Fixed And Sunk Costs

12 Key excerpts on "Fixed And Sunk Costs"

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  Cost and Optimization in Government

  • Aman Khan(Author)
  • 2000(Publication Date)
  • Praeger

    (Publisher)

  For instance, let us say that it cost a government $7,500 to replace an old desk- top computer it bought some years ago with a state-of-the-art system. Assume that it cost the government an additional $ 1,500 for the time it lost when the system could not have been fully used. The replacement cost for the computer will, therefore, be 7,500+1,500 = $9,000. Replacement costs generally do not include the costs of repair BASIC COST CONCEPTS 3 and maintenance since they are considered part of normal wear and tear. In contrast, a sunk cost can be defined as the cost of a good acquired in the past that has no resale or salvage value. Thus, if the computer has no resale value (assuming it has become obsolete), but it cost the government $7,500 when first purchased, the sunk cost will be the entire amount of $7,500. The reason it is called a sunk cost because it is a cost that has occurred in the past and past costs, once incurred, cannot be changed. Fixed versus Variable Costs. A cost is considered fixed if it does not change, regardless of the quantity of goods produced (or services provided); that is, it is independent of any output quantity and is equal to some constant dollar amount. This is true for all fixed costs, but only in the short trun. In the long run, all costs are variable meaning that they do not remain fixed over a long period of time. Examples of fixed costs will include rent, interest payments on debt, and depreciation on structure and equipment. A variable cost, on the other hand, changes in direct proportion to changes in the quantity produced. It is fixed per unit of output, but varies in total as output level changes. To give an example, consider a case where the demand for a certain item used by a government increased by 10 percent from 50 units last year to 55 units this year.

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  Survival Math for Marketers

  • Peter C. Weiglin(Author)
  • 2002(Publication Date)
  • SAGE Publications, Inc

    (Publisher)

  That is why it is always a good idea to find out just what costs are and are not included in the burden calculations that are handed to you, rather than assuming that the number is unchangeable. Sunk and Avoidable Costs Sometimes all of this allocation gives us an inaccurate picture of what something is really going to cost us in dollars. Our decision-making process has to take into account how much some-thing may already have cost us, also stated as how much we have sunk into a project so far. If we are going to switch from Process A to Process Costs and Profitability 75 B, we calculate the costs of Process B. But a cost analysis of any possible shift must also include the decision of whether we are willing to write off the investment we have in Process A. Will going to Process B save enough money to offset that write-off? Sunk costs are sunk; they’re gone. The decision you are to make right now must be made on the basis of future costs and returns. Many com-panies have taken sunk costs into consideration, staying with Process A in our example because of all the money invested in it. There’s a technical term for that approach: throwing good money after bad. Another example of a sunk cost is an additional task to be assigned to an employee who is being paid for a minimum number of hours. It is pos-sible that no “extra” cash outlay is involved here, because with the mini-mum payment, that labor cost may have already been incurred, whether or not the additional task is performed. Similarly, if we stop doing something, the “allocated cost” breakdown is an unreliable guide to our real potential cost savings. Even if we drive our car fewer miles, we still have the monthly car payment. The only costs we avoid by driving less are gasoline, tolls, perhaps oil and some fluids, and some wear and tear on tires and other things. Those are the avoidable costs. Other, fixed costs remain, and these will then have to be reallocated over the lower number of miles driven.

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  Pushing the Numbers in Marketing

  A Real-World Guide to Essential Financial Analysis

  • David L. Rados(Author)
  • 1992(Publication Date)
  • Praeger

    (Publisher)

