The idea that you need to spend money to make money is often thrown around in business, but is this always the case? Sometimes when you spend money, you don’t see any return. Here’s what you need to know about the sunk cost meaning and how it works.
Sunk costs explained
A sunk cost is money that’s already been spent and can’t be recovered. The concept of the sunk cost is used in economics to discuss investment that’s already been poured into a project. The sunk cost should be thought of as separate from the project since it’s in the past and you can’t get it back.
Managers often keep these costs in mind when making the decision to continue with the project, because they don’t want to lose their initial investment. However, it’s important not to consider sunk costs when making future investment decisions. Instead, businesses must focus on relevant costs which directly relate to the decision.
While all sunk costs are fixed costs, not all fixed costs are sunk costs. For example, equipment is a fixed cost. However, it’s not a sunk cost because it can be resold when you’re finished using it, even if the value depreciates.
Sunk cost vs. relevant cost
We’ve touched on relevant costs when answering the question of ‘what is sunk cost’ above, but here are a few more ways in which the two terms differ.
Sunk costs remain the same no matter what happens in the future
Relevant costs relate to a project’s future performance
This is why only relevant costs should be used in financial decision-making. Examples would include the costs of inventory or raw materials for product design. These costs still need to be incurred in the future, in contrast to sunk costs which have already been spent.
Sunk cost examples
How can you recognise what qualifies as a sunk cost? Here are a few examples for illustration.
Company A spends $10,000 on an in-depth survey to find out if there’s any interest in its new product design. The survey determines that the new product won’t be profitable. This $10,000 should be considered a sunk cost, since there isn’t any point in moving forward with a product that won’t produce profit.
Company B invests $5,000,000 over a five-year period to research and develop a new pharmaceutical product. Pre-launch, it’s found to be unsafe for consumers and there is no market interest. The project is a dud, and the $5,000,000 in expenses is a sunk cost that Company B will never get back.
Company C recruits a new employee and spends $5,000 on training courses. The new employee doesn’t make it through their trial period and decides to leave the company. The money spent on training is a sunk cost.
A student has spent $100 for a concert ticket, only to realise at the last minute that they’re meant to work on an important research project that same evening. It’s too late to sell the ticket, so the $100 is a sunk cost.
What is the sunk cost fallacy?
When you use the reasoning that you need to invest more money in a project because you’ve already lost money, it’s called the sunk cost fallacy. We can look at the sunk cost example above related to Company B. Imagine that the company decides that they’re going to continue spending money on a product that’s been proven to have no market value. They make this decision solely based on the fact that they’ve already spent $5,000,000 on research and development. The sunk cost fallacy involves a lack of logical reasoning. None of us like to lose money, but sunk costs should have no bearing on future investment decisions.
It’s important to understand the concept of sunk cost so that you can avoid wasting more time and money. When making financial decisions, take emotion out of the equation to maximise future value.
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