Understanding Sunk Costs in Business Decisions

One of the most difficult business decisions is to walk away from money that you have already spent. These losses are called “sunk” costs. This can be extremely frustrating, but the only efficient way to move forward is by focusing on future costs rather than dwelling on past losses.

Below we have put together some ideas to help you understand sunk costs, and how you should go about making business decisions after experiencing them. Should you have any questions we are only a telephone call away.

When a business incurs costs that can’t be recovered, those costs are of no use when making business decisions. These expenditures, called sunk costs, can include money spent, time, effort and energy used that are no longer recoverable.

For example: You’ve invested $40,000 in a new website, and it’s become apparent that it will cost another $20,000 to complete it. Regardless of what you do going forward, you’ll be unable to get back that initial $40,000. Now an opportunity comes along where you can buy a completed website for $12,000.

At this point, your only choice is whether to spend 20,000 or $12,000 for the same website. Whatever you decide, the initial $40,000 investment will be gone – a sunk cost. All else being equal, the best choice is the $12,000 facility.

Now assume the same $40,000 sunk cost with an additional $12,000 needed for completion. An opportunity to buy a similar completed website for $16,000 arises. Obviously you’ll go forward with the $12,000 completion costs, even though the total cost of the facility will be $52,000 rather than $16,000. The $40,000 sunk cost remains irrelevant.

Another example: Your company has spent time and money developing a new mobile app, and you’re understandably proud of the result. However, when you test market the product on your customers, you discover that most of them have no interest in it and wouldn’t buy it at any price. It is now time to swallow your pride (along with the sunk development costs) and walk away from your product.

It’s hard to forget about time and money you’ve already put into a project, but once such costs become irrecoverable, it’s counterproductive to factor them into your company’s decision making process. From that point forward, your choices should be based only on expected future costs.