Sunk Cost
An irrecoverable expense that has already occurred
What is a Sunk Cost?
An irrecoverable expense that has already occurred is referred to as a "sunk cost" or "retrospective cost."
The core of acknowledging these costs lies in the comprehension that these costs should not impact future choices. Decisions should be grounded in the marginal costs and benefits relevant to the current scenario.
These retrospective costs should be dismissed because they have no connection to future actions or decisions. Directing attention to future costs and benefits ensures that decisions are made clearly on what can be influenced moving forward.
For instance, envision a business project incurring substantial costs, like research and development expenses, yet not meeting expectations.
Following the sunk costs principle, a logical decision-maker would evaluate whether the expected benefits justify the additional costs required to continue the project.
The initial investment, categorized as a retrospective cost, should not play a part in this decision. The economically appropriate course of action may terminate the project if the projected benefits fail to cover marginal expenses.
Adequately understanding and managing the costs is a crucial part of economic decision-making.
It empowers individuals and businesses to avoid the pitfall of being swayed by irretrievable past expenditures, creating a focus on aspects that can influence future outcomes and elevate overall decision quality.
Key Takeaways
- A sunk cost is an irrecoverable past expense that ought not to influence choices made in the future. It emphasizes not lingering on previous investments but rather on the costs and rewards of the present and the future.
- Research & development, capital expenditures for training, equipment purchases, legal fees, project start-up costs, and human resource costs are examples of sunken costs.
- A cognitive bias known as the "sunk cost fallacy" holds that decisions made in the past have an excessive impact on those made now.
- The sunk cost fallacy may be avoided by emphasizing objectivity, changing the focus to future results, routinely reevaluating goals, obtaining other viewpoints, considering opportunity costs, developing decision-making processes, and adopting a learning mentality.
Examples of Sunk Costs
The costs that have already occurred and cannot be recovered are defined as Sunk Costs. They can take different forms. These costs are still fundamentally the same, but their classification depends on their situation.
Here are some common examples of these costs:
Research and Development Costs
Expenditures associated with research and development (R&D), such as testing novel goods or cutting-edge technology, can be deducted as retrospective costs. Whether or not these undertakings are successful, their resources become priceless.
Training and Education Investments
Costs associated with employee training programs, workshops, or educational courses become sunk once the investment is made. Whether the newly acquired skills contribute to improved performance or not, the costs related to training remain irrecoverable.
Equipment and Infrastructure Investments
Capital expenditures (CAPEX) refers to the amount expended on equipment acquisition and infrastructure investments that may turn into retrospective costs if the returns on machinery investments, for example, don’t materialize.
The equipment or infrastructural value only affects decisions once the funds have been used.
Legal and Compliance Expenses
Legal proceedings or compliance initiatives can be considered retrospective costs. Regardless of the outcome of a legal case or whether compliance measures achieve anticipated benefits, the expenses tied to these efforts are viewed as unrecoverable.
Initial Investment in Projects
When companies start projects that require large upfront expenditures, these expenses are buried if the project doesn't turn out as planned. Whether the project succeeds or fails, the original outlay is considered a retrospective cost.
Unused Subscriptions or Licenses
Payments for underutilized subscriptions, licenses, or memberships represent retrospective costs. Post-payment, any lack of utilization or non-use of the subscribed services does not impact the irrecoverable expenditure.
Human Resource Costs
Once these processes conclude, expenses linked to hiring, onboarding, and training employees are considered sunk. Whether an employee goes on to make significant contributions or quits soon after, the initial investment in their onboarding is deemed lost.
Decision-makers need to be aware of the many buried costs to avoid making the sunk cost fallacy. This is the false belief that choices taken in the past should still be applied in the present.
Recognizing these costs as non-recoverable facilitates more rational and forward-looking decision-making across diverse business and economic planning scenarios.
The Sunk Cost Fallacy
The cognitive bias that affects decision-making and occurs when past time or resource expenditures are given undue weight.
This bias appears when individuals or groups consider these irrecoverable costs while making choices, going against the conventional wisdom that says these costs shouldn't impact the situation.
Fundamentally, this fallacy emerges from an emotional connection to past investments. People tend to weigh the efforts, resources, or time already devoted to a particular endeavor, allowing this history to sway their choices.
People may persist with failing endeavors or activities due to the urge to explain or recover earlier investments, which commonly results in irrational decision-making.
The sunk cost fallacy is integrally tied to retrospective costs or irreversible spending once committed.
People could find it difficult to separate their emotional and psychological involvement from the decision-making process, even if it makes sense to acknowledge that these expenses shouldn't influence judgments made in the future.
This fallacy can manifest across various life facets, from business decisions to personal relationships. For instance, a business might continue funding a failing project due to substantial investment, neglecting diminishing returns and the potential for further losses.
Similarly, individuals might remain in unsatisfying relationships or pursue paths misaligned with their goals, rationalizing choices based on past investments rather than assessing current circumstances.
To overcome the sunk cost fallacy, one must adopt a different viewpoint. To avoid undue influence from the track record of previous investments, decision-makers should focus on a decision's present and future costs and benefits.
This strategy avoids the problems that come with continuing with unprofitable undertakings and promotes more objective and logical decision-making, leading to better results.
