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Sunk Costs: Definition & Examples

Sunk Costs: Definition & Examples
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  • 0:00 Definition of Sunk Costs
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Lesson Transcript
Instructor: Elizabeth Essex

Elizabeth has a PhD in Organizational Behavior and has taught and facilitated college courses in Organizational Behavior and Management.

In this lesson, sunk costs are defined and evaluated in the context of company decision making. Concepts are illustrated with examples from the construction industry and a small messenger business.

Definition of Sunk Costs

Companies in every industry have to spend money to make money. A company budget may allow for investing money in employee salaries, inventory, office space or any other cost of doing business. Once the company's money is spent, that money is considered a sunk cost. Regardless of what money is spent on, sunk costs are dollars already spent and permanently lost. Sunk costs cannot be refunded or recovered. For example, once rent is paid, that dollar amount is no longer recoverable - it is 'sunk.'

A family group also has a budget that contains sunk costs. For example, if they put $30 worth of gas in their car, they'll never get that money back. Their car has gas, but the cash is spent and permanently lost; it is a sunk cost.

Decision-making in a company is naturally linked to budgeting and costs. It's a common business tenet that sunk costs should never be considered a relevant factor in decision-making. Using sunk costs as a factor in a decision is simply trying to justify past choices.

Examples of Sunk Costs

An example of obvious sunk costs can be found in the construction industry. Let's say a construction company has begun development of a new housing sub-division. The lots and initial construction materials have been purchased, and framing has begun. A total of $4 million has been invested.

Suddenly, a crisis in the banking industry causes a recession, and subsequently the bottom falls out of the housing market. The sub-division land is now worth much less than the construction company paid for it. If the company abandons the project, it will take a $4 million loss. Some company executives want to finish the houses and sell them to recover at least a portion of the costs already spent - sunk costs. But it will cost an additional $6 million to complete the project.

One executive might say, 'We've already spent $4 million. We might as well finish the project.' A more enlightened executive will say, 'It doesn't matter that we've already spent $4 million - that's a sunk cost. We need to decide if investing in a housing development is a sound decision, given the current housing and banking environment.' Making the decision without considering the sunk costs will cause the executives to abandon the project and limit their losses to $4 million. The additional $6 million can be used for another project better suited to the current business environment.

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