Video Transcript: Sunk Cost

Hello, welcome. In this video, we're going to discuss sunk costs. A sunk cost is a cost that has already been incurred and thus 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 or past costs are  excluded from future business decisions because the cost will be the same  regardless of the outcome of a decision. So, if we already bought the raw  materials, right, and we are wanting to build our inventory out, well, the raw  materials that we already purchased for our inventory are going to be a sunk  cost because we've already purchased right the raw materials for this inventory.  The inventory now or the raw materials are in process, right? So they're known  as working capital, right? They're getting built out for inventory to sell. So we've  already bought these raw materials, right? We're not going to put these raw  materials back on the market to resell. So as we buy these raw materials, those  are sunk costs. Those are gone. We're not going to recover those costs, right?  So until we sell our inventory. But in the meantime, our raw materials are going  to be bought. So that's kind of seen as a sunk cost, right? In the in the near  term, right? Until we sell our inventory. Okay. So when making business  decisions, organizations consider relevant costs, which include the future costs  and revenue of one choice compared with another. Right, so businesses are  going to make decisions based on future outcomes or forecasted future  outcomes, and they're going to make decisions for their entity or their business  based upon what is going to be most profitable for them and their shareholders.  Now, to make an informed decision, a business only considers the costs and  revenue that will change as a result of the decision. Right. So, so in order to  make an informed decision, right, a business only considers the costs and  revenue that will be changed as a result of the decision, right. So if we want to  expand our operation, obviously it's going to be more cost burden in that, right?  It's going to cost more money to expand our operation. But what will be the yield of expanding that operation, right? Will we become more profitable? Will we  grow our revenue? What will be the result, right? So sunk costs do not do not  sunk costs that do not change are not considered in this decision-making  process, right? Because it's a sunk cost. We're not going to recover those costs, right? A manufacturing firm may have a number of sunk costs, such as the cost  of machinery, equipment, and the lease cost of a factory, right? So if we're  paying down a lease, we are not receiving any more benefit, but what we've  already paid for and all of our previous rent payments on the lease of that plant  has already sunk. It's gone. We're not going to recover those, right? We can't  get those back directly tied into the lease because we're not going to be able to  sell the factory. We're leasing it, right? So therefore, anything that we've paid out into the lease, we can't recover because we can't sell the factory, right? So 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. So let's 

assume, for example, the X Y Z clothing company makes baseball gloves, and  the company makes a basic model glove that costs $50 per unit, and sells the  glove for $70 The manufacturer can sell the basic model and earn a 20-dollar  profit, or it can continue production by adding $15 in cost and selling a premium  model glove for $90 to make this decision, the firm compares the $15 in  additional costs with the $20 of added revenue and decides to make the  premium glove and earn the $5 more in profit. The cost of the factory lease and  the machinery are both examples of sunk costs, right, and they're not a part of  the decision-making process. The machinery is already paid for. We've bought  that through capital expenditure, right? That is journaled as a capital  expenditure. We're not going to receive the money back, right? But now we want to upgrade, right, our our glove-making process, and we want to make a more  premium glove. Well, because we've already paid for the machinery, right? And  that's already gone. That cost is out of here. When we started our business, that was one of the first things that we bought. Capital expenditure, right? That's  already done, right? But the materials that we buy, that we put into the glove,  right? That can be recovered as we sell the glove, right? So, so the decision. to  make the premium glove versus the basic glove, right? The cost of the  machinery and the costs of the lease of the plant are not going to be factored  into that decision process because those are sunk costs, unrecoverable costs,  right? So those aren't. Even thought about anymore, right? Because we've  already paid up front for those. It's already gone. Now we can just work. We can  focus on developing our operation, increasing our profit margin like this. So  those sunk costs are not going to be factored in to future decision-making  process about profitability of the company. So let's look at another example,  right? 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, X Y  Z Clothing is considering shutting down a production facility, any of the sunk  costs that that have ending 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 costs and labor costs 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. So in this example, X Y Z clothing is considering  shutting down production. Right, they're falling short of their revenue profit goals. Right, and it doesn't make sense for them to continue manufacturing clothes  because maybe they're not profitable or they're breaking even, and they can  there's a better opportunity cost in the market for their capital, so they shut down the operation, and now because they've already paid out, let's say six months  ahead of the lease, right now we they don't have to incur that cost anymore,  right? And they won't be renting the facility in the future, right? So they can go  ahead and eliminate that cost, and therefore they won't have to worry about as 

they liquidate or sell off their assets to receive as much capital as possible after  the decision to shut down production. Now they don't have to pay for that lease  anymore. So, so now that sunk cost is eliminated, and it can be factored into the 

decision-making process because now we won't have to as we sell off our  assets or whatever we do with this company, now we won't have to project  forward any further costs for a lease for the for the facility.