Sunk costs: why they matter and how to avoid them

A sunk cost is a financial investment that can’t be recovered. Also known as a retrospective cost, it’s money already spent—on labor, software, marketing, or equipment—that no future decision can claw back. Because they can’t be changed, sunk costs are usually excluded from future decision-making.

Every business incurs them. This guide covers the types of sunk costs, why they matter, the sunk cost fallacy, and how to avoid it whenever possible.

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What is a sunk cost?

A sunk cost is a financial cost that can’t be recovered. This kind of cost often raises the question of whether to keep investing in the project or venture. Sunk costs are also unavoidable and unchanging, making them a type of fixed cost.

Sunk costs are an everyday financial occurrence and don’t only affect businesses. When you purchase a washing machine or a new phone, it will eventually need replacing. At that point, the amount you paid for the old item is a sunk cost. People try to limit unnecessary expenses by weighing warranties and estimating how long an item will last.

All businesses incur sunk costs, whether employees on a payroll or general capital expenditures, such as facilities, marketing, or equipment.

In most cases, sunk costs are irrelevant to present and future budgets—they’re fixed, past expenses that can’t change. Business decisions should focus on future goals rather than costs that can’t be recovered.

Five types of sunk costs

The most common types of sunk costs are:

Past expenses

This is past expenditure from operations or financing a previous project. Such expenses include:

• Wages
• Mortgages
• Rent
• Salaries
• Insurance

Initial investments

In the business world, the start-up capital used to begin operations and sales for a new venture is a type of sunk cost when the sum isn’t recouped or the break-even point isn’t achieved.

A leadership team that keeps pouring money into a failed initial investment is showing poor financial judgment. Review the type, the amount, and the duration of sunk costs before committing more.

Replacement expenses

This is the amount of money a business uses to replace an essential asset. This may include:

• Hardware
• Facility growth
• Physical assets

Opportunity costs

When a business pursues an alternative platform or service that doesn’t subsequently perform well or become profitable, the amount spent exploring the new direction is a sunk cost.

Abandoned projects

Projects can be abandoned due to factors such as:

• Mismanagement of funds
• Inadequate planning
• Insufficient capital
• Unskilled personnel

If a business launches a project but later abandons it, the expenses incurred are sunk costs, along with the initial investments.

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Why do sunk costs matter?

Sunk costs are unavoidable and impact everyday decisions. Although they can act as distractors in decision-making, that doesn’t mean they don’t matter or shouldn’t be considered.

A company’s historic sunk costs serve as a guideline for evaluating past and future performance. Since they’re fixed and kept out of future business decisions, historic costs can help you understand your upcoming sunk costs and spot others you could avoid or reduce. This helps you make financially sound decisions in the company’s best interest.

Systemic effects

In reality, sunk costs are fixed and difficult to avoid, which can have adverse consequences. Sunk costs unmet by sales can leave a company:

• Unproductive
• Stuck with outdated workplace practices
• Losing market share to competitors
• Producing low-quality goods and services

Examples of sunk costs

Let’s look at some real-world examples of sunk costs.

Marketing example

When a business launches a platform or service, it incurs marketing costs. To generate a profit, companies often invest in advertisements and software to manage their outbound and inbound marketing efforts and grow their network effect and customer base.

Marketing expenses are a classic sunk cost—any amount spent on advertisements or marketing software will never be directly recovered, despite potential earnings from the new product.

Research and development example

Research and development of a new product is unlikely to generate revenue directly, but it’s necessary. The money spent researching a product is a sunk cost, even if the developed product sells.

If a company develops a product and later decides not to sell it, that investment also becomes a sunk cost.

Training example

Training costs are expenses incurred to increase employee skills. For example, when a firm installs new software, it may hire an agency to train its employees on how to use it. The software may need upgrading after some time, requiring additional training. The initial training expenses are a sunk cost since they’re not recoverable.

Another training example: a business spends $400 on training an employee during onboarding. If the employee leaves the position, the $400 becomes a sunk cost—it can’t be recovered.

