In business and investing, a sunk cost refers to money that has already been spent and cannot be recovered. Unlike future costs that may be incurred, sunk costs are excluded from future decisions because they are irrelevant. Common examples of sunk costs include research & development spending, equipment purchases, leases, and marketing expenses. Understanding sunk costs is important to avoid the sunk cost fallacy and make rational business decisions going forward.
Sunk costs are bygone and unrecoverable expenses
As defined above, a sunk cost is an expense that has already occurred and cannot be recovered or changed. This contrasts with prospective costs that businesses may face in the future, such as decisions about production, inventory purchases, or pricing strategies. While future costs may be modified, sunk costs will remain the same regardless of any actions taken.
Sunk costs should not guide business decisions
When making decisions in business, sunk costs are excluded from consideration because they are viewed as irrelevant to current and future budgetary matters. Instead, organizations should focus only on the incremental revenues and expenses related to each potential course of action going forward. Analyzing sunk costs can lead to the sunk cost fallacy and irrational decision making.
Examples of common sunk costs
Typical sunk costs incurred by companies include research & development expenditures, equipment purchases, insurance premiums, leases, marketing campaigns, and non-refundable deposits. Salaries and wages may also be sunk costs if they are not affected by a particular decision. For individual investors, a stock purchase commission or an expired option contract premium would be considered sunk costs.
Avoiding the sunk cost fallacy leads to better decisions
The sunk cost fallacy describes the tendency of people and organizations to continue with an endeavor based solely on previously invested resources. However, rational decisions should be based on comparing incremental benefits and costs looking forward. By avoiding the sunk cost fallacy, businesses can pivot away from unsuccessful ventures and channel resources toward more productive uses.
In business and investing, sunk costs are bygone expenses that have already occurred and cannot be recovered. Unlike prospective costs, sunk costs are excluded from future decision making because they will remain unchanged. Avoiding the sunk cost fallacy can lead to more rational decisions.