What is a sunk cost?
Last week I explained opportunity costs. Let’s take a look at another cost, called a sunk cost.
We’ll take the same example as before.
You are self employed and have booked a two week cruise at a cost of R80 000 plus airfare of R10 000. Just before your holiday is about to start, you get an offer to present a series of seminars on the health benefits of gluten free food products, which is what your company makes and sells. The organisers, Discovery Ltd, will pay you R120 000 for the seminars, plus you reckon they are worth R250 000 in free advertising.
What is the benefit of cancelling the cruise?
The income and promotional value that you would earn R120 000 + R250 000 = R370 000 minus the cost of the cruise (there are no refunds) R90 000 = R280 000. Right? Wrong!
Why? Because the R90 000 spent already on the cruise is spent whether you go or not. It is history – a sunk cost. So, if you go on the cruise the benefit from the seminars will be zero and if you don’t go, it will be R370 000. The sunk cost has nothing to do with the calculation! It is a fundamental of decision making that you never include a sunk cost in the process. Expressions such as “I must finish it – I’ve already spent R650 000 on the project” are nonsense. The decision to cancel a project or see it through should be based on the net future benefit or future loss from going ahead, irrespective of how much it has cost to date.
A last trivial, but real, example from everyday life. You bought top dollar tickets for a concert – R350 each, or R700 for the two of you. Comes the day of the concert and the weather has turned icy. You’ve lit the gas fire at home and poured a couple of glasses of wine. You’re both feeling cozy. As the time to leave draws closer, your spouse says –
“Darling, it seems such a shame to go out when we’re so comfortable here”.
“What? We spent R700 on those tickets!”
Sunk cost, buddy. Sunk cost.