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Sunk Costs Definition
Before jumping right into the definition of sunk costs, let's get a quick refresher on what costs mean in economics. Firstly, we must know that economists measure costs differently than accounting costs. Economists are concerned with costs that will likely be incurred in the future so they can organize their resources in a way that aids businesses in minimizing costs and maximizing profits. Hence, we can define economic cost as a term used to describe a firm's costs while utilizing resources during production.
An economic cost considers all of the costs associated with production. Of course, the costs include fixed and variable costs, but there is another type of cost that is very important - opportunity cost. The benefit lost when a company chooses one alternative over another is referred to as opportunity cost. The opportunity cost is also an economic cost for a business.
Suppose Jack owns a building and operates his office there as he has to pay no rent. Does this imply that Jack has no rental costs associated with running a business? In terms of accounting cost, sure, it is zero; nevertheless, in terms of economic cost, Jack incurs a cost. Jack might have rented out the office building to another company and generated a considerable rental income. This lost rental income is the opportunity cost of running a business in the building.
Various types of economic costs must be assessed carefully by a firm to make informed decisions. One of them is sunk cost. Costs that have already been invested by the firm or an individual and cannot be recovered are known as sunk costs. As firms are not able to recover the sunk costs, firms must carefully assess them, and they must make sure those sunk costs are ignored while making business decisions. Sunk costs are typically the costs associated with failed research and development projects or the purchase of obsolete equipment for a single purpose with no other practical use.
- Various types of costs in economics include the following:- Opportunity Cost;- Sunk Costs;- Fixed Costs;- Variable Costs.
Economic cost refers to the expenses incurred by a company while using its resources for production.
Sunk costs are expenses that have already been incurred and cannot be recovered by the firms.
Want to learn more about other types of costs incurred by the firms?Check out our articles on:- Opportunity Cost;
- Fixed Costs;
- Costs in Economics.
Examples of Sunk Costs
Now, lets us comprehend sunk costs in detail through examples.
Let's use a real-world scenario where you had purchased a ticket to a football game, and the game was delayed and could get completely canceled because of extreme weather conditions. You had already purchased the ticket, but you couldn't reap all the benefits of it. Even if you stay or don't stay in the stadium, you will not be able to refund your money. So, in this case, the ticket price was your sunk cost.
Now, let's take an example of a firm that manufactures food and beverages. The firm was looking forward to producing new beverages and decided to invest the amount of $400,000 in the research and development process. After all of the money was spent, the company figured out that the beverage was harmful to the health of consumers and couldn't move forward with production. As the amount of $400,000 has already been invested and cannot be recovered, it is regarded as a sunk cost for the company.
Sunk Cost Formula
Now let us understand how sunk costs are calculated by economists and how it aids in their decision-making process.
Let's assume that you decided to manufacture a new software and had a projected total revenue of $50,000 and a cost of $30,000, which is a good opportunity in the market. You decided to start the development of software, and in the middle of the development process, after you had spent $20,000, you realized that the project would cost a total of $60,000. Now, should you move forward with the project?
The initially spent $20,000 is your sunk cost, as you wouldn't have started the project if you had projected $60,000 at the start of the project. But as an economist, you have to ignore the $20,000 sunk cost and move on with the software development process looking forward to the future benefits. By ignoring the sunk cost, the additional cost of software development will be $40,000. The initially projected revenue of $50,000 is still greater than the initial cost of $40,000. Here, in terms of accounting costs, there is a loss of $10,000, but in terms of economic costs, there is a revenue of $10,000. So, from an economic perspective, it is better to continue the project even after realizing a sunk cost of $20,000.
This example depicts that sunk costs must be ignored in decision-making as they have already been incurred and cannot be recovered.
To learn more about the economic and accounting costs, check out our article:
- Accounting Profit vs Economic Profit.
Sunk Cost Importance
The importance of sunk cost is immense when making an economic decision. Every company incurs a sunk cost at some point. This doesn't mean the company has to shut down; it simply has to ignore the sunk cost and move on if economic benefits are greater than the costs incurred.
