What are sunk costs?

Sunk costs refer to expenses that have already been incurred and cannot be recovered. These costs are relevant in decision-making because they should not be considered when evaluating future projects or investments. The rationale is that since the money has already been spent, it cannot be retrieved, and therefore should not influence current or future financial decisions.

Understanding sunk costs is crucial in finance and management because it helps prevent decision-making based on past expenditures rather than future potential benefits. For instance, if a company spends money on a project that is not yielding expected returns, it should not continue to invest in it solely because of the costs already incurred. Instead, the organization should assess the project's future viability based on prospective cash flows and benefits. This principle is commonly referred to as "the sunk cost fallacy," where individuals continue investing in a project due to past costs rather than its future potential.