What is sunk cost?
Sunk cost refers to money which is spent and cannot be regained. It is typically used in the context of businesses and business bookkeeping. For example, you might refer to the cost of machinery or office space as sunk cost. While these things are necessary for the success of it, they will not have directly correlated returns. Compared to opportunity costs, which is the lost of potential profits from time and money not used, sunk costs have already been spent.
In terms of business decisions, sunk costs are typically not considered when thinking about whether to continue a certain endeavor or investment. Instead, it is advisable to think about future costs as well as costs that have clear returns. As you consider which costs your business can incur, we strongly recommend creating a website for your business to feed growth, without setting you back monetarily.
The concept of sunk cost has been around for centuries, but it was formally introduced in economics in the early 1900s. Since then, it has become a widely accepted principle in both economics and business.
In essence sunk costs should,
Be costs that have already been incurred and cannot be recovered.
They should not be considered when making future business decisions
They can include time, money, and resources that have already been invested.
Example of sunk cost
It can be difficult to identify what should be included in the definition of sunk costs. That’s because a sunk cost might refer to initial items that are necessary for setting up a business. Here is a more specific example:
Imagine you are opening a flower shop. You decide to rent out a space that needs major renovation and are willing to pay for the renovation in order to better your business offering. After the renovation, you are assessing your costs and earnings and wondering if you can stay afloat financially. During this assessment, you might consider the costs of the flowers you buy as well as the rent that you pay monthly, which can be referred to as relevant costs.However the prior amount you spent on the renovation should not be included in your evaluation. Instead, this expense is a sunk cost.
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The sunk cost fallacy
The sunk cost fallacy is an economic phenomenon in which people continue to accrue costs in order to justify their initial investment. In other words, once we spend money on something, we feel the need to make the most of it or make it worth the investment, regardless of whatever additional costs might be necessary.
For example, you ordered takeout for dinner, but could only finish half of the meal. To justify the money spent, you may feel the need to eat the rest of the meal and not let it go to waste. This sense, despite the additional cost of a potential stomach ache, is considered the sunk cost fallacy.
Benefits of understanding what sunk costs are
Once you understand what sunk costs are, it can mean:
Avoiding making poor investment business decisions based on emotional attachment to previous investments.
Being able to focus on future opportunities rather than past mistakes.
Evaluating investments based on their potential return rather than their past cost.
How do you calculate sunk cost?
Sunk cost isn't something that can be calculated. It refers to costs that have already been incurred and cannot be recovered. When making future investment decisions, sunk costs should not be considered.
Sunk cost FAQ
Should sunk costs be considered when making business decisions?
No, sunk costs should not be considered when making business decisions because they are irrelevant to future costs and revenues. Only future costs and revenues should be taken into account when making business decisions.
Can sunk costs be recovered?
No, sunk costs cannot be recovered because they are already spent and cannot be refunded. The best course of action when dealing with sunk costs is to accept the loss and focus on future costs and revenues.