantify. The case deliberately raises it to test whether students can weigh qualitative factors alongside the numbers.
Students sometimes assume the plastic ring development cost of $7,500 is relevant to the decision about the steel inventory. It is not: the plastic ring decision and the steel inventory decision are separate, because the $7,500 will be spent regardless.
⚠️ The sunk cost fallacy is one of the most commonly tested concepts in managerial accounting. Expect a question asking you to identify which costs are sunk and which are relevant.
⚠️ Be prepared to calculate the incremental cost of converting raw steel into finished rings versus stopping production. The difference between full cost and incremental cost is a classic exam trap.
⚠️ Qualitative factors (reputation, customer trust, competitive positioning) are fair game. If a question asks you to "discuss" or "evaluate" the decision, do not limit your answer to the numbers.
⚠️ The $7,500 plastic ring development cost is a separate decision. Exams may test whether you can recognise that two decisions sharing the same meeting are analytically independent.
True or False: The $390,000 spent on steel inventory is a relevant cost in deciding whether to continue making steel rings.
Fill in the blank: A cost that has already been incurred and cannot be recovered is called a ________ cost.
True or False: The $7,500 development cost for the plastic ring should influence the decision about what to do with the existing steel.
Fill in the blank: The difference between the selling price and the variable cost per unit is called the ________ ________.
True or False: Reputational damage from selling an inferior product is irrelevant to the decision because it cannot be precisely measured.
Answers: 1. False (it is sunk). 2. Sunk. 3. False (it is a separate decision). 4. Contribution margin. 5. False (qualitative factors matter even if hard to quantify).
Q: Identify the sunk costs in the PWI case and explain why they should be excluded from the decision.
A: The $390,000 of steel inventory is sunk. It has been purchased and cannot be resold. Regardless of whether PWI converts the steel into rings or writes it off, that money is spent. Sunk costs are excluded because they do not differ between decision alternatives and therefore cannot affect which option is financially preferable.
Q: What are the relevant costs and revenues Hans Thorborg should consider when deciding whether to continue steel ring production?
A: The relevant costs are the incremental costs of converting steel into finished rings (additional labour, variable overhead, any further materials). The relevant revenue is whatever the steel rings can still be sold for. If the incremental revenue exceeds the incremental cost, there is a short-term financial case for continuing, though qualitative factors like reputation must also be weighed.
Q: Should PWI factor the $7,500 plastic ring development cost into the decision about the steel inventory? Why or why not?
A: No. The plastic ring development is a separate decision that has already been agreed upon. Whether PWI spends or does not spend $7,500 on the plastic ring does not change the economics of the steel inventory. Mixing the two decisions together clouds the analysis.
Q: What qualitative factors should PWI consider beyond the financial analysis?
A: Customer trust and brand reputation. If PWI continues to sell steel rings while knowing a longer-lasting, cheaper alternative exists, customers who discover this may feel deceived. The long-term cost of lost trust, reduced repeat purchases, and reputational damage could far exceed any contribution margin earned by clearing the steel inventory.
Q: A classmate argues that PWI should sell the steel rings at a discount to "at least get something back." Evaluate this argument.
A: The argument has a narrow financial logic: if the discounted price still exceeds the incremental conversion cost, selling generates positive contribution. However, it still treats the steel purchase price as something to recover, which is a sunk cost error. The discount decision should be evaluated on its own incremental merits, and the reputational risk of selling a known-inferior product, even at a discount, must be weighed.
This case connects directly to relevant costing and special-order decisions, where the same principle applies: ignore sunk costs, focus on incremental cash flows. It also links to inventory valuation topics (lower of cost or net realisable value), because the steel inventory may need to be written down on the balance sheet. The reputational dimension ties into broader strategy and marketing coursework on brand equity and customer lifetime value.
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