Sunk Cost Dilemma - Explained
What is a Sunk Cost Dilemma?
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Table of ContentsWhat is a Sunk Cost Dilemma?How Does a Sunk Cost Dilemma Work?Sunk Cost Dilemma and Rationality
What is a Sunk Cost Dilemma?
Sunk cost dilemma is an accounting term that helps an organization in deciding if they should continue or discontinue the project, provided they have invested their time and money, but still have not met any feasible objectives. Such concept, with a view to find a solution, attempts to find out if the company should make any additional investment for the project or not. Following the rational approach, a person would only take into consideration the variable costs. However, mostly, people factor the sunk costs on an irrational basis. Such dilemma is referred to as the Concorde Fallacy.
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How Does a Sunk Cost Dilemma Work?
Sunk costs refer to irrecoverable expenses. For instance, when you have already invested half of your money in renovating your house, and in the mid-way, you realize that it doesn't look that worthy, this is where sunk costs come in the picture. You have no option to return the services rendered during renovation, and get your money back. So, here the dilemma is if you should continue with your renovation hoping that you would like the final output, and not lose your money that you have already invested, or if you should accept the sunk cost, and replace the renovations made with new ones.
Sunk Cost Dilemma and Rationality
Costs that an organization bear in the past are referred to as sunk costs. However, this is not the same case always. For instance, if you get a cardigan for your sister, you have the option to return it, and get your money back in case, she doesn't like it. Hence, this cost would be a recoverable cost and not a sunk cost. A sunk cost is something that doesn't have any expiry date. Future costs can be referred to as sunk costs, provided they are unavoidable. For instance, if you have agreed upon a contract to pay $100 every month for a period of 12 months, and the contract cannot be terminated, then $1,200 turns out to be a sunk cost since it is mandatory for you to pay the specific amount every month. In extreme cases, you can prove if you become bankrupt. Avoidable costs refer to the costs based on your decisions. For example, you can choose to not pay the EMIs before making the decision to buy an automobile. However, after giving consent, the payment results in a sunk cost. Fixed costs that need to be incurred on a monthly basis are usually referred to as sunk costs. This is so because you cannot avoid the cost with your decision. As per rational approach, one should avoid sunk costs at the time of taking a decision. The main objective of a decision is to be able to make changes to the future actions. As sunk costs are fixed, you should not consider those costs when making a decision on how to go forward. However, it is not practical for human beings to have a rational approach. There is a sunk cost fallacy, a basic mistake in making a decision, that asks you to consider sunk cost at the time of taking a decision. If a person plans to avoid sunk costs, it results in several issues such as the sunk cost dilemma.