What Is a Sunk Cost?A sunk cost is money that has already been spent and cannot be recovered. In business, the axiom that one has to "spend money to make money" is reflected in the phenomenon of the sunk cost. A sunk cost differs from future costs that a business may face, such as decisions about inventory purchase costs or product pricing. Sunk costs are excluded from future business decisions because they will remain the same regardless of the outcome of a decision. Show
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Sunk CostUnderstanding Sunk CostsA 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. Because sunk costs do not change, they should not be considered. Businesses that continue a course of action because of the time or money already committed to an earlier decision risk falling into the sunk cost trap. Types of Sunk CostsAll 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 $50 but at the last minute can't attend. The $50 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. Sunk Cost FallacyThe 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 otherwise irrational decision-making. The sunk cost fallacy is deeply rooted in biological tendencies, as researchers from the University of California San Diego analyzed the sunk cost effect in humans as well as pigeons. Sunk Cost Fallacy - Psychological FactorsThere's five common explanations as to why the sunk cost fallacy exists. Here are the psychological reasons that explain why some decision-making processes fail.
How to Avoid Sunk Cost FallacyThe sunk cost fallacy can easily be overcome with mindfulness, dedicate, and thoughtful planning. Here's a few pointers on overcoming the mental challenge.
After trading for Joey Gallo, the New York Yankees outfielder struck out 194 times over 140 games. Instead of continuing to stick with their decision that didn't pan out as they'd hoped, the Yankees traded Gallo in August 2022. This is an example overcoming the sunk cost fallacy. Example of Sunk CostsAssume that XYZ Clothing makes baseball gloves. It pays $5,000 a month for its factory lease, and the machinery has been purchased outright for $25,000. The company produces a basic model of a glove that costs $50 and sells for $70. The manufacturer can sell the basic model and earn a $20 profit per unit. Alternatively, it can continue the production process by adding $15 in costs and sell 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 in order to earn $5 more in profit. The cost of the factory lease and machinery are both sunk costs and are not part of the decision-making process. If a sunk cost can be eliminated at some point, it becomes a relevant cost 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 end dates should be included in the decision. To make the decision to close the facility, XYZ Clothing considers the revenue that would be lost if production ends as well as the costs that are also eliminated. If 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 also be eliminated. If the total costs are more than revenue, the facility should be closed. What Is an Example of a Sunk Cost?Imagine a company decides it needs to expand its warehouse. It contacts an architect to design a new space who drafts some preliminary drawings for a fee. Then, an economy slowdown occurs, and the company is now unsure whether it should continue with the new warehouse. In this example, the architecture fees are an examl Are Salaries a Sunk Cost?Yes, any salary that has been paid to an employee is a sunk cost. As long as those wages are not recoverable, that salary represents an expense that has been incurred and can not be captured back by the company. What Is a Sunk Cost vs. a Fixed Cost?In business, fixed costs are expenses that have to be paid by a company independent of any specific work activities: They don't apply to a company's production of any goods or services, and they don't rise or fall with a change in the number of goods or services produced or sold. Sunk costs are a subset of fixed costs—specifically, a type of fixed cost that is not recoverable. What Is the Difference Between Sunk Cost and Relevant Cost?When making business decisions, organizations should only consider relevant costs, which include future costs—such as decisions about inventory purchase costs or product pricing—that still need to be incurred. The relevant costs are contrasted with the potential revenue of one choice compared to another. Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision. Why Are Sunk Costs Important?Sunk costs are important because may act as distractors in decision-making. When a company analyzes costs and benefits, sunk costs should have no bearing on the decision-making process as the sunk cost will be incurred regardless of the outcome of the choice. Sunk costs are important to be mindful of because incorrectly including them in an analysis may lead to a less favorable decision being chosen. The Bottom LineAll businesses and individuals incur sunk costs. Whether its the groceries already in your refrigerator, the employees on a company's payroll, or capital expenditure plans by your local government, sunk costs are a natural part of finance. These expenses are already committed to and nonrecoverable; for that reason, sunk costs should not be included in future decision-making as the expense for the sunk cost will be exactly the same in every situation. Is a cost that Cannot be affected by any future action?Sunk cost is a cost that cannot be affected by any future action. For example, depreciation represents an allocation of a cost already incurred. This is considered a sunk cost.
Which of the following would be considered a sunk cost?A sunk cost, sometimes called a retrospective cost, refers to an investment already incurred that can't be recovered. Examples of sunk costs in business include marketing, research, new software installation or equipment, salaries and benefits, or facilities expenses.
When the goods are sold their costs are transferred from work in process to finished goods True or false?Answer and Explanation:. Is the amount of increase or decrease in revenue that is expected from a course of action compared to an alternative?Also called incremental analysis. The amount of increase or decrease in revenue expected from a particular course of action as compared with an alternative.
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