What is a Sunk Cost? Definition and Overview

Imagine a non-financial example of a college student trying to determine their major. A student may declare as an accounting major, only to realize after two accounting classes that this is not the career path for them. The sunk cost fallacy would make the student believe committing to the accounting major is worth it because resources have already been spent on the decision. In reality, the student should only evaluate the courses remaining and courses required for a different major. A sunk cost refers to a cost that has already occurred and has no potential for recovery in the future.

• After some mental accounting, participants chose the course of action with a greater initial investment—even though they wouldn’t enjoy it as much.
• We saved more than $1 million on our spend in the first year and just recently identified an opportunity to save about $10,000 every month on recurring expenses with Planergy.
• Each method focuses on the same thing—setting goals that are specific and measurable, so you have a concrete way to gauge your project’s success.
• These costs are subjective and are important in the decision-making process.
• The profit on sales of premium-quality shoes is INR 500 (1,800-1,300).

Sunk costs also cover certain expenses that are committed but yet to paid. Imagine a company that has entered into a contract to buy 1,000 pounds of raw materials for the next six months. Businesses that continue a course of action because of the time or money already committed to an earlier decision risk falling into the sunk cost trap. You have job A which pays very well but demands long hours and is not a role you will be happy in.

Example 1 – Education decisions

Secondly, the social image hypothesis suggests that the frame in which the options are presented will affect the way the decision maker is viewed and will in turn affect their behaviour. Lastly, the frame may affect the expectations that people have about each other’s behaviour and will in turn affect their own behaviour. The framing effect which underlies the sunk cost effect builds upon the concept of extensionality where the outcome is the same regardless of how the information is framed. This is in contradiction to the concept of intentionality which is concerned with whether the presentation of information changes the situation in question. They tried to see if the sunk cost effect would reduce student effort.

A sunk cost is always classified as a fixed cost, though some fixed costs are not classified as sunk costs. A fixed cost that is a sunk cost cannot be recovered, as is the case with customized equipment for which there is no resale market. A fixed cost that is not a sunk cost can be recovered, usually by selling it to a third party; for example, a tractor trailer that can be sold on the resale market is not a sunk cost. A sunk cost business budget fallacy is often simplified to the idea of throwing good money after bad while refusing to cut one’s losses. If, for example, XYZ Clothing is considering shutting down a production facility, any of the sunk costs that have end dates should be included in the decision. To make the decision to close the facility, XYZ Clothing considers the revenue that would be lost if production ends as well as the costs that are also eliminated.

Sunk cost in investment decisions☆

This approach should reduce the risk of the sunk cost fallacy in your projects and also assist with streamlined decision making where needed. The sunk cost definition states that these are already incurred expenses and are not recoverable. These are related to past actions and are actual costs that have no role in future decision-making.

Understanding sunk costs and opportunity costs and their relevance to your business is essential. Smarter business decisions increase savings and cut costs, setting your business up for success. A sunk cost is the money that has already been spent and cannot be retrieved. Traditional microeconomics theory proposes the sunk cost should not influence an investment decision as it is already gone, and the cost will remain the same irrespective of the outcome of the decision. Only the prospective or future cost should be considered while making an investment decision. The decision of abandoning or operating an oil well depends on the future cash flow it can generate and not on the cost of the digging of the well.

What Is an Example of a Sunk Cost?

Ahead, we’re discussing some of the dangers of falling into this cognitive bias and outlining some common scenarios where sunk cost fallacy can show up in your life. Importantly, if sunk costs are included in the decision-making process, this makes it difficult for management to focus on the key decision variables. For example, one questionnaire study asked participants to imagine they had accidentally booked two ski trips in one weekend—one $100 trip to Michigan and another $50 trip to Wisconsin. Even though the researchers told participants they’d enjoy the Wisconsin trip more, the majority of people still said they would go on the Michigan trip.

The bias often results because you are averse to losses or do not want to admit that you have wasted your resources in a failed cause. However, most likely the additional promotional cost may not increase the audience, which further adds to the studio’s losses. 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. Certain costs will be incurred; although it is important to know how these can be avoided whenever possible, it is also crucial to prepare for these costs.

AP & FINANCE

Only moderate support for the contention that personal involvement increases the sunk cost effect is presented. The sunk cost effect was not lessened by having taken prior courses in economics. Finally, the sunk cost effect cannot be fully subsumed under any of several social psychological theories. A sunk cost is a cost that an entity has incurred, and which it can no longer recover. Sunk costs should not be considered when making the decision to continue investing in an ongoing project, since these costs cannot be recovered.