8.5: Fixed costs and sunk costs

The distinction between fixed and variable costs is important for producers who are not making a profit. If a producer has committed himself to setting up a plant, then he has made a decision to incur a fixed cost. Having done this, he must now decide on a production strategy that will maximize profit. However, the price that consumers are willing to pay may not be sufficient to yield a profit. So, if Black Diamond Snowboards cannot make a profit, should it shut down? The answer is that if it can cover its variable costs, having already incurred its fixed costs, it should stay in production, at least temporarily. By covering the variable cost of its operation, Black Diamond is at least earning some return. A sunk cost is a fixed cost that has already been incurred and cannot be recovered. But if the pressures of the marketplace are so great that the total costs cannot be covered in the longer run, then this is not a profitable business and the firm should close its doors.

Is a fixed cost always a sunk cost? No: Any production that involves capital will incur a fixed cost component. Such capital can be financed in several ways however: It might be financed on a very short-term lease basis, or it might have been purchased by the entrepreneur. If it is leased on a month-to-month basis, an unprofitable entrepreneur who can only cover variable costs (and who does not foresee better market conditions ahead) can exit the industry quickly – by not renewing the lease on the capital. But an individual who has actually purchased equipment that cannot readily be resold has essentially sunk money into the fixed cost component of his production. This entrepreneur should continue to produce as long as he can cover variable costs.

Sunk cost is a fixed cost that has already been incurred and cannot be recovered, even by producing a zero output.

R & D as a sunk cost

Sunk costs in the modern era are frequently in the form of research and development costs, not the cost of building a plant or purchasing machinery. The prototypical example is the pharmaceutical industry, where it is becoming progressively more challenging to make new drug breakthroughs – both because the 'easier' breakthroughs have already been made, and because it is necessary to meet tighter safety conditions attaching to new drugs. Research frequently leads to drugs that are not sufficiently effective in meeting their target. As a consequence, the pharmaceutical sector regularly writes off hundreds of millions of dollars of lost sunk costs – unfruitful research and development.

Finally, we need to keep in mind the opportunity costs of running the business. The owner pays himself a salary, and ultimately he must recognize that the survival of the business should not depend upon his drawing a salary that is less than his opportunity cost. As developed in Section 7.2, if he underpays himself in order to avoid shutting down, he might be better off in the long run to close the business and earn his opportunity cost elsewhere in the marketplace.

A dynamic setting

We need to ask why it might be possible to cover all costs in a longer run horizon, while in the near-term costs are not covered. The principal reason is that demand may grow, particularly for a new product. For example, in 2019 numerous cannabis producing firms were listed on the Canadian Securities Exchange, and collectively were valued at about fifty billion dollars. None had revenues that covered costs, yet investors poured money into this sector. Investors evidently envisaged that the market for legal cannabis would grow. As of 2020 it appears that these investors were excessively optimistic. Sales growth has been slow and stock valuations have plummeted.