As a business owner, learning from your past can help you make better choices in the future. Often, the lessons we learn early on put us on the path to success.
That said, it’s possible to focus too much on the past. One of the main ways this can happen is by dwelling on sunk costs and letting them impact your future business decisions.
What Are Sunk Costs?
A sunk cost is money you’ve spent or invested and can’t get back. In other words, it’s already been used up and can’t be recovered. Since there’s no way you’ll ever see that money again, that sunk cost shouldn’t be considered when making future decisions.
To get a better understanding of sunk costs, let’s consider an example.
What Is an Example of a Sunk Cost in Real Life?
Say you spend $500 on a computer programming course for your office staff, but after they finish it, you realize that you might actually be better off hiring an IT person. Because you can’t get the $500 back regardless of whether or not you hire an IT person, it’s a sunk cost and shouldn’t affect your future staff training decisions.
You shouldn’t avoid hiring a better trained and dedicated IT person just because your office staff took one computer course.
Another common question people have is whether sunk costs and fixed costs are the same. Let’s dive in.
Sunk Costs vs. Fixed Costs
Sunk costs refer to money you’ve spent and is completely gone, while fixed costs include expenses that stay the same, such as rent or loan repayments. In business, fixed costs are often referred to as overhead costs.
Sunk costs and fixed costs are two different things, but they can overlap. A fixed cost can become a sunk cost once you’ve paid for it if you can’t get the money back.
For example, let’s say you have one salaried employee who receives the same income each paycheck. This is a fixed cost because it doesn’t change. Once you run payroll for a given period, that salary amount also becomes a sunk cost because the money has left your business, and you can’t get it back.
That said, you can also have sunk variable costs. If you have an independent contractor who earns an hourly rate, that’s a variable payroll cost because their income changes based on their schedule. Still, once you pay them, that amount becomes a sunk cost.
Bonus Tip: Sunk cost or not, Hourly’s payroll software makes it easy to stay on top of your labor costs with seamless online payroll processing and automatic tax deductions.
Let’s dive deeper and see what other sunk costs exist in business.
12 Examples of Sunk Costs in Business
Here are 12 examples of sunk costs in business, starting with the four most common ones: payroll, equipment, marketing and advertising, and research and development.
- Payroll: Money paid to employees and independent contractors that you can’t get back even if you terminate an employee or they leave for another company.
- Equipment: The cost of equipment, which can’t be recovered once the equipment becomes obsolete. While you can sell equipment, only part of the initial cost is recovered, so the unrecovered depreciation amount becomes a sunk cost.
- Marketing and advertising: The cost of print, broadcast, or online advertisements. The cost is considered separate from any return you see from the advertising campaigns.
- Research and development: The initial investment spent on developing a new product, which you can’t recover even if you decide to discontinue the item.
- Training costs: The cost to train new employees or update training for current workers.
- Professional services fees: Money paid to outside professionals such as accountants or lawyers.
- Rent or lease payments: Although rent is a repetitive bill, rent is an example of a sunk cost. They are payments already made for your business properties that you can’t get back even if you decide to close up shop because there’s no foot traffic in the area.
- Interest payments: Interest payments on loans or other debts.
- Taxes: All tax payments, including property, income, and payroll taxes.
- Logistics expenses: Money spent managing materials and inventory, including transportation, warehousing, packaging, storage costs from days inventory outstanding (DOI), and distribution costs.
- Obsolete inventory: The money spent on inventory items that have reached the end of their lifecycle, have expired, or don’t sell.
- Unused subscriptions: Costs for subscribing to services, software, or publications, whether or not you get any use out of them.
All of these represent costs that you won’t be able to recover even if you’re not getting the benefits you expected.
What Is the Sunk Cost Fallacy?
The sunk cost fallacy is when people continue along a course of action that’s no longer profitable or aligned with their goals simply because they’ve already spent good money on it. Similar to the old saying, “throwing good money after bad.”
You may also hear it referred to as the sunk cost effect or the Concorde fallacy, after the British and French governments’ failed attempt to make costly supersonic air travel work.
Sunk Cost Fallacy Example
Say you run a coffee shop, and you invest $50,000 to expand into a second location. After six months, you realize the economics of the new location are not in your favor. The rent is much higher than your first location, and you don’t get enough foot traffic or customers to consistently generate profit.
That said, you think about that initial investment of $50,000 and decide to keep the new location open because you feel like you have already put in so much money. You spend an additional $40,000 to keep it open for six more months until you’re finally forced to close it because it never generated a profit.
The rational decision would have been to cut your losses at $50,000 once you realized the new location was not going as planned because that money is gone no matter what you do.
By continuing with the original plan, you end up with more expenditures that cost you an additional $40,000 even after you knew the location wasn’t profitable.
While the rational choice seems obvious in hindsight, the psychology of sunk costs can make it hard for people to see that in the moment, much like it is easy to pay for just one more pull at a slot machine.
