Reading: Sunk Cost

Sunk Cost

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 (past costs) are excluded from future business decisions, because the cost will be the same regardless of the outcome of a decision.

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 are can be sold as they are or can be processed further.

Assume, for example, that XYZ Clothing makes baseball gloves, and the company makes 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 selling 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 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 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.