  If the latter, there is no problem. They can be included in the arithmetic or omitted without affecting the relative preference for course A over course B. If the former, they are costs created by a decision made in the past that can not be changed by What to Know About Costs 25 any decision that might be made in the future. A cost can become sunk even before any money passes hands. As soon as a cost can no longer be recalled, it is sunk. The classic examples are investments in plant and equipment. Once a machine is installed its cost is sunk, and management can do only two things with it: use it or sell it. Using it will generate revenues; selling it will generate revenues. Since these revenues will occur in the future, it is not too late; they are still subject to modification, to control. But costs al- ready spent can not be unspent or called back. Another example is the choice faced by the meat wholesaler: sell it or smell it. This line of thinking gives rise to the Sunk Cost Principle: Because sunk costs can not be changed, ignore them in making a decision. The admonition to ignore sunk costs is familiar to every business stu- dent, and is found in a number of folk sayings, which increases one's confidence in the soundness of the admonition: Don't cry over spilt milk, That's water over the dam, Don't throw good money after bad. The last is a rule for poker players ignored only by losers. Even Lady Macbeth understood, as when she tells Macbeth: Things without all remedy should be without regard; What's done is done. (Ill, ii) Yet for all its powerful logic, sunk cost is not congenial to the human soul. It did not console Macbeth. Few people discover it on their own, and those who supposedly understand it often ignore it or misapply it. One takes to heart the advice not to cry over spilt milk for only the most trivial losses. The reader can expect vigorous argument in business on the ques- tion of including sunk costs with other costs relevant to a decision.

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  Advances in Management Accounting

  • Mary A. Malina(Author)
  • 2017(Publication Date)
  • Emerald Publishing Limited

    (Publisher)

  RESOLVING THE SUNK COST CONFLICT Alan Reinstein, Mohamed E. Bayou, Paul F. Williams and Michael M. Grayson ABSTRACT Purpose Compare and contrast how the accounting, organizational behav-ior and other literatures analyze sunk costs. Sunk costs form a key part of the decision-making component of the management accounting literature, which generally include previously incurred and unrecoverable costs. Management accountants believe, since current or future actions cannot change sunk costs, decision makers should ignore them. Thus, ongoing fixed costs or previously incurred sunk costs, while relevant for matters of account-ability such as costing, income determination, and performance evaluation are irrelevant for most short-and long-term decisions. However, the organi-zational behavior literature indicates that sunk costs affect decision makers’ actions especially their emotional attachments to the related project and the asymmetry of attitudes regarding the recognizing of losses and gains. Called the “sunk cost effect” or “sunk cost fallacy,” this conflict in sunk costs’ underlying nature reflects one element of incoherence in contemporary accounting discourse. We discuss this sunk cost conflict from an accounting and a philosophical perspective to denote some ambiguities that decision usefulness and accountability introduces into accounting discourse. Methodology/approach Review, summarize and analyze the above literatures Advances in Management Accounting, Volume 28, 123 154 Copyright r 2017 by Emerald Publishing Limited All rights of reproduction in any form reserved ISSN: 1474-7871/doi: 10.1108/S1474-787120170000028005 123 Findings Managerial accountants can apply many lessons from the vari-ous literature sources. Originality/value We also show how differing opinions on how to treat sunk costs impact a firm’s decision-making process both economically and socially.

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  Accounting For Canadians For Dummies

  • John A. Tracy, Cecile Laurin(Authors)
  • 2019(Publication Date)
  • For Dummies

    (Publisher)

  For example, say that you want to increase the number of books that your business produces next year to increase your sales revenue, but the cost of paper has just shot up. Should you take the cost of paper into consideration? Absolutely — that cost will affect your bottom-line profit and may negate any increase in sales volume that you experience (unless you increase the sales price). The cost of paper is a relevant cost. Irrelevant (or sunk) costs are costs that should be disregarded when deciding on a future course of action; if brought into the analysis, these costs could cause you to make the wrong decision. An irrelevant cost is a vestige of the past — that money is gone. For this reason, irrelevant costs are also called sunk costs. For example, suppose that your supervisor tells you to expect a slew of new hires next week. All your staff members use computers now, but you have a bunch of typewriters gathering dust in the supply room. Should you consider the cost paid for those typewriters in your decision to buy computers for all the new hires? Absolutely not — that cost should have been written off and is no match for the cost you’d pay in productivity (and morale) for new employees who are forced to use typewriters. Generally speaking, most variable costs are relevant because they depend on which alternative is selected. Fixed costs are irrelevant, assuming that the decision at hand doesn’t involve doing anything that would change these stationary costs. However, a decision alternative being considered might involve a change in fixed costs, such as moving out of the present building used by the business, downsizing the number of employees on fixed salaries, spending less on advertising (generally a fixed cost), and so on

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  Accounting For Canadians For Dummies

