2.3 - Sunk Cost Explanation
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Introduction to Sunk Costs
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Today we will discuss sunk costs and their relevance in our decision-making process for equipment replacement. Can anyone tell me what they think a sunk cost represents?
Isn't it something we’ve already spent and can’t recover?
Exactly! Sunk costs are costs that cannot be recovered. They shouldn't influence our current or future decisions—especially when choosing between keeping our current equipment or replacing it with a new one.
So if we have already spent money on old machinery, we shouldn’t factor that in when deciding?
Right! We always focus on what we can save or spend in the future. Remember this by associating "sunk" with "lost"—money lost to our past decisions.
Got it! What if past costs seem high?
We still ignore them; we must make decisions based only on relevant data for the future!
Current Equipment vs. New Equipment
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Let's compare our current equipment, the defender, with the proposed challenger. Can anyone tell me the annual cost of the defender?
I think it's 1,35,000!
Correct! And what about the challenger?
The challenger costs only 90,000 per year!
Right again! Lower operational and maintenance costs are key reasons to consider switching to the challenger. Can someone tell me the salvage value of both after five years?
The defender's is 6,00,000 while the challenger's is 12,00,000!
Exactly! When comparing these values, it highlights the potential financial benefits of switching to a new machine without being swayed by sunk costs.
Irrelevant Costs in Decision Making
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Now let's discuss the concept of irrelevant costs in replacement analysis. What are some costs that we should ignore?
The initial purchase price of the defender and its salvage value?
"Yes! Those costs are already incurred and should not affect our decision. We focus on the **current trading value** and not the past costs. What about the book value?
Sunk Cost vs. Opportunity Cost
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Today, I want to draw a difference between sunk costs and opportunity costs. Who can give me an example of an opportunity cost?
Isn’t that the potential benefit we miss out on when choosing one option over another?
Exactly! If we focus on past expenditures or sunk costs, we might lose valuable opportunities moving forward. Always remember, "Sunk = Lost; Opportunity = Potential!"
So, if we replace the defender with the challenger, we avoid losses while gaining potential savings.
Exactly! Always evaluate future benefits over what was already lost. That is strategic decision-making in action.
Introduction & Overview
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Quick Overview
Standard
This section elaborates on the concept of sunk costs within the context of comparing existing equipment (defender) and proposed new equipment (challenger) for replacement analysis. It specifies that sunk costs are irrecoverable expenses and should not influence replacement decisions.
Detailed
Sunk Cost Explanation
In this section, we explore the crucial concept of sunk costs, especially in the context of making decisions about equipment replacement. The discussion begins by comparing two types of equipment: the existing equipment referred to as the defender, and a new proposed equipment called the challenger.
Key Points:
- Operating and Maintenance Costs: The challenger has lower annual operating and maintenance costs ( 90,000 ) compared to the defender ( 1,35,000 ), making it economically advantageous.
- Salvage Value: The salvage value of the challenger is 12,00,000 after five years, compared to 6,00,000 for the defender.
- Irrelevant Costs in Replacement Analysis: When conducting a replacement analysis, certain costs are considered irrelevant, including:
- Initial purchase price of the defender ( 35,00,000 )
- Initial estimated salvage value ( 7,00,000 )
- Book value based on depreciation ( 23,80,000 )
- Remaining life estimate of six years.
These costs should not influence the decision because they have already been incurred. The concept of sunk costs involves recognizing that expenses (like the difference between the estimated book value of a machine ( 3,80,000 ) and its current trading value ( 22,50,000 )) cannot be recovered and should be ignored in future financial decisions.
Sunk Cost Significance:
Understanding and classifying these costs correctly is pivotal for making informed decisions that reflect true economic worth, without being biased by past investments. Ultimately, successful equipment replacement analysis focuses only on current values and future projections.
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Understanding Sunk Costs
Chapter 1 of 3
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Chapter Content
So, all your past estimates of your initial cost, your estimate of your useful life there, yearly estimates, the yearly estimates of salvage value of the defender and the sunk cost all are irrelevant in the replacement analysis. They should not be considered in the replacement analysis.
