A sunk cost represents money that has already been spent and cannot be recovered. It’s often reflected in the saying, “Spend money to make money.” Unlike future costs, such as inventory purchase decisions, sunk costs do not influence future business choices because they remain unaffected by any outcome.
Key Insights
- Sunk costs are incurred and nonrecoverable.
- They’re irrelevant to future business decisions, separate from relevant costs that are considered for strategic planning.
- The sunk cost fallacy can lead to irrational adherence to unsuccessful projects.
- Common examples include salaries, insurance, rent, nonrefundable deposits, and unrecoverable repairs.
Grasping Sunk Costs
Consider a manufacturing firm: investing in machinery, equipment, and factory leases are sunk costs. Whether to pursue additional processing for increased revenue depends on new costs and potential profits, excluding losses already incurred.
Continuing investments due to time or money already committed increases the risk of falling prey to the sunk cost trap.
Types of Sunk Costs
While all sunk costs are fixed (non-recoverable), not all fixed costs are sunk. If an equipment purchase can be cancelled or resold, it isn’t a sunk cost but a variable one.
- Personal Example: Buying a $50 theater ticket that you can’t use—unrecoverable, but irrelevant for future purchases.
Businesses and individuals both encounter sunk costs, though the latter often impact business profitability more significantly.
Sunk Cost Fallacy
This fallacy represents the improper mentality of continuing an endeavour due to prior investments. Avoiding this can ensure rational long-term strategic planning.
- Example: A student struggling in an unsuitable major should consider course requirements for a new major over previous investments.
Psychological Barriers in Sunk Cost Fallacy
- Loss aversion: Avoiding losses more than seeking equivalent gains.
- Commitment bias: Sticking to the original plan despite its weaknesses.
- Waste avoidance: Reluctance to abandon sunk resource investments.
- Personal attachment: Emotional ties to projects influencing decisions.
Overcoming Sunk Cost Fallacy
Achieving this requires critical thinking and informed analysis. Consider these steps:
- Frame the problem: Ensure your problem statement is specific and central to discussions.
- Remain independent: Avoid attachment-driven preferences; rely on reliable data.
- Trust the data: Trust relevant cost analyses for unbiased decisions.
- Adapt risk preferences: Embrace responsible risk appetite while acknowledging sunk costs.
Example: XYZ Clothing
xyz Clothing leases a factory at $5,000/month with purchased machinery worth $25,000. Producing basic gloves gains $20 profit per unit. Continued processing at $15 extra can yield $90 per glove, netting $5 additional profit—the factory lease and machinery remain sunk costs.
In case of shutting down, sunk costs with foreseeable expiration turn into relevant costs affecting the shutdown decision.
Further Insights: Common Questions
- Is salary a sunk cost? Yes, as long as it’s unrecoverable.
- How do sunk costs differ from fixed costs? All sunk costs are fixed but irreversible. Fixed costs may or may not be recoverable or apt for future fluctuations.
- Sunk cost vs. relevant cost: Future decisions consider only relevant costs and new investment potentials, excluding sunk commitments.
- Importance: Recognizing sunk costs prevents their misleading influence on future strategic decisions.
Final Thoughts
Sunk costs are ubiquitous from personal budgets to corporate finances. While these expenses linger as past commitments, they must not influence future planning. Wise decision-making disregards sunk costs, focusing pragmatically on evolving cost and revenue dynamics. By acknowledging and accounting for versus ignoring, tremendous strategic clarity can be achieved.
Related Terms: fixed costs, relevant costs, sunk cost fallacy, loss aversion, risk preference.
References
- National Library of Medicine. “The Sunk Cost Effect in Pigeons and Humans”.
- Major League Baseball. “Dodgers Get Slugger Gallo From Yankees”.
