Sunk Cost Definition & Overview

KEY TAKEAWAYS

• Sunk costs are an unavoidable fact of life—and business.
• Poor investments can lead to sunk costs.
• Never factor sunk costs into future business decisions.
• Strive to avoid sunk cost fallacy—at all costs!

What Is a Sunk Cost?

Sunk cost is any spent money that a business can’t recover. The phrase is loosely related to a “sinking ship.” The idea is that once an average cost gets sunk into a business, it’s not going to come back up, much like a sunken ship.

Businesses often incur sunk costs. When starting a business, sunk costs relate to many of the required starting costs. If a business is looking to expand, an initial investment into an expansion may be a sunk cost. Sunk costs are unavoidable in business.

Sunk Costs Are Independent

Because sunk cost is money already spent, it’s considered independent of any investment or project decisions. Many business owners have a hard time removing sunk costs from their decision-making process. But it is your personal responsibility to do so.

When making financial decisions, you should only consider relevant costs. A relevant cost is any cost directly related to the business decision. If you have a negative feeling about any business decision process, you should think twice before proceeding. 

All Sunk Costs Are Fixed Costs, But Not All Fixed Costs Are Sunk Costs

Fixed cost is any cost that remains constant, regardless of the number of goods produced. For example, rent is a fixed cost and a sunk cost. You are spending that money, and it will be the same cost, regardless of how much business you do.

Equipment is another fixed cost, but it is not sunk cost. That’s because you can sell equipment. And in doing so, you can recover some of the initial cost from your earlier investments.

Examples of Sunk Costs

Now that we’ve covered the definition of sunk costs and the sunk cost mindset, let’s take a look at a few examples. It’s important to gain a better grasp of how sunk cost works. You should then start to see an improvement in decision quality when it comes to your company and cost mindset.

• An automaker invests $1.5 million on tooling for a brand new automobile. As the tooling gets completed, the company receives information back from a marketing study. The study shows that buyers don’t want the tooling made for that vehicle.

The company can produce the remaining tooling for the vehicle and produce it for $500,000. Or they can make a new set of tooling for $1.75 million. Even though the company has considerable investment time in its operations, the $1.5 million spent on the existing tooling is a sunk cost. Therefore, it shouldn’t factor into any type of decision involving future cost factors.

• You spent close to $1,000 on an expensive trip as a treat to yourself. However, the trip dates overlap with a family event. Because you already spent $1,000, it is a sunk cost. Therefore, you shouldn’t factor it in when deciding whether to go on the trip or the family event.

Once you see an improvement in decision quality, each economic choice you make will be for the betterment of your company. Moreover, you’ll be more likely to make a careful analysis of every purchasing decision.

What you have to be careful of is the sunk cost bias. Using the example above, let’s assume the family event is the one you should attend. But because you spent the $1,000, you can’t allow yourself to sell or throw away the tickets for your trip.

That’s sunk cost bias. Don’t let yourself fall into its trap. Such biased decisions can have severely negative consequences on your bottom line. Cost effects play a role in every facet of your business. Whether they are biased depends on you.

“You Have to Spend Money to Make Money”: The Sunk Cost Fallacy

One of the oldest business sayings in the book is, “You have to spend money to make money.” While that may be true, many people tend to apply it to sunk costs. Inherently, this is incorrect.

Overall, this reasoning tells you to keep investing at all costs. This is a major lapse in judgment and a mistake in reasoning.

When considering whether or not you should continue your investment in money, you must remove sunk costs from the equation.

Examples of Sunk Cost Fallacy

To better understand sunk cost fallacy, consider the following examples.

Personal Scenario

You spent $500 on an upcoming ski trip. While it looks like it’ll be fun, you also discover a better ski trip that sells for $300. So you purchase tickets for it, as well. After purchasing both sets of tickets, you find out that they fall on the same weekend.

But because one trip costs more than the other, you forgo the cheaper and better trip in favor of the more expensive and less fun trip. This is a prime example of sunk cost fallacy.

Business Scenario

A company makes a line of products that indicates it will sell well based on a previous study. Because of the success of the field study, the company invests $500,000 in the product line. Unfortunately, the products don’t end up selling as well as initially thought.

Since the company invested $500,000 in the line, they made a biased decision to keep pushing the product despite low sales. This involves an additional cost investment of $250,000. Because the company referred to the initial investment, they didn’t stop manufacturing the product. As a result, it lost even more money in the long run.

How to Avoid Sunk Cost Fallacy

In a business, the best way to avoid sunk cost fallacy is to remove emotion from the decision-making process. Often, the most straightforward solution is to create a financial model to aid in economic decision-making.

Financial analysts often make cost models that remove emotion and focus solely on numbers. By doing this, you can remove the likelihood of the adverse behavior that stems from sunk-cost effects.

Summary

Sunk costs happen in all businesses, whether large or small. It’s important to not let yourself get hung up on sunk costs if and when they appear in your business. Instead, keep pressing on towards success. When you keep sunk costs out of your future business decisions, you’re more likely to make rational decisions for the good of your company.