Sunk cost refers to the sum of money which is an irretrievable investment and has zero potential for the future financial decision-making of a company. Professionals who own a business or work in the finance department can benefit from understanding various aspects of sunk cost.
By learning ways to identify sunk cost fallacies, you can help companies minimise risk and make the right business decisions. In this article, we define sunk cost fallacy, discuss effective steps to overcome it and provide examples to deepen your understanding.
What is a sunk cost fallacy?
Sunk cost fallacy is an economic term that refers to when someone considers sunk cost while making future business decisions. Using sunk cost fallacies while making decisions can harm businesses or cause more sunk costs. When a business has already incurred a cost and has zero hope of recovering in the near future then the cost in this case is sunk.
To evaluate the prospective costs, many companies and businesses prefer to make sound decisions. For example, they may predict the outcomes of implementing a new business strategy or launching a brand new product. Sometimes the outcomes can be different from the predictions and the cost may become irretrievable.
In such cases, businesses may make tough decisions of either continuing on the current investment and losing more money and time or accepting the loss by abandoning the investment.
Here is a good example that can help you understand the concept of sunk costs fallacy:
You purchase a movie ticket in advance and realise you have a meeting to attend on the day of the movie. In this scenario, either you may skip the movie and attend the meeting or go to the movie and skip the meeting. As per the concept of sunk costs, option one can be the rational decision. On the contrary, the latter is an irrational decision as you already spent the money on a ticket whether you go to the movie or skip it.
How to overcome sunk cost fallacy
Here are some effective steps that you can consider to overcome sunk cost fallacy:
- Stay unbiased
While making business decisions, staying unbiased can help you avoid any personal attachments. You can stay objective and overcome any influence to make the right decision. Sunk costs are investments of money and time that are irretrievable. As you are unable to change the already incurred losses, staying objective can help you in making logical decisions and selecting the best options for the business.
Consider evaluating the effectiveness of a decision by being impartial. You can evaluate the success of existing investments and business strategies. Another way to stay objective is by defining your goals and analysing if the current actions are producing the results you expected.
- Change your perspective
Sunk cost fallacies may occur when you get focused on a single decision or action. Consider trying a broader perspective while evaluating the effectiveness of an investment. You can set long-term goals and devise different strategies to find the one that can produce desired outcomes.
Widen your view on a specific strategy and assess the scale of the investment. By changing your perspective, you can analyse if the investment can be effective for the long term and you can avoid the loss.
- Encourage innovation
Encouraging innovation can help you implement effective changes in the strategies to achieve long-term business goals. Improving your flexibility and adaptive skills can also help in avoiding sunk costs. You can acknowledge poor investments and avoid following sunk costs to find desirable outcomes.
- Gain experienceÂ
By gaining experience, you can overcome sunk cost fallacies. With experience, you can identify when you are using sunk cost fallacies in business decisions. If you recognise sunk costs earlier, you can minimise the chances of further losses. The more you gain experience from actions that are unable to serve your long-term goals, the easier it can be to overcome the sunk cost fallacies.
- Improve productivityÂ
Finding alternative strategies can help you improve the output and productivity of a business. Consider developing strategies that improve profits without increasing costs. You can implement plans and strategies to optimise processes and make business operations more efficient. If you find something is hindering the productivity of your team, consider implementing strategies for improvement.
- Be accountable
Using sunk cost fallacy may decrease the confidence of team members in the leader’s decision. If you are in a leadership position, being accountable can help you gain the confidence of your team. You can take responsibility for the outcomes and results while using a sunk cost fallacy. It can help you motivate others to work towards common business goals. You can share your past mistakes of using sunk cost fallacy with your team members and help them achieve their goals.
Examples of sunk cost
Here are some examples that can help you understand sunk costs better:
Research and development
Many business owners spend time and money on the research and development of products or services. Sometimes the money you spend on the development of a product can become a failed investment and hence a sunk cost. For example, if you ₹50000 on the development of a new product. In case only a few customers purchase the released product, the ₹50000 you spent on the product can become a failed investment.
Hiring bonus
Many employers spend time and money on hiring professionals who may fail to meet the goals and standards of the organisation. In such cases, the amount spent on hiring is a sunk cost and may affect the business. For example, an employer provides a ₹15000 hiring bonus to a professional who fails to achieve the goals. In this example, the hiring bonus of ₹15000 is a sunk cost and the employer may make a decision to terminate the employment of that professional.
Market research
You may invest in evaluating if a product is going to be successful in the market. Many businesses spend time and money on marketing or advertising a product. A marketing expense can be a great example of sunk cost as this amount is irretrievable. For example, you create a website and spend ₹20000 on its marketing. If the marketing campaigns turn ineffective, the amount of ₹20000 is a sunk cost.
Factory setting
The lease expense on the factory or the cost of machinery can be sunk costs. The amount you spend in a factory setting can be an example of sunk costs fallacy. For example, a clothing factory spends ₹50000 on the lease cost and ₹70000 on the machinery. The business owner of this factory may consider setting a price that results in a profit. When deciding the price, the business owner may use the cost of lease and machinery as sunk costs.
Training
A business may spend time and money on training new employees and educating them about the company standards. The amount spent on training can be irretrievable if the employee fails to meet the goals of the organisation. For example, if a company spends ₹20000 to train an employee to use certain software. In case the software is unserviceable, the company may tell the employee to stop using it. In this example, the amount spent on training the employee is a sunk cost. The company may consider continuing training instead of stopping and changing the system. This can be a good example of sunk costs fallacy.
