![]() The ticket price is a sunk cost.Īnother example of the sunk cost fallacy is paying for an all-you-can-eat buffet, eating until you’re full, and then going back for more just to get your money’s worth. When you find out the movie is terrible, you should make a decision whether to sit through the bad movie or to do something more meaningful with your time – the price you paid for the ticket should not affect your decision. The sunk cost fallacy is when someone considers a sunk cost in a decision and subsequently makes a poor decision.Īn example of the sunk cost fallacy is paying for a movie ticket, finding out the movie is terrible, and staying to watch anyway just to get your money’s worth. A sunk cost, however, is always an irrelevant cost. A cost may be relevant to one decision and that same cost may be irrelevant to another decision. Whether a cost is relevant or irrelevant depends on the decision at hand. A sunk cost is not a relevant cost for decision making. When a manager is considering a particular decision, relevant costs are the costs that are incurred if the decision is made and irrelevant costs are the costs that are incurred whether or not the decision is made. When facing a potential project or investment, a manager must only consider relevant costs and ignore all irrelevant costs. In accounting, a sunk cost is a type of irrelevant cost. What is sunk cost? A sunk cost is a cost that has been incurred and cannot be recovered. Ten In-House Secrets for Reducing Your Company’s Legal CostsĬapital Budgeting Methods Sunk Cost Definition If the firm decides to build the new plant they will end up with a new, more efficient plant, they will be under budget by $2 million despite having to build two plants and will be able to recoup the capital costs of the construction quicker with the new plant.Sunk costs: How should they affect your future business decisions? The $20 million spent on the original plant is gone no matter what course of action the firm takes. This seems like a huge loss but because the new plant design is more efficient, the company can maximize their profit, save overall cost as the new plant is $2 million less than what is required to finish the current one, and the construction time is the same as the current plant. The firm should stop construction of the current plant and begin construction on the new plant (assuming the current plant cannot be sold or re-purposed). Since the beginning of construction, steam turbine technology and the overall efficiency of natural gas plant design has greatly improved and the firm can build a new plant for $11 million and can be constructed in one year. 3 years in, the construction has cost $20 million and needs $13 million more to be completed. Suppose a natural gas provider is 3 years into a 4 year construction project of a new plant. Therefore any decision made after they are lost should be made without sunk costs in mind. Regardless of any action taken, sunk costs are lost no matter what. This is the mistake of allowing sunk costs to affect the decision of whether or not to carry on a business when faced with a potential exit from the market. If the standard pipe is 1 m diameter and all the fixtures are made to fit the standard diameter, then the specialty pipe will become a sunk cost because it is specific to a use and cannot be bought by other companies and easily installed into standard size projects. If a pipeline company goes out of business and had a stockpile of specialty 0.75 m diameter pipe that was designed for a project which fell through, the firm will try to sell the stockpile. These assets are called specific capital, this is capital which cannot be easily transferred. If an asset cannot be sold or re-purposed easily then it will become a sunk cost. Firms must consider this when entering into contracts which might restrict their flexibility in the future. If the firm stops producing and wants to sublet their space to another firm they might be restricted by their contract from doing so and in which case, the firm will incur the rental cost that cannot be offset by production. Ī sunk cost is a cost that has been paid and it cannot be recovered, it is a fixed cost that is unavoidable. The opposite of a cost is a benefit and often both are considered together, for example, net cost is the difference between gross costs and benefits. Costs are defined in a variety of ways and under a variety of assumptions that affect their value. In economics, all resources are valued at their opportunity cost, which is the value of the alternative use of the resources. ![]() A cost is what a firm, an individual or society pays to produce or consume goods and services, it is the consumption of resources such as labour time, capital, materials, fuels, etc.
0 Comments
Leave a Reply. |
AuthorWrite something about yourself. No need to be fancy, just an overview. ArchivesCategories |