On a larger scale, the sunk cost fallacy can drive a company to stick with an underwhelming product or prevent them from keeping up with modern consumer demands or workplace trends. For example, a company might spend millions on a brand-new, state-of-the-art retail store, then lose market share to competitors that offer ecommerce. The sunk cost fallacy might keep the company from offering ecommerce as a way to try and force consumers into the store. As we mentioned above, the sunk cost fallacy can cause an individual to act against their own best interest. It does this by clouding their judgment and making it difficult to see whether continuing with a venture is worth the additional investment it requires. Going back to our medical school example, choosing to stay in the program would mean potentially doubling one’s student debt to complete coursework they aren’t genuinely passionate about.
Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate. Or, let’s say a SaaS company invests in usability testing for a new platform feature.
What Is an Example of a Sunk Cost?
Understanding the underlying psychology of the sunk cost mindset can shed light on why it’s so difficult to let go. The most common type of framing effect was theorised in Kahneman & Tversky, 1979 in the form of valence framing effects. This form of framing signifies types of framing. The first type can be considered positive where the ‘sure thing’ option highlights the positivity whereas if it is negative, the ‘sure thing’ option highlights the negativity, while both being analytically identical. For example, saving 200 people from a sinking ship of 600 is equivalent to letting 400 people drown. Taken together, these results suggest that the sunk cost effect may reflect non-standard measures of utility, which is ultimately subjective and unique to the individual. My Accounting Course is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers.
- Sunk cost fallacy can also sneak up on you by inflating your sense of confidence in a situation.
- Education is a billion-dollar industry in the U.S. and often, we are asked to pay for educational programs in advance.
- To leave early is to make this lapse of judgment manifest to strangers, an appearance they might otherwise choose to avoid.
- Respondents in one group earned an “asset” (a lottery ticket that paid $10 with a 10% chance) by performing well on a laborious task (thus requiring them to sink costs such as time and effort).
However, the scenarios do not typically cover the wide range of costs that can be sunk (e.g., money, time, effort, emotion). And we really have had no idea whether the answers to those hypothetical scenarios actually predict whether people succumb to the effect in a situation with real consequences on the table. Ahead, we’re discussing some of the dangers of falling into this cognitive bias and outlining some common scenarios where sunk cost fallacy can show up in your life. The sunk cost definition states that these are already incurred expenses and are not recoverable.
Benefits of understanding what sunk costs are
This does not apply to rental equipment; rental costs are only fixed until the renter decides to discontinue use. An example of a sunk cost would be spending $5 million on building a factory that is projected to cost $10 million. The $5 million already spent—the sunk cost—should not be taken into account when deciding whether the factory should be completed. What ought to matter instead are expectations of future costs and future returns once the factory is operational. Sunk cost, in economics and finance, a cost that has already been incurred and that cannot be recovered. In economic decision making, sunk costs are treated as bygone and are not taken into consideration when deciding whether to continue an investment project.
Rationally, they should consider earlier investments to be sunk costs, and therefore exclude them from consideration when deciding whether to continue with further investments. When making business decisions, organizations should only consider relevant costs, which include the future costs that still needed to be incurred. The relevant costs are contrasted with the potential revenue of one choice compared to another. To make an informed decision, a business only considers the costs and revenue that will change as a result of the decision at hand. Previously spent research, development, and advertising dollars are sunk costs and are unavoidable. They have no bearing on the current decisions that will affect the future.
What Does Sunk Cost Mean
But if that additional $100 will only add a feature to your product that your competitors already offer, it might not be worth the investment. If you spend the extra $100, you increase the overall investment but haven’t actually improved the product. The sunk cost dilemma is like a tricky puzzle we all face from time to time. By knowing what it is and learning how to handle it, we can make smarter decisions.
You might still go, thinking, “I’ve paid for it, so I might as well go.” This simple example gives us a glimpse into what’s called the sunk cost dilemma. Let’s explore what it is, how it affects us, and what we can do about it. Researchers address the challenge of measuring the effect by presenting people with questions about what they would do in various hypothetical scenarios.
Ever stayed in a friendship or relationship longer than you should have, just because you’ve put so much time into it? How many married couples still stay together long after the love has left the marriage? accounting explained with brief history and modern job requirements Do you still keep going even though the “use by date” is long passed? “But what about the kids? What about the last 18 years? Do we just chuck them away? That’s the sunk cost dilemma at work.
How to avoid it
Once created, the market is indifferent, and no one buys any units. The $2,000,000 development cost is a sunk cost, and so should not be considered in any decision to continue or terminate the product. Several examples of sunk costs are noted below, covering four common situations in which sunk costs are incurred. The Project Manager must start by working out what costs are ‘sunk’ in the project that can’t be changed. While these sunk costs remain important data points, the Project Manager must exclude them from the analysis of alternatives for a decision.
Relevant costs are future expenses like product pricing or inventory purchase and are important when making particular business decisions. The sunk cost fallacy states that making additional investments or commitments is justified since some resources have already been invested. A company invests $2,000,000 over several years to develop a left-handed smoke shifter.
Difference Between Opportunity Cost, Sunk Cost and Relevant Cost
Each scenario provides a realistic everyday situation that anyone should be able to easily imagine themselves in. Collectively, the scenarios cover a range of costs that can be sunk. In most instances a variety of costs are sunk because people’s resources tend to be highly interconnected. For these reasons it seems undesirable and futile to try to always refer to only one type of resource per scenario or to only offer scenarios that feature one resource. Rather, it is important to include scenarios that emphasize different mixes of resources. List out all the costs you’ll incur with each course of action you’re considering.
- To do otherwise would prevent one from making a decision purely on its merits.
- The upfront irretrievable payment for the installation should not be deemed a “fixed” cost, with its cost spread out over time.
- Examples of sunk costs in business include marketing, research, new software installation or equipment, salaries and benefits, or facilities expenses.
- It’s easy to imagine a scenario where fixed costs are not sunk; for example, equipment might be resold or returned at the purchase price.
It contacts an architect to design a new space who drafts some preliminary drawings for a fee. Then, an economy slowdown occurs, and the company is now unsure whether it should continue with the new warehouse.
Sunk Costs vs. Relevant Costs
They tried to see if the sunk cost effect would reduce student effort. There’s five common explanations as to why the sunk cost fallacy exists. Here are the psychological reasons that explain why some decision-making processes fail. The money initially spent is gone — sunk — and should not be factored into future decisions.
However, sometimes, a company or an individual may stick to a decision (even when it may not be the most appropriate one) as the cost has already been incurred. The company leases the factory premises but has invested in purchasing the machinery required to manufacture the footwear. The study concludes that the new product will not be profitable and may even be unsuccessful. In this case, the cost already incurred for the market research cannot be recovered and should not be taken into consideration while deciding on whether the company should launch the product or not. Since such expenses are irretrievable, they do not form part of any subsequent financial decision-making.