Sunk+Costs

=Sunk Costs= Strachman, Jason Bittle, Curtis

Sunk costs are costs which have been lost and no amount or form of economic activity will regain them. As such, they should not be factored into decision-making. Sunk costs are also more discretely refered to as non-recoverable fixed costs.

Sunk costs are barriers to exit. Despite proof of the existence of sunk costs, firms often find it difficult to ignore them in planning, even when better prospects are beckoning. This leads to the sunk cost fallacy, in which "we have a greater tendency to continue an endeavour once an investment in money, effort or time has been made."⁴

Entrants to a market, may likewise be daunted by seeing sunk costs in incumbents. This fear can be instilled or enhanced in entrants by incumbent companies utilizing limit pricing and raising rivals' costs strategies. In this sense, the fear of sunk costs are barriers to entry.

In many business sunk costs are a large part of daily operations. Research and advertising ovten become sunk costs.³ "In the case of an exporter, an example of sunk costs could be the costs of analysing the market and of exploring opportunities and seeking commercial partners. "²

__**Real World Example**__

A company bought a new machine to help its assembly line run more efficiently. The company paid $10,000 in cash for the machine. Then a year later, the machine's manufacturer brings a newer model of the machine to market. The new machine is twice as fast and produces parts with higher quality. The company's CEO says that he will not endorse the purchase of another machine since the company just spent $10,000 a year earlier. Since the original $10,000 was already spent, the cost has been incurred and it is lost forever. Therefore, the original $10,000 spent on the machine is a sunk cost and it should be ignored when determining if the new machine would benefit the company. If the company could sell the old machine for $4,000 then only $6,000 is sunk.

**__Real World Example__**
A guy goes to the grocery store and buys $30 worth of supplies to make pizza for dinner -- dough, sauce, cheese, pepperoni, sausage, and onions. He brings the supplies home and sets them on the counter in preparation. His wife comes home and says, "What are you doing?" He says, "I am making pizza for dinner." She says, "But honey I don't want pizza for dinner, I want to make spaghetti." The guys says, "I spent $30 on groceries already to make the pizza." His wife says, "Yes, but the money you spent is a sunk cost--plus only $27 are sunk because the sauce cost $3, and I can still use the sauce for the spaghetti."

**__Real World Example__**
The NFL draft is rapidly approaching--a good example of how understanding sunk costs may actually be a detriment. Each NFL team receives one draft pick in each round of the draft unless a team decides to trade the picks to other teams for either players or other draft picks. The previous season's record determines the draft order and therefore the pick selections. This means the worse a team is the year before the higher the draft pick and supposedly the better chance for the team to get better prospects to improve the following season. From 2003-2005, the Detroit Lions finished with a combined record of 16-32. In those three years they selected #2 (2003), #7 (2004), and #10 (2005) in the first round. In each of the three drafts, the Lions selected highly touted wide receivers -- Charles Rogers (2003), Roy Williams (2004), and Mike Williams (2005).

Since each of these individuals were high first round picks the were paid considerably more than if they were middle first round picks, lower first round picks, or out of the first round picks -- the pay scale typically starts at the #1 pick and then works downwards. The Lions selected Charles Rogers in 2003 and the ROI was not good. He broke his collarbone in 2003 and then again in 2004, and in 2005 was suspended for violating the NFL's substance abuse policy. He was cut last season from the team. Even after Rogers' lack of production in 2003, the Lions drafted another WR in 2004. Although Roy Williams also got injuried in his first year he was productive. Then in 2005, the Lions picked another WR with its first pick which again did not perform to the level of expectation.

This is an example of how the Lions understood the concept of sunk costs. When selecting players they must fill a complete team. With high draft picks available the Lions were in a good position to improve the team, but management understood that the costs associated with drafting Rogers were sunk so it picked Roy Williams. The costs associated with Roy Williams were sunk so it picked Mike Williams. Unfortunately if the Lions disregarded the concept of sunk costs, the team may have been scared off by the option of drafting multiple WRs in three consecutive rounds and would have selected other position players which may have improved the record over time.

**Test Question 1:**
A beer brewer and bottling company purchases a glass bottle maker machine for $20,000. As a part of the purchase agreement, the machine can be returned after 30 days for a refund of 50% of the purchase price. If the company returns the machine within the 30 day trial period, how much sunk costs does the company incur? If the company keeps the machine past the 30 day trial period, how much sunk costs does the company incur?
 * A.**

A soft drink bottling company hears that the beer brewer purchased the new bottling making machine. The soft drink company wants to try it out so that it doesn't have to spend the money up front to the manufacturer. The soft drink company offers the beer brewer $5,000 to try the machine out for 15 days to see if it is suitable for the soft drink industry. Should the beer brewer accept the offer?
 * B.**


 * Answers:**


 * A.** If the company returns the macine within the 30 day trial period, the sunk cost is $10,000 since it will recoup a $10,000 refund. If the machine is kept past the 30 day trial period, the full $20,000 is sunk.


 * B.** Yes, the beer brewer should accept the offer assuming giving the machine away for 15 days does not have a negative impact on its production process. If the machine is returned during the first 30 days, the beer brewer would recoup $10,000 leaving $10,000 as sunk cost, but if it receives $5,000 from the soft drink company which means that you only lose $5,000 off the payment of the machine. If the machine is not returned in the first 30 days, the entire $20,000 cost is sunk and if the company receives revenue of $5,000 from the soft drink company then the loss on the machine is $15,000.

Test Question 2:
Which of the following are likely to become sunk costs? A. Advertising B. Variable Costs C. Research D. A and B E. A and C

E
 * Answer:**

Test Question 3:
A sunk cost is

A. The cost of producing an additional unit of output. B. A cost that do not change with changes in output. C. A cost that is forever lost after it has been paid. D. A variable cost divided by the number of units of output.

C
 * Answer:**

**Test Question 4:**
Sunk costs should factor into decisions that are made. A. True B. False C. Only when the costs are above $500,000 D. Only when the costs have occurred during the past year.

B
 * Answer:**

Test Question 5:
Sunk Costs are: A. Barriers to entry B. Barriers to exit C. Important decision-making factors D. A and B

D
 * Answer:**

References: 1. //Manageial Economics and Business Strategy.// Michael R. Baye 2. http://www.economicswebinstitute.org/glossary/costs.htm#temp 3. http://www.economist.com/research/Economics/alphabetic.cfm?term=substitutegoods 4. http://sunk-cost.behaviouralfinance.net/