Question

Why might a manager want to consider sunk costs in making a decision? Provide two examples of sunk costs and explain why they are irrelevant in decision making.

Answer 1

A sunk cost is a cost that an entity has incurred, and which it can no longer recover. Sunk costs should not be considered when making the decision to continue investing in an ongoing project, since these costs cannot be recovered. Instead, only relevant costs should be considered. However, many managers continue investing in projects because of the sheer size of the amounts already invested in prior periods. They do not want to "lose the investment" by curtailing a project that is proving to not be profitable, so they continue pouring more cash into it. Rationally, they should consider earlier investments to be sunk costs, and therefore exclude them from consideration when deciding whether to continue with further investments.

Example1 : suppose a business executive of a financial consulting company is hired to build a financial analytics application and will receive $10 million at the end of the project. The business executive determines it will cost $7 million in total to finish the project and take one year. The company will profit $3 million for completing this project.

However, in the ninth month of operation, the team runs into problems with the main framework of the application. The firm already spent $5.25 million on this project, and the business executive must decide whether to continue with the project or cancel it. They estimate that this major setback will cost an extra $1 million. However, the company can still profit $2 million from the project.

Whether the business executive decides to continue with the project or cancel it, the costs spent for the nine months of operation cannot be retrieved. This should be irrelevant to the decision because only future costs and potential revenues should be considered. If the executive cancels the project, the company would incur a $5.25 million loss and have revenues of $0. If the executive continues with the project, the future revenue for the company is $10 million, and future costs are only $2.75 million.

They decide to continue with the project because it is a 3.64% return on investment, ignoring sunk costs. The consulting company delivers its application to the hirer and receives revenues of $10 million and has a profit of $2 million.

Example 2:

Hupana Running Company bought a machine for $50,000 that was used to make water bottles. The water bottle line never really took off, so Hupana decided to discontinue the line, and focus their efforts on the running shoes that were the profitable portion of the business. Even though, in hindsight, they should have never added a line of water bottles to their product line, the $50,000 they spent on the machine is a sunk cost.

It would be senseless for Hupana to keep making the water bottles to try to recoup the already spent $50,000, but they could try to sell the machine to another company who already makes water bottles!! No matter what they do with the machine, the 50K is a sunk cost, not to be recovered, and irrelevant to any decisions the company makes now. So we need to just let it go.

Other Examples:

• Marketing study. A company spends $50,000 on a marketing study to see if its new auburn widget will succeed in the marketplace. The study concludes that the widget will not be profitable. At this point, the $50,000 is a sunk cost. The company should not continue with further investments in the widget project, despite the size of the earlier investment.

• Research and development. A company invests $2,000,000 over several years to develop a left-handed smoke shifter. Once created, the market is indifferent, and no one buys any no units. The $2,000,000 development cost is a sunk cost, and so should not be considered in any decision to continue or terminate the product.

• Training. A company spends $20,000 to train its sales staff in the use of new tablet computers, which they will use to take customer orders. The computers prove to be unreliable, and the sales manager wants to discontinue their use. The training is a sunk cost, and so should not be considered in any decision regarding the computers.

• Hiring bonus. A company pays a new recruit $10,000 to join the organization. If the person proves to be unreliable, the $10,000 payment should be considered a sunk cost when deciding whether the individual's employment should be terminated.