Question

Chapter 5 introduces you to numerous cost concepts. One of these costs concepts is the “sunk cost” concept. The textbook defines sunk cost as a cost that is forever lost after it has been paid. The textbook also states , “since sunk costs are lost forever once they have been paid, they are irrelevant to decision making.” The above statement suggests that in economic decision making “bygones are forever bygones”, hence costs and benefits that have already been incurred are irrelevant to current economic decisions, or should be ignored in current economic decisions. However, ignoring sunk costs is difficult for managers. Explain the concept of sunk cost with the help of an example, real world or other. Your example should be substantive enough to demonstrate why ignoring it could be difficult for managers.

Answer 1

Answer : Sunk cost is the cost which has already incurred by the business but it cannot recovered. While making a decision by the manager cost is an important factor of businessman. In order to take relevant decision cost should be considered such as:

• Differential cost
• Opportunity cost
• Sunk cost
• Marginal cost

Example : A company started with new department in which new innovative technology has been applied. For application of technology that has been conducted $1 million on research and development two years ago. So, in this case calculating the profit of the department, Sunk cost cannot be avoided. For economic decision makers to calculate decision related to project. Sunk cost ( I.e cost related to research and development) cannot be avoided. As per practical decision only future cost has been taken into an account. But as per some case Sunk cost cannot be avoided. As per rational decision making only opportunity cost has been compared where as Sunk cost are considered to be Sunk. For instance in one financial year a project earn $3 million profit and opportunity cost of project is $1 million where as other expenses is $0.5million. So, as per rational decision making profit is only $1.5million . But if we consider sunk cost than profit is $0.5 million.So, practical it is very difficult to ignore the sunk cost in decision making where other technology required only $0.2 million cost and profit is $2.5 million.Expenses and opportunity cost remain same.So, economic profit without sunk cost is $1 million .Where as with sunk cost it is $1- $0.2= $0.8million.This shows that managers cannot ignore sunk cost while taking relevant decision.