The requirement of knowledge of sunk cost in decision making should never be underestimated. The absence of its knowledge can land you in a completely wrong decision which may prove to be detrimental to your organisation over a long period of time.
Let us see an example of the same.
Panorama Ltd. has purchased few kg. of Raw Material X worth Rs. 1,000 for manufacturing a finished product P. After purchasing the raw material X, suddenly government brought a law making the production of P illegal in the country. Now the company has 2 options. A) Either throw away the raw material X at a scrap value of Rs. 300 or B) use it to manufacture a different product Q the cost structure of which is as follows.
For 1 unit of Product Q:
Raw Material X: Rs. 1,000
Raw Material Y: Rs. 450
Labour Cost: Rs. Rs.200
Overheads: Rs. 100
Total Cost: Rs. 1,750
Selling Price: Rs. 1,600
Now if you are a manager & you do not know what is sunk cost & its significance, you are most likely to decide going for option A which will give you at least Rs. 300 vs Option B which shows that Product Q is a loss making product (Loss of Rs. 150 per unit).
However one must remember that the cost of Raw Material X in this case is a sunk cost because it is a history. If you go for option A there is no incremental cost. But your incremental revenue will be Rs. 300 resulting in incremental profit of Rs. 300.
If you go for option B your incremental cost is going to be not Rs. 1,750 but only Rs. 750 (because cost of X is already incurred). And incremental revenue is going to be Rs. 1,600. Hence you will in fact earn an incremental profit of Rs. 850 (1600-750).
So now tell me which one is a better option? A or B? Obviously B. Thus one error of not applying the appropriate principle of Cost Accounting may put the organisation into trouble the losses of which might be irreversible.
After all Sunk Cost is a matter of common sense which can be made applicable in our day to day life as well. Many times we undertake some activity & spend lot of efforts on it after which we realise that it is not going to bear fruits. But instead of stopping the efforts there itself, we continue pursuing it just because we do not want to leave it half the way & thus we end up spending more efforts & at the end achieve nothing except a solace that we completed our efforts! But that is actually a foolishness. The better thing would have been to stop the efforts half the way (because it is like a sunk cost) so that our efforts would have been minimized resulting in restricting our losses & in fact we could have focused on some other fruitful activity.
Cost Accounting is indeed a very interesting subject which should not be looked at merely as an audit formality. I will be elaborating on the subject more in my webinars. So keep visiting www.commercefunda.com & keep an eye on the courses announced..
Happy Cost Accounting!
Prof. Anil Joshi
B.Com, ACMA & ACS