What is a Sunk Cost?

A sunk cost is a cost that an entity has incurred, and which it can no longer recover. Sunk costs should not be considered when making the decision to continue investing in an ongoing project, since these costs cannot be recovered. Instead, only relevant costs should be considered. However, many managers continue investing in projects because of the sheer size of the amounts already invested in prior periods. They do not want to "lose the investment" by curtailing a project that is proving to not be profitable, so they continue pouring more cash into it. Rationally, they should consider earlier investments to be sunk costs, and therefore exclude them from consideration when deciding whether to continue with further investments.

A sunk cost is always classified as a fixed cost, though some fixed costs are not classified as sunk costs. A fixed cost that is a sunk cost cannot be recovered, as is the case with customized equipment for which there is no resale market. A fixed cost that is not a sunk cost can be recovered, usually by selling it to a third party; for example, a tractor trailer that can be sold on the resale market is not a sunk cost.

An accounting issue that encourages this adverse behavior is that capitalized costs associated with a project must be written off to expense as soon as the decision is made to cancel the project. When the amount to be written off is quite large, this encourages managers to keep projects running over a longer period of time, so that the expense recognition can be spread out over a longer period of time, in the form of depreciation.

Characteristics of a Sunk Cost

The characteristics of a sunk cost are as follows:

Irrecoverable. Sunk costs cannot be recovered once they are incurred, even if the project or activity they were associated with is abandoned.
Past expenditure. Sunk costs arise from expenses already incurred in the past, rather than those that will be incurred in the future.
Unalterable. Sunk costs are fixed and cannot be adjusted or reversed.
Not dependent on future outcomes. Sunk costs are independent of any future outcomes or benefits; they do not change based on what action is taken next.
Not relevant to decision-making. Rational decision-making focuses on costs and benefits that affect the future. Sunk costs should be ignored in decisions because they do not change regardless of the choice made.
Emotional impact. Sunk costs often lead to the sunk cost fallacy, where individuals or businesses continue investing in a failing project to justify prior expenditures, rather than focusing on future costs and benefits.

In summary, sunk costs are characterized by their irrecoverable nature, irrelevance to future decision-making, and emotional influence, making it critical to distinguish them from avoidable costs during financial planning and decision-making.

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The Sunk Cost Fallacy

The sunk cost fallacy is the belief that additional investments should be made in an activity, or else earlier investments in it would have been wasted. This is a spurious belief, since it encourages managers to continually add money to a project for which there is no possible return that can pay back the investment. For example, a company invests $100,000 in a pilot project to manufacture green widgets. The results reveal inadequate profitability, so the logical choice is to shut down the project. However, under the sunk cost fallacy, the business would continue to pour in funds in the hope of eventually turning a profit.

Examples of Sunk Costs

Several examples of sunk costs are noted below, covering four common situations in which sunk costs are incurred:

Marketing study sunk cost. A company spends $50,000 on a marketing study to see if its new auburn widget will succeed in the marketplace. The study concludes that the widget will not be profitable. At this point, the $50,000 is a sunk cost. The company should not continue with further investments in the widget project, despite the size of the earlier investment.
Research and development sunk cost. A company invests $2,000,000 over several years to develop a left-handed smoke shifter. 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.
Training sunk cost. A company spends $20,000 to train its sales staff in the use of new tablet computers, which they will use to take customer orders. The computers prove to be unreliable, and the sales manager wants to discontinue their use. The training is a sunk cost, and so should not be considered in any decision regarding the computers.
Hiring bonus sunk cost. A company pays a new recruit $10,000 to join the organization. If the person proves to be unreliable, the $10,000 payment should be considered a sunk cost when deciding whether the individual's employment should be terminated.

Sunk Costs vs. Relevant Costs

Sunk costs have already been incurred and no longer have any relevance to a business decision, since the cost will remain the same, irrespective of the outcome of that decision. Conversely, a relevant cost only relates to a business decision, since the cost will change in the future as a result of that decision. For example, a company wants to close one of its subsidiaries. A relevant cost associated with this decision is the severance pay that will be incurred if the subsidiary is closed, since the cost would not be incurred if the entity were to remain in operation.

Sunk Costs vs. Fixed Costs

A fixed cost must be paid for even in the absence of any business activity, such as the monthly rent payment. Conversely, sunk costs are costs that have already been incurred, and cannot be recovered. The two concepts are similar in terms of recoverability, since fixed costs are generally recurring and cannot be terminated until the underlying commitment has been settled, such as when a lease agreement is concluded.