written by | November 1, 2022

Understanding Sunk Costs | What is the Sunk Cost Fallacy?

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Table of Content


Imagine you decide to write a research paper on a topic you are interested in. But after a few days of writing, you are no more interested in the topic and want to quit. But something is holding you back from quitting; the time and effort you put into writing this far are stopping you. Those efforts and time you put in have now become worthless for you and are equivalent to the sunk cost, and the feeling holding you back from quitting is better known as the sunk cost fallacy.

Did you know? Air India incurred huge sunk costs for the Indian government as the airline lost a total of Rs 34,689.7 crores between 2010–2011 and 2015–2016.

What is a Sunk Cost?

A sunk cost is a cost that has already been spent and cannot be recovered. This can happen when a business does not yet have an idea of what the outcome for a particular budgeted cost will be. A customer, for example, might be showroom ready, but not yet delivered to the shipping dock because of delays in production. The customer would still be counted as part of the cost until they were actually out of warehousing and on the road to being fulfilled. Thus, we can say that not every investment is a sunk cost.

Sunk Costs are those costs that cannot be recovered by any means, i.e., money, once invested, is gone forever. They should not be considered for making any future decisions like whether to continue the investment or not, as these costs cannot be recovered, and decisions should only be made based on relevant costs.

Sunk costs are considered fixed costs, but remember that all fixed costs are not considered sunk costs.

Also Read: Human Resource Accounting: Concept, Objectives, and Benefits

Examples of Sunk Costs

  1. One simplest example of sunk cost is employees working on a probation period. You have paid a joining bonus to the probationer, but the results aren’t satisfactory, so you terminate the probation contract and fire the probationer from their job. The joining bonus is considered a sunk cost, as you won’t be seeing it again.
  2. Let’s assume you invested money in your company's product development. But the response to the product in the market isn’t good, and no one is interested in buying your product. The money you invested in the R&D of the product shall be considered a sunk cost and should not affect the company's future decisions.

Understanding the Sunk Cost Fallacy

Sunk cost is money once invested and cannot be recovered. However, sometimes the invested money may change one’s decision and force them to continue investing in the project even if abandonment of the project is more beneficial to them. The sunk cost fallacy creeps into many major financial decisions of a business and sometimes can become a significant reason for the downfall of a company.

Sunk cost fallacy tends to indulge a feeling that the already invested money will be wasted if the project is discontinued and tries to justify that the investing in the project is beneficial and thus leads the investors to throw in a good amount of money on something which is not at all beneficial for them.

Examples of the Sunk Cost Fallacy

  1. Let us consider that you purchased a food item and are excited to try it. You taste the article, and the taste is very disappointing. Despite the terrible taste, you continue to finish the food item as you have already spent money on it.
  2. Consider a new movie release; though the film's storyline may not be appealing, producers and directors invest considerable amounts in the marketing and promotions of the movie. But still, they don’t manage to gather an audience. Those investments can even be significant losses for the production house.

How the Sunk Cost Fallacy Influences Our Decisions – The Sunk Cost Bias

Consider Ram, who has recently bought an expensive jacket for the upcoming farewell party at his college. However, the jacket is ill-fitting and doesn’t suit him at all. But since it is more expensive than regular good-looking jackets, Ram decided to wear the expensive jacket to the party.

This is an example of the sunk cost bias. The sunk cost bias is the result of the sunk cost fallacy in our minds and can force people to make decisions that are not fruitful. Since they have invested money, people will continue using that product even if it is not good.

The sunk cost bias is another way to avoid admitting that your decision was wrong and that you have wasted your money on the faulty product.  

How is the Sunk Cost Fallacy Dangerous

Sunk cost fallacy can sometimes cost you more than just money. They don’t just affect small decisions like investing money or time, but they can also affect the entire functioning of the company or business. These effects can lead you to take decisions that can be the primary reasons for mental stress or other health problems.  

1. System failures

The best example of this effect is the Concorde fallacy. The aircraft companies of France and Britain decided to develop a supersonic aircraft known as the Concorde. Even after investing millions of dollars in the project, the agencies couldn’t recover the money from the aircraft, and as a result, the aircraft didn’t survive in the market.

This shows that even big companies can make mistakes that can lead to the malfunctioning of an entire company. The sunk costs only increased when the agencies invested more money and time in the project.

2. Individual Effects

The sunk cost fallacy can affect an individual's life and sometimes force them to make irrational decisions that further disrupt their lives.       

For example, you continue working in a company despite not being entirely satisfied as you have been in the company for a very long, and it seems like a safe option. We don’t think of the future and only make decisions based on current alternatives; this is where things generally go wrong.

Also Read: Matching Concept in Accounting: Benefits and Challenges

How to Avoid the Sunk Cost Fallacy 

Let’s discuss how you can stop falling prey to the sunk cost fallacy

1. Discussions Before Decisions

Before making significant decisions on a project, you should understand the problem's roots. Suppose you are struggling to understand the problem. In that case, you should discuss it with experts or seniors to frame the situation properly and then analyse it to find the best possible solution instead of blindly following your instincts.

2. Keep Track of Your Investments

You should keep a record of your current and past investments, time, or money. This will help to take better decisions and help you prepare a proper dataset for your business. The Returns on Investment can be understood with the help of such records. It makes it easier to identify the project/product that is no more worth investing in, thus saving you money.  

3. Follow the Data.

The main symptom of falling into the sunk cost fallacy is ignoring the indications of the data and emotionally taking the decisions. When investing in any project, be it time or money, you should keep a record of it from the start, as mentioned earlier. That dataset is the best way to identify projects no longer worth investing in and help frame a proper strategy for your future decisions. Even though sunk cost data should not affect your decision, they should be included while analysing the statistics and data.

4. Analyze the Risk Factors and Make the Right Decisions

While analysing the problem, most people calculate the risk factors, but even then, they still go for it as they think this would make them greater profits than before. Seeking out decisions on risk is no less than a gambling game. Instead, you should correctly calculate the risk factors and prepare your strategy if anything goes wrong.

Ultimately, making the right decisions is what matters the most.

Also Read: Differences between Financial Accounting and Management Accounting

Conclusion

Sunk costs are expenses that cannot be recovered and shouldn't influence your choices in the future. The sunk cost fallacy can occasionally be risky and set a project up for failure. To make any more investments in a project, we shouldn't only follow our gut feelings. Instead, we should use the facts to determine the risks involved and adjust our strategy as necessary. We hope this article might have helped you learn something new about sunk costs, the sunk cost fallacy, and how to tackle such situations.

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FAQs

Q: What is Sunk Cost?

Ans:

Sunk costs are the investments once made, cannot be recovered. For example, the money you paid for a movie ticket and could not visit the theatre. It is also known as embedded cost, one-time cost, sunk capital, etc.

Q: What has sunk cost fallacy?

Ans:

The Sunk Cost Fallacy is the feeling that pulls back a person from quitting investing in a project. Abandoning the project will be more beneficial as they have already heavily invested in the project.

Q: Is sunk cost fallacy dangerous?

Ans:

Yes, the sunk cost can prove to be dangerous sometimes. The feeling of getting returns in the future takes over the person’s senses and forces them to take decisions that are not for their benefit.

Q: What is the sunk cost bias?

Ans:

Being biased towards a product or a decision, even if it is not good, just because you have already invested in it, is called the sunk cost bias. It is a consequence of the sunk cost fallacy.

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The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.