Fixed Costs are Sunk Costs
Sunday, September 27th, 2009
Understanding transaction costs and other costs are critical to your business success. However, when you’re making decisions about which project to accept and which to take a pass on you’re going to have to come to terms with the maxim that fixed costs are sunk costs.
While the idea is basic there does seem to be a counter-intuitive leap in implementing this maxim in the real world, at least in the beginning. The concept is that when comparing two projects you only compare the relevant variable components – excluding rent and other fixed costs because they occur regardless of the decision. You’re tied into your fixed costs whether or not you’re taking either project or any project at all.
Which is why fixed costs are sunk costs. When you’re making any decision the sunk costs – how far your hole is dug in any direction – become irrelevant to the decision because you can’t recover them. Its a retrospective cost. The decision needs to be made only on the relevant costs associated with either project. To further understand sunk costs, if you had a week’s work invested in a small project and it appeared uncertain whether you were going to be paid do you cut your losses as a sunk cost, or do you keep digging your hole in the hope that it will pay off – risking further loss to your business?
Getting your head around costing is a critical component of making sound business decisions. What factors do you count and which do you ignore, however counter-intuitive that maxim appears at the time? You can’t get back what you’ve already lost, right? You can’t get out of spending your fixed costs either.
