Question

Are fixed costs also sunk costs? Explain.

Short answer

Fixed costs, which remain constant in the short term regardless of production levels, aren't always sunk costs. Unlike fixed costs, sunk costs refer to non-recoverable expenses that shouldn't influence future decisions. The two cost types can overlap in certain situations, such as when a business incurs unrecoverable fixed costs after deciding to relocate. Overall, fixed costs are not inherently sunk costs, but they can become sunk costs depending on the circumstances.

Step-by-step solution

Define Fixed Costs

Fixed costs are costs that remain constant in the short term, regardless of the level of production or sales. These are expenses that a business must pay regardless of its output, and typically include items like rent, salaries, and insurance. In other words, even if a business produces nothing, it still has to pay its fixed costs.

Define Sunk Costs

Sunk costs are costs that have already been incurred and can't be recovered. These costs should not be considered in future decision-making processes, as they are already spent and irrelevant. Examples of sunk costs include advertising expenses, R&D costs, or investments made into machinery that is no longer usable.

Determine if Fixed Costs are Sunk Costs

Fixed costs and sunk costs are not the same. Although both types of costs don’t vary with production levels, fixed costs are recurring expenses that a company must continuously pay (like salaries and rent) while sunk costs are one-time, non-recoverable expenses that shouldn't influence future decisions. Not all fixed costs are sunk costs, because companies might be able to recoup some expenses when adjusting production levels or selling assets. However, some fixed costs can become sunk costs, depending on the situation. For instance, if a business has signed a long-term lease for a building and later decides to relocate, the remaining lease payments might be considered sunk costs because they can’t be recovered. In conclusion, fixed costs aren't always sunk costs, but can occasionally become sunk costs under specific circumstances.