Rego, Arantes, and Magalhães point out that the sunk cost effect exists in committed relationships. For example, if a firm sinks $400 million on an enterprise software installation, that cost is “sunk” because it was a one-time expense and cannot be recovered once spent. A “fixed” cost would be monthly payments made as part of a service contract or licensing deal with the company that set up the software. The upfront irretrievable payment for the installation should not be deemed a “fixed” cost, with its cost spread out over time.
The money you keep investing in the initial plan could have been spent on a more profitable project. There is no specific sunk cost formula to calculate the retrospective costs incurred by a company. However, listing all assets that could not be sold and put to reuse help calculate the total irrecoverable amount spent. This value could be obtained by deducting the current value from the purchase price a firm or individual paid at the time of purchase. The depreciation in the figure obtained is the sunk cost for the company. The concept is simple, but sunk cost plays a major role in many personal and business decisions.
- Moreover, it differs from relevant costs that include company expenses that can be recovered and have a vital role in business decision-making.
- According to Milton Friedman, it is crucial to understand that sunk costs should not impact any decision-making process.
- To do otherwise would prevent one from making a decision purely on its merits.
- So, advertising and marketing expenses should not be considered in the decision-making process.
- Sunk costs are always fixed costs because they cannot be changed, but not all fixed expenses are sunk costs, as they can be recovered if an asset is sold or returned, for example.
For example, saving 200 people from a sinking ship of 600 is equivalent to letting 400 people drown. The former framing type is positive and the latter is negative. Just because a strategy worked in the past, it doesn’t mean it will work in the future since markets evolve. If you fail to achieve certain goals, reevaluate to work out where you can improve for better returns on investments. Before making startup investments, set a performance target that is obtainable and low risk. This gives you a clear target with identifiable measures and constraints to guide you to the successful completion of the first milestone.
Five types of sunk costs
The “variable costs” for this project might include data centre power usage, for example. After a year of operating, the business is consistently losing money and is unlikely to become profitable due to a saturated market and poor location. Despite these losses, you feel compelled to keep the restaurant open because of the initial investment. The $50,000 spent on renovations, equipment, and marketing is a sunk cost; it cannot be recovered.
Example 2: Sticking out a Bad Movie
Variable costs are only relevant in the decision-making process since they change depending on the decision made. Our psychology deeply influences our decisions around sunk costs. Even when we logically know better, emotional factors can make it hard to let go of investments. Here are key psychological factors that lead to the sunk cost fallacy. Sunk cost, in economics and finance, a cost that has already been incurred and that cannot be recovered.
When you recognize that sunk costs influence you, you can avoid wasting further efforts on lost causes. Irrational decision-making in the sunk cost dilemma involves making choices based on past investments rather than evaluating the current situation and potential future gains. This often leads to inefficient resource allocation, as capital is invested based on example of sunk cost what can no longer be changed instead of what has the most future benefit. As the costs escalated and the challenges mounted, the government and project stakeholders were faced with a dilemma.
Real-Life Examples of Sunk Costs
Other characteristics of sunk costs include being unavoidable and remaining the same, making it a type of fixed cost. While sunk cost is classified as fixed, not all fixed costs are retrospective costs. As the former is considered irrecoverable, the latter could be recovered in the resale market. For example, suppose a company resells equipment it bought earlier for production purposes. In that case, the money received in exchange becomes the recovered equipment cost, which then doesn’t remain sunk or stranded. For example, A company spent $ 10,000 to train its staff to use its newly introduced ERP system.
What is the approximate value of your cash savings and other investments?
The sunk cost fallacy is the tendency to continue with a plan even if the present costs outweigh the potential benefits. This happens when someone follows through with a financial decision even though the expenses incurred exceed the potential returns. A business example is a manager refusing to deviate from the original plans, even if profits aren’t generated. A company’s historic sunk costs serve as a guideline for evaluating past and future performance.