Definition: Sunk cost is the cost that has already been aroused in the past and cannot be recovered at any cost. Thus it is also known as historical cost. It is the written down value of the plant after reducing the reclaim value of the plant. However, this cost is not relevant for making the decisions as it has already been incurred and cannot be refrained by taking decisions in future.
Content: Internal Control
- Understanding Sunk Cost
- Examples of Sunk Cost
- Effect of sunk cost while decision making
- What is Sunk Cost Fallacy?
- Difference between Sunk Cost and Relevant Cost
Understanding Sunk Cost
Sunk cost is that cost that has been gone out of your pocket and cannot come back. As it has already been done, that’s why it is known as historical cost or past cost. This cost incurred as sunk cost expense and debited under the profit and loss account. Therefore such a cost is irrelevant for making decisions for the future.
Examples of Sunk Cost
1 . Suppose you have booked an online ticket for the movie, and suddenly due to some reason you cannot go to the show, and the ticket cannot be cancelled. Thus, the amount paid for booking tickets will be considered as a sunk cost that cannot be recovered.
2. The company’s marketing expenses for advertising their products are also considered a sunk cost for the companies. For Example, You started your online shopping application and spent 50000/- on marketing and advertising so that your application would be spread over amongst the consumer. Now, whether your application comes into consideration or not, the cost cannot be recovered. Thus, it is considered a sunk cost.
3. Amount invested in research and development of products is also considered as a sunk cost for the company. For Example, A car manufacturing company has invested 60000/- on research and development before launching their new car in the market, but the consumers did not give a positive response to the launched product, and the company faced a loss. Thus, the cost incurred on research and development will be considered as a sunk cost.
4. Another example of sunk cost is the company’s training cost for training their staff how to work on their existing software. For example: suppose a company has trained their employees according to the old software implemented by their headquarters and suddenly they changed their software, then the cost incurred on providing training of the old software will be considered as a sunk cost for the company as it has already been incurred and cannot be recovered.
5. Few companies provide hiring bonus to their newly recruited employees; sometimes, this already becomes a sunk cost for the company. For Example: If a company recruited an employee who seems promising to them and paid them a hiring bonus of 10000/-. However, after the joining of that employee company doesn’t found him/her relevant for the desired position and terminates them, in such condition the hiring bonus paid to that employee will become a sunk cost for the company as it cannot be recovered and the company again has to pay the hiring bonus to the another recruited employee.
Effect of sunk cost while decision making
Suppose XYZ Company manufactures bottles. It pays 20000/- a month for the factory rent and purchased machinery for modelling bottles worth rupees 50000/-. The company manufactures small-sized bottles that cost 40/- per bottle and sell them for 60/- per bottle. Thus, here the profit earned by the manufacturer is 20/-.
However, the company can manufacture the same bottles with some quality enhancement by investing 10/- in the cost of every bottle and can sell bottles for rupees 80/- instead of 60/-. Here, the decision whether to make enhanced quality bottles or not to make is taken based on the additional cost and added revenue difference, i.e., (20-10=10).
The cost incurred on factory rent and machinery purchased would be considered as a sunk cost.
What is Sunk Cost Fallacy?
It is the mistake made at the time of incorporating sunk cost consideration in the decision we are about to make. When we use arguments about the already made investments, it helps to justify decisions about the investments we might make in future, and then it is a fallacy. Let us understand with an example:
A student joined coaching classes; however, after attending few classes, he/she found that it is not helpful for them then also he/she attended all the remaining classes as they had already paid the fees for the entire classes.
Difference between Sunk Cost and Relevant Cost
However, both costs are incurred while running the business, and both costs result in the outflow of cash. But, the fact is that both the costs have various differences; some of them are as follows:
- Sunk cost is a past cost, whereas relevant cost is considered as a future cost.
- Sunk cost cannot be used for making decisions of the business, whereas relevant cost is taken into consideration for making any kind of managerial decisions.
Sunk cost is the actual cost that has already been incurred and cannot be recovered by any means or action taken in future whether they are beneficial for the business or not and therefore such cost is not relevant for making decisions of the future and are considered as an irrelevant cost of the business.