Sunk costs are those costs that have already been incurred and cannot be recovered in the future. They include time, money, or other resources that were spent on a project, investment, or other activity that cannot be recovered.
An important rule regarding sunk costs is that they should not be factored into economic investment decisions. This, since they correspond to the past and what is relevant is to evaluate future profit opportunities.
It is related to the opportunity cost, because the sunk costs are the costs that we have assumed when choosing an alternative. If we still have time to choose the other alternative, it does not matter the (sunk) costs that we incurred when we chose the first, because they are already spent and it is convenient to look ahead and take advantage of the time.
For example, suppose that between two alternatives, going to the cinema or going to the park to enjoy a sunny day, we choose to go to the cinema. But after half an hour we don’t like the movie at all. Therefore, these costs are the cost of the entrance to the cinema. If we want to re-consider whether to leave the cinema and go to the park, we must not take into account the cost of admission to the cinema, because we have already paid it and we are not going to get it back.
Example of sunk costs in a company
Suppose that a company wants to launch a new product for which it has commissioned a market study that costs 5,000 euros. In addition, he has hired a designer to make a model of the product on a small scale, this has cost another 8,000 euros. To this must be added the time, the research and the scale model, which took 6 months to complete.
Once the market study and the model have been obtained, the company is not convinced that the product will be successful. What decision should you make? How do sunk costs influence?
The first thing to recognize is that the expenses incurred (13,000 euros) are sunk costs, they will not be recovered and therefore should not influence the decision about the product. Although there is pressure to want to recover the money spent, this should not interfere with the evaluation of whether the investment is good or not.
Many entrepreneurs fall into this error, wanting to recover the sunk costs, they continue to invest in projects that are not profitable.