Sunk Cost

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Sunk Cost?

Sunk cost refers to the amount that firms spend with no chance of it being recovered in the future. Though these costs build setups for production and revenue generation, the firms do not get any direct return on these investments.

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Known by different names, like stranded cost, retrospective cost, past cost, embedded cost, etc., a sunk cost is an expense that cannot be regained or returned at any time in the future. Moreover, it differs from relevant costs that include company expenses that can be recovered and have a vital role in business decision-making.

Key Takeaways

  • Sunk costs are expenses incurred by the company in the past with no chance of its recovery in the future.
  • Since these costs cannot be recovered or regained, they are not directly considered while making rational decisions.
  • While all stranded costs are said to be fixed costs, not all fixed costs are sunk expenses.
  • Businesses can list all the assets, the cost of which could not be regained, to calculate this cost. Then, the difference between their current and purchase prices can be obtained to check the depreciation, indicating the sunk cost.

Sunk Cost Explained

Sunk cost, as the name suggests, is the cost that sinks and is never regained in the future. This could be the expense of building infrastructure, both physical and technological or setting up units that help in achieving the business goals of individuals or entities. Once the price is paid, it never gets recovered. 

For example, when one invests in stocks, the returns come as the regained amount. But, on the contrary, if one builds a plant or pays a lease for the manufacturing unit, it might lead to the production of goods, which, when sold, earns profits for businesses, but the amount paid for building the foundation never comes back.

While sunk cost is classified as fixed, not all fixed costs are retrospective costs. As the former is considered irrecoverable, the latter could be recovered in the resale market. For example, suppose a company resells equipment it bought earlier for production purposes. In that case, the money received in exchange becomes the recovered equipment cost, which then doesn’t remain sunk or stranded.

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Formula

There is no specific sunk cost formula to calculate the retrospective costs incurred by a company. However, listing all assets that could not be sold and put to reuse help calculate the total irrecoverable amount spent. This value could be obtained by deducting the current value from the purchase price a firm or individual paid at the time of purchase. The depreciation in the figure obtained is the sunk cost for the company.

Examples

Now, let us consider the following sunk cost examples to understand the concept better:

Example #1

Company A pays $5000 as a joining bonus to a new joiner. However, after the joining, the firm identifies the incapability of the employee in handling the job responsibilities. After considerable observation, when the organization found that the person did not improve, it had to terminate the contract. In this case, the $5,000 became an irrecoverable cost that sank with the termination of that recruit.

Example #2

Whether it is digital advertising or audio-visual advertising, companies conduct campaigns to ensure they keep on inviting new customers to their brand while retaining the old ones. They understand that advertising the products will help build the customer base and bring them to notice time and again. However, even if these campaigns don’t work, they must keep trying. In case the campaign fails, the investment made for running the adverts sinks, making it a sunk cost.

Importance

The sunk cost meaning specifies that it can neither be regained through reselling the products in question nor be recovered by returning products or refunds. As a result, these costs hardly get considered during business decision-making. 

These stranded costs, however, come as a lesson to the businesses and individuals who have incurred them. Though these do not play a direct role in decision-making, they could still act as guidance. Once incurred, these retrospective expenses cannot be recovered, but then the efforts put in and money spent are big lessons that help businesses identify what they should not do. This way, these costs let them not involve in anything irrecoverable in the future.

Sunk Cost vs Opportunity Cost

Sunk cost and opportunity cost are terms that identify two types of business costs. While the former is the cost that cannot be recovered, the latter is the cost missed out on because of choosing an alternative investment option. For more clarity on these two costs, let us have a look at the major differences between them:

CategorySunk CostOpportunity Cost
DefinitionThe cost cannot be recouped in the future, be it through reselling, return, or even refund.Cost of missed opportunity as businesses choose one option and miss the rest of the available opportunities.
TypeExplicit cost as actual cash flow involvedImplicit as no actual cash flow is involved.
AccountingAccounted for and reported as they are actual expenditures of the businessNot accounted for or reported in financial statements as they are notional.
RoleNo direct role in decision-making but could act as a lesson to remember in making future decisions.Vital in decision-making

Frequently Asked Questions (FAQs)

What is sunk cost bias?

It is a term that refers to the trap that individuals or businesses create themselves by not accepting the failed use of the amount that sank in the rush of achieving a business objective. Such bias restricts the growth and scope of improvement of the entities involved, limiting their efforts.

Why is sunk cost irrelevant?

Most businesses find these costs irrelevant as they think these expenses have no role to play in decision-making. However, if deeply observed, these costs offer businesses and individuals a life-long lesson to identify where not to invest in the future. As one accepts where they went wrong, they won’t repeat the mistake again and hence, make a better decision in the future.

What does sunk cost fallacy mean?

The fallacy or bias means almost the same thing that defines the tendency of the firms and individuals to continue making expenditures that are irrecoverable in the future despite knowing that it won’t be beneficial in any manner.

This article has been a guide to what is Sunk cost. Here we explain the concept along with its importance, formula, example, and differences with opportunity cost. You may learn more about accounting from the following articles –Sunk Cost Examples

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