Sunk cost

Sunk costs are past costs that have been incurred and cannot be recovered or reversed. Sunk costs are also known as stranded costs. Sunk costs are concerned with the price paid for an asset, and not with any losses that result from the difference between the original purchase price and the price that the asset is sold for at a later date. Sunk cost are costs that do not exist until a purchase is made, making it important to assess the potential of the purchase to deliver the satisfaction sought by the consumer.  For example a worn-out piece of equipment that has been bought several years ago is a sunk cost because the cost of buying it cannot be reversed.

Sunk costs are contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken. Both the sunk cost and prospective costs may be either fixed i.e. they are not directly dependent on the volume of economic activity, however measured or may be variable (dependent on volume).

Sunk costs can be explained with an example. Consider a person purchasing tickets for a sporting event. The ticket for the event carries a specific price that must be paid in order to attend the event. In this case the prospective buyer may consider the prospective cost in the form of the price of the tickets, and then makes a decision on whether or not to actually make the purchase. If the person considers proceeding with the purchase, the amount of money paid for those tickets represents a sunk cost.

The concept of sunk costs is irrelevant to financial decisions. Many people feel instinctively that because an investment has been made it is necessary to get a return on it. People can reject one course of action in favor of another that actually generates smaller cash flows. This happens in the case of business, portfolio investment and personal decisions.

Questions

• What is a sunk cost?
• How are sunk costs contrasted to the prospective costs? Explain with an example.