What is a sunk cost how is it important in making managerial decisions?

Let’s talk sunk costs. In business speak, a sunk cost is a payment or investment that has already been made. It can't be recovered and therefore shouldn't be a factor in decisions moving forward because no matter what, it can't be recouped. Businesses and organizations often have difficulty abandoning strategies because of the time spent developing them, even if they aren't the right choice for the company.

Imagine a company that decides to build a new factory. They already did their analyses and determined that the future benefit they will receive from the factory will outweigh the cost of construction. They pay for the factory up front and expect to earn a certain level of cash flows from the factory’s production each year. But after a few years, the factory is underperforming and cash flows are less than expected.

A decision has to be made: should the factory be shut down or not? At this point, the initial cost of the factory is a sunk cost and cannot be recovered. The decision should only be based on the future cash flows—or the future expected benefit—of the factory compared to the value of selling the factory today, not the original cost of the factory.

However, sunk costs aren't just useful for large companies deciding whether to enter new markets or close down factories. This principle can be applied in everyday life, and understanding it may impact how you make decisions. 

Feel free to leave the baseball game if it’s raining.

Some may call you a fair weather fan, but the cost became sunk the instant you purchased your ticket. You might feel obligated to stay and stick it out if the ticket was expensive, but if leaving makes you happier, do it! Either way, you aren't getting your money back.

Don’t go to the gym just because you have an annual membership.

Working out may be advantageous to your health, but your annual membership shouldn't dictate whether you go to the gym on any given day. If you paid up front, that’s money you won’t see again—if you’d rather take a hike, watch a movie, or spend an hour trolling Snapchat, you should. Your annual membership isn’t coming back into your checking account either way. (Although, this is not to say there are no other benefits to working out.)

There's no need to clean your plate.

How many times have you been at a restaurant and felt compelled to finish your meal? What about dessert? You ordered it, so you have to enjoy it and eat as much as you can. Before you give yourself a stomach ache and ruin a perfectly enjoyable meal, let’s think about this in terms of sunk costs: you've already committed to paying for the dinner and dessert in front of you no matter how much you eat. If you are full or don’t like the taste, stop eating. It’s that simple.

Sometimes there is an emotional component to sunk costs.

Maybe you went to law school, passed the bar, started working, and then realized you hate being a lawyer. What should you do? You invested so much time, energy, and money in that degree, so it can't be worth starting over again with a new career, right? Unfortunately, these are all sunk costs, so if your end goal is your own happiness, you might need to cut your losses and refocus your energies elsewhere. 

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Money that has already been spent and cannot be recovered is a sunk cost. The sunk cost phenomenon in business is a product of the idea you need to "spend money to make money." A sunk cost in product management could include marketing, new software, equipment, research, or facilities expenses.

Not all fixed costs are sunk costs, but all sunk costs are fixed costs. Sunk costs are specifically costs that can’t be recovered. For example, equipment is not a sunk cost if you can resell it or return it.

And sunk costs don't just affect companies — they happen in everyday life too. Let's imagine you spend $50 on a theater ticket but can’t go at the last minute. Your $50 investment would be considered a "sunk cost" and wouldn’t influence your decision to purchase theater tickets in the future.

So, what are some common examples of sunk cost?

For one: equipment. Office equipment, like printers, often need replacing after a few years. At this time, the money spent on the old equipment is deemed a sunk cost.

Sure, some of it may be recovered if you can sell off some parts. But all the money that was spent on it initially is sunk.

How to calculate sunk cost?

To calculate the sunk cost of a piece of equipment to be replaced, find its current as-new market price. Next, try to identify how much the item is worth in its current state, which should be possible with a little online research. Subtract the current value from the as-new price to find the sunk cost. To calculate the sunk cost of a project, list all equipment and/or tools that can’t be sold or reused. Find the purchase price and its current value to identify depreciation. Then assign a sunk cost. Next, add up the cost of labor for the project so far. Combine this with the cost of unsalvageable equipment and the sunk cost of goods that can be sold or reused. The result is the project’s sunk cost.

What is the sunk cost fallacy?

The sunk cost fallacy is a misconception that investing in a project or product further will allow you to reverse losses and still come out on top. The truth is that money has already been lost and additional investment will fail to recoup it.