What are sunk costs & how to rise above them?
Have you ever found yourself continuing to invest time, money, or other resources in a project or decision that is clearly not working out?
You’re not alone.
Many people fall prey to the sunk cost fallacy, which refers to the tendency to keep investing in something simply because we’ve already invested so much. But understanding the concept of sunk costs is essential for making rational decisions and avoiding the sunk cost fallacy.
In this article, we’ll explore what sunk costs are, why they matter, and how to make decisions that are based on expected future costs and benefits, rather than past investments.
What is a sunk cost?
A sunk cost is an expense that has already been incurred and cannot be recovered. This means that the cost has already been paid and the decision to incur that cost cannot be changed.
Sunk costs are not relevant to current decision-making because they cannot be recovered or changed, so they should not be considered when making decisions about future actions or investments.
For example, if a company has invested a large amount of money in a project that is not performing well, the money that has already been spent on the project is a sunk cost. Continuing to invest money in the project solely because of the sunk cost is known as the “sunk cost fallacy” and is not a rational decision-making strategy. Instead, the company should base its decision on the expected future costs and benefits of the project, rather than on the sunk costs.
What is the sunk cost fallacy?
The sunk cost fallacy is a cognitive bias in which people make decisions based on the amount of time, money, or effort they have already invested in a project or decision, rather than on the potential future costs and benefits.
Essentially, the fallacy is to think that since they have already invested a lot of resources in a particular project or decision, they should continue to do so regardless of whether or not it makes sense from a logical or economic perspective.
The sunk cost fallacy can lead people to make irrational decisions that can be detrimental to their overall well-being.
For example, a business may continue to invest money in a failing project because of the money already invested in it, even though it’s clear that the project will not be profitable in the long run. Similarly, an individual may continue to pursue a degree or career path that they don’t enjoy, solely because they have already invested a lot of time and money into it.
What are some examples of sunk costs in real life?
Here are some examples of sunk costs in real life:
- Buying a non-refundable ticket for a concert or event that you can no longer attend. The money you spent on the ticket is a sunk cost, and you cannot recover it.
- Paying for a gym membership for a year but not using it. The money you spent on the membership is a sunk cost and cannot be recovered, regardless of whether you use the gym or not.
- Investing in a company that is not performing well. The money you have already invested is a sunk cost, and you cannot recover it. You should base your decision to continue investing on the expected future returns, not on the sunk cost.
- Spending a lot of money on repairs for an old car that keeps breaking down. The money you spent on the repairs is a sunk cost, and you cannot recover it. You should base your decision on whether to keep repairing the car on the expected future costs and benefits of doing so.
- Continuing to study for a degree that you don’t enjoy because you have already invested a lot of time and money into it. The time and money you have already spent on the degree are sunk costs and cannot be recovered. You should base your decision to continue studying on the expected future benefits of the degree, not on the sunk costs.
Why are sunk costs important?
Sunk costs are important because they represent a significant investment of resources that cannot be recovered. Understanding the concept of sunk costs is essential for making rational decisions and avoiding the sunk cost fallacy.
By recognizing that sunk costs cannot be recovered and that they should not be factored into decision-making, individuals and organizations can make more informed and rational choices about future investments.
By focusing on expected future costs and benefits, rather than sunk costs, they can make decisions that are more likely to result in positive outcomes.
In business, sunk costs are particularly important because they can have a significant impact on profitability. By recognizing sunk costs as a separate category of costs, businesses can make more strategic decisions and allocate resources more efficiently.
In short, understanding the concept of sunk costs is important for making rational decisions, avoiding the sunk cost fallacy, and making the most effective use of resources.
Does sunk costs include only money? What about time & other resources?
Sunk costs can include both money and time, as well as any other resources that have already been invested and cannot be recovered.
In fact, time is often one of the most significant sunk costs in many situations.
For example, if you have spent months working on a project that is no longer feasible, the time you have invested is a sunk cost that cannot be recovered. Similarly, if you have spent years studying for a degree that you no longer want to pursue, the time you have invested is a sunk cost.
In short, sunk costs can include any resources that have already been invested and cannot be recovered, including time as well as money.
Sunk costs vs Opportunity costs
Sunk costs and opportunity costs are two different types of costs that are important to consider when making decisions.
Sunk costs are costs that have already been incurred and cannot be recovered, while opportunity costs are the potential benefits that are foregone by choosing one option over another.
For example, suppose you have already purchased a non-refundable ticket for a concert that is taking place on the same day as a friend’s wedding. The cost of the ticket is a sunk cost, as it has already been incurred and cannot be recovered. The opportunity cost, on the other hand, is the potential benefit of attending the wedding, which you would have to forego if you attend the concert.
Similarly, in business, a sunk cost might be the cost of machinery that has already been purchased, while the opportunity cost might be the potential revenue that could be generated by investing in a new product line.
In general, sunk costs are costs that have already been incurred and cannot be recovered, while opportunity costs are the potential benefits that are foregone by choosing one option over another.
It’s important to consider both types of costs when making decisions, as they can help to ensure that resources are allocated efficiently and effectively.
