Bill Morgan sells t-shirts at the home games of the local minor league baseball team.  Before the season opened, Bill purchased his vendor license for $50 and a tent and tables for $300.  He also went ahead and printed up 200 shirts at a cost of $20 per shirt.  

First off, Bill has fixed costs of $350.  No matter how many shirts he sells this season, the cost of the license, tent, and tables will be unaffected.  What about the costs of the t-shirts?  My first impulse is to say that this is a variable cost.  The overall cost of t-shirts will be impacted by the number he sells.  But not this first run of 200.  Whether he sells 5, 50, or 500, he’s out the $4,000 to print these.  This is a special type of cost referred to as a “sunk cost”. 

Imagine the season is suddenly cancelled due to another pandemic.  A local shop owner approaches Bill and offers to purchase his inventory of 200 shirts for $10 a piece.  Bill knows they’ll be worthless next year since he had the season printed on the shirt and he has no other offers.  But should he take this offer?

If he does, he’ll lose $2,350 for the season (i.e. $2,000 from the shop – $50 – $300 – $4000).  But if he doesn’t, he’ll lose the entire $4,350.  He’s unable to recover any of his initial outlays, they’re sunk.  And so, he accepts the offer.

Failing to ignore sunk costs is a common error.  I keep trying to finish a pretty mediocre marketing book on my shelf because I paid for it and it’s there.  Those two facts are irrelevant.  If it’s not worth my time, I should let it go.  I can’t get the price of the book back whether I read it or not.  As another example, consider the many unhappy attorneys, accountants, and perhaps even economists going to work, day after day, unwilling to make a career change because of the time and money they have invested in preparing for a job they dislike.

Just like Bill made the rational decision to sell off his inventory at a loss, you should be careful to never allow sunk costs to enter into your decision-making calculus.  Focus only on those costs and benefits directly impacted by the decision you’re facing.