In business, sunk costs are expenses that are already paid and can't be recovered. This could include equipment, factory leases for manufacturing, marketing and software costs in service-based industries, or salaries.
Monitoring these costs can enable a better understanding of expenditure and return on investment in your business. As Matthew Barton from The Institute of Financial Accountants notes, it assists in identifying unprofitable projects.
Here’s a breakdown of the various types of sunk costs in business along with examples and tips to avoid them.
Why it’s important to measure and track sunk costs
A business may struggle to scale back on funding an unprofitable project due to the fear of wasting invested resources. This notion is called sunk cost bias or the sunk cost fallacy and can prolong inefficient spending.
Barton suggests that closely monitoring sunk costs helps businesses manage future expenditures by uncovering areas for possible cost reductions, more effective investments and avoidance of unnecessary expenses. "It can also be used to set thresholds as a percentage of business turnover, and to help identify which particular business costs can be cut in the event of a reduction in turnover or profitability," he adds.
As a business owner, knowing your costs is key to making profitable investment decisions. The American Express® Business Gold Card lets you earn Membership Rewards® points on everyday business expenses. These points can be used for growth activities like business travel or buying tech or equipment¹. Plus, the added advantage of up to 54-day payment terms gives you more cash flow management control².
Types of sunk costs in business
Like any business expense, you should carefully monitor your sunk costs to ensure your investments are generating a return. Let's look at some examples.
Labour
Salaries are a crucial business expense, but also a sunk cost, explains Barton. Evaluating the performance of your employees, such as through quarterly or annual reviews, is one way to ensure you are getting the most from your investment in people.
Facilities and overheads
Money spent on overhead costs like rent, mortgages, utility bills, insurance, maintenance and hardware are also considered sunk costs.
Review these costs regularly, to ensure they continue to align with your needs. For example, if you're looking to trim costs, you could consider supporting remote working to either downsize your office or switch to renting co-working spaces.
Machinery and equipment
In manufacturing, sunk costs will include machinery, equipment and factory leases, says Barton, since it's unlikely you could return or sell these items for the same price you purchased them.
Marketing
Money spent on marketing is a sunk cost. For example, let's say you spent £4,000 on marketing your new range of sofas but the marketing campaign wasn’t very effective. Because you’ve already spent £4,000, this amount is considered to be a sunk cost as you cannot get your money back.
Research and development
As your business grows, you will likely invest in research and development to improve or expand your products and services. Be sure to closely monitor the success of these activities, to avoid overspending on any ventures that are proving to be unprofitable.
Why do business owners struggle with sunk costs?
Barton states that natural psychological traits often make sunk costs difficult for businesses to approach objectively. This can lead to overspending or funding failing projects due to factors such as fear of 'waste', difficulty in changing plans or professional pride.
Resistance to change
Businesses may resist change even with changing market conditions or technological advancements, out of habit. This runs the risk of missing more efficient and cost-effective methods.
Fear of failure
Personal or professional pride can lead business owners to continue investing in an unfavourable venture just to avoid the perception of failure, says Barton.
Waste avoidance
According to Barton, 'loss aversion' is another struggle where business owners make poor decisions fearing wasting past expenses and disregarding current and future costs and benefits.
Commitment bias
Barton explains that 'commitment bias', sticking with original plans even when not viable, poses a challenge for businesses by making it difficult to back down.
How to avoid sunk costs
Test and learn
Before investing heavily in a new project, validate the concept and market demand. For example, through a proof of concept (POC), which aims to gather data to support any further development of an idea. You could create a presentation of your project, with visuals and details of how it might work and the needs or problems it solves. Share this with clients and employees to gather their feedback.
“We have always operated in a data first, minimum viable product way,” shares Alec Dobbie, CEO and Co-Founder of MarTech company, FanFinders. “We test and learn as quickly and cheaply as possible, applying statistical significance to anything we do,” he adds. “If it's measurably good we use it, if it's not it's thrown away.”
Stay objective
“We have learned not to let personal feelings get in the way of data-driven decision-making,” says Dobbie. “Our test-driven ideology helps us not to over-invest in projects."
Try to put emotions and personal attachments aside when making business decisions and instead, let data guide your choices. If you’re starting a new marketing campaign, for example, establish your success metrics such as conversions, sales, or click-through-rates. Track these regularly and if you’re not seeing results, change strategy.
Continually re-evaluate your processes
Business owners should continually review their expenditures and particularly when circumstances change. For example, if there is a sharp increase in costs. Instead of continuing with planned investments, scrutinise the numbers to see if going ahead still makes economic sense.
Sunk cost example
As a technology business, Dobbie says his sunk costs include research and development, salaries, and marketing. He keeps a close eye on these costs, with daily commercial meetings that use data to ensure each investment is on track. This, he says, ensures they can react quickly to any changes.
Consider this sunk cost scenario of designing and manufacturing a new product:
- Design brief research: £5,000
- Agency design fee: £10,000
- Manufacturing equipment cost: £30,000
- Six-month marketing campaign expenditure: £30,000
£75K spent on creating and promoting a product is an example of a sunk cost.
But when the target isn't met after six months and data shows underperformance, your best move would be to stop further costs while you figure out why the product isn’t selling well enough. You can then decide whether to stop production or modify it.
Sunk costs vs. fixed costs
Fixed costs are expenses that stay the same no matter your level of business activity. In other words, they don't increase or decrease in response to the number of goods or services your business produces. They include expenses like office leases and salaries.
"All sunk costs are fixed costs, but not all fixed costs are sunk costs," says Barton. "This is because a sunk cost cannot be altered or changed after the fact, but a fixed cost can be stopped or changed if required."
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