Let’s take a look at why.
Why Does the Sunk Cost Fallacy Happen?
According to behavioral economics, the sunk cost fallacy happens when people let their emotions get in the way of making rational decisions. For example, someone may continue to defend a project that’s no longer working in order to avoid the guilt of having spent money without getting any results.
Several universal concepts about human decision processes shed light on why people are prone to giving too much importance to sunk costs.
Loss Aversion
Loss aversion is a cognitive bias where people feel losses more intensely than gains. In other words, a person will feel more pain at losing $100 than they would feel joy at gaining $100, even though the amount of money is the same. As a result, we have a greater tendency to try and avoid losses and the negative feelings that come with them.
When it comes to sunk costs, people may not want the pain of feeling like that money was lost or spent for nothing. So, instead of changing course to a better plan, they may make the irrational decision to make additional investments into a project that is already failing.
Forgetting Opportunity Cost
Opportunity cost is the loss of any potential money or gains you might have received by making a different choice. For instance, if you run a construction company and you choose to work on a home renovation project over a building repair project, the opportunity cost is the income you could have received by doing the repair job instead.
People may focus so heavily on their sunk costs that they forget about the opportunities they missed by choosing to stick with a strategy that’s not achieving the expected results. The money you keep investing in the initial plan could have been spent on a more profitable project.
Believing that Expensive Things = Higher Returns
People tend to believe that something that costs a lot of money will have a higher return on investment. It's called the overoptimistic probability bias.
This goes along with the idea that it takes money to make money, which can be true, but it doesn’t mean that spending automatically generates results. Still, someone might look at a project that’s not working out and think they can succeed just by throwing more money at it.
Outside Pressure
In business, decision-makers are often affected by stakeholders in the company, like the CEO or board of directors. If someone higher up in the company than you had the idea for a plan, you may feel pressure to continue following their idea, even if it’s not generating returns.
Protecting Reputation
Another reason people stay a course is to protect their pride. In short, they see sunk costs as a personal failure. As such, a person may hold out hope that they or their team can turn the project around and make it successful, so they keep investing in it out of desperation, even though it would make more economic sense to shut it down.
As humans, we’re not perfect, and all of these tendencies are normal. That said, you can take steps to avoid the sunk cost fallacy and improve your decision-making.
How To Avoid the Sunk Cost Fallacy
Learning about the pitfalls of the sunk cost effect can help you make more sound economic decisions for your business. Here are a few tips to follow.
Recognize Sunk Costs
Learn to identify sunk costs by checking whether or not you can recover the money. If a cost is truly sunk, then you can factor it out of your decision-making process by remembering that the money is gone no matter what choice you make.
And just because it is sunk doesn’t mean it wasn’t necessary. This will help you focus on the information that’s more relevant to the decision, such as whether or not your current plan is able to achieve the goals you set.
Learn to Accept Losses
Losses are a normal part of business. If you can accept that fact, you can avoid the temptation to add further investments to a project that no longer makes sense instead of cutting your losses and moving forward.
As a business owner, it’s not your personal responsibility to avoid every single loss. Instead, you want to minimize losses and maximize gains so that you can generate a profit in the long run.
Remember Opportunity Costs
Before you make a decision to keep going with one plan, ask yourself, “What opportunities am I giving up if I keep investing in the current course of action?” This way, you can avoid dwelling on past costs and instead focus on the potential of other opportunities you might miss out on if you keep defending your current strategy.
Look At External Factors
Costs aren’t the only factor to consider when making business decisions. You should also consider external factors such as the economic environment, market trends, and customer feedback.
Practice Staying Objective
Avoid the temptation to take sunk costs personally. Rational decision-making requires removing your emotions from the equation. This allows you to focus on relevant costs and information so you can make a better economic decision.
Sunk Costs vs. Relevant Costs
Relevant costs are the opposite of sunk costs. Relevant costs refer to the expenses that will occur if you make a decision. For example, say you have a second store location that costs $5,000 in monthly rent, and you’re deciding whether or not to keep it open.
Future costs like the upcoming rent tied to this store is a relevant cost, because if you choose to keep the location you’ll have to pay the rent. In contrast, the past rent that you’ve already paid is a sunk cost because you can’t get that money back even if you close the store.
Keep Sunk Costs Out Of Decisions About Your Business’s Future
Some sunk costs are simply part of doing business, like salary, rent, and equipment. Others may represent dangerous stumbling blocks for your business. But since you can’t recover that money either way, it’s important to remember that you shouldn’t consider sunk costs when making future decisions.
It can still be tempting to invest in a plan that’s no longer working because you want to make the lost money feel worthwhile, and that urge is the sunk cost fallacy.
If you want to make better business decisions, it’s important to recognize sunk costs for what they are and stop dwelling on the past. This way, you can focus on the future and learn when it’s time to cut your losses and work towards other opportunities.
Ready to transform your business into a profit-pumping machine? Learn how with our monthly newsletter.
