May 11, 2023
Sunk cost definition and how to apply it to your finances
- “Sunk cost” is a term primarily used in a business sense, but it can also apply to your personal finances and your decision-making.
- The sunk cost can be a consideration, but focusing on it can result in you making poor financial decisions.
- Sunk costs are always fixed costs, but not every fixed expenditure is a sunk cost, including those costs known as relevant costs.
When managing your personal finances, many business-centric terms can apply — one such term is “sunk cost.” While it’s a phrase primarily used in business, sunk costs can also play a significant role in your personal financial decisions. So what are sunk costs, and how do they impact you?
Below, we cover the sunk cost definition, explain how sunk costs can impact your financial decision-making, and provide some examples of how this critical financial term works in real life.
What is the sunk cost definition?
A sunk cost, also called a “retrospective cost,” generally mentioned in business decisions and refers to when a business spends money and can never recover it. In the business world, the money that has been spent is viewed as gone and never to return, so it’s not considered when a business makes future decisions and incurs future costs.
While it’s a term predominantly used in the business world, the idea of sunk cost can also play a role in your personal finances. Just like in business, a sunk cost in your personal finances is money that you’ve spent that you know you’ll never get back.
What is the sunk cost fallacy?
The sunk cost fallacy is when we think we need to follow through on a project because of the past costs we invested in it, such as money, effort, or time. And we may continue with a project with no regard to whether the current costs outweigh the potential benefits of completing the project.
Financial experts recommend avoiding this kind of outlook because it can cause us to justify irrational decisions based on the previous costs we’ve already paid, and it can make rational decisions hard to commit to. Instead of the cash we’ve already spent, we should focus our future decision-making solely on the ongoing costs and the benefits of completion.
Say you invest $100 into repairing your car, which is worth just $2,000 — only to learn, a week later, that it needs an additional $2,500 in repairs. An example of the sunk cost fallacy would be using that $100 investment to justify the further investment of $2,500, despite the car not being worth the cost of the repairs.
Economists warn strongly against allowing sunk costs to impact your future course of action. Sometimes we feel that since we already invested so much, we will “lose” that money if we don’t continue with a failing project. This results in us throwing good money after bad, meaning that we try to fix the failures of the past by spending even more cash. And then the more we repeat this process, the more invested we become, and the cycle continues.
What’s the difference between sunk cost and opportunity cost?
Opportunity cost is similar to the sunk cost definition but looks at costs in a more figurative sense rather than a literal one. While sunk costs are easy to recognize because you just have to look back to where you spent money in the past, and you can easily track them in your budgeting, opportunity costs are hypothetical instead of actual.
An opportunity cost is when you miss out on earning money from one opportunity because you chose another opportunity instead. So, like a sunk cost where you can’t recover the money you spent in the past, with an opportunity cost you cannot recover that lost opportunity. However, unlike a sunk cost, you don’t necessarily see this loss on your budget — or in the financial reports of a business — after the decision-making process unless you actively track it.
For example, let’s say a business’ decision-makers are considering buying two smaller companies, and they choose one of the two to buy out. That business does well and doubles the company’s investment in just a year. However, the business they decided not to buy was valued at four times the initial investment after a year. The value the business missed out on by passing on the second company is an opportunity cost.
Another example of an opportunity cost is loss aversion — which is preferring to avoid losing money as opposed to taking the chance of gaining an equivalent amount. So, suppose you practice loss aversion and choose not to make additional investments out of fear of losing money. In that case, any potential returns on the investments you passed on are opportunity costs. Sure, you didn’t lose any money, but you missed out on financial gain by being overly cautious about potential losses.
What’s the difference between sunk costs and relevant costs?
While they both deal with fixed costs — costs that remain consistent — the sunk cost definition and relevant costs are near opposites. While a sunk cost is a past expense that is unavoidable regardless of your current and future decisions, a relevant cost is an avoidable fixed cost that you only incur when you make a certain decision.
An example of a relevant cost in your personal life could be the decision to make a cake with ingredients you already have versus buying a cake from the store. You already purchased all the ingredients in the past, so those are sunk costs. The only remaining cost is your time to make the cake, which is the relevant cost. Weighing this relevant cost versus the cost of buying a cake in the store helps you make your final decision.
Businesses use relevant costs often when deciding on product pricing, whether they should continue to operate or close a portion of the business, how and where they source materials, and more.
Focusing on relevant costs instead of falling victim to the sunk cost fallacy is a great way to make wise financial decisions when options present themselves. Instead of thinking, “Well, I already spent this much so far, I might as well keep spending,” relying on the relevant cost forces you to look forward and make more informed financial decisions with your future money.
What are some real-life examples of sunk costs and the sunk cost fallacy?
We gave a car-repair example of a sunk cost earlier, but let’s look at a couple more examples. Perhaps you can relate because you’ve faced one of these sunk cost dilemmas in the past or these will help you think of other decisions you’ve had to make where the sunk cost fallacy might have influenced you.
Example one: You have a bookshelf full of textbooks from school. You don’t ever use them, and some of them are even outdated, but you spent so much money on them that you feel like you need to keep them. However, that money is already gone (a sunk cost), and holding on to the books isn’t going to bring the money back. In fact, if you let the books go, you’d have more shelf space, which would mean less clutter and less stress.
Example two: You have an old, unreliable central air conditioning system in your home. You’ve spent $500 each of the past two summers to make repairs and keep it running. Summertime rolls around again, and you need another repair. You thought about just getting a new air conditioner, but you’ve already spent $1,000 on repairs for this one. But the money you spent on those repairs are sunk costs. Instead, you should consider the future cost of repairs (and the inconvenience to your time and comfort) when deciding if it’s worth the purchase price of a new one.
Example three: Let’s say last year you wanted to get serious about your budget. You created a detailed Excel spreadsheet and spent a lot of time learning about Excel formatting and formulas. You’ve now learned about a new software that would really make your budgeting a breeze, but you’re hesitant to take the leap because you spent so much time on your spreadsheet. Remember, your time and effort can be a sunk cost too. So again, try to think of the future benefits and costs rather than the past cost when you’re making your decision.
Sunk costs can be useful to track, but don’t focus on them.
Now that you understand the sunk cost definition and how it plays a role in business and your personal life, you can monitor your sunk costs and ensure you don’t focus on them when making future decisions.
While keeping an eye on your sunk costs is important, your sunk costs should never become a focal point that drives future decisions. As mentioned above, focusing too closely on sunk costs can lead to poor economic decision-making that can put you in a financial bind. There comes a time when you must take personal responsibility for a poor sunk cost that resulted in a loss — and then just move on.
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