sunk cost accounting

sunk cost accounting

The Importance and Implications of Sunk Cost Accounting in Business Decision-Making

1. Introduction to Sunk Cost Accounting

This paper explores the importance and implications of sunk costs in various business decisions through a series of theoretical analyses. We define a decision or an action as being taken based on economic rationality if and only if the decision is based on future costs, benefits, and opportunities foregone rather than on the consideration of historical, sunk costs. We believe the economic principle of sunk cost accountancy as espoused in this paper will provide a simple, yet generally applicable framework for defining the economic rationality of business decisions. The principle presented has implications for business valuation as well as for analyses of business behavior such as research and development processes, technology adoption, decentralization of corporate resources, and strategic alliances. Our arguments and conclusions are developed through a series of illustrative models, each focusing on different decision-making environments and contexts.

2. Theoretical Foundations and Key Concepts

To explain accounting, while recognizing the explicit linking to research in both neutral processing and constructive capitalization, this reasoning is termed the Neutral Processing Theory, or NPT. This move is made not just to signal the extant distinction from each other, but also to link the seriously undertheorized accounting idea in a mainstream way to related theoretical accounting research in other areas such as NPT accounting manipulation, materiality, and full capitalization of sunk costs contentiousness. Following arguments encourage us to believe that sunk cost recognition accounting can be conceptualized and researched in these additional and different theoretical frames.

Building a coherent theoretical foundation is essential for thoroughly understanding the role of sunk cost thinking in decision-making practices across time and settings. In the sunk cost accounting research stream, the focus of such efforts is upon providing the logistics and decision-processing explanations for why and how sunk costs can affect decision-making, especially considering that evidence presented in numerous recent studies fails to support the soundness of the idea. It seems increasingly clear that sunk cost accounting needs more theoretical underpinnings. After all, reality behaves in an instrumental manner when theory assumes that it does. With this explicit argument in mind, a section on key concepts and the theoretical underpinning of our definition of sunk cost accounting is now developed.

3. Practical Applications and Case Studies

SP: The cost (if any) of Project recognized as a sunk cost within this period is elaborated in [Project, Sunk cost, end]. This part of the analysis is performed regardless of whether % or the RC decided in which period to recognize the ability of the Project decision to forgone the sunk cost. In this step, the decision of the forgiveness of the sunk costs made in the information evaluated, or any limitations associated with it now are eliminated. The maximum capacity of the idea to survive can be recognized if the evaluations are convincing and the ability of the decision to avoid sub-optimized business cases is perceived. The first step involves recognizing the project’s termination conditions, e.g. N years. With the idea of continuing the project after the Nth year or folding the mistakes made so far, options (i) and (ii), respectively, are evaluated.

Sunk cost was something unavoidable from the day an investment was made; still, the RC should also put an extra effort to identify the investments that end up becoming sunk costs associated with past projects. In our survey, it seems evident that the sunk cost is associated with the cost of projects that exceed the budget. It seems that project cost overruns nowadays are a direct consequence of the process of project termination. Folding the project intuitively means that numerous investments in systems, data, people, soft factors, hardware, software, etc., are considered as a waste of money. Essentially, most of the failure costs were created.

Sunk cost identification

4. Critiques and Limitations

Individuals would prefer to make a decision that leads to outcomes with less need for justification; therefore sunk costs are allowed to play on individuals’ perception of the situation and consequently provide the justification.

Finally, decision-makers often express a reluctance to “give up”. Often the attitudes and behaviors of the decision-makers themselves indicate a sense of embarrassment or guilt at having incurred the unrecoverable costs; unwinding the mistake is viewed as admission of this error. Thus the person making the decision finds it difficult to separate the decision for continued investment from the decision not to compound the loss with any further investment.

Another reason is that the extra resources, if any, needed for the investment or to convert the investment into something salvageable is all that matter; these extra costs are not part of the sunk costs and do not have to be charged against the decision.

First, it is not uncommon that decision-makers do not seem to care too much about sunk costs when they make decisions. Sunk costs might not matter for a number of reasons. One is whether the person making the decision actually paid for the cost is irrelevant; financial implications of decisions are the same for the firm as a whole regardless of the decision-making hierarchy, since all employees are presumably working for the same entity and with the same objectives.

Though the evidence in support of the effect of sunk cost accounting on decision-makers’ actions is quite robust and objective, it does have some limitations and weaknesses. These criticisms originate from observations of actual business decision-making situations.

5. Future Trends and Innovations

Topics for future research may involve possible ways to provide evidence of either bounded rationality / cognitive based modeling or true rationality. We may expect that unique empirical evidence can be found out in corporate ownership structure. Also, potential intervention conducted by external observers of SCA might influence and thus limit its importance. Moreover, there are theoretical and empirical implications of the accounting effect on contractual setting, environmental and social performance of organizations, together with its relationship with cultural differences and country institutional particularities. The commitment is to also investigate the potential empirical implications of the bounded rationality as similar evidence supports both efficient contracting and manager divergence. Whether convergence or divergence might be expected is an open empirical question and, given their relevance to the efficient contracting perspective, these areas are highlighted as promising for future research.

The field of behavioral economics has grown rapidly since the 1980s, when the standard assumption of fully rational behavior was considered inconsistent with quality data. Due to its high predictability, this traditional assumption had been the bedrock of economic theory which in turn had been used to inform risk management and governance. There is a long tradition in accounting and finance research to find evidence of the accounting number relevance. This chapter has documented empirical evidence that managers do take previous period costs into account, and that changes in accounting conventions affect economic decisions. In this respect, the study of accounting is scientifically sound. However, there are also limits to the importance of the observed SCA.