A cost incurred in the past that is not relevant to any current decision is classified as a(n):
a. Period cost.
b. Opportunity cost.
c. Sunk cost.
d. Differential cost.
The correct answer and explanation is :
The correct answer is:
c. Sunk cost.
Explanation:
A sunk cost is a cost that has already been incurred and cannot be recovered. Since it occurred in the past, it should not influence current or future business decisions. Sunk costs are irrelevant to decision-making because they remain the same regardless of the course of action chosen.
For example, suppose a company spends $100,000 on research and development (R&D) for a new product. However, after completing the research, they realize the product is not feasible or profitable. The $100,000 spent is a sunk cost because it cannot be recovered. Whether the company continues with the product or abandons it, the amount spent remains unchanged. The company should base its decision on future costs and benefits rather than the sunk cost.
Why Sunk Costs Should Be Ignored
- Irreversibility: Sunk costs cannot be changed or recovered, making them irrelevant for future decisions.
- Rational Decision-Making: Business decisions should be based on marginal costs and benefits, not past expenses.
- Avoiding the Sunk Cost Fallacy: Many people and companies fall into the sunk cost fallacy, where they continue investing in a failing project because of the money already spent. For example, if a business invests in advertising that does not generate sales, it should stop the campaign rather than continue spending simply because of prior investment.
Other Cost Definitions
- Period cost: Costs expensed in the period they occur, such as rent and salaries.
- Opportunity cost: The value of the next best alternative forgone when making a decision.
- Differential cost: The difference in costs between two alternative decisions.
Understanding sunk costs helps businesses and individuals make better financial decisions by focusing on relevant costs that affect future outcomes.