In finance and economics, the term "sunk cost" gets thrown around quite often. Whether we are discussing businesses, stocks, or everyday purchases, sunk costs are always prevalent. This topic is crucial to understand if you want to succeed with your finances. Let's take a look.
A sunk cost refers to money that has already been spent and cannot be retrieved. Unlike other costs that may vary depending on future decisions or actions, a sunk cost is essentially "gone" from the perspective of future financial decisions. For example, if you purchased a non-refundable concert ticket for $50, that $50 is a sunk cost once the ticket is bought. This is because it is "non-refundable".
Examples of Sunk Costs
1.) The salary of an employee who has just been laid off - the money paid to this ex-worker cannot be retrieved and it is a sunk cost to the business.
2.) Advertising and marketing for your new company - although this money can be made back off of sales, the money directed toward the investment of advertising will not be directly given back to the business
3.) Imagine a company invests $200,000 in developing a new software product. If the development is completed and the product doesn't perform as expected, the $200,000 spent is a sunk cost. It cannot be recovered, regardless of future actions.
The Sunk Cost Fallacy
In economics, there is a powerful and important fallacy known as the sunk cost fallacy. Essentially, the sunk cost fallacy is a common cognitive bias where individuals or organizations continue investing in a project or decision because of the resources already committed, rather than evaluating future potential.
For example, continuing to watch a movie you’re not enjoying just because you’ve paid for the ticket is an example of the sunk cost fallacy.
How exactly can we handle sunk costs?
Handling hard sunk costs can be difficult. However, we can do things to stop their hurt towards our personal finances and/or businesses. First, we can ignore past costs. We can focus purely on the future benefits of our personal finances or business and not think too much about the past, irretrievable losses. Second, we can assess whether or not the future investments toward our project or goals will yield benefits that can either make up for the incurred loss or exceed the loss. Lastly, we can simply be aware of the sunk cost fallacy. We can understand the fallacy and recognize that we need to be making financial decisions based on current and future circumstances, and not just the past and its incurred losses.
In conclusion, understanding sunk costs and how they function in our day-to-day finances can help us save money, time, and mental efforts. Furthermore, understanding the sunk cost fallacy and its harms can allow us to focus on the future, rather than dwelling on the past and our previous losses. Continue evaluating and making the most out of your past sunk costs, and you can expect to provide for yourself a better financial future. Stay learning!
