An unavoidable cost, often referred to as a “sunk cost,” is a cost that has already been incurred and cannot be recovered or reversed. Regardless of any future action or decision, these costs will not change. Since unavoidable costs cannot be influenced by future decisions, they are typically not considered when making forward-looking business decisions, especially in the context of decision-making based on incremental or differential analysis.
Characteristics of Unavoidable Costs:
- Irreversible: Once incurred, these costs cannot be refunded or eliminated.
- Past Oriented: They relate to past decisions and have no bearing on future operations or decisions.
- Not Useful for Decision Making: In economic and managerial decision-making, unavoidable costs are not considered when evaluating the merits of one option over another. Decisions should be based on relevant costs, which are those costs that will be affected by the decision at hand.
Example of an Unavoidable Cost
Let’s consider a scenario involving a tech startup for a detailed understanding of an unavoidable cost.
Scenario: DigitalBook Inc.
DigitalBook Inc. is a startup that developed an e-reader device. They spent $500,000 on research and development (R&D) over two years to create the first version of their product, which they launched a year ago.
Sales have not been as strong as projected, and there are now newer e-readers in the market with better features. The team at DigitalBook realizes they need to upgrade their product to remain competitive. They are faced with a decision:
- Invest in a completely new design, which will cost an estimated $400,000 in R&D.
- Modify the current design to improve its features, which will cost an estimated $250,000.
When making this decision, the $500,000 that DigitalBook spent on R&D for the first version is an unavoidable (sunk) cost. It’s money that has already been spent and cannot be recovered regardless of what decision they make next.
Decision Making Based on Relevant Costs:
- Completely new design:
- R&D Cost: $400,000
- Potential Sales Boost (estimated): 100% increase in current sales
- Modify the current design:
- R&D Cost: $250,000
- Potential Sales Boost (estimated): 50% increase in current sales
To make an informed decision, DigitalBook would likely compare the estimated costs against the potential benefits (like increased sales) for each option. The original $500,000 R&D expenditure should not play a role in this decision since it’s an unavoidable cost.
Let’s say, after evaluating other factors such as time to market, potential risks, and long-term strategy, DigitalBook decides to invest in a completely new design. The reason for this decision is based on future projections and not influenced by the past sunk cost of $500,000.
In this example, it’s clear how an unavoidable cost (the initial R&D) did not and should not influence the company’s decision about the next steps. Instead, the decision was based on future projections and the relative costs and benefits of each option.