Sunk Costs are Irrelevant to Financial Decisions
A somewhat counter-intuitive business rule worth wrapping your head around is whenever making financial decisions the money already lost or spent that is unredeemable up to that point in time (the sunk costs) are irrelevant. They need to be totally ignored in the decision making process.
A Quick Example of Sunk Costs
Hypothetically, in early 2009 you paid $20,000 for point-of-sale software that you were never quite happy with using… it failed to integrate into your workflow and had minor software issues, particularly with the user interface design.
Your choice is simple… Vendor A wants to sell you an upgrade to that software for $5,000… and Vendor B is offering you a better piece of software (that you have seen working in a friend’s business) for $10,000.
Problems with Sunk Costs
It should be an easy leap to realise the problem with sunk costs. You’ve already paid them… it’s money lost… it’s money that, regardless of the decision you take at that point forward, you will never be able to redeem. For that reason you should ignore all sunk costs when making financial decisions.
The saying “in for a penny, in for a pound” is the mentality that impels you to throw good money after bad.
The difficulty with ignoring sunk costs are that you have to deal with some pretty heavy decision biases and emotional justifications that were tied to your earlier decision to invest in the $20,000. You need to let go of that feeling of obligation. The only relevant decision is at this point in time what is your best option for moving forward?
Analysis of the Financial Decision
The temptation is to say… $20,000 PLUS $5,000 versus the loss of $20,000 PLUS $10,000.
When making any financial decision you can draw a red line through today and pretend that time only stretches forward. Your decision, ignoring sunk costs, is to invest $5,000 for Vendor A’s crap point-of-sale software versus $10,000 for Vendor B’s better software.
Ignore that $20,000 in sunk costs entirely because whatever decision you take that $20,000 is already lost. This is a fundamental principle of sound financial decision making.
