What Is Sunk Cost? How to Avoid the Sunk Cost Fallacy When Making Decisions?
Ever struggled to stop yourself from doing something that you know is bad for your business?
You might have considered how much money, time, or effort you invested. But that's not the only thing that can get in your way. Sometimes it's too late to stop yourself from doing something because it feels like too much work to back out.
This phenomenon is known as a "sunk cost," which happens when people make decisions based on past investments rather than future benefits. If you have ever been or are still there, breaking free from a sunk cost can be tough.
So, in this blog, we'll look at how sunk costs can hold you back, why it happens, and how to avoid them.
Let's dive in.
What Is Sunk Cost?
The sunk cost is money that has been spent—and cannot be recovered. The axiom "you have to spend money to make money" applies here: the more time and effort you invest in something, the harder it becomes for you to let go of your investment and walk away.
Unlike future costs, which businesses must account for when making decisions about inventory purchases or product pricing, sunk costs are irrelevant to a company's future business decisions. The reason is that they will remain the same regardless of how those decisions turn out.
An example of a sunk cost is a new product's research and development (R&D) cost. Once the R&D has been completed and the expenses incurred, they cannot be recovered, regardless of whether the product is successful. These expenses are sunk costs because they have already been incurred and cannot be recovered.
The investment spent on R&D is a sunk cost and should not be considered when deciding whether to continue investing in the product. Instead, the focus should be on future costs and benefits of the product, such as marketing and production costs and the potential for future profits.
What Is Sunk Cost Fallacy?
The sunk cost fallacy is a cognitive bias in which individuals decide based on the amount of money they have already invested into a project rather than its future potential for success or failure. In other words, people may persist with an unprofitable investment because they feel committed to it due to the sunk costs already incurred.
This can lead to irrational decision-making, as individuals may continue to invest in a project even if it is unlikely to yield positive results simply because they have already invested significant resources.
For example, a company may continue to invest in a failing product because it has already spent a lot of money on research and development, marketing, and production. Instead of cutting their losses, they may throw good money after bad, leading to even more significant losses in the long run.
The sunk cost fallacy is a common pitfall in business decision-making. You can overcome this by focusing on the project's potential rather than the sunk costs already incurred.
How Does Sunk Cost Fallacy Affect the Product?
When the sunk cost fallacy is present in your product, you may be tempted to keep working on it even after it becomes clear that it's not working. You may feel like you can't just waste all of the time and money already invested into it—even though there are better uses for those resources elsewhere.
This can lead to negative consequences for the product, such as:
1. Wasted Resources
Continuing to pour resources into a failing project can lead to significant waste. This is especially true if the sunk cost fallacy leads you to continue spending money on the product.
You may be able to recoup some of those costs by selling it, but it's unlikely that you'll recover all of them. Also, if you spend more time on a project than necessary because of this fallacy, you're wasting that time.
2. Missed Opportunities
Focusing on a failing project can prevent individuals or organizations from pursuing better opportunities that might be available. For example, if a company is working on a project that doesn't seem to be going anywhere, it may miss out on the chance to pursue another.
Or, if you spend too much time trying to save a failing business or relationship, you may miss out on opportunities for new ones.
3. Delayed Action
Holding onto an uncertain project for too long can delay critical decisions and actions necessary to turn the product around or pursue other initiatives.
4. Decreased Motivation
The sunk cost fallacy can lead to decreased motivation, as individuals or organizations may become demotivated when they realize that their invested resources are not yielding the expected returns.
5. Reputation Damage
Continued investment in a failing product can damage an organization's reputation, as stakeholders may see it as a sign of poor decision-making or a lack of accountability.
This can impact future projects, as stakeholders may be less likely to invest their time and resources in a project if they believe the organization will not make good on its promises.
What Factors Lead To Sunk Cost Fallacy?
