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 cannot be recovered or changed and is independent of any future costs a business might incur. Because a decision made today can only impact the future course of business, sunk costs stemming from earlier decisionsshould be irrelevant to the decision-making process.

Example 1 :

A drug manufacturing company A invests $ 2,50,000/- for many years for the R&D on a new drug for hair growth. When the company launched this product in the market, due to some side effects faced by many patients, doctors stopped recommended that pill to their patients. This issue forced the company to stop the production of that pill. In this case, $ 2,50,000/- has become a sunk cost, so it should not be considered in any decision for this product in the future.

Example 2 :

Let’s consider the example of Company A, which is into two-wheeler manufacturing and have a vast product line in their portfolio. Recently, the Company has launched one new two-wheeler model, and the board has decided to spend $5,00,000 on marketing and advertisement to promote its new product. Although they have not succeeded in this marketing campaign as the product efficiency was not up to the mark.

The company has already spent $5,00,000 on this failed marketing campaign. Still, they should not consider this expense in any future decision making for the same product or any other product of the company. This amount will be regarded as a Sunk cost.