Sunk cost is also known as a 'Standard Cost'. A sunk cost refers to a cost that cannot be retrieved. Sunk cost are usually associated with past costs. For ex: If you bought a machine and after a month you realize that some other machine is more efficient, you sell the machine you had bought at a depreciated price. That depreciated price is a sunk cost, it this that price which you cannot get back.
One must not consider the sunk cost before making a decision. This is because considering the sunk cost will interpolate the future decision. For ex: you bought a car for $20,000 and after a year you want to sell your car. Now the price of the car has fallen down $15,000 therefore after subtracting the depreciation you will have sell your car according to the market price and not at the price at which you bought your car.
What is Sunk Cost Dilemma?
It is a state of perplexity in making a choice between, proceeding with a project/a deal or quitting it. This dilemma arises because even after ignoring the sunk cost the outcome does not seem to be promising. The dilemma of sunk cost is associated with averting losses than taking a risk and maximizing gains. In this situation an individual needs to evaluate the total expenses already made on deal and assess if it is profitable to put in more funds.
An individual in this situation is between "throwing good money after bad" and minimizing losses. However the concept of sunk cost can be applied to things other than related to money-profit. Even the time wasted or unnecessary stress can also be termed as a sunk cost. The sunk cost dilemma is not just about having losses but it is about avoiding further losses in order to regain the sunk costs.
Sunk costs are a part of the overhead costs for businessmen. That is, initial cost incurred by the businessmen in developing a property is a sunk cost. Now if he thinks that the business is not working for him, and thinks of switching to working for a firm, in this case he is a dilemma if he should shut his business or switch to a job. This is a situation of sunk cost dilemma, as he has already invested some money in the business which he cannot get back.
Suppose a person has taken up a construction project worth $7,000,000. Now, as per the deal he is going to receive the entire sum after the completion of the project. Let's say that the person has already invested about $3,000,000 in raw material out of which material worth $1,000,000 got destroyed due to some reason. Should he leave the project now? If he quits the project right now he will get nothing back but will suffer a loss of $3,000,000 and if he chooses to continue his assignment he will be able to recover the amount lost from the final sum. Therefore, here the right decision is to continue the deal.
A person has spent $100 on a 4 hour long musical show. After just about 10 minutes that person realizes that the show is going to bore him to death he will have to choose between leaving the show right away or waiting back till the show ends to justify the amount he paid for it. In this case, if the person waits up till three and a half hours and is extremely frustrated and bored, this was a situation of "throwing good money after bad". Because that person not only wasted the $100 initially but eventually after all the time he spent waiting the show he also lost those three and a half hours in boredom. In this situation, the right decision was to walk out of the show, he would have wasted only $100 and still would have saved the time and avoided the mental torture.
In the above two examples when the person is in the midst of making a decision, he is in a sunk cost dilemma.
Resolving the Dilemma
Considering the first example given above, one way to avoid sunk costs is by getting payments at regular intervals. In the first example the entire expenditure was to be borne by the construction agency first and he would receive the entire sum only after the completion of the projects. This leads to a big risk for the agency. Instead he can make sure that in his future deals he gets payments from the other party at regular intervals to avoid bearing the entire burden by himself. In case of the second example, when a person is sure about him losing the invested money; it makes more sense if he can avoid further loss.
When you are in a 'sunk cost dilemma' situation, there are a few possible ways to reduce losses or even avoid them. You can try forecasting a situation beforehand and react accordingly. Another way is by making minimum losses than humongous losses; look at mitigating options. By applying this in personal relationship context, if you are in a bad relationship you could save yourself and your partner by breaking up if you are sure that things aren't going to work out; instead of holding on to the relationship because breaking up will make you the bad one. Analyze!