Question

What is sunk cost and what are some real world examples of sunk cost and why is it important to understand sunk cost?

Answer 1

Sunk cost are those costs which company incurs regardless of the project being undertaken or not. These costs cannot be recovered, hence, considered sunk as these costs are not considered in decisions taken by companies for future projects. These costs differ from other costs because these doesn't affect the cashflows of an investment, unlike Machinery cost or Inventory cost.

Some of the real life example of sunk cost can be an unused building which is incurring costs for a company regardless if a manufacturing facility is setup in the building or not, the cost of keeping the building will still be incurred.

Another example of sunk cost can be the Research & Development expenses by pharma companies for finding a drug or vaccine for a disease. If the find or developed product fails, R&D expenses incurred becomes sunk cost which cannot be recovered.

It is important for us to under Sunk costs because companies will continue to incur such sunk costs even if their efforts fails. Even though, these costs doesn't affect their project analysis, but high sunk cost for company definitely affects the shareholder value of a company. We have to remember that all companies have some amount of sunk costs, however, a lot of it makes the company undesirable for shareholders.