What Is an Example of Sunk Cost Fallacy in Personal Finances?

Sunk Cost Fallacy: Sunk Cost in Investments, Sunk Cost Examples

While running a business, we must incur certain expenses and costs that are important for its success. We make a budget for every expense and cost a business might incur now or in the future. But do we budget every cost that a business might induce? Not always, because there are still some costs that are way more challenging. One such cost is sunk cost. This guide will cover everything about sunk cost and how to overcome the sunk cost fallacy.

Key Highlights

  • Some costs are the costs that have already been incurred and are unrecoverable.

  • Sunk costs are not included while making future decisions as they are relevant to current and future budgetary concerns.

  • A sunk cost policy is psychological thinking where people put more resources into unsuccessful investments.

What Is a Sunk Cost, and Why Is It Important?

If we simply explain sunk cost, it is the money a business has already spent and cannot be recovered. Some costs arise because certain business activities require resources that cannot be quickly reallocated to other uses as they have a limited second-hand market. A sunk cost differs from a future cost, as business decisions will remain the same regardless of the decision and outcome.

Sunk costs are the costs that have already been paid and cannot be recovered. This cost is essential when you want to decide what to do next. When a company analyses its costs and benefits, it does not impact the decision-making process, as the cost is incurred regardless of the outcome. Therefore, it is essential to be mindful of it because any cost included correctly in an analysis leads to an unfavourable decision.

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What Is an Excellent Example of a Sunk Cost?

Let's understand sunk cost with an example.

Alice is in the car washing business, where she invested $10,000 to set up a business and gives $1,000 per month in lease and $200 in utilities. The car wash offers a basic wash for $10 or a premium for $15. The basic car wash cost her $5 per wash, while the premium wash cost her an additional $2. 

Now Alice wants to invest an extra $5,000 to buy new equipment where she would offer deluxe wash at $25 per wash. The Deluxe cost an additional $8.

Alice wants to analyse whether the investment would be profitable or not. When researching her investment, she should not consider the sunk cost, which is the initial $10,000 investment and $2,000 monthly lease cost. This is because the price will remain the same regardless of her decision about the deluxe wash. She only has to consider the incremental cost and benefits of the new equipment. 

The incremental cost of deluxe wash compared to premium wash is an additional $3 per wash. The incremental revenue for providing the deluxe wash compared to the premium wash is an extra $10 per wash ($25 for the deluxe wash- $15 for the premium wash).

By comparing her incremental cost in revenue cost, she can determine that her investment in the new equipment for the deluxe wash would provide her net incremental profit of $7 per wash. ($10 Incremental revenue - 3 incremental costs). Therefore, the decision to invest in the new equipment is profitable.

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What Is the Sunk Cost Fallacy, and What Is the Example?

The sunk cost fallacy is a way of thinking that happens when someone believes that as they have already invested so much money, time, and effort into something, they should continue to invest even if it's not worth it. This happens because people don't want to lose what they have already put in. 

Example of Some Cost Fallacy

A company has spent millions of dollars to develop a new product. After early tests, they found that the product may not be as successful as they hoped. As the company that has invested much money into marketing and production, the investors feel that they have already invested so much and should not lose that investment. Such a tendency is harmful as it can lead to more losses and missed opportunities for the company.

Why Is the Sunk Cost Fallacy a Problem?

The sunk cost fallacy is harmful as it involves making decisions based on past investments rather than evaluating the current situation and the potential for future gains. This might result in inefficient resource allocation as the capital is invested based on what cannot be achieved instead of what has the most future benefit.

How Do We Overcome the Sunk Cost Fallacy?

It is easy to overcome the sunk cost fallacy. All you need to do is recognise sunk costs, reframe your initial investment, evaluate the current situation, and consider opportunity costs. It would be best if you determined and should be mindful of your investment and its implications on future decisions.

How to Avoid Sunk Cost Fallacy?

The sunk cost fallacy is a common thinking that can lead to poor decision-making, and it is easy to overcome with the right mindset and approach. Here are a few ways how you can overcome the Sunk cost fallacy.

  • Frame the Problem: Start by writing down the problem you are trying to solve. This will help you focus on what's important and how to avoid other distractions.

  • Remain Independent: You must emotionally detach yourself from the decision. You must understand that your unsuccessful project doesn't reflect your decision-making; therefore, focusing on the best decision is essential rather than letting on the past investment.

  • Trust the Data: Remember to exclude sunk costs from your analysis after considering the different options. If you rely on the data without influencing your decision, the sunk cost will give you a more informed decision.

  • Change Risk Preference: Be open to accepting some level of risk in your investment. If you become more risk-averse, you will miss opportunities and hide your ability to make rational decisions. You must understand that sunk costs are a part of the risk you take investing there to focus on the overall value of your investment rather than being consumed by the fear of losing what you have already spent. 

What Is a Sunk Cost Vs. a Fixed Cost?

Fixed cost is the expense that a company has to pay regardless of how many goods or services it produces. The cost doesn't change with the production level associated with maintaining the business, like rent, utilities and administrative salaries.

Sunk costs, a subset of fixed costs, means expenses that have already been incurred and cannot be recovered. For example, if a company invests in a new machine that turns out to be faulty, the money spent on the machine is a sunk cost because it can't be recovered.

What Is the Difference Between Sunk Cost and Relevant Cost?

When a business decides, it focuses on the cost that will affect the future. This might include production costs, product pricing, or purchasing new inventory. The company must also consider how much money each choice would bring in. This is compared to how much it would cost to make the choice. Sunk costs are the costs that can't be recovered and should not be part of the decision-making process because the cost won't change no matter what the choice is.

Conclusion

All the businesses incur sunk costs. Sunk costs are because they cannot be recovered. The sunk cost fallacy is a psychological constraint where people put more resources into their failed attempts. You can easily overcome the sunk cost fallacy using the above tips. 

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01 Mar, 2024

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