What Is a Sunk Cost?

Sunk costs are expenses that have occurred in the past but have nothing to do with current decisions. From the perspective of decision-making, the cost incurred in the past is only a factor that causes the current state. What is considered in the current decision is the cost that may occur in the future and the benefits it brings, without considering the cost that occurred in the past. ^[1]

Sunk costs

Sunk costs are expenses that have occurred in the past but have nothing to do with current decisions. From the perspective of decision-making, the cost incurred in the past is only a factor that causes the current state. What is considered in the current decision is the cost that may occur in the future and the benefits it brings, without considering the cost that occurred in the past. ^[1]

Sunk costs are a historical cost, and for existing decisions

Sunk cost is one of the most difficult problems in the economic world. If it is not handled well, it can easily lead to two misunderstandings: fear of going to the "sedimentation cost" of unproductive output and not dare to invest; , Resulting in greater losses.

1. Planning or decision making errors. 2. Inadequate preparation for preliminary investigation, evaluation, and demonstration, which caused problems in the middle and could not be continued. 3. Have a good plan and plan, but the implementation is off track, causing things to go wrong. 4. Problems were found in the implementation, but the strategy and plan were not adjusted in time, but instead they went their own way. 5.

The impact of economic precipitation costs on investment can be analyzed from the following micro perspectives. Assuming that the cost of obtaining capital is always greater than the value of the abandonment, the difference between the two is the sunk cost.

When companies seek to maximize profits,

Measure the cost of an investment project and only include costs incurred as a result of conducting or selecting the action plan

Summary

Since sunk costs are defined as the part of an investment that cannot be fully compensated through transfers or sales. Specifically, the size of the sedimentation cost depends on the initial value of the asset (net of depreciation) and its salvage value (transfer or resale price).

Business operating expenses can be divided into productive expenses and

It is not enough just to recognize the sunk cost. In fact, there are still cognitive blind spots:

Examples of the concept of decision costs must be established: some prudent decision makers missed out on feasible projects because they took some irrelevant costs into account for decision costs; others made mistakes because they excluded related costs from their decisions Blindly optimistic estimates of the project beyond cost. It can be seen that it is important to establish the concept of decision costs when acting and making decisions.

From the perspective of the relevance of the decision, the sunk cost is the non-relevant cost of the decision. If the sunk cost is included in the decision, the project cost will be overestimated and the wrong conclusion will be obtained.

Considering the opportunity cost of the invested resources, the sunk cost is a non-relevant cost of the decision, but the opportunity cost accompanying it is a decision-related cost, which needs to be considered in the decision.

Opportunity cost is not a cost in the usual sense, it is not an expense or an expense, but an income or gain that may be lost by choosing a certain plan. Take the Chinese mainline aircraft project as an example, what is the opportunity cost of terminating the project? Obviously should be possible in the future to continue the project

2001 Nobel laureate in economics, Professor Stiglitz said that ordinary people (non-economists) often don't calculate "opportunity costs", while economists often ignore "sinking costs"-this is a wisdom . He said in Economics: "If an expense has already been paid and cannot be recovered no matter what choices are made, a rational person will ignore it. Such expenses are called sunk costs." He gave an example: "Suppose now that you have paid $ 7 for a movie ticket, you doubt whether this movie is worth $ 7. After watching it for half an hour, your worst suspicion is fulfilled: this movie is simply It was a disaster. Should you leave the movie theater? When making this decision, you should ignore the $ 7. This $ 7 is a sunk cost, whether you are going to stay or not, you have already spent the money. "

error

Many people are worried about "wasting" resources and are called "loss aversion." For example, many people will force themselves to watch a movie they don't want to watch because they are afraid to waste the money of buying tickets. This is sometimes called the "sunk cost fallacy." Economists would call these people "irrational" because similar behaviors are inefficient, making decisions based on irrelevant information and misallocating resources.

