Sunk Cost: Definition and Impact on Decision-Making

Definition of Sunk Cost

A sunk cost is an investment or expense that has already been made and cannot be recovered. In other words, it is a cost that has been incurred and is now irrevocable. Sunk costs are often associated with business decisions, but they can also apply to individual consumers.

Irrelevance to Decision-Making

Economists argue that sunk costs should not be considered when making future decisions because they will remain the same regardless of the outcome of a decision. This is because sunk costs are considered bygones, and making decisions based on them is akin to “crying over spilt milk.” Therefore, rational decision-making should focus solely on prospective costs, which are costs that can still be avoided if action is taken.

Examples of Sunk Costs

In a business context, examples of sunk costs include marketing expenses, research and development costs, the installation or purchase of new software or equipment, salaries and benefits, and facilities expenses. Sunk costs can also include nonrefundable deposits and repairs that cannot be recovered. For individual consumers, sunk costs may include the purchase of a theater ticket that cannot be used or the cost of a meal at a restaurant that was not enjoyed.

Distinction from Fixed Costs

It is important to note that sunk costs are different from fixed costs. While all sunk costs are fixed costs, not all fixed costs are sunk costs. Fixed costs are costs that remain constant regardless of the level of output, but they may still be recoverable. For example, rent is a fixed cost, but if a company decides to move to a smaller office, it may be able to recover some of the rent it has already paid. In contrast, sunk costs cannot be recovered, even if the company decides to change its plans.

Sunk Cost Fallacy

The sunk cost fallacy is a psychological barrier that ties people to unsuccessful endeavors simply because they have already committed resources to it. This fallacy is based on the premise that committing to the current plan is justified because resources have already been committed. This mistake may result in improper long-term strategic planning decisions based on short-term committed costs.

Avoiding the Sunk Cost Fallacy

To avoid the sunk cost fallacy, it is important to:

• Frame the problem: Clearly define the problem that needs to be solved and focus on relevant information.
• Remain independent: Avoid emotional attachment to decisions and be willing to change course if necessary.
• Trust the data: Rely on data and analysis to make informed decisions, rather than relying on past investments.
• Change risk preference: Be open to taking calculated risks and not being overly averse to loss.

By following these strategies, individuals and businesses can make more rational decisions and avoid the sunk cost fallacy.

References

• Arkes, H. R., & Blumer, C. (1985). The psychology of sunk cost. Organizational Behavior and Human Decision Processes, 35(1), 124-140.
• Investopedia. (n.d.). Sunk Cost. Retrieved from https://www.investopedia.com/terms/s/sunkcost.asp
• ProductPlan. (n.d.). What is a Sunk Cost? Retrieved from https://www.productplan.com/glossary/sunk-cost/
• Wikipedia. (n.d.). Sunk cost. Retrieved from https://en.wikipedia.org/wiki/Sunk_cost

FAQs

What is a sunk cost?

A sunk cost is an investment or expense that has already been made and cannot be recovered.

Why are sunk costs irrelevant to future decision-making?

Sunk costs are irrelevant to future decision-making because they will remain the same regardless of the outcome of a decision.

Can you provide some examples of sunk costs in business?

Examples of sunk costs in business include marketing expenses, research and development costs, the installation or purchase of new software or equipment, salaries and benefits, and facilities expenses.

How can individuals avoid the sunk cost fallacy?

Individuals can avoid the sunk cost fallacy by framing the problem, remaining independent, trusting the data, and changing their risk preference.

What is the difference between sunk costs and fixed costs?

Sunk costs are a subset of fixed costs. All sunk costs are fixed costs, but not all fixed costs are sunk costs. Sunk costs cannot be recovered, while fixed costs may still be recoverable.

Can sunk costs apply to individual consumers?

Yes, sunk costs can also apply to individual consumers. For example, if you buy a theater ticket but cannot attend, the money spent on the ticket becomes a sunk cost.

How can businesses avoid the sunk cost fallacy?

Businesses can avoid the sunk cost fallacy by conducting thorough cost-benefit analyses, considering opportunity costs, and being willing to change course if necessary.

What are some psychological factors that contribute to the sunk cost fallacy?

Some psychological factors that contribute to the sunk cost fallacy include loss aversion, framing effects, overoptimistic probability bias, sense of personal responsibility, and desire to avoid appearing wasteful.