Question

Why should sunk costs be ignored for decision making? Give an example of why it makes sense to ignore sunk costs and why it is often difficult to do so.

Answer 1

SUNK COST- sunk cost are those cost which have been incurred and the amount spent can not be recovered.since the cost can't be recovered and it won't impact the future decision thus there is no point to include the sunk cost while making any future decision.we can understand the entire concept with the following example-

EXAMPLE

• suppose Alpha Ltd. started investing in construction work and spent $1 million on marketing and advertisement.after some time the firm realized that there is requirement of huge funds for such businesses and the demand of newly constructed houses are declining and thus Alpha ltd wants to step back from such business.but now the amount spent on marketing and advertisement can't be recovered and as a result this expenditure has become sunk cost.
• ignoring sunk cost is not always an easy task.we can extend the same example-
• suppose Alpha ltd has constructed a house which is semi finished and $100000 has already spent and $50000 more is required to finish the house and all of a sudden Alpha ltd wants to exit from the business.this means if it won't continue the business then the amount invested in the semi finished house would become sunk cost.2/3 part of house is completed and has become sunk cost.either the Alpha ltd has to finish the house or has to exit the business,

the above situation represents the dilemma of the investor and therefore it is not so easy to ignore the sunk cost and make a new investment on a new project.