Question

What is a sunk cost? Why is it not considered a relevant cost in differential analysis? Explain in your own words, feel free to use examples, metaphors, etc.

In detail please! Thank you.

Answer 1

Sunk cost is a cost incurred in the past which cannot be recovered and has no relevance with the future rational decisions. These costs cannot be recovered by the future decisions.

We can understand this by, any past decision taken and costs have already incurred in the past regarding that, now any decision being taken in future cannot change that cost as they have already incurred.

Example - An organization has already spend $1490 on the training of its employees in which employees were trained how to use a particular equipment which the company was about to launch in coming months. The training was about to be over when the operations and maintenance team declared that the new equipment is outdated and does not match with the criteria of the new demand and hence this equipment would not be launced by the company. Now, this $1490 which the company already have spent cannot be recovered as employees would not be able to use the knowledge they gained from this training. So this cost turned out to be sunk cost for the company.

If we discuss about the differencial analysis, its a management decision where different alternatives are being analysed which have different cost, revenues and benefits regarding a particular problem. And the management decides the best among those alternatives. Thus, we can say that differencial analysis focus on those costs and revenues comparing which can bring changes in the future costs incurred by the company or are relevant for the future decisions.

Example - Following the above given example, Company is deciding which equipment should it launch so that it meets the criteria of its new demand and production. Company will focus on few alternatives, it will analyze all the costs that it would have to incur in launching each and the revenue and profit it could earn from each. After analysing, company will select the equipment which has capacity to generate highest profit. Now, this while decision process has nothing to do with the cost it incurred in training the employees on a different equipment which is not suitable to use and hence has converted into a sunk cost.

So, here we saw that the sunk costs that have been incurred in past, has no use in the future decision being made by the company. Hence it is clear that sunk costs are not relevant for the purpose of differencial analysis as those sunk costs have already being incurred and any decision taken in future cannot bring any changes in that costs being incurred.

So, sunk costs are not relevant cost in differencial analysis.