How to Avoid Sunk Cost Fallacy
Individuals and businesses must make rational decisions based on current and future considerations. The sunk cost fallacy should be avoided in the crucial decision-making stage.
The following considerations will help avoid falling victim to the sunk cost fallacy:
- Emphasize Objectivity Over Emotional Attachment: Strive for objectivity while considering the emotional ties with historical decisions when making judgments. Retaining emotions from the decision-making process allows for a more rational appraisal of the existing circumstances.
- Shift Focus to Future Outcomes: Redirect attention from past investments to future outcomes. Evaluate potential costs and benefits moving forward. Assess whether the current course aligns with future goals rather than dwelling on prior investments.
- Regularly Reevaluate Goals and Priorities: Review priorities and goals regularly. Situations evolve, and what was worthwhile in the past might not align with goals now. Ensure decisions align with the present and future.
- Seek External Perspectives: Consult with colleagues, mentors, or trusted individuals for an external viewpoint. External input offers an unbiased perspective, countering the influence of retrospective costs and emotional attachment.
- Consider Opportunity Costs: Assess decisions based on opportunity costs—the potential benefits foregone with one option over another. Focusing on potential gains and losses helps avoid fixation on past investments.
- Establish Decision Criteria in Advance: Set decision criteria based on current and future factors—predefined criteria guide decision-making, reducing the likelihood of being swayed by irrelevant past investments.
- Embrace a Learning Mindset: Foster a learning mindset. If a decision leads to unfavorable outcomes, acknowledge the mistake and be open to change. Learning from experiences contributes to informed decision-making.
- Regularly Review and Adjust Strategies: Regularly review projects or commitments. If a project isn't yielding expected results, be open to adjusting strategies. Proactive adjustments prevent entrenchment in the sunk cost fallacy.
- Implement Decision-Making Protocols: Establish decision-making protocols emphasizing rational assessments. Encourage a culture valuing adaptability and being unafraid to cut losses when necessary.
- Recognize Sunk Costs as Irrecoverable: Understand retrospective costs are unrecoverable. Acknowledge that past investments cannot be reclaimed. This understanding helps decision-makers focus on future considerations.
Sunk Cost Vs. Fixed Cost
Sunk and fixed costs are used in business and economics to characterize a company's financial status. Below are the differences between sunk and fixed costs:
| Sunk Costs | Fixed Costs |
|---|---|
| Sunk costs pertain to money already expended that cannot be recuperated. | Fixed costs denote expenditures unaffected by the level of production or sales. |
| Examples include failed project expenses or discontinued product development costs, which should not sway future decision-making. | Examples include rent, permanent staff salaries, and insurance premiums, which remain constant within the relevant range. |
| The fundamental notion is that the past investment is irrecoverable, directing attention toward current and future costs and benefits. | Covering fixed costs is vital to prevent losses. Under marginal analysis, avoidable fixed costs are essential in making short-term operational decisions. |
| Sunk costs are retrospective, representing bygone investments that should not influence future decisions. | Sunk costs are retrospective, representing bygone investments that should not influence future decisions. Fixed costs persist regardless of the activity and are to be covered by the firm's contribution margin. It’s important in determining the break-even point and formulating long-term financial strategies. |
Understanding these concepts is imperative for adept financial management. Sunk costs underscore the need to concentrate on the present and future, while fixed costs define a business's financial stability and long-term planning.
Together, these concepts furnish a comprehensive perspective on a company's financial health, aiding in informed decisions regarding resource allocation and strategy.
Conclusion
In summary, effectively handling sunk costs is vital for prudent economic decisions. Sunk costs, reflecting past investments that cannot be reclaimed, should not dictate future choices.
The crux is to base decisions on the current situation's marginal costs and benefits, sidestepping any influence from retrospective costs.
The assortment of these costs, covering areas like research and development or human resources, emphasizes the diverse nature of these non-retrievable investments.
Awareness of these costs is crucial to avoid succumbing to the sunk cost fallacy—a cognitive bias that incorrectly allows prior investments to impact ongoing decision-making.
The sunk cost fallacy can adversely affect decision-making in various spheres, prompting a persistence in failing ventures or the pursuit of misguided paths.
Overcoming this fallacy necessitates a change in mindset, prioritizing impartiality over emotional ties and concentrating on future outcomes rather than past investments.
Several strategies, such as seeking external viewpoints, routinely reevaluating goals, and fostering a learning approach, can assist individuals and organizations in steering clear of the sunk cost fallacy.
Moreover, acknowledging retrospective costs as irrecoverable and establishing decision-making guidelines contribute to fostering a mindset resistant to this cognitive bias.
Fixed costs, vital for generating operating profits, play an instrumental role in short-term operational decisions.
The distinction between sunk costs and fixed costs lies in their nature and impact, with retrospective costs representing past investments and fixed costs contributing to long-term financial stability and planning.
Overall, a nuanced understanding of retrospective costs, awareness of the sunk cost fallacy, and differentiation from fixed costs are pivotal elements of adept financial management.
By adopting logical decision-making approaches and focusing on existing and future considerations, individuals and businesses can navigate financial terrains more effectively, promoting resilience and adaptability in dynamic circumstances.
Researched and authored by Nathan Kulakovski | LinkedIn
Free Resources
To continue learning and advancing your career, check out these additional helpful WSO resources:
or Want to Sign up with your social account?