What Is a Sunk Cost?
A sunk cost is money that has already been spent and cannot be recovered. In business, the axiom that one has to "spend money to make money" is reflected in the phenomenon of the sunk cost. A sunk cost differs from future costs that a business may face, such as decisions about inventory purchase costs or product pricing. Sunk costs are excluded from future business decisions because they will remain the same regardless of the outcome of a decision.
- Sunk costs are those which have already been incurred and which are unrecoverable.
- In business, sunk costs are typically not included in consideration when making future decisions, as they are seen as irrelevant to current and future budgetary concerns.
- Sunk costs are in contrast to relevant costs, which are future costs that have yet to be incurred.
- The sunk cost fallacy is a psychological barrier that ties people to unsuccessful endeavors simply because they've committed resources to it.
- Examples of sunk costs include salaries, insurance, rent, nonrefundable deposits, or repairs (as long as each of those items is not recoverable).
Understanding Sunk Costs
A sunk cost refers to money that has already been spent and cannot be recovered. A manufacturing firm, for example, may have a number of sunk costs, such as the cost of machinery, equipment, and the lease expense on the factory. Sunk costs are excluded from a sell-or-process-further decision, which is a concept that applies to products that can be sold as they are or can be processed further.
When making business decisions, organizations should only consider relevant costs, which include the future costs that still needed to be incurred. The relevant costs are contrasted with the potential revenue of one choice compared to another. To make an informed decision, a business only considers the costs and revenue that will change as a result of the decision at hand. Because sunk costs do not change, they should not be considered.
Businesses that continue a course of action because of the time or money already committed to an earlier decision risk falling into the sunk cost trap.
Types of Sunk Costs
All sunk costs are fixed costs but not all fixed costs are sunk costs. The difference is that sunk costs cannot be recovered. If equipment can be resold or returned at the purchase price, for example, it's not a sunk cost.
Sunk costs don't only apply to businesses as individual consumers can incur sunk costs as well. Let's say you buy a theater ticket for $50 but at the last minute can't attend. The $50 you spent would be a sunk cost but would not factor into whether or not you buy theater tickets in the future. In general, businesses pay more attention to fixed and sunk costs than people, as both types of costs impact profits.
Sunk costs also cover certain expenses that are committed but yet to paid. Imagine a company that has entered into a contract to buy 1,000 pounds of raw materials for the next six months. If the company is contractually obligated to uphold their end of the deal, the raw materials are a sunk cost whether the company has paid for them or not because the company will incur the costs regardless of what the company decides to do with the materials.
Sunk Cost Fallacy
The sunk cost fallacy is the improper mindset a company or individual may have when working through a decision. This fallacy is based on the premise that committing to the current plan is justified because resources have already been committed. This mistake may result in improper long-term strategic planning decisions based on short-term committed costs.
Imagine a non-financial example of a college student trying to determine their major. A student may declare as an accounting major, only to realize after two accounting classes that this is not the career path for them. The sunk cost fallacy would make the student believe committing to the accounting major is worth it because resources have already been spent on the decision. In reality, the student should only evaluate the courses remaining and courses required for a different major.
In business, the sunk cost fallacy is prevalent when management refuses to deviate from original plans, even when those original plans fail to materialize. The sunk cost fallacy incorporates investor emotions that cause otherwise irrational decision-making.
The sunk cost fallacy is deeply rooted in biological tendencies, as researchers from the University of California San Diego analyzed the sunk cost effect in humans as well as pigeons.
Sunk Cost Fallacy - Psychological Factors
There's five common explanations as to why the sunk cost fallacy exists. Here are the psychological reasons that explain why some decision-making processes fail.
- Loss aversion. People may prefer to avoid a loss over an equivalent gain. These people are unwilling to commit to a guaranteed loss (i.e. ending a project that has a sunk cost) due to their low risk tolerance. All else being equal, some people have a tendency to avoid losses as opposed to seek gains.
- Commitment bias. People may stick to a plan because that was simply the original plan that was made. A project is given preferential treatment for no other reason than it was what was originally decided upon.
- Waste avoidance. People may want to avoid wasting company resources. Unfortunately, especially in research and development, not all opportunities pay off as due diligence spending may lead to nowhere.
- Personal decision-making. People may feel emotionally attached or responsible for a specific project or decision. This creates an emotional bias that the project may turn or the data may be incorrect.
