Sunk costs are defined as expenses that have already been incurred and cannot be reversed or recovered. They are past investments of time, money, or resources that have already been spent and do not offer any future returns.
Sunk costs are incurred due to decisions made in the past that cannot be changed by a subsequent decision in the future.
Examples of sunk costs include the purchase price of a product/service, research and development costs, advertising and marketing expenses, legal and accounting fees, salaries and wages for employees, and so on.
In business, it is important to understand the concept of sunk costs to make informed decisions. By recognizing the nonrecoverable costs, businesses can focus on avoiding future losses and maximizing profits.
Sunk Cost Examples
- Salary for employees who have been laid off: Even though an organization may have already paid a former employee’s salary, they cannot recover this cost. Such an employee’s salary can be considered a sunk cost.
- Research and development costs: Any expenses incurred for the research and development of a product or service cannot be recovered if the project is canceled. For example, if a company spends money on market research for a never released product, this cost would be assumed as sunk.
- Advertising and marketing expenses: Advertising and marketing costs, such as hiring a spokesperson or placing ads in print media, cannot be recovered if the project is terminated.
- Legal and accounting fees: Many companies must pay legal and accounting fees to prepare documents and complete transactions. These are expenses related to legal advice or tax filing services that cannot be recovered if the project is canceled or not completed.
- Machinery and equipment: Of course, every business needs to purchase and maintain machinery and equipment for their operations. The cost of buying and maintaining machines and equipment cannot be returned if it is no longer needed or becomes obsolete.
- Training costs: Companies spend money to train their employees for the job. If an employee is laid off or if the project is canceled, this cost cannot be recovered.
- Interest payments: Businesses paying interest on loans and debt are obligated to pay off the full amount even if they have no hope of getting any returns on their investment. Such interest payments can be considered sunk costs.
- Lease payments: Many companies often need to lease premises, such as office space or warehouses, to operate their business. The money spent on leasing these premises cannot be recovered if the business decides to move away or discontinue operations.
- Logistics costs: Almost all businesses incur costs for transporting goods and materials. It is a necessary step to start production or deliver the final goods to the customer. Still, these costs would be considered sunk if the product is discontinued or not sold.
- Taxes: Taxes are a part of doing business and must be paid even if the company does not get any profit from its operations. Therefore, taxes can be considered sunk costs.
- Educational investments: Many individuals invest time and money in obtaining degrees or certifications. However, if they switch careers or industries, the financial expenses and time spent on those qualifications become sunk costs and cannot be recovered.
- Travel and accommodation expenses: Businesses often send employees for conferences, meetings, or training. If the event is canceled or if no tangible benefits are derived from attending, the costs of travel and accommodation cannot be reclaimed.
- License and permit fees: Companies often need licenses and permits to operate legally. The fees paid for obtaining these licenses and permits cannot be recovered if the business changes its operation model or stops using them.
- Real estate improvements: Businesses sometimes renovate or upgrade their properties to enhance operations. If they decide to relocate or if those improvements don’t lead to increased profits, those costs become sunk.
- Software and technology costs: Investing in software or technology solutions can be expensive. If a business shifts its model or finds the tech solution obsolete, the initial investment becomes a sunk cost.
- Event sponsorships: Companies may sponsor events or shows to promote their brand. If the event fails to generate expected publicity or is canceled, the sponsorship money cannot be recovered.
- Merchandise inventory: Retailers often buy inventory in bulk. If certain items don’t sell or go out of style, the cost of unsold inventory becomes a sunk cost.
- Consulting fees: Companies may hire consultants for expert advice. If the advice doesn’t lead to anticipated results, the fees paid to the consultant become sunk costs.
- Prototype development: Before launching a product, businesses often develop prototypes. If the product never reaches the market, the money spent on these prototypes is considered a sunk cost.
- Employee benefits and perks: Companies might offer certain perks and benefits to attract talent. If an employee leaves or if those benefits do not lead to increased productivity, the expenses incurred become sunk costs.
- Initial franchise fees: Entrepreneurs might pay fees to buy into a franchise system. If the franchise fails or if they decide to exit, the initial franchise fee cannot be recovered.
Definition of Sunk Costs
English professor Colin Drury defines sunk costs as “costs that have been created by a decision made in the past and that cannot be changed by any decision that will be made in the future” (Drury, 2013).
In other words, a sunk cost is an expense that has been incurred in the past and cannot be recovered. It is a past investment of resources that offers no future returns.
They are excluded from any future decisions because they have already been spent and cannot be changed.
For example, if a business purchased a machine for $100,000 and it is no longer being used, the cost of the machine can be considered a sunk cost. It is because the money has already been spent and cannot be recovered, so it does not influence the decision-making process for future investments.
Organizations should consider only the relevant costs that still need to be paid when making any business decisions. These costs must always be weighed against the potential revenue expected to come from the decision (Broadbent & Cullen, 2014).
