Question

Why might a manager wnt to consider sunk costs in making a decision? Provide two examples of sunk costs and explain why they are irrelevant in decision making.

Answer 1

A sunk cost is a cost that cannot be recovered or changed and is independent of any future costs a business may incur. Since decision-making only affects the future course of business, sunk costs should be irrelevant in the decision-making process. Instead, a decision maker should base her strategy on how to proceed with business or investment activities on future costs.

Manager might want to take sunk costs into account in making a decision to prevent the mistakes of future sunk costs.

Examples of sunk cost

1. Marketing study. A company spends $50,000 on a marketing study to see if its new auburn widget will succeed in the marketplace. The study concludes that the widget will not be profitable. At this point, the $50,000 is a sunk cost. The company should not continue with further investments in the widget project, despite the size of the earlier investment.

2. Research and development. A company invests $2,000,000 over several years to develop a left-handed smoke shifter. Once created, the market is indifferent, and buys no units. The $2,000,000 development cost is a sunk cost, and so should not be considered in any decision to continue or terminate the product.