Sunk costs: why they matter and how to avoid them

The ultimate goal of business owners is to generate sustainable revenue and make a profit. However, when running a business, it is common to incur unavoidable costs.

A sunk cost is one such cost. Also known as retrospective cost, a sunk cost is a financial investment that cannot be recovered. These costs are usually excluded from future decision-making.

Let’s dive into sunk costs, including a definition, types of sunk costs, the sunk cost fallacy, and how to avoid them whenever possible.

A sunk cost is a financial cost that cannot be recovered. This kind of cost often raises the question of whether or not to continue investing in the cost, project, or venture. Other characteristics of sunk costs include being unavoidable and remaining the same, making it a type of fixed cost.

Sunk costs are an everyday financial occurrence and do not only affect businesses. For instance, when you purchase a washing machine or new phone, it will eventually need replacing. At that point, the amount you paid for the old washing machine or phone is considered a sunk cost. People try to avoid unnecessary expenses by considering warranties and trying to estimate how long the item will last.

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

In most cases, sunk costs are considered irrelevant to present and future budgets as they are fixed and can’t change as they are a past expense. Sunk costs should not affect business decisions as these are about future business goals rather than costs that cannot be recovered.

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 is not recouped, or the break-even point is not achieved.

A small business leadership team choosing to continue sunk costs is a reflection of poor financial and business judgment. It’s important to reflect on the type, the amount, and the duration of sunk costs.

Replacement expenses

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

• Hardware

• Facility growth

• Physical assets

Opportunity costs

When a business chooses to pursue an alternative platform or service that does not subsequently perform well or become profitable, the amount spent exploring the new direction is 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 considered sunk costs as well as the initial investments.

Sunk costs are unavoidable and impact everyday decisions. Although sunk costs can act as distractors in decision-making, it does not mean they do not matter or should not be considered.

A company’s historic sunk costs serve as a guideline for evaluating past and future performance. Since they are fixed and kept out of future business decisions, historic costs can help you understand your upcoming sunk costs and others you could avoid or reduce. This will help 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 make a company:

• Unproductive

• Have outdated workplace trends

• Lose market share to competitors

• Produce low-quality goods and services

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

Marketing example

When a business wants to launch a platform or service, marketing costs will be incurred. To generate a profit, companies often invest in advertisements and software to manage their outbound and inbound marketing efforts and increase their network effect and customer base. 

Marketing expenses are a great example of a sunk cost, as any amount spent on advertisements or marketing software will never be recovered. The business cannot directly recover marketing costs despite potential earnings from the new product.

Research and development example

Research and development of a new product is unlikely to generate revenue but is necessary. When researching a product, a sunk cost is incurred, even if the developed product is sold.

In addition, if a company develops a product and later decides not to sell it, this investment 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 have to hire an agency to train its employees on how to use it. However, the software may need upgrading after some time, and additional training will be necessary. Therefore, the initial training expenses are a sunk cost since they are not recoverable.

Another training example: a business spends $400 on training an employee during the onboarding process. If the employee leaves the position, the $400 becomes a sunk cost as it cannot be recovered.

Hiring example

There are two types of hiring sunk costs:

• A business hires a new employee who does not deliver as required

• If the new employee decides to end the contract, the hiring costs cannot be recovered

The sunk cost fallacy is the tendency to continue with a plan even if the present costs outweigh the potential benefits. This 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 if profits aren’t generated.

Sunk cost fallacy results from irrational decision-making. It is 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 be paid off.

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

Sunk cost fallacy can happen to anyone. Here are signs that you are falling victim to sunk cost fallacy:

• Resistance to change

• Irrational decision-making

• Defending an ineffective or outdated process

• Fear of admitting failure

The consequences are rarely positive. Sunk cost fallacy can lead to missed opportunities as people become more reluctant to pursue new ventures and cannot abandon or pivot from what they have already invested in.

Psychological factors

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

Loss aversion

This is a tendency to avoid making losses since the ideology of losing is psychologically powerful and painful.

Loss aversion prompts individuals to continue making poor choices because of the fear of losing.

Framing effect

In psychology, this is described as a tendency for people to choose a proposition based on how it has been positively presented or staged.

The framing effect occurs when information is reframed positively while ignoring facts that are perceived as negative. Even if two options lead to the same outcome, people tend to be biased toward the choice they view as a gain over one they view as a loss.

Overoptimistic probability bias

This is also known as unrealistic optimism. It happens when individuals or teams overestimate their chances of achieving a highly valuable goal and underestimate their chances of not reaching them.

For example, business owners may believe they have a good chance of success if they invest their finances 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 investments.

Sense of personal responsibility

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

To not appear wasteful

This is the psychological concept of continuing with poor investments to avoid the perceived shame of wasting money, resources, and time. People usually want to avoid being negatively viewed by their professional network, peers, and family as unintentionally wasting resources, including capital.

Luckily, we can avoid sunk costs and make rational decisions. Sunk cost fallacy can be avoided through the following strategies:

Being aware of sunk costs

When you are aware of the different psychological factors that cause 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 to change and holding on to original plans increases the chances of failing instead of pivoting.

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

Make logical decisions

Sunk cost fallacy defies logic. You can avoid sunk cost fallacy by thinking logically through every action you consider. Depending on the type of sunk cost, one of the best ways to avoid it is to make ongoing data, cost, and market-analysis decisions.

Set investment goals

Before making startup investments, set a performance target that is obtainable and low risk. This gives you a clear target with identifiable measures and constraints to guide you to the successful completion of the first milestone.

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

Look at the big picture

Sunk cost fallacy can be difficult to detect, especially if you or the leadership team do not 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 is in your best interest. Ensure that your investments are geared toward the future, not the past.

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

Some common examples of sunk costs are:

• Labor expenses

• Installation of new software systems

• Marketing costs

• Employee salaries

Yes, salaries are not recoverable; they are expenses incurred by the company.

The main difference is that sunk costs are not considered when making future decisions, while relevant cost is significant in the decision-making process and can be changed.

Sunk costs are always fixed costs because they cannot be changed, but not all fixed expenses are sunk costs, as they can be recovered if an asset is sold or returned, for example.

Key characteristics of sunk costs include having occurred in the past, and being irreversible and unrecoverable.

Sunk costs cannot be recovered, while non-sunk costs can be retrieved.

A sunk cost is calculated by subtracting a product's current value from its as-new price.

Opportunity cost is the benefit lost when you choose one course of action against another. A sunk cost is an incurred expense that cannot be changed.

Purchasing a car is a sunk cost as the full amount cannot be recouped or saved and depreciates over time.

Sunk costs, by definition, are part of the past and are not considered in decision-making since they have already occurred and cannot be recovered through future sales. However, all business expenses can be reviewed and decreased, including upcoming sunk costs.

Sunk cost fallacy is the psychological need to follow through with your original plans once you have invested resources into them.

Escalation of commitment is the tendency to increase investment, resources, energy, and time, even if this results in adverse outcomes or does not change the circumstances.