What exactly are Sunk Costs?
To put it simply, these are the resources your organization has already spent on a project and cannot be recovered. This can include money, time or another commodity which can be considered a good thing in your bookkeeping software or any other documentation.
For example, your company has hired software contractor to develop a new application for tracking inventory. 6000 dollars of billed hours later the contractor remains not finished and you also need to decide whether or not to continue development or cancel the project. The five thousand dollars already paid to the contractor can be a sunk cost.
Remember that an important part of the meaning above is the fact that these resources cannot be recovered. If you decide on a piece of equipment but tend to return it for any 10% restocking fee, than that 10% is a sunk cost. The remaining 90% of the purchase is recoverable.
The Sunk Cost Fallacy
If you don't understand sunk costs, you can make bad decisions that may hurt your organization. Typically executives may feel they have no choice but to keep on an expensive project because otherwise the amount of money spent is really a waste. This is the Sunk Cost Fallacy.
Inside the software example above, 5 thousand dollars recorded in your bookkeeping software program is already gone if the project continues or not. The decision to proceed should be based solely on which will be spent in the future. If the contractor is over budget and has made little progress, canceling the job would be the right decision. It hurts to get rid of the money already spent but that is no reason to throw big money after bad.
Making the best Decision
The best way to avoid situations just like the above would be to avoid sunk costs entirely or to minimize them whenever you can. The software contract might have been negotiated that all or a lot of the payment is received only upon delivery of the finished software, putting the duty on the contractor.
As the second example, say a vendor offers a discount in the event you put a nonrefundable deposit on new equipment before it's on the market. If this sounds like a purchase you absolutely know you are likely to make then the deal is practical. However an abrupt business reversal might have you suddenly not able to buy the equipment, and your down payment is forfeit.
Once you do have sunk costs, the very best decision is always to look to the long run not the past. It doesn't matter how much cash is recorded as spent in your bookkeeping software. Start at zero and balance what you have to spend against the benefit of spending.