Question

Question 4 15 MARKS
Answer the following questions:
a) What is a sunk cost?
b) Under what circumstances are sunk costs relevant to a decision?
c) Construct an example of a sunk cost.
d) Briefly discuss why you think financial reports for investors and managerial reports for
managers may or may not differ in their treatment of sunk costs.

Answer 1

a) Sunk costs are costs that result from past decisions and cannot be changed. A sunk cost refers to money that has already been spent and which cannot be recovered. In business, the axiom that one has to "spend money to make money" is reflected in the phenomenon of the sunk cost.

b) 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.

c) A movie studio spends $50 million on making a movie and an additional $20 million on advertising. But the film disappoints at the box office and grosses just $15 million. Any of that budget that isn't getting recouped is a sunk cost, and the possibility of it not getting recouped should be factored into other film production budgets even before it becomes one.

d) Financial reports are designed to provide investors with information that is, among other things, reliable. Such reports generally measure events on the basis of historical costs, which are obviously sunk costs reflecting past actions. Managerial reports are designed to provide decision makers with the information to make good decisions. Such reports omit sunk costs, which could lead decision makers to erroneous conclusions.