Sunk costs

Sunk costs are sums that have already been spent and can not be recovered.

The concept is important because sunk costs are irrelevant to financial decisions. Many people tend to feel instinctively that because an investment has been made it is necessary to get a return on it. This can lead to people rejecting one course of action in favour of another that actually generates smaller cash flows. This can happen to business, portfolio investment and personal decisions.

Suppose a hotel has calculated that their cost for providing a room is £100 per night, of which £50 covers their rental of the building (i.e. the cost of the rental divided the number of rooms) and £20 covers their other fixed costs (such as staff) and £30 covers the costs that result from having an extra guest (e.g. electricity, laundry, food included in the price etc.)

Now suppose the market rate for hotel rooms goes down and they are only able to charge £50 per night. The hotel is committed to remaining open. It appears that the hotel will make a £50 loss on each night per guest so they should not accept bookings until prices rise. Of course this is wrong as the rent and other fixed costs are already committed to and have to be paid anyway. The hotel should accept bookings at any price it can get above £30, as these make a positive contribution.

A common mistake made by investors is reluctance to sell securities at a loss. It does not matter what you paid for shares, if the market price has fallen you have already made that loss. It is a sunk cost and should be forgotten about. What matters is whether the shares are worth holding or not at the current market price. A key question is whether the shares would still be worth buying at current prices. If not, they are probably not worth holding.

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