Sunk Costs

Written By:
Adiste Mae

Imagine that you’re at an arcade that has one of those crane games.

You know, the one where you slot in a certain amount of money or tokens for a chance to get one of the prizes inside (usually stuffed animals or plush toys).

You decided to give it a try since one try doesn’t cost that much (let’s say a dollar per try).

You slot in a dollar, operate the crane, press the button… and you almost had it!

So you decided to give it another try thinking that you’d do better this time.

You do this about thirteen times without getting anything.

So you stop and think to yourself “huh, I already spent as much as I would if I just buy one of these plushies”.

So you’re in a dilemma on whether you should continue playing or not.

On one hand, you’re already this deep, and it’d be sad to walk away with nothing.

Besides, you might finally get one on your next attempt!

On the other, you’ve already spent enough.

If you continue playing, it would only cost you more.

Whether you decide to play more or not, the fact that you already spent $13 will remain the same.

And that $13 you already spent is something that you cannot get back.

This is what we refer to as a sunk cost.

What is a sunk cost?

A sunk cost is a type of expense that an individual or business entity has already paid for and which cannot be recovered.

In short, it is the money that one has already spent and cannot recover.

In theory, sunk costs should not be considered when making future decisions.

Whatever the outcome of a decision, the fact that these costs were already spent and cannot be recovered will remain the same.

Instead, future decisions should only be influenced by relevant costs.

For example, your business spent $4,000 in advertising to increase awareness about its newest product.

Now, whether the ad campaign becomes successful or not, the fact that your business already spent $4,000 (which you cannot recover in any way) will remain the same.

As such, when deciding on whether you should continue or discontinue the newest product, the cost of advertising should not be considered.

Another example, a business planning to purchase a new piece of equipment to replace its old one.

The old piece of equipment is no longer functional and does not have a salvage value.

Since nothing can be recovered from the old equipment, its cost is considered a sunk cost.

As such, it shouldn’t be considered when purchasing a new piece of equipment.

Sunk cost is also referred to as prior year cost, sunk capital, past cost, embedded cost, stranded cost, or retrospective cost.

Sunk Cost VS Relevant Cost

It must be reiterated that sunk costs shouldn’t influence your future decisions.

Instead, only relevant costs must be considered.

Relevant costs are costs that are related to a specific decision (e.g. the cost of each unit of a product when purchasing inventory).

They change depending on the decision.

Sunk costs are costs that were already incurred, while relevant costs are costs that are yet to be incurred.

Sunk costs remain the same whatever business decision is made.

Relevant costs change depending on what decision is being made.

To illustrate, let’s assume that you plan to operate an ice cream truck.

To start operating an ice cream truck, you would need to purchase a truck or van first.

So you purchase one for $10,000, and to give it more of an ice cream truck vibe, you spent an additional $2,000 to remodel and repaint it.

Now that you have your ice cream truck, what’s next?

Why, you start selling ice cream of course…

In the illustration above, the cost of purchasing and remodeling the ice cream truck are sunk costs.

Whether you decide to continue selling ice cream or not, you’ve already spent the $12,000 and you cannot recover it (unless you’re able to sell the truck).

The cost of selling ice cream will be your relevant cost.

It’ll depend on what kind of cream you’ll be selling, or whether you’ll be selling ice cream at all.

It could also influence how much you’d sell your ice cream for.

For example, if a tub of ice cream costs $50, and each tub has 25 servings, you might want to sell each serving of your ice cream for more than $2 to make a profit for every sale.

How does sunk cost affect your business?

In theory, sunk costs shouldn’t affect your future business decisions at all.

They’ve already been incurred right?

In practice, it’s easier said than done.

There’s just this thing in us that makes us see things through rather than cut our losses.

If it works out, then good for you.

But if it doesn’t, then it would just cost you more.

For example, your business already spent $4,000 in advertising to promote your newest product.

However, it failed to generate profits. So you spend another $2,000 in ads to promote it further.

If the second ad campaign works, great for you!

But if it doesn’t, that means that you spent $6,000 instead of just $4,000.

Your business would only have lost $4,000 it stopped after the first ad campaign failed.

Let’s take it up a notch.

Suppose your business is involved in the manufacturing of airplanes.

You already sunk in about $4,000,000 in the development of a new airplane, and you reckon that it would need $1,00,000 to complete.

However, before your business was able to complete the new plane, a better model was introduced in the market, making the plane that your business is currently working on obsolete.

Even if you finish production, your business probably won’t be able to sell it.

But it’s almost complete and only needs $1,000,000 more right?

The logical course of action here is to cut your losses and spend the $1,000,000 on developing and producing a new airplane that can compete with what’s available on the market.

Sure, it hurts to see the $4,000,000 you’ve already spent go to waste but it’s a sunk cost – it’s not something you can recover by throwing more money at it.

