However, it is important to realize that not all fixed costs are considered sunk costs. 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. The sunk cost dilemma is also commonly discussed when considering investments, primarily in volatile investments like equity markets. Investors that have limited capital must make decisions on whether to hold or sell securities and must make the decision independent of historical emotions.

That is because should taxes on stock influence your decision to buy or sell these costs have already been incurred; because there is no ability to recover these funds, the sunk cost should have no financial bearing on future decisions. The sunk cost dilemma may lead to irrational decision-making where individuals or organizations make choices that defy logic and reason. Instead of assessing the current situation objectively, they are influenced by past investments. The homeowner can’t necessarily discount the sunk costs, which tends to be a rational thought process.

But if he chooses to overlook the sunk costs, he falls into the sunk cost trap or the sunk cost fallacy. This happens when he makes an irrational decision, one made without considering the money he’s already spent. If, for example, XYZ Clothing is considering shutting down a production facility, any of the sunk costs that have end dates should be included in the decision. To make the decision to close the facility, XYZ Clothing considers the revenue that would be lost if production ends as well as the costs that are also eliminated. If the factory lease ends in six months, the lease cost is no longer a sunk cost and should be included as an expense that can also be eliminated. If the total costs are more than revenue, the facility should be closed.

When individuals or groups invest time, money, effort, or even personal emotions into something, they may become emotionally attached to the idea of recouping those investments. This emotional attachment can lead to several detrimental behavioral patterns. Businesses with the highest sunk costs tend be those with the greatest barriers to entry and biggest startup costs.

What Is the Difference Between Sunk Cost and Relevant Cost?

Sunk cost fallacy can also sneak up on you by inflating your sense of confidence in a situation. It can be really challenging to walk away from a situation where you’ve already spent any amount of time, money, or energy. What often happens is that you try to rationalize the situation by saying that, since the spent cost can’t be recovered, you might as well stay the course and/or allocate additional resources to try to make things better.

To make this decision, the firm compares the $15 additional cost with the $20 added revenue and decides to make the premium glove in order to earn $5 more in profit. The cost of the factory lease and machinery are both sunk costs and are not part of the decision-making process. Sunk costs don’t only apply to businesses as individual consumers can incur sunk costs as well. Let’s say you buy a theater ticket for $50 but at the last minute can’t attend.

At the point in time where you make this decision, everything you’ve spent so far is sunk cost. In this case it’s a considerable amount of money, and it may be painfully difficult to walk away. If you don’t, you run the risk of spending even more money that you’ll never recover if economic conditions don’t improve fast enough. The dilemma can be framed as one of certain loss versus uncertain success.During the U.S. recession many homebuilders chose to keep working, assuming this economic recovery would mirror past experience. It didn’t and many of them failed because there has been no sustainable rebound in the real estate market. In retrospect, they would have been better off ignoring their sunk costs and cutting their losses.

1. What ends up happening is that you may stay in a stagnant situation that’s unfulfilling and lose additional valuable resources, such as emotional energy, your time (which is finite), or money.
2. Admitting that resources were wasted can be emotionally difficult.
3. This is in contradiction to the concept of intentionality, which is concerned with whether the presentation of information changes the situation in question.
4. In Accounting from Northeastern University, and an MBA from Northeastern University.

We and our partners process data to provide:

Even large entities—such as governments, companies, and sports teams—are susceptible to the sunk cost fallacy. For example, they may continue to allocate more resources into projects, products, strategies, or programs that aren’t profitable or successful. For product managers, sunk cost fallacy can cloud rational thinking. Evangelizing a new feature or product and motivating others around them are central to the PM role.

It pays $5,000 a month for its factory lease, and the machinery has been purchased outright for $25,000. The company produces a basic model of a glove that costs $50 and sells for $70. The manufacturer can sell the basic model and earn a $20 profit per unit. Alternatively, it can continue the production process by adding $15 in costs and sell a premium model glove for $90. In business, the sunk cost fallacy is prevalent when management refuses to deviate from original plans, even when those original plans fail to materialize. The sunk cost fallacy incorporates investor emotions that cause irrational decision-making.

Overoptimistic probability bias

While a sunk cost is an expense that cannot be changed because it has already occurred. The sunk cost fallacy arises when decision-making takes into account sunk costs. By taking into consideration sunk costs when making a decision, irrational decision-making is exhibited. In both economics and business decision-making, sunk cost refers to costs that have already happened and cannot be recovered. Sunk costs are excluded from future decisions because the cost will be the same regardless of the outcome.

How to Avoid the Sunk Cost Fallacy

Ellingsen, Johannesson, Möllerström and Munkammar[40] have categorised framing effects in a social and economic orientation into three broad classes of theories. Firstly, the framing of options presented can affect internalised social norms or social preferences – this is called variable sociality hypothesis. Secondly, the social image hypothesis suggests that the frame in which the options are presented will affect the way the decision maker is viewed and will in turn affect their behaviour. Lastly, the frame may affect the expectations that people have about each other’s behaviour and will in turn affect their own behaviour. While these functions are framed differently, regardless of the input ‘x’, the outcome is analytically equivalent. Therefore, if a rational decision maker were to choose between these two functions, the likelihood of each function being chosen should be the same.

These would include capital-intensive industries that require large buildings, expensive tooling and a high ratio of fixed to variable costs. In fact, the level of sunk cost is a major barrier to entry to many of these businesses.The concept is simple and straightforward, but sunk cost plays a major role in many personal and business decisions. It’s important to have a decision-making strategy when confronted with the need to spend more money when the recoupment of the sunk cost may be in jeopardy. If you bought an advance ticket to a movie and then heard from several moviegoers that it was terrible, would you still go see it if you couldn’t get a refund or resell the ticket? Made on a purely economic basis, you wouldn’t go because the ticket is a sunk cost.

This bias can result in suboptimal decision-making, as the focus is on past investments rather than future benefits. When making business decisions, organizations should only consider relevant costs, which include the future costs that still needed to be incurred. The relevant costs are contrasted with the potential revenue of one choice compared to another.

Halfway through construction of the homes, the real estate market starts to crash. Do you keep working and finish the construction, hoping that the market will soon improve? Or, do you stop work and save the money you would have spent finishing all the homes?

Admitting that resources were wasted can be emotionally difficult. Economists suggest that, in theory, sunk costs are not relevant to future decision-making. In practice, however, sunk costs can and do significantly influence decisions about the future. This is largely because it’s psychologically challenging to let go of previously invested time, effort, or financial resources even if the outcome of those investments fails employee turnover to meet expectations. When considering opportunity costs, it is critical to disregard sunk costs.