Sunk costs represent investments irretrievably spent and unrecoverable. These investments can be financial, time-based, or emotional.
In contrast, other types of costs can be modified or avoided based on future actions. For example, variable costs fluctuate with the level of production or output, while opportunity costs indicate the potential benefits sacrificed when selecting one option over another.
For businesses, the concept of sunk costs is essential to understand because it plays a critical role in decision-making.
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Overview of the Sunk Cost Fallacy
Sunk cost fallacy is a cognitive bias that impacts personal and professional decision-making.
Many individuals and organizations fall prey to the sunk cost fallacy. This cognitive bias compels people to continue investing in losing endeavors based on the amount already invested rather than evaluating the endeavor’s future potential.
That isn’t good as it leads to irrational decisions. People may double down on failing projects to recover their sunk costs rather than cutting their losses and reallocating resources to more promising opportunities.
Several factors contribute to the sunk cost fallacy, including the following.
Loss aversion
People often exhibit loss aversion, a cognitive bias where they feel the pain of losses more intensely than the pleasure of gains. As a result, many focus more on avoiding losses than pursuing potential gains.
For example, someone may do more to avoid losing $500 than to gain $5000. The person chases after the sunk cost.
Cognitive dissonance
When people face contradictory information, they may experience cognitive dissonance. This is a state of mental conflict that occurs when a person’s beliefs, attitudes, or behaviors contradict. The discomfort arises because people desire consistency in those areas.
When inconsistencies occur, individuals feel a natural urge to resolve the contradiction. Cognitive dissonance can lead to changes in beliefs or behaviors to restore balance and reduce dissonance. For example, someone who believes in eating healthily but gobbles up a large piece of cake may experience cognitive dissonance.
It’s relevant to sunk cost because people can feel cognitive dissonance as they struggle to reconcile the desire to move forward with their reluctance to let go of something they already started. This is especially true when the sunk cost is high.
For example, someone may continue to invest in a failing business venture despite knowing it will not succeed. This is because the person is unwilling to accept the lost money already spent.
Emotional attachment
People may develop an emotional attachment to their investments, making it difficult to objectively assess the situation and leave a failing endeavor. For example, emotional attachments can cause leaders to ignore warning signs and continue investing in the face of losses.
Sunk Cost Examples
Here are several examples of sunk costs in various contexts.
- Business investments: If a company invests in new machinery or equipment, the cost of that investment becomes a sunk cost. The money spent is unrecoverable once the equipment is purchased and installed. That will remain true even if the machinery becomes obsolete or the company shifts its production focus.
- Research and development: Companies often spend significant amounts on research and development projects. The money on these projects becomes sunk costs. You can’t recover the investment if the project fails or the research doesn’t bring the desired outcomes.
- Advertising campaigns: Advertising money is sunk cost as you can’t get your money back regardless of the campaign’s effectiveness.
- Education and training: The money spent on tuition, textbooks, and other educational expenses becomes a sunk cost. These funds are unrecoverable regardless of whether the individual benefits from the education or training.
- Concert or event tickets: When you purchase a non-refundable concert or live event ticket, the ticket’s cost becomes a sunk cost. If you cannot attend the event or change your mind about going, the money spent on the ticket cannot be recovered.
- Employee salaries and benefits: Once a company pays its employees’ wages and benefits, these costs become sunk costs. Even if an employee leaves, the company cannot recover the investment.
How to Identify a Sunk Cost
Here are some tips to help you identify sunk costs in various situations.
- Determine the irrecoverable nature of the cost: The primary characteristic of a sunk cost is its irrecoverable nature. So, assess whether the cost is incurred and cannot be recovered or reversed. It’s not a sunk cost if the cost can still be altered or recuperated.
- Differentiate between past and future costs: Sunk costs are associated with past expenses or investments, whereas future costs are subject to change. Therefore, focus on the future costs and benefits when evaluating a decision and separate them from costs already incurred.
