A sunk cost is a cost that cannot be recovered or changed and is independent of any future costs a business might incur. Because a decision made today can only impact the future course of business, sunk costs stemming from earlier decisions should be irrelevant to the decision-making process.
Instead, decision-makers should base strategies on how to proceed with business or an investment based on future costs. Leaders who continue a course of action because of the time or money already committed to an earlier decision risk falling into the sunk cost trap.
Sunk Costs in Business
Suppose a business executive of a financial consulting firm is hired to build an analytics application for $10 million. The executive determines the project will require $7 million and one year to deliver, leaving a tidy projected profit of $3 million upon competition.
However, in the ninth month the team runs into problems with the main framework of the application. The consulting firm has already spent $5.25 million. The business executive must now decide whether to continue or cancel the project. It is estimated this major setback will cost an additional $1 million to rectify. However, this would leave the company with a projected profit of $2 million.
Whether the business executive decides to continue forward or cancel the deal, the $5.25 million spent over the past nine months cannot be retrieved. This should be irrelevant to the decision, because only future costs and potential revenue should be considered. Cancelling would incur a $5.25 million loss and leave the company with zero revenue from the project. If the executive continues, future revenue for the company is $10 million, and future costs are $2.75 million.
The executive decides to continue with the project because, ignoring sunk costs, an investment of $2.75 million would generate $10 million in revenue and $2 million in profit.