  • Cecile Laurin, Tage C. Tracy, John A. Tracy, John A. Tracy(Authors)
  • 2023(Publication Date)
  • For Dummies

    (Publisher)

  Fixed versus variable costs If your business sells 100 more units of a certain item, some of your costs increase accordingly, but others don’t budge one bit. This distinction between variable and fixed costs is crucial: » Variable costs: Variable costs increase and decrease in proportion to changes in sales or production level. Variable costs generally remain the same per unit of product or per unit of activity. Manufacturing or selling additional units causes variable costs to increase in concert. Manufacturing or selling fewer units results in variable costs going down in concert. » Fixed costs: Fixed costs remain the same over a relatively broad range of sales volume or production output. Fixed costs are like a dead weight on the business. Its total fixed costs for the period are a hurdle it must overcome by selling enough units at high enough margins per unit to avoid a loss and move into the profit zone. (Chapter 15 explains the break-even point, which is the level of sales needed to generate enough margin to cover fixed costs for the period.) CHAPTER 16 Accounting for Costs 313 The distinction between variable and fixed costs is at the heart of understanding, analyzing, and forecasting profit, which we explain in Chapter 17. Relevant versus irrelevant costs Not every cost is important to every decision a manager needs to make — hence the distinction between relevant and irrelevant costs: » Relevant costs are costs that should be considered and included in your analysis when deciding on a future course of action. Relevant costs are future costs — costs that you would incur or bring upon yourself depending on which course of action you take. For example, say that you want to increase the number of books that your business produces next year to increase your sales revenue, but the cost of paper has just shot up.

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  Microeconomics in Context

  • Neva Goodwin, Jonathan M. Harris, Julie A. Nelson, Pratistha Joshi Rajkarnikar, Brian Roach, Mariano Torras(Authors)
  • 2022(Publication Date)
  • Routledge

    (Publisher)

  Table 16.3 shows that at 150 bushels of corn (the best the farmer can do), the farmer loses $35 per acre—total costs are $575, and total revenues are $540. Her other option is to not produce any corn. In this case, she will still have to pay her fixed cost of $500 per acre. She avoids having to pay any variable costs, but she also receives no revenues. So, her losses will be $500 per acre if she produces no corn.

  Obviously, it is better to lose only $35 per acre than to lose $500 per acre. By producing some corn, rather than none, she is able to more than cover her variable costs, recovering a large portion of her fixed costs as well. In other words, as long as she is able to cover her variable costs, in the short term it makes economic sense to continue production, even if losses are occurring.

  A surprising implication of this conclusion is that it does not matter how big the fixed costs are. As long as there is something left over, after variable costs are paid, to go toward paying the fixed costs—whatever they may be—the farmer should continue to produce corn. Whether the fixed costs are $500 per acre or $5,000 per acre does not matter. You can prove this to yourself by calculating that the farmer does better by producing 150 bushels of corn and losing $4,535 per acre than by not producing and losing $5,000 per acre. The same would be true even if fixed costs were $1 million per acre!

  This is a specific example of a more general economic principle concerning production decisions. Sunk costs should not affect short-run production decisions. A sunk cost is a cost that, in the short run, is the proverbial “water over the dam.” The expense has already been incurred (or committed to) and cannot be reversed.

  sunk cost: an expenditure that was incurred or committed to in the past and is irreversible in the short run

  This principle often seems to contradict common sense. Humans seem to have an economically illogical but psychologically strong tendency to want to make past investments “pay off.” And the larger the past investment, the more likely people are to be influenced by sunk costs. This is true not only of production decisions but also of economic behavior in general. This is yet another example of seemingly irrational economic behavior, as we discussed in Chapter 7 . Economics teaches us that when making decisions we should focus on what is the best decision for us now, based on marginal analysis, and that past investment is irrelevant. (For some examples of how sunk costs can influence economic behavior, see Box 16.2

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  Business Planning and Control

