A sunk cost is that which has been incurred or committed in the past and is, therefore, irrelevant to the decision-making purpose because the decision-maker no longer has discretion over that.
For example, if a company purchased new machinery without a warranty that failed the next day, the purchase price is irrelevant to the present decision to replace or repair the machine. Only future costs are relevant and the purchase price of recently bought machinery does not affect future costs.
The reason that the recorded and book values and the depreciation amounts are sunk costs is that they have already been incurred. Depreciation represents the conversion of the capital expenditure into periodic expenses to be charged against revenues. They are not inherently relevant to future decisions. As tax-deductible business expenses, however, depreciation may become relevant. The tax effects of depreciation will be considered in capital budgeting decisions.
Although sunk costs are normally considered to have already been incurred, there is another category of costs that should be considered as sunk costs for practical purposes. Those costs that have not yet been incurred, but have been irrevocably and irreversibly committed by management, have the practical characteristics of sunk costs. For example, a contractual commitment for a future expenditure that involves compliance with a law, the violation of which would result in jail terms for corporate officers, should be considered a sunk cost. Even though it has not already been incurred, the cost commitment is irrevocable and irreversible in a practical business sense.
Impact of Sunk Cost on Decision-Making
Sunk costs should not influence decision-making because they represent costs that have already been incurred and cannot be recovered. Focusing on sunk costs can lead to irrational decision-making, as future decisions should be based on prospective costs and benefits rather than past expenses.
An important additional issue related to sunk costs must be considered. There is apparently an inherent bias for decision-makers to include sunk costs as relevant to the analysis. Studies by psychologists Kahneman and Tversky found that decision-makers are willing to invest money to “recover” sunk costs than to invest the money to earn the same net return.
Similarly, a study by Whyte found that decision-makers tend to escalate commitment to sunk costs. The practical implication of these findings is that management accountants must be particularly careful to develop information for decision-makers that separates sunk costs from differential future costs.