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 relate 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 on 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 on a snowboarding 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 get a refund on 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.
Applications in Financial Modeling
It’s a lot easier to avoid the sunk cost fallacy in financial modeling, as DCF models only look at future cash flows, and don’t give any consideration to the past.
For this reason, it can be helpful for a financial analyst to perform the exercise of building a financial model in Excel to remove any emotion (related to sunk costs) and look at whatever decision maximizes the Net Present Value going forward.
In both economics and business decision-making, sunk cost refers to costs that have already happened and cannot be recovered. Sunk costs are excluded from future decisions because the cost will be the same regardless of the outcome.
The sunk cost fallacy arises when decision-making takes into account sunk costs. By taking into consideration sunk costs when making a decision, irrational decision-making is exhibited.
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