What is a sunk cost? This is a common psychological trap that businesses can easily fall into, leading to wrong decisions and wasted resources. Once money has been invested in a project, continuing to invest just because of regretting the money spent, even though the project is not feasible, is a consequence of sunk cost.
The following article by Bizzi will help you understand more about sunk cost, how to recognize it, its impact and how to deal with sunk costs effective in business decisions.
What is a sunk cost?
Sunk Cost is the expense incurred in the past and irrecoverable, whether the business continues or stops that project or activity. This is a cost no longer influences future decisions, but again psychologically impactful managers, causing them to regret and make wrong decisions to "recover" the lost money. Sunk costs often appears when investment fails or decision goes wrong.
In short, sunk costs are independent of future factors.
Examples of sunk costs:
- A company invests 500 million to develop a software but then realizes that the product is not suitable for the market. This 500 million is sunk cost Because whether or not the business continues to grow, it cannot recover the money it has spent.
- Buying production machinery but after a while realizing it is ineffective. The cost of buying this machinery is also a sunk cost.
Characteristics of sunk costs
- Irrevocable: Once costs incurred, there is no way to get that money back.
- No impact on future decisions: Theoretically, these costs should not be taken into account when making investment or business decisions because they cannot be changed.
- Often overlooked in calculations, economic analysis: In cost-benefit analyses, sunk costs are often not considered because they do not affect future cash flows, and also cannot be compensated by future profits.
- Often viewed as a type of fixed cost: Because this cost does not change regardless of what decisions the business makes. However, not all fixed costs are sunk costs.
- Uncontrollable or unpredictable.
- Any expense can become a sunk cost if it does not yield the expected results.
- Regarding hidden costs: Sometimes, there are also hidden, unclear sunk costs behind investments or indirect costs.
Examples of sunk costs
- Non-Returnable/Non-Refundable Purchases: Money paid for shoes that are not satisfactory and cannot be returned or refunded.
- Market research costs for unfeasible projects: Money spent on market research for a new product that is not produced due to low market demand.
- Cost of unsuccessful product development: Money invested in research, development and production of a new product but the market does not accept it.
- Cost of building or purchasing unused assets: Costs paid for buildings, machinery, or technology that are no longer used or sold.
- Cost of training employees who quit or are ineffective: Money is invested in training employees but they leave the company or are not productive.
- Costs of unsuccessful advertising: Money spent on marketing campaigns did not achieve expected results.
- Money to buy followers on TikTok does not guarantee orders: The cost of buying followers to qualify for livestreams but does not generate sales.
- Cost of unsold inventory: Money spent on importing products that are not popular with customers.
- Cost of ineffective website design: Invested in website design but did not attract customers and increase sales as expected.
What is the difference between opportunity cost and sunk cost?
– Nature:
- Sunk costs: Cost has been arise in the past or a payment obligation has arisen and is committed to be performed. Should not be taken into account in the current assessment or decision.
- Opportunity cost: Future costs. Are the benefits foregone when choosing an alternative. Are the value of the best opportunity missed when making a decision.
– Measurement:
- Sunk costs: Measurable in money with certainty.
- Opportunity cost: An estimated, relative value that may include non-monetary values. Often difficult to quantify precisely, and is based primarily on estimates and assessments of the potential of different options.
- Present:
- Sunk costs: Expressed by numbers recorded according to accounting principles on the report corporate financial accounting.
- Opportunity cost: Not shown on the Financial Statements, but may be shown on some management reports.
– Role in decision making:
- Sunk costs: Should not be considered when choosing between options for decision making.
- Opportunity cost: Should be fully considered in weighing up alternatives for decision making. Represents the benefits foregone when choosing an alternative, and is therefore a factor to be considered in the decision making process.
Sunk Cost Fallacy
The sunk cost trap is a phenomenon where an individual or business continues to invest in a project or decision just because it has already incurred a large amount of costs, even though continuing to invest may not bring benefits or even cause further losses. Here are some common causes of this mistake:
- Loss Aversion Bias: Regret about the material and time invested in the old plan, so tend to persevere.
