Definition of 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 are sunk. A past or sunk cost will be there regardless of what is decided today or in the future. Expressed another way, since we cannot undo the past, every decision will affect only today and/or the future. As a result, the relevant costs and benefits for making a decision are the current and future costs.
Unfortunately, we do not find the future costs in a company’s general ledger. At best, those past/sunk costs may help us determine the relevant current and future costs and potential income tax benefits.
Example of a Sunk Cost
Assume that a year ago a company spent $100,000 to purchase and install a new machine. Today, a robot became available for $80,000 and it is expected to reduce expenses by $50,000 in each of the next 10 years. Today, the one-year-old machine can be sold for just $10,000. In the decision whether to purchase the robot, the $100,000 spent on the one-year-old machine is a sunk cost.
Ignoring any income tax consequences, what is relevant for the decision on purchasing the robot is whether to spend an additional $70,000 today (the $80,000 cost of the robot minus the $10,000 to be received from the old machine) in order to save $50,000 each year for 10 years. It may be difficult to accept that $100,000 was spent a year ago, but spending an additional $70,000 today to earn (reduce expenses) $50,000 each year for 10 year is really a simple decision.
