What is a Sunk Cost?

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Definition:

A sunk cost refers to money a company has already spent and that they won’t be able to recover.

🤔 Understanding sunk costs

There are some expenses that a company pays for that will result in a return on investment — They’ll be able to get that money back at a later point. With a sunk cost, however, there’s no opportunity to get your money back — It’s a past cost that can’t be changed or recovered. Unlike an investment, a sunk cost has no real bearing on future decisions or business. When a person or a business mistakes a sunk cost for an investment and tries to recover the cost, they’ve bought into the sunk cost fallacy.

Example

Let’s say a corporation is considering switching software programs. They purchase the new software and spend money teaching their executive team how to use it. But in the end, they decide the new software isn’t a good fit for their operations. As a result, the money spent on the new software becomes a sunk cost — The company can’t recover it, regardless of whether the company goes back to the original software or tries another one.

Takeaway

A sunk cost is like buying a nonrefundable movie ticket...

Once you buy a nonrefundable ticket, you can’t recover the cost. If you end up skipping the movie because other plans came up, the price of the ticket becomes a sunk cost.

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What is a sunk cost?

A sunk cost is a past expense that you can’t recover. It is retrospective, meaning it’s already taken place, and there’s nothing you can do about it now or in the future.

Let’s say you buy a book from a book store for $20. You’ve read great reviews about the book, and your friends keep telling you that you’re going to love it. You take the book home and start reading. You don’t make it halfway through the book before realizing you’re bored and don’t want to continue reading.

At this point, you have two options. You could keep reading and finish the book, or you could move on to a new one. Either way, the $20 you spent on the first book becomes a sunk cost — You can’t recover that expense regardless of whether you finish the book.

Sunk costs are pretty common in business. Let’s say you run a sneaker company and you’re brainstorming ideas for a new product line. You spend $5,000 on market research for a new design you’re excited about. The research comes back and shows that the design would not only be expensive to make, but it would also have a low chance of turning a profit. You decide to abandon the idea. The money you spent on the research becomes a sunk cost — You can’t recover it whether or not you move forward with the new design.

How do sunk costs affect decisions?

Because a sunk cost is something that took place in the past and can’t be recovered, you generally wouldn’t factor them into future business decisions. Just like you can’t change the past, it isn’t possible to recover your sunk costs.

Imagine you’re that business owner who spent $5,000 on market research for a new product idea that didn’t pan out. When it comes time to sit down and brainstorm your next product idea, ideally, you would no longer think about the $5,000. The money was spent, and can’t be recovered. It has no bearing on the likelihood that a new idea will have better luck working out.

But in the real world, individuals and businesses can struggle to keep sunk costs out of future decisions. It may be tempting to think that, since you’ve already invested $5,000 into an idea, you might as well move forward with it — So as not to “lose” the money they previously spent. This is a pretty common misconception about sunk costs.

What is the sunk cost fallacy?

The sunk cost fallacy happens when individuals or businesses make decisions on the mistaken belief that a sunk cost might lead to a return at some point. In other words, they mistake a sunk cost for an investment, rather than seeing it for what it is — A dead end.

Let’s say you’ve been driving an old used car for the past few years. Lately, the car has needed expensive repairs totaling several thousand dollars. The day after you pick up the car from the shop, the car’s transmission blows. You decide whether to repair the transmission or buy a new car.

To an outsider, a new car might be the obvious choice. But after spending so much money on repairs, you decide you’d rather fix the old car so that the money you spent previously wasn’t all for nothing. This is how the sunk cost fallacy works. You believe that you “invested” a lot of money into the car, and you don’t want to “lose” it by getting a new one.

But in reality, the money you spent on the repairs is an expense that can’t be recovered at this point, whether you fix the car or get a new one. Either option results in you paying more money.

The sunk cost fallacy also happens in business. Imagine your business is testing out new product ideas. You decide to pull the trigger on one prototype, and you spend money buying supplies to manufacture the new product. When the first round of manufacturing starts, you realize that the product’s quality won’t be good enough to compete with competitors. What do you do?

If you decide that you have to proceed with manufacturing because you’ve already “invested” money to develop the product, you’d be buying into the sunk cost fallacy. You know the product won’t succeed, but you feel you’d be wasting that money if you don’t continue. This is like the old used car; the money you’ve spent can’t be recovered, no matter what you do next.

Sunk costs are often an inevitable part of running a business. As a leader, it’s an important skill to be able to recognize a sunk cost for what it is.

What is the difference between sunk costs and fixed costs?

Running a business comes with different types of costs. One is the fixed cost — A cost that, as the name implies, doesn’t change depending on the company’s sales.

One example of a fixed cost is rent. Imagine you sign a lease for a small retail space to open a coffee shop — The total rent is $950 per month. No matter how successful or slow business gets throughout the year, the rent will remain at $950.

Variable costs, on the other hand, go up or down based on your level of sales. Think of the raw materials you use to make your product. The more products you make and sell, the more you’d spend on those raw materials.

A fixed cost can be a sunk cost. For example, if a new competitor moved in across the street from your coffee shop and ate into your business for several months, you’d still have to pay the $950 monthly rent during that time (a fixed cost). At some point, the rent may become an expense you can’t recover through your shop’s profit (a sunk cost).

However, not all fixed costs are sunk costs. Let’s say that instead of leasing the retail space for your coffee shop, you bought it and paid $950 per month on a mortgage. The monthly mortgage payment is still a fixed cost — You can’t pay less on the mortgage even when business is slow.

But the mortgage is not a sunk cost. Because you own the retail space, it has resale value. The money the company pays on its mortgage each month builds equity (aka ownership) in the property. In other words, each payment is money you might get back if and when you sell the space.

What is the difference between sunk costs and opportunity costs?

Another type of cost that companies have to consider is opportunity cost. An opportunity cost is the value of what you miss out on by choosing one option over another. It’s a future cost that you might consider when weighing a business or life decision.

A sunk cost, by contrast, is one you’ve already incurred and can’t get back — It’s water under the bridge. Like sunk costs, opportunity costs are just part of running a business. Every decision you make carries an opportunity cost of some kind.

Imagine you’re trying to decide between manufacturing one of two products to sell in your company. The problem is that the two products require different types of equipment, and you can only afford to go with one. In this case:

The opportunity cost of manufacturing Product A is the profit you could make from Product B. The opportunity cost of manufacturing Product B is the profit you could make from Product A.

Whichever product you choose, you’ll incur an opportunity cost.

Now let’s say you decide to go with Product A, and Product A doesn’t end up selling as well as you thought it would. If you can’t return the equipment you bought to manufacture the item, and it doesn’t have any resale value, the money you spent on the equipment becomes a sunk cost.

Opportunity costs are also common in everyday life, like deciding between two college majors. One is in an industry that is notorious for its low-paying jobs, but it’s a field of study you’re passionate about. The other major you’re considering will lead to a field with well-paying jobs, but doesn’t inspire you as much. Either way, you’d incur an opportunity cost.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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