Sunk Cost (Economics) - Explained
What is a Sunk Cost?
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What is a Sunk Cost?
A sunk cost is the money that has already been spent and cannot be retrieved. Traditional microeconomics theory proposes the sunk cost should not influence an investment decision as it is already gone, and the cost will remain the same irrespective of the outcome of the decision. Only the prospective or future cost should be considered while making an investment decision. The term was primarily used in the oil industry. The decision of abandoning or operating an oil well depends on the future cash flow it can generate and not on the cost of the digging of the well. The cost of digging has already been incurred and that cannot be recovered. So, while taking a decision about the well, that cost should not matter. The sunk cost is also known as stranded cost, retrospective cost, embedded cost or sunk capital.
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How does a Sunk Cost Work?
The firms need to carefully consider all the relevant costs while making a business decision. However, the costs which have already been incurred should not influence the decision. Only the future costs and the revenues are to be compared to take a sound decision. A sunk cost is different from economic loss. Say for example a firm buys machinery and subsequently resell it. The selling price is lower than the purchase price. This difference (including the transaction cost) is calculated as the economic loss. Now the price originally paid for purchasing the machinery should not affect the future decision about the machinery. If the company thinks they can derive more value by selling the machinery than not selling, then it should be sold. This original purchase price should not affect this decision. Thus, a sunk cost is not a precise quantity, rather it is a term to describe the amount that is paid in the past and no more relevant for future decisions. Firms can have various suck costs including the cost of purchasing machinery and equipment and lease cost of the factory. These costs are excluded from a sell-or-process-further decision. For example, let's assume, Company X manufactures a certain type of bags. The production cost of the bag is $30, and they sell it in $90. Now they have got an improved design for the bag. The new design bags cost $45 per bag and the seeing price can be $130. Now the company needs to compare these costs and revenues to make the decision whether to go with the new design. The sunk costs of machinery and factory lease are not considered in this decision-making process.
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