Cash Flow Analysis and Other Factors

Sunk costs are retrospective costs that have already been incurred and cannot be recovered. Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken.

Sunk costs are irrecoverable.

Impact on Investment Decision

The idea of sunk costs is often employed when analyzing business decisions. In traditional microeconomic theory, only prospective (future) costs are relevant to an investment decision. For example, the research and development of a pharmaceutical company are retrospective once it is time to market the product. Once spent, such costs are sunk and should not affect future pricing decisions. The company will charge market prices whether R&D costs one dollar or one million dollars. Therefore, the costs of R&D are considered sunk once they are retrospective and irrecoverable. At that point, they have no rational bearing on further investment decisions.

Difference from Economic Loss

The sunk cost is distinct from economic loss. For example, when a car is purchased, it can subsequently be resold; however, it will probably not be resold for the original purchase price. The economic loss is the difference between these values (including transaction costs). The sum originally paid should not affect any rational future decision-making about the car, regardless of the resale value. If the owner can derive more value from selling the car than not selling it, then it should be sold, regardless of the price paid.

In this sense, the sunk cost is not a precise quantity but an economic term for a sum paid in the past, which is no longer relevant to decisions about the future. The sunk cost may be the original cost or the expected economic loss. It may also be used as shorthand for an error in the analysis due to the sunk cost fallacy, irrational decision-making, or, most simply, irrelevant data.