Sunk costs are costs that occurred during a project that cannot be recovered. Take for example a construction project of a new cinema. The construction crew starts building the structure then they realize that they don’t have enough money to finish off the project. The partial building would be considered a sunk cost because the cost incurred cannot be recovered by the contractor. Three costs that are included in the net cash flow for initial investment are initial investment outlay, expected future net operating cash flows, and non operating cash flows.
When analyzing the different cash flows through the passage of time a financial analyst must calculate the present values of each cash flow. 2. The straight line depreciation method is a technique that provides a symmetrical breakdown of depreciation because the amount of depreciation is the same each year. This occurs due to the fact that the formula is (Asset – salvage value)/estimated useful life. The modified accelerated cost recovery system (MACRS) is more suitable to depreciate assets that have a short useful life such as computers or automobiles.
Machinery that is expected to last 20 years would be more suitable for straight line depreciation. 3. The example you mentioned of preliminary market research on a new product is something that I can relate too. A few years ago I worked at a start-up company that was developing a new product. The research team spent hundreds of hours on the project and the company invested over $50,000 in materials and related expenses. The product never reached the phase of being ready for introduction to the marketplace.
The money that was spent on materials and labor cost represent a sunk cost for the company. 4. Companies that incur in a lot of sunk costs due to the failure of projects are likely to have a lower overall profitability than companies that do not incurred in sunk costs. Sunk costs are a nightmare for a project manager because a sunk cost is an expense item for which the company receives no benefit. It is sad when a company invests millions of dollars to then be left with a series of sunk costs.
Sunk cost can destroy the economic position of a company that is starting out from scratch. 5. I agree with you that the timing of cash flows is extremely critical for the successful completion of a project. When the cash inflows are less than the cash outflows a project becomes at risk of failure. The overall time that it takes to complete a project is also an important consideration. I was involved in a project a few years ago that took too long to complete. Since the project took a long time to complete the firm ran out of money and as a consequence the project failed.
The cost associated with the project became a sunk cost. 6. An industry in which sunk costs are a constant factor is the pharmaceutical industry. It takes nearly $800 million in research and development to develop a new drug. The reason that costs are so high is due to the amount of failures that occur in the process. There are hundreds of ideas for new drug products that never reach the market. All the expenses incurred in drugs that never reach the market are categorized a sunk costs.
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