Let's take an example of a real-life giant company that had incurred sunk costs.
Google had a product named "Google Glass," which had a huge pre-release hype but had failed to meet customer expectations. It did not perform well in the market as was expected by Google and had to stop commercial production. The cost incurred during the research and development process of the product is regarded as a sunk cost.
But the question is, is Google stuck with the product as it had incurred a sunk cost during its development? No, they have moved on from the project and have ignored the sunk costs associated with the project, and they are still a huge success in the market.
Therefore, companies must ignore the sunk costs while making business decisions.
Sunk Cost Fallacy
While sunk cost aids in the decision-making process, many firms fall into sunk cost fallacy. It is the situation when the companies keep on adding further investment into the failed innovation in the hope that incurred sunk costs can be recovered. The firms must be aware of the nature of sunk cost and must not take it into account while making decisions.
An example of the sunk cost fallacy is when a business advertises a failed innovation in the hopes of increasing its sales and recovering the costs that have already been spent.
Sunk cost fallacy is when companies keep investing more money in a failed project or innovation in the hopes that the sunk costs will eventually be recovered.
Sunk Cost vs Opportunity Cost
Now, let's learn about opportunity cost and how it is different from sunk cost.
Opportunity costs are one of the most important types of economic costs and help organizations in various decision-making processes. The costs incurred or benefits lost when a company chooses one choice over another is known as opportunity cost.
Unlike sunk costs, which are only identified after they have been incurred, opportunity costs can be assessed before and help in making a decision that is most favorable for the firm.
Fig. 1 - Sunk Cost vs Opportunity Cost
Figure 1 illustrates the production possibility curve of a restaurant that specializes in making burgers and pizzas. It shows the different combinations of pizzas and burgers the restaurant can produce with its existing resources. The graph shows the concept of trade-offs where if the restaurant decides to make pizzas, they have to give up burgers and vice versa.
Suppose the restaurant moves from producing 2 burgers to 5 burgers. Then it will only be able to produce 20 pizzas instead of 30, which is a lot less than what it was producing initially. The number of pizzas the restaurant lost while producing burgers is known as an opportunity cost.
Opportunity cost is the benefit lost when a business selects one alternative over another.
The curve which depicts all of the possible combinations of output that can be produced by using existing resources is known as the production possibility curve.
Learn more about the concept of opportunity cost in our articles:- Opportunity Cost;- Opportunity Cost of Capital.
Sunk Costs - Key Takeaways
- Economic cost refers to the expenses incurred by a company while using its resources for production.
- Sunk costs are expenses that have already been incurred and cannot be recovered by the firms.
- Sunk cost fallacy occurs when companies keep investing more money in a failed project or innovation in the hopes that the sunk costs will eventually be recouped.
- Opportunity cost is the benefit lost when a business selects one alternative over another.
- The curve which depicts all of the possible combinations of output that can be produced by using existing resources is known as the production possibility curve.
- Sunk costs are only identified after they have been incurred, while opportunity costs can be assessed before they occur and can help a firm to make a sensible business decision.
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Frequently Asked Questions about Sunk Costs
Why is sunk cost important?
Sunk costs are important to the company as it helps them in their business decisions. The companies must carefully assess the sunk costs as they must not be included in any of their decision-making processes.
What is an example of sunk cost fallacy?
An example of the sunk cost fallacy is when a business advertises a failed innovation in the hopes of increasing its sales and recovering the costs that have already been spent.
How do you determine sunk cost?
Sunk costs are determined by adding up the costs that have already been spent but cannot be recovered by the firms.
What are two examples of sunk costs?
Two examples of sunk costs are Marketing costs and Research & Development costs.
What is meant by sunk cost?
Sunk costs are expenses that have already been incurred and cannot be recovered by the firms.
What is the difference between sunk cost and relevant cost?
Relevant costs are the future costs that have not been incurred yet and are considered in the decision-making process, whereas sunk costs are the ones that have already been incurred and are not considered in the decision-making process.
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