Sunk costs are those costs in the field of economics and business which are deemed non-recoverable once they have been experienced. Some people relate sunk costs to variable costs ad their incidence is dependent upon the undertaking of a certain action whereas others believe that it should be deemed a potential cost as it only occurs if and only if a certain action is undertaken. Now, if we look at the microeconomics, we see that only variable costs are considered to be the real relevant costs for a certain decision. This theory has been formulated by the basic notion that every executive business decision must be taken based on its value; a practice which would suffice to exist if sunk costs were allowed to play a pivotal role in the determination of business decision. Therefore, all business decision must be taken based on the cost/benefit analysis that is related solely to them and sunk costs of the business should not be taken as relevant costs for that specific business decision. Now, despite the fact that sunk costs do not affect the optimality condition of a rational decision maker, the actual process of the sinking of a cost can considerably affect this decision. This is because until a certain amount of supplies are essentially reserved for a specific process, the sunk cost becomes an unavoidable fixed cost as it has not been incurred till that point in time, which is why it becomes an essential part of the decision making process. (Bernheim et al, 2008)
Let us look at an example which will help explain sunk costs. Let us assume the existence of a hotel which bears the cost of $500 per night for providing a room to its customers. Out of this cost, $250 is the cost of rent that is appropriated to the room i.e. the total rent of the building divided by the number of rooms. $100 is appropriated to the fixed expenditures of the hotel e.g. staff wages etc and finally $150 is the marginal cost which is incurred for renting out a room to one additional guest; costs which include electricity laundry etc.
Now, if the hotel is only able to charge $250 per night, it would appear that a loss of $250 is being endured and the pragmatic decision for the hotel would be to shut down. However, in this case the relevant cost for renting out a room is only $150 as all the other costs have to be borne regardless of the activities of the hotel. Therefore, any price above $150 for a night’s stay in this hotel will secure economic profit for the hotel, and the $350 of the total cost is the non-relevant cost of the business as this comprises of the sunk costs of the business (assuming that the staff have to be paid their wages regardless of all circumstances).
In this light, the reluctance of investors to sell their securities in the market if the market price of their securities is less than the price they paid for is another case of misunderstanding of relevant costs. Once investors buy securities, then the money which was used for this purchase becomes a sunk cost. Now, the relevant decision that has to be made is not whether the current market price is greater than cost which was incurred at the purchase of the securities, but it is whether the investors would buy the same securities at the price which was offered in the market or not; a negation of which would ascertain the claim that the securities are indeed not valuable. (Graeme Pietersz, 2008)
The basic definition of relevant costs is those costs that alter in accordance with the decisions that are undertaken and implemented in an organization. Therefore, it becomes evident that only in hindsight or during the undertaking or a decision can costs be ascertained as being relevant or irrelevant; nothing can be demarcated in advance with regards to costs being relevant costs or not. Therefore, the most important action is the clear definition of the decision that has to take place. Arthur Schleifer Junior best explains this phenomenon when he says; “It is meaningless to discuss whether a cost or revenue is relevant or irrelevant unless a decision has been specified.”
Let us assume a hypothetical situation to better explain this case. For example, there is a fuel management company which wanted to increase its output of a specific type of fuel without increasing the capital base of investments, or changing the employment structure of the consumption. This decision only comes as a reaction to a hypothetical increase in the demand of this fuel. In this scenario, the fixed costs relevant to the refineries of the fuel management company become irrelevant and should be included in the comparison of the current situation of the company and the new hypothetical plan. Only the increased cost of purchasing the crude fuel before its refinement stays as a relevant cost in this decision. (Schleifer, 1991)
Bibliography
Bernheim, D. and Whinston, M. (2008) “Microeconomics”. McGraw-Hill Irwin, New York, NY
Pietersz, Graeme (2008) ‘Sunk Costs’ Web.
Schleifer Jr., Arthur (1991) “Relevant Costs and Revenues,” Harvard Business School Course Notes. Web.