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Business

Sunk Costs Explained: How to Recognize the Sunk Cost Fallacy

Written by MasterClass

Last updated: Oct 16, 2020 • 2 min read

Some business endeavors incur costs that cannot be recovered. In business decision-making, such expenses are called sunk costs.

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What Is a Sunk Cost?

In the field of behavioral economics, a sunk cost is an expense that will not be refunded or recovered. Also known as a retrospective cost, a sunk cost may involve a considerable amount of money or it may involve a small, largely symbolic sum. For example, a new business may take on sunk costs as part of its startup plan—such as making an initial investment in personnel or core equipment.

All sunk costs, by definition, cannot be recouped; however, not all sunk costs are the same. They can be fixed costs (flat rates that are the same despite fluctuations in output), or they can be variable costs (costs that vary based on the scale of business activity). In either case, once the cost is incurred, it’s unrecoverable.

The opposite of a sunk cost is a prospective cost, which is a sum of money due depending on future business or economic decisions. For instance, a successful business may take on prospective costs only if its decision-makers decide to expand, such as by building a new plant.

3 Examples of Sunk Costs

Sunk costs arise in both business and personal spending. Businesses and individuals routinely encounter variations of sunk costs. Some examples of sunk costs include:

  1. Startup capital: A common example of a sunk cost in the business community is the infusion of cash needed to get a business off the ground.
  2. Initial vendor payments: In both a business context and a personal context, you may hire a vendor or contractor who requires an upfront payment, with the remaining balance due upon project completion. That upfront payment is a sunk cost; even if the project derails and you fire the contractor, you should not expect to get that money back.
  3. Tickets to an event: In the realm of personal spending, a concert ticket, opera ticket, or movie ticket is generally a sunk cost. Even if you can’t attend the event you bought the ticket for, you won’t be able to get a refund for the ticket price.
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What Is the Sunk Cost Fallacy?

The sunk cost fallacy, or sunk cost effect, can be thought of as throwing good money after bad. You have a sunk cost you cannot recover, but you nonetheless spend more money in hopes of recouping the lost sum. By refusing to cut your losses, you create an escalation of commitment where the only way to tackle a bad situation is to invest in it further. The sunk cost fallacy can steer you far from rational decisions in a desperate attempt to make the most of an unfortunate initial decision.

How Do Sunk Costs Affect Decision Making?

If a sunk cost doesn’t yield the desired result, the purchaser faces a sunk cost dilemma. A common example of a sunk cost fallacy involves buying a car. Say you buy a used car that turns out to be a lemon: Should you put more money into the car to get it working properly, or should you cut your losses, discard the car, and move on? In situations like this, it can be easy to slip into the sunk cost fallacy, sinking even more money into a bad investment.

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