Sunk Cost, or “retrospective cost,” is money that has been spent and cannot be recovered. This means it’s excluded from further decisions.
In economics and business, Sunk Cost refers to an investment or cost that has been incurred but cannot be recovered. While a business aims to profit from its endeavors, certain expenses are unavoidable. Sunk costs can include a wide variety of expenses like marketing, hiring, training, and so on.
Businesses often incur sunk costs when investing in equipment or software or leasing a property. But these are necessary decisions and do not factor into future business decisions. Some sunk costs are necessary, while others are unavoidable.
This glossary article will discuss how it works, what the sunk cost fallacy is, and how these affect product management.
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How Does Sunk Cost Work?
For example, a company chooses to redo its app design because it’s undergoing a rebranding. After spending hours redesigning the app, they decide they don’t like the end result. That investment in the rebuild is now a sunk cost whether they choose to try and do it yet again or keep the new design since they cannot recover the money spent.
Some sunk costs are unavoidable when it comes to business. Marketing expenditures are often considered sunk costs, as are hiring and training expenses. These are also called past costs and are necessary expenses to keep the business running.
Still, businesses should not consider sunk costs in the financial analysis since they are irrelevant to current and future budgetary concerns.
What is the Sunk Cost Fallacy?
The sunk cost fallacy describes the tendency to spend effort on an activity or project in which someone has spent time and resources simply because they have already invested a lot of time, effort, and resources. The decision to continue is based more on the fact you have already spent a lot of time on it and not based on the actual benefits.
As people, we more easily commit to an endeavor once we’ve invested money, time, or effort into the decision. Even if it is no longer the best decision. This results in a further waste of time and resources that a company could have used on other projects.
To illustrate, let’s suppose a business invests in a new software product that, when released, is not well-received. That investment then becomes a sunk cost that the company does not recover. If the company doubles down by investing more into the product despite the lack of profit, it follows this fallacy.
This fallacy occurs because as humans, we struggle to make fully rational and objective decisions. Investing time and resources into a product or project later creates guilt when we do not follow through. We also feel the impact of a loss more than that of a gain.
Sunk Cost vs. Fixed Cost
A sunk cost is a fixed cost, but a fixed cost is not necessarily a sunk cost. A “fixed cost” is a necessary expenditure, regardless of any business activities. Profits or costs if goods dThe fixed cost is not affected by profits or costs of goods. Fixed costs include expenses such as rent, insurance, depreciation, and taxes.
An example of a sunk cost that is also a fixed cost is the resources required for training and onboarding new employees. A business can spend a fixed amount training its employees to use specific, necessary software. However, after a certain amount of time, that software becomes obsolete, and the employees now need to learn the new software.
That amount spent on training employees is both a fixed cost and a sunk cost. It is a necessary expenditure, but not one a company can recover.
Sunk Cost in Product Management
In product management, the sunk cost fallacy takes effect when a business overinvests in a poor product idea or continues investing until effort exceeds diminishing returns.
A brand should be ready to incur certain losses as it grows and expands. But it should avoid falling into the trap of this fallacy by employing different strategies to optimize its product development and product management processes.
Lean principles and agile frameworks also help minimize sunk costs by investing the minimum required and adapting to a changing market, respectively. Product managers should also learn to prioritize and cut their losses to avoid diminishing returns.
Understand Sunk Cost in Business
A sunk cost is something that has a negative connotation for a lot of reasons. However, at the end of the day sometimes it’s unavoidable. By understanding it and learning how to identify it, you can help improve your business’ operations and prevent your resources from going to waste.