What is Sunk Cost?
A sunk cost is the investment made in a business that you cannot recover. A metaphor that you can use to describe this better is that of a shipwreck where it’s impossible to get it back after the ship has sunk.
Because you cannot recover the sunk cost, it is often not included in any future budget. Some common examples of sunk costs are office tables, chairs, printers, and so on, which need replacement after a few years.
When the time for replacement comes, the money spent on the old equipment is considered a sunk cost. Pawning or recycling may help you recover some of the costs. However, There’s no way to get back all of the money you put in and, hence, it is sunken.
Let’s take another example of any SaaS organization that invests in testing for a new feature that the users ignore and doesn’t lead to any sales.
In such a case, the money invested in researching this feature would get considered a sunk cost because you cannot recover it.
The standard action that makes this worse is to put more money into the process to reverse the loss. It is a mistake that is also called sunk cost fallacy.
Sunk cost vs. Opportunity cost
Meaning:
The price of a missed opportunity or the profit/gain cut while opting for one business alternative over the other is known as opportunity cost.
Previous costs that have already been spent and cannot be retrieved are sunk costs.
Theoretical vs. Actual:
Because opportunity costs are hypothetical in structure and therefore do not result in an actual cash outflow for the company, they are implicit expenses.
Sunk expenses are explicit costs because they result in the entity’s actual cash outflow.
Cost estimation:
Opportunity cost estimation might be arbitrary. For example, suppose you assess the possible profit loss while evaluating alternatives. There may be some subjectivity in predicting the prospective loss of profit.
A sunk cost is calculated objectively without requiring estimates since they are actual costs already incurred.
Documenting:
Internal management reporting may include opportunity costs, which you don’t fit in financial accounts.
The published financial accounts include sunk costs.
How to calculate sunk cost?
Find the current as-new market price of a piece of machinery to be upgraded to calculate the sunk cost. Next, determine how much the object is worth in its current condition, which should be possible with some web research.
To calculate the sunk cost, subtract the current value from the as-new price. List all equipment and tools that can’t be sold or reused to assess a project’s sunk cost.
To determine depreciation, determine the purchase price and its current value. Then put a sunk cost on it.
Add up the labor costs for the project so far. Add in the expense of unsalvageable equipment plus the sunk cost of things that can be sold or repurposed, and you’ve got a recipe for disaster. The project’s sunk cost is the outcome.
What are the examples of sunk costs?
Example 1: ABC Limited is looking at expanding its operations and introducing a new product. The corporation invests INR 10 lakhs in market analysis to establish the new product’s viability.
According to the research, the new product will not be lucrative and may even fail. In this instance, the market research costs are not recoverable.
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Example 2: Assume you launched a music streaming service and spent $5,000 on marketing and advertising to reach out to potential customers. As a result, marketing and advertising campaigns fail to deliver results. This amount is considered the sunk cost since you’ve already spent $5,000.
FAQs
The sunk-cost dilemma requires deciding whether to continue a project with significant sunk expenses or abandon it. Sunk costs are unrecoverable funds already expended and are irreversibly committed to spending.
Sunk costs are not considered in future business decisions since they will not change regardless of the result.
Because the cost will be the same regardless of the outcome, sunk costs get removed from future decisions. When a decision includes sunk costs, the sunk cost fallacy occurs. A consideration of sunk costs leads to irrational decision-making.
Sunk Cost fallacy believes that further investment into a failing project can help reverse the losses from the sunk costs. Many businesses are likely to make such decisions to avoid risk.