And wouldn’t it be worse to lose $5,000,000 instead of just $4,000,000?

That’s the thing with sunk cost.

It’s money that you already spent on an expense that is non-recoverable.

But it’s not really feasible to avoid all of them either.

Some sunk costs are necessary for the operation and development of your business.

For example, for you to start a factory, you’d need to spend money on space and equipment.

And if you want to improve the production process or develop a new product, you’d need to spend money on research and development.

Avoiding sunk costs is not the proper approach to them.

Rather, your goal is to minimize them.

If one of your products fail and can no longer be redeemed, then the best option is to discontinue it and cut your losses.

Sure, you won’t be able to get back the money you already spent, but you can avoid losing more money by cutting your losses.

The Sunk Cost Fallacy

“I already bought the ticket and popcorn. Might as well finish the movie and get my money’s worth right?”  -thoughts of a moviegoer who found the movie to be boring.

“I already bought the paint and all. It’d be a waste not to use them.” -thoughts of a new homeowner who wanted to paint his/her room a certain color but it didn’t turn out a s/he expected

“We already spent so much on this project! It’s too late to back out now. If we’re given a little more funds and time, I’m sure that we can turn it around!” –says the project manager of a botched project.

All the quotes above have something in common – they were making decisions based on money that was already spent and non-recoverable a.k.a. sunk costs.

The first two quotes aren’t as bad as the third one though since they don’t involve the act of spending more money.

The third one is potentially hurtful for a business as it involves spending more money that it probably won’t recover.

In business, there is this axiom that goes “throwing good money after bad”.

This is what the sunk cost fallacy does to you.

You throw money at a failed investment hoping that it will turn things around.

The sunk cost fallacy is the belief that it’s okay to pour in additional resources (usually time and money) on an investment or activity (even if it’s failing or has already failed) as otherwise, the money you already spent on it would just go to waste.

This is dangerous for a business as it encourages managers to spend money on projects that we’re already proven to be unprofitable thinking that things will turn around eventually, or that the money, time, and effort already spent on them would just go to waste otherwise.

It welcomes the possibility of losing more, which isn’t something you should want as a business owner.

Let’s go back to the airplane example.

So your business already spent $4,000,000 on developing an airplane that is already obsolete.

Influenced by the sunk cost fallacy, you continue developing the airplane anyway and in the end, you spent $5,000,000 on a project you won’t able to make a profit from.

The logical choice was to discontinue the project and work on a new one.

Sunk Cost Dilemma

The feeling of regret and guilt associated with proceeding or abandoning a failing project that you already spent time, money, and effort on has a formal economic term – it is called the sunk cost dilemma.

In a world where everybody is a purely rational economic person, all future decisions will be made solely on relevant costs.

However, we don’t live in that world. Sunk costs can still affect future business decisions.

Let’s go back to the crane game example.

Remember when you had to decide whether to continue playing or not?

Can you imagine what you’d probably feel in such a situation?

That is what we call a sunk cost dilemma.

You base your decision on a cost that you already spent and cannot recover from.

Sunk cost VS Opportunity Cost

Opportunity cost is a potential gain or profit that one loses when he or she chooses a certain course of action over another.

In other words, it is the cost of making a decision.

For example, if you choose to put your money in a bank as a deposit instead of using it to buy stocks, then the opportunity cost is the potential profit you get from buying and eventually selling those stocks.

Just from the example above, it should be clear that sunk cost and opportunity cost are not the same thing.

Sunk cost is a cost that has already been incurred and is non-recoverable, while opportunity cost is a potential profit that has been given up in favor of a decision.

A sunk cost is an explicit cost since it shows up in the cash flow of a business entity.

An opportunity cost is an implicit cost and will not show in the financial statements of a business.

More examples of sunk costs

• Your business spent $60,000 on the research and development of a new product. When the product was completed, it turned out to be harmful to people, and so there is practically no demand for it. You now have the choice of discontinuing the product or pouring in more resources to make it marketable. No matter what choice you make, the $60,000 you spent on research and development shouldn’t be considered as it is a sunk cost.
• A business spent $20,000 to train its employees to use a new accounting system. However, the software turned to be borderline unusable, and so management decided to stop its implementation. The $20,000 that the business already spent for training its employees is a sunk cost and should not be considered when deciding to stop the implementation of the new accounting system.
• A company hired a seemingly competent employee with a signing bonus of $3,000. However, after the probation period, it turned out that the employee performed less than expected of him/her. The decision to keep this employee or not shouldn’t be influenced by the $3,000 signing bonus as it is a sunk cost.
• You spent $20 on a movie ticket. However, 30 minutes into the movie, you found it to be boring. The decision to stay or go should not be influenced by the cost of the ticket as it is a sunk cost.