Sunk Costs

8 Key excerpts on "Sunk Costs"

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  eBook - PDF

  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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  Introduction to Economics

  Social Issues and Economic Thinking

  • Wendy A. Stock(Author)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  If people include Sunk Costs , their decisions will not be correct. Sunk Costs are costs that, once incurred, cannot be recovered. For example, suppose that you recently purchased a car for $25,000, but your job now requires you to relocate to another country and you are considering selling your car. The best price you have been offered for the car is $15,000. Should you sell it? The answer depends on whether you will derive more benefit from selling it than from not selling it, not based on the price you paid for it, since the $25,000 you paid is a sunk cost. A sunk cost is a cost that, once incurred, cannot be recovered. Sunk Costs are irrelevant when making decisions at the margin. Sunk Costs and Penny Auctions People make poor choices when they allow Sunk Costs to affect their decisions. Indeed, online auction sites like QuiBids, Skoreit, and beezid survive in part because their customers consider Sunk Costs in their decision making. Each time a user bids on an item, he or she must pay an average of $0.60. In addition, each bid made extends the length of the auction by a few seconds. As an item’s price rises, some customers think to themselves, “I don’t want give up on bidding on this item, since I’ve already spent $10 (or $20 or $50 . . .) bidding on it.” Because of this reasoning, users continue to bid on items because they don’t want to “lose” their Sunk Costs (which, in fact, are already lost and once placed have no influence on whether or not the user will win the auction). It is typical for items on penny auction sites to sell for 90 percent less than their retail price. How do the sites make money? As an example, when a $25 gift card sells for $2 after 100 bids are placed for the card, the auction site makes $60 on the bid charges, for a net profit of $37. Since thousands of items are auctioned this way every day, that’s a lot of sunk cost! Economics is the study of choices.

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  Advances in Management Accounting

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

    (Publisher)

  Our prior factory example saw substantial incurred Sunk Costs to build the plant, but the economic climate shifted after it was built. Managerial accountants would ignore the prior costs to build the factory and focus on the generated returns to warrant the company continuing this pursuit. But, internal decisions entail many factors, including government and employee 146 ALAN REINSTEIN ET AL. relationships. While the economic costs to build this factory are considered sunk, the company can lose more than its initial investment. Pulling out of the project could damage the company’s reputation with its employees who left other jobs to work in the new factory and cause employee morale costs, plus lost reputation with the government officials who helped negotiate for state tax breaks. In summary, given today’s various economic perspectives to assess Sunk Costs, we should use a multifaceted process to assess Sunk Costs to help decision makers optimally consider this critical matter. Committed Costs Next, to help resolve the decision usefulness related to the sunk cost conflict, management accounting could focus on reporting committed or unrecoverable costs: (a) investments already made that cannot be recovered by any means, and (b) relevant unavoidable obligations, a similar concept to Clark and Wrigley’s (1995) sunk cost classifications as (1) set up Sunk Costs, (2) accumu-lated Sunk Costs, and (3) exit Sunk Costs. These unrecoverable amounts present a more comprehensive estimate of costs to be ignored in assessing the economic implications of a decision at the margin. Moreover, including recoverable costs as part of committed costs can help clarify variously-applied sunk cost terminol-ogies. Reporting committed or unrecoverable costs could require routinely gathering and reporting information not presently available, which should pro-vide net benefits to decision makers.

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  Stranded Assets and the Environment

  Risk, Resilience and Opportunity

  • Ben Caldecott(Author)
  • 2018(Publication Date)
  • Routledge

    (Publisher)

