Sunk costs

What it means

Sunk costs are costs that have already been incurred and cannot be recovered, whatever the company decides next. They may be money invested in product development, a marketing campaign, market research or non-refundable deposits.

In economic decision-making, sunk costs should not influence the choice between alternatives. Only future costs and revenues that differ between the options are relevant. The opposite concept is opportunity cost, which by contrast does belong in the decision.

Although the principle is logical, people often violate it in practice. The psychological effect known as the sunk cost fallacy leads us to continue a failing project simply because we have already invested a lot in it and do not want to admit the money is lost.

How it works in practice

When clients decide whether to continue a project, we help them separate past spending from future spending. The question is not “how much have we already spent” but “how much more must we spend and what will it bring”. To compare alternatives we use, for example, the net present value of future cash flows.

In management accounting, for decisions such as make or buy, continue or stop, we recommend preparing an overview of relevant costs only. Fixed costs that will not change whatever the decision, and amounts already spent, are excluded from the comparison.

When approving larger projects, it is wise to set checkpoints and criteria for stopping in advance. Rules agreed at the start are easier to follow later, when a lot of money and emotion has already gone into the project.

What to watch out for

Sunk costs do not mean past spending is irrelevant altogether. It matters for accounting and tax, for example when writing off an unfinished investment or recognising a loss. It should not, however, influence whether to invest further in the project.

The sunk cost fallacy affects smaller decisions too: keeping an expensive subscription the company no longer uses because “we already paid for the implementation”, or holding on to an unneeded machine because “it was expensive”. Reviewing such items regularly saves money.