Mental accounts serve as a type of restricted framing for humans where they keep things under check and comprehensible by a finite mind. The choice to invest further funds in a losing account, notwithstanding the availability of better options. This is coined as the sunk-cost fallacy and expensive error that occurs in both big and minor choices. Sunk cost fallacy is a common phenomenon for most people. Only by learning and becoming aware of the concept can people get rid of it.
What is Sunk Cost Fallacy?
Sunk costs are expenses that have already happened and cannot be recovered in any way. Sunk costs are unrelated to any particular occurrence and should be disregarded when making investment or project choices. When making such judgments, only relevant expenses (costs that are associated with a certain option and will vary based on that decision) should be addressed.
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Fixed costs include all buried expenses. However, not all fixed expenditures are deemed sunk costs. Bear in mind that sunk expenses are non-recoverable. Consider equipment (a fixed cost). At a certain price, equipment may be resold or returned. As a result, this is not a sunk cost.
Sunk cost is sometimes referred to as past expense, embedded expense, previous year expense, stranded expense, sunk capital, or retroactive expense.
Real-Life Example of Sunk Cost Fallacy
Example 1:
Assume you pay $150 for a concert ticket. You recall that you have an essential project due the same night as the performance. You must choose between attending the concert and completing your homework. The $150 ticket price is a sunk expense and should have no bearing on your choice.
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Example 2:
A corporation invests $5 million in the construction of an aircraft. Before the aircraft is completed, the management understands that there is no market for it. The aviation business has developed, and airlines now need a unique sort of aircraft.
The corporation must decide whether to complete the plane for an additional $1 million or to manufacture the new in-demand aircraft for $4 million. The $5 million already spent on the old aircraft is considered a sunk cost in this case. It should have no bearing on the outcome because the only expense that matters is the $4 million.
Example 3:
A business invests $10,000 in teaching staff how to utilise a new ERP system. The program reveals itself to be quite perplexing and untrustworthy. The top management team wants to abandon the new ERP system. The $10,000 spent on staff training is a sunk expense that should not be included in the decision to terminate the new ERP system.
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How can Sunk Cost Fallacy Impact Your Business?
Making decisions based on buried costs might have negative implications. For example, you may be tempted to maintain outdated software and hardware rather than digitally convert your organisation due to the significant investment you have already made. Or you are averse to altering your company model since it would imply abandoning established procedures, forsaking certain well-oiled habits, and even terminating some employees.
However, surrendering to the sunk cost fallacy in such instances may result in the loss of your company entirely. Garter believes that unless historic financial institutions digitise and innovate, 80 percent will go out of business or would remain just nominally without actively competing for clients. It's reasonable to infer that some of these institutions' board members are opposed to innovation, in particular, as a result of being ensnared in the sunk cost trap.
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The Concorde project, jointly sponsored by the French and British governments, was perhaps the largest sunk cost fallacy to date. Despite multiple setbacks and failures, the country's officials continued to invest in this jet for over three decades, despite widespread acceptance that it was a commercial disaster.
Finally, the sunk cost fallacy may lead CEOs to make corporate choices motivated by fear of loss rather than excitement for the future. And this propensity applies to working activities as well.
How to Avoid the Impact of Sunk Cost Fallacy
Now that you understand what the sunk cost fallacy is and have some instances to refer to. Let's discuss some methods for avoiding the sunk cost fallacy and making better informed financial choices.
Think Big
One of the simplest ways to become caught in a sunk cost trap is to lose sight of your main objective or plan. Regarding money, many of us are quick to grieve the loss of a few dollars here and there, but the cumulative cost may have a greater effect.
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When assessing your opportunity cost, consider the following: Will it cost me more money to absorb this expense now or to continue investing time and money in this investment?
Consider the Facts
If you ask any investor for their best piece of advice for someone new to stock investing, they're likely to remark something about not risking more than you're willing to lose. If your investment is doing badly, you may choose to take a loss now rather than face a higher sunk cost later.
Learn From Your Mistakes
People make errors, whether in economics, life, or love. What matters is that they can learn from them. If you notice that you continually purchase costly clothing but never use them, you may want to hold off on purchasing anything new until you're certain you'll utilise and like the item.
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Bottom Line
Sunk cost is a term that is used in both economics and corporate decision-making to refer to expenses that have already occurred and cannot be recovered. Sunk costs are not considered in future choices since they are constant regardless of the result.
When sunk costs are included in decision-making, the sunk cost fallacy occurs. When a choice is made with sunk costs in mind, illogical decision-making is shown.