Fixed Cost vs Sunk Cost
Sunk costs and fixed costs are two types of costs that a business incurs in the various business activities carried out. While sunk costs and fixed costs both result in an outflow of cash, sunk costs and fixed costs are quite different in terms of the manner in which they are incurred and the timing in which each types of costs are borne. The article explains with examples what fixed costs and sunk costs are and highlights the similarities and differences between the two.
What are Sunk Costs?
Sunk costs are expenses that have already been incurred or an investment that has already been made and cannot be recovered. Sunk costs or expenses that were incurred earlier and cannot be undone or recovered in any manner should not be used as a basis for making future decisions regarding a project or investment. However, more often than not investors and businessmen take sunk costs into consideration in making future decisions. A simple example of a sunk cost is, you purchase a ticket to watch a concert for $30, but you have some emergency and are unable to make it to the show. The $30 is a cost that you have already incurred and cannot recover, and it is referred to as a sunk cost.
In terms of a firm, research and development costs are referred to as sunk costs as there is no way in which these costs can be reversed or recovered. Taking an example, company ABC has spent a large sum of funds on a specific R&D project, but it has, however, not yielded any results. The company ABC can choose to consider the investment in the project as a sunk cost and move on to a new research project, which is the smarter thing to do as it is likely to yield better results. However, if the firm takes into consideration the sunk cost incurred, it may decide to continue research on the same project in the hope that further research to yield expected results (and thereby mean that funds already spent did not go to waste). However, it may lead to even higher losses.
What are Fixed Costs?
Fixed costs are costs that remain constant regardless of the levels of production. Examples of fixed costs are rental costs, insurance expenses, and cost of fixed assets. It is important to note that fixed costs are only fixed in correspondence to the quantity produced in the current period of time, and do not remain fixed for an indefinite period, since costs increase over time. The production of 10,000 cars incurs a fixed cost of $10 million each month to maintain the production facility, regardless of whether the full capacity is produced or not. In the scenario where the firm wants to increase its production to 20,000 units, more equipment and a bigger factory have to be bought. The disadvantage of fixed costs is that even during the times of lower production levels the firm still have to incur the high fixed costs.
What is the difference between Sunk Costs and Fixed Costs?
Fixed costs and sunk costs are similar to one another in that they are both costs that result in an outflow of cash. However, there are a number of differences between the two. A sunk cost is an expense that has already been incurred or an investment that has already been made and cannot be recovered. Fixed costs are costs that remain constant regardless of the levels of production. While sunk costs are costs that were incurred in the past, fixed costs are costs that are currently being incurred. It is possible that a sunk cost maybe a fixed cost in nature. Which means that a cost that was incurred as a fixed cost could turn out to be a sunk cost. For example, the fixed expense incurred for the purchase of a piece of machinery may become a sunk cost if the firm runs out of business and needs to shut down.
Summary:
Sunk Costs vs Fixed Costs
• Fixed costs and sunk costs are similar to one another in that they are both costs that result in an outflow of cash.
• A sunk cost is an expense that has been incurred or an investment that has already been made and cannot be recovered.
– A simple example of a sunk cost is you purchase a ticket to watch a concert for $30. However, you have some emergency and are unable to make it to the show. The $30 is a cost that you have already incurred and cannot recover.
• Fixed costs are costs that remain constant regardless of the levels of production.
– An example of fixed costs is the production of 10,000 cars that incurs a fixed cost of $10 million each month to maintain the production facility, regardless of whether the full capacity is produced or not.
• While sunk costs are costs that were incurred in the past, fixed costs are costs that are currently being incurred.