Question

Give two examples of sunk costs, and explain why they are irrelevant in decision making.

Answer 1

Examples of Sunk cost

1. Suppose A company spends $10 million on building an airplane and just prior to its completion , the managers realize that there is no demand for the airplane. The aviation industry has evolved and airlines demand a different model of plane . The company has a choice: either finish the plane for another $2 million or build the new in-demand airplane for $8 million. In this scenario, the $10 million already spent on the old plane is a sunk cost. It should not affect the decision and the only relevant cost is the $4 million.
2. A company spends $5 million to conduct a marketing survey to determine the profitability of a new product they will launch in the marketplace. The study shows the product will be heavily unsuccessful and unprofitable. Therefore, the $5 million is a sunk cost. The company should not continue with the product launch and the initial marketing study investment should not be considered when making decisions.

Why sunk cost is irrelevant in decision making ?

Sunk costs are those costs which cannot be recovered or changed and they are totally independent of all the future costs that a firm may incurr . Since decision making Focuses more on the future course of business and sunk costs do not affect the future course of business , sunk costs are considered irrelevant to decision making .