A sunk cost is a cost that the business has already incurred and cannot be recovered. It contrasts with prospective costs, which are costs that companies will face in the future, such as the cost of purchasing inventory or the cost of raw materials.
Because sunk cost cannot be recovered, it should not be considered when making a decision to continue investing in ongoing projects. It is irrelevant in decision making because it does not affect the course of the decision and will not require spending cash in the future.
Examples of sunk cost
Fixed costs such as machinery and equipment are sunk costs. Another example is quasi costs such as utilities, which remain the same over a certain output range but move to other constant levels outside the range.
Take a case, to increase production capacity, manufacturers buy a new machine. Because it has been purchased, the amount of rupiah the purchase has permanently lost. Businesses will also not count it as a cost in budgeting in the coming period.
In other cases, companies want to enter new markets for current products. The company decided to spend Rp20 million on market research. The company did not continue to expand into new markets and as such, Rp20 million was a loss.
Sunk cost fallacy
Sunk cost fallacy arises when the company strict to support the initial decision because it has put money on a project. The company thinks able to recover lost money. Though it will only result in higher losses and irrational decision making.
For example, the company has bought a machine to produce new products. Market research shows that the product will unsuccessful because consumers do not wish it. Instead of immediately selling these assets before they are obsolete, the company increases ad spending. The company hopes that with higher ad spending, consumers will become aware of and interested in buying the product. Thus, the company can avoid the loss of purchasing machinery.
However, what the company does creates more losses. Consumers do not buy the product, for example, because it is not as sophisticated as competitors’ products.