In other words, a sunk cost is a sum paid in the past that is no longer relevant to decisions about the future. The “sunk cost fallacy,” as you described, is when you make a bad decision based on your sunk cost.
What is sunk cost?
A sunk cost is a cost that an entity has incurred, and which it can no longer recover. Sunk costs should not be considered when making the decision to continue investing in an ongoing project, since these costs cannot be recovered.
However, if you ignore these sunk costs, you are free to make a choice about which career you prefer to do. The sunk cost fallacy is when we continue an action because of our past decisions (time, money, resources) rather than a rational choice of what will maximise our utility at this present time. For example, because we order a big meal and have paid for it, we feel a pressure to eat all the food. It just means an expenditure that one cannot expect to recoup.’ When people factor the sunk cost into their future decisions, that’s when it becomes the sunk cost fallacy.
As a result, many investors tend to remain committed or even invest additional capital into a bad investment to make their initial decision seem worthwhile. Assume you spend $200 on a snowboard trip at Grouse Mountain. Later on, you find a better snowboard trip at Cypress Mountain that costs $100 and you purchase that ticket as well. Unknowingly, you find out that the two dates clash and you are unable to get a refund on the tickets. Would you attend the $200 good snowboard trip or the $100 great snowboard trip?
When you identify a sunk cost, you realize that the money has been spent, and the decision is irreversible. When you commit the “sunk cost fallacy,” you are keeping something that is bad simply because you spent a lot of money on it. You are failing to identify the correct current value of something based on its high cost to you in the past. Believe it or not, regular meditation can help you make better decisions when it comes to sunk costs.
Economics 101: What is Sunk Cost
An example of the sunk cost fallacy is paying for a movie ticket, finding out the movie is terrible, and staying to watch anyway just to get your money’s worth. A sunk cost is a cost that has been incurred and cannot be recovered. When facing a potential project or investment, a manager must only consider relevant costs and ignore all irrelevant costs. Many investors are reluctant to admit, even to themselves, that they have made a bad investment. Changing strategies is viewed, perhaps only subconsciously, as admitting failure.
This type of marketing incurs costs that cannot normally be recovered. It is not typically possible to later “demote” one’s brand names in exchange for cash. Once spent, such costs are sunk and should have no effect on future pricing decisions. So a pharmaceutical company’s attempt to justify high prices because of the need to recoup R&D expenses is fallacious. The company will charge market prices whether R&D had cost one dollar or one million dollars.
However, R&D costs, and the ability to recoup those costs, are a factor in deciding whether to spend the money on R&D or not. A sunk cost refers to money that has already been spent and which 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.
In business, a sunk cost fallacy can cost a business greater financial losses. However, if CD’s are no longer selling, it would be more rational to write off these sunk costs, rather than wasting more money on developing a product which will never make a profit. Sunk costs are spent dollars that cannot be refunded or recovered.
Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision. Both retrospective and prospective costs could be either fixed costs (continuous for as long as the business is operating and unaffected by output volume) or variable costs (dependent on volume). A “fixed” cost would be monthly payments made as part of a service contract or licensing deal with the company that set up the software. The upfront irretrievable payment for the installation should not be deemed a “fixed” cost, with its cost spread out over time. The “variable costs” for this project might include data centre power usage, for example.
- In business, an example of sunk costs may be an investment into a factory or research that now has a lower value or no value whatsoever.
They are a normal part of doing business, and should never be used as criteria for decision-making. Not all investments will pan out favorably, and not all business decisions are good ones, but compounding losses by throwing good money after bad is never a good idea. We might as well finish the project.’ A more enlightened executive will say, ‘It doesn’t matter that we’ve already spent $4 million – that’s a sunk cost.
How To Recognize Sunk Costs
If a firm invests in a high profile project, it may be better to make continued losses rather than the reputational harm of admitting it made a failure. Suppose, you spend seven years gaining degree and qualifications to be a lawyer. The investment in education is now a sunk cost (in terms of time and money). However, once qualified, you find you don’t like the job and want to do something different like open up a cafe. If you wish to honour the sunk costs of education, you will continue to work as a lawyer, despite not enjoying it.
Mindfulness means being in the present, free of distractions. According to classical economics and traditional microeconomic theory, only prospective (future) costs are relevant to a rational decision. At any moment in time, the best thing to do depends only on current alternatives. Any costs incurred prior to making the decision have already been incurred no matter what decision is made. This is known as the bygones principle or the marginal principle.
A sunk cost is a cost that cannot be recovered or changed and is independent of any future costs a business may incur. Since decision-making only affects the future course of business, sunk costs should be irrelevant in the decision-making process. Instead, decision-makers should base strategies on how to proceed with business or investment activities on future costs.
A majority of people would choose the more expensive trip because, although it may not be more fun, the loss seems greater. The sunk cost fallacy prevents you from realizing what the best choice is and makes you place greater emphasis on the loss of unrecoverable money. Ryan Doody argues it is not always irrational to make decisions because of sunk costs. Doody argues that if we invest in a project, we may wish to continue with investment to hide our flaws and exhibit a strong reputation.
This is considered to be an incentive problem and is distinct from a sunk cost problem. The idea of sunk costs is often employed when analyzing business decisions. A common example of a sunk cost for a business is the promotion of a brand name.
What is an example of a sunk cost?
Regardless of what money is spent on, sunk costs are dollars already spent and permanently lost. Sunk costs cannot be refunded or recovered. For example, once rent is paid, that dollar amount is no longer recoverable – it is ‘sunk. Their car has gas, but the cash is spent and permanently lost; it is a sunk cost.
If decision-makers are irrational or have the wrong incentives, the completion of the project may be chosen. For example, politicians or managers may have more incentive to avoid the appearance of a total loss. A decision-maker might make rational decisions according to their incentives, outside of efficiency or profitability.
In business, an example of sunk costs may be an investment into a factory or research that now has a lower value or no value whatsoever. For example, $20 million has been spent on building a power plant; the value now is zero because it is incomplete (and no sale or recovery is feasible). The plant can be completed for an additional $10 million or abandoned and a different but equally valuable facility built for $5 million. Abandonment and construction of the alternative facility is the more rational decision, even though it represents a total loss of the original expenditure—the original sum invested is a sunk cost.
The additional $6 million can be used for another project better suited to the current business environment. In economics and business decision-making, a sunk cost (also known as retrospective cost) is a cost that has already been incurred and cannot be recovered. Sunk costs are contrasted with prospective costs, which are future costs that may be avoided if action is taken.