Sunk Cost – Costs that have already been incurred and cannot be recovered
To remember what sunk cost means use the following mnemonic:
After our boat was sunk, the cost (sunk cost) of it could not be recovered.
A sunk cost is an irretrievable cost. These are costs that have already been incurred by a firm or an individual but have no potential for recovery in the future.
An example occurs regularly in pharmaceutical companies where they may have to spend £10 million on research and development for, say, a new hair growth product for men. However, it’s found that it makes people’s ears turn yellow. The product fails and the production of it is stopped. The £10 million is a sunk cost.
Another example is a new beverage developed by a beer company that’s been launched but then found to be harmful to the health of the consumer. The £400,000 fund used to develop the product cannot be recovered.
A sunk cost doesn’t mean that the company has shut down, it just means that the money has gone and is considered irretrievable. Any decision now made by the company should be based on logic and not based on keeping the project going. The phenomenon whereby a company is reluctant to abandon a project because they have invested heavily in it, even when it is clear that abandonment would be more beneficial, is called the sunk cost fallacy.
Billionaire investor Warren Buffet once famously said, “When you find yourself in a hole, the best thing you can do is stop digging.” Companies/investors often fall in love with a project or investment, continuing to put money into it and not accepting that it is a mistake.
France and Britain developed the supersonic airliner Concorde at huge costs. It became obvious that it would be very difficult to make an operational profit, but the project was continued anyway due to pride and prestige.
An easy example to help you understand the sunk cost fallacy is within professional football. Often a player is bought at a huge cost but turns out to be a disappointment. Yet, because the team spent all that money, they continue to start the player every game. The same can be said for some employees, as a considerable amount of time and money is spent on their training, but they prove to be of little benefit to the company. Many companies will keep this employee on because of the money already spent.