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Sunk Costs

Presentation of Sunk Costs - Corporate Finance

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rahulkumarsingh12051998
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17 views9 pages

Sunk Costs

Presentation of Sunk Costs - Corporate Finance

Uploaded by

rahulkumarsingh12051998
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Sunk Costs

• A sunk cost refers to money that has already been spent


and cannot be recovered. A manufacturing firm, for
example, may have a number of sunk costs, such as the
cost of machinery, equipment, and the lease expense on
the factory.
• Sunk costs are excluded from a sell-or-process-further
decision, which is a concept that applies to products that
can be sold as they are or can be processed further.
• When making business decisions, organizations should only
consider relevant costs, which include the future costs that still
needed to be incurred.
• The relevant costs are contrasted with the potential revenue of
one choice compared to another. To make an informed decision, a
business only considers the costs and revenue that will change as
a result of the decision at hand.
• Since sunk costs do not change, they should not be considered.
Types of Sunk Costs
• All sunk costs are fixed costs but not all fixed costs
are sunk costs.
• The difference is that sunk costs cannot be
recovered. If equipment can be resold or returned
at the purchase price, for example, it's not a sunk
cost.
• Sunk costs don't only apply to businesses as individual
consumers can incur sunk costs as well. Let's say you buy a
theater ticket for Rs 350 but at the last minute can't attend. The Rs
350 you spent would be a sunk cost but would not factor into
whether or not you buy theater tickets in the future.
• In general, businesses pay more attention to fixed and sunk costs
than people, as both types of costs impact profits.
• Sunk costs also cover certain expenses that are committed but
yet to paid.
• Imagine a company that has entered into a contract to buy 1,000
pounds of raw materials for the next six months.
• If the company is contractually obligated to uphold their end of
the deal, the raw materials are a sunk cost whether the company
has paid for them or not because the company will incur the costs
regardless of what the company decides to do with the materials.
The Sunk Cost Fallacy
• The sunk cost fallacy is the improper mindset a company
or individual may have when working through a decision.
This fallacy is based on the premise that committing to
the current plan is justified because resources have
already been committed.
• This mistake may result in improper long-term strategic
planning decisions based on short-term committed
costs.
• Imagine a non-financial example of a college student trying to
determine their major. A student may declare as an accounting
major, only to realize after two accounting classes that this is not
the career path for them. The sunk cost fallacy would make the
student believe committing to the accounting major is worth it
because resources have already been spent on the decision. In
reality, the student should only evaluate the courses remaining
and courses required for a different major.
• In business, the sunk cost fallacy is prevalent when
management refuses to deviate from original plans,
even when those original plans fail to materialize.
• The sunk cost fallacy incorporates investor
emotions that cause irrational decision-making.

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