Sunk Cost is also known as ‘Past or Retrospective, embedded cost, prior year cost, or sunk capital’. Sunk costs are costs which cannot be recovered once they have been incurred. Since they are costs that can’t be regained so they shouldn’t be taken into account any longer in rational decisions. This can be explained with the help of the following examples:-
For example: If you sign a contract requiring you to pay $1200 for a year, and there’s no way out to cancel the contract, that $1,200 is a sunk cost because you’re legally obligated to pay the money.
Mining Company signs a deal with farmer to mine coal under his land. For this Mining Company offers a minimum payment of Rs XYZ per year for the next 5 years. If no mine is built, then also they have to make payment. So for that mining company that payment is considered as prospective cost.
Sunk cost can further be classified as fixed and variable. For example– For example, if a company sinks 50 lakhs on the installation of some new technology that cost is sunk because it was a one-time expense and cannot be recovered once spent. A “fixed” cost would be monthly payments made as part of a service contract or licensing deal with the company that set up the new technology software. The “variable costs” for this project might include data centre power usage etc.
Sunk cost should not be considered when decisions are being made. Because it is human nature to want to avoid failure, people will often continue spending time, effort or money to try and fix what isn’t working instead of cutting their losses and moving on. This tendency, which is known as the sunk cost effect, can be illustrated by the adage “throwing good money after bad.”
The sunk cost effect is known as the ‘Concorde effect.’
Is Sunk cost included in Accounting cost?
Of course it is. Sunk costs are something that you already paid for which would put it under actual expenses. Wikipedia has a good example that explains this:
1. Having paid the price of the ticket and having suffered watching a movie that he does not want to see, or;
2. Having paid the price of the ticket and having used the time to do something more fun.
In either case, the ticket-buyer has paid the price of the ticket so that part of the decision no longer affects the future. If the ticket-buyer regrets buying the ticket, the current decision should be based on whether he wants to see the movie at all, regardless of the price, just as if he were to go to a free movie. The economist will suggest that, since the second option involves suffering in only one way (spent money), while the first involves suffering in two (spent money plus wasted time), option two is obviously preferable.