The text book definition of “sunk costs” reads something like this: costs that were incurred in the past that cannot be recovered and thus are irrelevant for decision making.”
Well most costs are incurred in the past so that part of the definition is not all that helpful. More central is the idea of recoverability. But the key underlying idea, which is not spelled out in the definition, is that sunk costs are assets. Huh? How can costs be assets? Well keep in mind that costs involve the expenditure of resources (usually money). But expenditures come in two flavors: those that have only short term benefit and those that have long term benefit. Costs (expenditures) that have only short term benefits are called period expenses or just expenses. Examples include expenditures for monthly utilities and rent. Costs that are expected to create benefit into future periods are called assets. Examples are machinery, furniture and equipment.
Assets are sometimes referred to as unexpired costs to emphasize the fact that the expenditure will create benefits for future accounting periods. But these assets (unexpired costs) also come in two flavors: recoverable assets versus non recoverable assets. Most assets are recoverable at least to a degree. You buy a piece of equipment or furniture and you use it for a few years and it still functions so you can sell it in the used furniture or equipment market. Maybe you will not recover much of your original outlay but you will recover something.
But non recoverable assets are exactly sunk costs. You lay the money out and you cannot recover much of anything in the secondary market. Why not? Well these kinds of assets or sunk costs are usually custom made for very specific purposes. A piece of equipment specially designed to perform one unique function in a unique manufacturing process. A custom made software that only suits the specialized needs of one business.
So what is the big deal about these non recoverable assets that we call sunk costs? The big deal is that once we make an investment in these kinds of assets we are very reluctant to think clearly about whether or not we made the right decision. We are very reluctant to admit that we made a mistake.
You invest $2,000,000 in special equipment to manufacture a certain model of desk lamp. Excluding the original investment of $2,000,000 the unit cost of producing one lamp is $3.50. This unit cost includes labor and materials directly associated with producing the lamp. Now some time after you make the investment in the special equipment you find out that a factory in China will manufacture the identical lamp for $3.00 per unit delivered. What is the prudent course of action?Well the prudent course of action is to outsource the production and utterly disregard the $2,000,000 investment made in the special equipment. But the prudent course of action runs utterly contrary to human nature because abandoning the asset entails admitting to yourself that you made a $2,000,000 mistake.
How willing you are to abandon a bad asset investment is related to at least two things: the size of the investment and when you get the bad news that you made a mistake. If the sunk cost is large you are more likely to resist rational action than if the outlay is small. If data on your mistake becomes immediately obvious after making a large investment you will do everything in your power to ignore or refute the data. On the other hand if you have gotten some benefit from the investment over some period of time you will be more willing to act prudently and write the investment off.