Why should relevant costs be reflected in the objective function but not sunk costs?

Sunk costs (past costs) or committed costs are not relevant. Sunk, or past, costs are monies already spent or money that is already contracted to be spent. A decision on whether or not a new endeavour is started will have no effect on this cash flow, so sunk costs cannot be relevant.

Explanation:

Question:

Relevant costs should be reflected in the objective function, but sunk costs should not. Explain why that statement is true and give examples for relevant and sunk costs to support the answer. Make sure to share credible sources of the explanation.

Costs

Costs refer to multifarious expenses incurred by an organization while implementing a strategy to produce or purchase something. For example, the expenses associated with producing a car by an automobile company will be regarded as costs incurred by the company.

Answer and Explanation:

The statement is true because relevant costs are incurred by an organization while implementing a decision which can be avoided if the decision is not implemented. An example of the relevant cost will be expenses incurred by a company in purchasing a machine for producing a product. This is a relevant cost because if the company had decided not to produce the product, this expense would not have been incurred. Another example can be opportunity costs which a company incurs due to a change in management decisions. The third example can be incremental costs where for increasing the production of a product, several additional lands and machinery are purchased. Therefore, relevant costs are carefully calculated by the management while making a decision. They might not incur if the management effaces from implementing it.

On the other hand, sunk costs are the costs that do not affect the future cash flows for which it is considered as an irrelevant cost and are not included in the objective function. An example of sunk cost can be the expenses incurred while organizing marketing campaigns because this is a cost that cannot be recovered by any means in the future.

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