Sunk Cost vs Relevant Cost
Sunk costs and relevant costs are two distinctive types of costs that firms frequently incur in the running of businesses. Sunk costs and relevant costs both result in an outflow of cash and can reduce the firm’s income and profitability levels. Despite the fact that they both incur a cost to the firm, there are a number of major differences between sunk cost and relevant cost, in terms of the timeline in which each is incurred, and the impact that they have on making future decisions. The article clearly explains the concepts of sunk cost and relevant cost and highlights the similarities and differences between the two.
What is Sunk Cost?
Sunk costs refer to expenses that have already been incurred and arose as a result of decisions taken in the past. Sunk costs are a type of irrelevant cost. Irrelevant costs are costs that do not influence managerial decision making as they are a thing of the past. Since these costs and investments have already been made they cannot be reversed or recovered, and irrelevant costs such as sunk costs should not be used as a basis for making future decisions regarding a project or investment.
A simple example of a sunk cost is: a company purchases a software program for $100. However, the program does not work as the company intended to use it, and the seller does not offer any refunds and does not accept any returns. In this case, the $100 is a cost that has already been incurred and cannot be recovered, 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, a company ABC has spent a large sum of funds on a specific R&D project, which has not yielded any results. The company 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 this will likely yield better results. On the other hand, if the firm takes into consideration the sunk cost incurred, they may decide to continue research on the same project in the hope that further research will yield expected results. However, it is not a wise decision as sunk costs are not relevant to future decisions as they have already been incurred.
What is Relevant Cost?
Relevant costs are the costs that are able to impact and influence management decisions. Relevant costs will differ depending on the alternatives and options that a company has to choose among. Other features of relevant cost are that these costs are avoidable in the event that the decision is not taken, can result in opportunity costs to a firm and are incremental costs between the various options under consideration.
Businesses need to make the correct distinction between costs that are relevant and irrelevant, as not taking into consideration the relevant costs in making business decisions can be problematic to the company’s future. Relevant costs greatly influence a company’s future business activities and, therefore, must be considered when making business decisions. While taking relevant costs into consideration when making short term decisions can be useful, caution must be exercised when only considering relevant costs for long-term financial decisions. This is because relevant costs only consider the most immediate costs that affect future cash flows and decisions and do not cover costs that have been incurred over time.
What is the difference between Sunk Cost and Relevant Cost?
Sunk costs and relevant costs are both expenses that result in an outflow of cash and reduce a firm’s income and profitability. Since sunk costs are incurred in the past, they are a type of irrelevant cost that do not affect future cash flows and, therefore, are not considered when making decisions about a firm’s future. On the other hand, relevant costs are costs that will be incurred in the future, as a result of a decision made presently and, therefore, must be considered in managerial decision making.
It must however be noted that when making pricing decisions for a long term, all costs including relevant and irrelevant must be taken into consideration. This is because in order for a business to be afloat in the long term the prices quoted should offer a sufficient margin to cover all costs incurred (relevant and irrelevant both). Therefore, total costs must be factored in when making long-term financial decisions such as investment appraisal, expansion, new ventures, selling off business units, etc.
Summary:
Sunk Cost vs Relevant Cost
• Sunk costs and relevant costs are both expenses that result in an outflow of cash and reduce a firm’s income and profitability.
• Sunk costs refer to expenses that have already been incurred and arose as a result of decisions taken in the past.
• Sunk costs are a type of irrelevant cost. Irrelevant costs are costs that do not influence managerial decision making as they are a thing of the past.
• Relevant costs are the costs that are able to impact and influence management decisions.
• Relevant costs will differ depending on the alternatives and options that a company has to choose among.
• While taking relevant costs into consideration can be useful when making short-term decisions, caution must be exercised when only considering relevant costs for long-term financial decisions.
• This is because in order for a business to be afloat in the long term the prices quoted should offer a sufficient margin to cover all costs incurred (relevant and irrelevant both). Therefore, total costs must be factored in when making long-term financial decisions.