There's an old saying that you shouldn't throw good money after bad. It's founded in the common-sense principle that just because you've spent money on something up to a point, there's no reason to keep spending money on it if the chances of recovering your investment are doubtful. Economists have a term for spending on things you can't recoup your money from; they're called "sunk costs."

SEE: The Art Of Cutting Your Losses

Definition
A sunk cost is defined as "a cost that has already been incurred and thus cannot be recovered. A sunk cost differs from other, future costs that a business may face, such as inventory costs or R&D expenses, because it has already happened. Sunk costs are independent of any event that may occur in the future."

Businesses with the highest sunk costs tend be those with the greatest barriers to entry and biggest startup costs. These would include capital-intensive industries that require large buildings, expensive tooling and a high ratio of fixed to variable costs. In fact, the level of sunk cost is a major barrier to entry to many of these businesses.

The concept is simple and straightforward, but sunk cost plays a major role in many personal and business decisions. It's important to have a decision-making strategy when confronted with the need to spend more money when the recoupment of the sunk cost may be in jeopardy.

SEE: The Importance Of Trading Psychology And Discipline

Sunk Cost Dilemma
The best way to illustrate this concept is with an example that has played out many times over the past several years. You're a homebuilder during the bubble and you've started work on 20 spec homes in a small development. You've cleared the land, prepped the home sites and brought in power, water and sewer. Halfway through construction of the homes, the real estate market starts to crash. Do you keep working and finish the construction, hoping that the market will soon improve? Or, do you stop work and save the money you would have spent finishing all the homes?

At the point in time where you make this decision, everything you've spent so far is sunk cost. In this case it's a considerable amount of money, and it may be painfully difficult to walk away. If you do, that money is lost forever. If you don't, you run the risk of spending even more money that you'll never recover if economic conditions don't improve fast enough. The dilemma can be framed as one of certain loss versus uncertain success.

During the U.S. recession many homebuilders chose to keep working, assuming this economic recovery would mirror past experience. It didn't and many of them failed because there has been no sustainable rebound in the real estate market. In retrospect, they would have been better off ignoring their sunk costs and cutting their losses. The sunk cost dilemma is not resolved as long as the project is neither completed nor stopped.

SEE: The Risk Of Real Estate Sector Funds

Financial Aspects
To some degree, all businesses incur sunk costs at various times. When making a decision, it's useful to compare the benefits that will accrue from each choice to the additional costs associated with each. Economists refer to this approach as "acting on the margins" because you're focusing on the relative merits of future actions. This type of thinking should lead to the choice that provides the greatest net additional benefits, regardless of what has happened in the past. Since sunk costs will not change as a result of any choice you could make, they should be irrelevant for your next decision.

In a financial sense, a line can be drawn between sunk costs and other costs you incur that have no immediate benefit. An example would be insurance premiums that can be paid for years and years without ever making a claim. While those premiums might be considered sunk in a personal sense, they're not, because they provided you with a continuing benefit by protecting you from potential losses. The fact that you were lucky enough not to need the insurance doesn't mean the money was wasted.

SEE: How An Insurance Company Determines Your Premiums

The Bottom Line
If you bought an advance ticket to a movie and then heard from several moviegoers that it was terrible, would you still go see it if you couldn't get a refund or resell the ticket? Made on a purely economic basis, you wouldn't go because the ticket is a sunk cost. On a psychological level though, you might believe if you don't go you won't get your money's worth. Plus, there's always the chance that you might like it. But if you go and don't like it, you've not only wasted the cost of the ticket but a few hours of your time. You've compounded the financial loss with an opportunity loss.

In a strict economic sense, a rational person ignores sunk costs and only considers variable costs when making a decision. To do otherwise would prevent one from making a decision purely on its merits. However, this approach is in conflict with the irrational human tendency to avert loss under any circumstances. Sometimes it's not worth crying over spilled milk.

Related Articles
  1. Economics

    Understanding Organic Growth

    Organic growth is the increase in a company’s revenue and value due to internal operations.
  2. Economics

    Explaining Market Penetration

    Market penetration is the measure of how much a good or service is being used within a total potential market.
  3. Economics

    Calculating the Marginal Rate of Substitution

    The marginal rate of substitution determines how much of one good a consumer will give up to obtain extra units of another good.
  4. Economics

    Understanding Cost of Revenue

    The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
  5. Stock Analysis

    5 Reasons Thoratec Corp. Keeps Impressing Investors

    Learn about Thoratec Corporation and its position in its industry. Understand five key factors why the company has impressed investors.
  6. Entrepreneurship

    Startup Analysis: How Much Is Palantir Worth?

    Learn about the private company Palantir, its valuation and how its valuation was derived. Understand how the company operates and if it deserves the valuation.
  7. Stock Analysis

    Jawbone: An IPO You Should Have on Your Radar

    Learn about the company Jawbone and how it has become successful with multiple product lines. Understand the benefits of investing in an IPO
  8. Economics

    What is a Free Rider Problem?

    In economics, the free rider problem refers to someone being able to get, for less or even for free, what others pay more for.
  9. Stock Analysis

    Startup Analysis: How Much Is Dropbox Worth?

    Learn about the private company Dropbox and how it operates. Understand the company's current valuation, how it was derived, and if it deserves it.
  10. Stock Analysis

    Startup Analysis: How Much Is Lyft Worth?

    Learn about the private company Lyft and how it has become a successful rideshare company. Understand its most recent valuation and if it is deserved.
RELATED TERMS
  1. Black Money

    Money earned through any illegal activity controlled by country ...
  2. Horizontal Merger

    A merger occurring between companies in the same industry. Horizontal ...
  3. Head-Fake Trade

    A trade where a stock or market appears to be making a move in ...
  4. Crowded Short

    A trade on the short side with an overwhelmingly large number ...
  5. Factor Market

    A marketplace for the services of a factor of production.
  6. Marginal Rate of Technical Substitution

    The rate at which one factor has to be decreased in order to ...
RELATED FAQS
  1. How do companies use marginal analysis?

    Marginal analysis is the technique companies utilize when they have a cost-benefit approach to making resource allocation ... Read Full Answer >>
  2. Are all fixed costs considered sunk costs?

    In accounting, finance and economics, all sunk costs are fixed costs. However, not all fixed costs are considered to be sunk. ... Read Full Answer >>
  3. What are common examples of bad decisions made due to the sunk cost fallacy?

    The sunk cost fallacy is the theory that continuing to put money into a project or other investment that is failing is worthwhile ... Read Full Answer >>
  4. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  5. What does marginal utility tell us about consumer choice?

    In microeconomics, utility represents a way to relate the amount of goods consumed to the amount of happiness or satisfaction ... Read Full Answer >>
  6. What is the difference between JIT (just in time) and CMI (customer managed inventory)?

    Just-in-time (JIT) inventory management focuses solely on the need to replenish inventory only when it is required, reducing ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!