  Behavioural understandings of the decision-making processes of investors and individuals have advanced since the 1990s when Clark and Wrigley were writing, and it is thus possible to shift from an institutional and organisational perspective towards one which emphasises the individual agency and biases which influence stranded asset- and sunk cost–related decision making. Rational economic theory understandings at the time of Clark and Wrigley suggested that investors should not consider Sunk Costs in decision making but instead only consider future costs relevant to the investment decision (Arkes and Blumer 1985). However, more recent evidence from empirical behavioural finance literatures suggests that this theory does not stand up to real-world behaviour and that Sunk Costs do, in fact, influence investor decisions because humans are prone to loss aversion and framing effects (Kahneman 2011; Sewell 2007). This is important, as assuming that investors are not fully rational, both expected (future Sunk Costs) and historic Sunk Costs can influence decision making, and stranded assets risks can therefore be argued to have a similar influence – with expectation and experience of stranding able to affect investment decisions. This can manifest itself in a tendency to continue an endeavour once an investment in money, effort or time has been made – the ‘sunk cost fallacy’ (Caldecott and Rook 2015; Friedman et al. 2007; Putten and Zeelenberg 2010; Mcafee et al. 2010). Such behaviour can also be linked to other biases and heuristics, including the endowment effect, status quo bias and loss aversion (Caldecott and Rook 2015; Kahneman and Tversky 1979; Kahneman et al. 1991). Importantly, this suggests that investors who have assets in their portfolios which have required previous Sunk Costs are perhaps more unlikely to divest from them regardless of the risk of asset stranding. This can be seen in the continued holding of oil and gas majors (and other carbon-dependent stocks) that have already suffered some stranding in the portfolios of institutional investors.

  Based on the original work of Knight (1921), it is assumed in this chapter that ‘risks’ refer to circumstances in which the probabilities that particular outcomes or consequences will occur in the future can be known. In contrast, ‘uncertainty’ reflects decisions for which probabilities cannot be known or estimated. Such definitions are an important factor in the distinctions between Sunk Costs and stranded assets. Generally, when investors are dealing with standard sunk cost decisions, they are dealing with risk, as they know that they will (sooner or later) face Sunk Costs. Stranded assets, however, could complicate such notions of Sunk Costs, as environmental change and the transition to a lower-carbon economy add more uncertainty into decision-making processes.

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  The StartUp Masterplan

  How to Build a Successful Business from Scratch

  • Nikhil Agarwal, Krishiv Agarwal(Authors)
  • 2022(Publication Date)
  • Business Expert Press

    (Publisher)

  One factor that should not influence such decisions except in special circumstances is the amount already invested in the venture known as past or, as I shall call them, Sunk Costs. Sunk Costs should be ignored because they cannot influence future outcomes. If this suggestion sounds absurdly wasteful, the following simple scenario will illustrate the point.

  Say you decide to turn your living room into a corner shop. The conversion costs are 30,000 dollars. The business generates an income of about 200 dollars for a 70-hour week. After two or three years, you begin to tire of the long hours and meager returns. If you closed the shop and took a job stocking supermarket shelves, you could earn 350 dollars for a 40-hour week.

  Assuming your goal is to maximize your income and quality of life, you would be 150 dollars a week better off working in the supermarket, and have a lot more free time. Moreover, it becomes obvious that the 30,000 dollars invested in the shop are irrelevant when you reframe the problem as a choice between earning 2.86 dollars per hour in the shop or earning 8.75 dollars per hour in the supermarket.

  The Sunk Cost Trap

  Intellectually, that decision makes itself. However, research by psychologists suggests that, emotionally, Sunk Costs can exert a powerful hold.

  Part of the problem of letting go of Sunk Costs is that we become riveted to the past. We become obsessed with what was rather than seeing and acting upon what now is. For instance, if you buy shares at 10 dollars each and the price falls to 80p, you may be unwilling to sell for less than 10 dollars because, as you see it, that is the correct price. In other words, the 10 dollars invested becomes the reference point for subsequent decisions.

  Researchers who studied bidding prices on the Internet auction site eBay discovered something interesting. They wanted to know whether setting a reserve price is a good idea. By analyzing large amounts of information, they discovered that sellers who dispensed with reserve prices and who started from very low bids tended to achieve higher prices than those who imposed a reserve price. The researchers inferred from their results that starting low without a reserve price creates a sunk cost

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  Micro Economic Analysis in Agriculture in 2 Vols

  • Kumar, K Nirmal Ravi(Authors)
  • 2021(Publication Date)
  • Daya Publishing House

    (Publisher)

