What best defines a sunk cost?

A sunk cost is best defined as a cost that has already been incurred and cannot be recovered. This definition captures the essence of sunk costs, which are amounts that have been spent in the past and cannot be altered, regardless of future decisions. In financial decision-making, recognizing sunk costs is important because these costs should not influence current or future choices; rational economic theory suggests that decisions should be based solely on relevant costs and benefits that will be impacted by those choices.

In practice, sunk costs often lead to what's known as the "sunk cost fallacy," where individuals or businesses continue to invest in a project based on the resources already allocated, rather than evaluating future returns. A clear understanding of sunk costs helps individuals and companies avoid making suboptimal business decisions by focusing on potential future outcomes instead of past expenditures.