What characterizes a "sunk cost"?

A sunk cost is characterized as a cost that has already been incurred and cannot be recovered. This definition is critical in financial decision-making because it emphasizes that sunk costs should not influence current or future economic decisions. When evaluating options for a project, focusing on future costs and benefits is essential rather than on what has already been spent.

For example, if a company has invested a significant amount in research and development for a project that is now deemed unviable, that investment is a sunk cost. Decision-makers should disregard this amount when deciding whether to continue pursuing the project, as it does not impact future cash flows. Recognizing sunk costs helps to avoid the "sunk cost fallacy," where individuals continue investing in a failing endeavor simply to justify previous expenditures.

Understanding this concept ensures that decisions are made based on potential future returns rather than past costs that cannot be changed.