A sunk cost is a cost that an entity has incurred, and which it can no longer recover. Sunk costs should not be considered when making the decision to continue investing in an ongoing project, since these costs cannot be recovered. Instead, only relevant costs should be considered. However, many managers continue investing in projects because of the sheer size of the amounts already invested in prior periods. They do not want to "lose the investment" by curtailing a project that is proving to not be profitable, so they continue pouring more cash into it. Rationally, they should consider earlier investments to be sunk costs, and therefore exclude them from consideration when deciding whether to continue with further investments.
An accounting issue that encourages this adverse behavior is that capitalized costs associated with a project must be written off to expense as soon as the decision is made to cancel the project. When the amount to be written off is quite large, this encourages managers to keep projects running over a longer period of time, so that the expense recognition can be spread out over a longer period of time, in the form of depreciation.
Examples of Sunk Costs
Here are several examples of sunk costs:
Marketing study. A company spends $50,000 on a marketing study to see if its new auburn widget will succeed in the marketplace. The study concludes that the widget will not be profitable. At this point, the $50,000 is a sunk cost. The company should not continue with further investments in the widget project, despite the size of the earlier investment.
Research and development. A company invests $2,000,000 over several years to develop a left-handed smoke shifter. Once created, the market is indifferent, and no one buys any no units. The $2,000,000 development cost is a sunk cost, and so should not be considered in any decision to continue or terminate the product.
Training. A company spends $20,000 to train its sales staff in the use of new tablet computers, which they will use to take customer orders. The computers prove to be unreliable, and the sales manager wants to discontinue their use. The training is a sunk cost, and so should not be considered in any decision regarding the computers.
Hiring bonus. A company pays a new recruit $10,000 to join the organization. If the person proves to be unreliable, the $10,000 payment should be considered a sunk cost when deciding whether the individual's employment should be terminated.
A sunk cost is also known as a stranded cost.