What Is Sunk Cost: Meaning, Definition, and Examples

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.
 

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

Sunk costs are expenses that have already been incurred & cannot be recovered. They come in various forms & can impact both businesses & individuals. Here are some common types:

1. Financial Expenditures: These include costs like non-refundable deposits, prepaid expenses, & past investments in projects or equipment that cannot be recovered.
2. Time & Effort: Time spent on project or effort that cannot be reclaimed is also considered sunk cost.
3. Emotional Investment: Emotional energy invested in relationships or ventures that are no longer beneficial.
4. Depreciation & Amortization: These are accounting methods that spread cost of asset over its useful life, but once incurred, they are considered sunk costs.

Understanding these types of sunk costs can help in making more rational decisions by focusing on future benefits rather than past investments.
 

Example of Sunk Cost

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.
 

How To Avoid Sunk Cost Fallacy

The sunk cost fallacy is cognitive bias where individuals continue investing in decision based on cumulative prior investment (time, money, effort) rather than current & future benefits. To avoid this fallacy, it's crucial to recognize & accept that past investments are irrecoverable. Here are some strategies:

1. Awareness: Simply being aware of sunk cost fallacy can help you recognize when you're falling into its trap.
2. Objective Decision-Making: Make decisions based on current & future benefits rather than past investments.
3. Regular Reviews: Periodically review your investments & be willing to cut losses when necessary.
4. Pros & Cons: Create pros & cons list to evaluate decisions logically.

By focusing on these strategies, you can make more rational decisions & avoid pitfalls of sunk cost fallacy.
 

What is sunk cost dilemma?

The sunk cost dilemma refers to emotional & cognitive challenge of deciding whether to continue investing in project or endeavour that has already consumed significant resources (time, money, effort) without yielding desired results.

This dilemma arises because people often feel compelled to continue investing in order to justify resources already spent, even when rational analysis suggests that further investment is unlikely to be beneficial.

In essence, sunk cost dilemma is form of cognitive bias where past investments unduly influence current decision-making. For example, company might continue funding failing project because it has already invested millions, despite clear signs that project will not succeed. Overcoming this dilemma requires recognizing that sunk costs are irrecoverable & should not factor into future decisions. Rational decision-making should focus on potential future benefits & costs, rather than past expenditures.
 

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, & products. It can be difficult for them to recognize that product is not achieving its goals after investing time, energy, & resources. Understanding psychology behind 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 decision-making process. Sunk costs should not influence decision-making as these are incurred regardless of consequences. Sunk costs are important to consider, as including them incorrectly in decision-making process can lead to unlikely or unfavorable decision.
 

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.