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Sunk Cost

Sunk Cost

source: cbc.ca

Sunk Cost Definition

A Sunk cost is an expense that has been already done and cannot be recovered. It is also known as stranded cost or retrospective costs or unrecoverable expense. When sunk costs are higher it creates a wall to the entry of new firms since they risk huge losses if the companies decide to leave the market. Since these kinds of costs cannot be recovered or regained they shouldn’t be considered while making rational decisions.

Examples of Sunk Costs

Let us discuss a few examples of sunk costs:

  • A company spends $50,000 on ma arketing study of its new product to see whether the new product will be a success in the market. The study concludes that the new product will not have a good run in the market. Then the $50,000 becomes a sunk cost and the company should not invest more in the new product project.
  • A company invests $20,000 to provide training to its staff in the use of new technology I the office which will be used in taking new complaint requests. The technology while using could not handle the complaint volume and is often taking faulty requests so the company decides to discontinue their use. This training is taken as the sunk cost and should not be taken into consideration while decision making.
  • A company pays $5000 as a joining bonus to a new recruit in the organization. After recruitment, it is seen that the employee’s performance is not up to the mark and he needs to be given the pink slip. Then this $5000 is taken as a sunk cost as this cost cannot be recovered.
  • In today’s world companies use advertising to attract new potential customers as well as retain the older ones. They use the different type of media like the print or audiovisual media to help in mass advertising. This advertising doesn’t promise any positive return but if the money is spent once on advertising and the advertising campaign is running then the advertising expenditures are called sunk costs.
  • If a company dealing with a specialized product that they only offer purchases equipment then this purchase of equipment is considered as sunk cost fallacy this equipment cannot be sold in order to regain money.
  • If a company hires an SEO specialist or marketing consultant to boost its business then they have to pay a service fee beforehand for the services provided by the consultant even before the work is done. The company does not have any provision to check the sunk cost effect of the services before the work is done and whether the consultant has made any positive difference to the business. This service fee then becomes a sunk cost fallacy since the money is spent already and it cannot be recovered even if the company dislikes the services of the marketing consultant or the SEO specialist.

What is Sunk Cost Fallacy?

Sunk cost Fallacy happens when a business decides to continue its spending because of the pet decisions involved like time, money and resources instead of taking a rational decision and following choices which will maximize the returns in that time.

  • Sunk cost fallacy costs the business greater financial losses. It is human nature to think that once a cost has been made for a project or invested in a product it is better to invest more money even if the project or product is not a profitable one and is going to make losses.
  • For example, many individuals order too much food and then they overeat just to get their money’s worth. When factoring the costs of any exchange people tend to focus more on what they are going to lose in the bargain than on what they stand to gain.
  • Whenever businesses tend to cling to its costs because of the past time, money and resources already involved and take decisions based on that then this situation leads the business right into the sunk cost fallacy. This is also called Concorde fallacy describing it as an escalation of commitment.

Final Thoughts

Every organization faces the dilemma of sunk cost while decision making at some point. This costs cannot be avoided at any cost. Since these costs are in the past companies should not keep pouring money in these losses. Instead, companies must focus on the current market and ignore the previously spent costs. If there is no potential then they should stop investing and end the operations. We all don’t like losing money but letting go of the past in these situations can help in avoiding more losses in the future.

Recommended Article

This has been a guide to what is Sunk Cost? Here we discuss top examples of Sunk costs and also, how sunk cost fallacy happens when a business decides to continue spending on its pet projects. You may learn more about accounting from the following articles –

  • Differences between Fixed cost vs Variable cost
  • Differences between Cost vs Expense
  • Differences Between Indirect Costs
  • Explain Explicit Cost

The post Sunk Cost appeared first on Learn Investment Banking: Financial Modeling Training Courses Online.



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