However, I find this principle so applicable to our everyday life. Even though it is an accounting concept people will make much better decisions if they knew how to apply the principle of sunk costs.

I will like to illustrate with an example I recently experienced. While working on a client data file, I accidentally deleted some data that was pertinent to delivering exceptional work. The client used a very simple software (I normally work with the same software my client uses for simplicity) which does not undo this type of action. Also, there was no audit trail in the software that allowed me to go back to look at my last actions. I was faced with the decision of starting with the fresh copy of the client file or trying my best as possible to patch the data using the old client file as a template. I had been working on cleaning the data file for two days so if I chose the first option, it’s like two days is gone. The second option however was not going to be quicker because comparing two files could be quite time consuming if you are going to do a good job.

Knowing that I always want to deliver exceptional work and I understood that the two days I had spent earlier was sunk costs, I decided to scrap the project and start over. The second time around was actually much quicker because I knew how to retrace my steps and it only took me two hours instead.

If I had said to myself I have invested so much of my time into this and not scrap my work it probably would have taken two more days to complete the project. Sometimes, you need to know when to let go and start over. This is the lesson behind sunk costs: Let go and evaluate how your present actions can affect your future decisions without getting too tied to the past.

Business Application

So how does the principle of sunk costs apply to business? Let’s say you have invested $10,000 on a piece of equipment. You expected this equipment to last you five years. Also to keep this equipment running, you need to spend an additional $2,000 each month. Three years into your purchase, there is a new technology that does the work your old equipment does, faster, cheaper and more efficiently. The new equipment will cost you $8,000 but save you $1,000 a month in maintenance cost. How do you choose if to stay with the old equipment and keep incurring the $2000 monthly expense or to buy the new one. Also how do you compute what your true cost savings is? To answer this question correctly, you will need to apply the sunk costs principle.

Lay man thinking says I have spent $10,000 on the old equipment and I still have two years left on the equipment. If I replaced the equipment now I will be losing the money I have already invested into the old equipment. However, the $10,000 you have spent on the equipment has no bearing on your future cash flow. It is sunk costs: a costs that has already incurred which cannot affect future cash flow.

So now let’s see the right way to evaluate whether or not to replace the old equipment applying the principle of sunk costs:

If we kept the old equipment our annual cash outflow will be $24,000

However, if we replaced the old equipment our annual cash outflow will be computed as follows:

So as you can see replacing the old equipment will save you $5,000 on future cash flow.

Now what makes more sense, keeping the old equipment and spending $24,000 or replacing the old equipment and spending $19,000. Even though spending $19,000 to get better results makes more sense, human nature tends to hold on to things we have invested a lot of money and time into. As a lifestyle entrepreneur, you need to learn to recognize sunk costs.

As I mentioned earlier, the sunk costs principle goes beyond your business life and also applies in your personal life. I will like you to reflect on the following questions before moving on from this blog:

1. How are you going to apply the principle of sunk costs in your life?
   
2. Are there things in your life that you have invested so much of your time and money into that you are still holding on to because of past investments. Is it time to count this investment as sunk costs. Letting it go will allow you make better future decisions.
   

Sometimes the quickest way forward is to let go of the past. Holding on to the past is like running a 100 meter sprint with a bag of rocks on your back: You are definitely not going to win the race.