Several factors can lead people to make decisions based on sunk costs instead of the current situation, including:
1. Escalation Of Commitment
The sunk cost fallacy occurs when a person continues to spend money or time on something that has no chance of ever being profitable. One reason for this is an escalation of commitment.
This behavior is driven by the sunk cost fallacy, as it involves continuing to invest in a project due to the already invested resources rather than evaluating the project based on its potential future outcomes.
The sunk cost fallacy can result in significant cost overruns in specific tasks. This phenomenon has been found to follow a power-law distribution, according to the research conducted by Flyvbjerg (2009).
2. Personal Involvement
The more emotionally involved we are with a project, the greater our tendency to fall into the sunk cost fallacy. This is because it's easier for people to rationalize their decisions when they feel personally responsible.
3. Loss Aversion
Loss aversion is the concept that people feel more strongly about losing something than gaining something of equal value. For example, if we think about the difference between losing $100 and making $50, we're likely to feel better about making a $50 profit than we will about losing $100.
This leads to the sunk cost fallacy since people are likelier to stick with a project losing money or time, rather than cutting their losses and starting over.
4. Overoptimistic Probability Bias
This is the tendency for people to overestimate the likelihood of something positive happening and underestimate the possibility of something negative happening. As a result, the sunk fallacy occurs. People are likelier to stick with a losing project or investment because they think it will succeed.
How To Avoid Sunk Cost Fallacy?
The first step is to understand that sunk costs are irrelevant. You should only be concerned about whether your investment will pay off. If not, it's time to cut your losses and move on.
Here are some strategies that can help:
1. Outline The Desired Outcome
To avoid the sunk cost fallacy, you need to know your goals. If you haven't outlined them clearly, they can easily get lost in everyday life and work responsibilities.
Ask yourself,
- What's the goal that you want customers to achieve?
- What are the benefits of achieving that goal?
- Is it worth the investment to get there?
When you know what you want from an investment or project, it will be easier to decide when to cut your losses or stick with it until the end.
2. Seek Feedback
One way to avoid the sunk cost fallacy is to seek and incorporate feedback from multiple sources. This helps counteract the tendency to escalate commitment to a project due to the sunk costs already incurred.
By seeking honest and objective feedback, decision-makers can gain a more accurate picture of the costs and benefits of continuing to invest in a project and make more informed decisions about whether or not to continue.
Additionally, involving multiple stakeholders in the decision-making process can help diffuse the influence of sunk costs and ensure that decisions are based on a more complete and objective project evaluation.
3. Avoid Overinvesting Emotionally In A Project
To avoid being swayed by sunk costs, decision-makers should try not to overinvest emotionally in a project. You can accomplish this by objectively viewing the situation and recognizing that not every investment is worth pursuing at any cost.
If you become emotionally attached to a project, avoid getting too involved in its implementation. This will help you maintain an objective perspective on the decision-making process.
4. Make decisions based On The Experience
A study conducted by Harvard Business Review found that experience and knowledge can help people avoid the sunk cost fallacy rather than raw intelligence.
The researchers developed a scale to measure susceptibility to the sunk cost effect when people persist in a decision or behavior due to resources already invested. Those with above-average susceptibility scores were three times more likely to fall prey to the sunk cost effect in an experiment with real incentives.
This highlights the importance of making decisions based on experience and learned knowledge, rather than solely relying on intelligence, to avoid the sunk cost fallacy.
Conclusion
To wrap up, the sunk cost fallacy is a standard error that can lead to poor decision-making. By understanding the concept and its causes, you can avoid falling victim to it in your business.
To avoid falling prey to the sunk cost fallacy, it's essential to separate sunk costs from future considerations and base decisions on rational analysis rather than an emotional attachment. Additionally, gathering feedback and insights from stakeholders can provide a more well-rounded perspective on the potential future outcomes of a decision. Olvy offers a solution to help individuals and organizations make data-driven decisions considering multiple users' thoughts and opinions. Using Olvy, you can minimize the impact of sunk costs and make informed decisions that drive growth and success.