The Sunk Cost Fallacy: How It Affects Your Decisions

In other words, each payment is money you might get back if and when you sell the space. Include any benefits, such as health insurance or retirement contributions, in the sunk costs. So, payroll taxes, federal unemployment (FUTA), and state unemployment (SUTA) taxes are all sunk costs, too. If the person proves to be unreliable, the $10,000 payment should be considered a sunk cost when deciding whether the individual’s employment should be terminated. To calculate a sunk cost, you simply subtract the amount of money you’ve spent from the total amount of money you had available to spend.

Because only the amount you actually spent on the vehicle is a sunk cost, and you can still resell the vehicle. Say your employees frequently travel as part of their work for your business. You decide to purchase a company car to better track travel expenses. You purchase the car for $15,000 and have monthly payments of $200. Have you ever made a business decision that you thought might not be profitable, but you pressed on because you’d already invested time and money into it? For example, purchasing a machine to manufacture goods is a sunk cost because the business cannot resell the machine to recover the full cost of purchasing it.

Arkes and Blumer wanted to ensure that the sunk cost fallacy was still apparent in a real-life situation rather than in a hypothetical questionnaire. The researchers decided to provide discounted seasonal tickets at a theater to see if the money spent on a ticket affected how often people attended the shows. In creating and selling product, deciding whether to continue or back out of a project is challenging, especially when time, effort, and money are poured into a specific venture. By the rules of the sunk cost fallacy, one may prefer to continue with a project, knowing that it may not be the most profitable or successful if the alternative is giving it up. Although sunk costs can act as distractors in decision-making, it does not mean they do not matter or should not be considered.

What Is a Sunk Cost?

The sunk cost fallacy not only has an impact on small day-to-day decisions like attending a concert. It has also been proven to impact the decisions that governments and companies make. Sunk cost fallacy is when companies keep investing more money in a failed innovation in the hopes that the sunk costs will eventually be recovered. Google had a product named "Google Glass," which had a huge pre-release hype but had failed to meet customer expectations.

  • Rego, Arantes, and Magalhães point out that the sunk cost effect exists in committed relationships.
  • The $5 million already spent—the sunk cost—should not be taken into account when deciding whether the factory should be completed.
  • Individuals may not want to admit that they made a mistake in their earlier choices.
  • The initially projected revenue of $50,000 is still greater than the initial cost of $40,000.
  • Businesses with the highest sunk costs tend be those with the greatest barriers to entry and biggest startup costs.

This bias can result in suboptimal decision-making, as the focus is on past investments rather than future benefits. Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision. In accounting, finance, and economics, all sunk costs are fixed costs.

What Is a Sunk Cost Trap?

A sunk cost is money that has already been spent and cannot be recovered. In business, the axiom that one has to "spend money to make money" is reflected in the phenomenon of the sunk cost. A sunk cost differs from future costs that a business may face, such as decisions about inventory purchase costs corporate and investment banking and markets or product pricing. Sunk costs are excluded from future business decisions because they will remain the same regardless of the outcome of a decision. There are some expenses that a company pays for that will result in a return on investment — They’ll be able to get that money back at a later point.

Sunk costs can influence decision-making by creating emotional attachment and the desire to recoup past investments, leading people to make decisions that are not in their best interest. Let’s take a look at how the Sunk Cost Dilemma works and how it relates to rational thinking. The dilemma comes into effect when you consider the money you’ve already spent, as well as money that will be spent in the future. It’s not financially prudent to walk away from something because of the money you’ve put into the decision, but you also can’t walk away because doing so will cost you more money as well. Opportunity costs are also common in everyday life, like deciding between two college majors.

Even if you stay or don’t stay in the stadium, you will not be able to refund your money. Key characteristics of sunk costs include having occurred in the past, and being irreversible and unrecoverable. You can avoid sunk cost fallacy by thinking logically through every action you consider.

sunk cost

But after spending so much money on repairs, you decide you’d rather fix the old car so that the money you spent previously wasn’t all for nothing. You believe that you “invested” a lot of money into the car, and you don’t want to “lose” it by getting a new one. The sunk cost fallacy happens when individuals or businesses make decisions on the mistaken belief that a sunk cost might lead to a return at some point. In other words, they mistake a sunk cost for an investment, rather than seeing it for what it is — A dead end. The sunk cost fallacy is closely related to the bias of loss aversion, which describes how the pain of losing is psychologically more powerful than the pleasure of gaining. Read this TDL article to learn how this bias makes us buy insurance, avoid worthwhile financial risks, and how overcoming it can lead to highly advantageous decisions.

To leave early is to make this lapse of judgment manifest to strangers, an appearance they might otherwise choose to avoid. As well, the person may not want to leave the event, because they have already paid, so they may feel that leaving would waste their expenditure. Alternatively, they may take a sense of pride in having recognized the opportunity cost of the alternative use of time. As long as those wages are not recoverable, that salary represents an expense that has been incurred and can not be captured back by the company. After trading for Joey Gallo, the New York Yankees outfielder struck out 194 times over 140 games. Instead of continuing to stick with their decision that didn’t pan out as they’d hoped, the Yankees traded Gallo in August 2022.

Decision Fatigue

Sunk costs don’t only apply to businesses as individual consumers can incur sunk costs as well. Let’s say you buy a theater ticket for $50 but at the last minute can’t attend. The $50 you spent would be a sunk cost but would not factor into whether or not you buy theater tickets in the future.

Options trading entails significant risk and is not appropriate for all customers. Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount. Variable costs, on the other hand, go up or down based on your level of sales.

Examples of Sunk Costs

According to the results, people who were told they were eating the expensive cake were far more likely to say they would keep eating. Interestingly, this had nothing to do with who had bought it—friends, strangers, or the participants themselves. In one experiment, participants were asked to imagine that they were at a potluck party and that, after eating a few bites of a rich cake, they felt full.

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