Sunk Cost Definition
Sunk costs are all those costs which have been incurred by the company in the past time with no chance of its recovery in the future and are not considered while taking any of the decision as these costs will not change regardless of any outcome of the decision.
In simple words, A sunk cost is an expense that has already been done and cannot be recovered. It is also known as stranded cost or retrospective costs or unrecoverable expenses. When such costs are higher, it creates a wall to the entry of new firms since they risk huge losses if the companies decide to leave the market. Since these kinds of costs cannot be recovered or regained, they shouldn’t be considered while making rational decisions.
Interpreting Sunk Cost
Let us discuss a few examples of sunk costs and how to interpret the same.
- A company spends $50,000 on a marketing study of its new product to see whether the new product will be a success in the market. The study concludes that the product will not have a good run in the market. Then the $50,000 becomes a sunk cost, and the company should not invest more in the new product project.
- A company invests $20,000 to provide training to its staff in the use of new technology in the office, which will be used in taking new complaint requests. The technology, while using, could not handle the complaint volume and is often taking faulty requests, so the company decides to discontinue its use. This training is considered as the sunk cost and should not be taken into consideration during decision making.
- A company pays $5000 as a joining bonus to a recruit in the organization. After recruitment, it is seen that the employee’s performance is not up to the mark, and he needs to be given the pink slip. Then this $5000 is taken as a sunk cost as this cost cannot be recovered.
- In today’s world, companies use advertising to attract new potential customers as well as retain the older ones. They use different types of media, like print or audiovisual media, to help in mass advertising. This advertising doesn’t promise any positive return, but if the money is spent once on advertising and the advertising campaign is running, then the advertising expenditures are called sunk costs.
- If a company is dealing with a specialized product that they only offer purchase equipment, then this purchase of equipment is considered as sunk cost fallacy. This equipment cannot be sold to regain the money.
- If a company hires an SEO specialist or marketing consultant to boost its business, then they have to pay a service fee beforehand for the services provided by the consultant even before finishing the work. A company doesn’t have any provision to check the sunk cost effect of the services before completion of work and whether the consultant has made any positive difference to the business. This service fee then becomes a sunk cost fallacy since the money is spent already, and it cannot be recovered even if the company dislikes the services of the marketing consultant or the SEO specialist.
What is Sunk Cost Fallacy?
Sunk cost fallacy happens when a business decides to continue its spending because of the pet decisions involved like time, money, and resources instead of taking a rational decision and following choices that will maximize the returns at that time.
- Sunk cost fallacy costs the business more significant financial losses. It is human nature to think that once a cost has been made for a project or invested in a product, it is better to invest more money even if the project or product is not a profitable one and is going to make losses.
- For example, many individuals order too much food, and then they overeat just to get their money’s worth. When factoring the costs of any exchange, people tend to focus more on what they are going to lose in the bargain than what they stand to gain.
- When businesses tend to cling to their costs- past time, money, and resources already involved, they make decisions based on that. This situation leads the business right into the sunk cost fallacy. It is also called Concorde fallacy, describing it as an escalation of commitment.
Every organization faces the dilemma of sunk cost while decision making at some point. These costs cannot be avoided at any cost. Since these costs are in the past, companies should not keep pouring money in these losses. Instead, companies must focus on the current market and ignore the previously spent costs. If there is no potential, then they should stop investing and end the operations. We all don’t like losing money, but letting go of the past in these situations can help in avoiding more losses in the future.
This article has been a guide to what is Sunk Cost and its definition. Also, we discuss the meaning of Sunk costs Fallacy and how this happens when a business decides to continue spending on its pet projects. You may learn more about accounting from the following articles –