Detailed Explanation
Sunk costs refer to costs that have already been incurred and cannot be recovered. In the context of replacement analysis, it is important not to consider these costs because they do not affect the current or future decisions about making a replacement. For instance, whether a piece of equipment has been expensive to maintain in the past does not influence whether it should be replaced now; only the future costs and benefits matter.
Examples & Analogies
Imagine you bought a concert ticket for $100 but the day of the concert, you get an invitation to a wedding that you really want to attend. The $100 is a sunk cost because you've already spent it, and you will not get that money back whether you go to the concert or to the wedding. The decision should be based on what you would enjoy more now, not on the money spent.
Calculating Sunk Costs
Chapter 2 of 3
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Chapter Content
So, the estimated book value of the machine using depreciation accounting method it is currently 3,80,000. But your current trading value is only 22,50,000 this difference cannot be recovered, this difference is called as the sunk cost.
Detailed Explanation
When determining the sunk cost for an old piece of equipment, we take the estimated book value, which is value assigned to it based on depreciation, and compare it to its current market value. The difference illustrates the amount of money that has effectively been wasted and cannot be recovered. In other words, if you had an initial investment of 35,00,000, depreciation might suggest it's now worth 3,80,000, but if you can sell it for only 22,50,000, the difference has effectively become a sunk cost.
Examples & Analogies
Consider a car you bought for $30,000. Over time, due to depreciation, its estimated book value drops to $10,000. However, now you find that you can only sell it for $5,000. The $5,000 is the sunk cost that illustrates how much money you've lost which cannot be recovered when considering what to do with the car next.
Ignoring Irrelevant Costs in Replacement Analysis
Chapter 3 of 3
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Chapter Content
Hence it is advisable to replace your defender with a challenger. So, the construction company should replace the defender with the challenger, so this is a decision made.
Detailed Explanation
Replacement decisions should only be based on future costs and benefits, such as the current operation and maintenance costs of the existing equipment versus the new proposed equipment. By ignoring past costs like the purchase price or any estimated useful life, the analysis becomes more reliable concerning present-day operational efficiency and financial effectiveness.
Examples & Analogies
Think of a phone you bought for $800 three years ago. It's now outdated and you can't recover that amount by selling it. If a new phone works better for you and is available for $600, the decision to buy the new phone should be based solely on its features and performance—not how much you paid for your old phone or how long you've used it. Even if the old phone still has some functionality, if the newer phone offers significant advantages and is less expensive upcoming costs, it might be better to shift to the new model.
Key Concepts
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Sunk Cost: Costs that cannot be recovered and should not impact future decisions.
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Defender: The current equipment or asset being evaluated.
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Challenger: The proposed new equipment for replacement analysis.
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Salvage Value: The expected selling price of an asset at the end of its useful life.
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Operating and Maintenance Costs: Annual costs associated with the operation and upkeep of equipment.
Examples & Applications
An example of a sunk cost is the initial purchase price of the defender; even if it was expensive, it should not influence the decision to keep or replace the equipment.
When evaluating whether to replace the defender with the challenger, only current costs and future benefits, like the challenger's lower operating costs and higher salvage value, should be considered.
Memory Aids
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Rhymes
Sunk costs are lost, let them be, focus on future costs, that’s the key.
Stories
Imagine you invested in a vintage car that constantly needs repairs. You love it, but the costs keep adding up! You realize the money spent is gone, and the choice to keep or sell should focus on what you can save or earn from now on.
Memory Tools
Use the acronym 'SAVE' to remember: Sunk costs Are Valueless Expenses.
Acronyms
R.E.A.L - Remember to Evaluate All costs that are relevant and ignore past losses.
Flash Cards
Glossary
- Sunk Cost
A cost that has already been incurred and cannot be recovered; it is irrelevant for future decisions.
- Defender
The current piece of equipment being evaluated for replacement.
- Challenger
The proposed new equipment that is considered as a replacement for the current equipment.
- Salvage Value
The estimated residual value of an asset at the end of its useful life.
- Operating and Maintenance Costs
Recurring expenses associated with operating and maintaining equipment.
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