Technical Definitions: What is Sunk Costs? Sunk Costs Definition.

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Sunk Costs Definition

Sunk costs refer to costs that are non-recoverable fixed costs. Digital products usually have significant sunk costs (when compared to other fixed costs) in the form of research & development and intellectual property (patents etc.) for the product. If the product is not successful in the marketplace, the costs associated with the the product development (intellectual property, labor) cannot be recovered. Thus when making pricing decisions about the product in the future, one should not factor in the sunk costs. If a product's cost structure is made up of sunk costs (no other fixed costs) and zero marginal costs then any price above zero will contribute to the company's bottom line. Other fixed costs, that are not sunk (rent, depreciation on equipment etc.) should be factored in when making pricing decisions in the future, since these are ongoing costs to the company. The company will continue to have to pay these costs in the future, this is not the case for sunk costs.

The development of the Netscape browser is a good example of a product whose cost structure was comprised primarily of sunk costs. Regardless of the success of the product in the market, the major parts of the costs were already expended (product development). This enabled Netscape tremendous flexibility as it used its web site to allow users to download the product for free (actually it was not free, but Netscape did not pursue individual consumers for sales revenue). The only type of cost this presented to Netscape was the opportunity costs of lost sales from those who downloaded the browser for free. These free downloads enabled Netscape to build market share quickly, thus establishing first mover advantage and significant market leadership (for a short time!)

Another example of a sunk cost is the cost of a seat on an airplane to the airline. The Cost of an airline seat is primarily fixed and sunk (as long as one assumes the flight was going to take place regardless of whether the seat was sold) with a small portion attributed to variable costs if one considers the food and beverage service. Thus it makes sense for the airline to develop a pricing structure designed to maximize the revenue of the aircraft during a flight. They can do this by changing their pricing depending on the demand for a particular flight, and by offering additional benefits to their frequent flyers (to upgrade etc. 'course I am writing this on an airplane!) Essentially, as long as the price of a seat covers the variable cost of the seat, its revenue will contribute to the bottom line of the airline. This assumes opportunity costs are not a factor.

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