Understanding Sunk Cost Meaning: Examples & How it works
On the contrary, we are often influenced by our emotions, which tie us to our prior commitments even in the face of evidence that this is not in our best interests. An example of the sunk cost fallacy is when a business advertises a failed innovation in the hopes of increasing its sales and recovering the costs that have already been spent. Now let us understand how sunk costs are calculated by economists and how it aids in their decision-making process. Economic cost refers to the expenses incurred by a company while using its resources for production. Importantly, if sunk costs are included in the decision-making process, this makes it difficult for management to focus on the key decision variables. Product managers play an integral role in developing a new product or a feature in an existing product.
The Project Manager must start by working out what costs are ‘sunk’ in the project that can’t be changed. While these sunk costs remain important data points, the Project Manager must exclude them from the analysis of alternatives for a decision. A company spends $20,000 to train its sales staff in the use of new tablet computers, which they will use to take customer orders.
However, you still continue to sit through the movie since you have already spent the money for buying the ticket. The additional production cost will be INR 300 while each pair can be sold for INR 1,800. The profit on sales of premium-quality shoes is INR 500 (1,800-1,300).
It’s important to reflect on the type, the amount, and the duration of sunk costs. You decide to purchase new office equipment for your business, including desks, computers, free locksmith invoice template and chairs. The company you purchase the equipment from has a 90-day return policy. After the 90-day return policy expires, the equipment is now a sunk cost for the business.
The ultimate goal of business owners is to generate sustainable revenue and make a profit. However, when running a business, it is common to incur unavoidable costs. Include any benefits, such as health insurance or retirement contributions, in the sunk costs.
How do I calculate a sunk cost?
The meaning of sunk costs in projects or investments can be attributed to numerous economic principles and axioms including ‘let bygones be bygones’. In classical economics this is the ‘bygones’ or ‘marginal’ principle and is a very important lesson to learn about project management. To make this decision, the firm compares the $15 additional cost with the $20 added revenue and decides to make the premium glove in order to earn $5 more in profit. The cost of the factory lease and machinery are both sunk costs and are not part of the decision-making process. Therefore, companies must ignore the sunk costs while making business decisions.
- The bygones principle is grounded in the branch of normative decision theory known as rational choice theory, particularly in expected utility hypothesis.
- This is the psychological concept of continuing with poor investments to avoid the perceived shame of wasting money, resources, and time.
- While these sunk costs remain important data points, the Project Manager must exclude them from the analysis of alternatives for a decision.
- Sunk costs are important because may act as distractors in decision-making.
Relevant costs are future expenses like product pricing or inventory purchase and are important when making particular business decisions. The last major component of the sunk cost dilemma is opportunity cost. Opportunity cost is the concept of what you give up by choosing one option over another. When dealing with the sunk cost dilemma, people often neglect opportunity cost, which can have a significant impact on decision-making. When a business wants to launch a platform or service, marketing costs will be incurred.
Let go of attachments to investments
Opportunity costs are one of the most important types of economic costs and help organizations in various decision-making processes. The costs incurred or benefits lost when a company chooses one choice over another is known as opportunity cost. Now, let’s take an example of a firm that manufactures food and beverages.
Frequently asked questions about the sunk cost fallacy
Budgeting for these in advance is beneficial; for example, companies may estimate payroll expenses or rent while creating a personal budget. The dilemma is to decide if cutting further losses is better than pushing ahead trying to prevent the loss. However, most likely the additional promotional cost may not increase the audience, which further adds to the studio’s losses.
What Is Irrational Decision-Making in the Context of Sunk Costs?
While sunk cost aids in the decision-making process, many firms fall into sunk cost fallacy. It is the situation when the companies keep on adding further investment into the failed innovation in the hope that incurred sunk costs can be recovered. The firms must be aware of the nature of sunk cost and must not take it into account while making decisions. Before jumping right into the definition of sunk costs, let’s get a quick refresher on what costs mean in economics.
The sunk cost fallacy can affect our decisions in response to other people’s past investments. Instead of considering the present and future costs and benefits, we remain fixated on our past investments and let them guide our decisions. The sunk cost fallacy is the tendency for people to continue an endeavor or course of action even when abandoning it would be more beneficial. Because we have invested our time, energy, or other resources, we feel that it would all have been for nothing if we quit. Sunk cost fallacy is when companies keep investing more money in a failed innovation in the hopes that the sunk costs will eventually be recovered.
An example of sunk costs
This kind of cost often raises the question of whether or not to continue investing in the cost, project, or venture. Other characteristics of sunk costs include being unavoidable and remaining the same, making it a type of fixed cost. Relevant costs are all of the expenses that play a role in your decision-making process. And, future costs are also relevant costs because they are expenses your business will incur in the future that can impact your current decisions (e.g., product pricing). Consider your relevant costs with the potential revenue of the expense when making financial decisions. In project accounting, it is a good idea to ensure fixed costs are categorised, as are variable costs (costs that could change).