Introduction to Sunk Cost
Sunk costs are irrecoverable cost which is already spent by the company and doesn’t change with the acceptance or reject the decision of a project. The cost incurred doesn’t reduce the estimated budget of a project. These costs are not included in the decision-making process of a project.
Explanation
Sunk costs are mostly surveyed costs companies incur to get information regarding the viability of establishing a project. If a company plans to set up a petrol pump, it needs to survey the number of car owners in the area. So if the survey result is bad and the company plans to reject the project, the cost will not be recovered. So these costs have already occurred and can’t be retrieved at any cost. They are not included in the decision-making process.
Example
Company ABC is a Crude Oil Extraction Company. They have vast types of machinery that help them drill oil from the earth. Due to the depletion of crude oil levels, the company decided to extract oil through fracking.
Fracking is an entirely new form of extraction, where water is passed under high pressure under the rock’s surface to extract compressed oil. So due to changes in the business model. All old pieces of machinery will be obsolete, and new machinery will have to be bought. While considering the new technique, the loss due to the obsolescence of old machinery should not be considered in the decision-making process. This is called a sunk cost. The cost is irrecoverable and shouldn’t be considered.
Sunk Cost Fallacy
This is a behavioral bias that human beings possess. Though Sunk cost should be ignored while deciding on a new project, we tend to get sticky with the expense already incurred. As the company has already spent on survey costs, they tend to accept the project, even if the survey showed a negative outcome to recover the money. So sunk cost fallacy says that as investors have already spent time, money, and effort, so they continue with the endeavor.
Is Sunk cost included in Accounting Costs?
This is not included in the accounting cost. At the same time, it calculates the Net Present Value of a project. This shouldn’t be included in the initial outflow of the project. This is a cost that should be ignored while considering the project. Investment decisions shouldn’t be affected by sunk costs.
Sunk Cost Effect
Human beings have biases towards life. It gets difficult for investors not to accept a project after spending time, effort, and money on it. So sunk cost creates a dilemma in the investor’s mind. Even if they know the project will not be successful, they will keep on investing, hoping the situation will turn.
Importance
- Creates a barrier to entry. Several industries require considerable research investments to plan whether investments should be made or not. As the sunk cost in these industries is high, it gets difficult for other participants to enter the industry.
- This helps to make independent decisions. As sunk costs are not considered in decision-making, a project is judged based on the return it will generate on the fresh capital invested in the project. If the sunk cost had been considered, the recovery could have been negative, and the project may have declined.
- This helps to make the base on which the decision-making process starts. Though the costs are not included in the decision-making process, sunk costs are still necessary to judge a project’s feasibility.
Sunk Cost vs Opportunity Cost
Sunk costs are irrecoverable, which doesn’t result in any economic benefit. Opportunity cost, on the other hand, is the potential gain foregone to accept a project. Say a project is constructed in a factory. If the project were not built, the investor would have received a rent of $50,000 per month from the factory. So the rent of $50,000 is foregone to accept the project. The return from the project should be more than this. So opportunity costs are considered while making decisions.
Conclusion
Sunk cost are already incurred and can’t be recovered. They will not provide any economic benefit. So this must be ignored by all decision-making processes. This must be separately identified from the rest of the costs that a business incurs during the acceptance of a project. The main motive of management should be to increase the investor’s wealth. So if additional investment is helping to recover more money after ignoring the sunk cost, then that project should be accepted.
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