What Are Sunk Costs?
Sometimes when you spend money, you dont see any return. Heres what you need to know about the sunk cost meaning and how it works. Sunk costs explained  A sunk cost is money thats already been spent and cant be recovered. The concept of the sunk cost is used in economics to discuss investment thats already been poured into a project. The sunk cost should be thought of as separate from the project since its in the past and you cant get it back. Managers often keep these costs in mind when making the decision to continue with the project, because they dont want to lose their initial investment. However, its important not to consider sunk costs when making future investment decisions. Instead, businesses must focus on relevant costs which directly relate to the decision. While all sunk costs are fixed costs, not all fixed costs are sunk costs. For example, equipment is a fixed cost. However, its not a sunk cost because it can be resold when youre finished using it, even if the value depreciates. Sunk cost vs. relevant cost  Weve touched on relevant costs when answering the question of what is sunk cost above, but here are a few more ways in which the two terms differ. Sunk costs remain the same no matter what happens in the future  Relevant costs relate to a projects future performance  This is why only relevant costs should be used in financial decision-making. Examples would include the costs of inventory or raw materials for product design. These costs still need to be incurred in the future, in contrast to sunk costs which have already been spent. Here are a few examples for illustration. Company A spends $10,000 on an in-depth survey to find out if theres any interest in its new product design. The survey determines that the new product wont be profitable. This $10,000 should be considered a sunk cost, since there isnt any point in moving forward with a product that wont produce profit. Company B invests $5,000,000 over a five-year period to research and develop a new pharmaceutical product. Pre-launch, its found to be unsafe for consumers and there is no market interest. The project is a dud, and the $5,000,000 in expenses is a sunk cost that Company B will never get back. Company C recruits a new employee and spends $5,000 on training courses. The new employee doesnt make it through their trial period and decides to leave the company. The money spent on training is a sunk cost. A student has spent $100 for a concert ticket, only to realise at the last minute that theyre meant to work on an important research project that same evening. Its too late to sell the ticket, so the $100 is a sunk cost. When you use the reasoning that you need to invest more money in a project because youve already lost money, its called the sunk cost fallacy. We can look at the sunk cost example above related to Company B. Imagine that the company decides that theyre going to continue spending money on a product thats been proven to have no market value. They make this decision solely based on the fact that theyve already spent $5,000,000 on research and development. The sunk cost fallacy involves a lack of logical reasoning. None of us like to lose money, but sunk costs should have no bearing on future investment decisions. Its important to understand the concept of sunk cost so that you can avoid wasting more time and money. When making financial decisions, take emotion out of the equation to maximise future value. We can help  GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.