Sunk Costs

Definition

Sunk costs refer to expenses that have already been incurred and cannot be recovered, regardless of future decisions. They are past costs that are irrelevant for future decision-making as they do not affect the incremental costs and benefits of a decision. Understanding the concept of sunk costs is crucial in various managerial accounting contexts, such as identifying relevant information for decision-making, evaluating make-or-buy decisions, determining whether to keep or discontinue a segment or product, and assessing whether to sell or process a product further.

5 Must Know Facts For Your Next Test

1. Sunk costs should be ignored in decision-making because they are past expenditures that cannot be changed or recovered, regardless of the decision made.
2. Considering sunk costs can lead to the sunk cost fallacy, where individuals or organizations continue to invest in a project or decision solely because of the money already spent, even if it is no longer the best course of action.
3. Identifying relevant costs, which exclude sunk costs, is crucial for making informed decisions that maximize the organization's future benefits.
4. In make-or-buy decisions, sunk costs related to the in-house production of a component should be ignored, and the decision should be based on the incremental costs and benefits of outsourcing versus in-house production.
5. When evaluating whether to keep or discontinue a segment or product, sunk costs associated with the development or acquisition of the segment or product should not be considered, as they do not affect the future decision.

Review Questions

• Explain how the concept of sunk costs is relevant in the context of identifying relevant information for decision-making.
  • When making decisions, it is important to focus on relevant costs and benefits, which exclude sunk costs. Sunk costs are past expenditures that cannot be recovered, regardless of the decision made. By ignoring sunk costs and instead considering only the incremental costs and benefits associated with a decision, managers can make more informed and rational choices that maximize the organization's future performance.
• Describe the role of sunk costs in the evaluation of whether to make or buy a component.
  • In the context of make-or-buy decisions, sunk costs related to the in-house production of a component should be disregarded. The decision should be based solely on the incremental costs and benefits of outsourcing versus in-house production, as the sunk costs associated with the existing in-house production cannot be recovered regardless of the decision made. This allows the organization to focus on the future costs and benefits to determine the most economically viable option.
• Analyze how the concept of sunk costs should be applied when evaluating whether to keep or discontinue a segment or product.
  • When evaluating whether to keep or discontinue a segment or product, the sunk costs associated with the development or acquisition of that segment or product should not be considered. These past expenditures are irrelevant for the future decision, as they cannot be recovered. Instead, the decision should be based on the incremental costs and benefits of keeping the segment or product versus discontinuing it. This forward-looking approach ensures that the organization makes the most financially prudent decision, regardless of the historical investments made.

Related terms

Opportunity Cost: The potential benefit or value that is given up when one alternative is chosen over another.

Incremental Analysis: The process of evaluating the additional costs and benefits associated with a decision, ignoring sunk costs.

Relevant Costs: Costs that are affected by a decision and should be considered in the decision-making process, excluding sunk costs.