Sunk cost and opportunity cost

The correct answer: D. The $2 million is a sunk cost; decide by comparing the future costs and benefits of each option from today

✅ Why this answer

A sunk cost is money that has been spent and cannot be recovered whatever the decision. So it should not influence the decision. The right question: from today, what is the additional cost of each option, and what is its benefit? Finishing the current system (at an uncertain cost and date), or a proven product for $800,000?

❌ Why the other options are wrong

• (A): this is the sunk cost fallacy: continuing because we have spent a lot, not because continuing is the best option.
• (B): what was spent in the past says nothing about an option’s future value.
• (C): the build-or-buy decision depends on the situation, and there is no fixed rule.

💡 Key concept

A sunk cost looks at the past; a decision looks at the future. So the right comparison between the options starts from today: what will be spent from now on, and what will come back?

A related concept: opportunity cost, the value of the best alternative use of the same resources. Every dollar and every hour of work spent on the struggling system is not spent on another useful project.

In the exam: phrases such as “after everything we have spent” or “we can’t stop now” are the sign of the sunk cost fallacy.

🔗 Related facts and questions

• Why do managers fall into it? It is called the sunk cost fallacy, and it comes with escalation of commitment: the more that has been spent, the harder it is to admit the mistake. The cure is in governance, not in good intentions: stage gates with continue-or-stop criteria written before the project starts, and a regular review of the business case.
• Related types of cost: sunk (spent and not recoverable), opportunity (the value of the best alternative), fixed (does not change with the volume of work) versus variable (changes with it), and direct (attributed to the project itself) versus indirect (shared, such as electricity and administration).
• Tools for comparing from today: TCO (total cost of ownership over the system’s life: implementation, operation, maintenance, training and upgrades), NPV (net present value: future cash inflows and outflows discounted to today’s money, minus the initial investment), ROI, and the payback period.
  Practice question: the commercial product costs 800,000 to implement and 100,000 a year to run and maintain, and it will be used for five years. Which figure goes into the comparison with the custom system? → 1.3 million, its TCO, not the 800,000 alone.
• What does remain from the past? The money does not enter the calculation, but what it produced may: documented requirements, cleaned data, lessons learned. If these lower the cost or the risk of an option, they are part of its future calculation.
• Practice question: the informatics team spent a year repairing the struggling system, so the bar-code medication administration (BCMA) project was postponed. What is the name of what the hospital lost? → Opportunity cost.
• Build versus buy: "Build versus buy" (in the full bank).
• Calculating return on investment: "Calculating return on investment (ROI)" (in the full bank).