What is Sunk Cost?
Sunk Cost refers to the expenditure which is incurred before the time in question and the management has no control over it. It represents past expenditure on equipment or tangible productive resources, an intangible right or extended contract for service, whose value can be recovered when the asset is used throughout its useful life and use of the service over the term. Such costs have zero economic relevance to the present decision-making process.
Otherwise called as invested cost or recorded cost. It is an unavoidable cost and refers to all the costs incurred in the past, as the amount is unchangeable after they are being incurred. These are created by a past decision and cannot be changed/avoided by any future decision. Hence, at the time of decision making these costs are generally ignored or not considered.
For Example
The book value of the assets like plant and machinery, equipment, etc which are presently used is irrelevant in making replacement decisions of that asset. In the same way, the cost of land bought in the year 2017 is irrelevant in making a decision as to whether to sell the land or keep it.
Characteristics of Sunk Cost
Sunk Cost is characterized by:
- Sunk costs do not require current cash expenditure, as a prior investment of funds has already been made by the firm. These are the cost that is spent on a project and won’t be realized if the project is terminated.
- These costs remain the same, no matter what alternative has opted for. So, these are often disregarded while evaluating multiple alternatives as these are common to all of them.
- Depreciation, amortization, and depletion of intangible assets like the cost of issue of shares, preliminary expenses, etc are some common sunk costs.
- The possible gains and losses by selling these assets, the book value is irrelevant for decision making as to whether the assets are to be used or disposed off. Further, what is important is that how much cash could be recovered in the future when the asset is sold.
- Sunk costs are usually analyzed in detail prior to the decision-making regarding future courses of action.
- They play a significant role in making decisions about abandonment or continuing certain operations.
- Sunk cost is not affected by an increase or decrease in volume.
Example of Sunk Cost
Suppose the book value of the plant is Rs. 20 lakhs and its scrap value (salvage value) is Rs. 1.5 lakhs. Therefore, the sunk cost of the plant is Rs. 18.50 lakhs, i.e. book value less scrap value.
Basically, the total cost of the asset is not the sunk cost however, it is the difference between the purchase price of the asset and the net amount which could be received from the sales proceeds is the sunk cost.
What are Non-incremental Costs?
If the firm opts for a particular alternative over another, all the costs do not change. Therefore, some costs are fixed with regard to volume, while others are fixed with regard to change in plans. These costs are called non-incremental costs, which implies the costs which do not increase, and so they are irrelevant for deciding a particular plan. Hence, these are generally ignored at the time of decision-making.
One such incremental cost with certain special characteristics is called sunk cost.
Difference Between Sunk Cost and Irrelevant Cost
Here, one must note that sunk cost and irrelevant cost are not one and the same thing, i.e. all irrelevant costs are not sunk costs but all sunk costs are irrelevant.
We can understand this statement with an example: While making a choice between two alternative methods of production, when the direct material cost is the same in both the alternatives, it is an irrelevant cost. Although, direct material cost is not sunk cost as it is going to be incurred in the future also and so it is a future cost.
Wrap Up
Historical costs which are already incurred are termed as a sunk cost and plays no significant role in the decision making of the current period. Sometimes when the plant is closed down by the firm permanently, then the total amount invested and the salvage value is lost, i.e. sunk or becomes irrecoverable.
