Reviewed by Oct 05, 2020| Updated on
A sunk cost applies to money previously invested and not recoverable. In any industry, the axiom that one must "spend money to make money" is expressed in the sunken cost phenomenon.
A sunk cost varies from the potential costs that a company may face, such as decisions about the cost of purchasing inventories or pricing of goods. Sunk costs are removed from possible business decisions because, regardless of the result of a decision, the cost will remain the same.
Organisations must consider current/relevant costs when making strategic decisions that include the future costs that need to be incurred. The relevant costs are compared to the revenue contribution of two different choices. A sunk cost is not considered because they do not alter one's choice.
For instance, a manufacturing company may have a variety of sunk costs, such as machinery costs, equipment costs, land and factory lease expenses. Sunk costs are excluded while calculating the cost of deciding between a further sell or a buying process.
Assume that ABC Private Ltd manufactures cricket bats. It was charged Rs 1,00,000 a month for factory lease, and Rs 10,00,000 for the machine that was bought outright. The company makes Short Handle (SH) cricket bats which cost Rs 2,500 per bat and sell for Rs 3,199 per bat.
The manufacturer can, therefore, sell the basic SH cricket bat and receive a profit of Rs 700 per bat. Instead, it can proceed to introduce enhancements worth Rs 150 per bat in costs and sell the premium SH cricket bat for Rs 3,399 per bat.
The organisation must compare the extra Rs 150 expense to the revenue gained by Rs 200 to decide whether to proceed with enhancements. The sale of premium SH cricket bats will gain Rs 50 more profit per bat.
The costs of operating the plant and equipment are both sunken costs and not part of the decision-making process. When, at some stage, a sunk cost can be reduced, it is an acceptable expense which should be part of business decisions on future events.