January 29, 2022


Accounting + Finance Blog

Meaning of Sunk Cost and Key Explanations

Meaning of Sunk Cost and Key Explanations

Certain costs are useful for decision making. Others can be used for measurement purposes and historical accounting. In business, when making decisions only costs and revenues that are not past costs are important to it. Past costs including sunk cost are not necessary to make alternative choices. Let us examine sunk cost in this article.

Definition — What is Sunk Cost

A type of cost that has been spent by an entity in the past and cannot be recovered. It can also be defined as the cost which a firm has incurred but cannot be used by the management for decision making. Individuals and firms ensure that sunk cost is not considered in a project especially when calculating a project discounting cash flow (DCF).

Read: Cost classification: Period cost

Key Explanations

Already incurred cost. Sunk cost has already been incurred by the entity. It is as a result of a previous decision made by management of an entity. Therefore, we might say what’s sunk cost now was formally future cost.

A type of cost. Under this category, we have discussed the elements of cost. Avoidable and abnormal expenses were explained. Sunk expenses behave like irrelevant costs. This is so as the expense is not necessary in making future decisions by management.

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It can’t be recovered. The expenses cannot be recovered. For example, if an individual spent money to buy a TV set. Upon buying it, he notices that he actually needs a solar panel for his business. Well, the TV set has been bought and the money cannot be recovered.

Discounted Cash Flow Calculation. In calculating Discounted Cash Flow (DCF), the sunk cost is totally omitted. Only expenditure that will affect the current investment is considered. A firm that has invested say 80 percent on a new product only to discover that the product is no longer in vogue because of a legal ban on it.

The amount spent on that product cannot be recovered. Also, the expenses incurred are not required for future economic decisions. Furthermore, the business’s management will only consider current projects.

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Why Sunk Cost is Important

This expense is important to individuals and entities. To an individual, it helps him or her to know where to base his decision. A past cost should not be considered in making a present decision. There is no need to be bothered about what has gone. The person needs to focus on current expenditure.

Read: Five Principles of a good cost accounting information system

An entity’s management should let bygones be bygones. If a project cannot meet stakeholders needs, then, wasting further resources on it wouldn’t be necessary. Instead, the focus should be on current projects that will yield results.

Accounting Treatments for Sunk Cost

When a project becomes bad, the normal accounting treatment is capitalized such costs and a write-off made in the profit or loss account. Where it is not advisable to write-off the expenditure at a time. A decision will be agreed on to allocate a portion of the cost to profit or loss account on a yearly basis.

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Finally, sunk cost is not a required cost. It has been incurred and cannot be recovered by the entity or individual. It is advisable not to focus on this type of expense. But future cost should not be the important factor. In accounting, such expenditure is written off to the profit or loss account.