In economics and business decision-making, a sunk cost (also known as retrospective cost) is a cost that has already been incurred and cannot be recovered.
The sunk cost is distinct from economic loss. For example, when a new car is purchased, it can subsequently be resold; however, it will probably not be resold for the original purchase price. The economic loss is the difference (including transaction costs). The sum originally paid should not affect any rational future decision-making about the car, regardless of the resale value: if the owner can derive more value from selling the car than not selling it, then it should be sold, regardless of the price paid. In this sense, the sunk cost is not a precise quantity, but an economic term for a sum paid, in the past, which is no longer relevant to decisions about the future.
A sunk cost is a cost that has already occurred and cannot be recovered by any means. Sunk costs are independent of any event and should not be considered when making investment or project decisions. Only relevant costs (costs that relates to a specific decision and will change depending on that decision) should be considered when making such decisions.
All sunk costs are considered fixed costs. However, it is important to realize that not all fixed costs are considered sunk costs. Recall that sunk costs cannot be recovered. Take for example equipment (a fixed cost). Equipment can be resold or returned at a determined price, therefore it is not a sunk cost.
Sunk cost is also known as past cost, embedded cost, prior year cost, stranded cost, sunk capital, or retrospective cost.
Assume you spend $200 for a snowboard trip at Grouse Mountain. Later on, you find a better snowboard trip at Cypress Mountain that costs $100 and you purchase that ticket as well. Unknowingly, you find out that the two dates clash and you are unable to refund the tickets. Would you attend the $200 good snowboard trip or the $100 great snowboard trip? A majority of people would choose the more expensive trip because although it may not be more fun, the loss seems greater. The sunk cost fallacy prevents you from realizing what the best choice is and makes you place greater emphasis on the loss of unrecoverable money.
Sources:
1. Wikipedia
2. https://corporatefinanceinstitute.com/resources/knowledge/economics/sunk-cost/
Money already spent and permanently lost. Sunk costs are past opportunity costs that are partially (as salvage, if any) or totally irretrievable and, therefore, should be considered irrelevant to future decision making. This term is from the oil industry where the decision to abandon or operate an oil well is made on the basis of its expected cash flows and not on how much money was spent in drilling it. Also called embedded cost, prior year cost, stranded cost, or sunk capital.
Read more: http://www.businessdictionary.com/definition/sunk-cost.html
The sunk cost is distinct from economic loss. For example, when a new car is purchased, it can subsequently be resold; however, it will probably not be resold for the original purchase price. The economic loss is the difference (including transaction costs). The sum originally paid should not affect any rational future decision-making about the car, regardless of the resale value: if the owner can derive more value from selling the car than not selling it, then it should be sold, regardless of the price paid. In this sense, the sunk cost is not a precise quantity, but an economic term for a sum paid, in the past, which is no longer relevant to decisions about the future.
A sunk cost is a cost that has already occurred and cannot be recovered by any means. Sunk costs are independent of any event and should not be considered when making investment or project decisions. Only relevant costs (costs that relates to a specific decision and will change depending on that decision) should be considered when making such decisions.
All sunk costs are considered fixed costs. However, it is important to realize that not all fixed costs are considered sunk costs. Recall that sunk costs cannot be recovered. Take for example equipment (a fixed cost). Equipment can be resold or returned at a determined price, therefore it is not a sunk cost.
Sunk cost is also known as past cost, embedded cost, prior year cost, stranded cost, sunk capital, or retrospective cost.
Examples of Sunk Costs
- Suppose you buy a ticket to a concert for $150. On the night of the concert, you remember that you have an important assignment due on the same night. You must make a decision: go to the concert or finish your assignment. The $150 paid for the ticket is a sunk cost and should not affect your decision.
- A company spends $5 million building an airplane. Prior to completion, the managers realize that there is no demand for the airplane. The aviation industry has evolved and airlines demand a different type of plane. The company has a choice: finish the plane for another $1 million or build the new in-demand airplane for $4 million. In this scenario, the $5 million already spent on the old plane is a sunk cost. It should not affect the decision and the only relevant cost is the $4 million.
- A company spends $10,000 training its employees to use a new ERP system. The software turns out to be heavily confusing and unreliable. The senior management team wants to discontinue the use of the new ERP system. The $10,000 spent to train employees is a sunk cost and should not be considered in the decision of discontinuing the new ERP system.
- A company spends $10 million to conduct a marketing study to determine the profitability of a new product they will launch in the marketplace. The study concludes that the product will be heavily unsuccessful and unprofitable. Therefore, the $10 million is a sunk cost. The company should not continue with the product launch and the initial marketing study investment should not be considered when making decisions.
The Sunk Cost Fallacy
The sunk cost fallacy reasoning states that further investments or commitments are justified because the resources already invested will be lost otherwise. Therefore, the sunk cost fallacy is a mistake in reasoning in which the sunk costs of an activity are considered when deciding whether to continue with the activity. This is also often known as “throwing good money after bad.”Assume you spend $200 for a snowboard trip at Grouse Mountain. Later on, you find a better snowboard trip at Cypress Mountain that costs $100 and you purchase that ticket as well. Unknowingly, you find out that the two dates clash and you are unable to refund the tickets. Would you attend the $200 good snowboard trip or the $100 great snowboard trip? A majority of people would choose the more expensive trip because although it may not be more fun, the loss seems greater. The sunk cost fallacy prevents you from realizing what the best choice is and makes you place greater emphasis on the loss of unrecoverable money.
Examples of the Sunk Cost Fallacy
In the following examples, you can clearly see how sunk costs affect decision-making. Sunk costs cause people to think irrationally.- Tom purchases a movie ticket online for $12.50 and upon arriving at the theatres to watch the movie, Tom realizes that the movie is really boring and does not appeal to him. Tom decides to sit through the entire movie because he already bought a ticket.
- Jennifer pays a $100 entry fee to join a new tutoring club. After attending 4 of the 7 sessions, Jennifer decides that the tutoring sessions hosted by the club do not help her at all. She decides to attend the remaining 3 sessions despite it being unhelpful because of the $100 entry fee.
Sources:
1. Wikipedia
2. https://corporatefinanceinstitute.com/resources/knowledge/economics/sunk-cost/
Money already spent and permanently lost. Sunk costs are past opportunity costs that are partially (as salvage, if any) or totally irretrievable and, therefore, should be considered irrelevant to future decision making. This term is from the oil industry where the decision to abandon or operate an oil well is made on the basis of its expected cash flows and not on how much money was spent in drilling it. Also called embedded cost, prior year cost, stranded cost, or sunk capital.
Read more: http://www.businessdictionary.com/definition/sunk-cost.html
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