What is sunk cost?
Sunk cost (SC) is, by definition, an expense that cannot be retrieved, much like a shipwreck. Sunk costs are an unavoidable part of doing business. Furthermore, because they are non-recoverable, they should not be included in future budgetary estimates.
The Role Of Sunk Cost
The role of sunk cost is mainly about knowing what to ignore and what to consider when it comes to the business decision-making process. In other words, to divide the cost between actual cost and sunk cost.
Recoverable costs should be part of the business decision-making process, and the reason for that is that the business can still get them back. On the other hand, a sunk cost is the cost that the company considers unrecoverable and therefore does not count in the business decision-making process.
An Example of Sunk Costs
For example, let’s Imagine a SaaS company that recently had an unsuccessful new platform feature. They may believe that by studying and implementing additional features, they will eventually be able to recover the sunk cost of the first research.
However- This isn’t the case at all. The money They first spent is no longer available (it has been paid) and should not be considered in future decisions.
The most prudent course of action would be to recognize that customers prefer the platform as it currently exists and avoids incurring additional sunk costs by investigating other unwelcome enhancements.
Another example can be equipment. Office equipment, such as printers, frequently needs to be replaced after a few years of use. At this point, the money spent on outdated equipment is considered a sunk expense.
Yes, some of it may be recoverable if you sell off some components. However, all of the money spent on it upfront has been lost.
Alternatively, imagine that a SaaS company decides to invest in usability testing for a new platform feature. After being introduced, users mainly ignored the quality, and it generated no more revenues due to its inclusion.
In this situation, all of the money spent on research for the feature would be considered a sunk expense. And in this situation, the worst thing you can do is invest even more money to reverse the financial loss—a mistake known as the sunk cost fallacy, according to some experts.
How to Make Use of Sunk Cost Data
The main application we can make of sunk cost once we understand it is to use it as a pair of glasses to see the business reality.
For example, we can use sunk cost glasses during a product crisis. We wanted a product, and unfortunately, its sales were meager. Now we face the dilemma: what next? We need to ask ourselves: are we talking about a sunk cost or a relevant cost? Is there any reasonable chance for us to make this product sell better, or is the harsh truth that it just does not meet the market’s needs?
If that’s the situation, then no additional money we put into this product will save any money we already have. On the contrary, we will only be sinking deeper. We understand that the money we invested in this project is a sunk cost. So, in that case, the best action we can take is to cut up our losses and get out.