The cost that a company has already incurred and can’t be recovered is known as Sunk Cost. These costs are often irrelevant while considering a new investment or any new project. For example, when a company is replacing an old machine with the new one, it may be able to recover some money by selling the old machine. But, the company may never be able to recover anything close to what it for it.
The term sunk cost has its roots from the oil industry. In this particular industry, the decision to continue with the well or abandon it is made on the basis of future cash flows rather than the money spent in drilling the well. Other popular names for sunk cost are past cost, sunk capital, or retrospective cost.
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Fixed and Variable Sunk Cost
Companies can further classify sunk cost into a variable and fixed cost. For instance, if a company spends around $5 million for installing a new machine, it would be a one-time cost that is unrecoverable, and thus, is sunk cost.
Regular payments made for the maintenance of the machinery is the ‘fixed’ part. On the other hand, the ‘variable’ cost could be power consumption and other such costs.
Concorde Effect and Sunk Cost?
It is human nature to avoid failure and as a result, they continue to invest time and money to fix a failure instead of cutting down the losses. Such a tendency is the sunk cost effect or Concorde effect
Concorde was the name of the plane that British and French Governments were working on together. The aim of the plane was to fly its passenger from London to New York within four hours. Mid-way, both governments realize that the project is not economically viable.
However, instead of scrapping the project and realizing the loss, they kept on building the planes thinking that they have spent billions so they must carry on. Eventually, they end the project. The loss, however, was enormous, much more than what they would have incurred if they stopped the project earlier.
What one learns from this real story is that one must abandon the project after realizing its failure, rather than dragging it unnecessarily. Throwing good money after bad is something that describes the Sunk Cost most effectively.
Sunk Cost Dilemma or Fallacy
The quicker companies or even in normal lives we recognize the sunk cost, the better we would be able to manage further losses. For instance, assume you spend $100 to buy two tickets (non-refundable) for a movie A, and your spouse also spent $50 to buy two tickets for a movie B (non-refundable). The problem is that both the shows are on the same day and at the same time. The movie reviews are in favor of movie B.
A rational choice would be to go to the movie that will be enjoyable and fun. However, it is the human tendency to avoid losses, so many would opt for movie A as well. Studies reveal that humans have a fear of acknowledging the loss, and therefore, end up making the wrong decision that leads to more losses.
Sunk cost trap not just affects the individuals and inexperienced investors, but big business houses and companies as well. They keep running a project simply because they fail to acknowledge the loss. Moreover, they believe that at some point in time, the venture would turn profitable.
Similarly, investment decisions can sometimes go bad. But, rather than acknowledging the loss, most companies or individuals put more money just to keep it running. Such situations arise partly because of our inability to take the right decision and also the human tendency to acknowledge the loss.
For example, Microsoft has been in such a situation before when it was unable to infiltrate the portable MP3 player market with the Zune. After realizing the failure, the company ended its production.
Sunk Cost’s Accounting Treatment
Sunk Cost comes in the accounting cost since the company already paid for it. For instance, a company buys a machine that did not turn out to be productive. The first scenario is, the company keeps on using it only to make things worse and slow down the whole process. The second scenario is ditching the machine after realizing that investing in it was the wrong decision.
Though the loss could be less in the second scenario, in both the scenarios the company has actually spent the money on buying the machine. Therefore, the cost of the machine is already in the accounts.
Often companies add entire sunk cost in one go or on one financial year. This might make the books look bad for that financial year, but it is actually is the right practice.
Examples of Sunk Costs
Suppose a company spends $10,000 on surveying the feasibility of a new type of gadget. If the survey finds that there won’t much demand for it, then the company must not invest further in it. In this case, $10,000 is the sunk cost.
Research and Development
Similar to marketing study, the amount that a company invests in R&D of a product should also be sunk cost irrespective of the product fails or not.
Suppose a company hires a new employee and gave $5,000 as a bonus. If the employee leaves the company or proves to be unreliable, then the $5,000 will be sunk cost.
Suppose a company spends $3000 on training its employees to use new tablets. If the tablets encounter issues midway and are not usable, then training is a sunk cost.
How to Minimize Sunk Cost?
Understanding a few things and following them might prove helpful in avoiding the sunk cost and its dilemma to a great extent:
- A periodic review of the investment and its benefits can fetch better results.
- Recognize the sunk cost early rather than building up the losses.
- Separating the ego from the real work.
- Constantly keep in mind the target that you decided while starting the project.
- Consider other available alternatives that can help in reducing the loss.