Sunk Cost is not Relevant Cost

Next semester, I look forward to studying Cost and Management Accounting, alias CMA. During the introductory webinar, I understood that cost, above all else, is the one variable that a manager could and should have good control over. That is because costs are primarily incurred by the choices and decisions of the manager. Inadequate cost accounting practice would mislead managers to make decisions that hurt the organization. For instance, products and services could be priced wrongly – either overpriced or under-priced. A poor cost and management accounting regime could eventually mean that organization may close down certain aspects of its operations or even completely go out of business.

To cement our appreciation of the array of topics we shall be encountering during the course, we had to deliver written work on some basic cost accounting concepts. Two concepts stood out for me that I want to share in this piece – Sunk Cost and Relevant Cost. While sunk cost has been a buzzword that I had been familiar with, the relevant cost was quite brand new to me.

To some definitions:

Sunk cost is the cost already incurred and which cannot be recovered. Usually, a sunk cost is not relevant to determining the future viability of continuing a venture or an investment. An example of the sunk cost would be the maintenance cost for a piece of machinery. Once the maintenance cost has been spent, it can no longer be recovered. Let’s say the machinery breaks down often so that it spends more idle time going through maintenance routines. It also no longer meets its production quota. The decision criteria on whether to continue maintaining the machinery as often as it breaks down should not take into account the maintenance costs incurred in the past. Such a decision should be based on the direct benefits that incurring the maintenance cost would bring about in the present and the future

On the other hand, the relevant cost concept is the counter-proposal to sunk cost. Relevant costs are incremental costs, future cash flows, avoidable costs, and opportunity costs which are relevant for decision-making. To illustrate relevant cost, let’s return to the example of that piece of machinery. Let us say that incurring that maintenance cost would not generate adequate future cash flows to offset the cost of maintenance as well as the cost of idle time. Additionally, let us say that the total cost of outsourcing production is cheaper than the overall cost of maintaining that machinery. Then a manager should not decide to continue to carry out any more maintenance on the machinery. She should rather consider outsourcing production, for example.

In summary, in deciding on whether to continue a course of action, therefore, one should be guided by the relevant cost. Relevant cost matches up the present cost that will be incurred to the present and future benefits that would be derived from incurring it. It should never be evaluated by taking into account sunk cost which plays no role in future benefits that could be derived. In other words, a sunk cost is not a relevant cost.

To conclude this piece, I turn my reflection on this question: Should the Federal Government of Nigeria continue to invest in Turnaround Maintenance (TAM) of its refineries? Do the benefits derivable from this exercise outweigh the cost incurred? Should the money not be better spent on other alternative investment options? The TAM has not kept the refineries working.

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