US Airways (American Airlines) Owns Land Nearby ✓ Solved

US Airways (American Airlines) owns a piece of land near the

US Airways (American Airlines) owns a piece of land near the Pittsburgh International Airport. The land originally cost US Airways $375,000. The airline is considering building a new training center on this land. US Airways determined that the proposal to build the new training center is acceptable if the original cost of the land is used in the analysis, but the proposal does not meet the airline’s project acceptance criteria if the land cost is above $850,000. Assume the labor and raw materials total $1,720,000. A developer recently offered US Airways $2.5 million for the land. What is the economic profit, opportunity cost, and should US Airways (American Airlines) build the training center at this location?

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Executive summary

This analysis computes the opportunity cost of using the land for a training center, derives the firm's economic profit under alternative cost treatments, and advises whether American Airlines (US Airways) should build the training center on the land given a $2.5 million outside offer. Using standard economic principles, the market offer establishes an opportunity cost of $2,500,000; when combined with incremental construction costs of $1,720,000, the full economic cost of using the land is $4,220,000. Because the firm’s internal acceptance rule implies project benefits are between $2,095,000 and $2,570,000, the project is economically unattractive at the land’s market value and American Airlines should sell the land rather than build the center at that location.

Key numbers and definitions

Given data:

  • Original (book) cost of land: $375,000.
  • Labor and raw materials (incremental construction cost): $1,720,000.
  • Developer offer (market value of land): $2,500,000.
  • Firm’s internal test: project acceptable if land cost used = original cost ($375,000); project not acceptable if land cost > $850,000.

Definitions (standard economic/accounting):

  • Opportunity cost: the value of the best foregone alternative (here, the cash inflow from selling the land: $2,500,000) (Mankiw, 2014).
  • Sunk (historical) cost: a past expenditure that cannot be recovered and should not affect current decisions (the $375,000 book cost) (Horngren et al., 2013).
  • Economic profit (incremental): incremental benefits from the project minus incremental economic costs (including opportunity costs) (Brealey et al., 2019).

Calculate opportunity cost

The opportunity cost of using the land for the training center equals the forgone cash from selling it: $2,500,000. This is the value that should be included as the economic cost of using the land, because by occupying the site the firm gives up the ability to realize that cash today (Mankiw, 2014; Brealey et al., 2019).

Compute economic cost and economic profit expressions

Incremental construction costs = $1,720,000.

Economic cost of the project if the land is used (i.e., includes opportunity cost) = Opportunity cost of land + incremental construction costs = $2,500,000 + $1,720,000 = $4,220,000.

Let B denote the incremental benefit (present value of training center benefits) from building the facility at this location. Then economic profit Π (including opportunity cost) equals:

Π = B − (1,720,000 + 2,500,000) = B − 4,220,000. (1)

If instead the firm (incorrectly, from an economic viewpoint) treats the land as a sunk cost and uses the original book cost, the accounting profit (not economic profit) would be:

Accounting profit (book-land-cost basis) = B − (1,720,000 + 375,000) = B − 2,095,000. (2)

Interpretation using the firm's internal acceptance thresholds

The firm reports: “acceptable if original cost used” — so when using the $375,000 book cost the project passes the acceptance test; that implies B ≥ 2,095,000 (from equation (2)).

They further report: “does not meet criteria if land cost is above $850,000” — that implies if an analyst treated land cost as $850,000 the project fails: B < 1,720,000 + 850,000 = 2,570,000.

Combining these inequalities yields:

  • 2,095,000 ≤ B < 2,570,000.

Decision logic with the $2.5M offer

Compare the benefit range to the full economic cost when the market value of the land is used. The full economic cost is $4,220,000. Since the firm’s implied benefits B are less than $2,570,000 and certainly less than $4,220,000, the economic profit from building at this site is negative:

Π = B − 4,220,000 < 2,570,000 − 4,220,000 = −1,650,000.

Thus, even in the best case (B = 2,570,000), the project would lose approximately $1.65 million in economic profit if the firm uses the market value of the land. In contrast, using the book cost would (by the firm’s acceptance rule) show a positive accounting contribution, but that ignores the opportunity cost (Arkes & Blumer, 1985; Horngren et al., 2013).

Recommendation

From an economic (incremental, value-maximizing) perspective, American Airlines should not build the training center on this parcel of land if the $2.5 million offer is available and realistic. The correct economic treatment requires counting the forgone sale proceeds ($2.5M) as a cost. Because the implied project benefits (as inferred from the firm’s acceptance thresholds) are well below the total economic cost of $4.22M, the project destroys value relative to selling the land. Therefore the recommendation is to accept the $2.5M offer and either locate the training center at a cheaper site or consider leasing options (Brealey et al., 2019; Garrison et al., 2018).

Managerial caveats and strategy

1. Sunk-cost fallacy: Decision-makers must avoid letting historical cost (the $375,000) drive the decision. The book cost is irrelevant to the current incremental choice (Arkes & Blumer, 1985; Horngren et al., 2013).

2. Confirm the $2.5M offer: Before selling, verify the offer is realizable and not contingent; if the market value is uncertain, use a conservative market estimate and perform sensitivity analysis (Ross et al., 2019).

3. Consider non-monetary strategic factors: If there are strategic reasons for owning the site (control, regulatory, long-term strategic positioning) that generate intangible benefits exceeding the apparent shortfall, those should be quantified and compared to the $2.5M opportunity cost (Brealey et al., 2019).

Conclusion

Opportunity cost of using the land = $2,500,000. Total economic cost of building the training center on the site = $4,220,000 (opportunity cost + $1,720,000 incremental construction). Economic profit = B − 4,220,000, which—given the firm's internal signals about B—will be negative (likely by up to about $1.65M in the most favorable benefit scenario inferred). Therefore, based on standard economic and managerial accounting principles, American Airlines should not build the training center on this parcel if the $2.5M offer is available and there are no offsetting strategic benefits.

References

  • Mankiw, N. G. (2014). Principles of Economics (7th ed.). Cengage Learning. — Concept of opportunity cost and sunk costs.
  • Brealey, R. A., Myers, S. C., & Allen, F. (2019). Principles of Corporate Finance (13th ed.). McGraw-Hill Education. — Corporate investment rules and economic profit.
  • Horngren, C. T., Datar, S. M., & Rajan, M. V. (2013). Cost Accounting: A Managerial Emphasis (15th ed.). Pearson. — Distinguishing sunk costs vs incremental costs.
  • Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial Accounting (16th ed.). McGraw-Hill Education. — Managerial decision-making and relevant costs.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance (12th ed.). McGraw-Hill Education. — Investment analysis and value maximization.
  • Arkes, H. R., & Blumer, C. (1985). The psychology of sunk cost. Organizational Behavior and Human Decision Processes, 35(1), 124–140. — Behavioral considerations of sunk-cost fallacy.
  • Investopedia. (n.d.). Opportunity Cost. Retrieved from https://www.investopedia.com/terms/o/opportunitycost.asp — Practical explanation and examples of opportunity cost.
  • Investopedia. (n.d.). Sunk Cost. Retrieved from https://www.investopedia.com/terms/s/sunkcost.asp — Definition and decision guidance for sunk costs.
  • Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (3rd ed.). Wiley. — Valuation and incremental cash flow analysis used for project decisions.
  • Friedman, M., & Sunder, S. (1994). Experimental methods: A primer for economists. Cambridge University Press. — Use of controlled inference and sensitivity analysis in managerial decisions (supporting robustness checks recommended above).

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