  Integrating Accounting, Strategy, and People

  • Bruce Bowhill(Author)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  Irrelevant costs are general overheads and other costs that do not change. Sunk costs Sunk costs are those that have already been spent or the commitment has been made to spend them. Sunk costs are not relevant to a decision. For example, assume that Richmond is considering introducing a new product. The product development manager has undertaken a costing exercise (shown in Figure 3.10), which suggests that the product should not be launched. [ 69 ] F U R T H E R D E C I S I O N -M A K I N G P R O B L E M S Re: Profitability of Product A From: Product Development Manager To: Managing Director An analysis of the profitability of product A suggests that it will lead to a loss of £7000 (see below). The recommendation is therefore to not proceed with the launch of the product. Profitability of product A £ £ Revenue (note 1) 40,000 Variable costs (note 2) 20,000 Lease of machine (note 3) 5,000 Overheads (note 4) 8,000 Market research (note 5) 5,000 Product development (note 6) 9,000 Total cost 47,000 Loss on product A (7,000) Note 1. Revenue based on estimated sales of 2000 units at £20 per unit. Note 2. Variable cost per unit estimated at £10. Note 3. A machine will need to be leased for £5000. Note 4. General overheads are allocated to projects on the basis of 20% of revenue. Note 5. The cost of the market research exercise carried out earlier this year. Note 6. £4000 on product development has already been spent and a further £5000 is committed. Figure 3.10 Memo from product development manager on profitability of product A The managing director has asked the accountant to critically examine these figures and this has been provided in Figure 3.11. From: Accountant To: Managing Director Re: Profitability of Product A The analysis by the product development manager does not provide a true picture of the impact on Richmond PLC if it decides to progress with the development and launch of product A. In his analysis, a number of irrelevant costs have been included.

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  Industrial Organization

  Contemporary Theory and Empirical Applications

  • Lynne Pepall, Dan Richards, George Norman(Authors)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  This cost measure does depend on output, hence its algebraic representation is AC(q). Formally, AC(q) = [C(q) + F]/q. We may also decompose average cost into its fixed and variable components. Average fixed cost is simply total fixed cost per unit of output, or F/q. Average variable cost AVC(q) is similarly just the total variable cost per unit of output, C(q)/q. Alternatively, average variable cost is just average cost less average fixed cost, AVC(q) = AC(q) − F/q. Technology and Cost 67 3. Marginal cost: The firm’s marginal cost MC(q) is calculated as the addition to total cost that is incurred in increasing output by one unit. Alternatively, marginal cost can be defined as the savings in total cost that is realized as the firm decreases output by one unit. 3 We now add a fourth key cost concept—sunk cost. Like fixed cost, sunk cost is a cost that is unrelated to output. However, unlike fixed costs, which are incurred every period, sunk cost is a cost that is only incurred prior to a specific date—often prior to the entry date. For example, a doctor will need to acquire a license to operate. Similarly, a firm may need to do market and product research or install highly specialized equipment before it enters a market. The cost of the license, the research expenditures, and the expenditures on specialized assets are likely to be unrelated to subsequent output, so in this sense they are fixed. More importantly, should the doctor or firm subsequently decide to close down, only part of these specialized expenditures will be recoverable. It will be difficult to sell the license to another doctor and certainly not at the price that the first doctor paid. Similarly, the research expenditures are unrecoverable on exit and it will not be possible to sell the specialized assets for anything close to their initial acquisition costs. For example, the kilns that are needed to manufacture cement have almost no alternative use other than as scrap metal.

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  Restaurant Financial Basics

  • Raymond S. Schmidgall, David K. Hayes, Jack D. Ninemeier(Authors)
  • 2003(Publication Date)
  • Wiley

    (Publisher)

