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Sunk Cost

A sunk cost is an investment that has already been made and cannot be recovered. The concept of a sunk cost can have many applications across business, investing, and even your personal life.

We can probably all relate to a situation where you spent money on something you wish you hadn’t. Maybe we made an investment that went bad, bought a book we ended up hating, or bought tickets to an event we couldn’t enjoy.

While these are all very different situations, they all have one thing in common: that money is gone, and we can’t get it back. In other words, they are sunk costs.

Sunk costs can appear in many different parts of our lives. Most often, we use the term in reference to business or investment decisions. But from the examples above, you can see that sunk costs can also apply to your everyday life.

What is a Sunk Cost?

A sunk cost is one that’s already been paid for and can’t be recovered. The term sunk cost is often used in a business setting.

For example, the money a company spends on research and development for a potential new product would be considered a sunk cost. Regardless of whether they ever bring the product to market, the money the company has already spent is gone.

Generally speaking, sunk costs shouldn’t be factored into future business decisions since they can’t be recovered no matter what.

For business purposes, all sunk costs are considered fixed costs. However, not all fixed costs are sunk costs. The only fixed costs considered sunk costs are those that can’t be recovered. Some fixed costs can be recovered.

For example, if a company buys a piece of equipment, it doesn’t count as a sunk cost. Even if the company ends up not using the equipment, it could resell or return it to get at least some of its money back.

Examples of Sunk Costs

The concept of a sunk cost can have many applications across business, investing, and even your personal life. An example of a sunk cost we can all relate to is spending money from our budget on something we didn’t end up enjoying.

For example, let’s say you and some friends decide to try a new expensive restaurant in town. Regardless of how you feel about the meal, the money you’ve spent is a sunk cost since you can’t get it back. Similarly, let’s say you spend money to attend a local event. Whether you attend the event or not, you’ve already spent the money on the ticket and can’t get it back. As a result, it’s a sunk cost.

Sunk cost can apply to your personal life, but the term is most often used in terms of business and investment spending. For example, there are plenty of expenses a company may incur that would be considered sunk costs.

Those costs include the research and development costs and the market costs associated with creating a new product. Regardless of whether the product ever comes to market — and regardless of how well it sells — the money spent is a sunk cost. Another example of a sunk cost in this situation would be the payroll dollars spent on the employees working on the research and marketing of the product.

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What is a Sunk Cost Fallacy?

Often going hand-in-hand with the idea of sunk costs is the sunk cost fallacy. Under the sunk cost fallacy, individuals and businesses end up spending more money and other resources to avoid “wasting” the money they’ve spent on a sunk cost. This is known as throwing good money after bad.

Let’s go back to our example of a company spending money on the research and development of a new product. Suppose that during that process, the company finds many problems with the potential product and doesn’t think it will perform well.

Ideally, a company would use this information to conclude it shouldn’t move forward with the product. But if the company’s leadership falls for the sunk cost fallacy, they might decide to devote more money to research, development, and payroll to make the product work.

The problem is the company has already determined the product isn’t a good investment. It’s only moving forward with it because it doesn’t want to have wasted the money it’s already spent. But the truth is, the money is already gone and can’t be recovered, making it a sunk cost.

For a more relatable example of the sunk cost fallacy, imagine spending money on a book, only to get through the first few chapters and decide you don’t like it. The most logical choice would be to stop reading the book and avoid spending time on something you won’t enjoy.

But if you fall for the sunk cost fallacy, you might keep reading it to avoid having wasted the money you spent. Unfortunately, the money is already gone and can’t be recovered. The only thing you do by continuing to read it is to throw good money (or, in this case, time) after bad.

Avoiding Sunk Cost Fallacy

It’s easy to fall into the sunk cost fallacy because financial decisions are often fueled by emotions rather than logic. However, there are ways to avoid falling for this fallacy and, therefore, avoid wasting more time and money.

The best way to avoid falling into the sunk cost fallacy is to look at the big picture. Think about your desired outcome for any scenario. For example, if you’re a business owner deciding whether to continue investing in something, think about your goals, as well as the goals you have for your customers. Will spending additional money on a sunk cost help those goals come to fruition?

Additionally, run the numbers and compare your options. Think once again of the prospect of spending money on research and development for a new product, only to find the product isn’t ready. Run the numbers and find whether it would be more financially reasonable to spend the money necessary to get the product to where it needs to be or whether it makes more financial sense to invest in a different product that has a better chance at success.

Ultimately, avoiding falling into the sunk cost fallacy will require flexibility and a willingness to change course when things aren’t working. Yes, it may eventually mean spending money on something you end up letting go of. But in the long run, you’ll avoid wasting even more resources.

 

Author is not a client of Personal Capital Advisors Corporation and is compensated as a freelance writer.

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. Compensation not to exceed $500. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money. Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

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