Loading the player...

What is 'Sunk Cost'

A sunk cost is a cost that has already been incurred and cannot be recovered. A sunk cost differs from future costs that a business may face, such as decisions about inventory purchase costs or product pricing. Sunk costs (past costs) are excluded from future business decisions because the cost will be the same regardless of the outcome of a decision.

BREAKING DOWN 'Sunk Cost'

When making business decisions, organizations consider relevant costs, which include the future costs and revenue of one choice compared with another. To make an informed decision, a business only considers the costs and revenue that will change as a result of the decision; sunk costs that do not change are not considered.

Factoring in a Sell-or-Process-Further Decision

A manufacturing firm may have a number of sunk costs, such as the cost of machinery, equipment, and the lease cost of a factory. Sunk costs are excluded from a sell-or-process-further decision; this concept applies to products that can be sold as they are or can be processed further.

Assume, for example, that XYZ Clothing makes baseball gloves, and the company produces a basic model of glove that costs $50 per unit and sells for $70 per glove. The manufacturer can sell the basic model and earn a $20 profit, or it can continue production by adding $15 in costs and sell a premium model glove for $90. To make this decision, the firm compares the $15 additional cost with the $20 added revenue and decides to make the premium glove and earn $5 more in profit. The cost of the factory lease and the machinery are both sunk costs and are not part of the decision-making process.

Examples of Eliminated Sunk Costs

If a sunk cost can be eliminated, the cost becomes a relevant factor and should be a part of business decisions about future events. If, for example, XYZ Clothing is considering shutting down a production facility, any of the sunk costs that have end dates should be included in the decision. To make this decision, XYZ Clothing considers the revenue that would be lost if production ends and the material and labor costs that are eliminated. If, however, the factory lease ends in six months, the lease cost is no longer a sunk cost and should be included as an expense that can be eliminated. If the total costs are more than revenue, the facility should be closed.

RELATED TERMS
  1. Bag Holder

    Bag holder is an informal investment term used to describe an ...
  2. Incremental Analysis

    Incremental analysis is a decision-making technique used in business ...
  3. Long Run Incremental Cost - LRIC

    Long run incremental cost (LRIC) refers to the the changing costs ...
  4. Applied Cost

    Applied cost is a term used in cost accounting to denote the ...
  5. Cost Test

    A cost test is an analysis applied to a process to determine ...
  6. Avoidable Cost

    An avoidable cost refers to variable costs that can be avoided, ...
Related Articles
  1. Insights

    How To Recognize Sunk Costs

    Find out about sunk costs and why "getting your money's worth" can cost you more than you think.
  2. Investing

    Understanding Marginal Cost of Production

    Marginal cost of production is an economics term that refers to the change in production costs resulting from producing one more unit.
  3. Taxes

    How Your Government's Budgetary Decisions Impact the Public Sector

    Issues facing the public sector are not unlike some issues facing America’s oldest and largest companies, but with larger and broader impacts.
  4. Retirement

    Retirees: Should You Buy or Lease Your Car?

    To buy or lease – that is the question. For retirees, access to safer cars, comprehensive warranties and tax deductions may drive up leasing's appeal.
  5. Personal Finance

    The Pros and Cons of Leasing a Car

    Consider these pros and cons before deciding whether or not to lease a car.
  6. Managing Wealth

    When Is Leasing a Car Your Best Bet?

    Leasing a car isn't for everyone. But it's attractive for those who want low initial payments and the ability to get a new vehicle every few years.
  7. Investing

    The Hidden Costs Of Investing In Mutual Funds

    Find the hidden fees in your portfolio, so that you can increase your rate of return.
  8. Investing

    Buy Citi, Netflix on Rising Inflation: Goldman

    The Wall Street bank highlights stocks that have underperformed during the recent market sell-off.
  9. Personal Finance

    The True Cost Of Owning A Car

    Driving is the most convenient way to get around, but once you factor in expenses like the average gas cost per year, you realize just how much it costs.
RELATED FAQS
  1. How are period costs and product costs different?

    Product costs are the direct costs involved in producing a product. Period costs are all costs not included in product costs ... Read Answer >>
  2. How are cost of goods sold and cost of sales different?

    Cost of goods sold and cost of sales both represent the direct costs involved in production. However, some companies use ... Read Answer >>
  3. How Do Fixed and Variable Costs Affect the Marginal Cost of Production?

    Learn about the marginal cost of production and how it is affected by changes in fixed and variable costs. Read Answer >>
  4. How does marginal analysis help in managerial decisions?

    Find out how marginal analysis helps to identify the optimal distribution of resources and planning for an organization making ... Read Answer >>
  5. How is marginal revenue related to the marginal cost of production?

    Learn about the marginal cost of production and marginal revenue and how the two measures are used together to determine ... Read Answer >>
  6. What is the difference between fixed cost and total fixed cost?

    Learn what a fixed cost is, what a variable cost is, what total fixed costs are, and the difference between a fixed cost ... Read Answer >>
Trading Center