What Is a Sunk Cost?
A sunk cost refers to money that has already been spent and cannot be recovered. In business, the axiom that one has to "spend money to make money" is reflected in the phenomenon of the sunk cost. A sunk cost differs from future costs that a business may face, such as decisions about inventory purchase costs or product pricing. Sunk costs are excluded from future business decisions because they will remain the same regardless of the outcome of a decision.
- Sunk costs are those which have already been incurred and which are unrecoverable.
- In business, sunk costs are typically not included in consideration when making future decisions, as they are seen as irrelevant to current and future budgetary concerns.
- Sunk costs are in contrast to relevant costs, which are future costs that have yet to be incurred.
Understanding Sunk Costs
A sunk cost refers to money that has already been spent and cannot be recovered. A manufacturing firm, for example, may have a number of sunk costs, such as the cost of machinery, equipment, and the lease expense on the factory. Sunk costs are excluded from a sell-or-process-further decision, which is a concept that applies to products that can be sold as they are or can be processed further.
When making business decisions, organizations should only consider relevant costs, which include the future costs that still needed to be incurred. The relevant costs are contrasted with the potential revenue of one choice compared to another. To make an informed decision, a business only considers the costs and revenue that will change as a result of the decision at hand. Because sunk costs do not change, they should not be considered.
Businesses that continue a course of action because of the time or money already committed to an earlier decision risk falling into the sunk cost trap.
Types of Sunk Costs
All sunk costs are fixed costs but not all fixed costs are sunk costs. The difference is that sunk costs cannot be recovered. If equipment can be resold or returned at the purchase price, for example, it's not a sunk cost.
Sunk costs don't only apply to businesses. People can incur sunk costs, too. Let's say you buy a theater ticket for $50 but at the last minute can't attend. The $50 you spent would be a sunk cost but would not factor into whether or not you buy theater tickets in the future. In general, businesses pay more attention to fixed and sunk costs than people, as both types of costs impact profits.
Example of Sunk Costs
Assume that XYZ Clothing makes baseball gloves. It pays $5,000 a month for its factory lease, and the machinery has been purchased outright for $25,000. The company produces a basic model of a glove that costs $50 and sells for $70. The manufacturer can sell the basic model and earn a $20 profit per unit. Alternatively, it can continue the production process 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 in order to earn $5 more in profit. The cost of the factory lease and machinery are both sunk costs and are not part of the decision-making process.
If a sunk cost can be eliminated at some point, it becomes a relevant cost 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 the decision to close the facility, XYZ Clothing considers the revenue that would be lost if production ends as well as the costs that are also eliminated. If 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 also be eliminated. If the total costs are more than revenue, the facility should be closed.
What Is a Fixed Cost?
In business, fixed costs are expenses that have to be paid by a company independent of any specific work activities: They don't apply to a company's production of any goods or services, and they don't rise or fall with a change in the number of goods or services produced or sold. Sunk costs are a subset of fixed costs—specifically, a type of fixed cost that is not recoverable.
What Is the Difference Between Sunk Cost and Relevant Cost?
When making business decisions, organizations should only consider relevant costs, which include future costs—such as decisions about inventory purchase costs or product pricing—that still need to be incurred. The relevant costs are contrasted with the potential revenue of one choice compared to another. Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision.
What Is the Sunk Cost Fallacy?
In business, the axiom that one has to "spend money to make money" is reflected in the phenomenon of the sunk cost. However, there is also the axiom of “throwing good money after bad.” This is known as the sunk cost fallacy which is an error in reasoning that the decision maker should avoid. Essentially, this fallacy states that further investments into a certain activity are justified so that earlier investments in that activity will not have been in vain.