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HBX Business Blog

How Understanding Sunk Costs Can Help Your Everyday Decision Making Processes

Posted by Christine Johnson on November 3, 2016 at 3:16 PM


Let’s talk sunk costs. In business speak, a sunk cost is a payment or investment that has already been made. It can't be recovered and therefore shouldn't be a factor in decisions moving forward because no matter what, it can't be recouped. Businesses and organizations often have difficulty abandoning strategies because of the time spent developing them, even if they aren't the right choice for the company.

Imagine a company that decides to build a new factory. They already did their analyses and determined that the future benefit they will receive from the factory will outweigh the cost of construction. They pay for the factory up front and expect to earn a certain level of cash flows from the factory’s production each year. But after a few years, the factory is underperforming and cash flows are less than expected. 

A decision has to be made: should the factory be shut down or not? At this point, the initial cost of the factory is a sunk cost and cannot be recovered. The decision should only be based on the future cash flows—or the future expected benefit—of the factory compared to the value of selling the factory today, not the original cost of the factory.

However, sunk costs aren't just useful for large companies deciding whether to enter new markets or close down factories. This principle can be applied in everyday life, and understanding it may impact how you make decisions. 

Feel free to leave the baseball game if it’s raining.

Some may call you a fair weather fan, but the cost became sunk the instant you purchased your ticket. You might feel obligated to stay and stick it out if the ticket was expensive, but if leaving makes you happier, do it! Either way, you aren't getting your money back.

Don’t go to the gym just because you have an annual membership.

Working out may be advantageous to your health, but your annual membership shouldn't dictate whether you go to the gym on any given day. If you paid up front, that’s money you won’t see again—if you’d rather take a hike, watch a movie, or spend an hour trolling Snapchat, you should. Your annual membership isn’t coming back into your checking account either way. (Although, this is not to say there are no other benefits to working out.)

There's no need to clean your plate.

How many times have you been at a restaurant and felt compelled to finish your meal? What about dessert? You ordered it, so you have to enjoy it and eat as much as you can. Before you give yourself a stomach ache and ruin a perfectly enjoyable meal, let’s think about this in terms of sunk costs: you've already committed to paying for the dinner and dessert in front of you no matter how much you eat. If you are full or don’t like the taste, stop eating. It’s that simple.

Sometimes there is an emotional component to sunk costs.

Maybe you went to law school, passed the bar, started working, and then realized you hate being a lawyer. What should you do? You invested so much time, energy, and money in that degree, so it can't be worth starting over again with a new career, right? Unfortunately, these are all sunk costs, so if your end goal is your own happiness, you might need to cut your losses and refocus your energies elsewhere. 

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About the Author

Christine is a member of the HBX Course Delivery Team, focusing on Financial Accounting and Disruptive Strategy. She holds a B.S. in Management from UNC Asheville, an M.S. in Accounting from Northeastern University, and an MBA from Northeastern University. In her spare time, she enjoys reading business journals and watching NFL games.

Topics: HBX CORe, HBX Insights