What is the cost of sinking?
Key Points Overview
Sunken cost refers to costs that have been incurred and cannot be recovered.
Sunken costs do not affect current behavior or future decisions. Rational decision-makers should exclude the interference of sunk costs in investment decisions.
The fallacy of sunk costs refers to the phenomenon where people consider sunk costs when making decisions due to loss aversion psychology.
Concept Explanation
A sunk cost refers to cost expenditures that have occurred or been committed and cannot be recovered through any means. Sunk costs are historical costs, uncontrollable costs for existing decisions, do not affect current behavior or future decisions. In this sense, rational decision-makers should exclude the interference of sunk costs in investment decisions, and only consider variable costs (costs related to specific decisions and will change based on that decision).
Sunk costs can be fixed costs or variable costs. When a company closes a department or stops production of a product, sunk costs typically include both fixed costs such as machinery and equipment, and variable costs such as raw materials and components. In general, fixed costs are more likely to be sunk than variable costs.
Sunk costs can be total costs or partial costs. For example, with machinery and equipment that are discontinued midway, if they can be sold to recover some value, then their book value will not be fully sunk, only the part where the realized value is lower than the book value is a sunk cost.
One of the winners of the 2001 Nobel Prize in Economics, the American economist Stiglitz used a real-life example to explain what a sunk cost is. He said, 'If you spend $7 on a movie ticket, and you start to doubt whether the movie is worth $7. After watching for half an hour, your worst fears are confirmed: the movie is terrible. Should you leave the cinema?'
In making this decision, you should ignore the $7. It's a sunk cost, and whether you leave the cinema or not, the money will not be recovered.' However, many people will force themselves to watch a movie they don't want to watch because they are afraid of wasting the money they spent on the ticket, and this phenomenon is called the 'sunk cost fallacy'. This fear of 'wasting' resources is known as 'loss aversion.'
Typical cases of sunk costs
In the 1960s, France and the United Kingdom jointly developed a large supersonic civil aviation aircraft (Concorde aircraft). Midway through the development, many experts involved already realized that this project was very costly and had little economic benefit. However, hindered by the resources already invested in the initial stages, the governments of the two countries ultimately did not withdraw from the project. Instead, they continued to pour more silver into it (it is said that the total cost exceeded the budget by 8 times). The Concorde aircraft was eventually developed but had no competitiveness, ultimately ending in failure (with only a total of 16 aircraft put into civil aviation operation). Because the example of the Concorde aircraft is very typical, the 'sunk cost fallacy' is sometimes also referred to as the 'Concorde Effect.'
In contrast to the above example, in December 2000, Intel decided to cancel the entire Timna chip production line, which was a rational disregard of sunk costs. Timna was an integrated chip designed by Intel for low-end PCs. When the project was initially launched, the company believed that future cost reductions in computers would be achieved through highly integrated design. But later, the PC market underwent significant changes, and PC manufacturers had already achieved the target through other cost reduction methods. Intel saw this clearly and decided decisively to halt the project, thereby avoiding greater expenses.
