Business, Legal & Accounting Glossary
Money that has already been spent and cannot be recovered.
Money already spent and gone, which will not be recovered no matter what course of action is taken. Bad decisions are made when managers attempt to recoup sunk costs.
Sunk costs are funds that have already been spent and cannot be recovered. The phenomenon of the sunk cost reflects the axiom that one must “spend money to make money” in business. A sunk cost is distinct from future costs that a company may incur, such as inventory purchase costs or product pricing decisions. Sunk costs are not considered in future business decisions because they will remain constant regardless of the outcome of the decision.
Sunk costs are funds that have already been spent and cannot be recovered. A manufacturing company, for example, may have a number of sunk costs, such as the cost of machinery and equipment, as well as the cost of factory lease. Sunk costs are not considered in a sell-or-process-further decision, which applies to products that can be sold as is or processed further.
Organizations should only consider relevant costs when making business decisions, which include future costs that must still be incurred. The relevant costs are weighed against the potential revenue of one option versus 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. Sunk costs should not be considered because they do not change.
Fixed costs are all sunk costs, but not all sunk costs are fixed costs. The distinction is that sunk costs cannot be recouped. It is not a sunk cost if, for example, equipment can be resold or returned at the original purchase price.
Sunk costs are not limited to businesses. People can also incur sunk costs. Assume you purchase a $50 theatre ticket but are unable to attend at the last minute. The $50 you spent is a sunk cost that will have no bearing on whether or not you purchase theatre tickets in the future. Businesses, in general, pay more attention to fixed and sunk costs than people, as both types of costs have an impact on profits.
Assume XYZ Clothing manufactures baseball gloves. It pays $5,000 per month for the lease on its factory, and the machinery was purchased outright for $25,000. The company manufactures a basic glove for $50 and sells it for $70. The manufacturer can sell the basic model for $20 per unit. Alternatively, it can add $15 to the production costs and sell a premium model glove for $90.
To make this decision, the company weighs the $15 additional cost against the $20 increase in revenue and decides to produce the premium glove in order to earn $5 more profit. The factory lease and machinery costs are both sunk costs and are not considered in the decision-making process.
If a sunk cost can be eliminated at some point, it becomes a relevant cost that should be considered when making business decisions about future events.
If XYZ Clothing, for example, is considering closing a production facility, any sunk costs with expiration dates should be factored into the decision. To make the decision to close the facility, XYZ Clothing considers both the revenue that would be lost if production ceased as well as the costs that would be avoided. If the factory lease expires in six months, the lease cost is no longer a sunk cost and should be considered an expense that can be eliminated. If total costs exceed revenue, the facility should be closed.
The cost of their time is a sunk cost.
Economists refer to this as a sunk cost.
The original cost is historical and can therefore be considered to be an irrelevant sunk cost.
sunk cost, in economics and finance, a cost that has already been incurred and that cannot be recovered. In economic decision making, sunk costs are treated as bygone and are not taken into consideration when deciding whether to continue an investment project.
Fixed costs in business are expenses that must be paid by a company regardless of specific work activities: They do not apply to a company’s production of goods or services, and they do not change in response to a change in the number of goods or services produced or sold. Sunk costs are a subset of fixed costs—specifically, a non-recoverable type of fixed cost.
When making business decisions, organisations should only consider relevant costs, which include future costs that must be incurred, such as decisions about inventory purchase costs or product pricing. The relevant costs are weighed against the potential revenue of one option versus another. Sunk costs are not considered in future business decisions because the cost remains constant regardless of the outcome of the decision.
The phenomenon of the sunk cost reflects the axiom that one must “spend money to make money” in business. There is, however, the axiom of “throwing good money after bad.” This is known as the sunk cost fallacy, and it is a logical error that the decision maker should avoid. Essentially, this fallacy asserts that additional investments in a particular activity are justified in order to ensure that previous investments in that activity were not in vain.
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This glossary post was last updated: 26th January, 2022 | 0 Views.