How to Avoid Sunk Cost Fallacy
The sunk cost fallacy can easily be overcome with mindfulness, dedicate, and thoughtful planning. Here's a few pointers on overcoming the mental challenge.
- Frame the problem. The root of decision-making must start with a very specific problem that needs to be solved. This problem should be the central focal point of discussion and should drive all actions from analysts. This step helps frame what is important and what should be recognized as an unimportant distractor.
- Remain independent. When people become emotional invested in business decisions, they may lose sight into what is really happening. Instead of relying on data, they have an unrealistically optimistic outlook on their poor decision. Be mindful that unsuccessful projects don't always reflect the decision-maker, and ultimately making the right decision is what should matter most.
- Trust the data. When comparing several options, sunk cost is most often excluded. This may feel inappropriate to do, but the process makes sense and delivers the most reliable basis for decision-making.
- Change risk preference. Some investors actively seek out risk as they believe those types of investments offer the greatest returns. On the other hand, other investors still stick cash under the mattress and would rather forfeit any potential growth out of liquidity protection. By becoming more accepting of risk and not being consumed by risk aversion, investors can more easily come to terms that it is okay to have incurred sunk costs that will never be recoverable.
After trading for Joey Gallo, the New York Yankees outfielder struck out 194 times over 140 games. Instead of continuing to stick with their decision that didn't pan out as they'd hoped, the Yankees traded Gallo in August 2022. This is an example overcoming the sunk cost fallacy.
Example of Sunk Costs
Assume that XYZ Clothing makes baseball gloves. It pays $5,000 a month for its factory lease, and the machinery has been purchased outright for $25,000. The company produces a basic model of a glove that costs $50 and sells for $70. The manufacturer can sell the basic model and earn a $20 profit per unit. Alternatively, it can continue the production process by adding $15 in costs and sell a premium model glove for $90.
To make this decision, the firm compares the $15 additional cost with the $20 added revenue and decides to make the premium glove in order to earn $5 more in profit. The cost of the factory lease and machinery are both sunk costs and are not part of the decision-making process.
If a sunk cost can be eliminated at some point, it becomes a relevant cost and should be a part of business decisions about future events.
If, for example, XYZ Clothing is considering shutting down a production facility, any of the sunk costs that have end dates should be included in the decision. To make the decision to close the facility, XYZ Clothing considers the revenue that would be lost if production ends as well as the costs that are also eliminated. If the factory lease ends in six months, the lease cost is no longer a sunk cost and should be included as an expense that can also be eliminated. If the total costs are more than revenue, the facility should be closed.
What Is an Example of a Sunk Cost?
Imagine a company decides it needs to expand its warehouse. It contacts an architect to design a new space who drafts some preliminary drawings for a fee. Then, an economy slowdown occurs, and the company is now unsure whether it should continue with the new warehouse.
In this example, the architecture fees are an examl
Are Salaries a Sunk Cost?
Yes, any salary that has been paid to an employee is a sunk cost. As long as those wages are not recoverable, that salary represents an expense that has been incurred and can not be captured back by the company.
What Is a Sunk Cost vs. a Fixed Cost?
In business, fixed costs are expenses that have to be paid by a company independent of any specific work activities: They don't apply to a company's production of any goods or services, and they don't rise or fall with a change in the number of goods or services produced or sold. Sunk costs are a subset of fixed costs—specifically, a type of fixed cost that is not recoverable.
What Is the Difference Between Sunk Cost and Relevant Cost?
When making business decisions, organizations should only consider relevant costs, which include future costs—such as decisions about inventory purchase costs or product pricing—that still need to be incurred. The relevant costs are contrasted with the potential revenue of one choice compared to another. Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision.
Why Are Sunk Costs Important?
Sunk costs are important because may act as distractors in decision-making. When a company analyzes costs and benefits, sunk costs should have no bearing on the decision-making process as the sunk cost will be incurred regardless of the outcome of the choice. Sunk costs are important to be mindful of because incorrectly including them in an analysis may lead to a less favorable decision being chosen.
The Bottom Line
All businesses and individuals incur sunk costs. Whether its the groceries already in your refrigerator, the employees on a company's payroll, or capital expenditure plans by your local government, sunk costs are a natural part of finance. These expenses are already committed to and nonrecoverable; for that reason, sunk costs should not be included in future decision-making as the expense for the sunk cost will be exactly the same in every situation.