What are sunk costs in accounting?
February 16, 2013
Learn about sunk costs and how they impact investment decision-making.
You are probably familiar with an expression “It’s no use crying over spilled milk.” Sunk costs essentially represent the same idea.
Sunk cost is a cost that has already been incurred and will not be changed or avoided in the future.
In other words, sunk costs are costs that have already been recorded. In accounting, sunk costs represent costs that have already been incurred and will not require current or future cash expenditures. Because sunk costs cannot be changed or avoided in the future, they are not relevant for decision making purposes.
That is, when evaluating multiple alternatives, sunk costs should not be considered. Sunk costs are unavoidable and do not matter at that point. It might be somewhat counterintuitive for many people.
For example, let’s assume you bought a non-refundable bus ticket to get to work. Near the bus station, you meet your colleague who offers you a free lift to the office. You can either go by bus (i.e., you already have a ticket you paid for) or go with the coworker. No matter how much you have paid for the bus ticket, you have already incurred that cost – it’s a sunk cost and should not influence your decision. You should consider other factors when deciding between the methods of transportation: for instance, whether you can get faster to work by car, whether you would like to spend time talking to your colleague, etc.
An example of sunk costs in accounting is the book value of existing assets such as fixed assets (e.g., machinery, equipment), inventory, investments, etc. Depreciation, amortization, and impairments also represent sunk costs. For example, let’s assume company ABC purchased equipment for $10,000 with an expected useful life of 10 years (i.e., using straight-line depreciation, the company will recognize a $1,000 depreciation expense each year). After using the equipment for 8 years, the company decided to scrap it. The equipment is worth zero. The remaining book value is $2,000 (i.e., $10,000 – 8 x $1,000). Asset write down (i.e., loss) represents a sunk cost. Even if the company continued using the equipment for the next two years, the remaining $2,000 would still need to be “written” off as a depreciation expense. In any case, the cost of the equipment was incurred in the past, and the company cannot change its original cost now or in the future.
Important to note, sunk costs do not have to be fixed in nature. Variable costs that have been incurred in the past and cannot be changed or avoided in the future still represent sunk costs. That is, for decision making purposes fixed costs are not necessarily irrelevant (unavoidable) and variable costs are not always relevant (avoidable).
For instant, let’s assume Company XYZ invested in a construction project initially estimated to cost $150,000 (including both fixed and variable costs). After the company has already incurred $70,000 in construction costs, a different contractor offers to do the project for only $100,000 (vs. $150,000). Should the management of Company XYZ take the offer? Though at first it seems appealing to take the offer, the management should not accept it because it will cost the company more to use the services of the second contractor. The company has already paid $70,000 (i.e., sunk cost), and using its current contractor, it can finish the project for $80,000 (not $100,000). The company probably should have done more “contractor-shopping” before-hand, but at this point it does not make sense to accept the new offer.
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