Sunk costs are cash outlays incurred in the past. They are the results of past decisions, and cannot be changed by future decisions. Since they do not influence future decisions, they are irrelevant costs. They are unavoidable and irrecoverable historical costs; they should simply be ignored in the investment analysis.
Examples of sunk costs:
- Marketing study. A company spends $50,000 on a marketing study to see if its new auburn widget will succeed in the marketplace. The study concludes that the widget will not be profitable. At this point, the $50,000 is a sunk cost. The company should not continue with further investments in the widget project, despite the size of the earlier investment.
- Research and development. A company invests $2,000,000 over several years to develop a left-handed smoke shifter. Once created, the market is indifferent, and buys no units. The $2,000,000 development cost is a sunk cost, and so should not be considered in any decision to continue or terminate the product.
- A company spends $20,000 to train its sales staff in the use of new tablet computers, which they will use to take customer orders. The computers prove to be unreliable, and the sales manager wants to discontinue their use. The training is a sunk cost, and so should not be considered in any decision regarding the computers.
- Hiring bonus. A company pays a new recruit $10,000 to join the organization. If the person proves to be unreliable, the $10,000 payment should be considered a sunk cost when deciding whether the individual’s employment should be terminated.
Consider another example. A company set up a plant for a cost of Rs 20 crore to manufacture ball bearings. The project proved to be bad for the company, and it started accumulating losses. The total outflows to-date are Rs 30 crore. The company is thinking of abandoning the plant. Some executives consider it suicidal to abandon a plant on which Rs 30 crore have already been spent Others feel it equally unwise to continue with a plant which has been incurring losses and offers no possibility of any satisfactory return on that money spent. The arguments of both the groups do not make sense. The Rs. 30 crore spent by the company is a sunk cost; therefore, it is irrelevant. It is also not correct to discard the plant since it is not earning a satisfactory return on a sunk investment. The company should take the decision to sell or not to sell the plant today in light of the future cash flows mid return.
