Sunk Cost
Candlefocus EditorA sunk cost is a cost that has already been incurred and is therefore unable to be recovered. It is important to note that sunk costs are both past costs and irrecoverable costs. A business may incur a sunk cost due to a large capital expenditure or because of a financial transaction, such as rent or other overhead fees. It is not typically included when calculating future costs or when making a decision about a proposed business venture.
Sunk costs can be relevant to a business’s financial health and provide an indication of how a company has been handling its finances. As the cost has been incurred and there is no way to recover it, it should be viewed as a lost investment rather than a cost that was necessary to continue operations.
A clear example of a sunk cost is an employee’s salary. When considering the cost of an employee, salary will be taken into account. This means that the company can no longer recover that money and it is considered a sunk cost.
The Sunk Cost Fallacy
The sunk cost fallacy is the phenomenon whereby individuals make decisions based on sunk costs rather than making objective decisions based on future scenarios. This often manifests itself in the individual feeling they must continue with a project, even if it turns out to be unsuccessful, simply because they have committed a large amount of effort, money or resources to it. For businesses, it's important to avoid this cognitive bias when making decisions, as basing decisions purely on sunk costs can lead to further expenditure down a route that may not be beneficial.
The best way to avoid this fallacy is to evaluate future decisions objectively, as if no resources had already been invested into them. Step away from the project and think about it objectively, rather than focusing on all of the resources you have already sunk into it.
Conclusion
Sunk costs are those expenses which have already been incurred and are therefore unable to be recovered. These costs should not be taken into consideration when making future budget or business decisions, as they are irrelevant to the current financial scenario. The concept of sunk costs is linked to the sunk cost fallacy, whereby individuals can become emotionally attached to an endeavor as they have invested a lot of resources into it. Businesses must consider future decisions objectively and think through their options even if they have already invested money or other resources in an endeavor. Such an approach allows businesses to make the most of their resources and helps them to avoid the sunk cost fallacy.