Stock / Share Market
by 5paisa Research Team Last Updated: 2022-09-29T17:36:40+05:30

Everything About Sunk Costs and Its Impact on Decision-Making

Sunk costs are incurred costs that cannot be recoverable. In economics, sunk costs are considered not to make current and future budgetary concerns. They are contrasted with relevant expenses, which are future costs that have not yet been incurred. The sunk cost fallacy is a psychological constraint and generally locks people into failed attempts because they put resources into them. Some examples of sunk costs are wages, rent, non-refundable deposits, or repairs.
 

What Is Sunk Cost Definition?

To answer what is meant by sunk cost, it would be defined as the spent amounts that are irrecoverable. Sunk costs arise because certain activities require specialized resources that cannot be easily reallocated to other uses due to limited second-hand markets. Normally all Sunk costs are fixed costs, but the same does not hold vice versa as all fixed costs are not sunk costs. Examples of company-specific sunk costs include investments in equipment, product development, marketing expenses, and research and development expenses.
These are excluded from future budgets while making business decisions, and they remain the same irrespective of the outcome of any decision. For example, a manufacturing company may have several sunk costs, like rent paid for a plant, wages, machinery, equipment, etc.
Sunk costs meaning would also be retrospective costs that are excluded from a decision to sell or convert, which is a concept applicable to products that can be sold as is or have to be further transformed. Examples of Retail based sunk costs are marketing expenses, salaries, rent of shop, research, installing new software or equipment, or operating expenses. In comparison, the opportunity cost is the lost return on resources invested elsewhere.
Practically sunk costs impact future decisions, but economists assume that sunk costs are theoretically irrelevant for future decision-making. This is primarily because it is psychologically difficult to give up previously invested resources, even when the result does not live up to expectations. Industries, companies, and businesses only consider relevant costs while making business decisions that include future costs that have not yet been incurred. A business only considers expenses and revenues that may change, but because sunk costs cannot be modified, they are not taken into account.
 

Sunk Cost Formula

Although there is no specific formula to calculate sunk costs but to calculate the sunk cost, you must list all assets that cannot be sold or reused. You can then deduct the current value from its purchase price to derive the depreciation, which is officially a sunk cost.
 

What Is a Sunk Cost Fallacy?

The sunk cost fallacy is the wrong mindset a company or individual may have when making a decision. This misconception is based on the assumption that commitment to the current plan is justified because the resources have already been committed. This error can lead to inadequate long-term planning based on short-term cost commitments.
In business, the sunk cost fallacy is common when management refuses to deviate from the original plans, even if those original plans are not realized. The sunk cost fallacy involves leaders' emotions causing illogical decision-making.

Types of Sunk Costs

All sunk costs are fixed costs that cannot be reimbursed; however, all fixed costs are not sunk costs.
 

Sunk cost examples

If equipment bought by a manufacturing company has no resale value, it will be determined as a sunk cost. On the other hand, if the equipment can be returned at some expense, it will not be pocketed as a sunk cost. Sunk costs are not unique to businesses, as individual consumers can also have sunk costs.
For example, you bought a watch for Rs. 500 and lost it without wearing it even for a single day. It is a sunk cost. Or you purchased a movie ticket for Rs 200 but could not attend the show due to prior commitments. This will again be a sunk cost.
However, these costs don't signify that you won't buy a watch or a movie ticket in the future. Companies focus on fixed and sunk costs compared to people because both affect profits.
 

How Do Sunk Costs Affect Product Management?

The sunk cost fallacy can lead to irrational thinking among project managers as they are sensitive about their initiatives, new features, and products. It can be difficult for them to recognize that the product is not achieving its goals after investing time, energy, and resources. Understanding the psychology behind the sunk cost mentality can shed some light on why it's so hard to let go.
Sunk costs are important because they can distract you from the decision-making process. Sunk costs should not influence decision-making as these are incurred regardless of the consequences. Sunk costs are important to consider, as including them incorrectly in a decision-making process can lead to an unlikely or unfavorable decision.
 

Factors That Lead to the Sunk Cost Fallacy

Some of the main factors that lead to sunk cost fallacy are:

1. Loss aversion: For many, it is better to eradicate a loss than make a profit, and they are generally reluctant to accept a loss or complete a project with sunk costs due to their low tolerance for risk.
2. Personal Responsibility: The idea of linking a loss regarding an effort or investment to an individual or a group (blame-game)
3. Framing: Businesses generally frame avoiding loss as a positive frame while incurring a failure as a negative frame
4. Distortion of bonds: People may stick to a plan simply because it was the original plan. A project does not benefit from any preferential treatment for reasons other than initially decided.
5 .Overly Optimistic Probability Bias: Perception that Costs Increase Future Returns
6. Waste avoidance: People prefer avoiding wasted resources, but not all options are created equal, and sometimes due diligence efforts can go nowhere.
7. Personal decision-making: People get emotionally connected to a project which leads to an emotional bias that could alter the project, or the data could be wrong.

How To Avoid the Sunk Cost Fallacy

You can avoid the sunk cost fallacy with dedication and thoughtful planning. Here are some tips for overcoming mental challenges.

1.Understand what you want to achieve and analyze the options. 
2.Rethink prioritization and make sure you are working on the right things
3.See the bigger picture and focus on upcoming planning for the immediate future.
4. Accept uncertainty, change, and opportunity.
5. Don't get personal, as smart decision-making focuses on the product vision and strategy, not the decision maker.
6. Define the problem, make it the focus of the discussion, and guide the actions of all analysts. This step helps determine what is important and what is an unimportant distraction.
7. Stay independent instead of getting emotionally involved, and don't lose sight of what's happening. Instead, rely on the data.
8. Keep in mind that failed projects shouldn't affect the decision-maker.
9.It is inappropriate to ignore sunk costs when comparing different options. However, it provides the most reliable basis for decision-making.
10. Change your risk preference and start taking more risks to easily accept that sunk costs can not be recovered.
 

Conclusion

All companies and people have sunk costs, and whether it is a rotten fruit that you invested money in, payment of salaries to unproductive employees, or a local government's investment plans, sunk costs are an indispensable part of the financing. These expenses are already incurred and non-reimbursable, which is why they should not be considered in future decisions, as the effort involved in sunk costs is the same in every situation.
 

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