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In accounting, finance, and economics, all sunk costs are fixed costs. However, not all fixed costs are considered to be sunk. The defining characteristic of sunk costs is that they cannot be recovered. It’s easy to imagine a scenario where fixed costs are not sunk; for example, equipment might be resold or returned at the purchase price.
Individuals and businesses both incur sunk costs. For example, someone might drive to the store to buy a television, only to decide upon arrival not to make the purchase. The gasoline used in the drive is a sunk cost—the customer cannot demand that the gas station or the electronics store compensate them for the mileage.
Also, the sunk cost expenditure should not be a factor in determining whether or not to spend more money. In the previous example, just because the customer already spent the money on gas to get to the store should not be considered when deciding on buying the television or not.
Key Takeaways
- All sunk costs are fixed, but not all fixed costs are considered sunk. While sunk costs cannot be recovered, fixed costs can often be stopped or recouped, such as through selling or returning an asset.
- Sunk costs can occur in everyday activities and business operations. For example, the fuel used to drive somewhere, even if the purchase is not made, is a sunk cost because it’s already spent and irrecoverable.
- Businesses need to focus on fixed and sunk costs as they directly affect profitability. However, it’s crucial for financial decision-making to ignore sunk costs since they cannot be changed and should not influence future spending decisions.
- In financial accounting, a cost becomes sunk once it has occurred and cannot be altered or avoided. This concept helps businesses make objective decisions without being influenced by past expenses.
- Some variable costs can become sunk once they are incurred and cannot be recovered. When this happens, they essentially become fixed in economic terms, despite originally being variable.
Understanding the Impact of Fixed and Sunk Costs on Businesses
Businesses generally pay more attention to fixed and sunk costs than individual consumers, as the numbers directly impact a company’s profits. For businesses, fixed costs include anything that must be paid for production to occur, yet they remain the same whether production is high or low.
For example, the rent on a factory is a fixed cost as it does not change as output changes. If a company produced 100 widgets or 10 widgets, the fixed cost of rent for a factory would be the same. The cost does not change with a change in output.
In financial accounting, sunk costs must have already occurred, and they cannot be changed or avoided in the future. This does not apply to rental equipment; rental costs are only fixed until the renter decides to discontinue use.
Costs are considered sunk even if an item is never completely used. Suppose a company, SMR Producers, purchases a machine for $5,000 with an expected useful life of five years. Using straight-line depreciation, the company should recognize $1,000 in depreciation expense per year. If, after three years, the company gets rid of the machine, the remaining book value, $2,000, must be written off. Even though only $3,000 worth of accounting use came from the machine, the full $5,000 was initially paid and is considered sunk.
It is generally advised to ignore sunk costs, as nothing can be done about them in the future. This is particularly applicable in deciding on whether to continue spending on a specific project. Only a relevant cost should be considered, not a cost that has already been made and cannot be altered. It’s important to take this viewpoint when determining if one should cut their losses in any investment or project.
How Variable Costs Become Sunk Costs
In a certain sense, some sunk costs begin as variable costs. Once a variable cost is incurred and cannot be recovered, however, it becomes fixed in sunk terms. By definition, $1,000 worth of variable costs are sunk if they cannot be recovered; once incurred, the realized sunk costs become fixed. It cannot be changed.
The Bottom Line
Sunk costs and fixed costs are two different types of costs. A sunk cost is always a fixed cost because it cannot be changed or altered. A fixed cost, however, is not a sunk cost, because it can be stopped, for example, in the sale or return of an asset.
