What Is a Sunk Cost?
A sunk cost refers to money that has already been spent and which 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 the cost 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
When making business decisions, organizations only consider relevant costs, which include the future costs still needed to be incurred. The relevant costs are contrasted with the potential revenue of one choice compared to another. Because sunk costs do not change, they are not considered.
To make an informed decision, a business only considers the costs and revenue that will change as a result of the decision at hand.
For example, a manufacturing firm 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.
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 glove that costs $50 and sells for $70. The manufacturer can sell the basic model and earn $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 and 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.