Hiring example

There are two types of hiring sunk costs:

• A business hires a new employee who doesn’t deliver as required
• If the new employee decides to end the contract, the hiring costs can’t be recovered

What is sunk cost fallacy?

The sunk cost fallacy is the tendency to continue with a plan even when the present costs outweigh the potential benefits. It happens when someone follows through with a financial decision even though the expenses incurred exceed the potential returns. A business example is a manager refusing to deviate from the original plans, even when profits aren’t materializing.

The sunk cost fallacy results from irrational decision-making. It’s a type of cognitive bias arising from people’s tendency to get emotionally attached to their investments. They want to believe that if they continue, the costs incurred will eventually pay off.

It also comes about because people fear regret, loss, and not achieving their goals or ambitions. This clouds their judgment.

The sunk cost fallacy can happen to anyone. Here are signs you’re falling victim to it:

• Resistance to change
• Irrational decision-making
• Defending an ineffective or outdated process
• Fear of admitting failure

The consequences are rarely positive. The sunk cost fallacy can lead to missed opportunities as people become reluctant to pursue new ventures and can’t abandon or pivot from what they’ve already invested in.

Psychological factors

Researchers have identified five psychological factors that lead to the sunk cost effect.

Loss aversion. Losing is psychologically powerful and painful, so people work hard to avoid it. Loss aversion prompts individuals to continue making poor choices because of the fear of losing.

The framing effect. People tend to choose a proposition based on how positively it’s presented or staged. Information gets reframed positively while facts perceived as negative are ignored. Even if two options lead to the same outcome, people are biased toward the choice they view as a gain over one they view as a loss.

Overoptimism. Also known as unrealistic optimism, this happens when individuals or teams overestimate their chances of achieving a highly valuable goal and underestimate their chances of falling short. Business owners may believe they have a good chance of success if they invest in a particular venture, despite a similar venture failing in the past. A business owner may also assume that significant capital increases their return on investment.

Personal responsibility. This cognitive factor refers to linking efforts and investments with someone directly involved. When people feel responsible for previous expenses, they’re more likely to get trapped in the sunk cost effect and continue investing, furthering their losses.

Waste avoidance. This is the psychological pull to continue with poor investments to avoid the perceived shame of wasting money, resources, and time. People usually want to avoid being viewed by their professional network, peers, and family as having wasted resources, including capital.

How to avoid sunk cost fallacy

The good news: you can avoid the sunk cost fallacy and make rational decisions. These strategies help:

Being aware of sunk costs

When you’re aware of the psychological factors that cause the sunk cost fallacy, you’re more likely to make rational decisions and form healthy, sustainable budgets.

Some crucial questions you can ask yourself are:

• What fear is holding me back?
• What am I afraid of losing?
• What is the probability of my investments succeeding?
• Why am I resistant to change?

Let go of attachments to investments

Being inflexible and holding on to original plans increases the chances of failing instead of pivoting.

Let go of the fear of failure and accept that not every project, launch, or platform feature will succeed in a competitive marketplace.

Make logical decisions

The sunk cost fallacy defies logic, so think logically through every action you consider. Depending on the type of sunk cost, one of the best ways to avoid it is to base decisions on ongoing data, cost, and market analysis.

Set investment goals

Before making startup investments, set a performance target that’s attainable and low risk. This gives you a clear target with identifiable measures and constraints to guide you to the first milestone.

If you fail to achieve certain goals, reevaluate to work out where you can improve for better returns on investment.

Look at the big picture

The sunk cost fallacy can be difficult to detect, especially if you or the leadership team don’t regularly review your investments and capital spending.

Review your investment strategy yearly to stay on track. To achieve this, keep a record of past and current resources.

Embrace change

Let go of poor strategies and make new decisions based on what’s in your best interest. Ensure your investments are geared toward the future, not the past.

Just because a strategy worked in the past doesn’t mean it will work in the future—markets evolve.