January 10, 2020
Sunk Costs: Don’t Let Them Ruin Your Business
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 theory addresses 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
- Employee Training
- Research and Development (R&D)
- Hiring and Performance Bonuses