  By this definition, “cost” is the same as “expense.” PROFIT MARGIN An overall measure of management’s ability to generate sales and control expenses; profit mar- gin is calculated by dividing net income by total revenue. Costs and Sales Volume One way to consider costs is to think about how they change when there are changes in the activity (sales) of the restaurant. Costs can be seen as fixed, vari- able, or mixed (partly fixed and partly variable). Fixed Costs. Fixed costs remain constant in the short run even when sales volume varies. For example, food sales may increase by 5% or beverage sales may decline by 10%; in both cases a fixed cost such as interest ex- penses remains constant. Figure 7.1 shows a graph that tracks costs and revenue volume. It shows that total fixed costs remain the same even when sales volume increases. Common examples of fixed costs include salaries, rent and insurance ex- pense, property taxes, depreciation expense, and interest expense. Fixed costs are sometimes classified as either capacity or discretionary. Capacity fixed costs re- late to the ability to provide goods and services. For a restaurant, capacity fixed costs relate to the number of seats in the dining area and include depreciation, property taxes, interest, and certain salaries. There is a quality dimension related to capacity fixed costs. For example, if the restaurant were to eliminate its air conditioning system, it could still serve the same number of guests, but at a lower level of service. 157 U N D E R S TA N D I N G C O S T C O N C E P T S A N D B R E A K - E V E N FIXED COSTS Costs that do not vary in the short term even when sales volume varies; examples include salaries and interest expense. CAPACITY FIXED COSTS Charges relating to the prop- erty or its capacity to pro- vide goods and services. Total Fixed Costs Per Unit Fixed Costs 0 Sales Volume Costs Figure 7.1 Total and Per Unit Fixed Costs

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  Cost & Management Accounting N5 SB

  TVET FIRST

  • T Lakhan(Author)
  • 2015(Publication Date)
  • Macmillan

    (Publisher)

  Think about a factory canning jam. All the cans of jam will go through the same processes until they are complete and ready for sale. Costs are accumulated per process. UNIT 1.5: UNIT, FIXED, AND VARIABLE COSTS Period costs A period is time related. Period costs are those costs that are related to a particular period rather than a particular product. In a manufacturing concern, non-manufacturing costs, for example, advertising costs, are regarded as period costs. These costs are written off in the Income Statement in the period in which they occur. 19 Product costs Product or production costs are those costs that are incurred in the manufacturing of a product. They are related to the products being produced. Product or production costs include direct materials, direct labour, and manufacturing overheads. Relevant and irrelevant costs Relevant costs are those costs that are relevant to a particular decision, for example, if a business is evaluating the cost of buying a new machine, the cost of installing that machine is a relevant cost. Irrelevant costs are those costs that are not relevant to a particular decision. For example, if a business is evaluating the cost of buying a new machine, the cost of annual rates and taxes is an irrelevant cost in relation to that decision. Avoidable and unavoidable costs Avoidable costs are those costs that may be saved by not adopting a given alternative, whereas unavoidable costs cannot be saved (Drury, 2004 p. 38). These are also referred to as relevant and irrelevant costs. Sunk costs Sunk costs are costs that have already been incurred in the past. These costs cannot influence or affect any future decision as the expense for these costs has already been deducted and therefore cannot be changed. Opportunity costs Opportunity cost is a cost that measures the opportunity (chance) lost or sacrificed when the choice of one course of action requires an alternative course of action to be given up (Drury, 2004 p. 39).

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  Hospitality Management Accounting

  • Martin G. Jagels(Author)
  • 2006(Publication Date)
  • Wiley

    (Publisher)

  However, the motel owner would happily endure this opportunity cost if net income from running the operation were greater than any potential rent income. A standard cost is what a cost should be for a given level of sales revenue or volume of business. The final three types of cost discussed in this chapter were fixed costs, variable costs, and semifixed or semivariable costs. Fixed costs D I S C U S S I O N Q U E S T I O N S 321 are costs that do not change in the short run, regardless of the volume of sales revenue (the general manager’s annual salary is an example). Variable costs are those that do vary in the short run and do so in direct proportion to sales rev- enue (food and liquor costs are two good examples of variable costs). Most costs, however, do not fall neatly into either the fixed or the variable category; they are semifixed or semivariable costs. To make useful decisions concerning fixed and variable costs and their effect on net income at various levels of sales, the semicosts must be divided into their fixed and variable elements. Three meth- ods were used to illustrate how this can be done. 1. The high–low method, although quick and easy to use, may give misleading results if the high and low sales periods selected are not truly representative of the costs in all periods. 2. The multipoint graph eliminates the possible problem built into the high–low method. The graph is subject to some element of personal judgment, but in most cases will give results that are close enough for most decision-making purposes. 3. Regression analysis, which is the most accurate method, involves quite a number of calculations and can probably best be used as a spot check on the results of using one of the other two methods. D I S C U S S I O N Q U E S T I O N S 1. Differentiate between a direct cost and an indirect cost. 2. Define discretionary cost and give two examples (other than those given in the text).

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