SUNK COSTS

Sunk costs cannot be changed no matter what future course of action is taken because historical
transactions cannot be reserved. For example, managers could find that a previously acquired asset is no
longer adequate for its intended purpose, does not perform to expectations, is technologically obsolete,
or is no longer marketable. Managers must then decide whether to keep the asset. This decision uses the
current or future selling price that can be obtained for the asset but that price is the result of current or
future conditions and does not recoup the historical or sunk cost. The historical cost is irrelevant to the
decision. The following illustration includes simplistic assumptions regarding asset acquisitions but
demonstrate why sunk costs are not relevant costs.

Assume that Landry Mechanical purchases a robotic warehouse management system for $12,000,000 on
December 9. This original system is expected to have a useful life of five years and no salvage value. Five
days later, on December 14, Jill Landry, vice president of production, notices on advertisement for a similar
system for $10,800,000. This new system also has an estimated life of five years and no salvage value,
but it has features that enable it to perform better than the original system as well as save $355,000 per
year in labor costs. On investigation, Landry discovers that the original system can be sold currently for
$8,900,000. Exhibit 1 provides data on the original and new robotic warehouse management systems.

Exhibit 17.1 Landry Mechanical : Robotic Warehouse Management System Replacement Decision Data
Original System New System
(Purchased December 9) (Available December 14)
Cost $12,000,000 $10,800,000
Life in years 5 5
Salvage Value $0 $0
Current resale value $8,900,000 Not Applicable
Annual Operating Cost $855,000 $500,000

Landry Mechanical has two options:

Use the original system or

Sell the original system and buy the new system

Exhibit 17.2 indicates the relevant costs Landry should consider in making her decision. As the
computation show, the original systems $12,000,000 purchase cost does not affect the decision outcome.
This amount was sunk when the company bought the system. However, by selling the original system, the
company would have net cash outlay for the new system of only $1,900,000, calculated as follows:

Cash cost of new system $10,800,000

Less cash from sale of old system (8,900,000)
Incremental cash outlay $ 1,900,000

1
 Exhibit 17.2 Relevant Costs related to Landry Mechanicals Alternatives
Alternative (1) : Use of Original Systems
Operating cost over life of original system
($855,000 x 5 years) $4,275,000
Alternative (2) : Sell Original system and buy new
Cost of new system $10,800,000
Resale value of original system ($8,900,000)
Effective net outlay for new system $1,900,000
Operating cost over life of new system ($500,000 x 5 years) $2,500,000
Total cost of new system $4,400,000
Benefit of keeping the original system $125,000
The alternative incremental calculation follows:
Savings from operating the new system for five years $1,775,000
Less effective incremental outlay for new system ($1,900,000)
Incremental advantage of keeping the original system $125,000

Using either system, Landry Mechanical will incur operating costs over the next five years, but will spend
$355,000 less each year using the new system for lifetime operating savings of $1,775,000.

A common analytical tendency is to include the $12,000,000 sunk cost of the old system in the analysis.
However, this cost does not differ between the decision alternatives. If Landry keeps the original system,
the company will deduct the $12,000,000 as depreciation expense over the systems life. Alternatively, if
the system is sold, Landry will charge the $12,000,000 against the revenue realized from the systems sale.
Thus, the $12, 000, 000 depreciation charge or its equivalent loss is the same in magnitude whether the
company retains the original system or sells it and buys the new one. Because the amount is the same
under both alternatives, it is not relevant to the decision process.

Landry must consider only the following relevant factors in deciding whether to purchase the new system:

Cost of the new system ($10,800,000);

Current resale value of the original system ($8,900,000); and
Annual savings of the new system ($355,000) and the number of years (five) such savings would
be enjoyed.

This example demonstrates the difference between relevant and irrelevant costs,
including sunk costs. The next section discusses how the concept of relevant costing,
incremental revenues, and incremental costs are applied in making routine, recurring
managerial decisions.