What is Sunk Cost? (Examples and problems)
What is Sunk Cost? In both personal and business finance, the overall goal is to manage your money so that you do not suffer more than you have lost. However, there are times when you can not avoid wasting money. This is known as the Sunk Cost. All businesses have low costs. So understanding the concept is important for the success of your business. You need to be able to identify sunken costs so that you can prepare for them effectively.
In this article, we will talk about everything you need to know about sunken costs to help you succeed in your business.
What is Sunk Cost?
A sunken cost is a cost that has been paid and can no longer be recovered. This is the amount that no longer affects the future financial decisions of the business. The concept of submerged cost, also known as “retrospective cost”, is the opposite of “Relevant Cost”. This concept, also known as the “Prospective Cost”, is a projected cost for the future that has not yet been constructed and used.
In some businesses, sunken costs are not usually considered when deciding on the future of the organization. This is because sunken costs will not change and have nothing to do with current or future budget factors. For example, a factory owner should not reduce the cost of equipment, machinery, and building rent when deciding on the price of their products. For informed decision-making, it is important to consider the costs that are affected by those decisions, not decisions that will not change.
Falsehood in drowning cost
Although the sunken cost is no longer related to future planning, some people still believe that it should be considered when making future decisions. This is known as Sunk Cost Fallacy.
A drowning cost fallacy occurs when a person sticks to his decision only because the money has already been spent and does not want to feel that he has wasted it. Most people at some point in their lives make the mistake of drowning. For example, you may have already purchased a ticket for a concert and then, when the day of the concert arrived, realized that you had to be at work the next morning.
In this case, you have two options:
- You can skip the concert for a good night’s sleep.
- You can go to a concert and come to work the next morning tired.
- Economists tell you that the first option is a logical decision, while the second option is an irrational decision because it does not matter if you attend a concert or not – the money has already been spent.
The drowning cost fallacy is also known as the Concorde fallacy. The term borrows from actual decisions made by the British and French governments. These governments came together when they set up the plant to produce the expensive Concorde supersonic aircraft. In particular, the British government considered the project a commercial disaster. However, due to political and legal issues, this government could not leave the project. Just as many people today decide not to change their plans because they have already paid for them.
Ultimately, the drowning cost fallacy occurs because we are not entirely rational decision-makers. And are often influenced by our emotions. When we have already invested in our choice, we feel guilty or sorry if we do not pursue this decision.
Why does the drowning cost discrepancy occur?
There are many psychological reasons that lead to fallacy at a submerged cost. Behavioral economics suggests that business owners may experience one of the following five psychological factors when dealing with a sunken cost:
1 – Aversion to loss of Sunk Cost
This feeling is related to when business owners interpret the price paid as a measure of the value of the business unit. The price of a sunken fee must be irrelevant after payment to the person. Disgust occurs with loss because it is believed that the pain of losing power is greater than the thought of victory.
For example, a business owner may spend $ 10,000 on machinery to produce a product. $ 10,000 is a drowning cost. This amount cannot be considered when the business owner is determining and pricing the product.
2 – Framing effects of Sunk Cost
This happens when business owners decide on the lead option based on the positive or negative option of an issue. Under these circumstances, they may consider whether a decision is harmful or beneficial. Studies show that people avoid risk if they have a positive framework and take risks by providing a negative framework. For example, a gambler may stop playing after earning a large sum of money, but when his losses are significant, he puts everyone at risk.
3 – Possible and excessive bias
This happens when the investment has already been made. For example, a study by Knox and Anixter in 1968 found that people who bet become very optimistic after doing so. For example, people who have previously spent their money betting on horses believe that they have a better chance of winning than people who have not yet placed their bets.
4- Personal responsibility
A sense of responsibility for the sunken cost will influence your future decisions as a business owner. In a study by Stow and Fox, 96 business students were given a hypothetical $ 20 million to invest in their company. The first group was told that they had high liability for the sunken cost, while the second group was told that they had low responsibility for the sunken cost. This study showed that those with high responsibilities invest on average more than those with low responsibilities.
The result of speech
In the following text, we have tried to consider the issue of drowning costs. As mentioned, the sunken cost is the amount of money that has already been spent and is not recoverable. The submerged cost is different from the future costs that a business may face, such as decisions about inventory purchasing costs or product pricing. This cost should not be taken into account when planning for the next steps.