What is Sunk Cost?

Sunk costs are the incurred costs for a business that cannot be recovered. Sunk cost is also known as a retrospective cost or past cost. In future decision-making, sunk costs are not relevant. However, sunk costs can influence decisions about the future. A sunk cost example in business can be the funds spent on research and development (R&D) for a product that ultimately gets canceled or rejected. In this blog, we will explore sunk cost meaning, sunk cost examples, types of sunk cost, and a lot more. 

Examples of Sunk Costs

Now that you understand what is sunk cost, let’s look at a few examples. The following are the sunk cost examples for your reference

1. Research and Development (R&D): The most common example of sunk cost is when the capital is spent on developing a new product but it is discontinued.
2. Marketing Expenses: Sometimes huge funds are invested in advertising campaigns but they do not show the expected results.
3. Non-Refundable Deposits: Payments for reservations, such as event bookings, that are forfeited when plans change.
4. Software Development Costs: Expenses incurred in creating a software tool that the company later decides not to use.
5. Abandoned Projects: Investments in projects that are stopped mid-way due to changes in strategy or market conditions.
6. Equipment and Machinery: The purchase of equipment that becomes obsolete or unnecessary.

Types of Sunk Costs

The following are the types of sunk costs:

• Fixed Sunk Costs: Fixed sunk costs are unavoidable costs. They are not tied to any level of production or output. Examples of fixed sunk costs are lease payments and salaries of permanent staff.
• Time & Effort: Time dedicated to projects or activities that can’t be recovered, even if the project is abandoned.
• Emotional Investment: Energy and commitment in personal or professional relationships that may no longer serve any value.
• Depreciation & Amortisation: The above accounting practices will spread out the asset's cost over time, but once recorded, they are considered sunk costs.

What Factors Lead to the Sunk Cost Fallacy in Decision-Making

The following are the factors leading to the sunk cost fallacy in decision-making.

• Emotional Attachment: When there is a personal or emotional investment in a specific project then it can cause irrational decision-making.
• Desire to Avoid Loss: The fear of loss may cause someone to continue doing something that they are failing at.
• Assigning Blame: If the losses are to be attributed to some efforts or investments made, one is likely to blame individuals or teams, and thus fear is what will stop unprofitable projects.
• Positive vs Negative Framing: Businesses tend to present loss avoidance in a positive light, whereas acknowledging failure is seen as negative, influencing decision-making.
• Attachment to Original Plans: Adhering to a strategy for no other reason than being the original plan is irresponsible; following the original decision outweighs the weight of the decision.
• Optimistic Bias: It is the tendency to believe that higher costs of yesterday will call for even more returns tomorrow, where evidence negates this expectation, and "overly optimistic expectations are elicited.".
• Waste Avoidance: Despite best efforts to avoid waste, results may not always follow, and sometimes even due diligence may not provide the expected outcome.

What is the Sunk Cost Dilemma?

A sunk cost dilemma is a situation whereby a person or an organization finds themselves at a crossroads as regards either abandoning a project whereby they have lost vast resources or continuing with poor prospects. This is the situation in a clash between rational decision-making, being future-oriented to benefits, and the psychological pull of sunk costs. This causes extensive costly commitments that ultimately damage financial health.

Conclusion
Sunk costs play a significant role in not only personal finances but also in business finance, in the decision-making process. It is important to note here that sunk costs are sunk. So, forever decision-making has to be rational and not based on the previous expenditure but on the outcome in the future. The awareness of types of sunk costs and sunk cost implications as well as the psychological sunk cost factors can help avoid sunk cost fallacy in both personal and business life. Additionally, you can use an online trading app to stay updated about the market trends.