- Expected benefits: Maintain investment due to belief in the future benefits of the project and to prove the initial decision was correct.
- Never give up or “go all in” mentality (Commitment Bias): Once committed to a decision, people tend to don't want to change even though they know it's wrong. They believe that if they just try a little harder, things will change.
- Herd Mentality: Believe in perseverance and you will reap success.
- Pressure of reputation and personal pride: Unwilling to admit failure: Difficulty in giving up the costs already spent; Fear of losing face or receiving criticism: If giving up a project in which a lot has been invested.
- Failure to periodically review performance and lack of awareness of sunk costs: Continue investing on inertia without any other backup plan.
How do sunk costs affect business decisions?
– It is easy to make mistakes in decision making due to continuing to invest in ineffective projects:
Businesses often tend to “sunk cost effect” (Sunk Cost Fallacy), which means continuing to invest in a project or product even though it is no longer effective, simply because too much money was spent on it before.
For example: A company invested billions of dollars in a project but the market did not accept it. Instead of stopping to reduce losses, they continued to invest in the hope of "recover", resulting in heavier losses.
– Impact on business strategy
- If not clearly identified What is a sunk cost?, businesses can maintain ineffective projects.
- May miss out on new and more potential business opportunities
- Decisions affected by sunk costs are often suboptimal.
For example, a phone manufacturer invested heavily in a failed product line but continued to produce it instead of focusing on developing new phone models according to market trends.
– Misalignment of budget allocation
- Businesses can end up “throwing money into the fire” instead of investing in more potential projects.
- The correct approach is to look at future costs rather than what was lost in the past.
- Leading to capital deficit and serious waste of resources:
- Waste of resources: Continuing to spend capital, human resources and time on projects that have no prospects.
How to avoid sunk cost trap effectively
Identification and assessment
- Be clear about sunk costs: Understand the concept What is a sunk cost? and recognize that costs that have already occurred cannot be changed. Always distinguish between sunk costs (which are lost and cannot be changed) and costs that may influence future decisions.
- Understanding sunk costs: Clearly identify which expenses have been incurred and irrevocable, to avoid being influenced when making decisions.
- Separating the past and the future: Ask questions: “If I hadn't invested this money, would I have continued with the project?” If the answer is Are not, then consider stopping.
- Project review: Use analytical tools to re-evaluate projects based on future benefits and costs, not past ones.
Make decisions based on future benefits
- Looking to the future: Make decisions based on future potential and benefits rather than on past costs.
- Consider alternative options: Consider potentially better options if a project is no longer viable.
Using data and analytics
- Evaluate projects based on financial, market, ROI metrics instead of emotions.
- Build an objective scorecard to analyze investment performance.
- Reevaluate the costs and benefits of a project to decide whether to continue investing.
- Make decisions based on current information: Don't rely on the past, evaluate based on the actual situation to make the best decision for the future.
- Plan for multiple scenarios: Prepare backup plans to be flexible when the initial plan goes awry.
- Monitor the results of your advertising campaign or sales plan closely: To be able to consider timely changes. Use software overall business management to track business performance.
- Analyze market characteristics and target customers carefully: To make appropriate business decisions and avoid wasting resources.
Establish clear financial principles
- Determine maximum loss before starting a project to avoid getting caught in the “continuation investment trap”.
- Periodic review: Set the performance test time to decide whether to continue or not.
- Set clear limits on acceptable losses for each plan: If a project is no longer effective, be brave enough to abandon it instead of continuing to pour money into it in the hope of "recovering capital".
- Focus on ROI (Return on Investment): Only continue investing if the project has good return on investment in the future, rather than being influenced by the amount spent in the past.
Summary
Here is all the information about What is a sunk cost? as well as optimization, sunk cost assessment to come up with appropriate strategies. In general, sunk cost trap is one of the common but dangerous mistakes of businesses and investors. Don't let regret make you lose more! It is recommended that businesses focus on future performance rather than past expenses to optimize business strategy.
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