Sunk Costs

sunk cost

Cost that does not vary across decision alternatives

Inherent in the incremental cost concept is the principle that any cost not affected by a decision is irrelevant to that decision. A cost that does not vary across decision alternatives is called a sunk cost; such costs do not play a role in determining the optimal course of action.

For example, suppose a firm has spent $5,000 on an option to purchase land for a new factory at a price of $100,000. Also assume that it is later offered an equally attractive site for $90,000. What should the firm do? The first thing to recognize is that the $5,000 spent on the purchase option is a sunk cost that must be ignored. If the firm purchases the first property, it must pay a price of $100,000. The newly offered property requires an expenditure of only $90,000 and results in a $10,000 savings. In retrospect, purchase of the $5,000 option was a mistake. It would be a compounding of this initial error to follow through with the purchase of the first property and lose an additional $10,000.

In managerial decision making, care must be taken to ensure that only those costs actually affected by a decision are considered. These incremental costs can include both implicit and explicit costs. If long-term commitments are involved, both current and future incremental costs must also be accounted for. Any costs not affected by available decision alternatives are sunk and irrelevant.

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