Distinguish between a traceable cost and a common cost.
Chapter 2 DB Topic #3 – SUNK COSTS (Zuiderweg, Donna)
Our textbook describes a sunk cost as a “cost that has already been incurred and that cannot be changed by any decision made now or in the future” (p. 42). I recently heard an explanation of a sunk cost that really helped me understand this concept better since I’m an avid live music fan. The explanation was this: if you buy a non-refundable (and these days, also possibly, non-transferable) concert ticket four months before the concert and then the evening of the concert you’re sick and you’re trying to decide whether you should drag yourself to the concert or stay home in bed, you can comfort yourself with the decision to stay home by the fact that the concert ticket is a sunk cost. It was paid for and the money has been spent whether you go to the concert (and are miserable) or you stay home. The outcome is the same. The money is gone. The cost was sunk four months before the event.
I’ve recently been thinking about sunk costs a lot in the context of some decisions I have to make at work. For instance, we are planning a big fundraising event in June and a portion of the event is to be held outside. We are working on back-up plans in case of different weather events. My team wants to order 400 umbrellas to have on hand in case of light rain. (In addition to a desire to be well prepared in any circumstance, my team members are also superstitious and believe that if we have the umbrellas it’s insurance against rain.) It’s a $2,000 expense that will be charged to the event budget and will be sunk as soon the purchase is made. It’s not an outrageous amount of money but every dollar we spend decreases our event net-profit and also, what do I do with 400 umbrellas if there is no rain?
According to our textbook, once the cost is sunk it should no longer be relevant to later decision making. So for me, once we buy the umbrellas, I should no longer consider that cost when we decide whether or not we use them. Though I understand the rationale behind this, I do find the psychology of sunk costs very interesting. We are prone to continuing time, money, resource investments in situations where we would be best served by terminating our investment and chalking up the expenses as sunk costs and not relevant to future decisions. For instance, before understanding the concert sunk cost scenario, I would have been prone to dragging myself to the concert even though I wouldn’t have enjoyed it and would have been best served to stay home in bed to recover. I would have dragged myself to the show because I wouldn’t have wanted to “waste” the money that was already gone.
Noreen, E., Brewer, P. & Garrison, R. (2014). Managerial accounting for managers (4th ed.). New York, NY: McGraw-Hill.