What is a Sunk Cost?

The $2,000,000 development cost is a sunk cost, and so should not be considered in any decision to continue or terminate the product. Here at Planet Money, we believe there’s a lot of economics going on at the all-you-eat buffet, tucked in between the mountains of brisket and troughs of mashed potatoes. From classic concepts like adverse selection, sunk costs, diminishing marginal returns, to more exotic economic mysteries, like the flat rate pricing bias. This fallacy is closely tied to Prospect Theory, which states that people tend to become risk-takers when faced with a loss.

The sunk cost fallacy is deeply rooted in biological tendencies, as researchers from the University of California San Diego analyzed the sunk cost effect in humans as well as pigeons. It is what you face before falling prey to or avoiding the fallacy. The dilemma is to decide if cutting further losses is better than pushing ahead trying to prevent the loss. However, sometimes, a company or an individual may stick to a decision (even when it may not be the most appropriate one) as the cost has already been incurred. The study concludes that the new product will not be profitable and may even be unsuccessful.

It seems a simple enough approach that for ‘just another 100’ we can get our product out the door but therein lies the bias if considering sunk costs. To illustrate what this means for a project let’s go back to the earlier example where the project Board has directed the Project manager to limit overspend. The $100 you spent to test out the new product is a sunk cost because there is no return on investment when you decide not to sell the product. And, you cannot return the purchased materials or resell the materials to recoup the funds. Now let’s say you decide to go with Product A, and Product A doesn’t end up selling as well as you thought it would. If you can’t return the equipment you bought to manufacture the item, and it doesn’t have any resale value, the money you spent on the equipment becomes a sunk cost.

Example of the Sunk Cost Fallacy

This is because of the time and/or money they have already invested. The sunk cost trap is also called the Concorde fallacy after the failed supersonic Concorde jet program that funding governments insisted on completing despite the jet’s poor outlook. But after spending so much money on repairs, you decide you’d rather fix the old car so that the money you spent previously wasn’t all for nothing. You believe that you “invested” a lot of money into the car, and you don’t want to “lose” it by getting a new one.

The bygones principle is grounded in the branch of normative decision theory known as rational choice theory, particularly in expected utility hypothesis. Once sunk costs are spent by a firm, these shouldn’t influence their decisions at the margin. For example, if a new product is experiencing marginal costs higher than marginal benefit, then it is making an operating loss. The sunk costs shouldn’t come into the equation because they are gone. First, recognize the sunk costs, that is, those 60 thousand pesos and 4 months of work that have already left and will not return. Now you have to rethink the strategy, study what did not work and not let the pressure of wanting to recover the money influence future actions.

For example, a company may ignore market shifts that render their product obsolete. At certain points along a timeline, the company could have made more rational decisions; instead, it may now have invested funds it cannot recover and potentially not benefit from in the future. An example of a sunk cost would be spending $5 million on building a factory that is projected to cost $10 million.

Just like you can’t change the past, it isn’t possible to recover your sunk costs. People often fear that if they abandon a project or decision with substantial sunk costs, they will regret their prior investments. This fear of regret can be a powerful motivator to continue down an unproductive path. Individuals may not want to admit that they made a mistake in their earlier choices.

This fallacy is based on the premise that committing to the current plan is justified because resources have already been committed. This mistake may result in improper long-term strategic planning decisions based on short-term committed costs. Sunk costs don’t only apply to businesses as individual consumers can incur sunk costs as well. Let’s say you buy a theater ticket for $50 but at the last minute can’t attend. The $50 you spent would be a sunk cost but would not factor into whether or not you buy theater tickets in the future. In general, businesses pay more attention to fixed and sunk costs than people, as both types of costs impact profits.

Examples of the Sunk Cost Fallacy

The basic sunk cost meaning is that it has already been incurred and should not be a part of the decision-making process. In this case, the company did not consider the factory rent and the machinery cost as these are already incurred and have no relevance in the decision-making process. All embedded costs are fixed but not all fixed expenses are retrospective costs. Saving money in case of such costs does not mean recovering either part or whole of this amount but instead, it means reducing further losses in the future.

What is a Sunk Cost?

The sunk cost fallacy arises when decision-making takes into account sunk costs. By taking into consideration sunk costs when making a decision, irrational decision-making is exhibited. Even large entities—such as governments, companies, and sports teams—are susceptible to the sunk cost fallacy. For example, they may continue to allocate more resources into projects, products, strategies, or programs that aren’t profitable or successful.

When dealing with the sunk cost dilemma, people often neglect opportunity cost, which can have a significant impact on decision-making. But how does a sunk cost relate to a situation in the future when you haven’t spent the money yet? When you sign up, you’ll probably be under a contract to lock in your monthly rate. Most of these companies require a minimum time for you to stay with the service, mainly to keep you from jumping ship to a competitor who may offer you a better deal later on.

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Budgeting for these in advance is beneficial; for example, companies may estimate payroll expenses or rent while creating a personal budget. However, most likely the additional promotional cost may not increase the audience, which further adds to the studio’s losses. However, you still continue to sit through the movie since you have already spent the money for buying the ticket. The additional production cost will be INR 300 while each pair can be sold for INR 1,800. The profit on sales of premium-quality shoes is INR 500 (1,800-1,300). XYZ Limited decides to manufacture premium shoes to earn higher profits.

Are All Fixed Costs Considered Sunk Costs?

This psychological trap causes us to stick with a plan even if it no longer serves us and the costs clearly outweigh the benefits. It’s a lot easier to avoid the sunk cost fallacy in financial modeling, as DCF models only look at future cash flows, and don’t give any consideration to the past. In the following examples, you can clearly see how sunk costs affect decision-making.

But as you experiment, you do not sell the experimental baked goods and label the new products as testers for customers to taste. Sunk costs are the expenses you already incurred and do not play a role in purchases you plan to or will make. Ellingsen, Johannesson, Möllerström how to do payroll accounting and Munkammar[40] have categorised framing effects in a social and economic orientation into three broad classes of theories. Firstly, the framing of options presented can affect internalised social norms or social preferences – this is called variable sociality hypothesis.

Sunk Cost

They are impossible to avoid – some investments just won’t come off, whilst human error is also a factor. According to Indeed , a sunk cost can also be called a past cost, whether it paid off or not. For example, the marketing campaign guideline or the money you paid to change computers. Carefully considering your decision is important as every once in a while, you will have to incur some sunk costs. Opportunity costs are implicit and represent the potential gains that are foregone when you opt for one option from the different available choices.

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