In accounting, finance and economics, all sunk costs are fixed costs. However, not all fixed costs are considered to be sunk. The defining characteristic of sunk costs is that they cannot be recovered. It’s easy to imagine a scenario where fixed costs are not sunk; for example, equipment might be resold or returned at the purchase price.
Individuals and businesses both incur sunk costs. For example, someone might drive to the store to buy a television, only to decide upon arrival to not make the purchase. The gasoline used in the drive is a sunk cost – the customer cannot demand that the gas station or the electronics store compensate him for the mileage.
Fixed and Sunk Costs for Business
Businesses generally pay more attention to fixed and sunk costs than individual consumers. For businesses, fixed costs include anything that must be paid for production to occur, yet they remain the same whether production is high or low.
In financial accounting, sunk costs must have already occurred, and they cannot be changed or avoided in the future. This does not apply to rental equipment; rental costs are only fixed until the renter decides to discontinue use.
Costs are considered sunk even if an item is never completely used. Suppose a company, SMR Producers, purchases a machine for $5,000 with an expected useful life of five years. Using straight-line depreciation, the company should recognize $1,000 in depreciation expense per year. If, after three years, the company gets rid of the machine, the remaining book value, $2,000, must be written off.
Even though only $3,000 worth of accounting use came from the machine, the full $5,000 was initially paid and is considered sunk.
Variable Sunk Costs
In a certain sense, some sunk costs begin as variable costs. Once a variable cost is incurred and cannot be recovered, however, it is necessarily fixed in sunk terms. By definition, $1,000 worth of variable costs are sunk if they cannot be recovered; once incurred, the realized sunk costs become fixed.