Sunk Costs
June 30, 2008 – 6:04 am
Sunk Costs are costs that have been incurred that cannot be recovered. The problem with sunk costs is that they frequently enter our decision-making process, and this mistake can lead to making the wrong decisions. This is sometimes referred to as the sunk cost fallacy.
In the corporate world this most frequently relates to capital investments. Let’s assume a manufacturer decides to buy a new production line that costs $10MM. Once that line is purchased it’s not something that can be easily sold if the company finds out they don’t need it or want it. Therefore, the $10MM is a sunk cost. Once the money is spent, the company should decide what to do with the line regardless of the money already spent. Should they use it, spend more to enhance it, or use it as a giant box of spare parts? The feelings of loss (and loss aversion) related to this purchase should not sway the company’s decision regarding how to use the asset now that it is purchased.
Why Should I Care?
People also tend to make decisions based on sunk costs, and this can lead to making the wrong choice. Economics suggests that sunk costs should be ignored in decision-making, because a decision should be evaluated exclusively on its own merits. The decision to spend money on something in the past is done. It’s over. The money spent should not be considered when making future decisions (assuming you cannot reclaim those funds).
The concept of sunk costs ties in with loss aversion, because people typically think that current value of an item is related to the price they paid for that item. An example might be a purchased cruise ticket. If you spend $500 to go on a cruise and decide not to go, you would not be able to easily resell that ticket to someone else. Once you’ve purchased the ticket, you still have the choice to go on the cruise or not go on the cruise. The decision to go or not go shouldn’t be based on the cost of the ticket. Most of us, however, would feel like skipping the cruise would be the same as incurring a loss of $500. It’s not the same though. If you can’t exchange the ticket for $500, then it’s no longer worth $500. What you paid for the ticket is irrelevant to the decision at hand.
This type of situation can also cause people to throw good money after bad. Trying to buy your way out of a bad investment, a bad business deal, or a used automobile may not be the best thing to do. The problem is that we “feel” like we will incur a loss if we change directions, and these feelings cloud our judgment.
Beware of the sunk cost fallacy. These types of decisions can come up in any situation where the money you spent on an item no longer represents the value of the item. These scenarios come to mind:
- Purchasing or leasing a car
- Invested time in a relationship or friendship that you would no longer choose to pursue
- Investing time or money in a business that, based on the current situation, should not continue to exist
- Trying to recoup investment losses based on an inaccurate current value of those assets
- Continuing to pursue a career because of the time and effort you’ve invested and because it’s what you’ve always done
- Finishing a book that will no longer provide value to you
Image Credit: Ben Scicluna
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