Sunk Costs

Do you have any memories of eating an ice cream cone and having it fall to the ground unexpectedly? Will you pick it up and eat it again? Will the shop owner give you a refund? Certainly not. The moment the ice cream fell to the ground, the cost of purchasing it became sunk. Interesting, right? But what if sunk costs are not as small as the price of an ice cream cone? In the case of businesses, these costs can get pretty large! Would these sunk costs affect companies' decision-making? Let's dive right into this article and see how sunk costs are incurred by large firms and how it influences their decision-making!

Sunk Costs Definition

Before jumping right into the definition of sunk costs, let's get a quick refresher on what costs mean in economics. Firstly, we must know that economists measure costs differently than accounting costs. Economists are concerned with costs that will likely be incurred in the future so they can organize their resources in a way that aids businesses in minimizing costs and maximizing profits. Hence, we can define economic cost as a term used to describe a firm's costs while utilizing resources during production.

An economic cost considers all of the costs associated with production. Of course, the costs include fixed and variable costs, but there is another type of cost that is very important - opportunity cost. The benefit lost when a company chooses one alternative over another is referred to as opportunity cost. The opportunity cost is also an economic cost for a business.

Various types of economic costs must be assessed carefully by a firm to make informed decisions. One of them is sunk cost. Costs that have already been invested by the firm or an individual and cannot be recovered are known as sunk costs. As firms are not able to recover the sunk costs, firms must carefully assess them, and they must make sure those sunk costs are ignored while making business decisions. Sunk costs are typically the costs associated with failed research and development projects or the purchase of obsolete equipment for a single purpose with no other practical use.

• Various types of costs in economics include the following:- Opportunity Cost;- Sunk Costs;- Fixed Costs;- Variable Costs.

Examples of Sunk Costs

Now, lets us comprehend sunk costs in detail through examples.

Sunk Cost Formula

Now let us understand how sunk costs are calculated by economists and how it aids in their decision-making process.

Let's assume that you decided to manufacture a new software and had a projected total revenue of $50,000 and a cost of $30,000, which is a good opportunity in the market. You decided to start the development of software, and in the middle of the development process, after you had spent $20,000, you realized that the project would cost a total of $60,000. Now, should you move forward with the project?

The initially spent $20,000 is your sunk cost, as you wouldn't have started the project if you had projected $60,000 at the start of the project. But as an economist, you have to ignore the $20,000 sunk cost and move on with the software development process looking forward to the future benefits. By ignoring the sunk cost, the additional cost of software development will be $40,000. The initially projected revenue of $50,000 is still greater than the initial cost of $40,000. Here, in terms of accounting costs, there is a loss of $10,000, but in terms of economic costs, there is a revenue of $10,000. So, from an economic perspective, it is better to continue the project even after realizing a sunk cost of $20,000.

This example depicts that sunk costs must be ignored in decision-making as they have already been incurred and cannot be recovered.

Sunk Cost Importance

The importance of sunk cost is immense when making an economic decision. Every company incurs a sunk cost at some point. This doesn't mean the company has to shut down; it simply has to ignore the sunk cost and move on if economic benefits are greater than the costs incurred.

Let's take an example of a real-life giant company that had incurred sunk costs.

Therefore, companies must ignore the sunk costs while making business decisions.

Sunk Cost Fallacy

While sunk cost aids in the decision-making process, many firms fall into sunk cost fallacy. It is the situation when the companies keep on adding further investment into the failed innovation in the hope that incurred sunk costs can be recovered. The firms must be aware of the nature of sunk cost and must not take it into account while making decisions.

Sunk Cost vs Opportunity Cost

Now, let's learn about opportunity cost and how it is different from sunk cost.

Opportunity costs are one of the most important types of economic costs and help organizations in various decision-making processes. The costs incurred or benefits lost when a company chooses one choice over another is known as opportunity cost.

Unlike sunk costs, which are only identified after they have been incurred, opportunity costs can be assessed before and help in making a decision that is most favorable for the firm.

Fig. 1 - Sunk Cost vs Opportunity Cost

Figure 1 illustrates the production possibility curve of a restaurant that specializes in making burgers and pizzas. It shows the different combinations of pizzas and burgers the restaurant can produce with its existing resources. The graph shows the concept of trade-offs where if the restaurant decides to make pizzas, they have to give up burgers and vice versa.

Suppose the restaurant moves from producing 2 burgers to 5 burgers. Then it will only be able to produce 20 pizzas instead of 30, which is a lot less than what it was producing initially. The number of pizzas the restaurant lost while producing burgers is known as an opportunity cost.