Sunk Cost

What is Sunk Cost ?

A sunk cost, also known as a retrospective cost, is an expenditure that has already been made but cannot be recovered. Marketing, research, new software installation or equipment, wages, benefits, or facility charges are examples of sunk costs in the company. Opportunity costs, on the other hand, are the missed returns on resources that might have been spent elsewhere. Sunk costs, in principle, are irrelevant to future decision-making. In actuality, sunk costs may and do have a substantial impact on future choices. This is partly due to the psychological difficulty of letting go of previously spent time, effort, or money resources, even if the results of such investments fall short of expectations.

What Is a Sunk Cost Fallacy?

The sunk cost fallacy refers to our tendency to stick with anything in which we’ve committed money, effort, or time, even if the present costs exceed the advantages. When we fall victim to the sunk cost fallacy, we make illogical actions that are detrimental to our best interests, thereby digging ourselves further and deeper into a hole.

How Does This Cost Impact Product Management?

The sunk cost fallacy can cloud logical reasoning. PMs are naturally enthusiastic about their projects. The PM position includes evangelising a new feature or product as well as inspiring others around them. Recognizing that a feature or product is no longer meeting its goals after spending significant time, energy, and money may be difficult. Understanding the psychology behind the sunk cost perspective may help explain why it’s so tough to let go off.

How to Avoid Sunk Cost Fallacy in Decision-Making?

Here are some techniques for dealing with the ambiguity of whether to continue creating a new feature or product or put it on hold in order to spend money and time in a project that may provide better results:

  • Recognize the intended result (What do you want your consumers to accomplish? Are there other options?)
  • Review your priorities (Are you working on the appropriate things?)
  • Concentrate on the next sprints. (Consider the large picture in broad strokes, but save specific planning for the near future.)
  • Accept uncertainty (Success is more likely to follow when you are open to change and opportunities.)
  • Take nothing personally. (Instead of the decision-maker, smart decision-making focuses on product vision and strategy.)

What Factors Lead to the Sunk Cost Fallacy in Decision-Making?

The following are five variables that may contribute to the sunk cost fallacy in decision-making:

  • Loss aversion is the preference and proclivity to avoid loss in favour of an equal gain.
  • Framing is a cognitive bias that causes people to avoid danger with a positive frame and embrace risk with a negative frame.
  • Overoptimistic probability bias: The belief that increasing the expense would improve the future return on investment.
  • Personal responsibility: Linking the investment and effort to a specific person or organisation.
  • Wasteful: A desire to avoid being condemned for wasting time, resources, or money in an endeavour.

What is an example of a sunk cost?

A sunk cost is any investment that cannot be recovered. Here are some sunk cost examples to assist you recognise circumstances where the sunk cost fallacy may impact you.

Sunk expenses may include:

  • Opportunity expenses, such as time invested that might have been spent on something more productive
  • Effort, such as jobs that are exceptionally difficult
  • Mental tension, such as the concern you’ve felt
  • Infrastructure and overhead
  • Materials and tools
  • Investments, such as the purchase of a company
  • Subscriptions for a year
  • Non-refundable company expenses, such as legal fees or advertising

What is a sunk cost vs fixed cost?

Sunk expenses and fixed costs are two kinds of costs incurred by a firm in its different business operations. While both sunk costs and fixed costs result in an outflow of cash, they are substantially different in terms of how they are incurred and the period at which each kind of expense is borne.

Sunk costs are expenditures or investments that have already been made and cannot be recovered. Sunk expenditures or expenses made in the past that cannot be undone or recovered in any way should not be utilised to make future judgments about a project or investment. However, sunk costs are often considered by investors and companies when making future choices.

Fixed costs are costs that stay constant regardless of output levels. It is vital to highlight that fixed costs are only constant in relation to the amount produced in the present period of time, and they do not stay fixed indefinitely since expenses grow with time. The drawback of fixed costs is that the company must incur high fixed expenses even when output levels are low.

What causes sunk cost?

Because we are not fully logical decision-makers, we are often swayed by our emotions. We are more prone to feel guilty or regretful if we do not follow through on a decision we have previously invested in. The sunk cost fallacy is related to the commitment bias, which occurs when we continue to support earlier actions despite fresh data indicating that they are not the optimal course of action. We fail to consider that whatever time, effort, or money we have already invested will not be repaid. We end up making judgments based on past expenses rather than present and future costs and benefits, which are the only ones that should make a difference sensibly.

Difference between Sunk Costs and Relevant Costs

Sunk costs are expenditures that have already been incurred and emerged as a consequence of previous actions. Sunk expenses are a form of insignificant cost. Irrelevant expenses are costs that no longer impact management decision making because they have passed. These expenses and investments cannot be reversed or recovered since they have already been incurred, and irrelevant expenditures such as sunk costs should not be utilised to make future choices about a project or investment.

Relevant expenses are those that have the potential to affect and influence management choices. Relevant expenses will vary based on the alternatives and choices available to a corporation. Other characteristics of relevant costs include that they are preventable if the choice is not made, that they might result in opportunity costs for a company, and that they are incremental expenses between the many alternatives under evaluation.

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