Sunk Cost -

A sunk cost is a cost that an entity has incurred, and which it can no longer recover by any means.

Sunk costs should not be considered when making the decision to continue investing in an ongoing project, since you cannot recover the cost. However, many managers continue investing in projects because of the sheer size of the amounts already invested in the past. They do not want to "lose the investment" by curtailing a project that is proving to not be profitable, so they continue pouring more cash into it. Rationally, they should consider earlier investments to be sunk costs, and therefore exclude them from consideration when deciding whether to continue with further investments.

An accounting issue that encourages this adverse behavior is that capitalized costs associated with a project must be written off to expense as soon as the decision is made to cancel the project. When the amount to be written off is quite large, this encourages managers to keep projects running.

Examples of Sunk Costs

Here are several 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.

Training. 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 joint 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.

Similar Terms

A sunk cost is also known as a stranded cost.

What is an irrelevant cost?

An irrelevant cost is a cost that will not change as the result of a management decision. However, the same cost may be relevant to a different management decision. Consequently, it is important to formally define and document those costs that should be excluded from consideration when reaching a decision.

For example, the salary of an investor relations officer may be an irrelevant cost if a management decision relates to issuing a new product, since dealing with investors has nothing to do with that particular decision. However, if the board of directors is considering taking the company private, then it may no longer need an investor relations officer; in the latter case, the salary of the investor relations officer is highly relevant to the decision. As another example, the rent for a production building is irrelevant to the decision to automate a production line, as long as the automated equipment is still housed within the same facility.

Non-cash items, such as depreciation and amortization, are frequently categorized as irrelevant costs for most types of management decisions, since they do not impact cash flows.

Sunk costs, such as the purchased cost of a fixed asset that was incurred in a prior period, are also usually considered irrelevant when making decisions on a go-forward basis.

In accounting, what is meant by relevant costs?Relevant costs are those costs that will make a difference in a decision. Relevant costs are future costs that will differ among alternatives.

We can demonstrate relevant costs with the following situation. A company is deciding whether or not to eliminate a product line. The product line accounts for approximately 4% of the company's activities. If the product line is eliminated, the officers of the corporation will continue to receive the same salaries and the central office expenses will not change. The product line managers and other employees working directly on the product line will be terminated. Hence, their salaries will be eliminated.

The salaries of the product line managers and other employees whose salaries will be eliminated are relevant to the decision. If these salaries are $700,000 with the product line and $0 without the product line, the $700,000 of savings is relevant. Those cost savings and other possible cost savings will be considered along with the loss of sales revenues.

On the other hand, the officers' salaries are not relevant in the decision. In other words, it doesn't matter if the officers' salaries are $500,000 or $5,000,000. The officers' salaries will be the same with or without the product line. Similarly, the decision maker does not need to know the amount of its central office expenses, since they will be the same with or without the product line. Expenses from previous years are also irrelevant.

To recap, relevant costs are the future costs that will differ among alternatives. You might use the past costs to help you predict those future costs, but the past costs are otherwise irrelevant to the decision. Accountants refer to the past costs as sunk costs.

What is a relevant cost?A relevant cost is a cost that only relates to a specific management decision, and which will change in the future as a result of that decision. The relevant cost concept is extremely useful for eliminating extraneous information from a particular decision-making process. Also, by eliminating irrelevant costs from a decision, management is prevented from focusing on information that might otherwise incorrectly affect its decision.

This concept is only applicable to management accounting activities; it is is not used in financial accounting, since no spending decisions are involved in the preparation of financial statements.

For example, the Archaic Book Company (ABC) is considering purchasing a printing press for its medieval book division. If ABC buys the press, it will eliminate 10 scribes who have been copying the books by hand. The wages of these scribes are relevant costs, since they will be eliminated in the

future if management buys the printing press. However, the cost of corporate overhead is not a relevant cost, since it will not change as a result of this decision.

The reverse of a relevant cost is a sunk cost. A sunk cost is an expenditure that has already been made, and so will not change on a go-forward basis as the result of a management decision.