What is Sunk Costs? Difference between Sunk Costs and Opportunity Costs.

Definition of Sunk Cost

Sunk Cost is a past cost which is already incurred and can not be recovered. In Financial Management, the sunk cost is treated as an irrelevant cost and is ignored to make any investment decision because it cannot affect the future decision.

When a company intends to take a new project, or Investment, the manager of the business only consider the Relevant-cash-flows and will ignore the irrelevant cost. (Sunk Costs). 

All sunk costs are fixed cost but all fixed costs are not sunk costs. Say, for example, Though Equipment is fixed costs, it cannot be considered as sunk costs because it has a resale value or returned at a determined price. Again, in case of a decision relating to the replacement of an Equipment, the written down value of the existing machine is a sunk cost and hence irrelevant to decision making.

Sunk Costs will be excluded from the future business decision because the cost will be the same regardless of the outcome of a decision. This cost is also known as past costs, embedded costs, prior year costs, sunk capital, or retrospective costs.

Examples of Sunk Costs

The Book Value of existing assets, such as Plant and Equipment, Inventory, Investments in the securities are the sunk costs. But, the possible benefits or losses arising from sale of any assets , the book value is not relevant for decision making regarding whether to use them or dispose them off.

Some accountant argued that sunk cost is the difference between the purchase price of a fixed assets and the net amount that could be realized from the the sale of assets.

For Example, If the book value of Plant and Equipment is $100,000 and the scrape value is $ 6,000, the sunk cost is $ (100,000-6000) = $ 94,000 but not $100,000. Hence, we can say sunk cost is the difference between book value and scrape value.

Difference Between Sunk Costs and Opportunity Costs

The major difference between Sunk Costs and Opportunity cost is, in the case of Strategic decision making for the future, the management of the company must not consider the sunk costs as it incurred in the past and cannot be recovered. However, the opportunity cost would be useful for selecting the best option for alternative options. Hence, Sunk Costs are irrelevant to decision making and Opportunity costs are an important part of decision making.