What is the Sunk Cost Fallacy?
The sunk cost fallacy is people’s tendency to continue investing in an endeavor even after it has become unprofitable due to irrational decisions based on prior investments (Ronayne et al., 2021).
Simply put, people and organizations keep investing in something because they believe they have already invested time, money, or resources on it, so it should not go to waste.
Sunk cost fallacy often leads companies to continue investing in a product or service that has no chance of providing a return on investment and leads to further losses.
For example, suppose a company has invested $10,000 in developing a product. Yet, they believe they need to continue investing in the same product even though it is not selling because they have already spent so much money and time on it. This behavior is an example of the sunk cost fallacy.
In essence, the sunk cost fallacy is based on the erroneous belief that past investment means future returns.
Why Does the Sunk Cost Fallacy Exist?
The underlying causes of the sunk cost fallacy tend to be psychological, with five primary explanations accounting for its prevalence.
- Incentive to avoid admitting mistakes: People often try to avoid admitting their mistakes and taking responsibility for them. By continuing to invest in a project, despite its poor performance, they can avoid the embarrassment of admitting their decision was wrong (Arkes & Blumer, 1985).
- Fear of losing out: Some may invest additional resources in a project, even when it is not showing any returns because they fear that the investment might be lost if they decide to pull out.
- Pressure from others: Many investors may feel pressure from their peers or superiors to continue investing in a project despite its low returns. It can lead to the sunk cost fallacy, as people feel obligated to keep investing even when it is not wise to do so (Haita-Falah, 2017).
- Disregard for opportunity cost: People may continue to invest in a project simply because they are not considering the opportunity cost of their resources. Suppose a person is only focusing on the amount they have already invested. In that case, they may not take into account the potential returns they could get if they diverted their resources elsewhere.
- Bias towards action: Some may be biased towards action and may persist with a project even though it is not paying off because they feel like they are doing something. This bias can lead to continued investment in a project even when the returns are not there (Arkes & Blumer, 1985).
How to Avoid the Sunk Cost Fallacy
Sunk cost fallacy is a psychological bias that causes people to still consider sunk costs when making decisions. So, the best way to avoid it is to make decisions based on current and future potential costs and benefits instead of past investments.
- Consider the opportunity cost: Organizations and individuals should consider the opportunity cost of their decisions. It means looking at what else could have been done with the resources allocated to a project or activity instead of pouring more money into it.
- Take into account external factors: It’s also important to consider the external factors that may impact a project’s success. When deciding whether or not to continue investing in a project, organizations should consider things such as market trends, customer feedback, competitor activities, and other risks.
- Be willing to accept losses: Finally, organizations should also be willing to accept mistakes and losses. Cutting losses at the right time can help to prevent further losses or wasted resources.
Sunk Costs vs. Fixed Costs
Sunk and fixed costs are two different types of expenses. Sunk costs have already been spent and cannot be recovered. In contrast, fixed costs are ongoing expenses that must be paid regardless of the outcome (Wang & Yang, 2001).
Fixed costs are usually long-term commitments, such as rent or salaries. These are expenses that must be paid regardless of the outcome or results.
On the other hand, sunk costs are one-time investments that cannot be recovered. Examples of sunk costs include advertising, marketing, and training expenses. The money spent on these activities cannot be recovered if the project or activity is unsuccessful.
Sunk costs are expenses that cannot be recovered and are often overlooked when making decisions. Examples of sunk costs include advertising, training, and marketing expenses, as well as the opportunity cost of resources.
The sunk cost fallacy occurs when businesspeople continue to invest in a project despite its poor performance due to factors such as fear of losing out, pressure from others, disregard for opportunity cost, and bias towards action.
Organizations should strive to make decisions based on current and future potential costs and benefits, consider the external factors that may impact a project’s success, and be willing to accept losses if necessary.
These strategies will help businesses to avoid the sunk cost fallacy and make more informed decisions.
Arkes, H. R., & Blumer, C. (1985). The psychology of sunk cost. Organizational Behavior and Human Decision Processes, 35(1), 124–140. (Source)
Broadbent, M., & Cullen, J. (2014). Managing financial resources. Routledge.
Drury, C. (2013). Costing: An introduction. International Thomson Business.
Haita-Falah, C. (2017). Sunk-cost fallacy and cognitive ability in individual decision-making. Journal of Economic Psychology, 58, 44–59. https://doi.org/10.1016/j.joep.2016.12.001 (Source)
Ronayne, D., Sgroi, D., & Tuckwell, A. (2021). Evaluating the sunk cost effect. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.3823624 (Source)
Wang, X. H., & Yang, B. Z. (2001). Fixed and sunk costs revisited. The Journal of Economic Education, 32(2), 178. https://doi.org/10.2307/1183493 (Source)