- Distinguish between fixed and variable costs: Sunk costs are fixed costs, meaning they do not change based on the level of production or output. However, not all fixed costs are sunk costs. Be sure to distinguish between recoverable fixed costs (e.g., rent you can cancel) and irrecoverable ones (e.g., payment for a software license).
- Evaluate opportunity costs: Opportunity costs represent the benefits forgone when choosing one alternative over another. While sunk costs should not impact decision-making, consider opportunity costs in the decision-making process. But ensure you are not mistaking sunk costs for opportunity costs.
- Look for emotional attachments: As noted earlier, emotional attachment to an investment can make it challenging to identify sunk costs. So be aware of your emotional biases and assess whether they cloud your judgment when evaluating sunk costs.
- Consider external perspectives: Seeking advice from others, such as colleagues or other industry experts, can help you accurately identify sunk costs. External perspectives may provide a more objective assessment of the costs involved, free from emotional biases.
Why Ignore Sunk Costs in Decision Making
Many business leaders ignore sunk costs for the following reasons.
- Allows them to focus on future benefits: Since you can’t change sunk costs, including them in your decision-making can lead to a biased evaluation of potential future benefits.
- Helps avoid the sunk cost fallacy: As explained earlier, including sunk costs in decision-making can lead to the sunk cost fallacy. Ignoring sunk costs will help you avoid falling into the sunk cost fallacy trap and make more rational decisions.
- Optimize resource allocation: By disregarding sunk costs, decision-makers can focus on allocating resources more efficiently based on the future potential of various options. This can lead to better outcomes and maximize returns on investment.
- Encourage objective evaluation: Sunk costs can create emotional attachments to a project or investment, making it difficult to assess the situation objectively. Ignoring sunk costs allows decision-makers to evaluate options and make more informed choices.
- Facilitate adaptability: Adapting and pivoting are essential in a rapidly changing business environment. Ignoring sunk costs allows businesses to change directions more easily without being held back by past investments.
- Promote learning and growth: By disregarding sunk costs, you can learn from past experiences and make better decisions in the future. Recognizing that a sunk cost is part of the learning process can help decision-makers grow and develop more effective strategies.
One study by the Journal of Applied Psychology found that people were more likely to escalate their commitment to a failing project as the sunk costs increased.
This study involved 407 undergraduate business students. It investigated the relationship between sunk costs and the decision to continue investing in a research and development (R&D) project.
The participants read a scenario where varying percentages of a $10 million budget had already been spent on the project. Researchers then divided participants into three groups:
- The first group assessed the likelihood of allocating all remaining funds to complete the project.
- The second group determined the likelihood of allocating the next $1 million to continue the project.
- The third group evaluated the likelihood that the project would be profitable.
The results showed a strong sunk cost effect in the first two groups, with decisions influenced by the amount already invested, rather than considering incremental costs.
The third group had no significant correlation between sunk costs and expected outcomes.
Difference Between Sunk Cost and Relevant Cost
Relevant costs (aka incremental or differential costs) are expenditures directly affected by a specific decision or action. These costs can change based on choices, making them relevant to decision-making.
Relevant costs include variable costs, opportunity costs, and any costs that will be incurred or avoided depending on the decision. This can be the costs of raw materials, labor, and any additional expenses or savings resulting from choosing one decision over another.
In short, the primary difference between sunk and relevant costs is their impact on decision-making.
- Sunk costs should not influence future decision-making since you can’t change or recover these expenses.
- Relevant costs are directly related to future decisions or actions, so you should consider them in decision-making.
Sunk Costs Are Inevitable
Sunk costs are an inevitable aspect of financial activities for individuals, businesses, and government entities. From the groceries sitting in your fridge to the salaries of employees to infrastructure investments, sunk costs permeate various aspects of finance.
These costs represent committed and nonrecoverable expenses, so their influence on future decision-making should be null. Consciously excluding sunk costs from future decisions allows you to make more informed and rational choices that optimize resource allocation and maximize overall success.
