As humans, we have blind spots. Our thinking is subject to biases, logical fallacies, and irrationality. The goods news is, by understanding your biases and other logical blind spots, you can make better decisions.However, successfully countering irrationality in your decision-making process requires vigilance. To be vigilant you need to understand what you’re looking for so you can counteract it. To that end, this post will explain what sunk costs are and how to stop them from sinking your business.
What Are “Sunk Costs”?
The Street defines a sunk cost as “a cost that has already been paid for and cannot be recovered in any way.”To frame sunk costs in familiar terms, imagine you’re playing poker. Let’s say that in this game of poker, cards are dealt in two rounds. First, each player is dealt two cards and is asked for a bet. Then, the dealer places three cards on the table face up and each player must bet again.The first time you bet, you’re making a decision based on the cards in your hand. Once you make that bet, you can’t get it back. The amount of money you wagered is a sunk cost. Since it’s a sunk cost, it’s no longer relevant to your decision-making. Once the next three cards are placed on the table and it’s time for you to bet again, your first bet is irrelevant. The amount of the bet is “sunk”.These relevant costs affect both your business and personal finances. So, it’s important to understand what sunk costs are. Otherwise, you’re likely to fall victim to the sunk cost fallacy, which we’ll discuss in the next section.
What Is the Sunk Cost Fallacy?
The sunk cost fallacy is best explained with an example. Let's say you spend $1000 on planning a seasonal marketing campaign. Then, you spend $500 planning another seasonal marketing campaign. Later, you find out that you can only run one of the two marketing campaigns you planned.The sunk cost fallacy causes you to proceed with the $1000 campaign because it cost more to plan. This is because the loss seems larger. However, that $1000 is a sunk cost, so it’s irrelevant. The relevant number to consider, in this scenario, is the projected results of each campaign, not the cost.
Prospect Theory
Nielsen says the prospect theory, “describes how people choose between different options and how they estimate the perceived likelihood of each of those options.”This theory demonstrates the manner in which people over or underestimate probabilities of loss and gain. The prospect theory and sunk costs go hand in hand because sunk costs tend to cause us to mistakenly estimate risk. For example, investing in a project may make you less likely to invest more, even if further investment will result in a better payoff. In this scenario, the sunk cost is causing you to overestimate the risk associated with additional incremental investments.
Self-Justification Theory
The self-justification theoryaddresses how people justify their behavior and deny negative feedback associated with that behavior when it's inconsistent with their beliefs.This theory connects to the sunk cost fallacy because people often use sunk costs to justify their decision-making. For example, let’s say your marketing lead decided to continue investing in a channel that wasn’t providing results.To justify the decision, they might argue that thousands of dollars had already been spent on the unprofitable marketing channel. However, as you know, those sunk costs are irrelevant.In this way, the self-justification theory causes the sunk cost fallacy.
Examples Of Sunk Costs
Restaurant Lease Expense
Assume your restaurant lease costs $10,000 per month and you pay your lease each month on the first. After the first of each month, your lease becomes a sunk cost. There’s nothing you can do to get it back so it shouldn’t affect your short-term decisions.
Employee Training
Let’s say you purchase a new system that requires a $50,000 investment inemployee training. Once that money is spent, it’s an example of a sunk cost. If it turns out later that you don’t need the new system, the training cost is irrelevant.
Research and Development (R&D)
Depending on the nature of your business, you may need to invest in R&D. For example, you might invest $100,000 in R&D to develop a new product. If it turns out that you can’t sell the product for a profit, that $100,000 is sunk.
Hiring and Performance Bonuses
Whether you offer a hiring or performance bonus, it can turn into a sunk cost. A $5000 hiring bonus becomes a sunk cost if that person turns out to be a poor performer. So, that $5000 should be ignored when making the decision to fire that person.
How To Avoid Sunk Costs From Sinking Your Business
Sunk costs are an unavoidable part of doing business. Clearly, examples of sunk costs appear in a variety of ways — during hiring, product development, and more. However, the better you understand the sunk cost fallacy, the more equipped you are to avoid its effects. So, simply by reading this post, you’ve taken a big first step towards avoiding the negative effects of sunk costs.Of course, that doesn’t mean you can let your guard down. Constant vigilance is key. So, in the next section, we’ll outlinea few habits to develop. Each one will help you avoid the pitfalls of sunk costs.
Track Investments and Opportunity Costs
Karl Pearson said, “that which is measured, improves.” This is true in any aspect of your life, but especially in business. Every investment you make must be tracked. Otherwise, you have no basis from which to make better future business decisions.Moreover, you’ll be more subject to making decisions based on assumptions. The more assumptions you must make, the more subject to biases such as the sunk cost fallacy you’ll be. Of course, it takes time and effort to track investments and opportunity costs. Still, in this case, the cost is well worth the investment.
Don’t Hedge Your Bets On “Guaranteed” Success
Successful entrepreneurs aren’t afraid to take calculated risks. The problem is, it’s human nature to prioritize decisions that “guarantee” some level of success.For example, imagine you’re presented these two alternatives:Alternative A: You receive $10,000, no questions asked.Alternative B: You may receive $20,000 but there’s a 5 percent chance you receive nothing.Many people will choose Alternative A, simply because it’s a sure thing. However, the expected benefit of Alternative B is double that of Alternative A. So, a savvy entrepreneur would gladly take on the 5 percent risk for a chance at doubling his or her benefit.
Stay Business Minded, Don’t Get Personal
More often than not, poor business decisions are caused by emotions.In business, emotions maymotivate and fuel you, but they should have no role in your decision-making. Otherwise, you’ll certainly fall victim to one or more of the many biases and logical fallacies.This is easier said than done, so it’s best to give yourselfstrategies for taking the emotion out of your decisions. For example, you might consider stepping away from a decision temporarily if you find yourself getting too personally invested.Everyone has different temperaments, so try various strategies and see what works for you.
Keep Your Eyes On The (Future) Prize
As a business owner, no one’s telling you what to do. This is both a blessing and a curse because it’s up to you to avoid getting sidetracked. Focusing on the future success of your business is one of the most effective ways to stay on track. Still, you need to do more than just pay lip service to your long-term goals.Document your business goals. Review them with your partners and senior employees. Adjust them as needed, and look at them regularly. All your decisions — big and small — should make sense within the context of yourlong-term business goals.
Our Final Words
We’d all like to believe that every decision we make is based on logic and reasoning. The truth is, we arefar from rational.Fortunately, you can learn from and counter the many fallacies and biases that creep into your reasoning process. As we mentioned earlier, this requires constant vigilance but it gives you a critical competitive edge.Just remember to avoid beating yourself up if you’re misled by the sunk cost fallacy. Simply by being aware that you’ve made a mistake will put you ahead of your competition.Interested in tips to help you run your business more efficiently? Sign up for our newsletter!
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