Understand Sunk Costs and Historical CostsSunk costs are costs that have already been incurred and cannot be changed no matter what action is taken.
Given that sunk costs are costs incurred in the past, they are the same for all possible alternatives in the present and the future.
Therefore, sunk costs are relevant for cost-benefit analysis Opens in new window. Ironically, we often find ourselves including sunk costs when making decisions.For Example:
- Many people use the purchase price originally paid for their home to determine the listing price when they decide to sell.
- Other people stay to the final minutes of a football game to ‘get their money’s worth’; even though the weather has turned miserable and the home team is down by three touchdowns mid-way through the final quarter.
When a resource is acquired, the historical cost is usually a close approximation of the opportunity cost Opens in new window because it reflects the market value at that time.
Except for somewhat arbitrary write-downs (depreciation and amortization), however, the historical cost of the resource remains the same as long as the resource is held by the organization.
The historical cost does not change with changes in market value. The historical cost of a resource becomes a sunk cost following the purchase of the resource.
Financial reporting to outside investors is based on historical costs, and most internal accounting reports also use historical costs.
Although the historical cost approximates the opportunity cost of a resource Opens in new window at the time of purchase, the historical cost is a sunk cost subsequent to the purchase and should not be used for planning purposes.
Given potential deviations between historical costs and opportunity costs, we might question why historical cost accounting has survived.
In the last century, regulations may have been partly responsible for its survival.
Financial reporting requirements around the world are based on historical costs.
Yet the demand for opportunity costs (market values) by external parties for making planning decisions (e.g., investment decisions) might have some effect on regulations.
Another reason for the continued popularity of historical costs is their used for control decisions. Verifying the actions of managers is an important part of control.Historical costs generally are more useful than opportunity costs for control, as they reveal the past actions of managers.
These costs are easily verifiable and less subject to managerial discretion. These features are usually important when performance is being measured by historical costs. Thus, historical cost data can be utilized to motivate and reward managers.Situations exist when historical costs are used to make planning decisions.
Historical costs or simple adjustments to these figures might be reasonable approximations of opportunity costs.
- If the environment does not change very much from the time of the resource acquisition, the historical cost might remain a close estimation of the opportunity cost.
- Using rules of thumb to approximate opportunity costs, such as increasing historical costs by expected price inflation, also might be effective.
The problem for managers is to determine when to use historical cost numbers as reasonable estimation and when to expend additional efforts to determine the opportunity costs, which are more closely approximated by the market value.
Paul Wong is struggling to assemble his new home theater system. He has spent five hours thus far on the chore and estimates that at this rate, he will complete the assembly in two more hours.
Joan Jimenez walks into the room and informs Paul that he is doing it the hard way. She describes a simpler approach that will take only one hour to disassemble the work that he has done over the last five hours and re-assemble the system completely.
What should Paul do?
Paul should follow Joan’s advice because the remaining time to completion is less. The five hours of work that he has performed is a sunk cost.