What is a sunk cost?

A sunk cost is a cost that was incurred in the past and cannot be undone. Since most transactions cannot be undone, most amounts spent in the past can be described as sunk. In other words, a past or sunk cost will be there regardless of what you decide to do today or in the future.

To illustrate a sunk cost, let's assume that a company spent $100,000 last year to purchase and install a machine. Today, a better machine is available for $80,000 and it will reduce expenses by $50,000 in each of the next 10 years. Now the old machine can be sold for just $10,000. When deciding whether to purchase the new machine, the $100,000 that was spent on the old machine is a sunk cost.

Basically the decision is whether to spend an additional $70,000 today ($80,000 minus $10,000) in order to save $50,000 each year for 10 years. (Current and future income taxes will also be relevant.) It may be difficult, but we need to exclude sunk costs from our decisions.