Introduction to Sunk Cost
Sunk costs are irrecoverable cost, which is already spent by the company and doesn’t change with the, accept 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 survey cost that companies incur to get information regarding the viability of establishing a project. If a company is planning to set up a petrol pump and in order to do that, it needs to conduct a survey regarding the number of car owners in the area. So if the survey result is bad and the company plans to reject the project, then also the cost will not be recovered. So this are costs which have already been occurred and can’t be recovered at any cost. They are not included in the decision-making process.
Example
Company ABC is a Crude Oil Extraction Company. They have huge types of machinery which help them to drill oil from the earth. Due to the depletion of crude oil levels, the company decided to extract oil through the fracking procedure.
Fracking is a completely new form of extraction, where water is passed in high pressure under the surface of the rock to extract compressed oil. So due to change 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 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 behavioral bias that human beings possess. Though Sunk cost should be ignored while making a decision for a new project, we tend to get sticky with the expense already incurred. As the company has already spent on survey costs, so to recover the money they tend to accept the project, even if the survey showed a negative outcome. 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. While calculating 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.
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Sunk Cost Effect
Human beings have biases towards life. It gets difficult for investors to not 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 that the project will not be successful, still they will keep on investing, just in the hope that the situation will turn.
Importance
- Creates a barrier to entry. There are several industries, which require huge investments in research in order to plan whether investment should be done or not. As the sunk cost in these industries are high, so it gets difficult for other participants to enter the industry.
- This helps to take independent decisions. As sunk costs are not considered in decision making, so a project is being judged based on the return it will generate on the fresh capital that will be invested on the project. If sunk cost would have been considered, then return could have been negative and the project may have been declined.
- This helps to make the base on which decision-making process starts. Though the costs are not included in the decision-making process, still sunk costs are important in order to judge the feasibility of a project.
Sunk Cost vs Opportunity cost
Sunk cost are irrecoverable cost, that doesn’t result in any economic benefit. Opportunity cost on the other hand is the potential gain that is foregone in order to accept a project. Say a project is constructed in a factory. If the project was not constructed, then the investor would have received a rent of $50,000 per month from the factory. So the rent of $50,000 is foregone in order to accept the project. The return from the project should obviously be more than this. So opportunity costs are considered while taking 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 incur during acceptance of a project. The main motive of management should be to increase the investor’s wealth. So if after ignoring the sunk cost, additional investment is helping to recover more money, then that project should be accepted.
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