  In the beginning, few people learn healthy habits in a yoga centre. These people, in turn, disseminate these healthy habits among the people within locality and outside the locality. So, this positive externality when added to the private benefit will lead to higher social benefits. 10. Incremental Costs and Sunk Costs The incremental costs are additions made to the existing costs due to changes made in the nature and level of business activity. For example, a sugar factory may incur incremental costs by adding or replacing the machinery, by changing the distribution network for sale of the product etc. That means, these costs can be avoided by not bringing about any change in the activity and hence, these costs are also called as Avoidable costs or Escapable costs. Moreover, these costs are additional costs resulting from a contemplated change and hence, they are also called as Differential costs. This ebook is exclusively for this university only. Cannot be resold/distributed. Sunk Costs are the costs that do not change by varying the nature or the level of the business activity. For example, all the past establishment costs in a sugar factory are considered as Sunk Costs because, any change in the business activity say, depreciation on machinery and the resulting incremental costs will have to take these preceding costs as given. So, Sunk Costs are mostly related to fixed (establishment) costs only. These Sunk Costs are also called as Non-avoidable or Non-escapable costs. Among these two costs, Sunk Costs are irrelevant for decision-making, as these costs do not vary with the changes made in the business activity. So, incremental costs are important for decision-making compared to Sunk Costs. It is important that, in most cases, incremental costs are variable, but not always. Say, for example, if the sugar factory desires to purchase tables, chairs, install electricity wiring etc., these incremental costs fall under fixed costs.

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  Handbook of Consumer Psychology

  • Curtis P. Haugtvedt, Paul M. Herr, Frank R. Kardes, Curtis P. Haugtvedt, Paul M. Herr, Frank R. Kardes(Authors)
  • 2018(Publication Date)
  • Routledge

    (Publisher)

  However, Soman and Gourville (2001) suggested that the sunk cost effect is moderated by the ambiguity inherent in a bundled transaction. For unbundled transactions, costs and benefits are directly linked with each other, resulting in a strong sunk cost effect. But for products obtained with a bundled price, the association between costs and benefits is open to interpretation and could result in a much weaker sunk cost effect. In the above example, Mr. B who bought the ticket in a bundled price will have weaker sunk cost effect and is less likely to go to the game.

  It is a widely held view that consumers consider historic, non-recoverable transaction costs (time, money, and effort) when deciding on a future course of action, a phenomenon called the “sunk cost effect.” For a mechanism of tracking Sunk Costs, Thaler (1985, 1999) argued that a consumer creates a “mental account” upon entering a transaction (e.g., making payment) and closes that account upon completing the transaction (e.g., consuming the good or service). By establishing a transaction-specific mental account, the consumer creates a psychological link between the costs and the benefits of a given transaction.

  However, recent research suggests that the identification and consideration of such costs may not be straightforward. For example, it is significantly more difficult to identify and consider the cost of a purchased product when that cost is incurred by credit card or check than by cash (Prelec & Loewenstein, 1998; Soman, 2001). Specifically, when consumers pay a bundled price for multiple products, the relationship between the costs and the benefits is one-to-many. In such a transaction, there is far greater ambiguity as to what costs are paying for what benefits. As a result, price bundling may lead to the psychological disassociation, or decoupling, of transaction costs and benefits so that the costs become less relevant to the consumption decision.

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  Managerial Accounting

  • James Jiambalvo(Author)
  • 2016(Publication Date)
  • Wiley

    (Publisher)

  In many cases, products or services may not appear to be profitable because they receive allocations of common fixed costs. But what will happen to the common costs if the product or service is dropped? They’ll be allocated over the remaining products and services. That may result in another prod- uct or service appearing to be unprofitable. Consider Mercer Hardware as an example. If the company had decided to drop garden supplies, the $80,000 of common fixed costs would have been allocated over tools and hardware supplies. The new allocation would be $6,000 higher for tools, and it no longer would appear profitable—it would show a $1,000 loss. But what will happen to the common costs if it’s dropped? That’s right, they’ll be allocated to hardware supplies. Before long, the store (which is currently profitable) would be out of business! Summary of Incremental, Avoidable, Sunk, and Opportunity Costs A number of costs terms have been used earlier, and in this section we briefly review them. Recall that the basic approach to decision making is to compare decision alterna- tives in terms of costs and revenues that are incremental. Costs that can be avoided by taking a particular course of action are always incremental costs and, therefore, relevant to the analysis of a decision. Costs that are sunk (i.e., already incurred and not reversible) are never incremental costs because they do not differ among the decision alternatives. Therefore, they are not relevant in making a decision. Students of managerial accounting often assume that fixed costs are equivalent to Sunk Costs and are thus irrelevant (i.e., are not incremental costs), but this is not always the case. Fixed costs may be sunk and, therefore, irrelevant. Fixed costs may not be sunk but still irrelevant. Finally, fixed costs may not be sunk and may be relevant. Examples of these three possibilities are presented in Illustration 7-10.

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