These reflections may reflect inconsistencies in measuring the scale of utility, which is subjective and unique to consumers. If you really book a movie ticket and find that the movie is really not to your appetite, you may wait until the end to leave, and you feel that you have saved your face, which is also a satisfaction. If you leave midway, strangers will find your judgment wrong, which you may want to avoid. You may get some entertainment from finding faults in movies and be proud of your appreciation. Or do you feel qualified to criticize the movie in front of others.

The concept of sunk costs is used when analyzing business decisions. A common example of sunk costs is the promotion of a brand. This situation often results in a cost that cannot be digested normally, and it is not a typical way to reduce the brand's gold content in exchange for sales (unless a market exit strategy is implemented). When making future investment, sales, or advertising decisions, you should only consider future possibilities and not be cheap with a large advertising investment.

The sunk cost fallacy is sometimes referred to as the "Concorde effect," referring to the British and French government's continued funding of Concorde aircraft, when it became clear that such aircraft did not have any economic benefits at all. The project was privately called a "business disaster" by the British government. It shouldn't have been started at the time, but it should be cancelled at the time, but due to some political and legal issues, the two governments did not finally get out.

Worse off

From the perspective of "getting money to learn lessons" and "paying tuition fees", it is one-sided to view sunk costs. In fact, in addition to the extreme case of sunk costs caused by mistakes in investment decisions, sunk costs are often an essential expense. But sunk costs can also give companies an advantage in some ways.

For an industry or industry, the state of its sunk costs often constitutes the key to entry and exit barriers and ultimately determines the market structure. As early as 1956, Bain Consulting pointed out that if the fixed or sunk cost of an industry is high, a barrier to entry will be formed.

Capital-intensive industries with significant economies of scale and huge hardware investment, such as energy, communications, transportation, real estate, integrated circuits, medicine and other industries, have excessive returns that are tempting, but their amazing initial investment and high exit costs are often Many markets are "temporary entrants" because this is first and foremost a "who can afford to lose" competition.

Because these high sunk cost industries often have the characteristics of low marginal cost, the "losing" party will eventually become the market winner. Many companies with strong capital strength use sunk costs to build their own competitive advantages. Small businesses usually have to choose competitive industries that have lower sunk costs for development.

How to reduce sunk costs

In any case, while achieving the same strategic purpose, reducing the sunk costs as much as possible is undoubtedly the desire of all enterprises. Really, as in the fierce competition around the Internet companies around 2000, it is faster than most "burning money" and it can be said that most investors are unwilling to see it.

Try to avoid sunk costs due to decision errors

Of course, market and technology developments are changing rapidly, and investment decisions are unavoidable. In the case of investment mistakes, how to avoid mistakes is the real test for the enterprise.

An example of this is Intel's decision to cancel the entire Timna chip production line in December 2000. Timna is an integrated chip designed by Intel for low-end PCs. When I was working on this project, the company believed that in the future, computer cost reduction would be achieved through a highly integrated (integrated) design. However, the PC market has changed a lot since then, and PC manufacturers have achieved their goals through other system cost reduction methods. After seeing this clearly, Intel decided to dismiss the project and avoid larger expenditures.

Reduction of sunk costs through joint ventures or bilateral contracts Many times, sunk costs are not caused by the company itself, but are caused by disruption of cooperation by partners or upstream and downstream parties in the supply chain.

Investment mentality

For "sunk costs", investors should be: "I don't think this method can recover losses." The best way to avoid this misunderstanding is to ask yourself: If you don't have the stock or fund in hand, or give it another You have a sum of money, will you still buy it? If the answer is no, then it is best to sell it, not just because it has been trapped, for the so-called "cost reduction" on the "psychological account", to make a "wrong plus a wrong" decision. For a stock or fund, if it has made you lose too much and there is no sign of improvement in the fundamentals in the short term, instead of adding it blindly in exchange for an indefinite deadline, it is better to cut it quickly and accept the "sinking costs" and re-select the target , Start a new investment experience.

Calculation:

Sunk cost = book value of equipment-current market value = (original equipment value-depreciation over the years)-current market value