- Tags:decision making, investment, sunk costs
- By: Dan
- July 24, 2013
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What is sunk cost? A sunk cost is a cost that has been incurred and cannot be recovered. The money is spent. In accounting, a sunk cost is a type of irrelevant cost. When facing a potential project or investment, a manager must only consider relevant costs and ignore all irrelevant costs.
When a manager is considering a particular decision, relevant costs are the costs that are incurred if the decision is made and irrelevant costs are the costs that are incurred whether or not the decision is made. A sunk cost is not a relevant cost for decision making.
Whether a cost is relevant or irrelevant depends on the decision at hand. A cost may be relevant to one decision and that same cost may be irrelevant to another decision. A sunk cost, however, is always an irrelevant cost.
Sunk Costs Fallacy
The sunk cost fallacy is when someone considers a sunk cost in a decision and subsequently makes a poor decision.
An example of the sunk cost fallacy is paying for a movie ticket, finding out the movie is terrible, and staying to watch anyway just to get your money’s worth. When you find out the movie is terrible, you should make a decision whether to sit through the bad movie or to do something more meaningful with your time – the price you paid for the ticket should not affect your decision. The ticket price is a sunk cost.
Another example of the sunk cost fallacy is paying for an all-you-can-eat buffet, eating until you’re full, and then going back for more just to get your money’s worth. When you are full, you should decide whether you want to eat more or to stop eating – the fact that you paid for unlimited food should not affect your decision. The price of the buffet is a sunk cost.
Sunk Costs Examples
Let’s say a company spent $5 million building an airplane. Before the plane is complete, the managers learn that it is obsolete and no airline will buy it. The market has evolved and now the airlines want a different type of plane.
The company can finish the obsolete plane for another $1 million, or it can start over and build the new type of plane for $3 million. What should the managers decide? Should they spend that last $1 million to finish up the plane that’s almost done, or should they spend the $3 million to build the new plane?
At first glance, you may think the company should just finish the old plane. It’s only another million bucks and they already spent $5 million. But in reality, the five million is irrelevant. It is a sunk cost. The only relevant cost is the $3 million dollars. The managers should consider whether or not to spend $3 million on the new plane, and nothing regarding the old plane should affect the decision.
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Now, let's delve into the article on strategic CFO concepts and accounting principles, specifically focusing on the topic of sunk costs:
Understanding Sunk Costs in Decision Making
Definition of Sunk Cost: A sunk cost is a financial outlay that has already been incurred and cannot be recovered. In accounting, it falls under the category of irrelevant costs. The fundamental principle is that, when evaluating a potential project or investment, managers should only consider relevant costs and disregard sunk costs.
Relevance of Costs: In decision-making scenarios, relevant costs are those directly tied to the decision at hand, while irrelevant costs are incurred regardless of the decision made. Sunk costs are inherently irrelevant and should not influence decision-making.
Sunk Costs Fallacy: The article introduces the concept of the sunk cost fallacy, where individuals make poor decisions by factoring in sunk costs. Examples, such as staying through a bad movie to get your money's worth or overeating at a buffet to maximize the cost, illustrate how people sometimes let sunk costs influence decisions.
Practical Examples: The article provides a business example: a company investing $5 million in building an airplane, only to find it obsolete before completion. The decision between spending an additional $1 million to finish the obsolete plane or investing $3 million in a new model demonstrates the application of sunk cost principles. The key takeaway is that the initial $5 million is a sunk cost and irrelevant to the decision-making process.
Application in Business: Understanding sunk costs is crucial in business scenarios. Managers must focus on relevant costs when deciding on projects or investments. In the given example, the relevant cost is the $3 million needed for the new plane, not the sunk cost of $5 million spent on the obsolete one.
This knowledge is vital for effective financial leadership, ensuring that decisions are based on pertinent financial information rather than being swayed by costs that are already incurred and irrecoverable.
In conclusion, the strategic CFO must navigate decision-making with a keen awareness of sunk costs, avoiding the sunk cost fallacy to make informed and financially sound choices for the organization's success.
