In managing both personal and business finance, fiscal responsibility is important to minimize the risk of loss. However, sometimes, even if you act responsibly, there will be some money that is lost.
Certain costs will be incurred; although it is important to know how these can be avoided whenever possible, it is also crucial to prepare for these costs. Read on to know more.
What is sunk cost?
Sunk costs also known as past, embedded, or retrospective costs refer to amounts that have been already spent and are irrecoverable. These costs are not included in sell-or-process-further decisions.
This concept is applicable for products that can be sold either in their current state or with further processing.
Since such expenses are irretrievable, they do not form part of any subsequent financial decision-making. The money is already spent and cannot be included in your future budget.
Saving money in case of such costs does not mean recovering either part or whole of this amount but instead, it means reducing further losses in the future.
All embedded costs are fixed but not all fixed expenses are retrospective costs.
Types of sunk costs
Now that you know the answer for “what is sunk cost?” Here are some common types of such expenses that will help you understand them better.
- Marketing and advertising expenses
- Research and development costs
- Installation of new software systems
Examples of sunk costs
ABC Limited is planning to expand its business and is considering launching a new product. The company spends INR 10 lakhs for market research to determine the profitability of the new product.
The study concludes that the new product will not be profitable and may even be unsuccessful. In this case, the cost already incurred for the market research cannot be recovered and should not be taken into consideration while deciding on whether the company should launch the product or not.
Here is another sunk cost example. XYZ Limited manufactures and sells football shoes. The company leases the factory premises but has invested in purchasing the machinery required to manufacture the footwear.
Currently, XYZ Limited produces basic shoes at a cost of INR 1,000 per pair and sells them at INR 1,200, which gives a profit of INR 200. The company finds out that there is a demand for premium-quality football shoes.
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). XYZ Limited decides to manufacture premium shoes to earn higher profits.
In this case, the company did not consider the factory rent and the machinery cost as these are already incurred and have no relevance in the decision-making process.
About sunk cost fallacy
The basic sunk cost meaning is that it has already been incurred and should not be a part of the decision-making process.
However, sometimes, a company or an individual may stick to a decision (even when it may not be the most appropriate one) as the cost has already been incurred.
The sunk cost fallacy states that making additional investments or commitments is justified since some resources have already been invested.
If additional money is not put in, the already spent resources would be wasted. However, this fallacy often results in throwing good money after bad and should be avoided.
Sunk cost fallacy examples
You purchase a movie ticket for INR 250. After watching the movie for some time, you realize that it is not interesting.
However, you still continue to sit through the movie since you have already spent the money for buying the ticket.
Another example is that market research shows that a movie may not be popular or appeal to a wider audience. The studio then decides to spend more money on advertising to raise awareness and avoid loss.
However, most likely the additional promotional cost may not increase the audience, which further adds to the studio's losses.
What is sunk cost bias?
Have you held on to an ill-fitting outfit because it was expensive? Continued reading a book even if it was not interesting? Stayed in a business partnership or stuck with a strategy since you have invested a hefty amount into it?
If your answer to these questions is “yes”, then you have experienced the sunk cost bias. This is human tendency to continue investing additional resources in a losing proposition due to the investments that have already gone into these.
The bias often results because you are averse to losses or do not want to admit that you have wasted your resources in a failed cause.
Difference between opportunity cost, sunk cost, and relevant cost
Opportunity costs are implicit and represent the potential gains that are foregone when you opt for one option from the different available choices. These costs are subjective and are important in the decision-making process.
The sunk cost definition states that these are already incurred expenses and are not recoverable. These are related to past actions and are actual costs that have no role in future decision-making.
Relevant costs are future expenses like product pricing or inventory purchase and are important when making particular business decisions.
These costs are contrasted with the possible earnings of one alternative compared to another.
What is sunk cost dilemma?
It is what you face before falling prey to or avoiding the fallacy. The dilemma is to decide if cutting further losses is better than pushing ahead trying to prevent the loss.
For example, you paint two rooms in your home and then realize it is not what you want.
The dilemma then arises whether to continue painting the same color as you have already purchased the paint and completed two rooms or to buy a new color that meets your preferences.
Carefully considering your decision is important as every once in a while, you will have to incur some sunk costs.
Financial responsibility does not mean avoiding these expenses but knowing when and how to mitigate the damages.
Budgeting for these in advance is beneficial; for example, companies may estimate payroll expenses or rent while creating a personal budget.
This is a companion discussion topic for the original entry at https://jupiter.money/resources/understanding-sunk-cost/